Here's What We're Thinking...

September 6, 2017

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

Fundamentals remain solid; buy any Sept./Oct. seasonal weakness

  • Strategy: Markets have recovered from a recent bout of weakness but signs of hesitation and uncertainty remain. Risks surrounding geo-political events (North Korea nuclear weapons testing), domestic U.S. politics (widening Russia – White House probe, gridlock in Congress on health care and tax reform), natural disasters (Hurricanes Harvey and Irma), commodity price swings (oil falling/rising 10%), impending changes to monetary policy (Fed starting to shrink its balance sheet), etc. have resulted in markets trading in wider ranges over the late summer in thin trading conditions. These important event risks and the lack of a meaningful market correction of 7% or more for over a year-and-a-half while the S&P500 trades near recent all-time highs leaves the market susceptible to a pullback during the seasonally weaker September-October period. We would view a sizable pullback in markets as an opportunity to put any cash overweights to work given strong corporate fundamentals and low year-ahead recession risks. Canadian and international markets should continue to outperform the U.S. on USD weakness, broadening economic strength and cheaper valuations. From a sector standpoint, we prefer cyclicals to defensives, while credit is preferred over government bonds in fixed income.
  • Equities: Recent work by the Scotiabank GBM equity strategist has commented on narrowing leadership within the S&P 500 and S&P/TSX indices. For the former, on a quarter-to-date basis through yesterday’s close (05 Sep/2017), the Information Technology (+7.0% total return) and Utilities (+5.8%) sectors have been standout performers. The other nine sectors have delivered a far narrower range of returns (-1.7% to +2.2%). A modest decline in long-term interest rates (which tend to benefit the Technology and Utilities sectors) may help to explain this performance divergence, but so too may be some moderation in returns following the strong performance of the S&P 500 in the 12 months ended 30 June/2017, during which the index delivered an 18% total return including performance of 10%+ for six of its eleven sectors. A similar story has unfolded in Canada where the QTD total return (C$ basis) is flat for the S&P/TSX overall, with only Materials (+7.3% - helped by a base metals rally) and Telecom (+1.5%) in the green. This followed a one-year return ended mid-2017 of 11%, including 10%+ total returns for five of the index’s eleven sectors.
  • We believe a near-term pause in equity markets is a healthy development and remain of the view a modest near-term pullback is a possibility. However, with GPAG strategy work suggesting the next U.S. recession will not start until early-2019, we expect equities to continue offering relatively better value than fixed income and would view sell-offs as buying opportunities. We continue to believe sectors sensitive to the economic cycle should outperform in this late stage of the current expansion.
  • Fixed income: Canadian spreads have stabilized with lack of new issuance. Spreads stabilized last week after widening for most of August. Corporate Canadian spreads remain at the wides of this recent correction but a lack of new supply following bank earnings seemed to keep demand intact. There were some notable outperformers as telecom and integrated oil & gas producers recovered from underperformance earlier in August. However, bank subordinated debt and senior insurance bonds have lagged. We will keep our eye on these sectors in the coming weeks as they are both consistent with our cyclical overweight recommendation. Looking forward we are still wary of putting new money to work ahead of political uncertainty over the U.S. budget and debt ceiling. Once those risks have abated we would take advantage of any corrections within our long-term strategy of overweighting cyclical corporate sectors. GPAG recently published a short research piece on the credit cycle, and we believe we are still approximately 12 months from the end of the current credit cycle.
  • Preferreds: The market traded within a tight range over the last couple of weeks, breaking out to the higher end of its range following today’s Bank of Canada rate decision. The Bank of Canada announced its second rate increase of the year reversing the two stimulus measures that the Bank implemented in 2015. This rate decision sent bond yields soaring in Canada as the market was largely anticipating no change with 23 economists surveyed by Bloomberg expecting no change versus only 6 calling for a hike. The large upward movement in underlying yields is already positively influencing share prices, specifically within rate resets and floating rate preferreds. We remain biased toward the rate reset segment with the expectation that underlying interest rates will trend higher over the next twelve months, which should support further price appreciation. The lack of new issuance in the primary market should also continue to support demand for secondary issues, in our view. The floating rate segment of the market also provides some attractive opportunities; however, liquidity risk is a concern due to the smaller issue sizes within the segment.

Economics

BoC hikes on strong economy

  • The Bank of Canada (BoC) decided earlier today to raise its benchmark overnight rate target by 25bp to 1.00%.  While Scotia Economics had correctly forecasted a rate hike at today’s meeting, most economists surveyed by Bloomberg foresaw no change while markets had priced in only a 43% chance of a rate hike today. Scotiabank economists believe the statement from the BoC accompanying the decision was generally quite balanced, leaving the door open to further interest rate hikes in coming months. Bond yields jumped in response to the event with 2-year Canadas rising 8bp to 1.42% while the 10-year benchmark bond yield climbed 5bp to 1.91%. The Canadian dollar leaped 1.2% higher to US$0.8180, returning to two-year highs.
  • After solid growth in the first half of 2017 (6.9%), China’s August economic data releases are expected to show that momentum will likely hold up beyond the first half of the year. China’s official manufacturing Purchasing Managers’ Index (PMI) reported a strong beat last month, registering a 51.7 reading versus an estimate of 51.3 by economists. The Caixin manufacturing PMI, which captures smaller and medium-sized companies that are not covered by the official data, also surprised on the upside (act: 51.6 vs est: 51.0). August consumer price index (CPI) and producer price index (PPI) numbers will be released later this week and are both expected to show strength in the world’s second largest economy. Overall, August’s batch of economic data releases is expected to provide policy makers a comfortable cushion to widen and deepen reforms heading into a key political gathering in Beijing. The once-every-five-years National Congress of the Communist Party of China will open on October 18th, 2017. While President Xi Jinping is expected to consolidate his grip on power for the next five years as the party’s general secretary, a possible personnel shuffle within the top decision-making committee will be closely watched as a majority of the committee is due to retire at this congress. Investors will look for signs of any new direction in economic policy after the meeting, while restrictions on financial leverage as well as measures to cool the property market remain potential risks in the medium term.

Geopolitical

U.S. debt ceiling concerns stress T-bill market

  • Worries about a potential U.S. debt ceiling breach have been felt in the fixed income market. While most other markets remain calm, yields in the fixed income market have been pricing in the uncertainty surrounding a potential U.S. debt ceiling breach. Yields on Treasuries maturing after the deadline for a debt ceiling increase were higher than those immediately before. In fact, the Financial Times also notes the yield premium between maturity dates after and before the deadline has been significantly higher than the periods of time approaching past debt ceiling deadlines. Further evidence could be
    seen at a recent Treasury auction for four week notes - maturing just after the deadline – which drew the highest yield since the 2008 crisis. However, market anxiety has eased slightly since last week as a tentative agreement amongst U.S. lawmakers reached earlier today to attach the debt ceiling vote to a bill for Hurricane Harvey relief has calmed nerves. As the political jockeying plays out we would expect to see the probability of a debt ceiling increase - or lack thereof - being reflected in short term Treasury yields.

Disclaimers

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.

Scotia Capital Inc. is a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund

General Disclosures

The ScotiaMcLeod Portfolio Advisory Group prepares this report by aggregating information obtained from various sources as a resource for HollisWealth 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.

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