EQUITIES COMMENT - Powered By
During the second quarter, the TSX Composite continued to march higher and reached new record levels. The move was powered by strong economic data which is being reflected in corporate profit growth. Stocks have reacted to this better than expected performance with substantial gains over the past twelve months: TSX 34%, S&P 500 28% and MSCI EAFE 21% (all in Canadian dollars). The TSX is leading the pack due to its relatively large exposure to Financials and Energy.
The robust economic picture is influencing the sector performance of the stock market. Cyclical stocks, whose fortunes are closely tied to economic growth (Energy and Financials), have powered the markets’ gains so far this year. “Defensive” stocks, whose businesses tend to be stable or benefit from economic weakness, are trailing (Consumer Staples and Utilities). During the second quarter, Technology staged a rebound in both Canada and the U.S. Energy remained the leading sector as oil surpassed $70US. Real estate also did well as worries about the impact of “work from home” continuing after the pandemic eased. The only sector with a negative return was TSX Materials. The gold price weakened and this caused the stocks to decline.
Earnings are being powered by strong economic growth as unemployment declines and spending increases with the easing of lockdowns. Higher commodity prices and loan loss reversals for banks are particularly boosting earnings.
In the case of Suncor, one of the largest Energy stocks in the TSX, oil prices are turning losses into profits. In 2020, the oil price averaged $39.40US per barrel. It is currently over $70US. Last year’s loss totaled $2.1 billion or $1.38 per share. For 2021, profits are forecast to be $2.04 per share or $3.1 billion. The change is $5.2 billion or $3.42 per share in one year! Now let’s look at Bank of Nova Scotia, one of the largest Financials stocks in the TSX. In 2020, Scotiabank set aside over $6 billion of profits to cover potential defaults on loans. This year, loans loss reserves are running at less than half of last year’s levels. In 2020, BNS had earnings of $6.8 billion or $5.30 per share. This year, earnings are forecast to be $9.4 billion or $7.57 per share, an increase of $2.6 billion or $2.27 per share.
Gains in stocks are not being powered by rising valuations. P/E multiples (ratio of stock/index price to earnings) have remained stable since the end of the first quarter. Earnings forecasts have increased approximately 8%, in line with the second quarter gains in the TSX and S&P 500.
Strong earnings growth will power dividends. Dividends for the TSX are actually down 2% over the past year. While there have been some dividend increases among “defensive” companies, there have also been cuts among cyclical companies, particularly in the Energy sector. Financial stocks have not been allowed to increase dividends since last spring. Instead, regulators wanted them to build up extra capital reserves given the economic uncertainty and high unemployment caused by the pandemic. Recently, U.S. banks were allowed to raise dividends and there were some substantial increases. In Canada, the regulator is expected to make an announcement in the fall about when Canadian banks and insurance companies can increase dividends. We expect there will be some significant boosts to dividends. In the meantime, dividend yields in Canada at 2.6% remain attractive relative to the 10 year Canada bond yield of 1.4%. In the U.S., bond yields are slightly higher than dividend yields however, this is not unusual.
The strong economic and earnings recovery from the pandemic is powering the gains in stocks. What could go wrong? Rolling power outages The primary risk to the outlook we see is still related to the pandemic. If not enough people get vaccinated, COVID would remain a threat to the health care system and potentially require more lockdowns. The increase in variants is also cause for concern. If there is a delay in the economic recovery or growth proves to be disappointing, this would likely have a negative impact on stocks. Power surge Another risk we see is a further rise in bond yields in the near term due to higher inflation and/or faster than expected economic activity. This could put pressure on stock valuations, particularly those with high p/e multiples. 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. Power failure 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.
The fastest economic growth in years is powering a huge recovery in corporate profits and boosting stock prices. We are increasing our 2021 targets for the TSX to 21,200 and 4,450 for the S&P 500. 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.