Portfolio Advisory Group
Here’s What We’re Thinking ScotiaMcLeod Portfolio Advisory Group May 15, 2015 Equity valuations remain stretched; opportunities remain elusive; we recommend holding higher cash balances May 15, 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: Equity valuations remain stretched; opportunities remain elusive; we recommend holding higher cash balances  Equities: We are holding above average cash positions as we continue to believe that Canadian and U.S. equities are fully‐valued and clear opportunities remain elusive. With Q1 earnings season drawing to a close, earnings estimates for the remainder of the year have declined with the consensus forecast now expecting a modest 0.5% increase in S&P 500 earnings over 2014. While Q1 earnings were better than expected (expectations had declined to overly pessimistic levels), top‐line results were lackluster. Corporate revenue and earnings continue to face the ongoing headwinds of a relatively strong U.S. dollar and at the same time, U.S. economic data has been mixed. This presents a challenging environment for equity markets, particularly as valuation levels appear somewhat stretched with the forward 12‐month P/E on the S&P 500 at 17.1x and the TSX at 17.3x. While we believe equities will outperform other asset classes this year, returns are expected to be much more modest than we have seen in prior years – likely in the mid to high single digit range. Although volatility could persist in the near term, we could also be persuaded by the view that equities simply remain range bound as we enter the summer months. In that case, additional cash may lend itself to exploiting short term tactical opportunities. 2
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Fixed income: So far this year we have continued to advocate for a segmented approach to fixed income. In the early part of the year, as rates trended lower and markets braced for another potential Bank of Canada rate cut, we suggested investors focus on GICs in the 1‐5 year area, higher grade, liquid provincial credits (particularly Ontario and Quebec) in 5s‐10s, and potentially look to engage tactical trades at the longer end of the yield curve (Canadian government bonds or US Treasuries). This positioning, we believed, would provide maximum liquidity/flexibility in the event that rates began to unwind, as indeed they have. Until rate markets begin to demonstrate a more persistent trend, investors should remain short duration (i.e. reducing/closing exposures in the long end and middle part of the curve) and defensive. We remain cautious on High Yield (HY), particularly in the energy space as the current risk/reward proposition appears inadequate to us. The potential impact of secularly rising interest rates and rising default rates, if relatively low oil prices persist, suggests that HY spreads remain too low. 
Preferreds: Since reaching a low on April 21, the S&P/TSX Preferred Share Index has rebounded +4.03% with rate resets leading the Index higher as represented by the +5.88% gain in the S&P/TSX Preferred Share Laddered Index over the same period. Negative sentiment within the rate reset space has subsided in recent weeks as Bank of Canada rhetoric turned more constructive on the Canadian economy, signaling that the likelihood of a second rate cut is fairly limited. Consequently, underlying Government of Canada 5‐year benchmark rates have trended higher from 0.89% to 1.09%, helping to support the price performance of rate resets. With the market shifting to a more positive note, we became more constructive on the preferred share market about two weeks ago, as we started to see rate resets gain traction. Although we remain constructive on the preferred share market at the present time, we expect the illiquidity of the market to continue to cause large price swings among securities, particularly with the trading impact of ETF activity (i.e. where entire baskets of securities are purchased or redeemed within a short time frame). We continue to see opportunities within the rate reset space, however, and emphasize the importance of looking at yield not price as securities in an illiquid market can see price swings on a limited number of shares. In the past, we have recommended non‐NVCC bank rate resets; however, we believe these are now Portfolio Advisory Group
fairly valued. Good quality companies with longer‐dated resets continue to offer attractive yields with further upside potential if rates continue to move higher Capital Markets: Fixed Income volatility could persist but the global backdrop remains largely unchanged; China continues to face headwinds 
Over the past four weeks fixed income markets have experienced significant volatility, leaving global debt markets rattled and North American yields effectively back where they started 2015. Although the move higher in yields seemed to be initially spurred by comments from high profile bond managers suggesting that German Bunds represented “the short opportunity of a lifetime”, further credence seemed to be given to global re‐pricing when Fed Chair Yellen responded that market participants could see a sharp jump in long‐term rates after Fed liftoff. The volatility was compounded by the impact of high frequency Treasury trading, carry trade unwinds and lower market depth/liquidity resulting from tighter regulatory standards. Given the impact of this shifting landscape, volatility could persist, in our view. Having said that, the recent sell off is likely overdone, particularly given our increasingly collective view that Fed lift off may come later in the year (if at all) as US economic data has yet to convincingly make the case that Q1 softness has actually been transitory. As well, the key underpinning of lower global rates has been the impact of ECB QE. Although the anchor has seemingly been raised for the moment, the persistent unwind of European yields would threaten the European recovery, something that the ECB will likely push back against. The bigger picture here is that rate normalization will likely see significant bouts of volatility, and overshoots, as markets normalize. The fundamental backdrop of lower global growth and low inflation has not changed, in our view. 
