Here s What We re Thinking January 23, 2018 // 1 Here s What We re Thinking Global Portfolio Advisory Group The Investment Committee of the Portfolio Advisory Group meets regularly to formally discuss markets, sector allocation and investment recommendations. Below is a brief synopsis of our current views. For specific investment strategy relating to your investment portfolio, please contact your Scotia Wealth Management advisor. Investment Strategy: Global markets continue to reach new highs on solid fundamentals Strategy: Global markets are off to an impressive start to the year with the S&P500 index posting a 6.2% yearto-date gain while the S&P/TSX Composite index is up 1% in the same period (local currency terms). Meanwhile, WTI crude oil prices have climbed 6.7%, gold is 2.7% higher, and the Canadian dollar has appreciated 1% thus far in 2018. In large part, these gains are driven by strong and improving fundamental drivers including accelerating global economic growth, stable inflation, gently rising interest rates and bond yields, recovering commodity prices, a softer U.S. dollar, and healthy earnings growth. As a result, investor sentiment has jumped to a 7-year high, helping equity fund inflows surge in early 2018. Given we look for fundamentals to remain supportive through 2018, our investment strategy retains an overweight to equities and we would view any material pullback in markets as an attractive opportunity to put cash to work. The market has not experienced a pullback in excess of 5% for over 18 months. We would view any such correction as a function of short-term profit-taking and expect it would be temporary in nature given risks of a near-term recession remain very low. Equities: In our analysis, the S&P500 (which represents more than half of the global equity market capitalization) is approximately 1% cheaper on a blended 12-month P/E basis than it was a month ago. We believe with the recent uptick in the U.S. 10-year Treasury yield (approximately 25 basis point rise over the last 30 days), higher equity valuations are warranted. We would not be surprised to see the S&P500 s valuation exceed its recent (December, 2017) peak shortly. We believe the move up in yields reflects underlying strength in the U.S. labour market and the global economy, along with the historically low levels from which bond yields are rising. Until bond yields are considerably higher than they currently are, we believe yields and equity valuations should retain their positive relationship. Thus, we retain our two-year-old equity overweight bias, with a preference for international regions (including Canada) at the expense of the U.S. We believe commodity sectors (materials, energy) and financials will comprise the top three performing sectors in 2018. Fixed income: Corporate credit remains well bid for now. New issuance returned to the Canadian market over the last two weeks with $3.9B of supply (more than double the previous 4-week period) but the Canadian corporate market remained well-bid. All major sectors experienced spread compression and most credit curves flattened. Notable outperformers were in energy, subordinated bank debt, and real estate. We currently recommend overweight positions in the former two segments. At this time, we believe it prudent to express caution on current overall spread levels. Spreads for corporate debt remain at cycle lows and present little opportunity for further compression, in our view. We continue to believe these levels could persist provided the credit cycle remains intact. However, we would caution against adding exposure to BBB-rated credit as risk-reward is unattractive relative to A-rated credit, in our view. Additionally, BBB-rated credit is likely to be the first to experience spread widening within the investment-grade universe. Please be aware that this material is not to be distributed to residents of the European Union Registered trademark of The Bank of Nova Scotia, used under licence. Trademark of The Bank of Nova Scotia, used under licence. Scotia Wealth Management consists of a range of financial services provided by The Bank of Nova Scotia (Scotiabank ); The Bank of Nova Scotia Trust Company (Scotiatrust ); Private Investment Counsel, a service of 1832 Asset Management L.P.; 1832 Asset Management U.S. Inc.; Scotia Wealth Insurance Services Inc.; and ScotiaMcLeod, a division of Scotia Capital Inc. Wealth advisory and brokerage services are provided by ScotiaMcLeod, a division of Scotia Capital Inc. Scotia Capital Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
Here s What We re Thinking January 23, 2018// 2 Currencies and Commodities: As crude oil prices climb, will U.S. producers increase production? Bank of Canada turns slightly more hawkish In a past edition of Here s What We re Thinking, we highlighted a Wall Street Journal (WSJ) article that focused on recent investor frustration with U.S. oil producers and their emphasis on production growth rather than profitability. With WTI crude oil currently trading around US$64/bbl, many, including ourselves, wonder if U.S. shale producers will follow through with their cautious spending plans for 2018. According to the WSJ, for the first time during the shale revolution, U.S. oil companies could possibly spend less cash than they generate this year, a meaningful accomplishment, in our view, if it does occur. The surplus cash, typically earmarked for production growth, could potentially be used to reduce debt or put toward more shareholder friendly initiatives, such as share buybacks and/or dividend increases. Only time will tell which path U.S. oil producers take, but early