Harbour Monthly. Higher bond yields spook stocks as economic growth rolls on. All For One: You. RBC Dominion Securities Inc.

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1 RBC Dominion Securities Inc. The Harbour Group of RBC Dominion Securities Harbour Monthly An Exclusive Newsletter for Our Clients and Friends October 2018 Main Reception: Toll-free: RBC Dominion Securities Brookfield Place Bay-Wellington Tower 181 Bay Street, Suite 1520 Toronto, Ontario M5J 2T3 Peter Coward, HBA Investment Advisor Graeme MacGregor Portfolio Manager & Wealth Advisor Christopher Newall Portfolio Manager John Grant, CFA, MBA, M.Sc. Vice-President, Portfolio Manager & Wealth Advisor Robin Gullason, CFA Vice-President, Lead Strategist Tiffany L. Harding, CFP, TEP, CIWM, CDFA, FCSI Financial Planner All For One: You Putting you first, every time, to help you navigate the complexities of managing your wealth. All of our team members, all of our resources, all of our collective insight. Higher bond yields spook stocks as economic growth rolls on October looks determined to maintain its reputation as a difficult month for the markets as a rise in bond yields pressures equities. What is important is that yield are rising for the right reasons strong economic growth and firming inflation. We think this is a normal correction, and see no signals currently that this is morphing into something more concerning. As Canada breathes a sigh of relief as NAFTA morphs to USMCA, trade tensions elsewhere will continue. This deal gives the Bank of Canada cover to resume raising interest rates but we wonder how much good news is left for the Canadian dollar. The sharp rise in bond yields continues to suggest overheating is a bigger risk than recession, and opens up an opportunity for preferred shares. The mid-term elections are likely to carry more impact than usual, but history has been kind to investors in the year afterward. The rotation from growth to value has not begun yet, but when it does we think the TSX and Emerging Markets will be beneficiaries. October not doing its reputation any favours It is early days, but thus far October is living up to its reputation as a difficult month for the stock market has been characterized by stronger than expected economic and earnings growth, while inflation indicators finally approach central bankers targets. It seems the bond market finally got the message, with yields now pushing to new multi-year highs. Indeed, shorter-term yields in the U.S. are now at their highest level since 2008! While investors soothed by a decade of ultra-low rates may have been taken by Continued on page 2

2 2 Harbour Monthly surprise, our view is, Finally! In our opinion, interest rates have been suppressed for far too long by central bank intervention, and we are relieved to see bond yields hitting levels that actually exceed long-term inflation rates. as bond yields hit cyclical highs on a strong economy We are comfortable with this development because it seems that bond yields are rising for the right reasons, driven by stronger economic growth and inflation returning to normal levels. Exhibit 1 shows 10-year U.S. Treasury yields and the West Texas Intermediate crude oil price, which is seen by many as a global growth barometer. The correlation between the two for the past two years has been quite strong, suggesting to us that both are reflective of growth breaking out of the 2%-range that has been seen for most of the economic recovery. Stock markets, on the other hand, have been uncomfortable with the sharp jump higher in borrowing costs, and this is completely normal. In fact, stocks often react negatively to any sharp change in economic variables, be it interest rates, currencies or commodity prices. What we find more interesting is the type of stocks that are being impacted the most by higher rates. The most logical area of focus is stocks that look like bonds, i.e. those with high dividend yields and steady cash flows. Think consumer staples, real estate, telecom and utilities. while growth stocks take the brunt of the selling Indeed, real estate has fallen by more than the S&P 500 since yields took off in late August (August 24 through October 11, 2018), but utilities and consumer staples have actually outperformed. What has done worse than all of the above? Technology stocks and the FANG stocks in particular. In fact, the FANG stocks have been underperforming the market since mid-year as seen in returning to normal levels. Exhibit 1 shows 10-year U.S. Treasury yields and the West Texas Intermediate crude oil price, which is seen by many as a global growth barometer. The correlation between the two for the past two years has been quite strong, suggesting to us that both are reflective of growth breaking out of the 2%- range that has been seen for most of the economic recovery. Exhibit 1 10-year yields and crude oil largely moving together Source: Harbour Group of RBC Dominion Securities, Bloomberg; as of 10/12/18 Stock markets, on the other hand, have been uncomfortable with the sharp jump higher month in (September borrowing Market costs, and Note this Outliers) is completely in most normal. cycles, In the fact, sectors stocks that often go react up negatively the most often to any go sharp down change the most in when economic sentiment variables, turns. be it interest rates, Exhibit currencies, 2 or FANG commodity stocks prices. underperforming What we find more since interesting mid-year is the type of stocks that are being impacted the most by higher rates. The most logical thought is stocks that look like bonds, i.e. those with high dividend yields and steady cash flows. Think consumer staples, real estate, telecom and utilities. Indeed, real estate has fallen by more than the S&P 500 since yields took off in late Source: Harbour Group of RBC Dominion Securities, Bloomberg The net impact of this latest uptick in volatility is that valuations have become much more attractive as the year has gone on. Even though the S&P 500 is still up year to date, the P/E ratio has come down sharply (Exhibit 3) as earnings have grown much Exhibit more than 2. Why the is value this of happening? the market. We don t value see of valuation those cash being flows an can impediment change Simply to further put, gains. the value of a stock should be the current discounted value of all the future cash flows it pays. When a stock does not pay a dividend and is not projected to for some time, all of the value is on cash flows deep into the future, and when interest rates rise, the present materially. We would note that this move also fits with the even simpler thesis we put forth last month (September Market Note Outliers) in most cycles, the sectors that go up the most often go down the most when sentiment turns.

