CANADIAN EQUITIES TOP-DOWN CHARTBOOK

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1 CANADIAN EQUITIES TOP-DOWN CHARTBOOK May 1, 214 by Avery Shenfeld and Peter Buchanan Economics KEY FINDINGS TSX more levered to improving global outlook on constructive monetary, fiscal backdrop C$ depreciation to help resources, other sectors Energy to help drive above consensus EPS growth in 214 and 215 Lower neutral interest rate supportive for equity valuations in medium-term Bottom-up fundamentals remain important even with geopolitical tensions Neck and Neck The investment themes we set out for 214 were centred on a call that after trailing in 213, Canadian equities would outperform those in the US, and that investors should be weighted towards sectors that would benefit from improving global growth. On the first call, with a third of the year behind us, the TSX has opened a lead on the US and other G7 markets. We re retaining our view that 214 should be Canada s year to shine in a North American context, given its tighter correlation to global growth, which continues to pick up in the face of a diminished drag from fiscal restraint and a gradually healing financial system. We look for an almost-4% global GDP pace in , up from roughly 3% in 213. A More Normal Pace of Global Recovery (L) Should Support Canadian Stocks (R ) World GDP, % chg CIBC Fcst 11A 12A 13A 14E 15E correlation with global GDP growth, 1984-date TSX Composite S&P 5 Source: IMF,CIBC A Turn in EM Sentiment If there were doubts in recent months about the global rebound, they were focused more on emerging markets than on the US or Europe. While there s due scepticism on data accuracy, the disappointments over China s slow start were allayed by a bit better-than-expected Q1 GDP. A weaker yuan and announced stimulus for housing, should keep growth close to the 7½% target. Reversing early- 214 s pattern, emerging stocks have outperformed the advanced countries since mid-march. After fleeing earlier, fund flows data also suggest some investors are tentatively dipping a toe back in. Emerging Market Gloom Beginning to Fade? (L); China Defends Growth Target (R) Net Flows into EM ETFs ($Bn/week) CIBC World Markets Inc. PO Box 5, 161 Bay Street, Brookfield Place, Toronto, Canada M5J 2S8 CIBC (416) CIBC World Markets Corp 3 Madison Avenue, New York, NY 117 (212) 856-4, (8) Jan 15-Jan 29-Jan 12-Feb 26-Feb 12-Mar 26-Mar 9-Apr 23-Apr /4/213 8/15/213 Yuan/US$ 1/24/213 1/2/214 3/13/214 Source: EPFR, Bloomberg,CIBC

2 CIBC WORLD MARKETS INC. Canadian Equities Top-Down Chartbook May 1, 214 What s Hot, What s Not? The Canadian edge over the US is mostly centred on sector weighting differences that played in America s favour last year, but are being turned on their head in 214. The S&P s larger tech sector accounted for some 4% of the US outperformance in 213, but concerns over bloated valuations, particularly for social media stocks, could help the TSX win this year s race. Social media plays are absent from the TSX Composite, and the tech sector, once about 4% of Toronto s index during Nortel s hey days, now represents a scant 2% weighting today. Our call to lean towards global cyclicals has thus far paid off, with the TSX s energy sector being the best YTD performer here. The TSX as a Small Cap Index A turn to greater interest in small caps, typically seen when confidence about the state of the world improves, has also ordinarily lent support to Toronto stocks. Many of the firms in the TSX Composite are too small to be considered large caps in the US context. Historically, small cap sentiment has ranked second only to resources prices as a driver of Toronto s relative fortunes. Trends on that front also favour greater Canadian exposure, with TSX Small Caps picking up while those stateside continue their longer term outperformance. Commodities Through the Loonie Looking Glass Commodity prices, particularly for energy and base metals, have looked even more favourable when viewed from the perspective of Canadianbased producers. Typically, a resource upswing sends the Canadian dollar stronger, dampening the benefit to Canadian mines and wells. In this case, the resource