A mid-year market report card

Two men discuss container shipments on a loading dock.

As an exporting nation, the economic recovery in Canada largely depends on the strength of our trading partners, especially the U.S.

Equity markets roared back to life in the second quarter as investors latched onto signs of improvements in the global economy. A growing body of evidence suggests that not only did the coordinated policy response help avert a global depression, but the worst of the recession may be behind us. The so-called “green shoots” helped spark an 18% rally in the Canadian equity market, led by information technology, financials and energy stocks.

Although there is evidence that the economic backdrop is improving, the global economy has a long way to go before returning to normal growth. TD Economics is forecasting a 1.9% decline in global economic growth for 2009, with the most severe declines in the developed world. China and India are among the few countries expected to post positive economic growth. Most forecasters are calling for growth to resume next year, albeit at a modest pace. TD Economics’ forecast for 2010 calls for a 2.7% expansion in global growth, led by China and India.

Canada’s exports shrink

With China and India continuing to expand, investors are likely to focus on export-based countries, such as Canada, which produce goods these nations consume. As an exporting nation, the economic recovery in Canada largely depends on the strength of our trading partners, especially the U.S.

The volume of Canada’s exports is contracting at an accelerated pace and is down 17% from two years ago. As well, the size of Canada’s export industry has been shrinking and now represents roughly 33% of the total Canadian economy, compared with the traditional 40%. Compounding the difficulties for exporters is the 9% rise in the Canadian dollar since the end of March.

Although Canada stands to benefit from the continued growth in regions such as China and India, it will be difficult for Canada’s exports to fully recover without an increase in U.S. demand. In addition, similar to the U.S., our domestic economy remains fragile. April’s 0.8% decline in retail sales suggests that Canadian consumer demand remains sluggish, and rising unemployment will likely keep a lid on consumer sentiment.

Earnings slow to recover

First- and second-quarter earnings for 2009 were generally better than expected. Although earnings growth in both the U.S. and Canada was negative, the overall results were not as bad as investors feared. The outperformance in both quarters was largely driven by cost cutting, which helped companies post results ahead of greatly reduced earnings expectations. In the second quarter, half the companies also reported better-than-expected revenues.

Investors will be looking for improvements in both the top and bottom lines when Q3 results are released. In addition, guidance will be equally important as investors look for signs of future improvements in corporate earnings and the demand picture. Overall expectations are for earnings to dip during 2009 and recover in 2010.

Commodity prices rebound

For the Canadian market, 2009 estimates are expected to be less negative than originally thought due to the rebound in commodity prices (especially oil) and the better-than-expected results from the Canadian banks. That said, as Canada enters a seasonally weak period for commodity prices, they could easily soften if Chinese demand shows signs of slowing. This could cause investors to question the sustainability of the economic recovery. Given the significant resource weight in the S&P/TSX Composite Index (S&P/TSX) (energy and materials represent 45% of the S&P/TSX), near-term concerns over the outlook for commodity prices will have an impact on the direction of the S&P/TSX index.

Credit markets continue to thaw

Credit markets have continued to heal in recent months as evidenced by the increase in corporate debt issuance and the contraction in the London Interbank Offered Rate (LIBOR) spread. However, tight credit conditions persist and strains on the credit markets remain. Bond yields have crept higher over the past few months with the 10-year Government of Canada bond now yielding 3.6%. While bond yields remain low by historical standards, significant moves higher could pose a threat to equities — although this seems unlikely.

Valuations still attractive

The S&P/TSX is trading at 13 times the 2010 consensus earnings estimate, below the historical average of roughly 15 times. With an earnings yield of 7.7%, the S&P/TSX remains attractive relative to both the current and forecast 10-year bond yield. Finally, the dividend yield of 3.2% for the S&P/TSX continues to be supportive of equities.

While the economic backdrop remains fragile, the pace of economic advance would seem to point to a likely correction in equity markets. Investors may want to continue focusing on high-quality stocks backed by solid balance sheets, good earnings profiles and strong management teams, as well as large-capitalization, dividend-paying stocks.