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February 6, 2014

Report prepared by: Ryan Lewenza, CFA, CMT North American Equity Strategist

Market Update: Will EM Derail the Global Recovery? Highlights

Global equity markets have started the year on a negative note, with the S&P 500 Index (S&P 500), MSCI Europe Australasia Far East (EAFE), and MSCI Emerging Markets (EM) indices down 3.6%, 4.1%, and 6.4%, respectively, during the month of January. The weakness across the global equity markets can largely be attributed to: 1) softer economic data which points to weakening global economic momentum; and 2) the U.S. Federal Reserve s (Fed) move to reduce its asset purchases by an additional US$10 billion per month. The recent stock market rout was triggered by the January HSBC Flash China Purchasing Managers Index (PMI) which showed a contraction in the Chinese manufacturing sector. That coincided with the high for the S&P 500, with the index declining 20 points the following trading day. With the Fed cutting back on its asset purchases, the unprecedented liquidity that flowed into risky assets, such as the EMs, is now being withdrawn, resulting in steep declines of some EM currencies. The question then is whether the instability in the EMs will escalate and lead to a global contagion, similar to the 1997 Asian currency crisis. We believe this scenario is unlikely, and that as the markets acclimate to reduced Fed liquidity, the EMs will begin to stabilize. The U.S. economy has lost some momentum following a strong H2/13. However, we believe U.S. economic data could trough soon, possibly over the Spring/Summer. The upside of the recent equity market weakness is that equity valuations and investor sentiment have corrected from their elevated levels in Q4/13.

This Document is for distribution to Canadian clients only. Please refer to Appendix A of this report for important disclosure information.

North American Equity Strategy

February 6, 2014

Market Update: Will EM Derail the Global Recovery?


Global equity markets have started the year on a negative note, with the S&P 500, MSCI EAFE and MSCI EM indices down 3.6%, 4.1% and 6.4%, respectively, during the month of January. The weakness across the global equity markets can largely be attributed to: 1) softer economic data which points to weakening global economic momentum; and 2) the U.S. Federal Reserves move (Fed) to reduce its asset purchases by an additional US$10 billion per month. In our opinion, the recent stock market rout was triggered by the January HSBC Flash China Purchasing Managers Index (PMI) released on January 22, which showed a contraction in the Chinese manufacturing sector, with the index declining to 49.6 and a six month low. That coincided with the high for the S&P 500, with the index declining 20 points the following trading day. In Exhibit 1, we chart the official China PMI, which similar to the HSBC PMI report, recently rolled over and helped reinforce the concern that Chinas economy is slowing. This, in concert with the Fed slowly taking its foot off the accelerator, has precipitated the decline in equity markets. Exhibit 1 plots the year-over-year (Y/Y) percentage change in the Feds balance sheet, and provided it stays on the current path of reduced asset purchases through 2014, the tailwind provided by the Feds Quantitative Easing (QE) is likely to become a headwind in 2014. But how is this related to the selloff and growing concerns about the emerging markets? Exhibit 1: Weak China PMI Points to Softening Global Economic Momentum; Fed Balance Sheet Growth to Slow
U.S. Federal Reserve Balance Sheet Y/Y Change
200% 160% 120% 80%

QE1

QE3 QE2

40% 0%

Source: Thomson Reuters Datastream. As of January 31, 2014

-40% Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg Finance L.P. As of January 31, 2014

