Implications of the Chinese currency moves

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1 August 15, 2015 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor Implications of the Chinese currency moves Stock market outlook July and August historically have been relative quiet months in equity markets as participants around the world generally are enjoying vacation time. This, however, has not been true this summer as volatility has picked up significantly. In early July, investor concern centred on the potential fallout from a rise in U.S. interest rates in September or December. Most recently, global markets have been buffeted by the news on August 10 of the unfixing of the RMB/US dollar exchange rate. It was thought initially that this was one-shot adjustment which saw the currency fall 1.9% but two days later the currency was allowed to drop a further 1.6% for a total decline of 3.5%. As result, global markets were in turmoil especially the emerging markets. This Anchor Note will try to assess the implications of the change in approach by the Chinese central bank. What does this change by the Chinese central bank mean? The initial explanation by the People s Bank of China for the devaluation on August 10 was that the change to the daily fixing mechanism was intended to allow the exchange rate to be more market driven. This had in fact long been called for by the IMF and the U.S. Treasury (the trade-weighted exchange rate has increased over 20% over the last three years and against the yen the increase has been 60%). However, the second permitted decline in the value of the Remnibi last Wednesday confused and worried investors. What are the major concerns? The chief fear has been that China could be driving down the value of its currency to gain better terms of trade. If this were true, it could deliver a major deflationary shock to the global economy. This would be at a stage where the world is ill-equipped to deal with such a shock. This is because inflation rates in the developed economies are only running at about 1% currently, because central banks have very limited fire power left after extensive QE programs and, with interest rates still at very low levels, it means that a boost from interest rate reductions can only be very limited. Scope on the fiscal side is also limited since total debt to GDP ratios in the developed economies have risen sharply since the financial crisis (by about 30% in relation to GDP). We have sifted through numerous bits of financial commentary as well as looking at the latest statistics coming out of China to try to make a judgment as to where we believe that the Bank of China is going with this change, which is admittedly significant already since it represents the largest devaluation of the Remnibi in twenty years. It seems that the bulk of commentary runs along the lines that the currency adjustment will likely only run to about 5% before the Bank of China intervenes to put a stop to further declines. Why would this be? The answer to this question has several facets. The first would be that it has been the policy since Premier Li Keqiang came to power to shift the economy to more consumer led growth as opposed to export led growth. In addition, devaluation would probably not have a major impact on exports since demand is relatively weak in the major economies of the world. In addition, the Chinese authorities have recently taken significant fiscal measures to increase growth. For example, $205 billion of additional local government debt was issued between May and July which represents significant fiscal stimulus. Finally, the Bank of China as well as the Chinese administration is very conscious that a big decline in the value of the currency would be counterproductive to the official Chinese goal of having the Remnibi included in the SDR, which would almost certainly prompt a veto by the U.S. administration as a result of Congressional pressure. We think all these explanations are plausible but only

