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

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May 2016

Portfolio Strategy May 2016 Equity Strategy – Focus on High Quality Cyclical Stocks Stéphane Rochon, CFA, Equity Strategist

2016 has been a rollercoaster year to date. After the worst start on record, equity indices have largely recovered from the January/February selloff. By way of explanation, many pundits have pointed to the strong recovery in energy prices which relieved some of the pressure from energy company bonds and improved credit spreads generally. Since creditors (the top of the capital structure) must be repaid first, this positive trend in turn gave equity investors (bottom of the capital structure) the confidence to start buying stocks again, particularly in the bombed-out energy and basic material sectors which are now up 14% and 43% respectively year to date (end of April) in Canada vs. 7% for the S&P/TSX Composite Index (“the TSX”).

To illustrate this point, Figure 2 shows how closely related equity and fixed income markets have been over the last 12 months. High yield spreads are in red on the right hand scale (inverted so as the line rises, bond market conditions are getting better) and the S&P 500 Index is in blue (left hand scale). We find this chart comforting since it shows that the two markets are moving in unison.

The expected improvement in supply-demand fundamentals for oil—largely driven by a peak in U.S. production—was central to our more bullish call on Canada starting at the end of last year and, so far, the trend continues to improve. We hasten to add that this improvement is happening DESPITE the failure of OPEC to agree on any production cuts at the recent Doha meeting. Our view on this has always been that the market is the final arbiter of commodity prices and that “artificial” production curtailments (which are near impossible to enforce in any event) only have a transitory impact on markets.

Figure 1: S&P/TSX Composite Capped Sub-Indexes

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Energy Materials Source: BMO Nesbitt Burns Portfolio Advisory Team

Figure 2: S&P 500 Index and U.S. High Yield Bond Spread (inverted)

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S&P 500 (left axis) CDX High Yield CDS 5-year spread

Source: BMO Nesbitt Burns Portfolio Advisory Team, Barclays

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We expect the improvement to continue—at least over the next few quarters—as the rig count in the U.S. continues to decrease and capex budgets for national and private companies continue to contract. This reinforces our view that oil prices have bottomed and should trade in a broad US$35 to US$55 range. Keep in mind that there is a lot of supply that can come back on stream quickly in North America which is why we do not see oil getting back to the US$70+ range any time soon.

Figure 3: BMO Nesbitt Burns Investment Strategy Committee’s Recommended Asset Allocation (%)

Income Balanced Growth Aggressive GrowthRecommended 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 95Canadian Equity 15 15 25 25 35 35 35 40

U.S. Equity 10 5 25 15 25 20 35 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 Portfolio Advisory Team

However, this is more than a supply story. As Figure 4 shows, global demand continues to rise, which is a good omen for the economic recovery. Despite rampant pessimism, the European and U.S. economies are undeniably showing some economic momentum. This is the main driver for our recommendation to favor high quality cyclical (i.e. more economically sensitive) stocks at this juncture. Specifically, we feel that the risk reward is particularly favorable for industrial, tech, consumer discretionary, financial and even some areas for energy and basic materials.

Our call is grounded in historical analysis and, as always, please contact your BMO Investment Advisor for specific investment ideas that fit your financial objectives and risk tolerance.

Positive Economic Momentum: The Holy Grail for Positive Stock Returns

As we have often stated, we believe that the ISM New Orders Index1 is one of the best economic data series to track the economic cycle and it started a new up leg at the end of last year. This is particularly important as over the last 10 years, S&P 500 and TSX monthly returns (year-over-year) have been very highly correlated to this data series. As we have often noted, economic momentum trumps all other factors in determining equity returns.

