Led by the relatively stronger performance by the financial sector, the TSX has been doing better than the S&P 500, BMO Nesbitt Burns Inc. says in a new report. It’s a trend that will probably continue.

“The recent RRSP season was the weakest for mutual fund inflows in eight years as Canadian investors continue to shun stocks,” say BMO economists David Watt and Samuel Lee. “The decline in Canadian equities since the start of 2003 and the prospect of war with Iraq have done nothing to reinvigorate investor sentiment.

“However, in U.S. dollar terms, the TSX has been the top-performing G-7 stock market so far this year, helped by the surge in the loonie. But, there is more to it than just the currency.”

Even ignoring the impact of the currency, the TSX has outperformed the S&P 500 by 2.4% since the start of the 2003 and by 12.7% from a year ago, BMO says. Factor in the stronger C$ and the TSX has beaten the S&P 500 by 9.4% and 21.1% over those periods. “The TSX is poised to continue to outperform the S&P 500, based on both the favourable mix of industries in the TSX as well as firmer economic fundamentals in Canada,” BMO says.

“The best performances on the Canadian stock market so far this year have come from some of the smallest sectors, health care and IT, and from the largest sectors, financials and energy. In fact, by taking sector weights and year-to-date performance into consideration, we find that nine of the 10 equity subsectors contributed positively to the TSX’s relative outperformance,” say Watt and Lee. Oddly, golds have underperformed despite their “safe-haven” reputation.

Financials are the biggest factor behind the TSX’s outperformance, BMO says. “This is due to the modest decline in financial stocks on the TSX, compared to the 7.3% drop on the S&P, and to the sector’s much greater impact on the Canadian stock market. Financials carry 12.9% more weight in Canada than in the U.S.”

“The strong performance of Canadian financials can be attributed to a number of factors including better credit, the possibility of consolidation, and a stronger Canadian economy. The interest rate environment also favours Canadian banks relative to their U.S. peers,” the report says. “Whereas we expect the Fed to stay on the sidelines, the Bank of Canada has begun to remove monetary stimulus once again. As a result, Canada’s prime rate has been rising, a process we expect to continue in response to further Bank of Canada rate hikes. While higher interest rates are often viewed as negative for financials, rates have dropped to such extremely low levels that some modest increase could now help support margins.”

Energy stocks have also been stronger on higher oil prices. Again, its large relative weight has helped boost the TSX over the S&P 500.

BMO expects the Canadian economy to outpace the U.S. economy for the fourth consecutive year in 2003, and for the C$ to continue to strengthen, reaching US69.5¢ before yearend. “Furthermore, a solid domestic economy should continue to keep Canadian consumer loan books in good shape relative to over-leveraged U.S. consumers. Although crude oil prices will likely fall, the descent may take longer than anticipated, which adds to the attraction of the energy sector,” it says.