Trade war holds back Canadian stocks in first half, but tide could be turning

Canada's stock market, like so many Canadian industries, was left shaken as traders grappled with the prospect of a full-blown trade war with the United States in the first half of 2018.

Canadian equities started the year down,dragged lower byvolatility that rocked U.S. markets in the first quarter. But they have roared back to life in the past three months.

Yet, despite the highs and lowsof the past six months, the benchmark S&P/TSXcomposite index is trading around flat for theyearand, when compared to its G7 peers, is sitting near the bottom of the pack.

In the second quarter, however, the Canadian market outperformed most major developed markets by rising more than six per cent overall. If that's any indication of things to come, strategists say Canadian equities could bounce backdespite fears of a trade war.

Brian Belski, chief investment strategistat BMO Capital Markets, is betting on positive developments fromNAFTAnegotiations, pipeline approvals and a softening housing market to ultimately drive the TSXhigher in 2018.

"We continue to believe the pessimism [in Canada]is misplaced and investors should expect another year of positive stock market performance, despite all the concerns about domestic growth, NAFTA, oil prices, and weak gold prices," Belski said in a note to investors.

"Ultimately, Canada's longer-term fortunes are likely to mirror the accelerating growth in the U.S."

The U.S. economy is expected to grow 2.8 per cent this year, according to U.S. Federal Reserve, which is 0.5 percentage pointshigher than its growthlast year.In comparison, the Bank of Canada forecasts the Canadian economy will grow two per cent this year. It expanded by three per cent in 2017.

Bigger gains than last year?

Belskiforecasts that the TSXindex will jump more than eight per cent in the second half of the year, hitting a target of 17,600 points. That prediction puts the index's gain for this yearat more than eight per centhigher thansix per cent rise it saw in 2017.

Similarly, Ian de Verteuil, the head portfolio strategist at CIBC World Markets, is expecting anearly fiveper cent gain onthe TSXthis yeareven though trade disruptions remain asignificant risk to his investment strategy.

"White House threats on auto tariffs and a commitment to escalate if countries retaliate are concerning developments, but we still assume the [U.S.] administration is after 'more not less'trade," deVerteuil said in a note.

"Under all the rhetoric, there is some progress on autos and the China relationship, and even a renegotiated NAFTA is not too difficult to envisage. To be clear though, progress will not be in a straight line."

Meanwhile, Kurt Reiman, chief investment strategist at BlackRock Canada, said he didn't think matching last year's performance of a six per cent gainis a high hurdle for the TSXthis year, especially if the momentum in the energy sector remains strong.

But not all strategists are convinced that Canadian stocks will be able to weather the storm being brought on by the Trump administration.

Sadiq Adatia, chief investment officer at Sun Life Global Investments, thinks the Canadian market will continue to trade without making any significant gains in the second half of the year.

He predicts a target range of 16,000 to 16,250 points for the TSXin 2018.

Problem with consumers

Given Canada's lacklustre performance in comparison to other developed countries,many people have realized that other markets may not carrythe same risks this country is facing,Adatiasaid. He cited an overheated real estate market, high consumer debt and NAFTA.

"We also cannot forget that the Bank of Canada has also raised interest rates threetimes and going on to four,which should slow down consumer spending going forward," he said.

The Bank of Canada is widely expected to raise interest rates again next week after making three hikes since July of last year.

Adatiarecommends pulling back from stocks that are tied to consumers. Consumers arelikely not going to be able to contribute to the economy as they have in the past, he said.

Aggressive on energy

However, the strategists said that other sectors such as energy and technology should hold up well on the TSX for the rest of this year.

Belski is betting big on the energy sector, which was a keydriver of Canadian equities in the second quarter. He's upgraded his overweight positioning on the sector.

"We believe Canada is poised to outperform the second half as oil prices reset a new trading range (still a tight range, but higher) and housing prices firm," he said in an interview.

De Verteuil of CIBC has also become more aggressive on the energy sectorafter pulling back fromfinancialssuch as banks because of their exposure to consumer debt and the housing market.

Reiman, however, is taking amore cautious approach. He sees greater global economic uncertainty in the second half of the year and tighter financial conditions, such as higher interest rates.

"We recommend taking some risk out of equities, specifically our allocation to Japanese and European stocks where upside appears more limited, and investing the proceeds in short-duration fixed income [such as bonds],"Reiman said.