a shot across the bow - picton mahoney · 2020. 4. 16. · a shot across the bow q1 review and...

A SHOT ACROSS THE BOW

Q1 REVIEW AND OUTLOOKTHE TOPPING PROCESS IS UNDERWAY

ECONOMIC CONDITIONS APPEAR SOLID, BUT…

SPREADS STILL FAVOUR EQUITIES, BUT CUSHION HAS SLIPPED

A HISTORY LESSON FROM THE 1990S

SECTOR OUTLOOKS

VOLATILITY SPIKE CONFIRMS LATE CYCLE VIEW

2 | PICTON MAHONEY Q1 OUTLOOK 2018

“PMAM” refers to Picton Mahoney Asset Management. PMAM view is relative to the Bloomberg consensus estimate for each category. As at March 2018.

MACROECONOMIC

RiskAfter a quiet 2017, macroenconomic risk finally spiked in Q1 on the back of inflation fears, higher rates and spiking volatility. We expect risk levels to remain elevated going forward.

Global Real GDPGlobal growth estimates have finally caught up to the momentum being generated by synchronized global growth, which is likely to start facing headwinds from higher rates in the U.S., peaking leading indicators in Europe and the end of the emerging market easing cycle.

U.S. Real GDPThe impact of fiscal policy and tax cuts, together with the unrelenting optimism in the consumer sector and amongst small businesses, will likely help GDP surprise to the upside again.

Canada Real GDPAlthough Canadian economic growth has already disappointed this year, it is likely to continue to do so as cracks appear in the housing market, NAFTA renegotiation remains elusive, and small business optimism remains challenged, particularly in Ontario.

U.S. InflationU.S. inflation accelerated beyond expectations in Q1 amidst a tighter labour market and a positive output gap, but there is no reason to extrapolate the trend below these levels for the time being.

EQUITY RETURNS

U.S. EquitiesWhile we believe U.S. equities can churn out a positive year, average expectations of +16% are too high, and the return of volatility will hamper returns going forward as the cycle matures.

European EquitiesEuropean economic strength has surprised to the upside, but the peak in growth is now behind us. Though still positive for equities, the backdrop has moderated since last year.

Canadian EquitiesReturn expectations of +19% are not realistic for an economy at the mercy of external factors (oil prices, U.S. trade) with few positive domestic levers and many domestic risks (policy, indebted consumer, housing).

BOND YIELDS

Treasuries (U.S.10 yr)Higher inflation and less foreign buying have helped rates reach the 3% level, which seems reasonable at this point, as there are no further upside drivers in the near term.

Investment Grade CorpCorporate bonds do not perform as well in this phase of the economic cycle. The high correlation of corporate spreads to the VIX suggests yields should continue to increase.

High Yield CorpCorporate bonds do not perform as well in this phase of the economic cycle. The high correlation of corporate spreads to the CBOE Volatility Index suggests yields should continue to increase. Increased risk aversion will likely weigh more on high yield in particular.

OTHER

WTI Crude OilFalling inventories, backwardation and a weaker U.S. dollar continue to provide tailwinds to oil prices.

EPS Growth (S&P 500)EPS growth will appear high due to the one-time impact of lower tax rates. Stripped of this, incremental growth will be fleeting as leading indicators decelerate.

P/E (S&P 500)Multiples are already very stretched relative to their own history. Higher rates have also made equities less attractive relative to bonds and this should further weigh down multiples.

BELOW CONSENSUS ABOVE CONSENSUS













LESS RISK MORE RISK

PICTON MAHONEY Q1 OUTLOOK 2018 | 3

OVERVIEW

The early stages of the topping process for the equity market cycle have been triggered by the closing of the output gap in the U.S. and by tightening monetary policy around the world. The narrative of synchronized global growth has become the consensus view, but divergences are beginning to highlight some early cracks in the system. The volatility awakened in February is a long overdue challenge to the complacency that has been growing in investors over the past eighteen months. We think risk assets have more to run on the upside, but peaking economic indicators tend to usher in higher volatility and more muted returns that can shake investors out before the topping process is complete. There are, however, a number of strategies that can help investors better position themselves through this process.


In our last Review and Outlook, we noted that the Q3 2017 GDP print signalled the first positive “output gap” for this cycle (Figure 1) and set the clock ticking on the beginning of the end of the current economic cycle and bull market in risk assets.

