Harbour Monthly. Q Quarterly 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 APRIL 2016 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 Vice-President, 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. Q Quarterly Strategy Markets have staged an impressive recovery as fears of imminent U.S. recession have eased Oil prices are still driving market sentiment across many asset classes Canada leads the developed world in equity market returns Canadian dollar has recovered significantly although it is still trading at a discount to purchasing power parity Given the current economic backdrop we maintain the belief that it is prudent to have some USD denominated exposure Bank of Canada looks to be on hold as the Federal Budget delivered stimulus directly to consumers Fixed income views remain constructive on corporate bonds while Government bonds are a return of capital proposition We see opportunities in high yield bonds as energy stabilizes The preferred share market is in the early stages of recovery Is there an inflation problem brewing stateside? TSX led on way down and has led on the way up this trend is likely to continue in an environment of stable to higher oil prices A Federal Reserve on hold and a weaker U.S. dollar favour income strategies, commodity exposure and U.S. multinationals Markets Have Staged an Impressive Recovery as Fears of Imminent Recession Have Eased The one thing we were fairly certain we would see more of at the start of 2016 was volatility, and for better or worse this has come to pass. At the end of 2015 and into early 2016, U.S. economic data was weak, as evidenced by the RBC Economic Scorecard in Exhibit 1. Readings below zero suggest that economic Continued on page 2 THE HARBOUR GROUP OF RBC DOMINION SECURITIES

2 continued from page 1 data is coming through weaker than expected, leading to fears of a more protracted slowdown. Since January, however, we have seen an improvement in the data, and the market has followed suit. It had been our opinion that the changes in equity value prices were significantly in excess of the change in fundamentals, and fear of imminent U.S. recession have since passed. The consensus now seems to be back to slow but steady growth in the U.S. economy, which when combined with persistently low interest rates has proved to be an attractive combination for stocks. Exhibit 1 RBC Economic Scorecard 1-Month Rolling All that said, we cannot discount the effect of the rally in crude oil on equity markets. One of the strange phenomena of 2016 is the extraordinarily tight correlation between crude oil and the U.S. equity market. It has not been surprising to see the TSX move with oil given the heavy commodity weighting in the index and our economy as a whole. But in the U.S., oil and gas makes up a small (<7%) index weight, while the U.S. economy as a whole should benefit from lower oil prices. Nevertheless, the correlation with crude has persisted, well after oil has moved away from distressed levels under $30 per barrel. The fact that oil prices have rallied strongly after the production freeze announced by some OPEC members bolsters our view that the crude oil market is oversupplied, as opposed to showing deficient demand, but the relationship with stocks suggests that many are still treating the oil price as a real-time global growth barometer. While we question the logic here, the market certainly continues to care, and until that changes, all of us in the industry have little choice but to continue moonlighting as oil analysts. Continued on page 3 2 RBC DOMINION SECURITIES INC.

3 continued from page 2 Canada Leads the Developed World One of the themes we put forth for 2016 was that the TSX had an attractive set up to outperform the U.S. market this year. Canada was further along in the correction process than the U.S. market, and valuations were cheaper. This strategy hinged on catching some sort of a break on the oil price, which has begun to play out. Investors that were underweight Canadian stocks on a global basis or outright short sectors such as the banks have been forced buyers and we can see the results in the returns bank stocks have recovered sharply off their lows, and the TSX is the bestperforming developed market year to date, while the Canadian dollar has rebounded sharply off the panic lows of January. One way we track flows going into the Canadian market is by looking at how much money is going into the Canada ETF listed in the United States. By looking at the change in shares outstanding, we can get a sense of money moving into or out of the Canadian market by international investors. As seen in Exhibit 3, the shares outstanding for the Canada ETF have gone vertical since February, which corroborates with the anecdotal evidence we have heard about foreign money finding its way to Canada. In our experience, the TSX tends to perform best when foreign money is flowing in, and that has certainly been the case so far in The staying power of this outperformance will largely depend on the oil price, and on more evidence of a durable bottom it may be time to increase exposure to the energy Exhibit 2 S&P 500 and Crude Oil Exhibit 3 MSCI Canada ETF (U.S. Listed) Shares Outstanding Continued on page 4

4 continued from page 3 sector. We are fully prepared to miss the bottom given the damage inflicted to date, but we believe there will be plenty of return left to increase exposure once the sector turns. Exhibit 4 Rate cut probabilities continue to dwindle Bank of Canada Looks to Be on Hold One of the concerns that were top of mind as the year began was that the Bank of Canada was set to cut interest rates once or more in This view was driven by a speech from Governor Stephen Poloz in the months prior that suggested Canada could go to negative interest rates in an extreme scenario, coupled with new lows in oli prices in January. The Governor turned out to take a more measured approach, holding off in January with the view to see what the budget looked like as far as stimulus goes. It certainly didn t hurt that oil prices have recovered somewhat, and the market is now pricing in a 21% chance that the Bank of Canada cuts rates by July, down from greater than a 100% chance in January (Exhibit 4). Federal Budget Delivered Stimulus Directly to Consumers The Federal budget delivered in March suggests the government is looking to put money directly into the pockets of consumers, with less of an emphasis on infrastructure than was suggested. While the multiplier effect of this sort of stimulus will not be there, this sort of stimulus may provide a quicker jump to growth, though with an effect that is not as long lasting. Since the budget was delivered we have seen encouraging economic data on balance out of the Canadian economy, further boosting the case for the Bank of Canada to remain on hold. Low Interest Rates a Challenge for Fixed Income, But Opportunities are Emerging Last month we laid out our view on the fixed income markets (available here), and since then our views have not changed materially. Government bonds remain appropriate as a hedge to equity volatility and not much else for ultra-safe income we recommend GICs with protection from the Canadian Deposit Insurance Corporation. Corporate bonds have started to perform better and we see opportunities in high yield bonds as energy stabilizes. Here are some interesting statistics on the U.S. high yield bond market (Exhibit 5): Only six negative calendar years in high yield since Never two consecutive negative calendar year returns. Average one-year return in the year after a negative return is 28% (median 24%) Continued on page 5

