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NA Equity Strategy Q3 13

NA Equity Strategy Q3 13

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Published by dpbasic
Ryan Lewenza: N.A. Equity Strategy Q3 13
Ryan Lewenza: N.A. Equity Strategy Q3 13

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Published by: dpbasic on Oct 16, 2013
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Report prepared by:
Ryan Lewenza, CFA, CMTNorth American Equity Strategist
2013 Year-End Forecast
Index EPS P/E Price
S&P 500 Index $108 15.2 1,640S&P/TSXComposite Index$810 16.0 12,960
Sector Recommendations
Sector U.S. Canada Preference
Financials Over Over U.S.Consumer DiscretionaryUnder Market CanadaIndustrials Over Over U.S.InformationTechnologyOver Over U.S.Energy Market Market CanadaMaterials Under Under CanadaHealth Care Over Market U.S.Consumer StaplesMarket Market CanadaUtilities Under Under CanadaTelecomServicesUnder Under Canada
Source: Portfolio Advice & Investment ResearchOver=overweightUnder=UnderweightMarket=Marketweight
This Document is for distribution to Canadianclients only.Please refer to Appendix A of this report for importantdisclosure information.
North American Q3/13 Strategy Update
Q3/13 was another solid quarter for U.S. equities, with the S&P500 Index (S&P 500) up 4.7%, pushing the year-to-date (YTD)return to 17.9%. Small-cap stocks continued to outperform large-caps, with the Russell 2000 Index up 9.9%, and 26.4% YTD. TheS&P/TSX Composite Index (S&P/TSX), which has significantlylagged the S&P 500 this year, had a solid quarter up 5.4%,pushing the S&P/TSX into positive territory for the year.
 All eyes are on Washington as the U.S. approaches its debt limitdate. As at the time of writing, the most recent proposal was for abill to extend the borrowing authority to February, giving the twoparties time to work out broader budgetary differences. While thiswould be a positive development, taking the U.S. economy off theproverbial ledge for now, it does not resolve the budget impasseand the partial government shutdown, nor the future debt limitbattle, which would likely intensify in the weeks leading up to thepotential February debt limit date. We continue to expect an 11
 hour resolution of the fiscal issues.
Strong YTD gains for the S&P 500 have been driven by multipleexpansion. With the U.S. Federal Reserve (Fed) likely to “taper”its asset purchases in H1/14, valuation support could wane,making earnings growth necessary for further upside. With our expectation for improving economic momentum in 2014, we couldsee earnings grow at 6-7%, which could help push the stockmarket higher, despite the fact that the 56-month rally is now in-line with the average length of previous bull markets.
Despite the occasional pullbacks and increase in volatility due tointensified macro issues, the S&P 500 remains in a confirmeduptrend. Only a break below key support of 1,565 to 1,575 wouldalter our bullish technical stance on the S&P 500.
Our base case view is for economic momentum to improve as wemove into 2014. This should provide a supportive backdrop for cyclical sectors, with our preferred sectors being the industrials,financials and information technology. Given our view that interestrates will slowly grind higher as economic momentum improves,the interest-sensitive utilities and telecommunications sectorsshould underperform.October 16, 2013
North American EquityStrategyOctober 16, 2013Page 2
Indices Q3 Return YTD Return
S&P 5004.7%17.9%Small Cap (Russell 2000)9.9%26.4%Growth (Russell 1000)7.7%19.3%Value (Russell 1000)3.3%18.4%S&P/TSX Composite5.4%2.8%S&P/TSX Small Cap 7.1%-1.6%
Q3 Sector PerformanceU.S. (S&P 500)Canada (S&P/TSX)
Financials 2.4%7.6%Consumer Discretionary 7.4%7.7%Industrials8.3%2.9%Information Technology 6.1%4.9%Energy4.5%8.4%Materials 9.7%4.0%Health Care6.3%2.5%Consumer Staples0.1%2.8%Utilities-0.8%-4.3%Telecom Services-5.4%2.6%
Source: Baseline. As of September 30, 2013
North American Q3/13 Strategy Update
Q3/13 was another solid quarter for U.S. equities, with the S&P500 up 4.7%, pushing the YTD return to 17.9% (Exhibit 1). Small-cap stocks continued to outperform large-caps, with the Russell2000 Index up 9.9%, and 26.4% YTD. The S&P/TSX, which hassignificantly lagged the S&P 500 this year, had a solid quarter up5.4%, pushing the S&P/TSX into positive territory for the year.Similarly, Canadian small-caps outperformed in the quarter, up7.1%; however, the rally in Q3 was unable to offset the weaknessin H1/13, with small-caps still down 1.6% YTD.On a sector basis, cyclicals outperformed with the materials(9.7%) and industrials (8.3%) sectors posting the strongest returnsin the U.S., while the energy (8.4%) and consumer discretionary(7.7%) sectors outperformed in Canada. The interest-sensitiveutilities and telecommunications sectors posted the weakestreturns in both markets.
All Eyes on Washington
In our mid-year update we stated, “we believe the ‘goldilocks’ market environment of H1/13 is unlikely to persist and seethe potential for a more volatile second half.” That proved to be accurate; however, we believed the increased volatilitywould be the result of the Fed “tapering” its asset purchases, rather than the current dysfunction in Washington over theU.S. budget and rapidly approaching debt limit date. As at the time of writing, the most recent proposal was for a bill toextend the borrowing authority to February, giving the two parties time to work out broader budgetary differences. Whilethis would be a positive development, taking the U.S. economy off the proverbial ledge for now, it does not resolve thebudget impasse and the partial government shutdown, nor the future debt limit battle, which is likely to intensify in theweeks leading up to the potential February debt limit date. With respect to the budget and the partial governmentshutdown, we note the following: 1) the last government shutdown, which was in 1995, lasted 21 days and had a minimalimpact