indications suggest future U.S. oil production growth could be slower than many expect, further supporting the supply/demand rebalancing story and our favourable outlook on the energy sector. Moving on to monetary policy and the Canadian dollar, the Bank of Canada (BoC) raised its policy rate by 25bps last week and also provided a slightly more hawkish outlook. The BoC upgraded its assessment of the level of spare capacity in the economy, it upwardly revised its global growth forecasts, it raised its inflation forecasts, and it also slightly increased its 2018 and 2019 Canadian economic growth forecasts. This has all helped the CAD hold steady relative to the U.S. dollar since the January 17 th BoC announcement. However, the BoC s Monetary Policy Report does not explicitly indicate the bank views the strength in the Canadian dollar as an impediment to further rate increases. We maintain our view that monetary policy tightening by the U.S. Federal Reserve should support the USD relative to the rest of the developed market currencies in the first half of 2018, while the outperformance trend may struggle to extend beyond the second quarter as the monetary policy bias of other major central banks could turn more hawkish/less dovish. We view the Canadian dollar at around US$0.80 as a reasonable level for much of 2018. Economics: China registered a strong year in 2017 and aims for a more balanced and sustainable economy going forward China s last batch of economic data releases for 2017, released last week, came in stronger than expected. With GDP growing 6.8% in Q4 last year, the world s second largest economy registered 6.9% annual GDP growth in 2017, a pickup from 2016 s 6.7%. Meanwhile, industrial production for December also surprised on the upside, following the strong manufacturing purchasing managers index (PMI) reading and trade data from the week before. This flow of strong economic data came despite widespread concern last year about financial risks in China amid a government-led economic restructuring. The data reinforced the view that a moderation in China s GDP growth most likely will be the case in 2018 (economists forecast 6.5% growth for 2018, according to Bloomberg). Meanwhile, a more balanced and sustainable economy is expected to take shape faster than previously anticipated. However, headwinds - including tighter regulations (which could weigh on the property sector, although a sharp slowdown is unlikely), U.S. trade protectionism, and a possible softer consumer sector - could put downward pressure on China s GDP growth. Following last year s National Party Congress and Central Economic Work Conference, it became clear that China s main focus going forward will be on high-quality development along with battling financial risks, poverty and pollution. Although broad economic plans for China have been set, specific economic targets for 2018 as well as tactical details will not be publicly disclosed until March, at the country s annual parliamentary session. Geopolitical: One coalition comes together while another begins to fray German politics look to be heading in a constructive direction. On January 21 st, the Social Democratic Party (SPD) of Germany voted in favour of restarting negotiations with Angela Merkel s Christian Democratic
Here s What We re Thinking January 23, 2018// 3 Union (CDU). The vote was closer than expected and reversed an earlier vote by the SPD that struck down negotiations. The most recent vote de-escalates political tensions that have been present since the German federal election in September 2017. But those risks have not been completely eliminated as negotiations continue over key issues like immigration and healthcare. Regardless, the alternative a new vote or a minority government could have given the far-right Alternative for Germany party a chance to gain more power and further stoke the fires of European disintegration. in order to form a provincial governing alliance. That agreement was premised on a number of tenets, including commitments to targets on greenhouse gas emissions. Now, Green Party leader Andrew Weaver is concerned about reaching those targets following the NDP s courting of liquefied natural gas investors. Mr. Weaver has taken a hard-line stance on the subject, and if the agreement is broken, then British Columbians could be back to the polls within a year of the last election. British Columbia s coalition looks to be cracking. Last summer, British Columbia s New Democratic Party and Green Party signed a Confidence and Supply agreement
Here s What We re Thinking January 23, 2018// 4 Recommended Asset Allocation Asset Class Neutral Tactical Equities 60% 65% Canada 30% 33% United States 25% 25% International 5% 7% Fixed Income 40% 30% Government/Prov s 25% 15% Inv. Grade Corporates 10% 10% High Yield 0% 0% Preferreds 5% 5% Cash 0% 5% Sector Underweight Neutral Overweight Financials Industrials Materials Energy Healthcare Consumer Discretionary Technology Consumer Staples Ut ilities Telecommunications Real Estate
Here s What We re Thinking January 23, 2018// 5 Disclaimers Important Disclosures This material does not include or constitute an investment recommendation, and is not intended to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and talk to your investment advisor. The author(s) of the report own(s) securities of the following companies. None. The supervisors of the Portfolio Advisory Group own securities of the following companies. None Scotia Capital Inc. is what is referred to as an integrated investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. 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