Without a drop in interest rates, the U.S. subprime pain could spread throughout the financial system, says National Bank Financial Inc. in a new report.


NBF notes that the March 21 meeting of the Federal Open Markets Committee brought a return of optimism when the Fed removed its tightening bias, “prompting many investors to see easing right around the corner.”

NBF asks whether the Fed will succeed in engineering a soft-landing for the economy. “It’s still too early to say, but a rapid rise in risk premiums on debt tied to subprime mortgages has begun to spread to other debt, such as emerging bonds and credit default swaps,” it observes, warning, “Absent preemptive Fed easing, the entire financial system could soon feel the subprime sting if tougher lending rules trigger a bottom-up liquidity squeeze.”

Also, the firm notes that the Wall Street consensus now sees S&P 500 earnings growing just 6.4% this year, which would make 2007 the slowest earnings year since 2002. “Strangely, given the subprime worries, financials are the only sector whose earnings growth has been revised up,” it adds. “We accordingly see further analyst downgrades in the coming months.”

Currently, markets look cheap, it says, with the S&P 500 trading at 14.5 times and the S&P/TSX at 14.7 times 12-month forward earnings. “However, current earnings are 19% above the long-term trend in the U.S. and 33% above in Canada. If profits revert to trend in an economic slowdown, valuations will become less attractive,” it says, noting that the ratio of price to trend earnings is 18.7 for the S&P 500 and 21.7 for the S&P/TSX.

“The recent stress test of Canadian equities has comforted us in our sector recommendations. The sectors we flagged as defensive (Consumer Staples) and countercyclical (Health Care) have outperformed the market over the past month. The cyclical sectors we recommended underweighting (Energy, Materials, IT, Industrials) have lagged,” it concludes. “Since we expect the market to drift lower in the coming weeks, we reiterate our counsel of prudence in sector allocation.”