Highlights - National Bank

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Highlights - National Bank
September 2018

Highlights
 The positive return of the MSCI AC over the year to date is due almost entirely to the U.S. U.S.-led trade wars seem
  to be starting to hurt the world economy. Emerging economies, highly dependent on trade, have seen earnings
  revisions turn negative for the first time since 2016. Policymakers must now take steps to reaccelerate it in 2019.
 A better-than-expected economy with upside surprise in earnings took the S&P 500 to a new high in Q3. Importantly,
  this new record was reached on the strength of earnings growth, not multiple expansion. Though U.S. equities are
  vulnerable to a cooling of the economy and to downward earnings revisions, the good news is that Federal Reserve
  forward guidance has become hazier about the path of policy-rate normalization after its next hike (anticipated
  September 26).
 The S&P/TSX is barely keeping afloat in 2018. After eight months the benchmark has returned a meagre 0.3%. Were
  it not for high-flying cannabis stocks, classified under health care, the S&P/TSX would be in the red. Until NAFTA is
  resolved, it is difficult to see much of an uptrend for the S&P/TSX, even though its valuation is now below the
  historical average for the first time in more than two years.
 Our asset allocation and sector rotation are unchanged this month. Trade tensions between the U.S. and its trading
  partners (Canada, China, Europe) coupled with the plight of emerging markets and greenback appreciation prompt
  us to maintain our more prudent stance recommended in June. We take some comfort from the cautious tone of the
  Federal Reserve about monetary policy normalization, an essential element to prolong the economic expansion. We
  stand ready to redeploy our excess cash if opportunities arise.

Stéfane Marion
stefane.marion@nbc.ca

Matthieu Arseneau
matthieu.arseneau@nbc.ca
Highlights - National Bank
Monthly Equity Monitor
Global growth is downshifting                                                                                World: Distribution of trade flows by region
                                                                                                             Merchandise trade as percentage of world total (2017)

The benchmark global equities index has been stuck since                                                          30
                                                                                                                       %

the end of January in a tight range below its record high
                                                                                                                  25
of that month (chart).
                                                                                                                  20

 World: Perspective on global equities
 MSCI equity indices
                                                                                                                  15
 132
        Index, 2017m1=100
                                                                                                MSCI US
                                                                                                                  10
 128

 124
                                                                                          MSCI AC World           5

 120
                                                                                                                  0
 116                                                                                                                       EM Asia              Euro          U.S.            LATAM        Africa/Middle   Japan    EM Europe
                                                                                             MSCI AC                                                                                            East
 112                                                                                        world ex. US
                                                                                                               NBF Economics and Strategy (data via Bureau of Economic Policy Analysis or CPB)

 108

                                                                                                              World: Growth in global trade flows worst since 2016
 104                                                                                                          World trade volumes

 100                                                                                                              7
                                                                                                                       q/q % chg. saar
                                                                                                                  6
  96
          2017q1            2017q2        2017q3     2017q4      2018q1      2018q2    2018q3       2018q4        5

  NBF Economics and Strategy (data via Datastream)
                                                                                                                  4

                                                                                                                  3

The positive return of the MSCI AC over the year to date                                                          2

is due almost entirely to the U.S. (about 50% of the index).                                                      1

                                                                                                                                                                                                                     0
                                                                                                                  0
As the table below shows, diffusion is pretty bad so far in                                                       -1
2018, with Europe, Japan and Emerging Markets all down                                                            -2

year to date (table). Emerging Asia, the region most                                                              -3

exposed to global trade wars, is down 3.9% year to date.                                                          -4
                                                                                                                                   2015                              2016                         2017
                                                                                                                                                                                                                     Q2
                                                                                                                                                                                                                      2018
                                                                                                                  NBF Economics and Strategy (data via CPB)

