Slow growth means major rally doubtful but downside also limited

TORONTO, Aug. 27 /CNW/ - While concerns remain in Canada and the U.S. about sluggish recoveries, investors have likely already priced an economic slowdown into the stock market, finds a new report from CIBC World Markets Inc.

The report notes that although markets reacted to the recent drop in North American confidence indexes, the reality is confidence never really recovered much in the first place. While confidence did rise from the abyss set at the height of the financial crisis, it remained mired in normal recession territory in the U.S., with a slightly better outlook in Canada.

These growing concerns about the economy have seen investors dumping stocks in the last six months in favour of bonds and in particular government issues as they brace for continuing lean economic times. "Individuals have already pulled out of stocks and flooded into safer bonds at a breakneck pace," says Avery Shenfeld, Chief Economist at CIBC.

"Bond yields are so low that in the U.S. they assume the Federal Reserve Board will miss its inflation targets for 10 years to come. Stocks will be challenged to soar from here, but the downside also looks limited by the fear already priced in as investors pulled out. With so much fear built into their rally to date, government bonds could prove to be an unsafe haven for new buyers at these levels."

The report finds that corporate Canada is also concerned about a continued sluggish economy despite strong earnings from most sectors in the second quarter of 2010. Many companies are bracing for leaner times by holding off on capital spending and stocking away cash. CIBC estimates that corporate cash holdings are some 20 per cent heavier than normal relative to sales, a difference equal to $45 billion.

Despite this excess of cash, companies are beginning to delay dividend increases. The proportion of dividend announcements setting higher rates climbed from the recession's end to a high of 18 per cent late last year but has dropped back to 7.1 per cent. "That pattern suggests firms for now are inclined to hold onto some of their excess cash as a hedge against uncertainty," says Peter Buchanan, a senior economist at CIBC.

Mr. Buchanan notes that while "buybacks are sometimes favoured as a method of funnelling excess cash to shareholders, especially in cloudy economic times, activity on that front has also eased in recent quarters."

While Canadian boardrooms are taking a more cautious view of the economy, forward earnings expectations for the TSX are still fairly healthy, with the bottom-up analysts' consensus looking for increases of around 15 per cent this year and over 20 per cent for 2011.

"Looking at the two key drivers of earnings performance, profit margins for TSX companies continued to hold up well in Q2," says Mr. Buchanan. "The evidence suggests, in fact, that TSX stocks have done a bit better than S&P 500 members in that regard in recent years, despite widespread concerns over Canada's uninspiring productivity track record. Revenue growth, however, slowed sharply to a three per cent pace on the year.

"The higher Canadian dollar and flatter recent trend in resource prices likely contributed to the deceleration. Alongside more difficult year-on-year comparisons as the recovery matures, that's a reason to look for softer earnings growth in coming quarters."

The latest TSX earnings reports show the mining and fertilizer/chemicals-dominated materials group continuing to drive the earnings recovery. Although prices for a number of resource products softened on growth jitters and the housing credit's expiry hammered lumber, earnings still managed to record an impressive 89 per cent gain on the year in Q2, only modestly softer than the preceding quarter's triple-digit tempo.

Stronger outlays at domestic retailers and gains in both the media and auto parts sectors, reflecting supportive developments at home and abroad, bolstered earnings in the consumer discretionary group. Helped by an easy comparison to a weak prior year, earnings in that sector advanced by 53 per cent, the second best performance of any market group. While the higher Canadian dollar is a negative for a range of industries, it aids others, including many retailers, who benefit from lower input costs.

Benchmarked to analysts' consensus, the latest crop of TSX results beat the street's expectations in 53 per cent of all cases. On a comparative basis, the telecom and info tech sectors did well, with four-fifths of firms in those sectors surpassing the consensus. Two-thirds of industrial and consumer staples firms also surprised to the upside. While the beat rate was lower than the 75 per cent recorded for the S&P 500 that did not stop the TSX index from registering modestly stronger performance during the reporting period.

The complete CIBC World Markets Inc. report is available at:

http://research.cibcwm.com/economic_public/download/saug10.pdf

CIBC World Markets Inc. is the corporate and investment banking arm of CIBC. To deliver on our mandate as a premier client-focused and Canadian-based wholesale bank, we provide a wide range of credit, capital markets, investment banking, merchant banking and research products and services to government, institutional, corporate and retail clients in Canada and in key markets around the world.