Here's What We're Thinking...

October 17, 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

Synchronized global upturn reinforces bullish fundamentals

  • Strategy: Global markets have continued to grind higher in recent weeks despite volatile headlines thanks largely to supportive medium-term market fundamentals.  In particular, economic growth across major economies is hitting 7-year highs while the recovery has broadened out into a global synchronized upturn for the first time since the 2008/09 financial crisis. We expect this to continue into 2018 as well with unemployment rates remaining low and central banks keeping monetary conditions at stimulative levels despite some very modest interest rate hikes. Most of our indicators point to ongoing economic recovery with the earliest start to a recession pointing to 2019 with many indicators suggesting this may not start until 2020. Thus, there remains ample time left in the current equity bull market to view any near-term pullback (5%-10%) in stock markets as an attractive opportunity to put cash to work. We believe investments closely correlated with economic growth trends (cyclical assets) should outperform given our constructive global macro-economic outlook. As a result, we are overweight equities versus bonds with a preference for cyclical sectors (industrials, financials, materials, energy) and Canadian/international exposure over the U.S. for 2017/18. The near-term focus for markets includes third-quarter earnings reports (we expect results to beat modest consensus estimates), the naming of the next Federal Reserve Chair, a possible breakthrough or breakdown in NAFTA renegotiation talks, the European Central Bank’s expected announcement (Oct. 26th) to moderate monetary stimulus, and ongoing headline risks around possible U.S. tax cuts, North Korean missile tests and U.S.-Iran tensions.
  • Equities: In addition to our overweight in Canada, Europe and Emerging Markets at the expense of the U.S., we are encouraged to see the Pacific region (Japan & Australia) finally joining the risk-on regime within equities. For Japan, we believe Japanese investors could be selling their foreign bonds in favour of domestic equities on the back of rising global yields and improving Japanese economic data. Australia, in our view, is benefitting from a stronger currency and firming commodity backdrop.
  • Third quarter earnings reporting is underway in the U.S. and early indications are for another robust season with 81% of companies reporting EPS surprises above consensus estimates thus far and 78% reporting a positive sales surprise. We continue to see evidence that global equities offer better relative value than fixed income investments and remain an under-owned asset class. As a point of reference, the S&P 500 earnings yield (earnings/price) currently sits 168bps above that of the yield on 10-year U.S. Treasury bonds, leaving equities at the cheap end of their post-1960 relative value range versus fixed income.
  • Fixed income: Curve flattening has created opportunity in energy, in our view. Over the past two weeks, markets have seen a drastic flattening of the Canadian yield curve; 10-year yields have fallen 9bps while 2-year yields have remained flat. This was precipitated by comments from Bank of Canada officials that cooled off expectations about the pace of future rate hikes and emphasised data dependence in policy decisions. The shift in the curve has created opportunities in both the A and BBB sectors. For the BBB sector, both senior independent and integrated oil and gas producers have seen spread widening. In the A sector, deposit notes in the belly of the curve have widened out slightly. Both energy and financials remain part of our cyclical overweight recommendation, so cash could be deployed to these areas, in our view.
  • Preferreds: The preferred share market’s late September momentum carried into October. Thus far in October, the overall preferred share market, as represented by the S&P/TSX Preferred Share Index, has advanced 1.76% on a total return basis. This gain has been supported by rate resets, which have delivered a total return of 1.90% as measured by the Solactive Laddered Preferred Index. Each segment in the market has displayed positive returns with rate resets up 1.48% (price basis) alongside +0.93% and +0.92% gains in floaters and straight fixed perpetuals, respectively. The market as a whole has benefited from an improvement in credit spreads, which currently sit near cycle lows notwithstanding the movement in underlying interest rates. In addition, the lack of new issuance has helped to bolster demand within the secondary market.
  • Recent financing activity has also sparked demand for outstanding Canadian non-viable contingent capital (NVCC) rate resets based on the thought that new types of financial instruments may reduce the likelihood of near-term preferred share issuance from banks into the Canadian marketplace, enhancing the scarcity value of the outstanding preferred shares. Although we suspect this new type of financing may lead to a near-term supply disruption for Canadian bank preferred share issuance, we do not believe that this would completely undermine the potential for future Canadian NVCC preferred share offerings. We maintain our positive outlook for the preferred share market with the expectation that credit spreads remain constructive alongside upwardly biased underlying interest rates. 

