North of the border.  Is corporate Canada is on track to exit the profits recession that has ravaged income statements for nearly two years?  The consensus forecast for third-quarter earnings is for year-over-year profit growth of nearly 5 per cent for companies in the S&P/TSX Composite Index.  The rebound in energy prices, combined with brutal cost-cutting in the oil patch, are generating an energy-led recovery in Canadian profits, which last saw growth in late 2014.  As a result, no major stock index in the developed world has done better this year than the S&P/TSX Composite, which has risen by nearly 16% so far this year.  If oil prices hold up, the index should continue to rise through the end of the year.  Another positive is the improving outlook for emerging market economies, which are historically highly correlated with demand for Canadian resources.  Meanwhile, growing divergence between the U.S. and Canadian economies – and monetary policies – suggest the Canadian dollar is headed lower.  Those forces could result in a relatively rare combination of commodity strength and dollar weakness.  Foreign investors seem to be betting on this outcome as we have seen a strong flow of foreign funds into Canadian resource stocks this past year.  This optimism is also being reflected in earnings estimates, as shown in the chart below.  After six straight quarter of negative earnings growth, analysts are forecasting positive growth over the next six quarters that would take earnings to their highest level since 2008.  Only time will tell if this optimism is justified, but we are reticent to pay for that growth in stock prices today!Earnings Growth - TSX

While earnings have been the story lately, the economic picture will become the more important determinant of the earnings growth going forward.  The U.S. economy grew at its fastest pace in two years in the third quarter as a surge in exports and a rebound in inventory investment offset a slowdown in consumer spending.  Gross domestic product increased at a 2.9% annual rate after rising at a 1.4% pace in the second quarter.  That was the strongest growth rate since the 3rd quarter of 2014 and beat economists’ expectations.  Business investment improved last quarter, though spending on equipment remained weak.  But, despite the strength last quarter, overall growth continues to be anemic.  Over the first half of the year, growth had averaged just 1.1%.  This has been the trend across the globe as economies struggle to get consumers and businesses to spend following the financial crisis and despite record low levels of interest rates.  While this slow growth/low interest rate environment has been a panacea for financial markets, there is only so much that central banks can do to ‘move the growth needle’.  In fact the impact of these policies seems to be diminishing even as the central banks push into much more aggressive policies, such as negative interest rates.   While growth appears to be recovering slightly, the chart below shows how the current low level of unemployment in the U.S. has, in the past, been a better indicator of an end to an economic cycle.   The key difference from these past periods is that the central banks had been raising interest rates when unemployment dropped to such low levels.   The ‘dovish’ stance of global central bankers today seems to rule out any similar moves this time around and may allow for a more ‘extended’ economic cycle than we have seen in the past.U.S. recession approaching?

The low on bond yields is most likely behind us.  The 10-year note yield has risen from 1.36 percent in July to 1.84 percent recently.  Interest rates are rising across the globe as central bankers may have finally recognized that higher long-term rates are necessary both to provide savers a normal return and to maintain a healthy banking system.  In our view, the central bankers seem convinced that asset prices are not in a ‘bubble’ and that borrowing costs can normalize without hurting equity prices and economic growth.  But the current protracted economic and earnings malaise, coupled with record high stock prices and the reversal of a nearly decade-long zero interest policy could lead to a collapse in equity, bond and commodity prices concurrently.  The reversal of the central bank’s failed ‘trickle-down wealth effect’ could very easily cause a recession.  We have to look no further back than last December, when the Fed’s first rate increase in ten years sent stock prices tumbling over 10%, their worst start of a year in its history.  This, in our view, is the risk that faces investors.

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