The recent losses on the Toronto Stock Exchange were driven by unwarranted fears that the U.S. subprime meltdown would seriously impact global growth, finds a new CIBC World Markets report.

“Investors followed a circuitous route to link U.S. mortgages to Canadian equities over the past month,” says Avery Shenfeld, senior economist at CIBC World Markets. “Losses on subprime mortgages put some hedge funds at risk, which raised concerns about Wall Street’s liquidity. This led to widening spreads on high-yield bonds and loans, which left dealers stuck with loans on leveraged buyout (LBO) deals in process. This added to the risks to lending liquidity and pressured investment grade spreads, which raised concerns over global growth. The last leg of this Rube-Goldberg path entailed a broad-based drop in Canadian equities.”

Shenfeld notes that there is a missing link between the very evident troubles in the U.S. mortgage market and credit quality in the corporate world. He notes that global corporate defaults are low, as are debt burdens outside the LBO world. Economic growth continues to surprise on the upside, even in Canada, and TSX operating earnings are on track for a 16% gain this year and a double-digit gain in 2008. Only a small minority of the M&A wave that supported Canadian stocks has been in LBO deals and the world’s resource giants have ample cash flow to finance further deals in Canada.

“Buoyant global growth and the pick-up seen in Canada, underpin our optimism on the equity outlook, driving earnings on both sides of the Canada- US border to materially exceed the street’s expectations in Q2,” adds Shenfeld. “But unfortunately, over the last month investors have been throwing out babies with the U.S. mortgage bathwater.”

As a result of this, CIBC World Markets is sticking to its overweight position in equities. Within the equity market, it is taking profits by trimming its overweight in base metals based on the dwindling field of M&A targets, and adding to energy. It has also added to its consumer staples holdings, where heavily weighted retail importers will benefit from a stronger Canadian dollar as it resumes its climb up the currency ladder on evidence of healthy global growth.

The bank has further cut its bond underweight by shifting an additional two percentage points into cash. It expects that the recent rally in the bond market will be short-lived as investors’ flight to safety begins to melt away and in anticipation of another Bank of Canada rate hike in September.

The report forecasts that when the dust settles in the credit markets, funding for private equity leverage buyouts is unlikely to return anywhere near its previous terms and spreads. However, CIBC World Markets does not expect a chill in LBO private equity buyouts to take the toll on global stock markets that some claim, as there is little evidence that stocks were pricing in a large across-the-board premium for such takeovers.

The report notes that while private equity has been a significant, if not dominant source of fuel for the M&A boom in the U.S., it has been less critical elsewhere. Private equity accounted for 27% of deal volume in the U.S. over the last two years. In Europe, which now outpaces the U.S. in deal volume, private equity has accounted for just 13% of recent deal activity, and in Asia only 6%.

Including some pending deals, buyout firms have been responsible for a modest 17% of takeovers of Canadian targets in the last two years. Even that share is largely concentrated in telecom and media targets. Strip out the high-profile telecom deals and private equity’s M&A share has been just seven%, a quarter of that stateside. Such LBOs have accounted for less than one% of mining acquisitions and just five% of deal volume in the energy patch.

Corporate acquirers, typically other resource producers, have accounted for about 95% or more of the recent takeovers in Canada’s resource sector. Such activity is unlikely to be affected by a less favourable credit environment given unprecedented cash flows and balance sheet strength and the ability of many of these firms to partially fund acquisitions via asset sales. Share buybacks, running at two to three times last year’s pace, should also support Canadian equities.

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/psaug07.pdf.