 MSCI composite index: Price Performance
                                                                                                             Emerging economies, highly dependent on trade, were hit
                                                      Month to            Quarter to   Year to date          hard in Q2. Volume exports declined at 2% annualized. As
                                                       date                 date
                                                                                                             a result, earnings revisions have turned negative for the
   MSCI AC World                                          0.9                3.8            3.5
    MSCI World                                            1.1                4.3            4.4
                                                                                                             first time since 2016 (chart).
       MSCI USA                                           3.1                6.7            8.7
       MSCI Canada                                        -1.5               -0.3           0.4               World: Negative earnings revisions for emerging markets
                                                                                                              3-month change in 12-month forward EPS for MSCI EM
       MSCI Europe                                        -2.6               0.5            -2.0
       MSCI Pacific ex Jp                                 -0.8               0.7            0.2               4
                                                                                                                   %
       MSCI Japan                                         -0.8               0.7            -4.0              3
    MSCI EM                                               -0.7               0.4            -3.5              2
       MSCI EM EMEA                                       -0.1               1.9            -3.0
                                                                                                              1
       MSCI EM Latin America                              -2.7               3.0            -1.1
                                                                                                              0
       MSCI EM Asia                                       -0.6               -0.2           -3.9
                                                                                                             -1
   8/31/2018
                                                                                                             -2
  NBF Economics and Strategy (data via Datastream)
                                                                                                             -3

                                                                                                             -4

U.S.-led trade wars seem to be starting to hurt the world                                                    -5

economy. The latest CPB data confirm that global trade                                                       -6

volume was flat in Q2 — the worst quarter since 2016 —                                                       -7

as U.S. tariffs on steel and aluminum imports and the                                                        -8
                                                                                                                        2011             2012          2013           2014          2015          2016       2017        2018

retaliatory measures of affected trade partners took                                                          NBF Economics and Strategy (data via Datastream)

effect.
                                                                                                             Adding insult to injury, The Wall Street Journal recently
                                                                                                             reported that the Trump administration is reviewing tariff
                                                                                                             breaks the U.S. previously granted to poorer nations to
                                                                                                             promote their economic development. India, Thailand and
                                                                                                                                                                                                                                2
Highlights - National Bank
Monthly Equity Monitor
Brazil are the most exposed to that program. It’s not so                         World: Perspective on commodity prices
                                                                                 Copper price
much that the numbers are huge as that the move would
                                                                                 8,400
come on top of everything else — China-U.S. tension,                                      USD/tonne

                                                                                 8,000
NAFTA, tightening of sanctions on Russia and Turkey). We
                                                                                 7,600
hope the White House is aware that emerging economies
                                                                                 7,200
account for almost 60% of world GDP (up from 42% at the
                                                                                 6,800
time of the Asian crisis) and that USD appreciation due to
                                                                                 6,400
risk-off reaction will jeopardize both global growth and
                                                                                 6,000
the outlook for U.S. corporate profits.
                                                                                 5,600

                                                                                 5,200
 World: Emerging market account for close to 60% of global GDP
 Share of GDP on a PPP basis                                                     4,800

 60                                                                              4,400
        %
                                                                                 4,000
 58
                                                                                                2013               2014              2015   2016   2017   2018
                                                                                  NBF Economics and Strategy (data via Datastream)
 56

 54
                                                                                 While China’s recently announced plan to boost infra-
 52
                                                                                 structure spending is good news for commodity prices, the
 50
                                                                                 longer-term outlook will depend on the commitment of
 48
                                                                                 the large economic powers to the value of globalization.
 46
                                                                                 We take solace from the agreement between Chinese and
 44
                                                                                 U.S. trade negotiators to map out a road to solution of
 42                         Asian crisis
                                                                                 their trade impasse before the November 30 G20 meeting
 40
       1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
                                                                                 in Buenos Aires, which Mr. Trump and Mr. Xi are scheduled
  NBF Economics and Strategy (data via IMF)
                                                                                 to attend. However, given the acrimony of U.S.-Canada
                                                                                 discussions on renewal of NAFTA, rapid abatement of trade
 USD: At a record vs. emerging markets
 Broad dollar index (C26) vs. OITP index (19 currencies)
                                                                                 tensions between Washington and its trading partners
120
                                                                                 cannot be taken for granted.
        Index, 2015 = 100
                                                                         OITP
118

116
                                                                                 Growth is set to slow in Q3. Policymakers must now take
114
                                                                                 steps to reaccelerate it in 2019.
112
                                                                         Broad
                                                                          USD
110

108

106

104

102

100

  98
                   2015                             2016   2017   2018
 NBF Economics and Strategy (data via Datastream)

These developments are bad news for commodity prices.
As the next chart shows, the price of copper is still down
18% from its June high.