The Chinese central bank lowered its lending and deposit rate by ‐0.25% which is the 3rd cut in 6 months. This move coincides with some of the weak economic data that have been released including: exports (‐6.2% vs. 0.9% est.), imports (‐16.1% vs. ‐8.4%), retail sales (10% vs. 10.4%) and fixed asset investments growth (12.0% YOY vs. 13.5%). As well, surveys of manufacturers showed factory employment in April fell to its weakest level in a year. Although China has said it is ready to move away from an economic model based on export growth, the transition remains a challenge for Beijing. Doubts linger as to whether the country will meet its 7% growth target for the year. 
With 455 companies from the S&P 500 Index having reported Q1 results to date, 68% have reported positive earnings surprises with Q1 earnings tracking toward $27.62 versus $27.60 last year, indicating 0.07% YoY earnings growth versus consensus estimates that anticipated a 3.0% decline. Economics: U.S. data still not demonstrating “transitory” Q1 weakness; Canada continues to surprise but we remain cautious; Alberta no longer blue…but Orange? 
US job growth rebounded in April (+233K vs. 228K est.) yet it was disappointing to see the March figures revised down to +85k. The US trade balance also remains a concern as the U.S. deficit widened substantially in March (‐US$51.4B vs. –US$41.7B). U.S. retail sales disappointed in April (0.0% vs. +0.2% est.) which continues to bode for a softer second quarter. Finally, US import prices were down –0.3% m/m in April, effectively a –10.7% y/y decline. Although the bulk of the import price declines appear to be due to falling oil prices (ex‐oil, import prices were down only –2.7%) the overall impact of recent US dollar strength has been somewhat deflationary. So far, the argument for transitory Q1 softness remains unconvincing, in our view, while the impact of a stronger USD continues to act as a headwind. 
Canada’s April employment data did show some strength in the details, despite printing at worse than expected headline levels. April’s job data printed at ‐19.7K (vs. ‐5K est.). Job losses were concentrated in part time jobs while full time jobs increased by +47K. The market’s focus has remained on the oil‐producing regions. Alberta’s resilience was surprising, adding more jobs than any other province in April. Markets May 15, 2015
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Here’s What We’re Thinking
priced in a lower probability of another Bank of Canada rate cut following relatively hawkish comments from Governor Poloz, who stated “there is no need to take further action”. However, it may be too soon to see the repercussions of the fall in oil, and expectations could shift as we move through the balance of the year. 
The results of the Alberta election have sparked concern within the energy space after the New Democratic Party beat both the PC’s and Wildrose parties in a landslide victory. The party won 53 seats in Alberta’s 87‐
seat legislature capturing a majority, while the Wildrose claimed second, making it the official opposition party. Although the polls predicted the outcome in the end, this was an unanticipated outcome heading into the elections, marking a major shift to the left for a province that historically has elected “right‐wing” governments. The potential impact on the province remains uncertain as the central framework of the NPD platform was to review the royalties structure within Alberta, raise corporate income tax from 10% to 12%, apply more stringent environmental policies and to step away from publicly supporting pipeline initiatives (e.g. Keystone and Northern Gateway). Other economic policies promised during the campaign, which could impact the Alberta market if enacted, include a major hike in the minimum wage from $10.20 to $15 an hour over the next three years, replacing the province’s current flat tax by four new progressive brackets, and protecting lower and lower‐middle income workers against a tax hike by a promise to cancel fee hikes and a proposed health levy. In general, the expected impact to Alberta‐based energy companies is an increase in costs on both an absolute‐basis and relative‐basis compared to peers located in other jurisdictions. Having said that, we’d expect that the tone of these initiatives will likely soften somewhat as the government begins to engage the private sector. Geopolitical: Iran nuclear agreement continues to face headwinds; Recent bond market volatility highlights risks a Grexit could pose to European peripherals 4
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An Iran nuclear deal continues to face obstacles and potential delays. The US House of Representatives overwhelmingly passed legislation Thursday afternoon (400‐25) that could threaten to delay implementation of a nuclear deal with Iran (Iran Nuclear Agreement Review Act of 2015). President Obama has signaled he would sign the bill if it was adopted in the form passed by the Senate last week (98‐1). The legislation would ensure that Congress has the opportunity to review a final nuclear agreement with Iran. In effect, the Act would afford Congress a period of review and oversight between the US, its partners and Iran. The legislation also limits the President’s authorities to implement terms of a nuclear deal during the period of Congressional review. Britain, China, France, Germany, Russia and the United States – currently remain engaged in negotiations with Iran in the hope of achieving a final agreement by June 30. A "framework agreement" with Iran was announced on April 2. 
