Harbour Monthly. Q4 Strategy. The Harbour Group of RBC Dominion Securities. 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 All For One: You An Exclusive Newsletter for Our Clients and Friends OCTOBER 2015 Main Reception: Toll-free: RBC Dominion Securities Brookfield Place Bay-Wellington Tower 181 Bay Street, Suite 1520 Toronto, Ontario M5J 2T3 Peter Coward, hba Vice-President & Director, Investment Advisor Graeme MacGregor, fcsi, cim Vice-President & Director Portfolio Manager & Wealth Advisor Christopher Newall, fcsi, cim Vice-President & Director, Portfolio Manager John Grant, cfa, mba, msc Portfolio Manager & Wealth Advisor Robin Gullason, cfa Vice-President, Lead Strategist Private Wealth Management 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: All for one: you. Q4 Strategy Economic indicators continue to suggest further growth in the economy, and we view this as a typical correction, even though corrections never feel typical. Outside of commodity-afflicted sectors, earnings estimates continue to trend higher. Volatility is back and we don t expect it to abate any time soon. This bout of volatility is different in that it is not one large issue driving uncertainty. Our view on corrections has been to seek out bargains in the volatility, which is what we are doing now. We think a lot of bad news is priced into Canadian markets, and there are signs the weak currency is starting to have a positive effect. The TSX index is trading at levels seen in 2011, but the dividend yield is 32% higher, highlighting the value of dividend growth. Government fixed-income markets continue to be uninspiring, but we see opportunities in high-yield debt and preferred shares. Current round of volatility looks to be more of a market event than an economic one, which leaves us constructive on equities as forward returns have improved. The Correction is Here - Now What? In previous publications we have talked about the lack of volatility in the U.S. equity market and that such a state of affairs was unlikely to last indefinitely. That wasn t so much making a call as stating historical fact corrections typically happen every months and going three years without one was abnormal. Well, the long awaited (or feared) correction is now upon us and the big question is what to do? Our advice previously has been that trying to get out of the way of a correction was futile. This correction held true in that regard, as it seems to largely have been driven by things we have known about for some time did indications of weaker Chinese growth really surprise anyone? The fact that the Fed is looking to raise interest rates? How about weak commodity prices? As is typical, markets Continued on page 2 THE HARBOUR GROUP OF RBC DOMINION SECURITIES

2 continued from page 1 are fickle and issues that had previously been ignored become front and centre in a correction as investors look to fit a story to the price action. Exhibit 1 U.S. Initial Jobless Claims Unlike previous corrections, which saw a quick recovery after the crisis of the day was sorted, we think this one will take some time. Fears over China, Fed rate hike uncertainty, and Emerging Markets/commodity pain are unlikely to be resolved quickly or all at once, and it is therefore unlikely that we see investors step back into the market en masse. While it is definitely more satisfying to see the market spring back to new highs immediately following a setback, we are using the volatility to revisit securities we had passed over in prior months and years due to valuation, which now look a lot more attractive. Growth Concerns Re-Emerging In light of a disappointing U.S. employment report for September, a lot of investors are getting pessimistic on growth. We would note that the employment report appears to be out of synch with nearly every other employment indicator. As seen in Exhibit 1, initial unemployment claims, a weekly series that gives a real-time look into the employment situation, continues to be supportive of a buoyant employment outlook with the series sitting near multidecade lows. Looked at another way, U.S. job openings (Exhibit 2) are at a record high going back to 2000, suggesting that there are ample employment opportunities in the U.S. Before getting too concerned about one jobs number, we would want to see some deterioration in these metrics to corroborate the data and start to worry more about a slowdown. Exhibit 2 U.S. Job Openings Continued on page 3 2 RBC DOMINION SECURITIES INC.