5 continued from page 4 The Preferred Share Market is in the Early Stages of Recovery The S&P/TSX Preferred Share Index rose 8.74% in March, its biggest monthly gain on record but in the context of what has been a challenging start to the year. We have also continued to see bank new issues trade above $25 per share, which we expect will help the secondary market find a floor. We recently laid out a list of signs we believe are required for a recovery in preferred shares: Exhibit 5 U.S. High Yield Bond Market Returns Exhibit 5: U.S. High Yield Bond Market Returns Stabilization in the five-year Canada bond yield Better performance in corporate bonds Improvement in the new issue market In the last few months we have seen some positive developments on these overhangs. The outlook continues to be for the Bank of Canada to keep interest rates on hold, and as long as this view stands, it is difficult to see the five-year Canada bond trading below 0.5%, (which is the current overnight rate) for a prolonged period of time. Corporate bonds have seen strong demand of late, a positive sign for risk appetite. Lastly, as mentioned above, new bank preferred shares continue to trade well in the secondary market, which is a positive for the preferred market as a whole. Source: Bank of America Merrill Lynch Inflation Problem Brewing in the U.S.? Recent commentary from the U.S. Federal Reserve suggests that the timeline for higher short-term rates continues to lengthen. This despite a lower unemployment rate, and core inflation (Exhibit 6) that is now running at 2.3%, tied for a postcrisis high. In a recent speech, Fed Chair Janet Yellen stressed global developments, which we take as code for China, which has been the epicenter of market volatility for the last nine months. Even though inflation and unemployment make up the dual mandate of the Federal Reserve, it seems that there is a third mandate, which is to keep the U.S. dollar in check. On that front they have succeeded, as the broad U.S. dollar index is down on a year on year basis, while it has recently depreciated rapidly versus the Canadian dollar. Should these trends continue, we would expect large U.S. multinationals to outperform, as this group has been hampered by the stronger USD when they translated foreign earnings back home. A weaker USD also tends to be positive for commodities, and by extension, the TSX. Continued on page 6

6 continued from page 5 Currency No Longer a One Way Bet As seen in Exhibit 7, the Canadian dollar continues to be tied at the hip to crude oil futures. We continue to see fair value for the Canadian dollar in the $0.80 range, and if oil were to rally to $50 or greater we may see fair value on the CAD but we would note that we have seen a very significant move off the lows. As it stands, the Federal Reserve is still likely to raise rates before the Bank of Canada, a relationship that is just as strong as oil as far as the loonie is concerned. The strong rebound in the loonie has put a damper on the returns of USD-denominated assets but this pales in comparison to the value these have provided portfolios in the past few years. The fact remains that foreign markets provide diversification opportunities that are difficult to come by on the TSX, which leads us to maintain USD exposure. In mid-january with the CAD trading at 68 cents, many were asking us why we weren t 100% in U.S. assets. Today that argument is reversed. As usual, the truth probably lies somewhere in between and while we are not going to take a draconian stance that we will maintain current country exposures at all costs, any changes are likely to be evolutionary as opposed to revolutionary. Exhibit 6 U.S. Core Inflation Year over Year Exhibit 6 U.S. Core Inflation Year over Year Exhibit 7 Canadian Dollar and Crude Oil Continued on page 7

7 continued from page 6 Bottom Line Recent comments from Federal Reserve officials suggest the interest rate normalization process will continue to be a slow one, and will be done with an eye of keeping the USD in check. Low rates and a softer USD suggest three themes will be in play: the potential for a durable bottom in the crude oil market, investors returning to cash flow-oriented securities such as dividend stocks and high yield bonds, and a revival in sectors that have suffered from a stronger dollar, particularly U.S. multinationals in the industrial and consumer products space. The year to date has provided a lot of excitement to investors (both good and bad!) while fundamentals have not changed materially despite all of the volatility, the crude oil price is essentially back where it started 2016 and earnings per share expectations for the S&P 500 have not changed all that much. As with all of the corrections in the bull market that has been in place since 2009, the correction in January and February was due to yet another panic attack. At some point, serious concern over the state of the global economy, and by extension the stock market, will be warranted but we do not believe that time is now. 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. 16_90451_L4B_014 (04/2016)