CIBC World Markets is moving to upgrade its exposure to the energy-heavy Toronto Stock Exchange with high oil prices slowing the economy, and forestalling the need for interest rate hikes.

“Surging Chinese energy demand, and record-low OPEC capacity have led us to upwardly revise our forecast for crude prices, which should average over $50 per barrel over the next three quarters,” said chief strategist, Jeff Rubin, in the Canadian Portfolio Strategy Outlook for October.

“Central banks may not yet realize it, but the bond market already senses that rapidly rising crude prices will act as a significant brake on the North American economy,” Rubin notes. “As $50-plus crude prices quickly substitute for central bank tightenings, we are moving to an overweight position in the TSX, where over half of the index consists of energy and financial stocks.”

The firm is also raising its bond weighting, with both the Bank of Canada and the Fed now expected to tighten only modestly from current levels. It notes that its quantitative analyst also sees further gains for bonds.

To make room for higher bond and stock positions it has cut cash back to 3%. “With market fears of rapid-fire rate hikes diminishing, strong double-digit quarterly earnings growth should fuel a near-term rally in the TSX. Our dividend discount model suggests valuations have room to climb to 9300 next year, a target also shared by our technical analyst,” Rubin said. “An expected 11% jump in operating earnings next year should see the TSX forward price earnings ratio continue to hug long-term historic averages of around 16 times earnings.”

CIBC World Markets predicts that the rally is likely to find leadership from the energy and financial sectors, which are both overweighted in its portfolio. “Based on our cash flow projections from $50 oil and higher natural gas prices, we see another 20-25% upside in the oil and gas sector. The prospect of falling long bond yields leads us to modestly overweight financial stocks. High dividend stocks are also likely to catch favour with investors,” Rubin said. “On a defensive note, we have a slight overweight in health stocks that are also favoured by our Equity Research department.”

“Ultimately higher energy prices will take a toll on global industrial production and we have underweights on both the materials and industrial sectors of the TSX. Not only are higher energy prices historically bearish for other commodity prices, but soaring crude costs are already squeezing margins in a number of industries, in particular forest product producers and airlines,” Rubin said.

Within the financials sector, CIBC stock analysts said, “We expect the Canadian banks to benefit from a gradual recovery in commercial borrowing activity, which has been evidenced in the latest Fed lending survey. Canadian insurers with significant excess reserves for variable annuity and segregated fund guarantee risk should have the capacity to deal with a material deterioration in equity markets. A decline in the value of the Canadian dollar relative to the US dollar and other currencies should have a positive impact on the earnings of the Canadian insurers.” CIBC World Markets recommends maintaining market weights of each sub-sector.