rally has not reversed last year s tumble in the loonie, which was rooted in a more dovish perspective on rates from the Bank of Canada. Historically, a number of sectors, including those outside materials and energy, have outperformed their US counterparts in the wake of C$ softness. That includes a number of industrial sectors, which could also benefit from the last decades competitive-enhancing shakeout in Canada s factory sector. TSX More Levered to Global Growth, Less to Tech Than a Decade Ago % of Market Cap Apr-91 Dec-96 Aug-2 Sep-8 Resources (Energy + Materials) Drivers of TSX vs S&P 5 Outperformance Importance based on "normalized" regression analysis, Resource Prices Up Smartly in C$ Terms (L); Historical TSX Depreciation Winners (R) Oct Nov 23-Dec Higher Commodity Prices* 23-Jan 23-Feb 23-Mar 23-Apr BoC Commodity Price Index (as reported) converted into C$ Improving Small-cap sentiment** Reduced Risk Aversion*** Auto components Machinery Life & Health Insur Info Tech Source: Bloomberg,CIBC *Bank of Canada Commodity Price Index **S&P Small Cap/S&P 5 ***VIX Index Canada vs US GDP Factors Contributing Historically to Superior TSX Performance vs S&P 5 Source: CIBC CAD/USD based on sector's performance vs matching S&P 5 segment during past C$ selloffs.5 Railroads Hotels/Hospitality Source: Bank of Canada, Bloomberg,CIBC 2

3 CIBC WORLD MARKETS INC. Canadian Equities Top-Down Chartbook May 1, 214 More Gains Ahead in Some Key Areas Commodities have been among the best performing asset classes this year, indicative of an upturn in global growth, and some specific supply-side issues. Base metals have been helped by Indonesia s nickel ore export ban, and political uncertainties in supply chains that extend into Russia. Gold could still have downside as we get closer to Fed hikes and the resulting firming in the US dollar. Lumber prices are being held back by a slower-than-forecast turn in single family homebuilding in the US, but there is plenty of upside given pent-up demand for housing, which perhaps needs a bit more improvement in mortgage availability and income growth, to show its full colours. Commodity Price Forecast (f) 215 (f) Oil (WTI) $/bbl Natural Gas (Henry) $/Mn Btu Gold $/troy oz 1657* 124* 12* 125* Silver $/troy oz 31.1* 19.47* 2.* 22.75* Copper $/lb Aluminum $/lb Nickel $/lb Zinc $/lb Lumber** $/' bd ft Potash $/tonne * end of period, **1st CME Futures Source: Bloomberg,CIBC Still Fuel Left in the Tank Energy stocks have been helped by firmer nat-gas spot and futures prices after a harsh winter drained inventories, and healthy demand for both WTI and Canada s heavy crude benchmarks. But oil futures prices are still deeply discounted, reflecting in our view an overly pessimistic view of the path ahead that should brighten as prices prove resilient given growth in global demand. M&A action could further re-price Canadian assets, with transactions volumes picking up this year as global majors look to add production capacity, and Canadian assets attractive in terms of returns on equity. US Self-Sufficiency Overplayed A superior run-up in energy shares contributed to the US market s strong gains in 213. American plays were central in the excitement over non-conventional oil and gas prospects. That, and pipeline delays, also cast a shadow on Canada s ability to find a market in the US or elsewhere for its own energy output. But Canada is displacing other US imports in the oil sector, and is still in the game in terms of competing for future LNG activity to Asian markets. Even in North America, prices are still well above those required to meet hurdle rates of return. The US has oil, but it is not cheap oil, and US demand is now growing in line with the improvement in transportation activity. Oil Patch Driving 54% Rise in 214 Canadian M&A Deal Flow (L); Oil Sands Investor Returns Competitive (R) Others -42% y/y Communications +286% y/y Energy +224% y/y Other Resources +72% y/y Distribution of $55 bn YTD volume Internal Rate of Return by Play (%) Bakken- Core Alberta, In Situ Rising US Domestic Production Displacing Other Countries Oil, Not Canada s Permian Eagle Fordcondensate Bakken- Non-core Source: Bloomberg, Standard & Poors,CIBC 5. US Oil & Product Imports, Mn bbl/day Jan- Jan-2 Jan-4 Jan-6 Jan-8 Jan-1 Jan-12 Jan-14 Canada Mexico Other OPEC Saudi Arabia Source: US DOE 3

