Risks of recession place TSX resilience in jeopardy

Growing fears about slowdown send some investors fleeing from key index

Recession fears are dimming chances that the Canadian market can continue this year's outperformance.

While the S&P/TSX Composite Index's drop is less steep than other global indexes, a looming economic downturn could test its resilience. Surging oil and gas prices helped boost energy stocks and kept the nine-per-cent slide for Canada's key benchmark from following the S&P 500 Index to its 19-per-cent plunge.

Now those energy price surges are fading amid growing concerns about an economic slowdown, sending some investors fleeing from the value-heavy S&P/TSX.

Strategists like Macan Nia, Manulife Asset Management's co-chief investment officer, are focusing on the next move by U.S. policy-makers.

“If there is a pivot in Fed tone where they become less hawkish, then the U.S. markets will rally versus the TSX,” Nia said in an interview. “The outperformance that we have seen in the first half of the year between Canada and the U.S. — Canada could give that up.”

Energy stocks dominated in the first half of the year amid a commodity boom as investors sought safe havens amid escalating geopolitical risks.

Of the top 10 companies with the strongest gains, nine are oil and gas companies.

Athabasca Oil Corp. soared 114 per cent and Tourmaline Oil Corp. surged 72 per cent.

Now, that rally has fallen victim to recession fears because of the potential for lower demand if the economy slows.

The S&P/TSX slid from its record high in March into a correction, as financials and materials turned negative, while still managing to outpace the tech-heavy S&P 500.

In part, that's because oil, mining and financial stocks make up more than 60 per cent of the Canadian index.

Those found favour with investors amid a revival of enthusiasm for value stocks.

The Canadian market started the year strong with market strategists broadly calling for the S&P/TSX to outperform its U.S. counterpart.

By early April, the benchmark had risen to outdo the S&P 500 in its widest quarterly outperformance in 13 years.

As concerns over a recession escalated, the S&P/TSX gave up those gains.

While energy still stands tall as the only sector up this year, it's down 13 per cent from its peak in early June.

Materials erased the climb it made earlier in the year and banks tumbled as low as 20 per cent from their record high in February.

On Tuesday, the S&P/TSX edged lower as data showing a drop in U.S. consumer confidence weighed on investor sentiment, but gains for the energy sector helped shield the market from deeper losses.

The Toronto Stock Exchange's S&P/TSX composite index ended down 35.58 points, or 0.2 per cent, at 19,222.74, but holding on to much of its gains over the previous two days.

“The TSX has been a nice hiding spot today,” said Greg Taylor, a portfolio manager at Purpose Investments.

“It feels that a lot of pain in the markets has been in the tech stocks, which are really pulling back from the bounce they had last week.”

Bank of America Corp. equity strategist Ohsung Kwon is still bullish on Canada's energy sector.

He's projecting that the S&P/ TSX is set to outperform the S&P 500 this year, so long as a recession doesn't ravage the index's value stocks.

“Energy still has room to run,” Kwon said in an interview.

“Energy stocks are not really pricing in the full benefit of US$120 oil and if you look at free cash flow yields for these companies, producers are on average expected to generate 15-per-cent free cash flow yield this year compared to the S&P yield of about five per cent, so there is still a big valuation discount.”

Other strategists are still convinced that the Canadian market will outperform this year, even if there's a recession.

Kurt Reiman, BlackRock Inc.'s chief investment strategist, said energy and materials valuations are low even though their earnings are set for strong growth, and that will propel the S&P/TSX to beat the S&P 500 on an annual basis for the first time since 2016.

“If the risk does grow around a recession and that starts to hit the commodities, then we'll have a garden-variety sell-off,” Reiman said at an advisory conference hosted by Royal Bank of Canada last week.

“But our view is that commodity prices are more elevated here and because of the nature of the return of cash to shareholders, we find this to be an attractive relative performer.”