The Great Canadian Uphill BattleWhile pockets of opportunity exist, headwinds remain for Canadian equities

Bruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee

June 2018

N E W T H I N K I N G

2 | T HE GRE AT C A N A D I A N UPH I L L BAT T L E

In March 2017, the Wealth Asset Allocation Committee (WAAC) made a decision to underweight Canadian equities in favour of international equities. Throughout 2018, one of our key themes has been a preference for global over Canada from an equity perspective and, after reviewing our stance, WAAC (“we”) retain this positioning.

When we made this decision over a year ago, Canadian equities, which had performed strongly over the previous year, were close to their all-time highs. With economic and earnings growth expected to be muted, we didn’t feel there was a significant impetus for further equity gains. In conjunction with the positioning change to Canadian equities, we increased our international equity weighting, due in large part to our expectations for European equities. European equity returns had lagged those of their North American counterparts and valuations were attractive, sitting well below their all-time highs. Economic momentum was also favourable, with earnings poised to benefit from improving economic growth and higher inflation in the region.

What has happened since?

Since we made the decision to underweight Canadian equities, they have lagged their global peers as illustrated by the chart below. Canada’s stock market ended 2017 with the lowest equity market returns among developed nations. The country’s lagging performance can be attributed to the many headwinds facing the country including, economic

$90

$95

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$105

$110

$115

$120

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Inve

smen

t V

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)

Date

S&P/TSX Composite TR MSCI EAFE* GR CAD S&P 500 TR CAD

$117.57

$110.89

$104.95

Canadian equities lagged global marketsGrowth of $100 from March 2017 to April 2018

Source: Bloomberg Finance L.P., Data as of April 30, 2018 *Europe, Australasia and Far East

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growth sustainability, uncertainty surrounding the North American Free Trade Agreement (NAFTA) as well as the sector composition of the Canadian market, with its minimal weight in the high flying technology sector and heavy weights in resources and financials. These differences have driven large divergences in earnings growth between Canada and the U.S. in recent years, as seen in the chart below.

At this juncture we don’t see the headwinds facing Canada subsiding meaningfully enough for a reversal in the trend, and while Canadian equities have performed relatively well recently, we feel they may underperform again in 2018 for reasons we will outline below. This is in contrast to what we see in international markets (EAFE) and the U.S. Strong economic growth, more broad-based earnings growth and reasonable valuations all point to potentially stronger gains globally. Canada isn’t all “doom and gloom” though, as we do see some pockets of opportunity (discussed a bit later). For now, let’s outline the top headwinds we feel may still provide for a challenging investing environment in Canada.

Canadian earnings have materially underperformed the U.S. over the last 10 yearsForward Earnings

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110

130

150

170

S&P 500 Index S&P/TSX Composite Index

163

108

Inde

x Ba

se

Source: Bloomberg Finance LP, TD Asset Management. As of March 16, 2018. Index Base begins at 100 for both Indexes.

4 | T HE GRE AT C A N A D I A N UPH I L L BAT T L E

High household debt - New data continues to show rising debt levels in Canada, with the average Canadian now owing $1.70 for every dollar of disposable income¹. This degree of indebtedness is a new record for Canadians. The Canadian housing market and other interest rate sensitive industries have taken a hit in recent months, and the expectation is that this trend may continue, should debt and interest rates continue to increase in lockstep in the near term.

The greatest risks to the management of household credit-market debt are economic shocks that lead to job losses that make debt servicing difficult or increases in the interest rate that raise debt-servicing costs. Even without a dramatic rise in risks, our base case is that growth in Canada may remain lackluster for some time as consumers retrench and repair their balance sheets. This in turn may create headwinds for domestically focused businesses.

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Canadian household debt to disposable income

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Date

Canadian household debt reaching all time highsHousehold debt to disposable income

NAFTA uncertainty - NAFTA, which has underpinned economic integration and prosperity in North America for nearly 25 years, has come under intense scrutiny by the U.S. The current U.S. administration announced it was looking to renegotiate and rewrite the terms of the trade agreement in an effort to transform the U.S. economy for decades to come. After several rounds of meetings with NAFTA leaders, the final outcome still remains unclear, and more rounds of negotiations are being planned for the near future.

Source: Bloomberg Finance L.P., Data as of December 1, 2017

170.3%

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In 2016, Canadian exports to the U.S. stood at $255 billion (USD), which accounts for about three-quarters of all outward trade from Canada. That’s equal to roughly 20% of this country’s economy. Canadian companies, meanwhile, currently have roughly $475 billion worth of cross-border investment in the U.S., and NAFTA supports about 3.4 million Canadian jobs by way of trade and investments with the U.S². Our belief is that NAFTA has benefited all three member countries and that a modified agreement that is mutually beneficial is still possible. However, U.S President Donald Trump and several members of his administration appear to be increasingly antagonistic to free trade. Depending on the outcome from the NAFTA negotiations, we would anticipate the Canadian dollar to be negatively impacted.

Politics surrounding pipelines - Though Canada has the third-largest proven oil reserve in the world³, the extraction of oil from these reserves has proven particularly difficult in recent years. These challenges are not necessarily due to any natural hindrances, but may stem from government intervention on both Federal and Provincial levels. The news pertaining to the ongoing delay in building Kinder Morgan’s Trans Mountain pipeline is the most recent example of politics impacting economic development within Canada. Similar circumstances stemming from political intervention were also what led to the cancellation of both the Northern Gateway pipeline and Energy East project in prior years.

