Despite the recent pullback in equities, conditions are in place for fundamentals to for improve, justifying higher prices, according to a new report from TD Economics.

In the July 2003 Global Markets report, TD economist Craig Alexander concludes, “In terms of equities, the strength of the recent rally does suggest that a pullback related to some profit-taking is likely at some point in the near term. Nevertheless, stronger economic growth should bring higher corporate profits, which in turn would support higher equity valuations.”

Alexander notes that the recent rally suggests that investors have bought into the view that better times are ahead for the North American economy. Since the end of the first quarter, the Nasdaq has gained 27%, the S&P500 is up 17% and the S&P/TSX has gained 12%. “The rally reflects expectations of stronger economic growth and corporate profits in the second half of 2003. At the same time, a sell-off in bonds signals that fixed-income investors are also becoming more optimistic about economic prospects and are less worried about talk of deflation.”

He says that a recent rebound in the U.S. dollar also suggests that currency markets have also become less pessimistic about the U.S. outlook. And, that rising commodity prices are foreshadowing stronger economic times, too.

“But, is the financial market optimism justified?” he asks. “In our opinion, the pre-conditions for stronger economic growth are all in place. In the United States, the impact of tax cuts, the stimulative stance of monetary policy and the prior weakening of the U.S. dollar are all powerful catalysts for a pickup in economic activity. In Canada, the fallout from SARS will pass, and better economic conditions south of the border should help the export sector.”

Alexander sounds a cautionary note, too, pointing out that in the U.S. the jobless recovery and weak prospects for business investment are likely to constrain the recovery. And, Canada must deal with a stronger dollar and a dependence on the U.S. recovery.”

He predicts that the Bank of Canada will lower rates by a further 25 basis points in September, but that the U.S. Federal Reserve Board will likely hold rates steady.