Equity Strategy. Further Reducing Interest Rate Sensitivity Stéphane Rochon, CFA, Equity Strategist. September 2013

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1 September 13 Equity Strategy Further Reducing Interest Rate Sensitivity Stéphane Rochon, CFA, Equity Strategist What is your portfolio s interest rate sensitivity? This may not be the most gripping way to start a cocktail party conversation but we believe that the trajectory of interest rates will be the single biggest driver of portfolio returns for the foreseeable future. No hyperbole here, it is that important! While no one knows how quickly interest rates could rise from current levels, our view is that the bond bull market is now behind us. In other words, interest rates will likely be on an upward trajectory for the next number of years. Separately, Syria is the Middle Eastern tension du jour, and the escalation of that conflict has put upward pressure on oil prices. Given that higher gas prices act as a tax on the consumer and reduce economic growth, we believe the rise in crude prices should be monitored closely, but we do not believe it will be enough to derail the U.S. economic recovery barring a super spike, which we consider unlikely at this point. There is no change to our broad asset allocation this quarter underweight fixed income (with a marked preference for shorter duration bonds) and overweight equities (with an emphasis on U.S. and international stocks). Still, while we advocate maintaining diversified portfolios, we are acutely aware of rising interest rate risk and are concerned about the impact rising interest rates has on REITs, Telecoms and Utilities. However, we believe the life insurance companies will be one of the few equity sectors which will benefit from higher interest rates. Understanding and managing the risk of higher interest rates has been one of our most important investment themes over the last year. As we noted in January 13: We believe long-term interest rates are poised to move higher in 13 and 1. This could be the single most critical factor driving portfolio returns for the next few years given that the asset class (i.e., bonds and equities) and sector return implications of such a move would be profound. To illustrate this point, consider the fact that if interest rates rise by 1% Canadian - year bonds would lose approximately % of their value clearly an undesirable outcome for an asset class most investors consider to be safe. We firmly believe there is currently a bubble in safer assets, meaning that government bonds and defensive sectors such as Telecoms, Utilities and REITs are fundamentally overvalued and that this risk is not fully understood by investors The potential increase in rates is not limited to North America and could become a global phenomenon. On this point, our technical analyst Russ Visch states that after trading sideways for most of the past year, long-term bond yields for many developed nations have reversed to the upside in a meaningful way. Some have already broken out of their intermediate-term base patterns, while others will likely break out soon. Figure 1: BMO Nesbitt Burns Investment Strategy Committee s Recommended Asset Allocation Income Balanced Growth Aggressive Growth Recommended Benchmark Recommended Benchmark Recommended Benchmark Recommended Benchmark Asset Mix Weights Asset Mix Weights Asset Mix Weights Asset Mix Weights Cash Fixed Income Equity Canadian Equity U.S. Equity EAFE Equity 5* 5 5* 5 * 15* 15 Emerging Equity * Within EAFE, we specifically recommend Continental European equity. Source: BMO Nesbitt Burns Private Client Strategy Committee Member-Canadian Investor Protection Fund All figures in C$ unless otherwise noted Equity Strategy September 13 Error! Reference source not found. Error! Reference source not found.

2 The recent spike in U.S. and Canadian -year bond rates has given investors a stark reminder of the negative impact such a rise can have on asset prices. Case in point, in August the DEX Universe Bond Index lost another -.%, while defensive capital intensive equity sectors such as REITs and Utilities were hit even harder, with losses of 3% and 7%, respectively. The key problem for these sectors is that rising interest rates increases the costs of financing (since these companies tend to borrow billions to finance their plants, buildings, etc.) and lowers the relative attractiveness of their dividend yields relative to government bonds. By way of illustration, Figure 3 shows the sharp drop in the preferred share market over the last few months. The selloff has been so pronounced that Pat Keene, our Preferred Share Specialist, believes we finally have attractive entry points for certain highquality names. For specific recommendations, please contact your BMO Nesbitt Burns Investment Advisor. Figure : Rising Interest Rates in Action -Year Government of Canada Bond Yield Dec-11 Feb-1 Apr-1 Jun-1 Aug-1 Oct-1 Dec-1 Feb-13 Apr-13 Jun-13 Aug-13 Figure 3: S&P/TSX Preferred Share Index Feb-11 May-11 Aug-11 Nov-11 Feb-1 May-1 Aug-1 Nov-1 Feb-13 May-13 Equity Strategy September 13

3 Looking at equities, we continue to emphasize our longstanding preference for non-canadian stocks (and the U.S. market in particular, where we are considerably overweight). We continue to recommended buying blue chip European stocks (the Euro Stoxx 5 Index) as we see a contrarian, value opportunity in the Old Continent, where economic growth and credit markets are stabilizing and equities are very inexpensive. Emerging Market stocks have been weak of late primarily due to Chinese economic growth concerns, their high correlation with commodity prices and the fear of global liquidity diminishing when the U.S. Federal Reserve (the Fed) begins to reduce its bond buying program (presumably in September). Still we believe this presents long-term investors with a buying opportunity given improving economic momentum (even in China where economic growth appears to have bottomed), superior long-term growth prospects from the emerging consumer class and very cheap valuations. Having some exposure to Emerging Markets is all the more important given their significant and growing importance to the world economy. According to the International Monetary Fund, for the first time ever, the combined gross domestic product (GDP) of emerging and developing markets, adjusted for purchasing price parity (PPP, which adjusts for the relative cost of comparable goods in different economic markets), has eclipsed the combined measure of advanced economies. Advanced economies will have a PPP-adjusted GDP of US$. trillion in 13, while that of emerging economies will be US$. trillion. More importantly from an investment perspective, emerging markets are still growing at roughly triple the rate of advanced economies. Figure : Global GDP Growth (Percent; Quarter-over-Quarter, Annualized) Source: IMF Staff Estimates On the home front, last quarter we reduced our recommended weighting in Canadian stocks by 5%, thereby moving to an underweight stance relative to our benchmark. Despite the recent bounce we have seen in base and precious metal miners, we continue to be bearish on the group and would use recent countertrend strength to reduce positions. Interest Rates Why Do We Believe There Continues to be Upside Risk to Rates? Our argument continues to be both fundamental and technical. Global economic momentum has been strengthening recently (even in China, as noted previously). Economic momentum is a very important factor in determining the trajectory of interest rates as historically a strengthening economy has driven up inflation expectations and interest rates (since bond investors have to be compensated for the erosion of real returns when inflation picks up). Equity Strategy September 13 3

