Apr 24, 2017

Peter Brieger's Top Picks: April 24, 2017

BNN Bloomberg

Peter Brieger , BNN

Peter Brieger, chairman and managing director at GlobeInvest Capital Management

Focus: North American large caps
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MARKET OUTLOOK
The merry month of May may not be so merry depending on the outcome of two elections: one in France on May 7 and the other in Iran on May 19. While early polls in France indicate the moderate independent Emmanuel Macron trouncing Marie Le Pen (64 per cent to 36 per cent), my opinion of polls is akin to a former Canadian Prime Minister’s. In Iran, the incumbent President Hassan Rouhani will be up against his major opponent Ebrahim Raisi. I don’t know enough to suggest who might be the better candidate from a Western perspective. Those and other geopolitical risks notwithstanding, I think generally both the Canadian and U.S. economies are in relatively good shape even after taking into account the March pause in some U.S. data and the growing worries that President Trump’s tax legislation (supposedly being announced this week) and other proposed measures may get stalled in Congress.

Assuming none of the proposed legislation is passed, the question then becomes: Is the U.S. economic recovery to date sufficiently resilient to continue on its growth path? I conclude yes, but perhaps at a slower rate than currently expected. In support of that view, leading indicators, real per capita income, real wages and salaries per payroll employee continue on their upward path. Consumer confidence (as measured by the Conference Board) has exceeded 2005-2007 levels but is still below 2000 levels. Unemployment rates are down to levels not seen for a decade or more as the number of jobs not able to be filled is climbing, but again still not back to 2000 levels. Housing continues to be a positive. However, I admit that the auto industry looks like it has peaked for this cycle and at best may remain flat but more likely may decline. Also, a number of other indexes, such as the U.S. Manufacturing PMI, the Non-manufacturing PMI index and others showed a decline in March (weather related?). So at this point, excluding any major geopolitical upset and/or a more-than-expected spike in interest rates, I think the U.S. economy can continue to grow into 2018 and possibly 2019 (the latter guesstimated by Yardeni Research Inc.).

As for interest rates, given my growth scenario one would have expected interest rates to continue to rise, especially in view of the two further anticipated increases in rates by the Fed this year. But that’s not what has been happening. For example, in Canada and the U.S., rates for the two- to 30-year government bond maturities peaked March 10 at 0.84 per cent and 1.35 per cent for the two-year, 1.27 per cent and 2.10 per cent for the five-year, 1.81 per cent and 2.57 per cent for the 10-year and 2.48 per cent and 3.16 per cent for the 30-year. As of April 21, yields had declined to 0.72 per cent and 1.18 per cent for the two-year, 1.01 per cent and 1.77 per cent for the five-year, 1.46 per cent and 2.23 per cent for the 10-year and 2.13 per cent and 2.90 per cent for the 30-year. One possible answer is that the latest U.S. CPI reading showed a decline in growth, showing a 2.4 per cent increase Y/Y compared to a 2.7 per cent Y/Y increase for the prior month. Food, which has a 13.7 per cent index weighting, declined 0.3 per cent (for the first time since June 2016), and energy, which has a 7.2 per cent weighting, declined for the second month in a row (March being -3.2 per cent) after rising for more than a year. On a global basis, food outputs and other commodities, such as cotton, are increasing. Also, in spite of OPEC’s determination to reduce overall oil oversupply, including a recommended six-month extension of the current production reductions, U.S. shale producers are doing the opposite. This indicates a continuation of oversupply conditions and a possible decline in the price of WTI and Brent as compared to some $60.00-$70.00 2018 forecasts that are “on the street.”

Another answer may be that the economic growth we have seen to date will not be sustained and will slow down. Or as suggested by Bay St. icon David Rosenberg, “The unemployment rate is a lagging indicator and it is typical for a recession to start six months after the rate hits its cycle trough.” He also suggests, “When consumer confidence peaks, that tends to mean households are satiated and pent-up demand has been satisfied. Recessions on average begin about a year later.” My response is that, as mentioned many times before, given that “this recovery may go on longer than normal given the severity of the last recession” and the relatively slow recovery to date, the unemployment rate may stay lower for longer. Also, I observe that consumer confidence, while higher than 2007 levels, is still well below 2000 levels and therefore, could still move higher.