Since 2001, the median annualized performance of the S&P 500 and TSX when the ISM New Orders index is above 50 and rising has been close to +20% with significantly higher returns generated by cyclical sectors. As Figure 7 shows, at this point of the cycle (when the index is above 50 and rising), cyclical 1 The ISM Manufacturing index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys. Source: Investopedia

Figure 4: Global Oil Supply and Demand, million barrels per day

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Figure 5: S&P/TSX Composite Index Monthly Returns (Y/Y) and ISM New Orders Index Show a Strong Correlation

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sectors have had more than double the annualized performance of defensive sectors in the S&P 500 (+19.2% vs. +9% respectively). Notably, basic materials, energy, autos and other consumer discretionary stocks, industrials and financials have had a very strong performance historically and we expect this to be the case again for the balance of 2016.

In Canada, the year-to-date rallies in energy and basic materials have been far stronger than prior episodes. We believe this has a lot to do with these sectors rebounding strongly from desperately oversold conditions at the end of last year. In other words, many of these stocks were left for dead and a better probability of survival is enough to catapult them higher.

Figure 6: S&P 500 Monthly Returns (Y/Y) vs. ISM New Orders Index Show a Strong Correlation

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Figure 7: Market Return when the ISM New Orders Purchasing Managers’ Index is above 50 and Rising (shaded areas are cyclical)

Period DatesNo. of

MonthsTSX Index Materials Energy Financials S&P 500 Basics Energy Industrials Tech Financials Discretionary Autos

3 Dec 01 - May 02 6 -0.8% 52.0% 31.0% 11.0% -13.6% 21.0% 6.6% -20.3% -39.3% -0.5% -4.6% 34.3%5 Feb 03 - Jan 04 12 30.0% 25.8% 18.3% 28.5% 34.5% 39.2% 25.3% 40.4% 50.6% 38.8% 40.8% 53.4%7 May 05- Dec 05 8 27.1% 36.2% 60.8% 25.0% 7.2% 15.1% 23.2% 5.1% 7.4% 13.6% -0.7% -21.4%9 Aug 06 - May 07 10 20.0% 31.5% 7.0% 19.2% 21.2% 35.3% 28.2% 24.8% 23.6% 16.1% 26.8% 23.8%13 Jun 09 - Mar 10 10 19.5% 23.6% 12.3% 25.6% 33.5% 40.1% 18.4% 53.4% 38.3% 41.5% 52.3% 100.0%15 Sep 10 - Feb 11 6 30.6% 26.9% 55.1% 22.9% 35.3% 47.1% 91.8% 39.9% 36.0% 37.8% 38.7% 63.1%17 Jul 11 - Jan 12 7 -13.7% -2.8% -16.6% -20.3% -9.4% -19.4% -9.9% -16.6% 1.2% -26.8% -6.6% -34.6%19 Jul 12 - Aug 14 26 14.4% -5.6% 14.5% 18.7% 18.8% 18.6% 15.5% 20.3% 17.8% 23.9% 23.5% 31.9%21 Dec 15 - May 16 6 15.0% 104.9% 30.2% 9.3% 2.1% 16.7% 25.5% 10.7% -6.7% -5.0% 2.5% -9.1%

Average 15.8% 32.5% 23.6% 15.5% 14.4% 23.7% 25.0% 17.5% 14.3% 15.5% 19.2% 26.8%Median 19.5% 26.9% 18.3% 19.2% 18.8% 21.0% 23.2% 20.3% 17.8% 16.1% 23.5% 31.9%Cyclical Avg. 19.2%Defensive Avg. 9.0%

CANADA UNITED STATES

Source: Bloomberg

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Stock Fair Value Update

Our DCF (Discounted Cash Flow) models for the TSX and S&P continue to yield fair values of 15,000 and 2,300 respectively. Our conclusion is that both the S&P have better than 10% upside from current levels with certain cyclical sectors offering even higher returns.

As shown in the summary tables below we start by using current EPS consensus estimates as a starting point (which we believe is reasonable at this juncture given global economic momentum is picking up and corporations are still beating estimates on average) and then assume declining mid-single digit EPS growth through 2021 and a 2% terminal real growth rate which does not appear aggressive by historical standards.

