Here’s What We’re Thinking

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Here’s What We’re Thinking Global Portfolio Advisory Group The Investment Committee of the Portfolio Advisory Group meets regularly to formally discuss markets, sector allocation and investment recommendations. Below is a brief synopsis of our current views. For specific investment strategy relating to your investment portfolio, please contact your Scotia Wealth Management advisor.

Investment Strategy: Supportive market conditions maintain our constructive outlook. Near-term pullbacks will offer opportunities to build cyclical exposures. • Strategy: We see the medium-term (6-12 month) environment remaining constructive for risk markets. These supportive conditions include global central banks stuck in ‘easy money’ mode (ECB, BoJ, PBoC, BoE) and/or demonstrating patience (U.S. Federal Reserve) alongside a diminished size of the full rate hike cycle. As well, economic growth risks continue fading, the U.S. dollar’s appreciation looks capped, commodities (in particular oil and gold) are stable/recovering, cyclical sector and international market exposure remains cheap and under-owned, investor cash levels remain high and Q2 earnings reports largely beat expectations. We take heart in a variety of confirming signals over the past few months including value/cyclical sector outperformance, recovering fund inflows, improving economic data, etc. Following recent strong gains over the past two months, there is ample scope for near-term profit-taking pullbacks. However, we would use any material market weakness as an opportunity to deploy large overweight cash allocations. Our strategy remains biased towards recovering segments which benefit from the abovementioned conditions including cyclical equities, credit and emerging markets.

• Equities: Despite setting new all-time highs repeatedly over the past several weeks, the U.S. equity market appears to be plateauing as it awaits catalysts to propel it higher. To emphasize the importance of currency fluctuations, the S&P500 has delivered a total YTD return of 8.5% in USD but only 1.3% in CAD terms. Upside catalysts include evidence of earnings growth (next earnings season is two months away) and further entrenchment of the ‘lower for longer’ sentiment on interest rates that could drive already high P/E ratios even higher. Sluggish profit growth (vs. the 13% YoY consensus growth forecast for 2017) and a surprise rate hike by the Federal Reserve are the primary downside catalysts. We think the tug of war between these set of catalysts are likely to keep the U.S. equity market range bound in the near-term until one of these catalysts prevails. While the overall market may remain flat, sector rotation into cyclicals such as Financials, Industrials, Energy, and Materials could enhance investor returns. In Canada, the rally in commodities (Energy and Materials) has accounted for over 70% of the YTD 13.5% rally. With these sectors already discounting somewhat higher commodity prices than current spot prices, a substantial move higher for crude oil, gold, and base metals is required for these sectors to continue outperforming in the second half of 2016. Another attempt by OPEC and some non-OPEC members to freeze production levels at a September 26 meeting could be a catalyst for oil to breach the top end of its recent trading range (see below). We continue to view instances of market weakness as opportunities to deploy excess cash in portfolios. • Fixed Income: The last two weeks have seen strong new issuance and “risk-on” trades in the Canadian corporate bond market while short

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Here’s What We’re Thinking

government yields have moved higher. These moves have caused spreads on A and BBB rated short bonds to continue to tighten. Spreads have also tightened on longer dated BBB bonds as investors become more comfortable with taking on risk in the bond market. At the same time, Government of Canada yields have backed up, providing potential entry points for investors. Given our continued view of “lower for longer” we see interim increases in yields as opportunities to extend duration. • Preferreds: After a solid start to the month, the preferred share market has shown a bit of weakness over the last week. Underlying bond yields continue to be pressured with yields remaining relatively range-bound over the past couple weeks, while credit spreads have also remained tight. Bank reporting kicked off this week, starting with BMO yesterday – the remaining banks report over the rest of the week and into next week. The Big Six reporting schedule is as follows: BMO (Tues), RY (Wed), TD & CIBC (Thursday), BNS (Aug 30) and NA (Aug 31). We haven’t seen a bank issue since National issued its 5.40% NVCC rate reset (4.66% reset spread) in mid-June. If we were to see an attractively priced bank issue, likely in the 4.50%-5.00% dividend rate range, we would expect this to lead to near-term downside market pressure given spreads have tightened considerably on existing preferreds as prices have moved higher. The market will remain susceptible to ongoing volatility as the market digests the potential for further new issuance. We would recommend investors that are looking to put new money to work to be patient and wait for banks to finish reporting in the event we do see new issuance.