                                                                                                                                                                 3
Highlights - National Bank
Monthly Equity Monitor
U.S.: Immune for how long?                                                                                 A better-than-expected economy with upside surprise in
                                                                                                           earnings took the S&P 500 to a new high in Q3 (chart).
The advertised near-term benefits of fiscal stimulus have
materialized. U.S. GDP growth accelerated to 4.2% in the                                                    U.S.: Equities at a record high
second quarter, with tax cuts propping up both consumer                                                     S&P 500

spending and business investment. Government outlays also                                                  2,920
                                                                                                                    index
                                                                                                           2,880
increased. All in all, real final sales, i.e. GDP excluding                                                2,840
inventories, grew at 5.3% annualized. In nominal terms                                                     2,800
                                                                                                           2,760
the Q2 growth was a whopping 8.4%, the strongest since                                                     2,720
2006 (chart). So the only reason real growth did not top                                                   2,680

5% was drag from inventories. That drag, however, is good                                                  2,640
                                                                                                           2,600
news for inventory rebuilding and thus for Q3 output.                                                      2,560
                                                                                                           2,520
                                                                                                           2,480
 U.S.: Final sales surge in Q2                                                                             2,440
 Nominal final sales of domestic product
                                                                                                           2,400
10                                                                                                         2,360
       % (q/q, saar)
                                                                                                           2,320
 8                                                                                                                    2017Q2             2017Q3            2017Q4   2018Q1   2018Q2   2018Q3   2018Q4
                                                                                                            NBF Economics and Strategy (data via Datastream)
 6

 4
                                                                                                           Importantly, this new record was reached on the strength
 2                                                                                                         of earnings growth, not multiple expansion. As the chart
 0                                                                                                         below shows, 12-month forward P/E is well off its cyclical
 -2
                                                                                                           high and is not far from its historical average.
 -4

 -6

 -8
      2002           2004      2006           2008    2010    2012        2014         2016   2018
 NBF Economics and Strategy (data via Datastream)

Strong Q2 growth was a major boost for corporate profits,
as were the recently enacted corporate tax cuts. As the
chart below shows, after-tax profits in Q2 were up 16%
from a year earlier, the strongest increase in more than
five years (chart).

 U.S.: Tax treatment boosts after tax profits
 Corporate profits from current production: before and after tax on corporate income

  18
          % (y/y)                                                                             After tax
  16
  14
  12
  10                                                                                              Before   An uncertain geopolitical picture, with the Federal Reserve
                                                                                                   tax
      8                                                                                                    still inclined to hike this fall (albeit modestly) despite a
      6
      4
                                                                                                           strengthening of the U.S. dollar, could challenge earnings
      2                                                                                                    growth and thus equity markets, since P/E expansion is
      0
   -2
                                                                                                           very hard to come by in this mature phase of the economic
   -4                                                                                                      cycle. As the next table shows, the bottom-up consensus of
   -6
                                                                                                           equity analysts sees robust 13.3% earnings growth over the
   -8
 -10                                                                                                       coming year.
 -12
                    2013           2014              2015          2016                2017       2018
  NBF Economics and Strategy (data via BEA)

                                                                                                                                                                                                        4
Monthly Equity Monitor
 S&P 500 composite index: EPS Performance                                                                 U.S.: What next for earnings revisions?
                                                                                                          1-month change in 12-month forward EPS vs. CITI economic surprise index
                                                                                          12 months
                                2017                2018           2019          2020                     6                                                                                                    120
                                                                                           forward            %                                                                                        index

  S&P 500                      11.5                 23.1           10.2          10.2        13.3         5                                                                                                    100

  ENERGY                       354.3                 92.0          23.8          12.1        37.9         4                                                                                                    80
  MATERIALS                     14.7                 30.1           7.3          11.7        13.3
                                                                                                          3                                                                                                    60
  INDUSTRIALS                    4.8                20.5           12.2          11.0        14.4
  CONS. DISC.                    6.3                 18.6          12.1          14.0        13.8         2                                                                                                    40
                                                                                                                                                                                           Earnings
  CONS. STAP.                    6.3                 11.2           6.2           7.5         7.2         1
                                                                                                                                                                                           revisions
                                                                                                                                                                                                               20
                                                                                                                                                                                             (left)
  HEALTH CARE                    8.0                 14.6           8.0           9.3        10.0
                                                                                                          0                                                                                                    0
  FINANCIALS                     6.5                 32.5           9.5          10.0        15.8
  IT                            18.6                 23.4          11.1          11.2        12.5        -1                                                                                                    -20