For the TSX discount rate, we use 9.5% which is the sum of a 3% long bond yield + 4.5% equity risk premium (the last 110 year average for North America) + an extra 2% premium we add for conservatism and the inherent commodity sensitivity of the Canadian market. We use a slightly lower discount rate for the U.S. market given its greater defensiveness and its generally higher quality constituents.

Results are below.

Figure 8: S&P 500 Index Estimates

Present value % of valueEarnings per share growth

Discount rate

Period 1 (2016-2019) 444.14$ 19.1% 7% 8.5%Period 2 (2020-2024) 493.23$ 21.2% 5% 8.5%Period 3 (2024 - ) 1,386.16$ 59.7% 2% 8.5%

Total fair value 2,323.53$ 100.0% Consensus EPS for 2015 118.00 Rounded 2,320.00$ Implied terminal mult. 15 X

Current Price SPX 2,052.00$ Long Bond 3.0%Historical Equity Risk Premium 4.5%

Upside Potential 13% Additional Risk Premium 1.0%Total discount rate 8.5%

Source: BMO Nesbitt Burns Portfolio Advisory Team

Figure 9: S&P/TSX Composite Index Estimates

Present value % of total

present valueConsensus earnings per share growth

Discount Rate

Period 1 (2016-2019) 3,379.06$ 22.4% 6% 9.5%Period 2 (2020-2024) 3,453.56$ 22.9% 4% 9.5%Period 3 (2024 - ) 8,224.60$ 54.6% 2% 9.5%

Total fair value 15,057.22$ 100.0% Implied terminal multiple 13.2 XRounded 15,060.00$ Consensus EPS for 2016 975.0

Current Price TSEC-TSE 13,630.00$ Long Bond 3.0%ls Historical Equity Risk Premium 4.5%

Upside Potential 10% Additional Risk Premium 2.0%9.5%

Source: BMO Nesbitt Burns Portfolio Advisory Team

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The Technical Picture— Medium-Term Structure Still Bullish, Buy Any Pullback Russ Visch, CMT, Technical Analyst

Coming into May, all aspects of our medium-term equity models remain bullish. For example, weekly momentum models continue to improve from the oversold extremes that developed in the fourth quarter of 2015.

Figure 10: S&P/TSX Composite Index Weekly Momentum Indicators

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Figure 11: S&P 500 Index Weekly Momentum Indicators

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Figure 12: Percentage of New York Stocks Over their 10 and 30 Week Moving Averages

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95PERCENTAGE OF NYSE STOCKS OVERTHEIR 10-WEEK MOVING AVERAGE(Investor's Intelligence)

Source: BMO Nesbitt Burns Technical Analysis

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Historically, buy signals in these indicators typically lead to rallies lasting three to six months on average, which suggests the rally could carry well into the second quarter.

Breadth models, which measure the quality of a market rally in terms of the number of stocks participating also continue to improve. At the beginning of the year we saw buy signals in medium-term breadth oscillators such as the percentage of NYSE stocks over their 10 and 30-week moving averages.

More recently we have seen broad measures of equity participation such as the traditional NYSE Advance-Decline line and the S&P 500 A-D line break to new all-time highs.

Figure 13: Advance – Decline Lines

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NYSE ADVANCE DECLINE LINE

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S&P 500 ADVANCE DECLINE LINE

Source: BMO Nesbitt Burns Technical Analysis

This sort of improvement “underneath the surface” increases the probabilities that major U.S. indexes such as the S&P 500 break to new all-time highs at some point this year.

Last but not least is sentiment. All of the sentiment surveys we subscribe to continue to reflect an increase in risk appetite – everyone from retail investors to professional futures traders. The net result is a six month high in our Composite Sentiment Indicator.

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Figure 14: Composite Bullish Advisory Sentiment

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Source: BMO Nesbitt Burns Technical Analysis

An increase in the number of bullish market participants means more investors committing capital to the markets which is obviously a good thing.

