EQUITIES COMMENT - Economy vs. Bond Yields

Economy better than expected The TSX Composite has been steadily rising since the March 2020 meltdown. Last year at this time, markets were dominated by uncertainty about the severity and duration of the pandemic. Due to unprecedented monetary and fiscal support as well as vaccine breakthroughs, the impact on the overall economy has been less damaging than feared. Stocks have reflected this better than expected economic performance with substantial gains over the past twelve months: TSX 44%, S&P 500 38% and MSCI EAFE 28% (all in Canadian dollars).

Cyclicals outperform defensives The robust economic picture that is now being forecast for 2021 is influencing the sector performance of the stock market. Cyclical stocks, whose fortunes are closely tied to economic growth (Energy and Financials), are experiencing the strongest gains. “Defensive” stocks, whose businesses tend to be stable or benefit from economic weakness, are trailing (Consumer Staples and Utilities) . In Canada, Health Care was the strongest performing sector. Hopes for legalization of marijuana across the U.S. as well as positive company specific developments boosted the returns. The worst performing sector for the TSX was Materials. Gold stocks (considered defensive) were down and this outweighed the positive returns on copper mining and forestry stocks (cyclical). Technology is lagging—while growth is on track, valuations are under pressure.

Stronger economy means bigger profits Earnings estimates for stocks are increasing due to the robust economic outlook. For the TSX, earnings are now estimated to increase over 50% in 2021 after a 37% decline in 2020. The largest sector, Financials, is benefitting from reductions in loan loss provisions as well as higher bond yields. The second largest sector, Energy, is being boosted by oil prices over $50 and increased demand. For the S&P 500, profits are forecast to rise over 25% this year. This sounds great but earnings are only one-half of the equation.

Valuations pressured by higher bond yields In previous Equity Comments we’ve written about the valuation measure known as the p/e multiple (the ratio of the index value to the earnings generated by the stocks in the index). Here is an illustration:

Historically, there has been an inverse relationship between p/e multiples and bond yields; the lower the bond yield, the higher the p/e and vice versa. As a result of the recent increase in bond yields, we are now incorporating a lower p/e multiple for our 2021 TSX and S&P 500 forecasts. However, due to the higher expected earnings, our targets have not changed: 19,350 for the TSX and 3,900 for the S&P. If growth continues to surprise on the upside, we could increase our forecasts.

Dividends still look attractive Dividend yields in Canada at 2.9% remain well above the 10 year Canada bond yield of 1.5%. However, in the U.S., the 10 year Treasury bond yield of 1.7% is now higher than the 1.5% dividend yield. There is no doubt that the increase in bond yields has reduced the relative attractiveness of stocks however, is it to the point where investors would prefer bonds? We don’t think so. Dividends are poised to increase significantly over the next two years as earnings recover. In Canada, the banks have been barred from increasing dividends since the beginning of the pandemic in order to boost capital. We could see double digit increases once they are allowed to raise dividends again.

Risks to our forecasts The primary risk to the outlook we see is still related to the pandemic. While the vaccination rollout in the U.S. has been faster than expected, Europe is struggling. The increase in variants is cause for concern as more lockdowns are being required in some regions. If there is a delay in the economic recovery or growth proves to be disappointing, this would likely have a negative impact on stocks.

Another risk we see is a further rise in bond yields in the near term. This could put pressure on stock valuations (p/e multiples), particularly those with high p/e’s. While rising bond yields are expected over the next two years, earnings growth should provide enough support for stock prices to increase even as the p/e multiple declines. Consumers and businesses have increased savings dramatically during the pandemic. Depending on how much and how quickly savings are spent could make our forecasts too conservative or too optimistic.

Bottom line – economy trumps bond yields There has been a powerful rally in stocks since the end of March 2020 driven by a stronger than expected economy. Bond yields have recently increased to reflect higher growth expectations. Have they risen enough to reduce the attractiveness of stocks? We don’t think so. However, we would not be surprised to see some consolidation or a pullback in stocks during the next six months given the gains that have taken place. In the meantime, we are continuing to emphasize high quality dividend paying stocks that earn an attractive and growing level of income while trading at reasonable valuations.