December 2015 Portfolio Strategy Equity Strategy: Roadmap for 2016 – Get Ready for the Global Recovery Stéphane Rochon, CFA, Equity Strategist Looking out to 2016, we remain bullish on stocks globally and believe that equities generally continue to hold far better relative value than fixed income (our team emphasizes shorter duration bonds which have less interest rate risk). While we do not think interest rates will go up substantially next year, we do think an underappreciated risk could be a build-up in inflationary pressure in the back half of 2016. We will be monitoring wage inflation which could be the proverbial canary in the coal mine for a (slight) pickup in consumer price inflation which could, in turn, lead to higher interest rates. More on this further in the report. Looking at North America equities specifically, we just turned slightly more bullish on Canada last month after emphasizing U.S. exposure relentlessly over the last four years. We expect the Canadian dollar return of the S&P/TSX Composite Index (the TSX) to at least keep pace with the S&P 500 Index (the S&P) over the next three or four quarters. With our fair value estimates yielding a value of approximately 15,000 for the TSX and 2,300 for the S&P, we see about 10% upside for both markets from current levels. We continue to recommend exposure to Europe, which is benefitting from the European Central Bank’s (ECB) quantitative easing, a slight pickup in economic momentum, long term margin improvement potential and cheap valuations. Finally, a small position in emerging markets (with emphasis on emerging market consumers) appears appropriate after significant underperformance for markets such as China and Brazil over the last year. Our more positive stance on Canada is not based on the dawn of a new commodity super cycle. As we stated in our last report, we still believe that we are in the midst of a protracted commodity bear market. In fact, Ned Davis Research, one of our research providers, recently noted that since the early 1800s, the average historical downturn for commodities has lasted 20 years (we are less than five years into the current downturn in our view). That being said, even in the midst of bear markets, rallies can be violent and profitable. Specifically, we think that oil prices have limited downside risk from here despite a still oversupplied market (Saudi Arabia continues to refuse to advocate a supply reduction from OPEC) thanks to a slight improvement in the supply/demand fundamentals. Given the TSX and Canadian dollar are so highly correlated to oil and copper prices we believe a more market weight position in energy stocks is now appropriate. From a sector perspective we think that with reaccelerating economic momentum, investors will be well-served to overweight cyclicals such as financials, technology, industrials and some consumer discretionary stocks (i.e. we still like U.S. housing and auto related plays) and underweight expensive, defensive sectors such as utilities and telecoms. Figure 1: BMO Nesbitt Burns Investment Strategy Committee’s Recommended Asset Allocation (%) Income Balanced Growth Aggressive Growth Recommended Benchmark Recommended Benchmark Recommended Benchmark Recommended Benchmark Asset Mix Weights Asset Mix Weights Asset Mix Weights Asset Mix Weights Cash 5 5 5 5 5 5 0 5 Fixed Income 65 70 35 45 15 25 0 0 Equity 30 25 60 50 80 70 100 95 Canadian Equity 15 15 20 25 25 35 25 40 U.S. Equity 10 5 30 15 35 20 45 30 EAFE Equity 5* 5 5* 5 10* 10 15* 15 Emerging Equity 0 0 5 5 10 5 15 10 * Within EAFE, we specifically recommend Continental European equity. Source: BMO Nesbitt Burns Private Client Strategy Committee BMO Nesbitt Burns Inc. is a Member-Canadian Investor Protection Fund. Member of the Investment Industry Regulatory Organization of Canada. All figures in C$ unless otherwise noted Portfolio Strategy | December 2015 Error! Reference source not found. | Error! Reference source not found. We also think returns could be far greater for certain Figure 2: Swiss and German Fixed Income Yield Curve (horizontal axis in stocks exposed to our favourite themes: 1) the U.S. years) Housing and Auto Recovery and the “Wealth Virtuous 2.0% Cycle”, 2) Canadian, U.S. and European financials 1.5% which should benefit from the global recovery and the eventual normalization of interest rates and 3) the 1.0% Commercial Construction Recovery and 0.5% Reindustrialization of America. 