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Canada’s main stock market index is approaching a record high. In a curious twist, that rally is being driven by simmering concerns about a weaker global economy.

But can Canadian stocks power ahead if the economic outlook brightens?

After gaining for nine of the past 11 trading sessions, the S&P/TSX Composite Index is now just 132 points, or 0.8 per cent, below the record set in April. Since the start of the year, the index has risen 15.5 per cent, closing at 16,537.34 on Tuesday.

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All 11 of the index’s sectors have contributed to the gains in 2019, suggesting a widespread rally.

But there are clear differences beneath the surface. Financials and energy stocks, which are closely associated with rising economic activity and strong oil prices, have been lagging the broader index with gains of 12.6 per cent and 8.2 per cent, respectively.

Conversely, utilities, consumer staples, real estate investment trusts and materials have been leading the rally with respective year-to-date gains of 26.1 per cent, 20.6 per cent, 17.8 per cent and 16.9 per cent, in what looks like a nod to approaching economic clouds. (Technology stocks, up 50.3 per cent, are also standouts, but the sector is largely driven by one company, Shopify Inc.)

Utilities, consumer stocks and REITs are relatively immune to shifts in the economic cycle, given that consumers rely on electricity, food and shelter through good times and bad. Gold producers, which reside within the materials sector, have surged 33.2 per cent this year as the price of gold (seen as a haven by some investors) hit a fresh six-year high last week.

What’s more, many of the companies within these leading sectors pay big dividends, which look particularly attractive when bond yields are falling. On average, utilities yield 4.2 per cent and REITs yield 4.4 per cent.

Compare these payouts to the yield on the five-year Government of Canada bond, which fell below 1.14 per cent last week – down from a seven-year high of nearly 2.5 per cent in October, 2018. Yields fall as bond prices rise.

Similarly, the yield on the 10-year U.S. Treasury bond slipped below 1.5 per cent in late August and early September, down from over 3.2 per cent in November.

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Clearly, financial markets expect that central banks will be cutting their key interest rates to bolster economic growth. And the fact that U.S. short-term bonds have been yielding more than long-term bonds recently – a rare reversal known as an inverted yield curve – suggests to many observers that a recession is brewing.

“Market expectations have deteriorated. Signs of a potential recession have increased with the yield curve inversion, increased stock market volatility, weaker PMIs [purchasing managers’ indexes, which are key economic indicators] and deteriorating confidence surveys,” DBRS, the credit-rating agency, said in a report released on Tuesday.

DBRS added that the Federal Reserve Bank of New York in late August put the probability of a U.S. recession within the next 12 months at 38 per cent – the highest probability since 2007, prior to the financial crisis.

But the Canadian stock market index can’t thrive on gloom alone, given its heavy exposure to economically sensitive financials, energy stocks and industrials.

Perhaps it doesn’t have to, given its reaction to rising bond yields over the past week.

The yield on the 10-year U.S. Treasury bond touched a one-month high of 1.44 per cent after rising for five consecutive sessions, including Tuesday. Yields on Government of Canada bonds have also risen over this period, suggesting either that a recession is not a done deal amid hopes that trade tensions between the United States and China are easing, or that financial markets are already looking beyond the next recession.

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“When a recession is just a few months away, there is a high probability that the economy will be back to growth twelve months later,” Eric Lascelles, chief economist at RBC Global Asset Management, said in a note.

Whatever the case, Canadian REITs and utilities have retreated over the past two days, reinforcing their sensitivity to bond yields. And financials and energy stocks have rallied over the past five days – raising the question of whether the next record high for the S&P/TSX Composite Index will be a triumph for optimistic bullish investors or a victory for the bears.

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