As for the TSX, its outlook in no small part depends on one’s outlook for 57.8 per cent of its index (as of March 31). For example, banks were 23.8 per cent, energy 21.4 per cent, insurance 6.6 per cent and gold 6.0 per cent. I am positive on banks, insurance and gold but still cautious on energy depending on how well OPEC discipline is maintained and the resulting WTI and Brent prices.

As for the S&P 500, I look at its current valuation from two perspectives. The first assumes that no favourable tax or any other legislation will pass this year. The second assumes that some will, particularly the tax cuts. In the first scenario, the consensus forecast for earnings and price earnings multiples are 18.0 for 2017 and 16.0 for 2018. This compares to a post-2000 high multiple of 18.4 reached in about 2004. Therefore, I conclude that in this scenario, the S&P is fully priced and could pull back five per cent to 10 per cent for any reason, economic and/or geopolitical. In the second scenario, tax cut legislation could produce incremental earnings of between $8.00 and $13.00 per share in 2017 and 2018 depending on what is passed and its effective date. Assuming it results in potential 2017 and 2018 EPS of $142.00 and $150.00, the multiples decline to 16.5 and 15.7. Still not super cheap (long-term average 13.9) but less elevated, thus leaving room for a further modest multiple expansion and continuing earnings growth.

In summary, while being fully aware of some of the risks going forward, I remain optimistic about the stock markets’ outlook in either scenario but lean to the view that tax cut legislation is likely to be passed this year. I would use any weakness as a buying opportunity.

TOP PICKS

TD BANK (TD.TO)
Close 04/21: $65.63; One-year target: $71.00; Target gain: 8.3 per cent; Yield: 3.7 per cent; One-year target total return: + 12.0 per cent; Date and price of last purchase: 04/20/17 at $66.22; Brokers’ ratings: 2/4/10/1/0
In reviewing the outlook for Canada versus the U.S., we think the economic outlook for the latter is much better than Canada’s and therefore bodes well for Canadian banks with U.S. exposure. In Canada, real estate exposure is said to be a potential worry. TD has the lowest exposure to Canadian real estate. Oil loans are becoming less of a worry. In the U.S., net interest margins and income is rising and in the case of the TD, wholesale loan growth has and will likely continue to accelerate. We think future dividend growth will track earnings growth.

PEMBINA PIPELINE (PPL.TO)
Close 04/21: $44.28; One-year target: $48.90; Target gain: 10.5 per cent; Yield: 4.6 per cent; One-year target total return: +15.1 per cent; Date and price of last purchase: 02/23/17 at $42.51; Brokers’ ratings: 1/14/2/0/0
In western Canada, PPL has an extensive network of liquids-gathering pipelines, gas-processing facilities and gas-fractionation facilities. Its main areas of focus are on the Montney and Duvernay fields. Based on its past investments, it is in an excellent position to positively leverage future growth through modest incremental capex. A recent deal with Chevron lays the base for incremental infrastructure spending. Long-term dividend growth is expected to come from its fee for service business.

XYLEM (XYL.N)
Close 04/21: $50.65; One-year target: $55.15; Target gain: 10.3 per cent; Yield: 1.4 per cent; One-year target total return: + 10.3 per cent; Date and price of last purchase: 04/20/17 at $50.02; Brokers’ ratings: 3/5/7/0/0
As demand for fresh water grows worldwide, the appetite for companies that distribute, purify, pump, filter and monitor usage, will be in increasing demand. Xylem is such a company, providing on water technology on a global basis with a focus on higher-value technology applications. Its recent purchase of Sensus further focuses the need for improved technology apps in the water business. Its R&D has now increased to five per cent of sales. XYL serves four markets: public utilities, industrial, commercial and residential. Globally, it expects rapid growth in China, India and the Middle East. Consensus estimates for EPS growth in 2017, 2018 and 2019 are 12.8 per cent, 14.4 per cent and 14.9 per cent, respectfully.