It’s worth reviewing the “Roadmap to Recession” that we outlined in that commentary (see Figure 2).

Given the slow pace (so far) of central bank tightening around the world, and a perhaps poorly timed move to boost fiscal stimulus in the U.S., it may be prudent to add a couple of quarters to the timelines in the roadmap below. While late-cycle stock markets usually deliver positive returns, they are often characterized by greater volatility and more violent sector rotation. The first of these events has now arrived.

EVENT COMMENTS OBSERVED OR ANTICIPATED TIMING

Output gap turns positive

A positive output gap leads to excesses building in the economy, prompting the central bank to become more aggressive in tightening monetary policy

September 2017

Curve inversion For our purposes, this occurs when the Fed Funds rate exceeds the yield on 10-year bonds

On average, this typically occurs 10 months after the output gap turns positive, which suggests the curve will invert in Q3 2018

Slowing economy, rising unemployment

Although one would expect the market to anticipate this, peaks in the S&P 500 Index have coincided with, rather than predated, the first increases in the unemployment rate

Based on past averages, expected to occur in mid-2019

Broad-based recession (as defined by NBER)

Typically follows approximately one quarter after economic growth slows and unemployment rises

Q3 or Q4 of 2019

Fig 2: The “Roadmap to Recession”

THE TOPPING PROCESS IS UNDERWAY

VIX Index (lhs) VXX ETF Short Interest ($MN USD, rhs)

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Fig 1: The U.S. GDP output gap has become positive for the second straight quarter

Source: Bloomberg L.P., PMAM Research. As of: Dec 31, 2017. Based on the recession indicators from the U.S. National Bureau of Economic Research (“NBER”).


Rising equity volatility: The first shot across the bow

The conditions for a spike in volatility were ripe in January. The eventual correction in February scorched trend-following investors who had been shorting volatility in many forms (we noted a record short position in VIX futures last fall) as a way of generating higher returns than those available in more traditional assets offering close to historically low yields.

As Figure 3 shows, old habits die hard. Despite February’s swift correction and its effects on equity volatility, short interest in the iPATH S&P 500 VIX Short-Term Futures ETN (VXX) (an exchange-traded note designed to offer exposure to the short-term path of volatility) remains near all-time highs.

The emergence of equity volatility as a pseudo–asset class creates the possibility that the tail (volatility) is wagging the dog (sentiment). Many modern portfolio construction strategies use asset class volatility and changes in volatility to help determine optimal asset class weightings. Other strategies use trend following to weigh asset classes. Therefore, investors who were once happy to increase risk asset allocations in low-volatility, positive-trending environments may quickly reverse course and sell assets in response to upward outbreaks of volatility.

This relationship is likely to have important implications not only for equities but also for other asset classes. While the effects of February’s spike in equity volatility were largely contained to equities, future increases in expected volatility may not be.

The next shot across the bow: Credit markets?

Credit market spreads are beginning to widen. This has been a very robust credit cycle, characterized by historically tight spreads, but there are risks brewing in the credit markets:

- Investment-grade credits are trading at historically high durations, with little extra yield compensation to offset the risk of higher interest rates.

- The share of BBB-rated credit in the investment-grade universe has roughly doubled since the beginning of 2009 (it is now 50%), and new issues are increasingly light on covenants that protect investors.

- In both the high-yield and investment-grade credit markets, price discovery has been compromised by passive strategies that often pay “through the quote” to assure fast execution when flows are rolling in.

For the past year or so, high-yield bond funds have seen outflows that increased amid recent volatility. Figure 4 shows this phenomenon, and calls attention to the apparent relationship of trailing three-month average flows with movements in credit spreads, as recent outflows from passive strategies (chiefly ETFs) have coincided with the increase in credit spreads. As with other markets in this stage of the cycle, changes in fundamentals can be exacerbated by liquidity and flows.

At the same time, the issuance of collateralized loan obligations (CLOs) is at record highs. As these CLOs are merely packaged loans, one should be skeptical as to the credit quality, structure and term of these vehicles. Memories of the debacle in mortgage-backed securities that occurred in 2007 and 2008 seem to have faded at a late enough stage in the cycle where investors should be considering taking on less risk and not more.

