Halfway there MONTHLY PERSPECTIVES PORTFOLIO ADVICE & INVESTMENT RESEARCH

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1 Halfway there MONTHLY PERSPECTIVES PORTFOLIO ADVICE & INVESTMENT RESEARCH July 215 In this issue TD ECONOMICS Central banks set a course for diverging paths... 2 FIXED INCOME A wild joyride for interest rates... 3 NORTH AMERICAN EQUITIES The view from here THE LAST WORD A picture is worth a thousand words... 6 Martha Hill, CFA In this issue of Monthly Perspectives, we review the first half of the year and provide you with an outlook for what is likely to follow. We begin with TD Economics discussion about the varied outlook for monetary policy among the world s major central banks. With some central banks tightening monetary policy while others inject stimulus into their economies, they have set a course for diverging paths. We discuss the developments in fixed income markets and the volatility that investors have experienced globally. In addition, we provide insights on the Canadian preferred share market. We also revisit our 215 North American equities outlook to refocus our lenses and offer our view from here. We discuss the various sectors within the Canadian and U.S. equity markets and outline factors that have affected and potentially will impact the performance of these sectors going forward. PERFORMANCE MONITOR Monthly market review... 7 APPENDIX A Important information... 8 This document is for distribution to Canadian clients only. Please refer to Appendix A of this report for important disclosure information.

2 2 MONTHLY PERSPECTIVES July 215 TD ECONOMICS Central banks set a course for diverging paths Beata Caranci, Vice President and Chief Economist, TD Economics Global financial markets kicked off 215 with three major concerns: the threat of deflation, persistent weakness in key economic regions, and a varied outlook for monetary policy among the world s major central banks. These factors all played a role in boosting the value of the U.S. dollar, weakening other currencies, lowering bond yields globally, and stirring up volatility in equity markets. Now at midyear, the veil of uncertainty is lifting on some, but not all of these concerns. In particular, the threat of deflation seems less pressing to market participants and green shoots have started to sprout in the European economy. This is placing an increased focus on deciphering the next steps of central bankers. At the centre of these discussions are the U.S. Federal Reserve (Fed) and the Bank of England, which seem the most likely candidates to begin a tightening cycle among the advanced economies. This is in stark contrast to ongoing commitments by the European Central Bank (ECB) and the Bank of Japan to keep injecting monetary stimulus into their economies. And then there s the Bank of Canada, which is likely to ride up the middle by keeping policy static until the clock winds down on 216. A world of divergent policy should keep the U.S. dollar favoured by investors and raises the prospect that the trough in global yields has passed. To understand the path to diverging monetary policy, one needs an appreciation of the forces at work. Concerns over deflation subside Let s start with the abating deflation risks that are providing a floor to global yields. Earlier in the year, the market s deflation fears were fuelled by the combination of soft global growth and the dramatic fall in oil prices. West Texas Intermediate crude oil plunged from around US$1/barrel to less than US$5/barrel within six months. Headline consumer price inflation around the world turned south and even contracted within the large economies of the U.S. and the euro zone. This trend fuelled financial market worries over price stability, which subsequently pressured global bond yields lower. However, these concerns were exaggerated. First, oil prices have stabilized, in part due to swift supply adjustments in North America. Second, true deflation requires prices of goods and services to fall broadly within an economy. This did not occur in any dramatic fashion and the prospect for it is becoming increasingly remote. In particular, the ECB responded to the deflation threat by shoring up market expectations with aggressive monetary policy, while rising wage pressures in the U.S. are helping to quiet the voices of some of the naysayers. Perceptions of weakness being revisited Financial markets are revisiting some of their expectations on the economic landscape. In the euro zone, past structural changes to the banking system, aggressive monetary policy tactics, a low euro and cheaper energy prices are proving to be a potent combination, lifting the growth trajectory of its economies. At the other end of the globe, a three-pronged approach in Japan to inject fiscal and monetary stimulus, and start on structural reforms is also finding some success in underpinning near-term growth prospects. One area where market sentiment remains downtrodden is China, and emerging markets in general. However, this reflects a broader theme. Global growth will accelerate on the back of the advanced economies at this stage in the business cycle, rather than emerging markets a sea-change from the experience coming out of the Great Recession. Divergent paths of monetary policy This