EQUITIES COMMENT - TSX in the Sweet Spot
TSX Composite a Winner The TSX Composite was one of the top performing stock markets in the world during the first quarter thanks to the relatively large exposure to commodity related stocks like energy. On the other hand, the S&P 500 had a decline due to weakness in Technology and Technology related stocks. For the quarter, the TSX Composite gained 3.8% and the S&P 500 lost 5.7% in Canadian dollar terms. Over the last twelve months, the TSX was up 20% and the S&P was ahead 15%.
Energy Soars While Tech Falls Energy was once again the strongest performing sector. The North American oil price benchmark increased 33% during the quarter due in part to improving demand but more importantly, the threat of supply disruptions from Russia, the world’s second largest producer. Despite increased earnings, Technology (and Technology related stocks like Amazon) fell. P/E multiples (the ratio of the stock price to the earnings generated per share) for these stocks declined as bond yields rose (more about this to follow).
TSX Earnings Outlook for 2022 Improves Many commodity prices were higher in 2021 due to improved demand and/or supply constraints. Now with the war in Ukraine and sanctions on Russia, many commodity prices have increased further due to anticipated shortages. These two countries are significant producers of metals, oil, natural gas, fertilizers and wheat. Close to 30% of the TSX is made up of the Materials and Energy sectors so when prices are rising for the underlying commodities, it has a very positive effect on earnings. The S&P 500 has 6.5% in these two sectors so the impact on earnings is minimal.
More about P/E Multiples One of the key factors supporting p/e multiples (the stock price divided by earnings per share) has been low interest rates. Given our forecast for higher rates this year, we were expecting lower P/E multiples, particularly for the S&P 500. During the quarter, both the Federal Reserve and Bank of Canada raised rates .25% while ten year bond yields increased more than .75%. This weighed on p/e multiples, particularly for stocks with high ones, like Shopify and other Tech names. Shopify’s share price declined over 50% during the quarter as the p/e contracted from 60 to 29. Due to less exposure to Technology, the TSX is not as vulnerable to a decline in p/e’s as the S&P.
Risks to 2022 Outlook In our last report we outlined four risks to the forecast for stocks this year. Now we are adding the war in Ukraine.
Inflation has shown no signs of slowing down and is being exacerbated by the impact of the war in Ukraine on commodity prices like energy and wheat. Although a moderation later in the year is still expected by most economists, inflation will most likely be well above the U.S. and Canadian central banks’ target of 2%. Inflation is still being affected by the pandemic so as the impact of COVID recedes and things get back to normal (hopefully), some price pressures should ease.
Central banks are now expected to increase rates at a faster pace and to a higher level than previously forecast due to stubbornly high inflation. This is putting downward pressure on p/e multiples. Rising interest rates will eventually have a negative impact on economic activity, however, there is usually a 6-9 month lag between when rates rise and growth starts to slow. Given the higher level of consumer debt in Canada, rates may not increase to the same extent as in the U.S.
The global economy is still being held back by the pandemic. Increased vaccinations will allow greater movement of people and improved economic activity. Although we are currently experiencing a rapid spread of COVID, the advent of a more lethal or vaccine resistant variant would have a negative impact on economic growth, to say nothing of the health effects for people.
So far, the world economy is managing to withstand significantly higher energy prices. Typically, increased oil prices act like a tax and reduce economic growth. The impact may not show up for a while however, a further material rise in energy prices should Russia restrict exports would most likely dampen growth.
The recent invasion of Ukraine by Russia has increased the risk that stocks could have negative returns this year should energy supplies be cut off and/or the war spread to NATO countries.
We still expect stocks can deliver returns including dividends of 5%-10% this year however, we no longer view this forecast as conservative. Bond yields have become more competitive with dividend yields on a pre-tax basis and downside risks to growth have increased. For now, we are sticking with targets of 22,750 for the TSX and 4,900 for the S&P 500.