Currencies & Commodities

Copper Rebounds from September Dip; WTI Crude Oil Continues to Hold Above US$50/bbl

  • Copper is surging once again after taking a breather in September. The commodity is up ~10% from its September lows, hitting three-year highs earlier this week and is bringing base metals equities along for the ride. In particular, this week’s move higher in the commodity was likely driven by much better-than-expected Chinese economic data released over the weekend, specifically producer prices, which were firmer on the back of higher infrastructure spending. If the U.S. dollar remains soft over the next year, base metals will likely extend their upward trend and outperform the rest of the commodity complex, in our view.
  • WTI crude oil continues to trade above the psychologically significant US$50/bbl level as geopolitical developments over the last week helped support the commodity. Concern that a possible conflict between Kurdish and Iraqi military forces in northern Iraq could disrupt important oil supply in the region sparked a jump in prices. Also supportive of the price of WTI was a continued drift lower in the U.S. oil rig count. Data from October 13 showed that the U.S. oil rig count declined by 5 week-over-week. This now brings the rig count down by 25, or 3%, since the highs in August. The fundamental demand/supply backdrop for crude oil remains constructive, supporting energy equities, in our view.

Economics

The ECB expected to lay out its 2018 plan; China’s twice-a-decade National Party Congress kicks off

  • Recent releases of economic data in Europe could pave the way for the European Central Bank to start tapering its Quantitative Easing program soon. The final reads of September’s inflation reports confirmed that inflation trends are stabilizing around 1.5% while Eurozone economic growth momentum remains solid, pointing to a 2.3% expansion this year. These trends should provide the ECB with the needed confidence to taper its monthly asset purchases as soon as early next year. The governing council of the ECB is meeting next week (Oct. 26th) to discuss its monetary policies and many are expecting the central bank to lay out its plans to dial-back its extreme monetary policy accommodation setting. The ECB currently buys €60bn worth of both private and public sector securities on a monthly basis and the monetary easing program is intended to be carried out until the end of this year. Economists are expecting the Asset Purchase Program (APP) to be tapered starting early next year at a gradual pace and would eventually come to an end at some point later next year or in 2019.
  • China’s long-anticipated once-every-five-year National Party Congress will kick off tonight and many economists expect policy makers to deepen economic reforms and continue to shift the growth model away from investment toward consumption. Economic data releases in the past two weeks have been supportive ahead of the gathering. The September consumer price index (CPI) was in line with estimates, while the producer price index (PPI) topped expectations. Meanwhile, imports registered a strong beat thanks to rising volumes across key commodities, although exports disappointed. Aggregate financing along with new Yuan loans indicated increased activity in the credit market. The strong read of PPI along with rising volumes in commodity imports signaled that manufacturing activity as well as construction spending, which includes government-led infrastructure investment, continues to spur economic growth in the world’s second largest economy. The leadership meeting, which typically runs for one week, will likely witness a reshuffle in the top decision-making committee within the party, while President Xi Jinping will most likely stay on for another term as the General Secretary of the Communist Party of China. Note that China’s Q3 GDP number will be released later tonight and economists are expecting 6.8% growth on a YoY basis versus Q2’s 6.9% rise.

Geopolitical

NAFTA negotiations enter critical stage

  • The fourth round of NAFTA negotiations has concluded amid rising contention. Headlines published today have reported that Mexico and Canada have rejected U.S. demands regarding dairy, autos, dispute panels and a sunset clause. These U.S. demands were expected heading into the beginning of talks this week but it was not known how aggressively they would be pursued. Canadian government yields and the Canadian dollar both fell in response to the headlines. Canada and Mexico both stated that they are open to continued negotiations on these topics, while Bloomberg notes progress was made in other sections of the fourth round. These less contentious topics are focused on updating aspects of the current agreement. As for the rest of NAFTA negotiations, a new schedule is being proposed that will extend talks into 2018 which will give the three governments more time to hash out details of these and many more cross-border topics.

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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