Finally, foreign demand for U.S. corporate bonds has likely been an important driver of spread compression in the past few years. However, as Figure 5 shows, foreign money has recently begun to move out of U.S. corporate bonds. It certainly appears


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Fig 3: The VIX spike in February did not seem to deter the “short vol” trade

Source: Bloomberg L.P., PMAM Research. As of: March 23, 2018.


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Fig 6: Excess liquidity and equity returns



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Fig 5: Foreign purchases of U.S. corporate bonds

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that foreign buying coincided with the implementation of quantitative easing (QE) by the European Central Bank (ECB), which drove many sovereign bonds to negative yields. Perhaps the sudden turn in demand is a result of investors anticipating the eventual end of QE by the ECB later this year.

Liquidity: Another cause for concern

Most market participants acknowledge that the rampant liquidity furnished by QE programs around the world has been a tailwind for asset prices and the real economy as well. As seen in Figure 6, changes in excess liquidity—as proxied by money supply (M2) less industrial production—have been a leading indicator of equity market returns. However, excess liquidity is declining of late, which does not appear to be supportive of continued broad equity momentum.


Many stock market bulls hang their hats on the considerable improvement in the global economy over the past couple of years. For instance, optimism among U.S. small business owners has recently reached a 35-year high (Figure 7). This is a nice follow-through from the initial reaction to President Trump’s “pro-business” election victory, driven by large tax cuts for businesses and the potential for large government infrastructure programs as well.

The bulls contend that fiscal stimulus will kick in meaningfully enough to offset tightening monetary conditions and extend the cycle. The U.S. tax bill passed in December promises a boon to corporate profits, yet we have noticed a reluctance among analysts to incorporate the positive effects of the legislation into their forecasts, at least until company management teams officially and explicitly outline the impact. Furthermore, hordes of U.S. dollars are expected to be repatriated from foreign subsidiaries of U.S. multinationals, which could usher a spending spree on capital expenditure and capital markets activity.

Around the globe, while some regional disparities exist, the narrative is one of reasonably synchronized global growth, with the U.S. leading the charge.

However, we have previously noted indications of peaking economic conditions, especially from leading indicators such as the Purchasing Manager Indices. Historically, this has meant that what remains of this economic cycle will create far bigger “chop” amid the remaining opportunities. Meanwhile, short-term interest rates have been rising steadily as policy-makers attempt to normalize the massive stimulus wrought by years of QE. There is increasing evidence that the “central bank put” is no longer, and that investors’ long-held view, going back to

ECONOMIC CONDITIONS APPEAR SOLID, BUT…


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Fig 7: Optimism in small business


the period when Alan Greenspan was the Chairman of the U.S. Federal Reserve (Fed), that central banks “have your back” may start to come under pressure. Recent central bank statements from the ECB and the Fed’s new Chairman, Jerome Powell, seem to indicate the volatility in markets will be tolerated. Not to be outdone, the regular scheduled meeting of the Bank of England (BoE) on February 8 (in the crescendo of volatility) saw the BoE guide markets toward rate hikes far sooner than expected. (Interest rate futures markets were discounting the first BoE rate hike in 2019.)

As the term structure of interest rates responds to this reality and the yield curve flattens, investors will become increasingly


nervous about the prospects for the economy and will likely demand higher spreads on credit and cheaper multiples to invest in stocks. That said, a flat/inverted curve can remain in place for some time before recession takes hold.

Of course, most unemployment measures are so robust (especially in the U.S.) that there is but one direction for them to go. Against the backdrop of tightening monetary policy, even a small uptick in unemployment could be a very unnerving sign of what is to come for the economy and risk assets.

So long as the global economy remains in expansion, earnings growth is still on offer. After that, as economic growth decelerates, so too will the momentum in earnings estimates. Based on our modelling, positive analyst estimate revisions will likely peak in the next six months. Following that, engineering higher earnings per share through equity buybacks will have a harder time offsetting the effects of slowing growth.

Other divergences appear when we compare major regions around the world. China has seen a persistent deceleration in business activity as a result of the central authority’s putting the brakes on a series of excesses in the economy. China has been tightening monetary policy for some time, with a marked effect on its property markets (Figure 8). A scenario of continued fiscal tightening in the world’s second-largest single-country economy suggests the end of globally coordinated growth and more immediate downside risk.