  TELECOM                        0.4                17.1            3.2           1.7         7.3                                                                                     Economic
                                                                                                                                                                                       surprise
                                                                                                         -2                                                                             index
                                                                                                                                                                                                               -40
  UTILITIES                      2.7                  6.8           4.7           5.0         5.4                                                                                       (right)

  REAL ESTATE                  -12.4                -10.1           0.9           6.8        -3.0        -3                                                                                                    -60

  8/31/2018                                                                                              -4                                                                                                    -80
                                                                                                                  2015                  2016                               2017     2018
 NBF Economics and Strategy (data via Datastream)                                                         NBF Economics and Strategy (data via Datastream and Bloomberg)

Interestingly, close to 60% of that earnings growth over the                                             The good news in the meantime is that Federal Reserve
coming year is expected to come from margin expansion.                                                   forward guidance has become hazier about the path of
As the table below shows, profit margins are expected to                                                 policy-rate normalization after its next hike (anticipated
increase over the next 12 months in all main sectors of                                                  September 26). The last thing we need is for the Fed to
the S&P 500 except real estate. However, that margin                                                     keep flattening the yield curve beyond an economic
expansion becomes a tall order if Washington levies more                                                 breaking point. As the chart below shows, the yield spread
import tariffs.                                                                                          between a 10-year Treasury and a 3-month T-Bill is currently
                                                                                                         78 basis points. Though this is the narrowest spread in more
 S&P 500 composite index: Profit margins                                                                 than a decade, it is still above the danger zone of 50 basis
                                                                                  12-month    12-month   points historically associated with bad times for equity
                           2017              2018           2019          2020
                                                                                   trailing    forward   markets.
 S&P 500                   10.5              11.9           12.5          13.3       11.5        12.3
 ENERGY                     4.1               6.6            7.8           8.9        5.9         7.4
 MATERIALS                  9.4              10.9           11.5          12.3       10.5        11.3
 INDUSTRIALS                8.8               9.8           10.5          11.1        9.5        10.3
 CONS. DISC.                7.1               7.8            8.2           8.8        7.6         8.1
 CONS. STAP.                7.0               7.4            7.6           7.9        7.3         7.6
 HEALTH CARE                9.7              10.5           10.8          11.2       10.2        10.7
 FINANCIALS                14.4              18.3           19.1          20.6       17.1        18.9
 IT                        20.3              22.3           23.1          23.8       22.0        23.0
 TELECOM                   12.9              14.1           13.9          14.1       13.7        14.0
 UTILITIES                 11.8              12.4           12.7          13.1       12.2        12.6
 REAL ESTATE               20.8              16.8           16.2          16.5       18.0        16.4
 8/31/2018
 NBF Economics and Strategy (data via Datastream)

So the U.S. equity market is vulnerable to a cooling of the
economy and to downward earnings revisions. As the next
chart shows, the Citi economic surprise index for the U.S.
has turned negative for only the second time since Mr.
Trump’s election, an indication of waning momentum.                                                      Canada: An uncertain outlook
Perhaps the White House will take note and reassess its
position on trade.                                                                                       The S&P/TSX is barely keeping afloat in 2018. After eight
                                                                                                         months the benchmark has returned a meagre 0.3%. Were
                                                                                                         it not for high-flying cannabis stocks, classified under
                                                                                                         health care, the S&P/TSX would be in the red (table).

                                                                                                                                                                                                                     5
Monthly Equity Monitor
 S&P/TSX composite index: Price Performance                                                            Canada: Earnings hit a record in Q2
                                                                                                       Trailing earnings for the S&P/TSX
                                                                     Quarter to
                                         Month to date                               Year to date
                                                                       date                           1,040
                                                                                                               EPS
   S&P TSX                                           -1.0               -0.1                  0.3     1,000
   HEALTH CARE                                       28.4               17.0                 15.1
                                                                                                        960
   IT                                                5.1                2.9                  25.5
                                                                                                        920
   REAL ESTATE                                       1.9                3.5                   6.4
    BANKS                                            1.6                4.0                   1.5       880

