National Bank Financial says that it is continuing to underweight equities, as it expects the mergers and acquisitions boom to cool and interest rates to rise.

“North American equities have been propelled in 2007 by two drivers, earnings growth and a global M&A boom. But rising interest rates have lately knocked the bulls off their pace,” it notes in a new report.

NBF says that years of low interest rates created the perfect environment for several higher-risk asset classes. “With long-term real-return bonds issued by the U.S. Treasury yielding less than 2.5% or even 2% since 2002, many pension funds and insurance companies have understandably turned to riskier asset classes in search of higher returns. Now that many central banks (including China’s) are tightening simultaneously, nominal and real interest rates seem to be rising across the yield curve. The rise in real long rates could lead to repricing of many asset classes,” it cautions.

“The M&A boom is at risk,” NBF adds. “A high proportion of deals have been financed with borrowed money. As rates have risen over the last month, the weekly value of global M&A announcements has fallen to the lowest this year.”

“Yet another effect of higher interest rates is to prevent an expansion of multiples. A year ago the S&P 500 was trading at 13.6 times 12-month forward earnings. The forward P/E is now 15.2. Multiples tend to expand when long rates are falling, not rising as at present,” it notes.

“Since we expect M&A activity to continue cooling and earnings downgrades to intensify as U.S. economic growth slows and the Canadian currency appreciates, we continue to underweight North American equities,” it says, adding that its one-year target for the S&P/TSX remains 12,800, 16 times 12-month estimated earnings, and its 12 month target for the S&P remains 1500, also 16 times expected earnings.

“In sector rotation, to protect our portfolio from higher interest rates, we continue to be cautious on Energy, Materials and Information Technology,” it concludes. “We have downgraded Utilities in view of likely Bank of Canada tightening. We continue to believe that Telecommunications and Consumer Discretionary stocks will outperform the market.”