The Russian/Ukraine crisis has the potential to flare up again following the release of a report compiled by slain opposition leader Boris Nemtsov prior to his death. The report indicates the number of Russian soldiers in Ukraine is as high as 10,000 and that Moscow has spent 53 billion rubles (US$1billion) in military support for the pro‐Russian insurgency. U.S. officials are highlighting the possibility of a new pro‐Russian offensive that insurgents have been preparing for since fighting subsided in February. 
The Greek bailout crisis may have subsided for now, but there are still a number of risks present. On Tuesday, the ECB’s Governing Council raised the cap on Greece’s funding by €1.1 billion to €80 billion after the country’s renewed willingness to meet the ECB’s requirements. However the Greek government must convert its promises into policy action, which remains to be seen. We expect to see more of the same brinkmanship going forward, keeping in mind that Greece does have large debt redemptions due in July (€3.491billion) and August (€3.188billion). While the probabilities of a Grexit remain relatively low (Prime Minister Alexis Tsipras has stated that he’s not considering leaving the currency bloc and is focused on getting the aid he needs to avoid a default) Bloomberg did report this week that Euro‐area governments are considering putting together an aid package for Greece to cushion the country’s economy if it was forced Portfolio Advisory Group
out of the euro – a move which would effectively ring fence Greece both politically and economically in the event of an exit. Although we continue to see the likelihood of this event as low, recent fixed income volatility has highlighted the risk that such a move could pose to European peripherals – with or without cushions in place. Portfolio Advisory Group May 15, 2015
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Here’s What We’re Thinking
Recommended Asset Allocation
May 15, 2015
Underweight
Equities
Canada
U.S.
Fixed Income
Government
Provincial
Corporate
Preferred
Rate reset
Fixed perpetual
Cash
= Current recommendation

= Previous recommendation
Source: Portfolio Advisory Group, ScotiaMcLeod
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Neutral
Overweight
Portfolio Advisory Group
Important Disclosures The author(s) of the report own(s) securities of the following companies. None. The supervisors of the Portfolio Advisory Group own securities of the following companies. None. Scotia Capital Inc. is what is referred to as an “integrated” investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. As a result we recognize that we there are inherent conflicts of interest in our business since we often represent both sides to a transaction, namely the buyer and the seller. While we have policies and procedures in place to manage these conflicts, we also disclose certain conflicts to you so that you are aware of them. The following list provides conflict disclosure of certain relationships that we have, or have had within a specified period of time, with the companies that are discussed in this report. General Disclosures The ScotiaMcLeod Portfolio Advisory Group prepares this report by aggregating information obtained from various sources as a resource for ScotiaMcLeod Wealth Advisors and their clients. Information may be obtained from the Equity Research and Fixed Income Research departments of the Global Banking and Markets division of Scotiabank. Information may be also obtained from the Foreign Exchange Research and Scotia Economics departments within Scotiabank. In addition to information obtained from members of the Scotiabank group, information may be obtained from the following third party sources: Standard & Poor’s, Valueline, Morningstar CPMS, Bank Credit Analyst and Bloomberg. The information and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. While the information provided is believed to be accurate and reliable, neither Scotia Capital Inc., which includes the ScotiaMcLeod Portfolio Advisory Group, nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report is provided to you for informational purposes only. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Nothing contained in this report is or should be relied upon as a promise or representation as to the future. The pro forma and estimated financial information contained in this report, if any, is based on certain assumptions and management’s analysis of information available at the time that this information was prepared, which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will be realized Opinions, estimates and projections contained in this report are our own as of the date hereof and are subject to change without notice. Copyright 2012 Scotia GBM Inc. All rights reserved ® Registered trademark of The Bank of Nova Scotia, used by ScotiaMcLeod under license. ScotiaMcLeod is a division of Scotia Capital Inc. Scotia Capital Inc. is a member of Canadian Investor Protection Fund. May 15, 2015
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