Stocks treading water as global economic growth slows down

By Martha Hill, CFA, Vice President & Canadian Equity Strategist, TD Waterhouse, Portfolio Advice & Investment Research

The Canadian economy is currently expanding at a healthy pace, but growth is expected to moderate.

For equity investors, it has been a challenging six months, characterized by uncertainty, swings in sentiment and volatility. Triggered by problems in Greece, Europe’s fiscal woes and the potential for a credit and liquidity crisis were in focus for much of the second quarter of 2010. The bearish sentiment was compounded by concerns of a possible slowdown in China.

Uneven recovery

Although global economic growth is expected to be healthy, the recovery is uneven. Emerging markets are experiencing very strong growth and authorities are beginning to focus on how to control inflation without stifling the economic recovery.

In contrast, European growth is expected to be challenged by across-the-board fiscal restraint. Moves to cut bloated fiscal deficits will weigh on economic spending as governments increase taxes and reduce spending. While the weakness in the euro triggered by the fiscal problems is helping exporters, it is unlikely to fully offset the effect of the lower spending.

The Canadian economy is currently expanding at a healthy pace, but growth is expected to moderate. Expectations for reduced government spending, softer demand from the U.S., and cooling in the housing market should lead to a slower pace of expansion. TD Economics is forecasting 3.6% growth in Canadian gross domestic product (GDP) in 2010 and 2.5% in 2011.  

Growth in the U.S. is positive, but the pace of expansion is diminishing. The first-time homebuyer’s tax credit has expired. Census hiring, which was responsible for 95% of the total increase in jobs recently, will become a drag on job creation. Infrastructure spending will begin to wind down. As government spending eases, private-sector demand needs to become the primary driver of growth. The combination of the removal of the fiscal stimulus, expectations for a modest recovery in personal consumption and softer exports as a result of the stronger U.S. dollar point to slower growth in the second half of 2010.

As widely expected, the Bank of Canada (BoC) increased its overnight rate one quarter of a percentage point, to 0.5%, on June 1st. Although the BoC has initiated a new cycle of tightening, it was quick to communicate that subsequent rate hikes will depend upon both global and domestic economic conditions.

The market is pricing in an overnight rate between 1.0% and 1.5% by the end of the year. Even though the BoC has started down the path of tightening, short-term rates remain extremely low by historical standards and have a long way to go before reaching normal levels.

Against a backdrop of a half-speed recovery in the U.S., continued elevated unemployment levels and benign inflation, the U.S. Federal Reserve (the Fed) remained on hold. TD Economics believes the Fed will not move to increase rates until the first quarter of 2011 and anticipates the Fed Funds Rate will reach 1.5% by the end of 2011.

Strong corporate earnings

Corporate profits and cash flow have been strong. For the opening quarter of 2010, earnings for companies listed on the S&P/TSX Composite Index (S&P/TSX) grew by roughly an average of 43% year over year.  The strong results were in part due to fairly easy comparisons versus the first quarter of 2009; however, cost-cutting as well as a recovery in revenues also helped drive the strong earnings growth.

The key going forward is expectations for future earnings growth. We expect earnings to remain positive. However, we are of the view that current estimates may be too high. Expectations are for economic growth to cool somewhat over the second half of 2010 and 2011. In addition, as we progress through the year and into 2011, earnings comparisons will become more challenging and year-over-year earnings growth is likely to slow.  

Reasonable valuations

At the end of March, equity markets appeared to be fully discounting the strong earnings rebound. The pull-back in markets since late April has brought valuations down to more reasonable levels, although they are still far from compelling.

Based on current forward consensus estimates, the S&P/TSX is trading at 13.8x, compared with its long-term historical average of approximately 15x. Based on trailing earnings, the S&P/TSX is trading at 16x, also below its long-term average. At 7.2%, the forward earnings yield remains very attractive relative to the 3.0% yield on 10-year Government of Canada bonds.

Although valuations appear reasonable, it is our view that earnings estimates could be too high and the equity market is more expensive than forward P/E multiples suggest.

Still cautious near term

The European fiscal crisis is unsettling for markets and will take time to be resolved. Uncertainty will continue to weigh on sentiment and cause volatility. This could be compounded by lower liquidity during the traditionally weak summer months.

Interest rates are likely to remain lower than the historical average and supportive for equity markets. With economic and earnings growth expected to moderate, equity market returns are likely to be modest. We recommend high-quality, large-cap, dividend-paying stocks for equity portfolios.

We continue to believe investors need to diversify portfolios outside of Canada for exposure to sectors under-represented in the domestic market, in particular health care, consumer staples and technology stocks. The Canadian dollar is expected to be relatively range-bound, which suggests currency headwinds are unlikely to be significant for investors.

In this issue		September 2010
	Review and analysis of the June 2010 meeting of world leaders in Toronto		New WebBroker research centres can help you find mutual funds and ETFs
	Stocks treading water as global economic growth slows down