How does recent market action impact our strategy?

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1 October 15 th, 2014 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor How does recent market action impact our strategy? Stock market outlook Two weeks ago, we provided our quarterly market outlook. When we wrote that report, the TSX was trading just under the 15,000 level. In the intervening two weeks, volatility in equity markets has picked up sharply and the TSX had a number of days of sharp declines. Since month end, the TSX has fallen 6.2% while the S & P 500 is down by 4.7%. From their respective 2014 peaks, the TSX is down 10.6% and the S & P 500 down 6.9%. The greater loss for the TSX is attributable to its relatively heavier weighting in the back-end-of-cycle sectors. For example, the price of oil is down sharply from the latter part of June by 22.2% and since the end of August by 14.6%. Thus, the energy as well as the basic materials groups with a higher weighting in the TSX than in the S & P 500 have created a greater drag on our index. It is always somewhat of a mug s game to try to forecast where the market is going in the very short term. However, both the TSX and the S & P 500 have been showing some signs of getting oversold in recent days if, for example, the vast majority of stocks (i.e. 90%) in an index decline for two days in a row, that is more than likely to be the sign of an end to a correction rather than something more serious. This very high proportion of declining versus advancing stocks certainly occurred in the last two trading days of last week. In addition, in the case of oil we saw quite a one day reversal last Friday. On Friday, the WTI oil price closed at $85.51 but it had touched a low during the day of $ It was net down $0.26 on the day. A classic reversal signal would be when a stock or commodity is down sharply during the day but manages to close above the previous day s closing price. Even more reliable is a reversal where the same phenomenon is observed on a weekly basis. On Tuesday October 14, however, the price was back down sharply again to a closing number of $ Thus, one can t make any definitive statements about the oil price weakness being over but, if the US dollar marks time or pulls back against a basket of other currencies for a few weeks (it has been slightly down in the first half of October after rising a sharp 8% from mid-year), there is a decent prospect of some kind of a bounce short term in the price of oil. Clearly, whatever the short term course of the oil price, expectations of future cash flow levels in the sector will be revised downwards. On the other hand, some of the Canadian economic numbers such as the recent employment figures and gains in manufacturing have been very positive of late and so it would be premature to be downgrading TSX EPS and CFPS forecasts for next year at this stage. In essence, we have been using a 10-year average historical multiple for the appropriate investment criterion and applying it to consensus forecasts for EPS, CFPS and Book Value for the TSX and to EPS alone for the S & P 500. As explained in our October 1 Market Outlook that gives a target for the TSX of 15,800, which from current lower levels than at the beginning of the month gives an upside potential of 12.6%. With the expected dividend

