Why Canadian stocks have been quietly outperforming despite a 'wall of worry'

Key Concepts

Wall of Worry: A market condition where stock prices continue to rise despite widespread investor concerns and negative sentiment.
Fiscal Stimulus: Government spending or tax cuts designed to boost economic activity.
Monetary Stimulus: Actions taken by a central bank, such as cutting interest rates, to increase the money supply and stimulate economic growth.
USMCA (United States-Mexico-Canada Agreement): A trade agreement that replaced NAFTA, crucial for Canada's economic relationship with its North American neighbors.
Valuation Rerate: An increase in the market's perceived value of a company or sector, often due to improved fundamentals or investor sentiment.
Brinksmanship: The practice of pursuing a dangerous policy to the limits of safety before stopping, typically in politics.
Entity Lists: A list of companies that a government restricts from doing business with, often due to national security concerns.
Rare Earth Exports: Minerals critical for advanced technologies, the control of which can be used as a geopolitical tool.
Mercurial Administration: An unpredictable and changeable government, referring to the US administration.
Tariffs: Taxes imposed on imported goods.
FOMC (Federal Open Market Committee): The monetary policymaking body of the Federal Reserve System.
Structural Changes: Fundamental shifts in the economy that monetary policy may not be well-suited to address.
Yield Curves: A graph showing the yields of bonds of the same credit quality but different maturities.
LNG (Liquefied Natural Gas): Natural gas that has been cooled to a liquid state for easier transport.

Canadian Market Resilience and Future Outlook

Market Performance Amidst Concerns

Canadian markets have demonstrated remarkable resilience throughout the year, defying expectations by climbing a "never-ending wall of worry." Despite concerns about tariffs, politics, and a fragile economy, the market has continued to push higher. This upward trend has been attributed to a combination of factors, with the CSX composite index experiencing a significant rise of "a little over 20% year to date."

Drivers of Market Resilience

Michael O'Brien, portfolio manager at TD Asset Management, identifies two primary drivers behind this resilience:

Mitigation of Worst-Case Scenarios: The anticipated negative events, such as trade wars and political instability, have not fully materialized. Instead, they have been "mitigated, delayed, watered down, or kicked down the road." This avoidance of the worst-case outcomes has been a significant factor in market performance, where "sometimes not losing is a win."
Policy Maker Intervention and Renewed Optimism:
- Monetary Policy: The Bank of Canada has played its part by implementing "a couple rate cuts this year," providing "a little monetary stimulus to protect the economy."
- Fiscal Policy and Political Landscape: A significant "sea change" has occurred on the political and fiscal front with the new Liberal government and Prime Minister Carney. The focus on "nation-building projects" has had a "direct stimulative effect" through a "more stimulative fiscal stance." Crucially, this has also been a "real boon to confidence" and boosted "people's optimism." This newfound optimism about Canada, which has been absent for a while, has been a key driver.

Lingering Cautions and Future Risks

Despite the positive momentum, O'Brien expresses caution, emphasizing that "this is not done."