leads back to the likely divergent paths for central bank policies in 215 and 216. Japan and the euro zone s economic recoveries remain hinged to large scale monetary stimulus. For example, the ECB launched an asset buying program this year akin to the quantitative easing program previously run by the Fed. This has lowered the value of the euro and contributed to bond yields falling into negative territory for some debt maturities in selected countries, like Germany. In contrast, a more positive economic backdrop for the U.S., particularly in terms of broadening labour market strength, has led the Fed to express unease about leaving rates zero-bound for much longer. If the data continues to meet expectations, the fed funds rate will likely begin to rise by the end of this year. Similar conditions exist for the U.K. economy, where markets are prepping for an early 216 hike by the Bank of England. Whereas the start of this year was dominated by excessively low European sovereign yields acting as a weight on yields in North America and elsewhere, the end of the year is more likely to be centered on European yields tempering the pace of adjustment in U.S. Treasury yields, but not actually preventing them from moving higher. That said, any central bank embarking on a rate hike cycle will do so cautiously given the degree of global and domestic uncertainty. The Fed is likely to act in a stepwise manner that will see only 5-1 basis points in rate hikes per year. In contrast, the Bank of Canada surprised markets with a rate cut in January as an insurance policy against the downside risks to the economy from the fall in oil prices. However, the central bank does expect continued growth of roughly 2% and appears to be comfortable sitting on the sidelines for the time being. This may cause some downward pressure to resume on the loonie once the Fed s policy diverges. However, the Canadian dollar is in a position to outperform non-u.s. peers given that its economic fortunes are closely tied to its southern neighbour. This linkage may also pull Canadian yields slightly higher even with the Bank of Canada standing pat.

3 3 MONTHLY PERSPECTIVES July 215 FIXED INCOME A wild joyride for interest rates Sheldon Dong, CFA Analysts expect interest rates to rise this year as global economic growth continues to recover and gain strength. This may be the path, but the journey so far in getting there has been rather wild. Since the beginning of the year, central banks in developed economies have gone from Zero Interest Rate Policy (ZIRP) to Negative Interest Rate Policy (NIRP), and now in the case of the U.S. Federal Reserve to the anticipated Rising Interest Rate Policy (RIRP). The combination of weak global economic growth and lower global inflation (deflation in some parts) has allowed central banks more latitude from a price stability perspective to promote economic growth. The Bank of Canada (BoC) surprised markets with a rate cut in January to help offset the negative economic impact from the sharp drop in oil prices, while the European Central Bank introduced quantitative easing (QE) in March that led to negative interest rates in order to fend off deflationary expectations. As a result of policy actions, recessionary and deflationary fears have receded and interest rates have made a round trip and returned to their original destination of moving modestly higher over time. Investors looking for market volatility should pay attention to interest rate markets, as strange things happen when figures approach zero. One is that volatility gets magnified. A good example is Germany's benchmark 1-year bond yield, which moved from a record low of.49% on April 17, 215 to a recent high of 1.57% on June 1, 215 a jump of over 2% in just a little over seven weeks. Germany's yield curve has gone from being negative out to nine years in maturity back to four years over that same time span. In the U.S., the benchmark 1-year Treasury yield jumped 52% from a record low of 1.64% on January 3, 215 to a recent high of 2.5% on June 11, 215. Canadian government yields have gone on a similar joyride this year. As of June 26, 215, benchmark 2-year (.64%), 5-year (1.3%), 1-year (1.88%), and 3-year (2.47%) yields are up from their record lows on February 2, 215 of.38%,.58%, 1.23% and 1.83%, respectively. In percentage terms, the jump in yields was 68% for 2-years, 78% for 5-years, 53% for 1-years and 35% for 3-years. Despite the sharp movement in interest rates, they remain near historically low levels and are near TD Economics' forecast for year-end 215. Further, rates are expected to move only modestly higher in 216 as the BoC is not expected to begin raising interest rates until the fourth quarter. Interest rates in Canada are still expected to remain relatively low for longer. There are two major forces that lean against a sharper move in yields over the forecast horizon to the end of 216. First, strong global demand for high-quality liquid assets namely highly rated sovereign bonds will keep downward pressure on yields. This is in part due to continued central bank buying, particularly the European Central Bank (6 billion euros a month to the end of September 216) for the purposes of QE. With many European government bonds having negative yields or rates