   FINANCIALS                                        1.1                3.3                  -0.1       840

   INDUSTRIALS                                       0.6                5.4                  11.4       800
   TELECOM                                           -0.9               2.9                  -4.4
                                                                                                        760
   UTILITIES                                         -1.3               -0.7                 -9.1
                                                                                                        720
   CONS. STAP.                                       -1.7               -0.9                 -4.2
   CONS. DISC.                                       -3.7               -4.0                 -1.7       680

   ENERGY                                            -4.0               -3.1                 -0.4       640
   MATERIALS                                         -8.2              -11.9                 -9.6
                                                                                                        600
   8/31/2018                                                                                                      2008      2009      2010      2011       2012     2013   2014     2015   2016   2017   2018   2019
  NBF Economics and Strategy (data via Datastream)                                                     NBF Economics and Strategy (data via Datastream)

This disappointing performance is not due to lacklustre                                                S&P/TSX composite index: EPS Performance
economic growth or disappointing profits. Market watchers
                                                                                                                                                                                                         12 months
will probably be surprised to learn that despite escalating                                                                              2017                     2018            2019        2020        forward
trade tensions, the most surprising economic performance                                                S&P TSX                           28.8                     13.0           13.1         9.4          12.9
                                                                                                        ENERGY                           313.1                     32.0           26.7         4.8          28.1
of recent weeks has been that of trade-exposed Canada.                                                  MATERIALS                         66.5                     14.8           17.8        12.4          16.9
As the chart below shows, the economic surprise index for                                               INDUSTRIALS                       16.0                     10.8           17.9        15.5          15.7
                                                                                                        CONS. DISC.                       15.4                     14.2           11.7        11.6          12.7
Canada recently surged to a six-month high.
                                                                                                        CONS. STAP.                       12.1                     10.3           13.7        11.5          13.6
                                                                                                        HEALTH CARE                      -30.1                    -10.3           29.5        21.2          12.9
 Canada: Economy continues to surprise on the upside                                                    FINANCIALS                        15.4                     8.8             7.6         8.6           7.5
 Economic surprise index (daily data)                                                                    BANKS                            10.4                     11.0            5.9         8.1           6.7
                                                                                                        IT                                12.4                     17.8           14.7        14.5          13.2
  120    Index                                                                                          TELECOM                           3.6                      7.9             5.7         7.6           6.4
  100                                                                  Developed economies              UTILITIES                         -8.9                     11.2           16.7        12.1          20.1
                                                                       Canada                           REAL ESTATE                       27.6                     7.9            -3.9         4.7          -0.5
   80                                                                  Emerging economies
                                                                                                        8/31/2018
   60
                                                                                                        NBF Economics and Strategy (data via Datastream)
   40

   20

     0                                                                                                In August Canada finally rejoined NAFTA negotiations only
  -20                                                                                                 to be faced with a fait accompli: a U.S.-Mexico agreement
  -40                                                                                                 on a revamped deal. Mr. Trump was eager to call the new
  -60                                                                                                 pact the “U.S.-Mexico trade agreement” and drop the
  -80                                                                                                 name NAFTA. Changing a name is one thing; scrapping an
 -100                                                                                                 existing agreement is another. Despite Mr. Trump’s stated
                 2017Q3                2017Q4               2018Q1         2018Q2            2018Q3
  NBF Economics and Strategy (data via Bloomberg)                                                     desire to shred NAFTA, he is unlikely to have the authority
                                                                                                      to formally terminate the agreement without congressional
How long this will continue, now that surprises have turned                                           approval. So we continue to think his preferred route is to
negative in both developed and emerging economies,                                                    include Canada in a three-way pact that he wants signed
remains to be seen. After fairly strong GDP growth in Q2                                              at the end of the month. We are looking at very intense
(+2.9% annualized) that fuelled a new high in earnings per                                            negotiations over the next few weeks.
share, we expect economic growth to slow markedly in Q3,
                                                                                                      Ottawa says: “Canada will only sign a new NAFTA that is
to about 1.2%. At this writing the bottom-up consensus of
                                                                                                      good for Canada and good for the middle class." Hmm. We
equity analysts expects earnings growth of 12.9% over the
                                                                                                      say it’s time to be pragmatic. The U.S. has stated that if
next 12 months (table). However, this expectation does
                                                                                                      Canada refuses to negotiate, its easiest path would be to
not take into account a possible trade imbroglio in a
                                                                                                      increase auto tariffs. As the table below shows, that would
critical sector of the economy.
                                                                                                      expose 4.1% of Ontario’s jobs to punitive tariffs. We doubt
                                                                                                      this is something our middle class would appreciate. It’s
                                                                                                      time for Canada to make a few concessions.