3 3 Harbour Monthly leaving overall valuations quite attractive The net impact of this latest uptick in volatility is that valuations have become much more attractive as the year has gone on. Even though the S&P 500 is still up year-to-date, the priceto-earnings (P/E) ratio has come down sharply (Exhibit 3) as earnings have grown much more than the value of the market. We don t see valuation as being an impediment to further gains. NAFTA reborn, but no relief for the TSX The first day of October brought a sigh of relief for Canadians, as the tensions surrounding NAFTA dissipated over a weekend and left us with the USMCA. While there are some tweaks around the edges, from a broad economic perspective there should be essentially no change to the growth outlook, assuming it is signed by all parties. This leaves the Bank of Canada more leeway to resume raising interest rates and should be positive for capturing higher yields on bonds and for the performance of rate reset preferred shares. While Canada can now rest easy, we don t believe this is the last we have heard on the trade file. Remember, the U.S. administration s experience thus far has been more tariffs = higher stocks, and while we would argue the U.S. market has done well in spite of tariffs, don t be surprised if this thesis is pushed to its maximum, particularly when it comes to China. For better or for worse, we think this is something investors will have to live with and may take some time to resolve. We would note that Canadian interest rates and the Canadian dollar likely had a lot of good NAFTA news priced in, as the dollar jumped on the day of the news but has reverted back into its previous trading range. With the TSX failing to react to the recent trio of good news (i.e. NAFTA, LNG Canada green light and a potential acquisition in the energy space with Husky bidding for MEG Energy), we believe there is value emerging in some of the Exhibit 3 The silver lining: market valuations are easing Source: RBC Wealth Management; FactSet; data through 10/11/18 Exhibit 4 TSX forward P/E minus S&P 500 forward P/E The first day of October brought a sigh of relief for Canad surrounding NAFTA dissipated over a weekend and left u there are some tweaks around the edges, from a broad e should be essentially no change to the growth outlook, as parties. This leaves the Bank of Canada more leeway to r and should be positive for capturing higher yields on bon of rate reset preferred shares. While Canada can now rest easy, we don t believe this is the trade file. Remember, the U.S. administration s exper What could be a catalyst for better performance out of the TSX? We believe Exhibit 5 holds some clues. In both March and June we saw a bounce in Canadian heavy oil prices coincide with stronger returns for the TSX compared to the S&P 500 in unloved parts of the Canadian equity a improving P/E ratio if investors go Canadian dollars. While timing a reversal is difficult, historically sharp drops such as market, namely utilities, telcoms and looking for safety again. As seen in we are experiencing now have reversed themselves just as violently. potentially even energy infrastructure. These are sectors where we can capture high tax-advantaged current yields, and have some potential for Exhibit 4, the TSX is trading at the largest discount to the S&P 500 in 15 years.