substantially below Canadian government rates, international arbitrage should help provide a ceiling on how high domestic rates can rise. Second, inflationary pressure in the Canadian economy is forecast by TD Economics and the BoC to remain fairly modest. Therefore, a sharper rise in longer-term yields would not be in line with economic fundamentals. While interest rates have deviated early this year from the roadmap, the (relatively) lower for longer destination remains unchanged. The Canadian preferred share market has experienced significant weakness in the first half of 215. With few exceptions (notably Enbridge Inc.), the plunge in the rate-reset market is not related to credit concerns. It has been a product of low interest rates and resultant fears of dividend reduction. The BoC's surprise decision to cut the overnight rate by 25 basis points in January sent the Canadian yield curve sharply lower in the latter half of the month and caused market participants to push any expectations for monetary policy tightening in Canada well into the future. The rate reset market has experienced exceptional weakness since that time, but so have floating rate and fixed-to-float preferred shares. Essentially any preferred shares that pay variable dividends have come under pressure as the market seems to be assuming that future dividend reductions are a certainty. Many of the most negatively impacted rate-reset issues are those with reset dates in 215 and 216, as the potential for reduced cash flows looms. These issues generally have low reset spreads. The combination of low reset spreads and the low Government of Canada yield environment will likely result in significant cash flow reductions for many of these securities assuming that bond yields don't move higher. As of June 23, 215, the broad S&P/TSX Preferred Share Index (TXPR) had declined 1.7% year-to-date, while the S&P/ TSX Laddered Preferred Share Index (TXPL), which is comprised entirely of rate-reset preferred shares, had declined almost 14.2%. Going forward, new issuance and dividend reduction through reset are factors that will likely continue to weigh on the rate-reset market, while rising interest rates (9-day T-bills, 5-year) are likely to be supportive for issues that have variable dividends.

4 4 MONTHLY PERSPECTIVES July 215 NORTH AMERICAN EQUITIES The view from here Yogesh Oza, CFA; Catherine Carlin, CFA Having now reached the midway mark of the year, we take this opportunity to revisit our 215 North American equities outlook, published in the December 214 issue of Monthly Perspectives. The macroeconomic environment continues to evolve largely as we expected despite another very cold winter and labour disruption at a major U.S. port that dampened first quarter Gross Domestic Product (GDP). Recent data on the North American labour market, housing, and consumer confidence as well as strong free cash flow in the corporate sector suggest that the economic acceleration will continue in the coming quarters. This should lend support to equity markets, particularly the more cyclical sectors, although we recognize the risk of higher volatility due to the uncertainty of the timing of the well-telegraphed first rate hike by the U.S. Federal Reserve. The year-to-date performance of the S&P/TSX Composite Index and the S&P 5 Index, broken down by sector is shown in table 1. The health care sector has posted the strongest returns so far this year The health care sector has posted outsized returns thus far in 215, in Canada driven almost exclusively by the higher risk, growthby-acquisition company, Valeant Pharmaceuticals Inc. In the U.S. the sector has benefitted, and we expect will continue to benefit, from the introduction of the Affordable Care Act, favourable demographic trends, further international expansion, and FDA approvals and developments in breakthrough technologies such as immuno-oncology. For the balance of the year, we continue to be cautious on this sector in Canada because of the security-specific risk; investors may find good opportunities south of the border to benefit from the positive trends. We were largely positive on the cyclical sectors at the beginning of the year, and so far they have posted mixed returns with consumer and technology sectors rallying, while weak oil and natural gas prices have held back returns in the energy and industrial sectors. As expected, the consumer discretionary sector in North America and the consumer staples sector in Canada have performed very well so far and we are not changing our outlook on these groups for the balance of the year. The macro trends driving the consumer sectors, particularly the consumer discretionary sector are playing out well. The information technology sector performed well through the first half of the year, outperforming the market indices on both sides of the border. We expect this trend may continue with potential growth drivers including big-data analytics, data security, and software-as-a-service migration. The growth in technology spending by corporations may take over from what has been a consumer spending led sector. The well-publicized oil supply glut has resulted in a material reduction in drilling activity by North American energy producers. While we believe this will gradually bring more