0.0% We believe following these broad guidelines will help -0.5% investor portfolios outperform in 2016. Please contact -1.0% your BMO Nesbitt Burns Investment Advisor for specific recommendations. -1.5% 0 5 10 15 20 25 30 Bonds are Expensive Globally Switzerland Germany We continue to be underweight fixed income as bonds Source: Bloomberg are quite expensive relative to other asset classes. Figure 3: U.S. Unit Labour Costs and 10-year Government Bond Yields Looking across the Atlantic, some European yield curves 20% are actually negative for the next several years meaning that investors who buy these bonds and hold them to 15% maturity are guaranteed to lose money on their investment! This, in and of itself, does not mean they 10% need to correct anytime soon, but it does show how little margin of safety there is when investing in these 5% instruments. While North American bonds still provide positive yields, they are also very low by historical 0% standards. We believe the “canary in the coal mine” for a more -5% sustained increase in interest rates could be a continued Feb-59 Feb-70 Jan-81 Dec-91 Dec-02 Nov-13 rise in U.S. wage pressure, which we will be monitoring U.S. Unit Labor Costs U.S. 10-year yield closely in light of generally improving labor market Source: Bloomberg conditions south of the border. BMO Capital Markets Economics (BMO Economics) recently noted: “The unemployment rate has been halved since peaking in the aftermath of the Great Recession (from 10.0% in October 2009 to 5.0% in October 2015), and now hovers in the FOMC’s longer-run projection range (4.9%-to-5.2%).1 And, broader measures of labour market slack are now improving more quickly than the jobless rate For example, the (U6) underemployment” rate is now 9.8%, falling a full percentage point faster than the jobless rate over the past year (compared to 0.7 points in the year to October 2014 and only 0.1 points during the year before). In turn, wage pressures, even seen in average hourly earnings, are starting to sprout.” That some early signs of mounting wage pressures are coinciding with some early indications of faster-rising core services prices is no coincidence; the traditional wage-price dynamic appears to be once again taking root. Although it’s early, this should help make the Federal Reserve (“The Fed”) feel “reasonably confident that inflation will move back to its two percent objective over the medium term.” Now don’t get us wrong, wage inflation still remains under control for now. Historically, wages have started accelerating upward once the unemployment rate nears 4.5% and we are getting close to this level. Also, anecdotal evidence suggests that there is 1 FOMC refers to the Federal Open Market Committee. Portfolio Strategy | December 2015 2 growing political pressure to increase the minimum wage and many retailers and fast food restaurants are already boosting hourly wages (e.g. Wal-Mart, McDonalds etc). Figure 4, which goes back to the early 1960s, clearly shows the relationship between unit labour costs and ten-year interest rates. Why We Are Still Long Term Bulls on North American and Global Stocks Simply put, because the long term macro drivers which truly matter for stock returns are still positive. As the table below shows, better stock returns have all been associated with low or declining inflation, a declining unemployment rate, a rising fed funds rate (at least at first), a steepening yield curve (meaning higher long term than short term rates) and an improving Purchasing 2 Managers’ Index (PMI). The good news is that we still find ourselves in the sweet spot for these factors. Figure 4: Where We Are in the Cycle Current S&P 500 (Annual Price S&P/TSX (Annual Price Cycle Return) Return) U.S. CPI and Market Returns (1963 to Present) Average Median Average Median CPI Rising 0.9% 0.0% 4.6% 4.0% CPI Declining X 10.2% 16.1% 5.3% 8.5% U.S. Unemployment Rate and Market Returns (1962 to Present) Unemployment Rate Rising -3.0% -4.1% -4.8% -5.6% Unemployment Rate Declining X 9.0% 11.8% 10.3% 9.6% Fed Funds Cycle and Market Returns (1971 to Present) Fed Funds Flat or Rising X 8.2% 9.0% 9.6% 10.6% Fed Funds Declining 0.9% 7.2% -5.5% -3.0% U.S. 10 Year Rate Cycle and Market Returns (1962 to Present) 10 Year Rising 8.9% 4.6% 9.7% 9.7% 10 Year Declining X 9.5% 12.6% 2.3% 2.7% Yield Curve Shape (10 Year - 2 Year) (1976 to Present) Steepening X 11.0% 9.5% 10.6% 9.1% Flattening 5.7% 5.4% 2.8% 6.3% S&P 500 Cyclical Defensive ISM New Orders Index (Period Return) Avg. Avg. Above 50, Rising X 16.6% 19.8% 9.8% Above 50, Declining -1.5% -2.0% 2.4% Below 50, Rising 5.1% 7.7% -1.4% Below 50, Declining -23.6% -25.9% -18.3% Source: Bloomberg The Yield Curve is a Great Forward Looking Indicator for the Market Back in July, we took a close look at the historical impact of the yield curve on the stock market – focusing on the difference between 2 year and 10 year U.S.