4 CIBC WORLD MARKETS INC. Canadian Equities Top-Down Chartbook May 1, 214 Valuation Gap Has Closed, But One plus for relative returns in the TSX for 214 as a whole was that we entered the year with less elevated valuations, in terms of a P/E multiple on four-quarter-ahead earnings. That gap has now been closed with both markets trading at roughly 15½ times current-year earnings. But that needn t imply that stocks are equally rich or cheap. The E in P/E is based on bottom-up analyst expectations. Investing is all about identifying where those expectations, and those of the market, have it wrong. If the trend is your friend, the momentum in earnings expectations for the TSX looks much more encouraging than what s happening stateside. Although we re far from alone in expecting the US to outpace Canada in real GDP gains this year, full-year earnings expectations for the S&P 5 have been dropping since January, while TSX analysts have been revising earnings projections higher. PE Gap has Closed (L ), But TSX Earnings Momentum Stronger Lately (R ) Mar-13 4-Qtr Forward PE Ratio May-13 Jul-13 Sep-13 S&P 5 TSX Composite Nov-13 Jan-14 Mar-14 Consensus 214 Index-Adjusted Earnings Expectations TSX Composite S&P 5 Mid-Jan April 28th Source: Bloomberg, CIBC TSX E to See Upside Surprise Our top-down model for TSX earnings, which relates the annual bottom line to broad macro variables (Canadian and US growth, key commodity prices, etc.), suggests that further surprises are in store this year. Last year, the same model forecast low single-digit earnings gains, well below consensus, although it turns out, still a bit too optimistic. For 214, the model projects a 15% gain vs. the bottom-up consensus of 12%, well ahead of the S&P s sluggish pace. CIBC s Leading Indicator (L) Suggests Support From Earnings Surprises (R) Jan-93 I Jan-96 Jan-99 Jan-2 Jan-5 Jan-8 Jan-11 Jan-14 Actual Index Earnings in following 12 months CIBC Leading Indicator of TSX Earnings % change CIBC +13% Consensus +15% 14(f) 15(f) Note: Earnings are deviation from underlying trend, standardized data Source: CIBC 4

5 CIBC WORLD MARKETS INC. Canadian Equities Top-Down Chartbook May 1, 214 Rich Multiples? Not vs Bonds Some might fear that even if the TSX is relatively cheaper, that both markets are expensive at a 15½ times PE multiple. But all asset classes houses, stocks, toll bridges, commercial real estate should trade at higher multiples to cash flows in an era of low interest rates. Relative to today s 1-year bond yields, implying the equivalent of a 4 multiple on (admittedly risk-free) cash flows, stocks look like a screaming buy. True, 1-year rates won t hold below 3% forever, particularly with both the Fed and Bank of Canada likely to initiate a gradual tightening cycle in 215. But in a recent analysis, we highlighted that the longrun neutral overnight rate is likely to be far below the conventional wisdom (and the FOMC s forecast) that puts it at 4%. In both theory and historical data, the neutral rate is correlated with potential GDP growth, which should be lower in this cycle in North America as demographics slow the growth in the working-age population. If the neutral rate in both the US and Canada sits near 2½%, 1-year bonds could settle at less than a 4% yield, at which a 15½ multiple would still make stocks look attractive. That said, rising bond yields should still see the most yield-oriented stock sectors underperform the broader market in the next four quarters. Stock Valuations Still Attractive in a New World of Sustained Low Yields % 4. Historical *based on 2% inflation,.5% real "neutral" rate Current* "Neutral" Short-term rate TSX-Current 1 year GOC, today 1 year GOC, assuming peak YTM of 4% Forward PE, Stocks vs Bonds** ** P/E ratio for bonds is inverse of the yield Source: OECD, Bloomberg,CIBC Stock Pickers Market As top-down analysts, we focus on sectors, rather than individual stocks. But we concede that it s become more of a stock-pickers market recently. Earlier in the recovery, the broad market was moving in sync with an overall risk-on or risk-off swing. Of late, since late 211, when jitters over the US budget impasse and Eurozone fiscal risks were in play, the CBOE s implied correlation measure of expected comovements in the S&P s 6 largest firms has been on a quieting trend. Macro issues still matter, but individual stories are now also coming to the fore. Stocks Still Showing Individual Personality /3/7 S&P 5 Implied Correlation Index 8/7/7 3/1/8 1/1/8 Lehman "Moment" 5/13/1 12/15/1 7/19/11 US Default & Euro angst 2/19/13 9/23/13 4/28/14 Source: Bloomberg 5

