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Why TSX outperformance will likely fade in 2017

In an era of ultra-low interest rates, stocks become more attractive and investors are more willing to pay for future earnings.

Canadian stocks are hitting the year's home stretch with their biggest lead over the rest of the world in decades.

On track for a near 20-per-cent rise this calendar year, it would take a substantial change of course over the next month for any other major market to unseat Canada's position atop the markets of the developed world. No other major benchmark has even risen by double digits so far this year.

Plus, the S&P/TSX composite index is well on its way to besting the S&P 500 index for the first time in six years.

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But it's likely to be a short reign.

"Canadian stocks will likely take a back seat to their U.S. neighbours again in 2017," Brian Belski, chief investment strategist at BMO Nesbitt Burns, said in a report.

"Indeed, a broad policy shift in the U.S., especially relative to Canada, will likely see asset flows swing back to the U.S. at some point during the year."

Still, a good year for the U.S. economy and stock market would certainly provide a boost for Canadian prospects. Call it a consolation prize.

U.S. equities have rallied following the election on rising economic and inflation expectations, in light of president-elect Donald Trump's campaign promises to increase fiscal spending and cut regulations.

The downside reaction many expected following a Trump upset has not materialized, at least not yet.

"Investors have been climbing the wall of worry for eight years and counting," Mr. Belski wrote. "Chances are the same type of wall of worry applies to president-elect Trump as well."

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A dramatic transformation of the market, however, is due to unfold.

U.S. stock appreciation over the last several years has been driven by the expansion of trading multiples and supported by loose monetary policy.

The years ahead are shaping up to be just the opposite, with stock gains fuelled by earnings growth and backed by fiscal stimulus, Mr. Belski said.

In an era of ultra-low interest rates, stocks become more attractive relative to bonds and the multiples that investors are willing to pay for future earnings go up.

"We believe this trend has largely played out, particularly given the interest rate and inflation outlook," Mr. Belski said.

If true, the continuation of the bull market would rely on earnings growth, which was long absent from the U.S. market.

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The S&P 500 index has recently gone through the most severe earnings recession since the financial crisis, with profits declining for five consecutive quarters.

But with the inflection point having finally been reached with moderate third-quarter earnings growth, a substantial rebound in earnings is now expected over the next several quarters.

As a result, Mr. Belski has a 2017 year-end target on the S&P 500 of 2,350, representing an 11.9-per-cent increase from 2,100, which is where he expects the index to end this year.

His target for the S&P/TSX composite index, meanwhile is 16,000, which would amount to a 4.6-per-cent gain from his 2016 year-end estimate of 15,300.

While Canadian index exposure has paid off this year, U.S. equities have once again become more attractive, according to Ian de Verteuil, head of portfolio strategy for CIBC World Markets.

That view is partly based on Canadian dollar weakness.

The loonie's recent drift lower against the U.S. dollar is poised to continue, considering rising U.S. economic and inflation readings, and the fiscal expansion expected from a Trump administration.

And when the Canadian dollar undergoes sustained weakness, investors have historically been better off by moving money to U.S. assets, Mr. de Verteuil said in a report.

Over the past five periods of loonie weakness, the S&P/TSX composite index has lagged the S&P 500 on average by more than 10 per cent, and by far more in Canadian dollar terms, he said.

"We think there is a strong case to reverse the 'Buy Canada' trade that appealed to us at the start of the year."

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About the Author
Investing reporter

Tim Shufelt joined the Globe and Mail in August, 2013, primarily to cover investments for Report on Business. Prior to the Globe, he worked as a staff writer at Canadian Business magazine, a business reporter at the Financial Post, and covered city news and courts for the Ottawa Citizen. More

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