© Copyright 2000 Rogers Media. The following article first appeared in the April 2001 edition of BENEFITS CANADA magazine.

Equities Report--Canada

Ignore the bumps in the road. All signs point to Canadian stocks outperforming in the near term.

By Sharon Ranson

This volatility has made it challenging for Canada's pension plan sponsors to identify sound investments that can ride out the ever-changing marketplace. Of course, nobody knows what really lies ahead, but many portfolio managers agree that investors need to look past the bumps in the road and concentrate on the opportunities they create.

To date, Canada has seen robust economic growth. Last year, the real gross domestic product (GDP) continued to rise on the heels of increases in consumer spending, residential construction and business investments.

While the U.S. economy slowed considerably in the third quarter of 2000, the Canadian economy continued to fire on all cylinders as the GDP came in at a blistering 4.8% annualized rate.

Fourth quarter data appears strong as well, with manufacturing shipments and new orders up noticeably by 1.7% and 4.3%, respectively, in October. The trade surplus remained at $4.6 billion in October.

Continued low unemployment, which came in at 6.8% for December, also contributed to the health of the domestic scene. Meanwhile, productivity gains played a role by keeping the increase in unit labour costs below 1%.

The upshot to all of this is that after years of underperformance, the Canadian equity market finally made a comeback in 2000. Investors who deserted domestic equities and equity funds in the wake of the stock market's poor performance have returned in droves. The big question now is: will this trend last?

SHIFTING GEARS

Going forward, economic conditions are still favourable for the Canadian equity market. But at first glance, it might seem otherwise. With roughly 85% of domestic exports heading south of the border, many analysts argue that Canada can no longer escape a U.S. slowdown and will closely mirror the American economy through 2002.

There is reason to be hopeful, however, that the slowdown in Canada will be considerably milder than in the U.S. As the American economy shifts into second gear, Canada's growth will be aided by tax cuts that took effect in January. What's more, fiscal stimulus and pent-up domestic demand will likely give Canada a performance edge over most other G-7 nations.

In Canada, the revival of government infrastructure investments and the rebound in resource sector profitability have already given the economy some additional steam. Canadian consumers are also playing catch-up. A decade of underperformance has left families with pent-up demand for new housing and major household items, which is bolstered by a stronger pace of job creation and greater fiscal stimulus on this side of the border.

Even with the economic slowdown in the U.S. expected to reduce Canadian exports to that country, the Bank of Canada still finds that growth in domestic demand remains robust. As a result, the Bank of Canada does not have the same urgency to ease monetary policy as the U.S. Federal Reserve.

Despite the continued price pressure from the energy sector and the lower Canadian dollar, there is no evidence of higher levels of core inflation on the horizon. The Bank of Canada welcomes this inflation performance, as it continues to target core inflation in the 1% to 3% range.

This is the soft landing scenario anticipated for some time. It is based on the expectation that economic activity will begin to shift down a notch towards its long-run growth potential, and the fact that core inflation will remain under control.

RALLY IN STOCKS

In the short term, Canadian equities will likely experience ongoing volatility as investors continue to worry about a possible U.S. recession and its effect on corporate profits. That's the bad news. The good news is that markets are expecting further interest rate cuts by the U.S. Federal Reserve, which should lead to a short-term rally.

In the longer term, the swift moves by the Federal Reserve and the proposed tax cuts in the U.S. should help bolster consumer confidence, the U.S. equity market and, in turn, Canadian stocks. Expect corporate earnings to improve and equities to stage a solid rally once the rate cuts take effect.

Another positive fundamental underlying today's Canadian equity market is that valuations have declined dramatically over the past nine months. With earnings disappointments factored into the market, we may be coming to the end of the current correction. One thing is certain--investor expectations are much more realistic.

Last year, many stocks were priced to perfection. This is referred to as the rising-tide-lifts-all-boats phenomenon. Today, investors have become much more rational about differentiating between winners and losers. Some market analysts argue that we have not yet hit the bottom, and that there may be more downside in the short term.

But don't be surprised to discover that Canadian stock prices, on average, are higher a year from now. The Canadian stock market, as represented by the Toronto Stock Exchange 300 composite index, will most likely return about 10% to 11% over the next 12 months.

While the past 18 to 24 months have seen global funds getting the lion's share of investor assets, both retail and institutional investors could very well begin to focus more on Canadian investments this year. All the right signs are there for the Canadian stock market to outperform the U.S. and other major markets. These factors include: superior economic growth; subdued inflation; relatively lower stock valuations; rapid earnings growth; and relatively lower personal and corporate taxes.

What does all of this mean for pension plan sponsors? Canadian investors may still favour global stocks and funds today, but they will soon be encouraged to recognize domestic investments as a more integral part of their portfolio mix.

Sharon Ranson is vice-president, Canadian equities with TAL Global Asset Management in Toronto and manager of the firm's Talvest Cdn. Equity Leaders Fund. info@talvest.com.

The big three

There are three industrial themes for 2001:

• Financial services. The best overweight position will continue to be financial services, particularly in banks and insurance and mutual fund companies, due to further interest rate cuts, continued industry consolidation and ongoing wealth management trends.
• Technology. While the outlook for the technology sector remains positive for the long term, short-term volatility will remain. Investors are concerned about the uncertainty and sustainability of growth rates in the sector in the face of a slowing economy.
• Oil and gas. Maintain a neutral weight in oil and gas, with an overweight in natural gas, due to expectations of a continued shortage in gas supply.

Selectivity is key

Keys to identifying the most attractive investment opportunities in Canada:

• Focus on market leaders.
• Use a top-down approach and look for overall themes.
• Add a bottom-up approach by stock picking in a sector context.
• Select an investment horizon of 12 to 18 months, adjusted according to market movements.
• Pick primarily, but not exclusively, mid- to large-cap stocks.
• Ensure that your portfolio has broad diversification with 40 to 50 companies across all key sectors.
• Ensure that you are fully invested.
• The top 10 stocks in your portfolio should represent less than 35% of total assets.

The next big thing

What's the next big thing in technology? That's the question on every technology investor's mind. In particular, investors want to know what will defy valuation norms like the dot-coms.

Given the technology market correction in Canada and abroad, many investors may assume that the high-tech revolution is over. Far from it. The Internet and its intranet counterparts continue to create a demand for new technologies.

The Internet is also expanding. Despite the collapse of many e-retailers, an Internet strategy is still a key business component for brick-and-mortar retailers. In addition, corporations are only in the early stages of conducting business electronically.

So, where can investors make money? Mostly with those companies that enable other firms to engage in business-to-business electronic commerce.

Underlying the growth of the Internet is the need for better fibre optic networks, wireless devices, servers, routers, storage capability, enabling software and power solutions--all of which bode well for the technology sector in Canada.

The plumbing behind the Internet will drive technology stock growth for the next 10 years, offering opportunities that are not affected by either the component gluts, the commoditization of personal computers or an economic slowdown.

The Romanow Commission has released its final report on the future of healthcare in Canada.

For Commissioner Romanow's recommendations, click here.

Click here for Senator Michael Kirby's report, "The Health of Canadians – The Federal Role: Recommendations for Reform."