EQUITIES COMMENT – “STOCKS REACH RECORD HIGH’S DESPITE TRADE AND MIDDLE EAST TURMOIL”

U.S. trade policy dominated global equity markets trading.   Tariff announcements, trade deals, extensions of tariff and trade deal deadlines- all contributed to volatility in stocks during the second quarter.  Surprisingly, the short lived conflict between Israel and Iran had little impact on stocks.  For the quarter, the TSX Composite rose 8.5% and the S&P 500 gained 5.2% in Canadian dollar terms including dividends.

In the graph, you can see the sell off that occurred after “Liberation Day”.  As discussed in last quarter’s Equity Comment, the level of tariffs Trump originally proposed was much higher than had been expected.  Concrete signs that tariff rates would be lower and implemented later provided relief for stocks and supported the subsequent gain in prices. 

Let’s see which sectors fuelled the rise in stocks so far this year.  In Canada, Materials was the most influential sector with an increase of 29% due to large gains in gold stocks.  The price of gold was up 26% in the first half.   Gold benefitted from the uncertainty surrounding U.S. trade policy, worries about U.S. fiscal spending, weakness in the U.S. dollar and Middle East tensions.  Gold stocks accounted for about one-third of the gain in the TSX Composite year to date.  Another sector that did well in Canada was Consumer Discretionary with a rise of 13%.  Canadian Tire and Dollarama were both up more than 30%.

Looking at the U.S., the Tech and Tech related giants were among the strongest performers during the second quarter.  However, year to date, Industrials was the leading sector with a 12% gain, closely followed by Communications at 11%.  Aerospace and Defense stocks benefitted Industrials while Netflix, AT&T and Meta were the influential Communications stocks.

What will the stock market do for an encore in the second half?  Let’s start by looking at the U.S. and Canadian economies.   With the improved tariff outlook, forecasters dialed down the probability of a recession (two quarters of back to back negative growth) in North America.  However, the future path for growth in the U.S. and Canada is more difficult to gauge than usual.  This is because four key government policy areas (trade, fiscal spending, immigration and regulation) are being disrupted by Trump’s ideologies and Carney’s economic plans.  They will likely have conflicting effects on the economy. 

Tariffs are like a tax on the economy.  At this time, we do not know what the actual level of U.S. tariffs will be but it certainly appears they will be significantly higher.  The next question is, how much, if any, of the tariffs will producers absorb and how much will be passed on to the end buyer—consumers and businesses.   Low income consumers and small businesses will be hurt the most by tariffs.   Canada is now feeling the negative effects of tariffs on exports of aluminum, steel and autos.  So far, Canada has not implemented retaliatory tariffs which would increase inflation and reduce purchasing power for Canadian consumers and businesses.  Weaker sales, such as in the auto sector, are resulting in layoffs.

The recently passed fiscal spending bill has extended the tax cuts passed in the first Trump administration which is positive for corporate earnings.  It has also lowered taxes for the wealthy and cut Medicaid and disability payments for the poor.  Because low income consumers spend a greater proportion of their incomes  than the wealthy, spending could weaken and it accounts for about 70% of GDP growth.   The 2025 budget deficit will be roughly 6.2% of GDP.

In Canada, the new federal government will be issuing a fall budget.  It is expected to increase spending on defense, investments in resources and infrastructure as well as housing.  Carney has asked government officials to find ways to cut expenses elsewhere.  Carney has also promised a tax cut for middle income Canadians.   We expect the budget to be neutral to positive for economic growth.  The current deficit to GDP is 2.2%.

The U.S. and Canadian populations are aging and one way to keep the economy growing is to maintain, if not increase, the number of working age people.  Both countries have been doing this through immigration.  Poor demographics (a low growing or declining population with an increasing age) weigh on growth.  We can see examples of this in countries like Japan and Italy where immigration has been discouraged and a large portion of the population is of an advanced age.  The average age in Japan is 49.5 years, Italy 48.1, Canada 42.4 and the U.S. 38.5.  In Canada and the U.S., immigration is being reduced.  This will ultimately have a negative impact on growth.

Both Canada and the U.S. are moving in the same direction when it comes to regulations.   In Canada, the focus has been on reducing red tape to approve major infrastructure projects and removing intraprovincial trade barriers.  This should have a positive impact on growth.  Trump has taken limited action on the regulatory front so far however, significant cuts to regulations are expected.  In particular, he wants to reduce the capital requirements for banks—regulations that were put in place after the 2008 Financial Crisis.  While this could initially boost growth by giving banks the capacity to take on more loans, it could subtract from growth in a recessionary environment as banks will have less resources to cover loans in default.  Overall, deregulation is generally viewed as a pro-growth policy.

Corporate profit growth, a key factor affecting the direction of stock prices, will be influenced by the rate of economic activity in Canada and the U.S.   To date, there has been little change in corporate earnings forecasts for this year and next.  Given the conflicting effects of the various government policies being enacted, it is possible forecasts for TSX and S&P 500 earnings will remain unchanged overall.  Among individual stocks and sectors, there will likely be more revisions. 

Stock valuations, as measured by the p/e multiple (ratio of price to earnings), have increased since the end of last year, particularly for the TSX.  The p/e for the TSX Composite is near 16 which is above the long term average.  The S&P 500 p/e is at 22 which is also above the long term average and at a significant premium to the TSX and other world equity indices.  We believe there is a good chance this gap will narrow over the next few years as Carney implements his plan to boost Canadian economic growth and U.S. government policies put downward pressure on the U.S. dollar.   P/E multiples are likely to receive support from central bank rate cuts should economic growth falter and tariffs not cause a significant and lasting increase in inflation.

Our target of 6,400 for the S&P 500 in 2025 looks to be on track however, we are going to increase our TSX target to 27,500.  This assumes gold stocks remain near current levels.   Negative or positive surprises related to government policies could alter the trajectory of stocks at least in the short term.  Overall, we expect modest single digit returns, including dividends, during the second half of the year.

Equity investors are breathing a sign of relief as the most damaging aspects of Trump’s trade policies appear unlikely to occur.    At times like this with heightened uncertainty, it pays to remember the long term benefits of investing in stocks.   The accompanying graph shows the growth of $100,000 invested in the S&P 500 and TSX Composite since 1990.  There were four recessions during that period (gray shaded areas).  After each one, stocks came back stronger and went on to reach new all-time high levels.