Is a Rally in the Canadian Stock Market Sustainable?

After a sluggish second quarter, the Canadian stock market rebounded strongly in the third, driven in part by a series of rate cuts from the Bank of Canada. Lowering interest rates helped to cool inflation and supported a broader economic recovery, positioning the market for a more optimistic outlook for the remainder of the year and beyond.

For the three months ending Sept. 30, the Morningstar Canada Index returned a healthy 11.58%, building on a modest 1.31% gain for the second quarter. The S&P/TSX composite index saw a 9.3% rise in the quarter, boosted by solid gains for real estate, financial, and technology stocks.  

What Contributed to the Rebound?

The Bank of Canada reducing interest rates by 75 basis points so far in 2024, along with the further cuts that are expected, have served to reignite the real estate market, lifting both it and financial services stocks. The trend is evidenced by a sharp rebound in the Morningstar Canada Large-Mid Cap Index (featuring the top 90% of the Canadian investable universe by market cap), which rose 12.17% during the quarter. That gain marked a significant recovery from the 1.52% loss the previous quarter. A similar resurgence was witnessed by the Morningstar Canada Small Cap Index, which climbed 11.37% following a 1.87% gain in the second quarter.

This was the strongest quarter for Canada’s main stock index in four years, clocking a 9.32% return. One of the key catalysts for the recovery was the Bank of Canada beginning a cycle of cutting interest rates in June, according to Jimmy Jean, vice president and chief economist at Desjardins Group. “The Bank of Canada cutting rates and signalling more cuts to come was a boon to the real estate industry, hence its position as a leader in the recovery,” he notes. “Financials have also done well, as the rate relief will help support credit performance.” 

Canadian stock’s strong performance in the third quarter was also a function of the tailwind of rebounding global markets. As economies around the world showed signs of recovery and investor sentiment improved, Canadian equities benefitted. “Generally, global stock markets did well in the third quarter, with gains driven by solid earnings, and the Federal Reserve’s pivot towards rate cuts in the context of a weakening but still-solid US economy,” notes Jules Boudreau, senior economist at Mackenzie Investments. Indeed, the Canadian stock market was “one of the best-performing markets globally in the third quarter of 2024,” after being one of the worst performers in the second.

Sectors Leading the Charge

In sharp contrast with its second-quarter underperformance, the S&P/TSX Composite Index’s strong rebound was felt across sectors, with the biggest contributions from financials, technology, and real estate. “We hadn’t seen that since the first quarter of 2019,” says Boudreau.

Notably, Canadian tech stocks outpaced their US and global peers in the quarter. “Tech stocks were one of the worst sectors in the US, squeaking by with a tiny gain, but the TSX IT sub-index had a great quarter, driven by solid performance from Shopify and Constellation Software,” says Boudreau. The S&P/TSX Information Technology Index rose 14.1% in the quarter. The substantial weight of financials in the TSX tends to have an outsized impact on the index’s performance. Financial stocks did well in most stock markets globally, “but because they make up such a large portion of the Canadian index, the effect was magnified,” he adds.

Additionally, the quickening pace of the Bank of Canada’s rate cuts helped the real estate industry in no small measure. The widespread expectation of further rate cuts created a strong tailwind for the sector, “hence its position as a leader in the recovery,” notes Jean. The rate relief will bolster credit performance and give banks a much-needed breather amid the looming threat of the mortgage renewal cliff.

If all goes well, and if the Bank of Canada continues to cut rates as expected, the remainder of the year could see real estate and financial sectors continue to flourish as lower mortgage rates help reduce borrowing costs and ease some of the pressure on Canadian households and boost demand for housing. 

It is noteworthy that the TSX showed strength despite its energy subindex barely registering gains in the quarter. The S&P/TSX Composite Energy (Sector) Index rose 0.95%. “It could have been much worse for the sector, given the slide in oil prices,” says Jean, who adds that “the Trans Mountain (TMX) pipeline provided some support for the sector.” 

Additionally, rising geopolitical tensions have propped up oil prices and kept them from falling even further, which benefited the energy sector. As the armed conflict in the Middle East broadens and intensifies, it could push oil prices higher and boost energy sector profits and performance in the fourth quarter.

How Much will the Bank of Canada Cut Rates?

Key economic data–including lower inflation rates, a weaker labor market, and slowing economic growth–continue to support the case for lower interest rates. The Canadian market is pricing in a 25% chance of a 50-basis-point rate cut in October. However, some experts feel the odds of a jumbo rate cut are greater than 50%. “The Canadian economy has shown very few signs of inflecting higher,” says Boudreau. While a strong September jobs report in the United States might give the Federal Reserve pause about cutting rates more aggressively, “we haven’t seen this kind of turnaround in Canada at all,” he adds.

The anemic economic growth remains a concern even if Canada has managed to avoid recession. Growth in the third quarter was likely well below what the Bank of Canada was projecting back in July. As a result, “I believe the Bank of Canada will announce a 50-basis point rate cut at the upcoming meeting [later this month],” asserts Jean.

The Canadian job market has softened noticeably, and headline inflation has returned to the 2% target, although housing costs remain elevated. “The case to maintain very restrictive monetary policy has therefore diminished, and the Bank of Canada has already opened the door to speeding up the return to a neutral setting,” says Jean.

Outlook for the Fourth Quarter

Analysts expect Canada to underperform the US and other international markets, but it could still eke out a positive return. “The strong US economy and a stabilization of China should keep global markets afloat, including Canada,” Boudreau argues.

The Canadian market also benefited in part from attractive valuations relative to US equities. Jean sees this advantage persisting through 2025, but expects the fourth quarter to be volatile. “The US election remains a dead heat, and a Trump victory would have adverse economic consequences for Canada, which could weigh on Canadian equities,” he says.

Jean forecasts that the current geopolitical environment favors energy and materials, although some commodities, such as gold, are vulnerable to correction from current lofty levels. “Overall, it may be difficult to repeat the strong performance of Q3, even if our base-case scenario remains broadly constructive over a longer horizon,” he says.

In Boudreau’s estimation, materials could be a drag on the Canadian market in the fourth quarter. The sector has a high weight in Canada, which “could cause it to underperform other global markets, with recent gains in metals prices being a bit overdone in our view,” he says. Further, Canadian financials are priced almost for perfection. “Any further deterioration in the Canadian economy could cause them to give back recent gains,” he cautions.

Source link