February Looking Back: 2017 Market Review

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1 February 2018 Looking Back: 2017 Market Review Back in 2009, in the midst of one of the worst markets in history, and one of the deepest recessions in over 60 years, who would have thought that the U.S. stock market would be entering one of its longest bull markets in history? But that's exactly what happened. Despite persistent concerns over anaemic GDP growth, unprecedented central bank money supply, record-setting debt levels, high market valuations and on-going banking concerns in Europe, the S&P500 index has climbed higher year-after-year for nine consecutive years. Not bad for a market nobody wanted to be in back in Which reinforces the lesson that comfort and opportunity seldom go hand-in-hand. As the U.S. market continued its impressive run in 2017, with a 20.5% gain in the S&P500, the rest of the world decided to join in as well. The European and Japanese indexes climbed 25.3% and 19.1% respectively; the emerging markets index followed suite with a return of 34.3%; and Canada, seemingly uninvited to the main party, climbed out of a mid-year hole to end 2017 with a respectable 9.1% return. To be fair to poor old Canada though, we did have one of the best performing equity markets in the world in 2016, with a gain of 22.0%, so it was a bit ahead of itself going into Bond prices, feeling the pressure from rising interest rates (remember, when rates rise, bond prices fall) could only manage a return of 2.5% for the year; which is actually quite impressive considering the extremely high valuation bonds are currently trading at and the expectation of more rate hikes in High yield bonds, fortunately, picked up some of the slack and had a pretty good year, returning 5.6% over the twelve months (based on the ishares U.S. High Yield Bond Index C$ hedged). Looking beyond basic stocks and bonds, alternative investments had a pretty good year as well. You may recall, we selectively utilize alternative assets to help maximize the Daniel E. Girard, CFP, FMA, CIMA, B.A. (Econ) Portfolio Manager, Investment Advisor, First Vice-President daniel.girard@cibc.ca Alan Pilkey, CPA, CA, CFA, CFP Associate Investment Advisor alan.pilkey@cibc.ca

2 risk/return profile of our clients portfolios (i.e. return per unit of risk). Alternative investments typically have a low correlation to stocks and bonds, which when added to a portfolio smooths out returns and makes the portfolio less exposed to market volatility. In an environment like we find ourselves today, where the global economy looks good, but equity valuations are very high and bonds offer little chance for positive returns (due to rising rates), alternative assets become an even more useful tool. The investments we include in the alternative space are: private and public real estate, commercial mortgages, private corporate loans, specialty fixed-income, and lowvolatility hedge funds. Although it turned out in 2017 that we didn t really need the riskmitigating qualities of these investments, each (other than one) had a pretty good year in their own right and thus added to overall returns: Canadian REITs (investment real estate) returned 11.2% for the year Polar (hedge fund) gained 6.5% Timbercreek mortgage corporation returned 18.7% Timbercreek private real estate partnership gained 8.6% for the year PIMCO, our global fixed-income manager, provided a 7.0% return And lastly, Goldman Sachs Business Development Corporation (specialty finance) was the laggard with a small 0.15% loss Putting it all together Looking at 2017 returns from a total portfolio perspective, it was another pretty good year for our balanced-growth portfolio. The model returned approximately 8.5% (net) for the year, in-line with the balanced-growth benchmark 1, which was up 8.3%, and above the annual return target of 6.1% (recall the target return for the balanced-growth mandate is 4.5% plus inflation, and inflation was 1.6% last year). So we re happy with the results, especially given the slightly defensive posture we had in the model (as the risk of a stock market correction, due to high valuations, is heightened), how late we are in the cycle, and the double-digit returns we earned in With that said, however, based on the strength in the international markets, one could feel that the 8.5% return was a little lower than expected. It s important to keep in mind though that international returns look a little different from a Canadian perspective.

3 Specifically, the 6.9% gain in the C$ vs the USD last year reduced gains on foreign investments. As well, for risk management purposes, we balance our Canadian and global equity holdings to account for the additional risks associated with foreign holdings. So although a 20.0% return in a particular market certainly increases a portfolio s total return, it doesn t necessarily translate into a corresponding 20.0% gian for the portfolio. If a portfolio has a 60% allocation to stocks, and 50% of that was in the U.S. last year, that would mean that 30% of the total portfolio returned 13.9% (S&P 500 return in CAD), providing a gain from U.S. equities of 3.93%. Which is great, but can be a little underwhelming when 20.0% is the headline number. I know in a raging bull-market it seems like valuations don t matter, and strong global growth, tax cuts in the US, low interest rates, and the internet (again) will make it different this time and we should simply be fully invested in the U.S. But it felt exactly like this in 1999 and 2007 as well just before the U.S. market dropped over 40.0% and 38.0% respectively. So although we think 2018 will actually be a good year for global equities, including the U.S., and thus we re positioned for growth, we also believe in Newton s law of universal gravitation which says, and I m paraphrasing, the bigger the gain, the bigger the drop. Thus, not thinking it wise to question Newton s brilliance, we re employing what we see as the right mix of opportunism and caution to help you, our valued-clients, grown your wealth, but also keep focused on protecting it as well Returns for the Various Capital Markets: Bellwether Indices (Canadian $) Source: CIBC Wood Gundy As at December 31, 2017 Price Performance % Change 1 mo 3 mo 6 mo 12 mo YTD S&P/TSX Composite Index S&P 500 US Index MSCI EAFE (Europe & Japan) TMX Canada Bond Universe Index Canadian vs. U.S. Dollar Balanced Portfolio Benchmark The balanced portfolio benchmark is designed to simulate a typical Canadian pension plan s return in order to give clients an approximation of how their portfolio has performed in any given time period. It is composed of 40% FTSE TMX Canada Universe Bond Index, 30% TSX/S&P Composite Index, 20% S&P 500 Index, and 10% MSCI EAFE Index. Actual client portfolio returns will vary based on portfolio composition, cash flows, personal return target, tax situation, etc.