3 continued from page 2 Sticking with the U.S labour market for a moment, RBC s economics team did some interesting work on what typically happens in the quarter after bonds outperform stocks by a significant margin as has been the case in Q3. RBC Capital Markets work suggests that in quarters after 10-year Treasuries outperform bonds by 9.5% or greater, the probability of stocks gaining back some ground versus bonds is quite high so long as employment growth is positive. Over the last 45 years there have been 18 instances where the relative outperformance of 10-year Treasuries was 9.5% or greater. Equities outperformed two-thirds of the time the following quarter, by 7.7% on average. In fact, only once in the data series did equities underperform the following quarter when payroll growth was positive (and was only at 60K in that instance), which is an interesting set up into the end of the year. Not All Doom and Gloom By Any Means What are some other bright spots? If history is any guide, we should see a positive response from the sharp decrease in gas prices hit the economy soon. In one of the more interesting economic indicators we have come across, cigarette sales are up for the first time in nine years, and showing the largest gain in at least 15 years. Why? Lower gas prices. Cigarettes are a typical discretionary purchase at gas stations, as are confectionary items, snack foods, etc. and it appears that consumers with an extra $10 in their pocket after filling up are spending it. Our view is that as these savings begin to feel more permanent, consumers will work the savings into their budget and drive other sectors of the economy. This thesis is borne out in the historical data as seen in Exhibit 4, which shows Exhibit 3 Up in Smoke: As Gas Prices Go Down, Cigarette Sales Go Up Sources: Bloomberg, National Association of Attorneys General, U.S. Alcohol and Tobacco Tax and Trade Bureau Exhibit 4 Delayed Reaction: U.S. GDP Rises 18 Months After Oil Prices Fall the year on year change in crude oil prices (inverted) and GDP growth, the U.S. economy typically picks up about 18 months after a serious oil price decline. Why 18 months? We think the anecdote above serves as a good example. In the first days of a price decline, people assume it is temporary Continued on page 4 3 RBC DOMINION SECURITIES INC.

4 continued from page 3 ( oil will be back at $75 by the fall ). After a year of lower prices, consumers get used to the new price level and budget accordingly, with the gasoline windfall making its way back into consumption of other goods. Exhibit 5 Canadian Monthly GDP Growth Canadian Growth Improving After a rough patch in the first half of the year, we are starting to see some data that suggests the Canadian economy is turning the corner. Unlike the U.S., Canada reports gross domestic product growth on a monthly basis (Exhibit 5), giving us a more granular look at economic growth. On this basis, growth turned the corner in June and continued in July. Commodities are unlikely to provide a tailwind to growth anytime soon, but it must be noted that we will soon start lapping low oil prices on a year over year basis. This should have two effects the year over year change in the value of commodity exports should stop declining so long as commodity prices do not go any lower. Second, the effect on inflation will be similar, as once a price has fallen and stabilized, it is no longer deflationary once the year on year change stops being negative. Exhibit 6 Canadian Exports We are also starting to see some evidence that the weaker Canadian dollar is having an effect on exports (Exhibit 6). After falling to start the year, exports have picked up pace over the summer, a trend that should continue to be supported by a depressed loonie. Valuations Have Gone From Reasonable to Attractive When taking a multi-year view of the TSX and its dividend yield, two things strike us as interesting. First, the TSX on an index level now sits back where it was at its 2011 highs, due largely to the significant underperformance of energy and materials sectors. We have said in the past that the TSX makes

5 continued from page 4 a poor benchmark for risk-averse, income-seeking investors. We still believe that, but it doesn t mean we (or our clients) are able to ignore index levels and it is certainly noteworthy that the index has not made any progress in three years. What we find more interesting is that even though the index is at the same level seen in 2011, the dividend yield is now 32% higher, representing dividend growth over that timeframe (Exhibit 7). Exhibit 7 TSX and Dividend Yield (RHS) It is data points like this that make it a lot easier to take a long-term view when investing in equities. Everyone likes to see their capital value go up, but the market is a fickle being, and as seen in Exhibit 8, sentiment drives performance short term but in the long term, it is earnings and dividends that are the reliable generators of return. Our best advice for dealing with corrections is to keep the focus on the cash flow provided by dividend income and the long term earnings power of great businesses. Fireworks in Fixed Income From 2011 to 2014, most facets of the fixed-income market were relatively tame government interest rates were unattractive, credit spreads were in a tightening cycle and preferred shares were popular with investors fearing higher interest rates. Fast forward to 2015 and many of these themes have been turned on their head. The collapse in energy prices has led to a repricing of the high yield bond market, and years of equity investor-friendly behaviour (debtfunded share buybacks, mergers and acquisitions) have caused investors to demand a higher premium (credit spread) to hold investment-grade corporate debt. These markets are approaching valuations that we find attractive relative to government Exhibit 8 Exhibit 8 Historical Return Contributions (%) From EPS and P/E Source: S&P, Thompson Financial, FactSet and RBC Capital Markets Note: Based on returns since 1965 bonds but we also have to be mindful of the signal the bond market is sending. Credit spreads (Exhibit 9) often prove to be a leading indicator in predicting economic weakness, but at this point credit spreads would be one of the very few indicators we watch that indicate any trouble on the horizon. In our view, the weakness in credit markets is likely due to a spillover from the energy and mining sectors, lack of liquidity in these markets and a deluge of supply this year, which makes us more inclined to buy than sell these securities unless we get confirmation that the economy is indeed peaking.