                                                                                                                                                                                                                       6
Monthly Equity Monitor
    Canada: Considerable exposure of jobs to automotive exports to U.S.
    Exposure of Canadian employment to U.S. protectionism

                      Table 2 ‐ Employment exposure to industry Canadian exports to U.S.
     (Employment dependent on specific Canadian industry exports to the U.S. as a % of total employment ‐ 2013)
    Exporting industry                                CA     NL     PE     NS     NB     QC     ON     MB     SK     AB     BC
    A ‐ U.S. Protectionist rhetoric
    111 ‐ 112 Crop and Animal Production              0.3%   0.0%   0.6%   0.1%   0.3%   0.1%   0.2%   0.7%   1.0%   0.4%   0.3%
    3115 ‐ Dairy Products Manufacturing               0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%
    321 ‐ Wood Product Manufacturing                  0.3%   0.0%   0.0%   0.2%   0.9%   0.4%   0.1%   0.2%   0.2%   0.2%   0.9%
    326 ‐ Plastics and Rubber Products Man.           0.3%   0.0%   0.0%   0.9%   0.2%   0.4%   0.4%   0.3%   0.0%   0.1%   0.1%
    3311 ‐ Iron, Steel mills, Ferro Alloy Man.        0.1%   0.0%   0.0%   0.0%   0.0%   0.0%   0.1%   0.1%   0.0%   0.0%   0.0%
    3312 ‐ Steel products from purchased steel        0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.1%   0.0%   0.1%   0.0%   0.0%
    3313 ‐ Alumina and Aluminum prod. & proc.         0.1%   0.0%   0.0%   0.0%   0.0%   0.4%   0.1%   0.0%   0.0%   0.0%   0.0%
    3315 ‐ Foundries                                  0.0%   0.0%          0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%
    335 ‐ Electrical equ., appliance and comp. man.   0.1%   0.0%   0.0%   0.0%   0.0%   0.1%   0.1%   0.1%   0.0%   0.0%   0.1%
        3352 ‐ Household Appliance Man.               0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%
    3361 ‐ Motor Vehicle Manufacturing                0.9%   0.2%   0.2%   0.2%   0.3%   0.4%   1.8%   0.4%   0.2%   0.3%   0.3%
    3362 ‐ Motor Vehicle body and trailer man.        0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.0%   0.1%   0.0%   0.0%   0.0%
    3363 ‐ Motor vehicle parts manufacturing          0.4%   0.0%   0.0%   0.0%   0.1%   0.1%   0.8%   0.1%   0.1%   0.1%   0.1%
    3364 ‐ Aerospace product and parts man.           0.2%   0.0%   0.6%   0.3%   0.0%   0.5%   0.1%   0.5%   0.0%   0.0%   0.1%
    Sub‐total                                         2.8%   0.4%   1.6%   1.9%   1.8%   2.5%   4.1%   2.4%   1.8%   1.2%   1.8%