4 Looking Ahead Notwithstanding my cautionary tone above, a strong economic story did unfold in 2017: we achieved globally synchronized economic growth (all 35 OPEC nations had positive growth in 2017, for the first time in almost ten years), China began reforms to deal with its debt issues and get the second largest global economy on a more stable growth footing, despite Brexit the European Union held together just fine, the U.S. and Canadian economies (and employment) are doing extremely well, and corporate earnings, which ultimately drive equity prices, on average beat expectations in North America. Even geopolitical concerns look to be stabilizing. All of which lead to the impressive gains in global stocks last year, and to the equally impressive low volatility in the markets. As we move into 2018, economic indicators continue to show all the positives mentioned above, which should allow for further growth in corporate earnings and strong employment, likely leading to improved wage growth. Given this backdrop, and combined with what we expect will be only modest increases in North-American interest rates, equity prices should continue their upward trend. Perhaps not quite as strong as they were in 2017, due to higher valuations today, but in-line with expected corporate earnings growth of approximately 8-10%. Fixed-income, and other investments that are considered bond-proxies (utilities, REITs, telecom, etc.) on the other hand, are likely in for a difficult year as central banks continue to raise interest rates throughout This doesn t mean that we abandon these assets, as they have important defensive qualities and provide attractive longterm return potential, it simply means we need to manage them properly to account for the current environment. Now of course, there s risk in that forecast. Stock valuations, to say the least, are high. And if central banks overdo their monetary tightening (i.e. increase rates too quickly), the global economy slows, geopolitical concerns rise, or U.S. protectionism expands, equity markets could let some air out very quickly. We don t see any of those risks as especially high, but they are present, and thus need to be factored into portfolio positioning.

5 Asset Allocation We continually aggregate economic and market research to develop an investment thesis at any given time. We then use that thesis to try to follow The Great One s advice about skating to where the puck is going to be, not to where it s been. To do that, we overweight and underweight asset classes, and specific investments, to give us the best balance between risk and reward at any given point. Our current thesis, and thus portfolio positioning, is based on the following assumptions for 2018: Positive GDP and corporate earning s growth globally continues for the year; especially in the U.S. as tax reform provides an extra lift to earnings Valuations are high in the U.S., but likely remain so in 2018 as interest rates are not going up enough to offer competition for investment dollars. Stock prices, therefore, likely move higher, but only in-line with earnings growth Equity valuations look more attractive in Europe and Japan, and thus could outperform the U.S. in 2018 Commodity price strength, reasonable valuations, and U.S. economic strength all favour Canadian stocks; however, NAFTA negotiations, troubling consumer debt levels, and real estate price risk, present risks and could lead to Canadian stocks underperforming again this year Canadian dollar likely weakens based on the above mentioned risks Interest rates move higher in Canada and the U.S., but modestly (as inflation remains low) Bonds (including high yield) are pressured from rising rates and likely experience small losses for the year Based on the these forecasts, we are: Overweight international & emerging markets equities Slightly underweight U.S. equities Slightly underweight Canadian equities Slightly underweight dividend stocks (due to rates rising)

6 Very underweight investment-grade bonds Overweight alternative fixed-income (loans, mortgages, global bonds) Underweight public real estate and overweight private real estate Underweight high-yield bonds Final Thoughts Economically, everything looks good for So we re expecting another year of solid returns, likely in the neighbourhood of 6-8% net on our balanced model. But valuations are high and we are a little long-in-the tooth in this economic expansion, so an increase in volatility should be expected. Our positioning factors this in and the investments we own will allow us to make good returns if markets continue upward, but can also withstand a short-term correction without serious concern. Our balanced posture would also allow us to take advantage of a sell-off if one were to occur. Speaking of balance, I know it s easy to get caught up in a booming stock market, and feel that balance isn t necessary any longer. But wealth is created by long-term compounded returns, not big gains followed by big losses which is typically what happens when one forgets about risk. If history has taught us anything, it s to keep these two facts in mind: bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria, and, pigs get fat, but hogs get slaughtered. We ll see if this time is truly different. As always, please don t hesitate to ask if you have any questions on this commentary, or about your portfolio in particular. We re always here to help. Sincerely, Disclaimers This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. The views contained herein are that of Daniel Girard and not necessarily that of CIBC Wood Gundy. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. CIBC World Markets Inc