balance to the market, this may not happen in 215. Add to this the political change in Alberta, which has introduced uncertainty around royalty rates, and we are more cautious about the energy outlook in Canada for the balance of the year than we were six months ago. Our neutral view on energy in the U.S. is unchanged, and we have reduced our outlook on the Canadian sector to neutral from positive. We believe that security selection is particularly important, and suggest that investors look to companies with strong balance sheets and lowcost, well-located assets to help weather the current environment. Table 1: Canadian and U.S. Sector Performance (Year-to-date) Canadian Sectors Price Return S&P/TSX Comp. Health Care 59.5% S&P/TSX Comp. Consumer Discretionary 6.4% S&P/TSX Comp. Consumer Staples 3.9% S&P/TSX Comp. Information Technology 3.6% S&P/TSX Comp. Materials.6% S&P/TSX Composite Index.1% S&P/TSX Comp. Financials -1.6% S&P/TSX Comp. Telecommunication Services -1.9% S&P/TSX Comp. Utilities -4.9% S&P/TSX Comp. Industrials -5.9% S&P/TSX Comp. Energy -6.5% Source: TD Securities Inc., Bloomberg Finace L.P. As at June 19, 215. U.S. Sectors Price Return S&P 5 Health Care 1.6% S&P 5 Consumer Discretionary 7.5% S&P 5 Materials 3.5% S&P 5 Information Technology 3.1% S&P 5 Index 2.5% S&P 5 Telecommunication Services 1.4% S&P 5 Financials.8% S&P 5 Consumer Staples.2% S&P 5 Industrials -1.2% S&P 5 Energy -4.9% S&P 5 Utilities -9.4%

5 5 MONTHLY PERSPECTIVES July 215 NORTH AMERICAN EQUITIES The view from here (cont d) Yogesh Oza, CFA; Catherine Carlin, CFA The swoon in oil prices also negatively impacted the industrials sector. Some of the hardest hit stocks in the sector were the railways. As a result of the oil price selloff, it is expected that crude-by-rail growth will moderate, after years of strong growth. U.S. industrial companies with international operations were also hurt by the 7.3% rally in the U.S. Dollar Index, somewhat offset by the improving outlook in developed countries. Our initial view that stronger corporate spending should improve operational efficiency is intact. We continue to have a preference for U.S. industrial stocks over the Canadian industrials, given the commodity price headwinds faced by the Canadian industrials and the greater breadth of the U.S. sector. Our modestly positive outlook on the financials sector at the beginning of the year has not played out yet, although we have begun to see some traction south of the border, particularly among the U.S. banks. Nevertheless, we maintain our favourable view on the group as the improving consumer and business trends are still positive though somewhat protracted. Company fundamentals and balance sheets are strong, and the sector should benefit when yields begin to rise. We point to more attractive valuations and better growth opportunities for this sector in the U.S. Within the sector in Canada, we have a preference for insurance companies over banks and Real Estate Investment Trusts (REITs) for relative growth and valuation reasons, as well as the potential for sentiment toward REITs to be hurt in the event of rising rates. Interest rate risk also colours our outlook for the utilities and telecommunications sectors, where our cautious outlook has played out so far this year. We are not changing our view on these sectors in the U.S. In Canada, we are now more cautious on the utilities sector and slightly less cautious than we were on the telecommunications sector as the oligopoly dynamics continue in this sector for now, the companies provide above average yield and have reasonable growth prospects. Figure 1: Canadian and U.S. Index Performance S&P 5 Index S&P/TSX Composite Index 85 1/1/15 2/1/15 3/1/15 4/1/15 5/1/15 6/1/15 Source: Thomson Reuters Datastream. As at June 29, 215. The materials sector has posted a return slightly exceeding the index performance and we are now less negative on the group than we were at the beginning of the year. The sector has performed so poorly that there may be little room left for further material downside. Certain subsectors, such as chemicals or lumber may benefit from improving economic conditions. Focus on companies that have excellent business models, defensible franchises, management with a history of strong execution and well-funded balance sheets Our overriding preference is to focus on companies that have excellent business models, defensible franchises, management with a history of strong execution and well-funded balance sheets. Further, we believe that investors should rely less on positioning their investment portfolios against an industry index and instead, consider their individual investment goals and risk tolerance. Table 2: Canadian and U.S. Sector Preference Sector U.S. Canada Preference Energy Marketweight Marketweight U.S. Materials Marketweight Marketweight No Preference Industrials Overweight Marketweight U.S. Consumer Discretionary Overweight Overweight No Preference Consumer Staples Underweight Marketweight Canada Health Care Overweight Underweight U.S. Information Technology Overweight Overweight U.S. Financials Overweight Marketweight U.S. Telecom Services Underweight Marketweight Canada Utilities Underweight Underweight Canada Source: Portfolio Advice & Investment Research. As at June 19, 215.