Flow of trade between NAFTA partners

Source: U.S. Census for U.S.- Canada and U.S. - Mexico trade flows (2016 data). Statistics Canada for Canada-Mexico trade flows (2015 data). All figures in U.S. Dollars.

Mexico - Canada $14 Billion

Canada - Mexico $6 Billion

Canada - U.S. $255 Billion

U.S. - Canada $246 Billion

U.S. - Mexico $212 Billion

Mexico - U.S. $271 Billion

6 | T HE GRE AT C A N A D I A N UPH I L L BAT T L E

Energy plays a crucial role within the Canadian economy and political impediments to investment in the industry have far-reaching effects. Suncor’s CEO recently noted that his company’s investment in Alberta will be constrained until there is better visibility on pipelines being built and the pipeline debate is likely an overhang on foreign investment in the country4. As such, the politics of pipelines can be considered a headwind that may be inhibiting Canada’s economic growth and holding back Canadian equities.

Sector composition - Over the 10 years leading up to 2017, the technology and healthcare sectors in the U.S. grew their earnings per share at a compound annual rate of 10% and 8% respectively. Combined, these sectors comprise of close to 40% of the U.S. market, compared to only 5% of the Canadian market5. The structural underweight in the Canadian market of these high growth, high cash generative businesses in favour of more cyclical, capital intensive sectors is an ongoing challenge for Canada, and a compelling reason for global diversification for Canadian investors. Given that innovation in technology and healthcare may drive the economy for years to come, we anticipate earnings growth in these sectors may continue to be strong.

Canada’s structural underweight to high growth sectors

Sector Weight as a % of the S&P/TSX Composite Index Weight as a % on the S&P 500 Index

Information Technology

25.58%

Health Care

13.86%

Information Technology

3.80%

Consumer Discretionary

Consumer Staples

EnergyFinancialsHealth Care

Information Technology

IndustrialsMaterials

Real Estate

Telecommunication ServicesUtlities

12.72%

6.63%

6.43%

14.72%

10.02%

12.72%

19.89%

34.15%

9.89%

11.59%

2.77%4.40%

3.43% 5.53%3.28%

2.91%2.66%

1.81%2.68%

Health Care

1.27%

Source: Bloomberg Finance L.P. As of May 21, 2018.

5.07%39.44%

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Pockets of opportunities in Canada

While there are obvious headwinds, pockets of opportunities do exist in Canada. Energy producers and banks are two sectors we think could provide some bright spots for Canadian equity markets in 2018.

In the energy sector, high quality producers have been lowering their costs for many years. This means that, as oil prices have rallied on the back of the Organization of the Petroleum Exporting Countries (OPEC) production cuts and global inventory declines, those quality producers are now starting to generate significant free cash flow that may translate to dividend growth over time. These stocks have generally lagged the market in recent years and consequently their valuations now look attractive. If interest rates increase, financials — particularly the banks — may benefit and see higher profits. The costs of loans for bank’s customers generally increase faster than interest payouts to investors on investments like term deposits and Guaranteed investment certificates (GIC), allowing them to increase the spread between lending and borrowing and increase revenue. Moreover, recent concerns about the housing market have had a somewhat detrimental impact on bank stock prices as well, which may provide an opportunity to invest in high quality companies at a good valuation.

Taking advantage of international opportunities

While there are pockets of opportunities in Canadian equities, valuations may be more attractive in the international space. Canadian investors today still underestimate the strength of the global economy and overestimate their exposure to global investments. With international economic growth accelerating, fundamentals suggest that the Europe, Japan and emerging markets, specifically the cyclical sectors within these regions, may be a source of returns in the coming months.

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¹ Bloomberg Finance L.P., period ending December 31, 2017² Export Development Canada, 2016³ U.S. Energy Information Administration, International Energy Statistics, accessed 3 Sept. 2016.4 Financial Post, Feb. 8, 20185 TDAM, Bloomberg Finance L.P.The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. 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, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. The TD Wealth Asset Allocation Committee (“WAAC”) is comprised of a diverse group of TD investment professionals. The WAAC’s mandate is to issue quarterly market outlooks which provide its concise view of the upcoming market situation for the next six to eighteen months. The WAAC’s guidance is not a guarantee of future results and actual market events may differ materially from those set out expressly or by implication in the WAAC’s quarterly market outlook. The WAAC market outlook is not a substitute for investment advice. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. All trademarks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.

About the author

Bruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee

@BruceCooper_TD

About TD Asset Management

TD Asset Management (TDAM), a member of TD Bank Group, is a North American investment management firm. Operating through TD Asset Management Inc. in Canada and TDAM USA Inc. in the U.S., TDAM brings new thinking to investors’ most important challenges. TDAM offers investment solutions to corporations, pension funds, endowments, foundations and individual investors. Additionally, TDAM manages assets on behalf of almost 2 million retail investors and offers a broadly diversified suite of investment solutions including mutual funds, professionally managed portfolios and corporate class funds. Collectively, TDAM manages over C$295 billion in assets as at September 30, 2017.