    NBF Economics and Strategy

The U.S. wants changes to Canada’s agriculture supply
                                                                                                                                   Another major point of contention between Canada and
management system, which includes production quotas for
                                                                                                                                   the U.S. is Chapter 19, the binational panel before which
milk, eggs and poultry and tariffs of up to 300% on imports.
                                                                                                                                   one of the partners can challenge the legality of the other’s
We think Canada will ultimately agree to concessions. As
                                                                                                                                   trade barriers. Rulings by this panel cannot be appealed
argued by our colleague Angelo Katsoras last December,1
                                                                                                                                   to domestic courts. The Trump administration maintains
this view is based on Canadian concessions in past trade
                                                                                                                                   that Chapter 19 infringes on U.S. sovereignty and wants to
negotiations. For example:
                                                                                                                                   revert to settling disputes in U.S. courts. While common
Under the now-collapsed Trans-Pacific Partnership, Canada                                                                          ground on this issue will be difficult to find, a compromise
had agreed to a 3.25% increase in the amount of foreign                                                                            might entail allowing more U.S. arbiters on the panels.
dairy products entering Canada tariff-free. The plan was                                                                           The U.S. could also agree to keep this dispute panel intact
for dairy farmers to receive financial compensation for                                                                            in exchange for concessions elsewhere (agriculture?).
their resulting losses.
                                                                                                                                   As our colleague Angelo argued in his note of June 11,
Under the Comprehensive Economic and Trade Agreement,                                                                              “NAFTA: Is a ‘bad deal’ really worse than no deal for
Canada has agreed to accept more European dairy products.                                                                          Canada?,” our country can ill afford to risk a loss of
Over the next few years, tariff-free cheese imports will                                                                           investment in Canada by companies uncertain of access
go from 5% to 9% of Canada's current cheese market.                                                                                to the U.S. market. Canada’s difficult position is best
With the U.S. accounting for 76% of Canada’s total trade                                                                           summed up in the following quote: “With NAFTA in place,
compared to just under 10% for the European Union, logic                                                                           Canada is an option when globally oriented firms consider
dictates that Canada should offer concessions to the U.S.                                                                          their North American strategies; without it, Canada is a
as well.                                                                                                                           smallish market that probably can be served from the U.S.
                                                                                                                                   or elsewhere.”2 A working paper published August 25 by
As the next chart shows, the province most exposed to                                                                              the Bank of International Settlements showed that our
concessions on supply management is P.E.I., given the                                                                              country had the most to lose from a failed NAFTA
weight of dairy production in its economy, followed by                                                                             (bis.org/publ/work739.htm). So until NAFTA is resolved,
Quebec and Manitoba.                                                                                                               it is difficult to see much of an uptrend for the S&P/TSX,
                                                                                                                                   even though its valuation is now below the historical
                                                                                                                                   average for the first time in more than two years (chart).

1                                                                                                                                  2
 See “Update on NAFTA negotiation” by Angelo Katsoras,                                                                              “Canada could pay a steep price for ‘progress’ in NAFTA
December 18, 2017.                                                                                                                 talks,” Financial Post, January 30, 2018
                                                                                                                                                                                              7
Monthly Equity Monitor
Canada: Perspective on valuation
12-month forward for the S&P TSX
                                                                                                     Asset allocation
24
      ratio
                                                                                                     Our asset allocation remains unchanged this month.
22                                                                                                   Trade tensions between the U.S. and its trading partners
20                                                                                                   (Canada, China, Europe) coupled with the plight of
18
                                                                                                     emerging markets and greenback appreciation prompt us
                                                                                                     to maintain our more prudent stance recommended in
16
                                                                          Average
                                                                                                     June. We take some comfort from the cautious tone of
14
                                                                                                     the Federal Reserve about monetary policy
12                                                                                                   normalization, an essential element to prolong the
10                                                                                                   economic expansion. We stand ready to redeploy our
 8
                                                                                                     excess cash if opportunities arise.
 6
          1990             1995               2000      2005       2010             2015
NBF Economics and Strategy (data via Datastream)
                                                                                                     Sector rotation
                                                                                                     Our sector rotation remains unchanged this month.
S&P/TSX : Price to 12-month forward earnings
                                                                                            5 year
                                      8/31/2018      A year ago   10 year ave.
                                                                                           average
     S&P TSX                              14.4          15.6          14.4                  15.6
     ENERGY                               16.2          23.6          23.2                  30.3
     MATERIALS                            15.9          22.3          17.3                  20.7
     INDUSTRIALS                          18.0          17.0          15.0                  16.3
     CONS. DISC.                          13.8          14.2          13.3                  14.3
     CONS. STAP.                          15.6          17.3          15.5                  17.2
     HEALTH CARE                          23.1          8.5           13.4                  11.9
     FINANCIALS                           11.5          11.6          11.6                  11.9
     BANKS                                11.1          11.1          11.0                  11.2
     IT                                   25.6          22.2          16.7                  20.6
     TELECOM                              15.3          17.0          14.3                  15.9
     UTILITIES                            17.9          19.3          17.9                  19.1
     REAL ESTATE                          13.4          NA            NA                     NA
     8/31/2018
 NBF Economics and Strategy (data via Datastream)

                                                                                                                                                            8
Monthly Equity Monitor
                     NBF Asset Allocation
                           Benchmark       NBF          Change (pp)
                              (%)    Recommendation (%)
Equities
 Canadian Equities            20               20
 U.S. Equities                20               20
 Foreign Equities (EAFE)       5                8
  Emerging markets          5                    3
Fixed Income               45                   39
Cash                        5                   10
Total                      100                 100
NBF Economics and Strategy