6 CIBC WORLD MARKETS INC. Canadian Equities Top-Down Chartbook May 1, 214 Avery Shenfeld (416) Benjamin Tal (416) Peter Buchanan (416) Warren Lovely (416) Andrew Grantham (416) Nick Exarhos (416) This report is issued and approved for distribution by (a) in Canada, CIBC World Markets Inc., a member of the Investment Industry Regulatory Organization of Canada, the Toronto Stock Exchange, the TSX Venture Exchange and a Member of the Canadian Investor Protection Fund, (b) in the United Kingdom, CIBC World Markets plc, which is regulated by the Financial Services Authority, and (c) in Australia, CIBC Australia Limited, a member of the Australian Stock Exchange and regulated by the ASIC (collectively, CIBC ) and (d) in the United States either by (i) CIBC World Markets Inc. for distribution only to U.S. Major Institutional Investors ( MII ) (as such term is defined in SEC Rule 15a-6) or (ii) CIBC World Markets Corp., a member of the Financial Industry Regulatory Authority. U.S. MIIs receiving this report from CIBC World Markets Inc. (the Canadian broker-dealer) are required to effect transactions (other than negotiating their terms) in securities discussed in the report through CIBC World Markets Corp. (the U.S. broker-dealer). This report is provided, for informational purposes only, to institutional investor and retail clients of CIBC World Markets Inc. in Canada, and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. This document and any of the products and information contained herein are not intended for the use of private investors in the United Kingdom. Such investors will not be able to enter into agreements or purchase products mentioned herein from CIBC World Markets plc. The comments and views expressed in this document are meant for the general interests of wholesale clients of CIBC Australia Limited. This report does not take into account the investment objectives, financial situation or specific needs of any particular client of CIBC. Before making an investment decision on the basis of any information contained in this report, the recipient should consider whether such information is appropriate given the recipient s particular investment needs, objectives and financial circumstances. CIBC suggests that, prior to acting on any information contained herein, you contact one of our client advisers in your jurisdiction to discuss your particular circumstances. Since the levels and bases of taxation can change, any reference in this report to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors. Past performance is not a guarantee of future results. The information and any statistical data contained herein were obtained from sources that we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. All estimates and opinions expressed herein constitute judgments as of the date of this report and are subject to change without notice. This report may provide addresses of, or contain hyperlinks to, Internet web sites. CIBC has not reviewed the linked Internet web site of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided solely for the recipient s convenience and information, and the content of linked third-party web sites is not in any way incorporated into this document. Recipients who choose to access such third-party web sites or follow such hyperlinks do so at their own risk. 214 CIBC World Markets Inc. All rights reserved. Unauthorized use, distribution, duplication or disclosure without the prior written permission of CIBC World Markets Inc. is prohibited by law and may result in prosecution. 6