Saying there is greater upside in valuations than investors appreciate, UBS Securities Canada Inc. has boosted its 12-month target for the TSX Compostie Index to 14,500 from 13,500.

In a report announcing the new call, UBS says that while price-earnings ratios are at near normal levels, returns on equity are historically high and corporate bond yields are low.

“We believe equity markets will be driven by the increasing necessity for corporates to relever to protect ROE, and the historically large gap between earnings yields and bond yields will allow them to do so. Cash on the balance sheet is high, and so relevering should be an enduring theme, and historically has boosted P/E multiples,” UBS says.

Apart from corporate releveraging, UBS says it believes the emergence of a positive employment growth trend “could provide a huge boost that the recovery is at least embarking on a path that could be self-sustaining. Investors will need time to confirm that trend, and that it is strong enough to be sustained even if stimulus were to be gradually withdrawn at some future point.”

One dampening factor is the return of political interference in the economy, signaled by the federal government’s rejection of the bid for Potash Corp. “Though it appears to be a unique situation, the implications include potentially lower valuations in the oil sands and other resource areas,” UBS says.

Risks in the current environment, both upside and downside, remain much higher than normal, UBS adds, including: the role of China and other emerging markets in shaping resource demand and prices; the U.S. recovery, which affects the export environment for the industrial and technology sectors; and the domestic economy, which shapes the financial, consumer and telecom sector calls.

“The major upside scenario includes perhaps the surprising emergence of sustainable employment gains which would boost resource prices, earnings generally and valuations. While downside risks are the opposite of that, and have to include renewed financial tremors, an additional consideration for international investors is that the path of the [Canadian dollar] will exacerbate returns in either direction, and positive economic and fiscal fundamentals have caused it to trade at a premium to levels indicated by commodity prices alone,” US says.

Its highest conviction ideas for a 12-18 month horizon are all buys: Barrick Gold Corp, Canadian Tire Corp, Cenovus Energy, First Quantum Minerals, Onex Corp, Quebecor, and Royal Bank of Canada.

IE