2 time will tell for sure. As ever, the Chinese political situation is inscrutable and it is possible that there is internal political strife which means that there is no definitive longer term plan. In terms of how the Chinese economy is doing, there are some recent encouraging signs. Although July industrial output was 6.0% versus 6.8% in June, the two month average was slightly above that of the previous five months of the year and demonstrates that it is no longer deteriorating to any major degree. Total property investment in China in the first half of the year rose 20.3% compared with a year earlier to 3.68 trillion yuan ($599.3 billion), according to data from the National Bureau of Statistics. Readers will know that we use real M1 growth as a lead indicator of future economic growth. According to the Federal Reserve Board of St. Louis, M1 growth has been accelerating in recent months and with Chinese core inflation being flat, this bodes well for Chinese economic growth improving and potentially putting to rest concerns that the Chinese economy is in line for a hard landing. The major market impact of the move by the Chinese central bank has been weakness in emerging markets and new lows in many commodity prices. The knee jerk reaction of investors was to believe that this could be the start of a major devaluation of the Remnibi with a deflationary impact on the developing countries as well as on the emerging economies and in particular commodity producing countries. Sceptics are remembering the Asian currency crisis of 1997/1998 but it should be remembered that this caused the Fed to put an end to its tightening stance and after that the MSCI World Index rose by a double-digit percentage in the following year. These events in China could also push the fed to delay its increase in interest rate beyond September. Based on the change in the October contract, the probability of a September rate increase has dropped from 56% after the release of the July labour market data to 40% currently. In sum, on balance, we think the odds favour the devaluation of the Remnibi being fairly limited from here on in and not the start of a major devaluation with its risk of a major global deflationary shock. If that is the case, that should mean that the emerging market weakness should be temporary and that commodity prices should recover from their recent slump. If that turns out to be true and it will take some time to evaluate the degree of any Remnibi devaluation then there could well be some good value opportunities in the commodity sectors. As illustrated below in the segment on portfolio changes, we have started to make the first modest moves towards re-accumulation in the commodity area. We are encouraged that global real money growth is supportive of modest reacceleration in global economic growth. Portfolio changes Manulife s second quarter earnings were moderately disappointing to us and we now believe the shares are likely to trade sideways for the next while. We therefore sold our MFC positions in each of the three Anchor funds. In addition, we took some modest profits in Just Energy in the Anchor Dividend Growth fund after it reported strong Q1 earnings. We were showing a 25% plus gain on our holding. We still have a better than 5% weighting in the stock after the trade. In that fund, the proceeds of the JE trade and the MFC sale were used to make small additions to our positions in Brookfield Renewable Energy, Brookfield Property Partners, Fortis, Transalta Renewables and Canadian National Railways. The latter four had very solid Q2 results (in CNR s case despite weak volumes) while we continue to like Brookfield Renewable for the option on an improvement in electricity prices over the long term. As mentioned above, we also started to modestly increase our exposure in the commodity area. We did this by adding to our Peyto and Goldcorp holdings as well as re-initiating a holding in Arc Resources at this stage a small 1% position. In total, our commodity exposure in the Anchor Dividend Growth fund is now just over 10%. In addition, we added modestly to our positions in CIBC and BMO. We are hopeful that upcoming Q3 results will not be as negative as the market has been assuming, thus allowing a decent rally in these and other bank stocks. All of these purchases were replicated in the equity segment of the Anchor Defensive Income fund with the exception of the commodity stock purchases as this fund is not permitted to own any commodity based equities. In addition, we added to our Royal Bank and TD holdings as well as purchasing a small initial position in IPL and Brookfield Asset Management. The latter is undertaking a significant increase in its fund raising in light of the investment opportunities that it sees currently while we are replacing the IPL position that we sold last year but at a decently lower price. In the

3 Anchor High Income fund, we sold the Manulife and used the proceeds to buy Fortis. Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaMcLeod PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGE. 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

4 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. This information reflects Mr. Majendie s opinions as of the date of these notes. These opinions may change at any time and neither Mr. Majendie, ScotiaMcLeod nor their affiliates undertake to update the information or opinions. This information and opinion does not constitute investment advice or an offer to trade securities. Anchor hold securities of the following issuers referred to in this note: Arc Resources Ltd, Bank of Montreal, Brookfield Asset Management Inc., Brookfield Property Partners LP, Brookfield Renewable Energy Partners LP, Cameco Corp., Canadian Imperial Bank of Commerce, Canadian National Railway, Fortis Inc., Goldcorp Inc., Inter Pipeline Ltd., Just Energy Group Inc., Manulife Financial Corp., Peyto Exploration & Development Corp., Royal Bank of Canada, Toronto Dominion Bank, Transalta Renewables Inc. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Arc Resources Ltd, Bank of Montreal, Brookfield Asset Management Inc., Brookfield Property Partners LP, Brookfield Renewable Energy Partners LP, Cameco Corp., Canadian Imperial Bank of Commerce, Canadian National Railway, Fortis Inc., Goldcorp Inc., Inter Pipeline Ltd., Just Energy Group Inc., Manulife Financial Corp., Peyto Exploration & Development Corp., Royal Bank of Canada, Toronto Dominion Bank, Transalta Renewables Inc. 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 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

5 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 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.