Institutional investors, spying possible investment opportunities in Canada, are awaiting the Canadian government's fiscal 1995-'96 budget with more than normal interest.
A budget that shows the government is serious about tackling its budget deficit could spark rallies in both Canadian equity and bond markets, some institutional investors believe.
The budget is expected to be unveiled at the end of the month.
With market participants now more leery of risky situations, partly because of Mexico's debacle, investors believe Canada needs to deal with its budget deficit and its accumulated debt.
While the country's problems aren't comparable to those of Mexico, Canada's external debt as a percent of gross domestic product stands at 44% - the highest of all industrialized nations.
International investors hold a large percentage of Canadian government debt, which explains both their clamor for debt/deficit reduction before any serious problems erupt, and the government's need to accommodate the investors.
Serious efforts to reduce the deficit will please institutional investors. Already, there's potentially plenty to like in the bond market, with real yields on 10-year government bonds at 9%. And if the bond market rallies strongly, stocks should get a boost. (Through Feb. 14, the Toronto Stock Exchange 300 stock index was down 2.7% this year.)
The budget deficit is projected to be C$39.7 billion (U.S. $28.2 billion) in the current fiscal year, but will probably come in somewhat lower. The target is C$25 billion in fiscal 1996-'97, which would be 3% of GDP. The upcoming budget is expected to explain how the government will reach its target, but many think it won't go further in deficit reduction than is already expected.
Hitting the current deficit targets would be neutral to slightly positive for market sentiment.
Dick Howard, senior economist with Julius Baer Investment Management, London, said his firm would like more than the targeted reduction. But even if that doesn't occur, "the situation would not be getting worse in Canada," he said. Julius Baer has been positive on Canada's high-yielding bonds.
MacKay-Shields Financial, New York, has a "strongly positive view on Canadian bonds and the Canadian currency, which are both extremely undervalued," said Michael Perelstein, the firm's managing director, international investments.
MacKay-Shields has about 10% of its international bonds in Canada, up from about 4% to 5% before the Canadian dollar hit its lows early in the year.
MacKay-Shields is optimistic about the contents of the upcoming Canadian budget. As Mr. Perelstein put it, "our betting is that the government will make some big changes in the budget deficit."
Not everyone is so bullish on Canada or its upcoming budget. In fact, those who expect market rallies this year in Canada usually cite conditions in the United States as more of the reason.
While the Canadian bond market could gain somewhat on news of a favorable budget, it would take a U.S. bond market rally to ignite bond prices in Canada. In turn, the rally in the United States should come with "definite signs that the U.S. economy is slowing," said Marc Levesque, associate editor, International Bank Credit Analyst, a Montreal investment and economic forecaster.
Later in the year, Canadian equities should do well - and even outperform the U.S. market, predicted Mr. Levesque.
However, foreign investors can find a host of reasons for minimizing their positions in Canadian stocks. Excuses range from concerns about Canada's weak currency to the fact that Canada is excluded from the Morgan Stanley Capital International Europe Australasia Far East Index - meaning many international investors pay less attention to Canadian shares than to those in EAFE markets.
Alan McFarlane, institutional managing director for Global Asset Management Ltd., London, cites three problems with Canada's market: the Canadian dollar's long-time weakness vs. the U.S. dollar; its budgetary problems; and "uncertainty" about the possible secession of Quebec.
"For top-down investors, Canada has a higher risk profile now than for some time," he concludes.
Global Asset Management takes more of a stock-picking approach in North America. At the end of December, it had less than 2% of its North American portfolios invested in Canada. That, according to Mr. McFarlane, "isn't a judgment about Canada," but a statement about the attractiveness of specific stocks.
Hotchkis & Wiley International, Los Angeles, hasn't been adding to its Canadian holdings. That means the firm's Canadian exposure has fallen with the inflow of new cash. Now the firm has 7% of its international stock portfolios in Canada, compared with a high of 11% in 1991-'92. Some of the detractions to Canada's market: its high correlation with the U.S. stock market; its exclusion from EAFE; and high bond yields that make stocks look pricy. As international portfolio manager Sarah Ketterer points out, "Canadian bond yields have soared over the last 18 months."
However, Canadian-based managers typically can find more to like in their market. In part, they have to, because Canadian pension funds can't invest more than 20% internationally.
Nonetheless, some money managers say economic trends favor a strong market performance this year in Canada.
Small-capitalization stocks, which underperformed last year, should fare well in 1995, believes Robert Tattersall, president of Howson Tattersall Investment Counsel Ltd., Toronto, which specializes in small-cap investing.
"I think this is a good time for small caps," said Mr. Tattersall. Not only are they coming off a poor year in 1994, but the stocks tend to be cheaper according to various valuations, including price-to-book value and price-to-cash flow. In addition, the weak Canadian dollar helps protect smaller companies in the domestic market from foreign competition, he said.