Moderate returns ahead for Canadian Stocks

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

High-quality companies look promising in 2010.

The month of March 2010 marked the first anniversary of the 2009 equity market lows. Investors willing to look through the economic malaise and invest in stocks were handsomely rewarded as the S&P/TSX Composite Index (S&P/TSX) and global equity markets soared over the last year.

Thanks to fiscal and monetary stimulus, the Canadian economy has bounced back and is stronger than many others. Indeed, the economy grew at an annualized rate of 5% in the final quarter of 2009. Although unemployment remains elevated (at 8.1%), it is down from the August 2009 peak (8.7%). Canada’s housing market remains robust. Although the fiscal deficit has increased as a result of the stimulus, Canada’s debt/GDP ratio is the envy among the G-8 countries.

Stimulus exit strategies

This time last year, governments around the world were on a spending spree, rolling out various fiscal packages to help stimulate economic growth. The spending is expected to continue through much of 2010; however, it should ease in 2011 as the stimulus is removed and governments look to cut costs.

Rates heading higher

The Bank of Canada (BoC) is expected to raise short-term rates before the U.S. Federal Reserve Board (Fed) and the market is currently already discounting a 25% probability of a Fed Funds rate increase in November 2010. Short-term interest rates and the Canadian dollar have been rising, reflecting the market’s change in expectations for the BoC. TD Economics is of the view that the BoC will raise rates by 25 basis points, as soon as June 1. By the end of 2010, the BoC’s key interest rate is expected to reach 1.50% — up from the current rate of 0.25% (as at May 17, 2010).

Earnings growth is key

Earnings growth has been strong, with the most recent quarterly earnings revealing close to a 20% increase in S&P/TSX earnings year-over-year. We believe further advances in stocks require sustained earnings growth, and based on consensus expectations, S&P/ TSX earnings are expected to grow by 23% between 2009 and 2010.

The strength of the Canadian dollar is presenting headwinds for earnings for Canadian companies with significant exports or operations outside the country. At the same time, companies with U.S.-dollar inputs (such as retailers) can benefit from cost savings as the Canadian dollar appreciates.

Valuations still reasonable

Canadian stocks have enjoyed a significant expansion in valuations over the past 12 months. We believe that valuations in Canada, while no longer compelling, are reasonable. Using the consensus forward-earnings estimate, the S&P/TSX is trading at 15.7x, essentially in line with its long-term average. The earnings yield of 6.4% is very attractive relative to the 10-year Government of Canada bond, which is yielding 3.5% (as at May 17, 2010), as well as forecast bond yields. (TD Economics forecasts a 4.55% yield on the Government of Canada 10-year bond in Q4/10.) The dividend yield on the S&P/TSX is also appealing at 2.6%.

Debt levels remain a risk

The significant spending by governments to help restore economic growth has added to already high debt levels. The troubles with Dubai World and Greece have provided a view into the impact of potential sovereign debt defaults. As we know from the Canadian experience during the 1990s, there is no simple fix for the high debt levels. From a longer-term perspective, the high levels of debt will dampen economic growth rates and contribute to a loss of competitiveness.

Higher rates also a risk to stocks

A more immediate risk facing equity markets is the fragile state of the global economic recovery. Debate continues regarding the shape of the recovery (is it “V-shaped” or will it be a “W”?). The private sector’s ability to pick up spending while government spending winds down is unclear.

The potential for rising interest rates also poses a threat to equity markets. Based on past experience, we expect markets to experience a brief correction when the Fed begins to tighten. However, we do not expect the increase in rates will be enough to derail stocks, as rates are likely to remain low relative to historical levels.

Can stocks move higher?

On balance, we believe the combination of strong earnings growth, improved corporate balance sheets, reasonable valuations, and expectations for sustained (albeit modest) economic growth remain supportive of a further advance in equities.

We expect returns to be muted relative to 2009 and therefore suggest clients consider large-cap, high-quality companies, with a focus on dividend-paying stocks.

As the loonie flirts with parity, it is providing investors with an opportunity to diversify their portfolios outside of Canada. When doing so, we suggest adding to sectors under-represented in the Canadian market such as health care, information technology, and consumer staples.

In this issue		June 2010
	Loonie expected to remain strong		Moderate returns ahead for Canadian stocks