We are well into the second quarter of 2018 and the performance of the S&P/TSX Composite Index remains mired in negative territory, down 3.3 per cent as of Friday’s close. The question on many investors’ minds is a simple one: Who’s responsible?
A closer look at the year-to-date performance attribution for the domestic benchmark highlights pipeline stocks, telecommunications and – perhaps surprisingly – Canadian banks as the biggest detractors from equity returns so far.
The 3.3-per-cent decline in the benchmark equates to a fall of 540 points. The first chart depicts the stocks that contributed most to the negative point tally.
Pipeline builder Enbridge Inc. is by far the largest factor behind the TSX’s weak performance in 2018, pulling the index lower by 128 points. Enbridge has company-specific issues, notably a legal setback for its proposed Line 3 pipeline, but competitor TransCanada Corp. is also on the list of biggest negative influences. This strongly suggests that both high-dividend stocks are being hurt by rising bond yields.
Higher government bond yields are likely also the culprit behind BCE Inc.’s year-to-date weakness. The telecom giant has pushed the benchmark lower by 30 points, despite first-quarter profits that exceeded analyst estimates.
Canadian Imperial Bank of Commerce and Royal Bank of Canada have cost the index 29 and 28 points, respectively, in 2018, although their lack of performance remains a bit of a mystery. After the most recent earnings reporting season, Scotiabank analyst Sumit Malhotra wrote that the domestic banking sector as a whole “generated an operating [return on equity] of 16.7 per cent in the first quarter of 2018, the highest level since mid-2014,” and also noted that valuation levels were extremely attractive in light of an expected compound annual growth rate in earnings of 8 per cent to 2020.
The banks remain profitable and the stocks are not expensive, so I checked to see whether a flat bond yield curve was behind their underperformance. Banks prefer steep yield curves because profits on basic lending are determined by the difference between short-term rates (where the banks borrow funds) and the long-term interest rates they charge clients for mortgages and other loans.
The performance of bank stocks in 2018, however, has not tracked changes in the yield curve (not shown in the charts), which implies the curve is not responsible for bank underperformance.
If it’s not valuation, not profit growth, and not the yield curve, concerns surrounding the potential for a housing market slowdown is the likely candidate for share price weakness. Where banks are concerned, investors must decide whether Mr. Malhotra’s growth projections are reliable because the stocks are attractively valued in that case.
The second chart illustrates the more positive side of the ledger – stocks with the highest upside effects on the index – for comparison purposes.
Performance attribution – knowing why the index is down rather than merely the fact that it is down – is an important exercise. In this case, it has underscored the negative effects of rising rates on some equity market sectors and also growing concerns about what have historically, and for good reason, been the most trustworthy domestic stocks.
Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.
Scott Barlow