In Europe, it appeared Germany had finally passed the torch of growth to the broader eurozone. That too proved fleeting, as the ECB remains trapped by its own QE program, having purchased far more bonds than are being issued. By maintaining liquidity, the ECB has been stymied by growth and inflation that will not self-sustain. Now, as rates rise globally, one wonders where the incremental demand for European bonds will come from. And even mighty Germany is starting to see a decline in its leading indicators.

Canada faces its own structural issues, which we have addressed at length in the past. The Bank of Canada faces its own conundrum: raise interest rates too quickly and the housing market may crack, putting roughly 30% of prior years’ GDP growth at risk; or pause in raising interest rates and the economy may continue to grow even more dependent on rate-sensitive industries such as real estate, financial services and prolific government spending. Suffice to say that Canada is seemingly in a truly unenviable position, with the longer-term outlook for the currency becoming increasingly negative.


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Fig 8: Chinese property prices and bond yields



SPREADS STILL FAVOUR EQUITIES, BUT CUSHION HAS SLIPPED

Equities have looked attractive relative to interest rate proxies for some time now. However, recent interest rate increases have eroded the large relative valuation cushion that existed. Figure 9 shows that the earnings yield of the companies in the S&P 500 Index is converging with the average yield on investment-grade corporate bonds. At this point, credit markets and the yield curve still appear conducive to growth, which will hopefully allow the gap to fully close and produce conditions resembling those prior to the great financial crisis in 2008.

Central banks have found it difficult to break the deflation narrative of this cycle, but seem to have made progress more recently. However, as the new narrative of normalization takes hold and short-term interest rates climb, a new valuation hurdle has emerged. For the first time in almost 10 years, the yield on two-year treasury bonds is decisively higher than the dividend yield of the S&P 500 Index (Figure 10). At what point do investors decide to seek the relative safety of short-term government bonds and shun the higher volatility associated with higher-risk assets such as equities?


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Fig 10: Yield of the two-year U.S. treasury bond and the S&P 500 Index



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Fig 9: S&P 500 Index earnings yield vs. corporate bonds



A HISTORY LESSON FROM THE 1990S

As we survey markets today, we see parallels to the mid-1990s, when Fed Chairman Alan Greenspan chided investors for their “irrational exuberance” (Figure 11). In that cycle, volatility had begun to rise before Greenspan made these comments, and then continued in an upward trend, with some periodic spikes around global events such as the Asian currency crisis, the Russian default and the leverage problems at Long Term Capital Management. We envision a similar path to volatility this cycle as well. What potential crises lay ahead of us today: An unintended inflation spike? Banking crises? Policy accidents? An impeachment? How about trade wars? A recent report from Bloomberg Economics estimates that “a global trade conflagration could wipe US$470 billion off the world economy by 2020.” Whatever your view, it seems clear to us that the environment is ripe for surprises whose outcomes skew to the negative. The “good” news was that following the shots across the bow in 1998, the Fed was forced to reverse course, and markets soared to new highs. This will be something we are watching for as this year progresses.

Concluding remarks

While our outlook is decidedly more cautious than in our last report, it is not exactly pessimistic. To our eye, all evidence suggests that the era of easy money and commensurate risk-taking is behind us for this cycle. But despite our belief in this market’s late-cycle backdrop, we believe equities can rally from current levels, driven by solid earnings growth and a normalizing of investor sentiment. We do, however, expect higher realized volatility in returns. While we are prepared to buy on the recent dip in equities, we are also moving to a position of selling in ensuing rallies. As NFL great Otto Graham famously quipped: “Do not throw in the towel. Use it to wipe the sweat off your face.” In other words: to earn the returns to come, expect to work harder, to sweat more and to be confronted by the temptation to pack it in too early.


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SECTOR OUTLOOKS


From a style perspective, we see evidence that growth and momentum will continue to perform, as is generally the tendency in late-cycle markets. Figure 12 shows that U.S. valuation spreads (i.e., the difference between earnings yields of the top- and the bottom-decile companies) are well below longer-term averages, suggesting there is no inherent advantage at this time in seeking out “value” as a factor-attribute to garner meaningful alpha. In fact, as time passes and economic growth begins to decelerate, earnings growth will become a scarcer commodity and should be sought by investors.