Jan-13

Jan-14

Some of the money created from the Feds QE programs made its way into the EMs, where interest rates were higher. Now, some of this is being reversed, as investors sell EM assets (stocks and bonds) and repatriate funds to the U.S. Countries with large current account deficits are particularly vulnerable, as they require foreign capital to fund their deficits (Exhibit 2). With the Fed cutting back on its asset purchases, the unprecedented liquidity that flowed into risky assets, such as the EMs, is now leaving these regions, resulting in steep declines for some EM currencies. The Argentine Peso and Turkish Lira have been hit particularly hard, declining 18% and 6%, respectively in January. The question then is whether the instability in the EMs will escalate and lead to a global contagion, similar to the 1997 Asian currency crisis. We believe this scenario is unlikely, and that as the capital markets acclimate to reduced Fed liquidity, the EMs will begin to stabilize. Moreover, growth in the developed markets should help to offset weakness from the EM countries. Exhibit 2: EM Countries with Current Account Deficits and Their Respective Currencies Movements
EM Current Account Deficits As % of GDP
0 -1 -2 -3 -4 -5 -6 -7 -8 -7.2 -4.4 -3.6 -3.7 -0.7

5%

Emerging Market Currencies

0%
-5% -10% -15% -20% 31-Dec

Brazilian Real Per USD Indian Rupee Per USD Turkish Lira Per USD Argentine Peso Per USD
6-Jan 12-Jan 18-Jan 24-Jan 30-Jan

Turkey

India

Brazil

Indonesia

Argentina

Source: Bloomberg Finance L.P. Values are as of August 31, 2013

Source: Bloomberg Finance L.P. As of January 31, 2014

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North American Equity Strategy

February 6, 2014

The U.S. economy has lost some momentum following a strong H2/13 in which U.S. GDP grew 4.1% and 3.2% for Q3 and Q4, respectively (Exhibit 3). Nonfarm payrolls were extremely weak in December with just 74,000 jobs created in the month. The ISM manufacturing report released this week captured the deceleration in economic activity, with the headline index declining 5 points to 51.3 and the leading new orders sub-index slumping 13 points to 51.2. This follows softer U.S. housing data, which points to a pause in the housing recovery after the spike in mortgage rates in H2/13. Despite this we believe U.S. economic data could trough soon, possibly over the Spring/Summer period. We highlight the U.S. Citigroup Economic Surprise Index, which captures economic releases relative to their expectations. Over the last few years this index has fairly consistently peaked in Q4, declined in Q1, and then bottomed in Q2/Q3 (Spring/Summer). We believe this pattern could be repeated again this year. In addition, the extreme cold temperatures and winter storms experienced across most of the U.S. and Canada has likely impacted economic activity. While we are reluctant to use the weatherrelated excuse to explain the recent weakness in economic data, the U.S. did experience its coldest January since 1994, which we would expect to crimp consumer spending and economic activity. As such, we could see a rebound in spending and activity once the polar vortex has passed. In sum, we see the potential for a reacceleration in the coming months, and therefore do not believe the unfolding EM stresses will derail the U.S. economic recovery. Exhibit 3: Strong U.S. Economic Activity Seen in H2/13 Could Re-emerge in the Spring/Summer

Source: Thomson Reuters Datastream. As of January 31, 2014

Source: Thomson Reuters Datastream. As of January 31, 2014

The upside of the recent equity market weakness is that equity valuations and investor sentiment have corrected from elevated levels. The S&P 500 forward P/E has declined over a full point, from 16.7x in late December to 15.5x currently (Exhibit 4). Towards the end of 2013 it was difficult to find high-quality companies at attractive valuations; however, following the pullback we are finding a lot more attractively valued stocks. Looking at investor sentiment, many of our sentiment indicators were at extreme bullish readings at the end of 2013, which led to some short-term concerns for us. Looking at the Individual Investors sentiment poll, 55% of investors polled in late December were bullish (just 18% were bearish), which is an extreme reading, and well above the long-term average of 39%. As of last week, this sentiment reading was at 32% and approaching levels where sentiment typically bottoms. From a technical perspective, we believe there is the potential for additional near-term weakness, with the S&P 500 possibly declining to its 200-day moving average (MA), currently 1,709. If correct, we would expect investor sentiment to turn increasingly bearish, possibly setting the stage for an end to the pullback. Exhibit 4: S&P 500 P/E Has Declined 1x to 15.5x; Bullish Investor Sentiment has Corrected from Elevated Levels
S&P 500 Forward P/E
18 17 16 15 14 13 12 11 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
Source: Thomson Reuters Datastream. As of January 31, 2014