6 continued from page 5 Preferred Shares: Depressed Due to Liquidity and Ultra Low Rates The Canadian rate reset preferred share market deserves its own special mention. These securities were issued (and purchased for portfolios) with the intention of protecting investors from rising interest rates. With a dividend that resets every five years at a set premium to government of Canada bonds, investors did not have to worry too much about a rise in interest rates as they would either be redeemed or capture that higher rate upon reset. Unfortuantely, interest rates have fallen to what were once unthinkable levels, taking rate reset preferred shares sharply lower as existing issues are reset at lower divdends than they were issued with (though in line with the terms of the securities). Investors have been unwilling to buy preferred shares at yields much below 4%, and prices have gone to levels that provide a 4% yield or higher depending on credit quality. While we agree that this makes sense for issues that reset immediately, we think it is overly pessimistic to stretch this logic to preferreds that don t reset for 3, 4, or 5 years. The issuance of coupon floor rate reset preferred shares has been another contributor to the latest leg down in the preferred share market. We think the coupon floor preferreds are attractive for risk-averse investors as these issues should not suffer when bond yields go down, as the rest of the market currently does. That said, these features are designed to fight the last war. A coupon floor when the 5-year Canada is at 0.80% is nice, but unless rates stay down here for the long term, it is a feature that is unlikely to be required. Exhibit 9 BBB Credit Spreads Discounted Rate Resets Offer a Rare Option on Higher Interest Rates Meanwhile, many previously issued and now deeply discounted rate resets have a similar degree of protection built into them. Many preferreds are trading at levels that even if they were reset today would provide yields over 5%. If yields go to zero, that won t be the case, but if one is willing to make a call that we won t be at sub-1% 5-year Canada yields in three to five years time, we think these are more attractive for those seeking total return. The coupon floor preferreds are unlikely to provide much more than their dividend income as they have a high probability of being called in a typical credit environment. The deeply discounted deals provide high current income, a strong probability of attractive income at reset in one to four years time, and the possibility of double-digit capital gains in an environment where interest rates go anywhere near what we consider normal. As year-end approaches, we expect tax-loss selling will continue to cause significant volatility, but see a better supply/demand dynamic once the calendar turns.

7 continued from page 6 Canadian Dollar at the Whims of Oil Prices To those that read last month s commentary (available here), forgive us for sounding like a broken record on the Canadian dollar but it continues to bear mentioning. Currency has proven to be a boost to performance given the broad U.S. dollar strength we have seen over the past few years. With the Canadian dollar (Exhibit 10) now trading below fair value (or put another way, the USD is overvalued compared to the Canadian dollar), some may question if it is time to repatriate U.S. dollar investments to Canada. We would argue no for a couple of reasons. First, we do not want to let the currency tail wag the investment dog, as our U.S. holdings generally represent investments that are not available in the Canadian domestic market and provide a valuable diversification tool. Second, while we view the Canadian dollar to be undervalued on a long-term basis, currency trends typically persist for long periods of time. So long as oil prices stay low and we have a Bank of Canada more likely to cut rates than raise them in an environment where the Federal Reserve wants to take their rate off zero, the Canadian dollar is likely to have a difficult time gaining sustained momentum. Exhibit 10 Source: DB FX Research, RBC GAM Our inclination is to use episodes of Canadian dollar strength to increase USD exposure until we begin to get a sense that the bear market in commodities is near an end. Bottom Line We are currently in the midst of a correction, and if history is any guide, we are probably about half way through the process toward recovery. To see new Canadian Dollar & Purchasing Power Parity highs in equities we likely need to see some concerns around Chinese growth and the Federal Reserve get resolved. Once that happens, many fixed income and equity markets are now priced to provide stronger forward returns than they were earlier in the year, and we think it is an opportune time to put excess cash to work. This commentary is based on information that is believed to be accurate at the time of writing, and is subject to change. All opinions and estimates contained in this report constitute RBC Dominion Securities Inc. s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates, market conditions and other investment factors are subject to change. Past performance may not be repeated. The information provided is intended only to illustrate certain historical returns and is not intended to reflect future values or 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. Registered trademarks of Royal Bank of Canada. Used under licence RBC Dominion Securities Inc. All rights reserved. 15_90451_L4B_052 (10/2015)