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The only real issue we have is that equity markets appear to be vulnerable on a short-term basis after a 16-18% rally from the February lows. Buying pressure has been drying up for quite some time now, recently resulting in a new multi-month low in the 10-day moving average of NYSE volume.

Figure 15: NYSE Composite Volume

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Major negative divergences also continue to build in daily breadth and momentum oscillators and it’s only a matter of time before the deterioration in these indicators has an impact on equities.

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Figure 16: S&P/TSX Composite Index Daily Momentum Indicators

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Figure 17: S&P 500 Index Daily Momentum Indicators

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Figure 18: New York Advancing/Declining Stock Ratio

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Overall, we remain constructive on our outlook for equities in the second half of the year. However, risk exists for a pullback under 13,000 in the S&P/TSX Composite while the S&P 500 is likely to come back under 2000 again. That’s where we would prefer to be putting money to work, not chasing stocks at these levels.

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Fixed Income Strategy— We May Have Seen the Best for Canada Richard Belley, CFA, Fixed Income Strategist

The global economy was relatively unchanged over the month as global monetary policies remained very accommodative amid weak growth and inflation. There have been some exceptions, including Canada. The strength in oil, commodities and the Canadian dollar resulted in surprisingly strong Canadian economic data, the Bank of Canada (BoC) shifting from potentially easing policy to joining a select group of central banks that could tighten monetary policy over the next 12 months.

Robust first quarter Canadian gross domestic product (GDP) benefited from the tailwinds of improving energy and manufacturing sectors. A stronger labor market, declining unemployment rate, surge in building permits and robust retail sales pushed growth above expectations and buoyed interest rates.

Interest rates were also affected by a reawakening of inflation. Hourly earnings growth rose the most since 2009 and the core consumer price index (CPI)2 inched above the BoC’s target of 2%. The combination of a stronger Canadian economy and price pressure in comparison to the softer U.S. data helped explain the underperformance of Canadian fixed income markets.

2 Core CPI: The CPI excluding eight of the most volatile components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, inter-city transportation and tobacco products) as well as the effect of changes in indirect taxes on the remaining components. Source Bank of Canada

Figure 19: Canadian Economic Surprises (inverted) Compared to Odds of a Bank of Canada Rate Cut

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Figure 20: Canadian Gross Domestic Product Growth

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Figure 21: Yearly Increase in Canadian Average Hourly Earnings (Quarterly)

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Canada’s economic momentum depends on ongoing recoveries in the manufacturing and energy sectors. In our opinion we may have seen the best of the Canadian economy for the moment and believe more downside risk lies ahead. In particular, the combination of the recent rise in interest rates and the stronger Canadian dollar has driven financial conditions to the tightest level since the financial crisis; certainly not ideal conditions to support a fragile economy.

Figure 23: The Bank of Canada Target Rate and the Overnight Rate (CDOR)

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We remain sceptical of the upside potential for oil prices considering that the global supply glut continues relatively unabated, something we have discussed at length in recent monthly reports. The glut has eased recently with U.S. production cuts but we doubt the 6% or approximately 600,000 barrels/day drop from last year’s peak is enough to justify higher prices at a time when others can increase production (i.e Iran, Iraq). In addition, record-high inventories in the U.S. and around the world continue to grow. Expectations for concrete action at the upcoming OPEC meeting in June are limited given the failure of recent attempts.

As for demand growth, the consensus expectation has been for an improving global outlook, but many hurdles remain as

Figure 22: Lending Conditions for Canadian Non-Financial Firms Continue to Tighten

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struggling economies including China, Japan, the Euro Zone and slower U.S. growth continue to be a drag.

We note that beyond the supply and demand dynamic, oil prices and commodities have benefitted from a weakening U.S. dollar, something that we think may not be sustainable in the short-term. We agree with the argument that substantial investment cuts in the energy sector will impact long term capacity and output, and this will be reflected in prices. We also understand that unexpected production cuts/disruptions (Alberta fires) and geo-political events could lead oil prices higher. However, considering the current fundamental background, we are less optimistic as to the timing of supply and demand re-balancing, which leads us to believe oil prices will likely remain depressed with risks to the downside.

