1. business and industrial
2. energy
3. oil

Portfolio Advisory Group
Here’s What We’re Thinking ScotiaMcLeod Portfolio Advisory Group February 10, 2015 We’re warming up to oil; Fixed income and preferreds to remain volatile as another rate cut is expected
February 10, 2015
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Here’s What We’re Thinking
Here’s What We’re Thinking 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 ScotiaMcLeod advisor. Investment Strategy: We’re warming up to oil; Fixed income and preferreds to remain volatile as another rate cut is expected 
Equities: Crude oil prices are in the US$50s/bbl, and there is still a ~2 million barrel/day surplus globally, but we think the foundations of a meaningful supply response have been laid by non‐OPEC producers, particularly in North America. Dramatic capital expenditure cuts announced by energy producers since the oil price slide started in October has resulted in U.S. drilling activity that is 25% lower than the November peak. In Canada, the seasonal winter surge in drilling is nonexistent as drilling rig activity is running 39% lower than last year (see below for further data on drilling rigs). With the path toward flatter North American production now more visible, we are becoming more constructive on energy equities. Our investment strategy during the past few months had been to high‐grade energy exposure by trading sideways into the highest quality producers (integrateds and senior producers), while maintaining an overall market weight exposure to energy. This defensive strategy has proven to be worthwhile as many of these equities have recovered most of their earlier losses. However, with many of these equities now discounting US$70‐US$80/bbl oil, we think it’s time to begin shifting to an offensive strategy by slowly returning to intermediate and junior producers which remain well below September 2014 levels. However, with balance sheets and dividend policies still on unstable terrain, we prefer to add this exposure via an ETF rather than selecting individual names. While the oil services sector could eventually experience significant torque under an oil price recovery scenario we are not ready yet to venture into this subsector. 
Fixed income: After strong U.S. employment data last week, we see two divergent groups participating in the U.S. bond market: those that feel the U.S. recovery is robust and are selling U.S. bonds as they feel yields are too low given the recent economic data, and those that are buying due to even lower benchmark yields in other jurisdictions and to seek safety from geopolitical risk. Day‐to‐day these two groups are creating heightened yield volatility. As such, we continue to favour staying with high quality names where spreads are more likely to contract or remain relatively stable given lower Canadian government bond yields. Given the ongoing cuts to energy spending and the lower Canadian dollar (which favours manufacturing), we continue to view the provincial bonds of Ontario and Quebec as relatively attractive. As well, provincial exposures would provide greater liquidity relative to corporate names should rates suddenly reverse course. In the BBB space, we view REITs as quality additions to a portfolio. 
Preferreds: The preferred share market was in freefall in January on the back of (1) ETF redemptions (2) a surprise rate cut by the Bank of Canada and the ensuing drop in the 5‐year Canada bond yield, and (3) Royal Bank’s NVCC rate reset issuance with a reset spread of a +2.74%, which set a new tone in the rate reset market. While it’s been nice to see some green on the screen in February, we are still expecting more price fluctuations on both short dated rate resets (2015, 2016) as well as in the floating rate sector as there is the potential for the Bank of Canada to cut its overnight rate further leading to lower underlying yields. At this time, rather than add preferred shares trading at a deep discount ‐ we recommend investors purchase longer dated rate resets which should be less volatile in price with near‐term movements in the underlying 5‐year GoC bond yield. 2
Portfolio Advisory Group
Capital Markets: Fed rate hike this summer back on the menu; Further idling of drilling rigs supportive for oil 
Spectacular U.S. employment data (see below) did not go unnoticed by the bond and currency markets, with short and long term U.S. Treasury yields increasing 12 and 14 bps, respectively, and the trade‐weighted USD strengthening 1.2% after the release of January jobs data on February 6th. The Street also revised expectations for the first Fed short‐term interest rate hike, raising the probability of a rate hike in June to 26% from 17% before January jobs data. The probability of a rate hike in September increased to 58% from 45% earlier. Meanwhile, with unemployment in the Eurozone stuck at double digit levels (11.4% in December) and January’s core inflation rate decelerating further toward dangerous deflationary territory (0.6% YoY, the lowest since the birth of the euro), the European Central Bank is likely married to ultra‐low rates for a prolonged period. Despite stronger than expected January employment data, the probability of another 25bps interest rate cut by the Bank of Canada at its March meeting remains above 50%. Recent economic data suggests further USD strength against the CAD and euro. 
The rapid decline in oil and gas drilling rig activity, particularly in shale oil regions, is giving us confidence that the bottom for crude oil prices may have passed. The weekly active rig count, as reported by Baker Hughes, showed a further decline of 87 rigs in the U.S. (5.6% WoW decline, and 25% cumulative decline since the November high), with the largest drops in Texas (home of the Permian and Eagle Ford shale basins) and North Dakota (Bakken basin). While these declines are significant, total U.S. oil production remains at multi‐decade highs as there tends to be a lag of up to six months between drilling and production of oil. Should the decline in rig activity continue at this pace, we continue to expect total production to begin leveling off by mid‐year and potentially decline modestly by year end. Enhanced by technology, increased drill rig productivity in recent years means that rig count data is important to monitor but the impact on total production may be less predictable than historical experience. Although reduced activity in the sector is a reason to be optimistic that oil prices will rise over the medium‐term, a growing strike by U.S. refinery workers is worsening a short‐term glut by increasing crude inventories further. 
With 328 companies of the S&P 500 Index having reported Q4 results to date, 71% have reported positive earnings surprises with Q4 earnings tracking toward $30.35 versus $28.46 last year, indicating 6.6% YoY earnings growth versus consensus estimates that anticipated 4.4% growth. Economics: The U.S. job market continues to shine bright; Why the U.S. fiscal deficit is no longer “news” 
Not only did January non‐farm payrolls beat expectations by a wide margin (257k vs. 228k est), the Bureau of Labor Statistics upwardly revised the previous two months data by an aggregate 147k jobs, raising the rolling three‐month jobs number to over 1000k for the first time in 10 years. In addition to the headline data there were other signs that indicate ongoing momentum, namely an increased participation rate (62.9% vs. 62.7% last month) and increased wage inflation (2.2% YoY vs. 1.9% last month). For those keeping track of job creation since the depths of the financial crisis, the U.S. has created 11.2 million net new jobs since the beginning of 2010 and 2.5 million jobs since the beginning of 2008 when the slowdown started. 
Ever wonder why the U.S. debt and deficit has disappeared from the news headlines? It’s because the U.S. federal deficit‐to‐GDP ratio has improved significantly to what is considered a sustainable level. As of the end of 2014, the U.S. fiscal deficit‐to‐GDP ratio had declined to 2.8%, a dramatic decline from 10.1% at the end of 2009. To put this into context, the average deficit ratio during Ronald Reagan’s “fiscally conservative” two terms was 3.8%. The U.S. Congressional Budget Office is projecting a deficit ratio of 2.6% for 2015 and 2.5% for 2016. The Republican controlled House and Senate will likely be mindful of this progress and the public disapproval during past debt ceiling debates when negotiating the next debt ceiling increase expected this spring or summer. February 10, 2015
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Here’s What We’re Thinking