4 4 Harbour Monthly as oil prices hold the key What could be a catalyst for better performance out of the TSX? We believe Exhibit 5 holds some clues. In both March and June we saw a bounce in Canadian heavy oil prices coincide with stronger returns for the TSX compared to the S&P 500 in Canadian dollars. While timing a reversal is difficult, historically sharp drops such as we are experiencing now have reversed themselves just as violently. Emerging markets are another pocket of value Emerging markets are another pocket of value that has opened up as trade tensions with China and a strong U.S. dollar have pressured valuations. Exhibit 6 shows RBC Global Asset Management s fair value bands for emerging markets, with current values sitting at the lower end of the bands. While we can t be certain of timing, we think there is scope for a return to outperformance for emerging markets equities when sentiment turns. Studying for the mid-terms Two years of post-trump election politicking will come to a head on November 6 as Americans go to the polls in what will largely be viewed as a referendum on Trump s term in office thus far. While much ink will be spilled on the different election permutations and the outlook for markets, history suggests the election should not be an impediment for market returns. Exhibit 7 from our colleagues at RBC Global Asset Management shows that under the three likely scenarios this election, the S&P 500 has put up average or better compounded returns in the two years following the election. Further, going back to 1950, there has never been a down 12-month period for the S&P 500 following the mid-terms, with an average gain of 15.3%. While records were made to be broken, we can t help but be encouraged by the historical batting average. What could be a catalyst for better performance out of the TSX? We believe Exhibit 5 holds some clues. In both March and June we saw a bounce in Canadian heavy oil prices coincide with stronger returns for the TSX compared to the S&P 500 in Canadian dollars. While timing a reversal is difficult, historically sharp drops such as we are experiencing now have reversed themselves just as violently. Exhibit 5 Western Canadian select discount to WTI Exhibit 5 merging markets are another pocket of value that has opened up as th China and a strong U.S. dollar have pressured valuations. Exhibit obal Asset Management s fair value bands for Emerging Markets, lues Source: sitting Harbour at Group the of lower RBC Dominion end Securities, of the Bloomberg bands. While we can t be certain nk there is scope for a return to outperformance for Emerging Mar hen sentiment turns. Exhibit 6 Emerging market datastream index normalized earnings & valuations Source: Datastream, RBC GAM. wo years of post-trump election politicking will come to a head on N mericans go to the polls in what will largely be viewed as a referend ump s term in office thus far. While much ink will be spilled on the ection permutations and the outlook for markets, history suggests t ould not be an impediment for market returns. Exhibit 7 from our c BC Global Asset Management shows that under the three likely scen ection, the S&P 500 has put up average or better compounded retur

5 5 Harbour Monthly Bottom line Abrupt market corrections like we are experiencing right now are always unnerving. Throughout this cycle we have always done our best to step back and look at the bigger picture when evaluating what actions to take in portfolios. From that lens, the outlook remains constructive, and we think this is another normal correction. While they never feel all that normal while we are living through them, as we have stated before, living with flare-ups in volatility is the price of admission for earning equity market returns. At the core of this recent market flare-up is a sharp rise in bond yields, but we feel that higher bond yields are unmitigated good news for investors. Getting bond yields back near historical levels will allow investors to de-risk portfolios and still remain on track to meet their financial goals. We are not there yet, but we are the closest we have been in a long time and look forward to the day where we can lock in attractive yields on safe government bonds once again. Exhibit 7 Political permutations Bottom Source: FiveThirtyEight, Line Predictit, Predictwise, RBC GAM Abrupt market corrections like we are experiencing right now are always unnerving. Throughout this cycle we have always done our best to step back and look at the bigger picture when evaluating what actions to take in portfolios. From that lens, the outlook remains constructive, and we think this is another normal correction. While they never feel all that normal while we are living through them, as we have stated before, living with flare ups in volatility is the price of admission for earning equity market returns. At the core of this recent market flare-up is a sharp rise in bond yields, but we feel that higher bond yields are unmitigated good news for investors. Getting bond yields back near historical levels will allow investors to de-risk portfolios and still remain on track to meet their financial goals. We are not there yet, but we are the closest we have been in a long time and look forward to the day where we can lock in attractive yields on safe government bonds once again. Historically, Mid-terms have not been an impediment to returns This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. / TM Trademark(s) of Royal Bank of Canada. Used under licence RBC Dominion Securities Inc. All rights reserved. 18_90451_L4B_049 (10/2018)