6 6 MONTHLY PERSPECTIVES July 215 THE LAST WORD A picture is worth a thousand words Chris Blake, CFA Figure 2: Global Stock Market Performance 3.% 25.% 2.% 15.% 1.% 5.%.% Source: Thomson Reuters Datastream. As of June 24, 215. Local currency Canadian dollar The Canadian stock market has underperformed most developed global markets on a Canadian dollar basis so far this year, although in local currency terms, the S&P 5 Index's 2.4% return just squeaks by the S&P/TSX Composite Index's 2.2% return. By far, the outstanding returns for the year (to June 24) have gone to Canadian dollar based investors in the Far East with Hong Kong's Hang Seng up 24.3% and the Nikkei in Japan giving a 23.4% return. Europe has also posted good returns year-to-date in both local currency and the Canadian dollar. Hang Seng Index (Hang Seng) Hong Kong Nikkei 225 Index (Nikkei) - Japan CAC 4 Index (CAC 4) - France DAX Index (DAX) - Germany FTSE 1 Index (FTSE 1) - England S&P 5 Index (S&P5) United States S&P/ASX 2 (ASX 2) - Australia S&P/TSX Composite Index (S&P/TSX) - Canada Figure 3: U.S. New Single Family Sales and Inventory Sales - new single family homes (LHS, thousands - annualized rate) Inventory - single family homes (RHS, months) Figure 4: U.S. household formation and employment growth U.S. household formation volume U.S. employment growth - 25 to 34 age group /1/95 6/1/98 6/1/1 6/1/4 6/1/7 6/1/1 6/1/ /1/ 6/1/4 6/1/8 6/1/ Source: Bloomberg Finance L.P. As of June 24, 215. Source: Bloomberg Finance L.P. As of June 24, 215. The housing market in the U.S. is gaining steam. Housing sales are making a slow crawl back to the pre-housing bubble levels and the months' supply of houses in inventory is coming down to low levels. This is not surprising given the improved capital position at U.S. banks, which is encouraging lending; and, a notable recent pick up of employment in the critical year old cohort is leading to some of the highest levels of household formation that have been seen since 211. Figure 5: U.S. Bearish Investor Sentiment Readings '8 '9 '1 '11 '12 '13 '14 '15 Source: Bloomberg Finance L.P. As of June 24, 215. The marked uptick in bearishness on the part of individual investors has proven itself warranted as fears of high valuations in the market and European debt negotiations seem threats worthy of starting a major market disruption. However, a strengthening U.S. economy, high cash balances in accounts and an impending asset shift from bonds will prove formidable obstacles for the bears to overcome as they try to wrestle this bull market into submission. From a contrarian point of view, seeing the market with a wall of worry to climb is a positive.

7 7 MONTHLY PERSPECTIVES July 215 PERFORMANCE MONITOR Monthly market review (%) (%) (%) (%) (%) (%) (%) (%) Canadian Indices ($CA) Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years S&P/TSX Composite (TR) 44, S&P/TSX Composite (PR) 14, S&P/TSX 6 (TR) 2, S&P/TSX SmallCap (TR) U.S. Indices ($US) Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years S&P 5 (TR) 3, S&P 5 (PR) 2, Dow Jones Industrial (PR) 17, NASDAQ Composite (PR) 4, Russell 2 (TR) 5, U.S. Indices ($CA) Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years S&P 5 (TR) 4, S&P 5 (PR) 2, Dow Jones Industrial (PR) 21, NASDAQ Composite (PR) 6, Russell 2 (TR) 7, MSCI Indices ($US) Total Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years World 6, EAFE (Europe, Australasia, Far East) 6, EM (Emerging Markets) 1, MSCI Indices ($CA) Total Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years World 8, EAFE (Europe, Australasia, Far East) 8, EM (Emerging Markets) 2, Currency Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years Canadian Dollar ($US/$CA) Regional Indices (Native Currency) Price Return Index Level 1 Month 3 Months YTD 1 Year 3 Years 5 Years 1 Years 2 Years London FTSE 1 (UK) 6, Hang Seng (Hong Kong) 26, Nikkei 225 (Japan) 2, Bond Yields 3 Months 5 Years 1 Years 3 Years Government of Canada Yields U.S. Treasury Yields Canadian Bond Indices ($CA) Total Return Index Level 1 Month 3 Month YTD 1 Year 3 Year 5 Year 1 Year FTSE TMX Canada Universe Bond Index FTSE TMX Canadian Short Term Bond Index (1-5 Years) FTSE TMX Canadian Mid Term Bond Index (5-1) FTSE TMX Long Term Bond Index (1+ Years) Sources: TD Securities Inc., Bloomberg Finance L.P. TR: total return, PR: price return. As at June 3, 215.

8 8 MONTHLY PERSPECTIVES July 215 APPENDIX A Important information The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, trading, or tax strategies should be evaluated relative to each individual s objectives and risk tolerance. TD Wealth, The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. 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