4 The Citigroup Economic Surprises Index (a comparative measure between actual economic data releases and consensus expectations) is turning up in every region. The U.S. (blue line) and Europe (grey line) have had the most positive surprises but Emerging Markets are also rebounding. Figure 5: Citigroup Economic Surprises Index Jan-11 Apr-11 Jul-11 Oct-11 Jan-1 Apr-1 Jul-1 Oct-1 Jan-13 Apr-13 Jul-13 CESI - U.S. CESI - Euro CESI - Emerging Markets CESI - Asia Pacific More recently, we have seen confirmation of this economic rebound from later cycle data points such as the new jobs growth (and the declining unemployment rate) in the U.S. and a strongly rebounding U.S. residential housing market. We believe Canadian and U.S. government rates will move in tandem as Canadian and U.S. -year yields have been over 95% correlated since 199 Figure : -Year Canada Bond Yield versus -Year U.S. Treasury Yield 1 Jan-9 Jan-9 Jan-9 Jan-9 Jan-9 Jan- Jan- Jan- Jan- Jan- Jan- Jan-1 U.S. -Year Treasury Yield Canada -Year Bond Yield Equity Strategy September 13

5 Figures 7 through show that there is currently a very large disconnect between -year rates and the U.S. ISM New Orders Index (the best economic leading indicator, in our view), the Consumer Price Index (CPI) and the labour market. An improving labour market in the U.S. has historically lifted yields and the jobs picture is clearly improving, as shown by Figure 7. Figure 7: -Year U.S. Treasury Yield versus U.S. Initial Jobless Claims (Thousands) The jobs picture is clearly improving Jan-9 Jan-9 Jan-9 Jan-9 Jan-9 Jan- Jan- Jan- Jan- Jan- Jan- Jan-1 7 U.S. -Year Treasury Yield (LHS) U.S. Initial Jobless Claims (RHS - Inverted) Figure : -Year U.S. Treasury Yield versus U.S. Unemployment Rate Jan-9 Jan-9 Jan-9 Jan-9 Jan-9 Jan- Jan- Jan- Jan- Jan- Jan- Jan-1 11 U.S. -Year Treasury Yield (LHS) U.S. Unemployment Rate - Seasonally Adjusted (RHS - Inverted) Equity Strategy September 13 5

6 Figure 9: -Year U.S. Treasury Yield versus U.S. ISM New Orders Index The spread between the U.S. ISM New Orders Index and -year yields is very wide by historical standards. 3 3 Mar-1 Mar- Mar-3 Mar- Mar-5 Mar- Mar-7 Mar- Mar-9 Mar- Mar-11 Mar-1 Mar-13 U.S. -Year Treasury Yield (LHS) ISM New Orders (RHS) Figure : -Year U.S. Treasury Yield versus U.S. CPI The spread between the U.S. CPI and -year yields is at its widest since the crisis. 1 Jan-9 Jan-9 Jan-9 Jan-9 Jan-9 Jan- Jan- Jan- Jan- Jan- Jan- Jan-1 U.S. -Year Treasury Yield (LHS) U.S. CPI Y/Y (RHS) -.5 Equity Strategy September 13

7 Market Valuations: Equities Continue to Look Attractive In our view, stocks continue to be inexpensive in absolute terms given robust corporate earnings and cash flow trends. Stocks also appear compelling relative to government bonds both in Canada and the U.S. Looking at multiples, valuations are reasonable with both the S&P/TSX Composite and S&P 5 trading at around 15x forward expected earnings. This is not expensive by historical standards and is particularly attractive considering the current very-low rate environment. Figure 11: S&P 5 Earnings Yield versus -year Treasury Yield 1 Figure 1: S&P/TSX Earnings Yield versus -year Canada Bond Yield Jan- Jan-3 Jan- Jan-9 Jan-9 Jan-95 Jan-9 Jan-1 Jan- Jan-7 Jan- Jan-13 U.S. -Year Treasury Yield S&P 5 Earnings Yield Source: Bloomberg Jun-9 Jun-9 Jun-9 Jun- Jun- Jun- Jun- Jun- Jun- Jun-1 -Year Canada Bond Yield S&P/TSX Earnings Yield Source: Bloomberg Figure 13: S&P 5 Index Sector Total Returns to August 3, 13 S&P 5 Index Sector Total Returns (%) MTD YTD Health Care Cons. Discretionary Financials Industrials S&P 5 Index Consumer Staples Energy Info. Technology -.5. Utilities Materials -..9 Telecom. Services Source: Bloomberg Figure 1: S&P/TSX Composite Sector Total Returns to August 3, 13 S&P/TSX Composite Index Sector Total Returns (%) MTD YTD Health Care Info. Technology Cons. Discretionary.97. Consumer Staples Industrials Financials Energy S&P/TSX Composite Index Telecom. Services Utilities Materials Source: Bloomberg Equity Strategy September 13 7

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