Source: Bloomberg Finance L.P. As of January 31, 2014

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North American Equity Strategy

February 6, 2014

Conclusion The global capital markets are adjusting to a more normalized Fed monetary policy as the Fed slowly reduces its asset purchases. During these periods, equity markets typically come under short-term pressure as investors begin to price in less accommodative monetary policy. In our 2014 Investment Outlook we suggested that the equity markets could encounter increased volatility in Q1/14 around this event, but that North American equities could still post positive returns for 2014 on the back of stronger earnings growth. This remains our view. We believe the current EM concerns will subside and that the U.S. economy could improve in the Spring/Summer timeframe providing the foundation for equity markets to climb higher in H2/14.

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North American Equity Strategy

February 6, 2014

Appendix A Important Disclosures


General Research Disclosure The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. This report is for informational purposes only and is not an offer or solicitation with respect to the purchase or sale of any investment fund, security or other product. Particular investment, trading, or tax strategies should be evaluated relative to each individuals objectives. Graphs and charts are use d for illustrative purposes only and do not reflect future values or future performance. This document does not provide individual financial, legal, investment or tax advice. Please consult your own legal, investment and tax advisor. All opinions and other information in this document are subject to change without notice. The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Waterhouse Canada Inc. and/or its affiliated persons or companies may hold a position in the securities mentioned, including options, futures and other derivative instruments thereon, and may, as principal or agent, buy or sell such securities. Affiliated persons or companies may also make a market in and participate in an underwriting of such securities. Technical Research Disclosure The opinions expressed herein reflect a technical perspective and may differ from fundamental research on these issuers. Fundamental research can be obtained through your TD Wealth advisor or on the Markets and Research site within WebBroker. The technical research opinions contained in this report are based on historical technical data and expectations of the most likely direction of a market or security. No guarantee of that outcome is ever implied. Research Report Dissemination Policy TD Waterhouse Canada Inc. makes its research products available in electronic format. These research products are posted to our proprietary websites for all eligible clients to access by password and we distribute the information to our sales personnel who then may distribute it to their retail clients under the appropriate circumstances either by email, fax or regular mail. No recipient may pass on to any other person, or reproduce by any means, the information contained in this report without our prior written consent. Analyst Certification The Portfolio Advice and Investment Research analyst(s) responsible for this report hereby certify that (i) the recommendations and technical opinions expressed in the research report accurately reflect the personal views of the analyst(s) about any and all of the securities or issuers discussed herein, and (ii) no part of the research analysts compensation was, is, or will b e, directly or indirectly, related to the provision of specific recommendations or views expressed by the research analyst in the research report. Conflicts of Interest The Portfolio Advice & Investment Research analyst(s) responsible for this report may own securities of the issuer(s) discussed in this report. As with most other employees, the analyst(s) who prepared this report are compensated based upon (among other factors) the overall profitability of TD Waterhouse Canada Inc. and its affiliates, which includes the overall profitability of investment banking services, however TD Waterhouse Canada Inc. does not compensate its analysts based on specific investment banking transactions. Corporate Disclosure TD Wealth represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Wealth Private Banking (offered by The Toronto-Dominion Bank) and TD Wealth Private Trust (offered by The Canada Trust Company). The Portfolio Advice and Investment Research team is part of TD Waterhouse Canada Inc., a subsidiary of The Toronto-Dominion Bank. Trade-mark Disclosures Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. TD Securities is the trade name which TD Securities Inc. and TD Securities (USA) LLC. jointly use to market their instituti onal equity services. TD Securities is a trade-mark of The Toronto-Dominion Bank representing TD Securities Inc., TD Securities (USA) LLC, TD Securities Limited and certain corporate and investment banking activities of The Toronto-Dominion Bank. All trademarks are the property of their respective owners. The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.

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