Key Concerns for 2026 and Beyond

USMCA Review (Primary Concern): The most significant issue facing Canada is the upcoming six-year review of the USMCA (United States-Mexico-Canada Agreement). This review, which has "just kicked off," is critical to the Canadian economy and will be a dominant story "well into the first half of 2026." The core question is whether Canada can secure a "palatable arrangement" that preserves its "favored trading relationship with the US."
- Mercurial US Administration: O'Brien highlights the "mercurial" nature of the US administration, where "goalposts tend to be moved quite a bit." This unpredictability means that even with optimism for an agreement, "the carpet's been pulled out from underneath Canadian negotiators a number of times." He anticipates "a lot more twists and turns" before a resolution.
- Tariff Leverage: Even if the Supreme Court rules against certain tariffs, O'Brien believes the US administration has "a lot more tools in the toolkit" and remains "determined to wield tariffs in some form or another as a source of leverage." He anticipates similar tariffs impacting sectors like "Canadian steel, automobiles, aluminum, lumber" could emerge.
Geopolitical Trade Disputes: The skirmish between the US and China serves as an example of the potential for misunderstandings and miscalculations in trade deals. The announcement of a trade deal can be quickly followed by "restrictions and rare earth exports" or companies being placed on "entity lists," demonstrating the volatile nature of international trade relations.
Monetary Policy Stance:
- Bank of Canada: The Bank of Canada has "done about as much as they can do for now," having delivered "several rate cuts." They are currently on pause, acknowledging that monetary policy is not well-suited for certain "structural changes" facing the economy and that inflation remains at the "high end of what we would used to consider a comfortable range" (around 2.5-3%).
- Federal Reserve (US): While the market anticipates more rate cuts from the Fed next year, recent signals from FOMC speakers have "downplayed the potential for a December rate cut," contributing to a recent "market wobble." The sentiment that "central banks have our backs" is crucial for investor confidence.

Sector-Specific Analysis

Banks

Performance: Banks have had a "very solid year," "handily outperforming the market by and large," with returns "up a little over 30% year to date."
Drivers: This performance was driven by "better than expected outcomes" in loan books and "multiple appreciation" (valuation rerate).
Outlook for 2026: The outlook is "solid at this point in time provided the Canadian economy holds up." However, with valuations at "the very high end of where banks traditionally trade" (around 13 times forward earnings), there is "isn't a lot of room for slip ups on the earnings front." The key challenge is whether the economy holds up and banks deliver expected earnings, as there is "not a lot of valuation cushion."

Insurers

Performance: Insurers are seen as looking "very solid."
Drivers: Their business model benefits from "steep yield curves" and "reasonably elevated long-term rates." Strong equity market performance in 2025, if it continues, also boosts their wealth and asset management businesses.
Valuation: They are trading at "10-11 times earnings," which is considered reasonable in an expensive market.
Capital Position: Insurers have "excess capital" and have been consistently "buying back shares."

Oil and Gas Producers

Current State: Companies are in "as good a shape as I've seen in years," characterized by "disciplined" capital spending and a commitment to "returning cash to shareholders."
Concerns for 2026: The primary concern is the "macro," specifically "where does the oil price go in 2026." There is "a lot of negative sentiment towards the oil market" due to "sloppy supply demand balances" expected in the next "3 to 6 months." The key question is whether a "sloppy oil market" will weigh on profits.

Natural Gas

Fundamental Change: The "ramp up of LNG Canada on the west coast" is a "game changer" that should "tighten up gas markets in Western Canada."
Future Support: The potential for "two very large LNG projects" to reach "final investment decisions" or "project sanctions sometime in 2026" would provide significant "medium-term support" by further tightening the Western Canadian gas market.

Fiscal Policy and Economic Growth

The federal budget is seen as crucial for supporting the economy, especially given its current "fragile" state.

Direct Stimulus: The budget aims to provide "much needed" "pure old-fashioned fiscal stimulus" by directing money into the economy.
Confidence Building: Beyond direct spending, a significant goal is to "increase the confidence of households, but especially businesses to begin investing and making decisions." This is intended to "unfreeze this decision-making" that has "handicapped the Canadian economy this year."
Bull Case: If the government can "win over corporate Canada and get them investing private dollars alongside the public incentives," it could have a "real positive effect through 2025."

Conclusion and Takeaway for 2026

For investors looking ahead to 2026 and Canadian stocks, O'Brien advises adopting a balanced outlook.

Positives: There are "a lot of things to be positive about," including the "renewed optimism around getting things done in Canada," which is a "game changer."
Fragile Underpinning: However, it's essential to recognize that the current economic foundation is "very fragile."
Key Watch Item: The most critical factor to monitor remains the USMCA. The ability to "settle this trade issue" and "put that to bed" is paramount for Canada to "start getting on with business."