2 yield, that gives a potential total return of over 15%. In the case of the S & P 500, if we use a similar projected P/E of 15.5 times (the TSX s last 10- year average) on blended forward 12-month EPS, we get a target of 2,000 for a more modest capital gain and a total return about half of that for the TSX. Equity Strategy We have made some adjustments in the Anchor funds over the last couple of months. Chiefly, that has comprised of profit taking in sectors that have done very well over the last year and where valuations had appeared to us to be getting stretched. Thus, as observed in previous Anchor Notes, in that same time frame, we have trimmed our holdings in Enbridge, Pembina Pipelines, Canadian National Railways and to a more modest extent in the Canadian banks. Largely, we have reinvested those profits in more defensive areas principally initiating a full position in Emera and adding to our holdings of Fortis and Telus. We have confidence in the dividend growth prospects for these companies. In hindsight, we would have done well to have taken profits in our holdings in the energy sector a couple of months ago. With additional modest positions in basic materials in the Anchor Dividend Growth and High Income funds, our overall exposure in those two funds has been in the 22%-24% range. Where do we go from here? Clearly, we have been surprised by the extent of the weakness in the oil price. We think it was partly due to the totally unexpected move by Saudi Arabia the world s swing producer to lower its price to Asian buyers to gain market share. Weakening global economic activity has impacted the demand side of the oil situation while, aside from Saudi Arabia, other OPEC producers including Iran have increased their discounts to Asian buyers to preserve their market share, thus increasing supply. Venezuela s oil minister has called for an emergency meeting of OPEC members (the next formal meeting is not due until November 27) but this plea has so far fallen on deaf ears. Strength in the U.S. dollar has also weighed on oil as it has with other commodities. However, recently Fed officials have been publicly questioning raising the Fed funds rate in the face of weaker global economic activity. This could halt the rally in the U.S. dollar in the short term, although unlikely to change its long term upwards trajectory against the major currencies. Thus, with the WTI oil price on Tuesday October 14th trading down in the $82.30 area, which is getting close to the breakeven level for many U.S. shale oil producers, we could well see short term stabilization or even a modest recovery in the oil price and a bounce in energy stocks. Similarly, there have been fears in commodity markets about a hard landing in China. However, the September trade data, released on Monday October 13, showed that, on a seasonally adjusted basis, exports rose 3.1% month over month and 15.6% year over year to a new record high. Imports rose 11.7% month over month and 7.2% year over year. The copper price bounced off the $3.00 per pound level to $3.10 per pound the following day. In sum, we suspect that now is not the time to be cutting back our back-end-of-cycle exposure but would review our weightings on any recovery in these stocks as the fourth quarter unfolds. The message of slowing global growth and the attraction of North America as a safe haven for investment has resulted in renewed strength in government bond prices. The yield on 10-year U.S. Treasuries and GOC bonds has dropped sharply to 2.20% and 1.94% respectively. That has resulted in some utilities in the Anchor funds actually hitting new 52-week highs in the last two weeks. Emera and Fortis fall into this category. We also have healthy weightings in Brookfield Renewable Energy and Brookfield

3 Property Partner, which have also hit 52-week highs recently, following an increase in their new targeted distribution growth to 5-9% in each case. In addition, another of our holdings, Canadian Tire, has also touched new highs on a more ambitious long term growth plan, strong free cash flow prospects and potential return of capital to shareholders. In sum, the strength in bond prices and certain stocks with predictable, defensive characteristics attests to the likelihood that the world has entered a period of slower growth. In addition, the U.S., which has been considered a beacon of economic growth in the developed world, is likely to be facing a period of slower growth in the first half of next year. The ECRI Weekly Leading Indicators (WLI) registered a reading of 1.6% last Friday, which is the lowest since October The WLI tend to lead economic activity by about eight months. The good news is that the WLI are not forecasting a U.S. recession currently because the prospect of a recession would change our opinion that the current weakness in North American stocks is a correction in a bull market as opposed to the start of a new bear market. Now that Q3 earnings reporting season has started, we will be reviewing results against expectations but, historically over the last 50 years, the strongest period in the four year Presidential election cycle on average has been the six months following the mid-term Congressional elections, which are a month away. Those four weeks could well continue to be volatile and that is why we elected recently to reduce our equity weightings to 39% in our Anchor Defensive Income fund from 49%. Preservation of capital is a key objective in this fund and we always prefer to err on the side of caution. Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaMcLeod PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGE.

4 i The Bank of Nova Scotia is the parent company of Scotia Capital Inc. ( SCI ) and is therefore a related issuer of SCI. Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of SCI, is the manager of the Anchor. ScotiaMcLeod, a division of SCI is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on Anchor hold securities of the following issuers referred to in this note: Brookfield Renewable Energy Partners LP, Brookfield Property Partners LP, Canadian National Railway, Canadian Tire, Emera Inc., Enbridge Inc., Fortis Inc., Pembina Pipeline Corp., Telus Corp. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Brookfield Renewable Energy Partners LP, Brookfield Property Partners LP, Canadian National Railway, Canadian Tire, Emera Inc., Enbridge Inc., Fortis Inc., Pembina Pipeline Corp., Telus Corp. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice. The statements in this newsletter may contain statements related to future financial performance of certain securities, indices or the Anchor Managed funds that may constitute forward-looking

5 statements. These statements may be identified by words such as expect, look forward to, anticipate, believe, seek, estimate, project, potential, predict, or words of similar meaning. Such statements are based on the current expectations and certain assumptions of the author, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond the author s control, affect the performance of the securities and capital markets indices and therefore the performance of the Anchor funds and could cause the actual results, performance or achievements of the securities, indices or the Anchor funds to be materially different.