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  • Writer's picturePatricia A. Stewart | CFA

EQUITIES COMMENT - "TSX On the Sidelines".....

While other world stock markets enjoyed further gains during the second quarter, the TSX missed out on this action with a decline of 1.6%. Why? Global economic growth continues to show broad based strength, inflation is low, corporate profits are rising and the Canadian economy is much stronger than forecasters expected.

Weakness in commodity prices was the main reason for the disappointing TSX performance. In particular, oil fell from over $50 per barrel to $46 and the Energy group declined 9% during the quarter. Since the OPEC and non-OPEC agreement to cut oil production has been in place, production has been in line with consumption. The expectation was consumption would exceed production and deplete the glut of oil that built up in 2015/2016. While the International Energy Agency is forecasting world demand to surge by 1.3 million barrels a day this year, rising production from the U.S. and two OPEC countries not included in the agreement, Libya and Nigeria, is satisfying much of this increase. The rise in oil exports from Libya and Nigeria was unexpected given political instability in these countries. The short term outlook for oil is uninspiring given still high stocks. Longer term, at a price less than $50, many new sources of production are uneconomic. This will eventually result in lower production as existing wells are depleted. Inventory levels could decline faster than expected if demand is stronger than forecast, further cuts in production take place and/or there is a supply disruption in the Middle East.

Another negative influence on the TSX was the Home Capital scare which inflamed investors’ worries about the Canadian housing market and our banks. Home Capital is an alternative mortgage lender. It issues mortgages to borrowers that have difficulty getting loans at the banks, for example, self-employed individuals and recent immigrants. The Ontario Securities Commission launched an investigation into Home Capital’s lending practices. This shook confidence so investors pulled their money out of Home Capital savings accounts and sold the stock and bonds. Confidence improved somewhat when renowned investor Warren Buffett announced the purchase of $400 million Home Capital shares and provision of a $2 billion line of credit. Nevertheless, bank stocks were negatively affected and weighed on the TSX.

Back in the Game? Aside from a rise in oil prices, what could spur better performance in the second half for the TSX? Recent chatter by central bankers in Europe, the UK and Canada that monetary stimlus could be reduced is causing yields to rise. Modestly higher interest rates would have a positive impact on earnings for banks and insurance companies and should be reflected in share prices. Progress on implementing deregulation and pro-business tax measures in theU.S. would also benefit Canadian companies.

Our target for the TSX in 2017 remains 15,650. Even though earnings in the resource sectors are likely to be weaker, strong results in other groups are an offset. Banks, telecommunications, rails and consumer stocks are benefiting from the stronger growth environment. In the near term, the TSX could trade down to 14,500 if the normal seasonal pattern of weakness occurs this summer. On a long term basis, the low, albeit rising level of interest rates continues to be supportive of stocks. At the end of June, the dividend yield on the TSX was 2.85% compared to the ten year Canada bond yield of 1.75%. Historically, bonds have had higher yields than stocks however, this relationship changed after the financial crisis. Long term, we expect bond yields to move higher and eventually surpass dividend yields.


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