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Inside the Market The time is right for beaten-up Canadian forestry stocks

Are Canadian forestry stocks set for a rebound? Some brave investors are betting that the worst is over, given tentative rallies earlier this week by West Fraser Timber Co. Ltd., Interfor Corp. and Canfor Corp., among others.

Nimble investors can point to several upbeat signs for the beaten-up sector, including tumbling borrowing costs that could stimulate U.S. home construction. Shares have also been pummelled over the past 12 months, making the downside risks look relatively slight.

But perhaps the best thing going for forestry stocks: The potential returns are huge if investors get the timing right for this notoriously cyclical sector. The last time forestry stocks rallied, from mid-2016 to mid-2018, West Fraser shares surged 170 per cent – giving investors plenty of incentive to pay attention to subtle shifts in the sector’s underlying fundamentals.

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“Definitely from a demand, supply, pricing and profitability perspective, the worst is over and we’re going to see things improve,” said Paul Jannke, a principal for Forest Economic Advisors, a global industry analysis firm based in Littleton, Mass.

He expects that lumber prices could rebound as much as 40 per cent this year, turning money-losing mills into cash generators. Hamir Patel, an analyst at CIBC World Markets, expects that Interfor’s share price could rally 67 per cent over the next 12 months, but he sees double-digit gains ahead for the entire sector.

So far, so good. West Fraser shares rallied 4 per cent on Monday and 3.7 per cent on Tuesday, before retreating 2.74 per cent on Wednesday.

Yes, the gains coincided with big moves in the S&P 500 and the S&P/TSX Composite Index on Tuesday, when the U.S. Federal Reserve said it would consider cutting interest rates if the economy deteriorated, implying an indiscriminate rush toward stocks that might benefit from monetary stimulus.

But the gains by forestry stocks indicate something far more specific.

Lumber stocks tend to mirror the U.S. housing market, which has been notching steady improvements since the financial crisis. Doubts began to creep in during the second half of 2018, though, amid continuing interest-rate hikes by the U.S. Fed and surging bond yields, which raised borrowing costs.

At the same time, a number of economists began to anticipate slower U.S. economic growth and some commentators even warned that the U.S. economy was on the verge of sliding into a recession.

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U.S. single-family housing starts (the number of homes under construction) fell to a 21-month low in February, reflecting these headwinds. Add in a severe winter and wet spring, which stymied construction, and it’s little wonder that lumber prices have tumbled more than 50 per cent over the past year. Oriented strand board (or OSB, structural wood panels) is down sharply as well.

Stock prices are showing the gloom. West Fraser Timber shares fell 46 per cent between June, 2018, and May 31, 2019. Shares of Norbord Inc., a Canadian-based OSB maker, fell 55 per cent over the same period. Other forestry stocks have also slipped deep into a bear market.

So why should investors entertain any optimism?

One thing in the forestry sector’s favour: The Fed has been dropping hints that its campaign of interest-rate hikes is over this year. Fed chairman Jerome Powell said on Tuesday that the central bank could even cut rates if the economic outlook deteriorates. Economists at Barclays and JPMorgan Chase expect the Fed will cut its key rate in September and December.

Lower borrowing costs could stimulate a housing market that is already showing signs of recovering thanks to retreating bond yields. In April, U.S. housing starts – key to lumber demand – increased 5.7 per cent, month over month. And in May, the National Association of Home Builders index, which measures confidence, rose to a seven-month high.

These upbeat conditions could spur demand for lumber.

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As for supply, lumber producers have been cutting production since the fourth quarter of 2018 in response to a lumber glut and weak prices. On Monday, Canfor announced that it would shutter a B.C. sawmill in July.

“We expect LumberCo share prices to react favourably to signs of much needed capacity rationalization emerging in British Columbia,” Mr. Patel, the CIBC analyst, said in a note this week.

Mr. Jannke warns that more curtailments are needed, but he’s optimistic that lower borrowing costs, rising home sales and drier weather will spur demand for lumber: “Then we’ll get the inventories consumed and the lumber prices moving up,” he said.

There are a lot of moving parts here – but when things go right, forestry stocks take off.

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