Where to invest for the rest of 2015

Stick with steady, secure stocks with high valuations

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The year is barely half-finished, and it’s already been packed with surprises. A dreadful economic performance in Canada has dashed hopes that the impact from lower oil prices will be slight. In contrast, the European economy has rebounded more strongly than expected this year—but risks still abound. Greece is again verging on default, and China’s economic overhaul keeps hitting bumps. Throughout it all, though, markets have continued their climb largely unabated, even as the bull market should be nearing the end of its charge. How, then, should equity investors prepare to deal with uncertainty, slow economic growth and a market that could lose steam any day?

With prudence and low expectations, perhaps. Indeed, investors face a choice of chasing growth with companies that are not so sensitive to the broader economy but may pose greater risks—hello, high-tech!—or sticking with steady, secure stocks that come with high valuations. Mike O’Brien, head of the core Canadian equity team at TD Asset Management, is leaning toward the latter. “This is not the time in the market cycle when we should be swinging for the fences,” he says. “It’s an environment where we should be a little more cautious.” O’Brien is advising clients to expect a return from Canadian equities in the mid-single digits this year. To understand why, it helps to know what’s happening in the broader economy.

Canada’s top 200 stocks of 2015 »

Canada is puttering along at best. The Bank of Canada is calling for 1.9% growth this year, down from the 2.5% estimate it issued last fall, thanks to the crash in oil prices. Governor Stephen Poloz was not far off when, earlier this year, he warned investors to prepare for an “atrocious” first quarter. It turns out that the Canadian economy shrank by 0.6% on an annualized basis, the first time it has contracted since 2011.

The outlook for the rest of 2015 isn’t quite as bad. “Consumers benefit almost right away from lower oil prices,” says Douglas Porter, chief economist at the Bank of Montreal, which is calling for GDP growth of 1.5% this year. “The positives from lower oil prices tend to work their way through to a lower Canadian dollar and maybe a stronger global economy eventually, so those benefits show up much later on.”

And there is reason to believe oil prices will, at the very least, remain steady. The price of Western Canadian Select, a heavy oil benchmark, is up 50% year-to-date, and the spot price for Brent crude, the global standard, is up about 12%. “The potential for oil prices to retain their recent gains is high,” wrote National Bank economists Stéfane Marion and Matthieu Arseneau in a recent report. Part of the reason is that production is tightening in response to depressed prices. The U.S. Energy Information Administration predicts production will fall by 86,000 barrels per day in June, the largest decline since 2007. “If an investor has a three-to-five-year time horizon, there will be opportunities here,” O’Brien says. He favours high-quality names like Suncor Energy (TSX: SU), Cenovus (TSX: CVE) and Canadian Natural Resources (TSX: CNQ). While these companies might not appreciate as much as smaller producers (which may also be more leveraged and therefore riskier), O’Brien says the established names provide added stability.

Where to invest $1000 now »

Aside from resources, the other big component to the Canadian equity investing universe is the financial sector. The big banks have persistently surprised investors by growing earnings even in a slowing consumer-lending environment. But looking out over the next two to three years, Andrew Marchese, chief investment officer at Fidelity Canada, has a hard time seeing how the conditions will get any better for the banks than they are today. The main risk concerns the banks’ credit books. “Loan loss ratios are at cyclical and secular lows,” owing to low interest rates that make carrying debt relatively affordable, Marchese says. “We know that only has one way to go—and that’s up.” A rise in loan defaults could potentially lead to negative earnings revisions over time.

Of course, much of what happens in Canada will depend on the U.S. economy. Frank Mersch, chairman of Front Street Capital in Toronto, argues that positive momentum is building. “It feels like we’ve been going sideways for a long time, and now it feels like it’s going to break out,” he says. The U.S. consumer has been paying down debt and benefiting from lower oil prices and could start spending again, which bodes well for the retail sector. In April, U.S. housing starts surged to their highest level in more than seven years, too. That represents only one month of data, Mersch cautions, but he’s optimistic: “If we start to see numbers get stronger, that will be a big push for the U.S. economy.”

The U.S. Federal Reserve is signalling that it may raise rates later this year or early next year. That would take some air out of the stock market (not necessarily a bad thing in areas where valuations are rich, such as in biotech), but Mersch isn’t particularly worried. “We have to understand why the rate hike is occurring, and obviously it’s because of a better economy,” he says. An improving economy means that companies will be able to grow earnings and revenue, a more sustainable path than the current focus on cost-cutting and share buybacks.

There is some concern over U.S. stock valuations, however, and many fund managers are looking at shifting money elsewhere. A survey conducted by Bank of America Merrill Lynch released in April showed that 68% of fund managers believe the U.S. is the most overvalued region in the world, and some are responding by moving money to European equities. But even that trade might be played out. “That was a good move nine months ago,” says Bill Onslow, co-head of U.S. equities at Addenda Capital. “It’s not an undiscovered trade anymore, and it may be becoming a little crowded.”

European companies, particularly exporters, have benefited from weaker currencies, and quantitative easing by the European Central Bank is boosting equities—much like what happened in Japan over the past couple of years. But there are signs of underlying growth. For the first time since 2010, all four of the eurozone’s largest economies—Germany, France, Italy and Spain—expanded in the first quarter of the year. Spain led the way with a 0.9% jump in growth. Although the numbers are modest, the eurozone still beat predictions.

“People were expecting no or slow growth, and here we are, partway into the year, and economists have taken up their growth estimates,” says Stephen Lingard, a senior vice-president and portfolio manager for Franklin Templeton Solutions. If the trend keeps up, Lingard estimates European companies could see 20% growth in earnings this year. Equities across industries could see a boost as well. Banks could outperform because expectations for their earnings are so low. Consumer-focused companies should benefit too, as unemployment has fallen in some regions and energy prices have dipped. But high-yield stocks, such as utilities, are already quite expensive and likely don’t have as much room to move, Lingard says.

Value bears vs momentum bulls »

Expectations are more subdued for emerging markets. “We’re bearish for the next couple of years,” says François Bourdon, associate chief investment officer at National Bank Financial. Developing economies have been affected by the slowdown in commodities and Bourdon contends that investment dollars will flow back to developed economies as interest rates normalize. The relative competitiveness between developing and developed markets has shifted, too, as emerging-market currencies have gained strength, while the euro and even the U.S. dollar have weakened. “You’ve seen and will continue to see manufacturing moving back to North America and Europe, and that’s bad news for emerging markets,” Bourdon says.

If there’s an emerging market that still has appeal, it’s China. The country is in the process of reorienting its economy away from investment spending on things like infrastructure and toward consumer spending. In that environment, e-commerce retailers such as Alibaba are poised to benefit. Lingard says there is a lot of money flowing to the Chinese stock market right now as a result of overnight rate cuts and a reduction in the reserve requirement ratio for banks this year, allowing them to lend more. “But it’s hard to say whether this is a bubble waiting to pop or a new generation of people investing in stocks,” he says.

That kind of uncertainty applies to the entire equities landscape, in a way. But with investing, as with life in general, there are no sure things. So as long as you set realistic expectations for your investing goals in the year ahead, you might very well be satisfied with the result.

This article was originally published on Canadian Business.

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