From a fixed income perspective, labor and capital investment cuts in the energy sector along with a slowly-recovering manufacturing sector should continue to be headwinds for the economy, interest rates and credit markets. While the current landscape points toward the necessity of higher rates, other indicators like the stronger Loonie, tighter financial conditions, and energy sector weakness would suggest otherwise, likely leading the BoC to be more patient before changing direction.

The Fed Should Wait Beyond June

We believe the U.S. Federal Reserve (Fed) will continue to be patient before raising rates, delaying the next hike beyond its June meeting amid soft economic data. For the third year in a row, first quarter GDP was weak, but this time weather didn’t play a role as the last winter was one of the mildest on record. This weakness in growth contributed to a decline in the U.S. dollar. While in previous years the economy strengthened significantly in the second quarter, this pattern may not be repeated this year. Despite the labor market remaining relatively solid, recent data on housing has been mixed at best and business capital investments and exports have remained soft resulting in downward revisions to second quarter GDP expectations. The Fed’s GDPNow forecasts that second quarter growth will come in at 1.7% (from 1.8%), Bloomberg at 2.3% (from 2.5%) and BMO Capital Markets Economics at 2.3% (from 2.6%). In addition, rising uncertainties related to the upcoming U.S. election seem to have increased household concerns. Recent University of Michigan surveys show the U.S. consumer losing confidence in the economy, this loss of confidence in turn affecting spending and consumption and likely leading the savings rate to one of its highest levels since 2012; certainly not a good start to the quarter.

Figure 24: Is China’s Economic Growth Stabilizing? Year-over-year Chinese Gross Domestic Product Growth

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Figure 25: U.S. Dollar Index and Crude Oil Prices (inverted axis)

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In its April meeting, the Fed chose to maintain a relatively dovish tone acknowledging the broad-based weakness in the U.S. economy, leading markets to push forward their expectations for further tightening. While the Fed reduced its expectation of rate hike decisions this year to two, market participants continue to expect only one rate increase later this year. Even recent comments from two non-voting Fed officials suggesting that the possibility of a hike at June’s meeting should not be eliminated had little impact on markets. Arguably, with six weeks of data remaining before it reconvenes, we think it will be difficult for the Fed to justify a move. Given the Fed has not surprised the market since 1994 with a rate hike, it will only raise rates if it gets some help from strong economic data and embarks on a communications effort to telegraph its intentions. While not impossible, this leaves little time to prepare the market so as to avoid major disruptions. Inflationary pressures could change the decision timeline, but recent upticks in prices and wage inflation continue to be dominated by temporary factors. In the near term, the combination of the lower U.S. dollar, higher energy prices and higher rents will likely weigh on general price levels, something the Fed seems willing to accept. Assuming growth gradually strengthens later in the quarter, we believe July or even September would be better timing for the Fed.

Interest Rate Forecast and Total Return Expectations

We believe the domestic economic environment will continue to justify low yields with some downside risk. International considerations including the more than US$7 trillion of negative-yielding sovereign and corporate securities in the world and the uncertainties surrounding the U.K. June vote on its European Union membership should continue to pressure rates lower. This is reflected in the recent interest rate forecasts, including those from BMO Capital Markets Economics which now predicts the 10-year Canada yield will likely end the second quarter of 2017 at around 1.60%, compared to month-end closing of 1.51%. This contrasts with last December’s fourth quarter 2016 forecast of between 2.0-2.1%. As a result, the expected total returns over the next 12 months, assuming that these forecasts are realized, have turned positive for almost all maturities as seen in Figure 28.