Capital Markets: Another attempt by OPEC to freeze production • Crude oil prices have rebounded almost 20% after declining below US$40/barrel earlier this month. While the decline was brought on by further increases in OPEC production, a modest but steady rise in U.S. drilling activity, and lacklustre declines in U.S. inventory levels, recent gains have been driven by renewed optimism that OPEC, Russia, and Mexico may agree to a production freeze at an upcoming meeting in Algiers on Sept 26. Compared with the

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Doha meeting in April, where Iran’s boycott dashed hopes for a deal, there are higher expectations for all members to at least attend the upcoming meeting. The primary reason for Iran’s no-show in Doha was that its production hadn’t rebounded to pre-sanction levels. Based on latest market data, however, Iran was producing at a rate of 3.725 million barrels/day in July, a 32% YoY increase and closing the gap considerably to Iran’s historical peak production of approximately 4.0 million barrels/day. We view an agreement to freeze production as a material catalyst that could allow crude oil to breach the US$50/barrel resistance level in the near-term. Ultimately, however, we think a return to supplydemand equilibrium is needed (likely in late 2017 based on current forecasts) for a sustainable oil price recovery.

Economics: All eyes on the Fed’s Yellen at Jackson Hole; China increasingly talks of ‘proactive’ fiscal policy • The near-term outlook for U.S. monetary policy has come to dominate market trends as of late and will likely continue to do so in coming weeks. The U.S. Federal Reserve’s next interest-rate policy setting meeting occurs Sept. 20-21 leaving markets to hang on every economic data release and comment from Fed officials in the interim. The next important event to focus on is this Friday’s scheduled address by Fed chair Janet Yellen to the Jackson Hole symposium. Given the topic of her speech is medium-term in nature (likely focused on how the Fed might respond to the next recession amidst historically low interest rates) and the minutes of the last FOMC meeting expressed ongoing patience, we expect her to provide only a modest mention of the current policy outlook with a balanced assessment of conditions. Our view is that the Fed remains divided about the need for a September rate hike and that a majority will vote for continued patience - making a December rate move the next likely opportunity. • Recent comments suggest a pivot towards a more ‘proactive’ fiscal policy in China is taking hold. In recent weeks there has been a steady stream of government officials including from the central bank, finance ministry and the national economic planning commission calling for increased fiscal spending and

Here’s What We’re Thinking

reduced corporate taxes to help stimulate the economy. In part, this increasing preference for fiscal policy support is a reflection of the growing acknowledgement that monetary policy is having a diminishing impact while also contributing to Chinese currency weakness which has been a source of global market instability over the past year. A sizeable boost to fiscal stimulus by Chinese authorities (if it materializes) could provide further support to emerging markets, commodities and general global market sentiment in coming months.

Geopolitical: China may broaden debt-for-equity swap to deal with elevated corporate debt levels; Deepening strains likely keep EU agreements elusive • A report from the Chinese government’s State Council indicates it may be considering broadening its current debt-for-equity swap program. Currently the program is limited to the state-controlled banking sector, who could convert their outstanding debts into equity of state-owned enterprises. With the expansion of the program the swaps would be available to business partners or suppliers to convert – for example, accounts receivable – into equity. Not only could this alleviate the current debt issue within

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China’s state-owned sector, but could also lead to lower borrowing costs and consolidation. However, the proposal has raised concerns over how the government might regulate the broader exchange market and the risks of loose oversight. • Leaders of the three largest remaining EU economies met this week in Italy to discuss the bloc’s future ahead of the EU summit on September 16th. The three were looking for common ground with economic growth, unemployment, migration and terrorism as foci for the meeting. This could prove difficult as each came with their own set of goals and hurdles. For French President Francois Hollande, the need for counterterrorism cooperation is paramount, but he is restricted by April elections and low opinion polls. Meanwhile Italian Prime Minister Matteo Renzi will be looking for authorization for tax cuts and spending increases, in order to get voters back on his side for the country’s referendum ahead of the end of the year. However, German Chancellor Angela Merkel spent a lot of political capital defending tighter fiscal discipline and is not likely to reverse stance. Wrap all of this in a political climate where new member states are more willing to speak up rather than let others set the agenda. This will make for a September summit where it could be hard to find common ground.

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Recommended Asset Allocation August 24, 2016 Underweight

Equities Canada U.S.

Fixed Income Government Provincial Corporate

Preferred Rate reset Fixed perpetual

Cash = Current recommendation

a

= Previous recommendation

Source: Portfolio Advisory Group, Scotia Wealth Management

Neutral

Overweight

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