on economic growth and the stock market (Exhibit 2); 2) it is estimated that the current partial shutdown is costingthe U.S. economy US$160 million per day, which assuming a similar 21 day closure, could cost the economy 0.9% of GDP in Q4/13; and 3) recent polls show that Americans overwhelmingly blame the Republicans for the current impasse.Given these observations, we believe a deal will soon be reached over the budget and government shutdown, resulting ina minimal impact on the U.S. recovery. Obviously, the longer the shutdown persists, the greater the impact to theeconomy. Regarding the extension of the debt limit to February, while it buys some time, it does not remove the risk thatwe could be faced with a similar situation in February, given the dogmatic views held by both parties. Either theRepublicans will need to concede defeat and look to fight another day on their demands for spending and entitlementcuts, or the Democrats will finally need to realize that tough decisions need to be made in order to address the deficits,escalating debt levels, and significant future entitlements costs. The upside of the acrimony in Washington is that it likelystrengthens the case for continued supportive monetary policy from the Fed, which is likely to maintain it’s assetpurchases until H1/14. Overall, we continue to expect an 11
hour resolution of the fiscal issues, with the U.S. recoveryonly hitting a speed bump in Q4/13.
Exhibit 2: U.S. Debt Limit to Be Reached in Mid-October; S&P 500 Performance Following Similar Battles
U.S. Debt Limit
U.S. Total Debt OutstandingU.S. Statutory Debt Limit
In Trillions
The U.S. governmentis projectedto hit its debt limit in the October-November period
Source: Bloomberg FinanceL.P. As of October 4, 2013
S&P 500 Following 1995 Government Closure and2011 US Debt Downgrade
Source: Bloomberg Finance L.P. As of October 4, 2013It took 36 days for S&P500 toget back to even followinggovernment shutdown in 1995.It took 115 days to getback to even followingU.S. debt downgrade.
North American EquityStrategyOctober 16, 2013Page 3
Economic Update
U.S. economic growth accelerated in the second quarter to 2.5% from 1.1% in Q1, driven by strength in exports, personalconsumption and residential fixed investment. We expect another 2%+ print for Q3 GDP, as many key economicindicators are pointing to a slowly improving economy. For example, job growth has averaged 184,000 per month over thelast year, helping to push the unemployment rate down to 7.3%, while U.S. initial jobless claims are at the lowest levelssince 2007. The ISM Manufacturing and Service indices continue to improve, with the manufacturing index hitting over a2-year high of 56.2 in August. While auto sales dipped in September to 15.3 million annualized, this was likely do to thefact that there were two fewer shopping days in the month, with a bounce back in sales likely in the coming months(Exhibit 3). We remain constructive on U.S. auto sales given pent-up demand, which should support the manufacturingsector and industrial production into 2014. Additionally, we note that Edmunds, a U.S. auto industry forecaster, ispredicting new-vehicle sales to hit 16.4 million in 2014, the highest level since 2006. For the most part, economic data hasbeen coming in better than expected, with the exception of the housing market, which likely slowed down due to the surgein mortgage rates over the summer. We see the recent moderation in housing statistics as simply a pause in the recovery,as mortgage rates remain historically low, while affordability remains high. Overall, we see key areas of the U.S. economyimproving, which supports our reacceleration thesis. That said, the U.S. government partial shutdown has the potential todent growth in Q4/13, especially if the shutdown lasts longer than we anticipate. TD Economics believes the impact to theU.S. economy will be modest, and is forecasting the U.S. economy to grow at 2.6% in 2014, up from 1.6% in 2013.
Exhibit 3: U.S. Auto Sales Remain Strong; Housing Market Recovery Should Continue into 2014
U.S. Total Auto Sales (SAAR)
Source: Bloomberg Finance L.P. As of October 4, 2013
(in millions
In Canada, economic growth slowed to 1.7% in Q2, in part due to the Alberta floods and a construction strike in Quebec(Exhibit 4). TD Economics is forecasting a rebound in economic activity in H2/13, as the impact from these one-off eventsdiminish. The outlook for the Canadian economy remains mixed, with weakness from the corporate sector (corporateprofits are down in five of the last six quarters), and exports, being offset by strength from the consumer and residentialconstruction. TD Economics is forecasting growth of 2.4% in 2014, up from the 1.7% expected this year, with growthexpected from the export sector, business capital investment and consumer spending. For us, the key risks to theCanadian economy remain the heavily indebted consumer (Exhibit 4), the “frothy” Canadian housing market and theresource sector, which is being impacted by slowing global growth, particularly in China. Overall, we see growth for theCanadian economy improving but see the potential for the U.S. to outperform the Canadian economy in 2014, which is in-line with TD Economics’ current forecasts.
Exhibit 4: Canada GDP to Improve Into 2014; Key Risk to Outlook Includes Heavily Indebted Canadian Consumer 
Canada Real GDP Q/Q Annualized
Source: Bloomberg FinanceL.P., TD Economics. As of October 4, 2013
Key Point:
The U.S. and Canadian economies are expected to improve driven by growth in the labour market,manufacturing and housing for the U.S, and exports, business investment and consumer spending in Canada.
U.S. Housing
U.S. Existing Home Sales (LHS)S&P/Case-Shiller Home Price IndexSource: Bloomberg Finance L.P. As of October 4, 2013
(in millions) (in thousands)
Canadian Household Debt to Disposable Income Ratio
Source:Bloomberg Finance L.P. As of October 4, 2013

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