Figure 27: Current and 1-Year Forecast Canada Yield Curve, April 2016

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Figure 26: U.S. Personal Savings as a Percentage of Disposable Personal Income

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Figure 28: BMO Capital Markets Forecast Returns as of April 2016

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Total Returns Based on BMO CM Interest Rate Forecast

Source: BMO Capital Markets

This environment supports a more aggressive portfolio interest rate sensitivity, but with low yields comes higher volatility risks and for that reason we continued to maintain a neutral duration for longer mandate of approximately 4.5 years. For shorter mandates (5-years and under) we prefer a more aggressive duration/interest rate sensitivity posture above three years as cash, cash equivalents and ultra short-term securities remain expensive.

From a sector allocation, slower economic growth, weak corporate earnings along with credit risk concerns in the U.S. non-investment grade (High Yield) sector amid rising default rates lead us to favor provincial and municipal securities over lower rated corporate credits. We continue to favor an overweight allocation to corporate bonds (investment / non-investment grade) but believe there are still some downside risks to the sector and would prefer to wait for a better entry level before rolling maturities or initiating new positions.

Figure 29: U.S. Investment Grade Bond Spreads (basis points)

0

100

200

300

400

500

600

700

Jan-09 Feb-10 Mar-11 Apr-12 May-13 Jun-14 Jul-15

Source: St. Louis Federal Reserve

Figure 30: Five Year Canadian Corporate Indicative Spreads

40

90

140

190

240

290

340

390

440

490

540

590

640

Jan-06 Mar-07 May-08 Jul-09 Sep-10 Nov-11 Jan-13 Mar-14 May-15

AA A BBB

Source: BMO Capital Markets

17

As for the high-yield bond sector, we know that roughly 75% of all securities that defaulted over the last 12 months were from the energy, metals and mining sectors. But we are now seeing defaults on a greater scale with over US$50 billion of corporate issuers defaulting so far this year, a number that has accelerated at its fastest pace since the end of the financial crisis (as reported by Standard & Poor’s) with 46 defaults compared to slightly over 70 in 2009. Also, the watch lists of corporations at the greatest risk of default in the near future have lengthened at both Standard & Poor’s and Moody’s. Adding to these concerns is the growing Chinese debt wall of US$571 billion (3.7 trillion yuan) in local corporate bonds that are maturing this year. Given weaker demand, these bonds could be difficult to refinance. In this environment, we recommend prudence and selectivity when allocating to the sector.

We reiterate what we stated in last month’s strategy report:

We have resisted adding exposure to the non-investment grade bond sector, especially in HY index mutual funds and ETFs due to our concern over the risk in the energy, commodity and materials sectors. We also had concerns over the general liquidity of these sectors. We maintained our recommendation for a limited allocation to the Senior Loan sector, but our focus was on actively managed mutual funds and ETF portfolios.

In consideration of global uncertainties and other risks cited above, we believe that corporate bonds still face downside risk and caution against buying these sectors blindly. We note, however, that an average yield of 7.65% for the HY index ex-energy is relatively attractive in the context of a low yield environment and may satisfy the diversification needs of some investors. Our recommendation focusses on actively managed ETFs and funds which should succeed in avoiding some of the credit and default risks and delivering superior returns.

Figure 31: FTSE TMX Universe Bond Index Returns (For Period Ended April 30, 2016)

-0.08%

0.26%

-0.44%

-0.13%

0.01%

0.92%

2.43%

0.49%

0.06%

0.09%

1.31%

2.90%

1.08%

0.28%

0.15%

-1.00% -0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%

Universe Bond Index

Long-Term Bond Index

Mid-Term Bond Index

Short-Term Bond Index

91 Day Treasury Bills

Year-to-date 3-Month Month-to-date

Source: FTSE TMX

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http://researchglobal.bmocapitalmarkets.com/documents/2013/prior_rating_system.pdf

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Technical Analysis Disclaimer

Recommendations and opinions contained herein are based on Technical Analysis and do not necessarily reflect fundamental recommendations and opinions and may relate to companies which, in some instances, are not followed on a fundamental research basis.