Strong January employment data in Canada (jobs: +35k vs. 5k est; unemployment: 6.6% vs. 6.7% est) was a welcome respite from an otherwise gloomy start to 2015. However, many economists interpreted this data as underwhelming as all of the gains came from part‐time employment (full‐time jobs declined 12k) and because jobs data is regarded as a lagging economic indicator. Job losses in the oil patch are expected to hurt the national job picture in coming months. 
The People’s Bank of China’s decision to boost stimulus by cutting bank reserve requirements (the first cut in six years) was seen as a necessary step as recent data shows key industries are contracting. China’s official manufacturing PMI reading for January (49.8 vs. 50.2 est) dipped below the critical 50 level for the first time since 2012 indicating a loss in momentum. Chinese trade data for January was also disappointing as both exports (‐3.3% YoY vs. +5.9% est) and imports (‐19.9% YoY vs. ‐3.2% est) were well below expectations, and bode ill for some commodities (mostly metals) in the near‐term. Geopolitical: Could the rest of Europe call Greece’s bluff?; U.S. military aid headed to Ukraine? 
European leaders, the ECB and IMF continue to play hardball with Greece’s new Prime Minister Alexis Tsipras by refusing to give in to Greece’s demand to renegotiate its debt. Fatigue amongst lenders to Greece appears to have set in as some European leaders have started to openly weigh the merits of a Greek exit from the Eurozone. Meanwhile, Tsipras has already started to rollback some austerity measures ahead of a critical February 11 meeting among Eurozone members. 
The conflict in Ukraine is approaching a critical juncture as some European leaders press Russian leader Putin for a diplomatic solution, while the U.S. assesses further sanctions against Russia and whether to supply military aid to Ukraine to fend off Russian‐supported separatists. 
Iran and the U.S. stepped up rhetoric surrounding the need for a deal on Iran’s nuclear program, with a goal of agreeing to a framework by the end of March. Meanwhile, Israel’s Prime Minister Benjamin Netanyahu has been invited by Republican John Boehner to address Congress on March 3, where it is expected that Netanyahu will speak out against any agreement with Iran. The White House announced that President Obama, Vice President Biden and Secretary of State Kerry will not attend Netanyahu’s speech. 
Africa’s third largest economy and OPEC member Angola announced plans to reduce government spending by one‐third as the 1.8 million bbl/day of oil production bring in lower oil revenues at current oil prices. Portfolio Advisory Group 4
Portfolio Advisory Group
Recommended Asset Allocation
February 10, 2015
Underweight
Neutral
Overweight
Equities
Canada
U.S.
Fixed Income
Government
Provincial
Corporate
Preferred
Rate reset
Fixed perpetual
Cash
= Current recommendation

= Previous recommendation
Source: Portfolio Advisory Group, ScotiaMcLeod
February 10, 2015
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Here’s What We’re Thinking
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