When considering investing in markets outside the US, individual investors often ignore neighboring Canada and look to more “foreign” markets in Europe, Asia, and Latin America. Institutional investors, on the other hand, have been increasing their investments in Canada. State Street Global Markets reported on May 25 that the latest 5-day cross-border equity flows to Canada were at the highest level since October 2004. These flows are reflected in the performance of the Canadian market. The MSCI Canadian equity market index is up 35.9% year-to-date (June 1), far stronger than the international benchmark index, MSCI EAFE, up 8.97%. This Commentary summarizes why we also are attracted to Canada at this time.

The Canadian economy, eleventh largest in the world, was, of course, struck by the global financial crisis and sharp slowdown in global demand. It is reported to have declined 5.4% in the first quarter, very close to the 5.7% drop in the US. However, there have been increasing signs that the Canadian economy is stabilizing: an April bounce in payrolls, a rebound in existing home sales, and a jump in the Ivey PMI (Purchasing Managers Index). A recovery of the Canadian economy in the second half of this year is looking increasingly likely.
                                                              
The Canadian economy is highly integrated with the US economy, which accounts for some 78% of Canada’s goods exports and provides 52% of Canada’s imports. The Canadian equity market is strongly affected by developments in the US equity markets. Indeed, the one-year correlation between equity prices in the two markets is close to 1.0. However, short- and medium-term variations in the two markets can differ significantly. The 6-month correlation between the iShares Canadian market ETF, ewc, which tracks the above-mentioned MSCI Canadian market index, and the SPDR ETF that tracks the S&P 500, spy, is 0.74.

Along with differences in economic policies and other macro influences, there are important differences in the sector composition of the two economies. Energy and raw materials sectors together account for 50.8% of the sector weights of the MSCI index for Canada; financials account for 30.2%.  In comparison, energy and raw materials account for just 16.3% of the S&P 500 and financials are only 10% (3/31/2009 weights).

The above differences help explain the outperformance of Canada thus far this year. The long-term global boom in commodity markets has returned, with the pickup of demand in China being a major factor. For example, the commodity ETF, dbc, which tracks the Deutsche Bank Liquid Commodity index, is up some 31.5% from its March 2 low.  Similarly, energy markets are recovering from their steep fall. The Powershares Deutsche Bank Oil ETF, dbo, is up 57% from its mid-February low. With respect to the financial sector, Canadian banks are in better condition than their US counterparts, thanks to their more conservative approach to lending, particularly with respect to the housing sector.

The Canadian market ETF, ewc, that we use in our international accounts, has diversified holdings of the equities of 100 firms. The top ten firms are the Royal Bank of Canada, ENCANA, Barrick Gold, Toronto-Dominion Bank, Goldcorp, Potash Corp of Saskatchewan, Bank of Nova Soctia, Research in Motion, Canadian Natural Resources, and Suncor Energy. To focus in more on the energy sector in Canada we also use the Claymore/SWM Canadian Energy Income Index ETF, eny, which tracks the Sustainable Canadian Energy Income Index. Its main holdings are Toronto Stock Exchange-listed Canadian royalty trusts and oil sands resource producers.

Finally, we have recently added a long position in the Canadian dollar (the “loonie”) to our Global Multi-Asset Class Portfolios, using the Currencyshares Canadian dollar ETF, fxc. The currency markets have taken note of the emerging strength of the Canadian economy and equity market. In May the Canadian dollar registered the largest monthly advance since the Korean War (October 1950). The loonie’s 19% advance since its four-year low, reached on March 9, has added significantly to the returns received by US dollar-based investors in the Canadian market. The currency’s strengthening versus the US dollar accounted for almost half of the 35.9% year-to-date market gain cited in the first paragraph. The loonie’s advance appears still to have legs, but in view of the extent of the gains thus far, a pull-back later in the year is quite probable if the nascent recovery in the US economy gathers momentum