                     NBF Market Forecast                                                  NBF Market Forecast
                              Canada                                                            United States
                                    Actual           Q42018 (Est.)                                    Actual     Q42018 (Est.)
Index Level                        Sep-04-18            Target        Index Level                    Sep-04-18      Target
  S&P/TSX                           16,161              16,500          S&P 500                       2,897         2,950

Assumptions                                          Q42018 (Est.)    Assumptions                                Q42018 (Est.)
  Level:         Earnings *         1002                1021            Level:          Earnings *     151           155
                 Dividend           477                  486                            Dividend        52            54
 PE Trailing (implied)              16.1                16.2           PE Trailing (implied)           19.2         19.0
                                                     Q42018 (Est.)                                               Q42018 (Est.)
  10-year Bond Yield                 2.24               2.57            10-year Bond Yield             2.90         3.07
* Before extraordinary items, source Thomson                          * S&P operating earnings, bottom up.
NBF Economics and Strategy

                                                                                                                                 9
Monthly Equity Monitor
      NBF Fundamental Sector Rotation - August 2018

      Name (Sector/Industry)                                  Recommendation S&P/TSX weight

      Energy                                                  Market Weight       20.2%
        Energy Equipment & Services                            Market Weight      0.6%
        Oil, Gas & Consumable Fuels                            Market Weight      19.6%
      Materials                                               Market Weight       11.4%
       Chemicals                                               Underweight        2.3%
       Containers & Packaging                                  Market Weight      0.5%
       Metals & Mining *                                       Market Weight      2.8%
       Gold                                                    Overweight         5.1%
       Paper & Forest Products                                 Market Weight      0.6%
      Industrials                                             Underweight         10.1%
        Capital Goods                                           Market Weight     2.5%
        Commercial & Professional Services                      Underweight       1.8%
        Transportation                                          Underweight       5.7%
      Consumer Discretionary                                  Underweight         5.6%
        Automobiles & Components                                Underweight       1.3%
        Consumer Durables & Apparel                             Overweight        0.7%
        Consumer Services                                       Underweight       1.4%
        Media                                                   Market Weight     0.9%
        Retailing                                               Underweight       1.3%
      Consumer Staples                                        Overweight          3.5%
        Food & Staples Retailing                                Overweight        2.7%
        Food, Beverage & Tobacco                                Overweight        0.8%
      Health Care                                      Market Weight              1.3%
        Health Care Equipment & Services                Market Weight             0.2%
        Pharmaceuticals, Biotechnology & Life Sciences  Market Weight             1.1%
      Financials                                              Market Weight       33.1%
        Banks                                                  Market Weight      23.0%
        Diversified Financials                                 Market Weight      3.8%
        Insurance                                              Market Weight      6.3%
      Information Technology                                  Market Weight       4.1%
        Software & Services                                    Market Weight      3.9%
        Technology Hardware & Equipment                        Market Weight      0.2%
      Telecommunication Services                              Overweight          4.4%
      Utilities                                               Overweight          3.5%
      Real Estate                                             Market Weight       2.8%

      * Metals & Mining excluding the Gold Sub-Industry for the recommendation.

                                                                                              10
Monthly Equity Monitor
Economics and Strategy
Montreal Office                                                                                                                             Toronto Office
514-879-2529                                                                                                                                416-869-8598
Stéfane Marion                                  Matthieu Arseneau                                                                           Warren Lovely
Chief Economist and Strategist                  Deputy Chief Economist                                                                      MD & Head of Public Sector Strategy
stefane.marion@nbc.ca                           matthieu.arseneau@nbc.ca                                                                    warren.lovely@nbc.ca

Krishen Rangasamy                               Paul-André Pinsonnault                           Marc Pinsonneault
Senior Economist                                Senior Fixed Income Economist                    Senior Economist
krishen.rangasamy@nbc.ca                        paulandre.pinsonnault@nbc.ca                     marc.pinsonneault@nbc.ca

Kyle Dahms                                      Jocelyn Paquet                                   Angelo Katsoras
Economist                                       Economist                                        Geopolitical Analyst
kyle.dahms@nbc.ca                               jocelyn.paquet@nbc.ca                            angelo.katsoras@nbc.ca

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Monthly Equity Monitor
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