INDUSTRIALS

Our bullish Industrials outlook remains unchanged. Macro and business confidence survey data continue to trend better, is beginning to translate into a pickup in capital goods orders and freight volumes for North American industrials. U.S. tax reform is expected to add to earnings growth in 2018 and beyond.

That said, the recent sentiment-driven unwind in February, and rumours regarding trade wars, have led to meaningful volatility and a significant pullback over the past two months. While we’re gradually adjusting our positioning toward defensive secular names, these market-driven events have not changed our long-term thesis on the names we like in this space.

We continue to favour companies with idiosyncratic growth, margin expansion and/or capital structure optimization opportunities. One of our preferred names remains Waste Connections Inc. (WCN), whose management team continues to deliver solid growth and impeccable execution in integrating the highly accretive Progressive Waste acquisition. We also believe Bombardier Inc. (BBD/B) has meaningful upside, given that the company has successfully offloaded CSeries-related risk, maintains a strong and growing transportation backlog and will likely benefit from an improved business jet environment.

TECHNOLOGY

Global enterprise demand is hot and likely ahead of itself. The adoption of digital tools has recently been accelerated by exogenous demand kickers, including U.S. corporate tax rate cuts, accelerated depreciation and repatriation of foreign capital. Regulatory risks for engagement-based internet business models likely remain top of mind because of the political appetite to take Facebook Inc. to task regarding the Cambridge Analytica fiasco, multiple European Commission inquiries into Alphabet Inc.’s dealings and the impending General Data Protection Regulation (GDPR) European enforcement. Accordingly, we are cutting down our overweight positioning in Technology.

In Canada, we like Kinaxis Inc. (KXS CN), a leading provider of cloud-based supply chain analytics software. It is executing on its growth strategy by expanding its partner base, pushing deeper into key industry verticals and upselling its existing customers. The impact from the fallout with Samsung Electronics Co. Ltd. in mid-2017 has been minimal and has not affected its pipeline or other customer relationships.

Internationally, we like Varonis Systems Inc. (VRNS US), the leading supplier of data protection cyber-security software. Its comprehensive product portfolio is seeing successful cross-selling results, and GDPR could be a positive catalyst for demand.

CONSUMER DISCRETIONARY

We remain slightly overweight in the Canadian Consumer Discretionary sector but have reduced our exposure over the past six months. Discretionary stocks pulled back along with the broader S&P/TSX Composite Index in Q1 2018, creating opportunities to add to core positions including Spin Master Corp. (TOY) and BRP Inc. (DOO). Against an increasingly uncertain macroeconomic backdrop, we believe that stock selection becomes even more crucial, as companies are only rewarded for best-in-class execution and having a reasonable “moat” around their businesses to fend off competition.

Our favourite name in the space is Spin Master Corp. (TOY), which offers under-appreciated top-line growth combined with a strong free cash-flow profile and a healthy balance sheet. As Spin Master Corp. continues to deliver 20%+ annual revenue growth and steady margin expansion, both estimates and the multiple should move higher over time. We do not believe the liquidation of Toys R Us stores will have a meaningful long-term impact on the toy industry generally or Spin Master specifically.

BRP Inc. (DOO) is another stock that is delivering exceptional results and market share gains, benefiting from disruption to its key competitor, Polaris Industries Inc. We believe there is further upside to DOO’s earnings, particularly should oil-exposed markets recover.


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Fig 12: Valuation spreads are below long-term average

Source: Thompson Financial, IDC, Compustat, PMAM Research. As of: March 31, 2018.


OVERVIEW

The early stages of the topping process for the equity market cycle have been triggered by the closing of the output gap in the U.S. and by tightening monetary policy around the world. The narrative of synchronized global growth has become the consensus view, but divergences are beginning to highlight some early cracks in the system. The volatility awakened in February is a long overdue challenge to the complacency that has been growing in investors over the past eighteen months. We think risk assets have more to run on the upside, but peaking economic indicators tend to usher in higher volatility and more muted returns that can shake investors out before the topping process is complete. There are, however, a number of strategies that can help investors better position themselves through this process.

MATERIALS

After a strong 2017, Base Metals begin the new year on a softer footing on both a seasonal lull and demand concerns. In our view, with China entering into a new political-economic cycle, Beijing’s attempts at deleveraging could risk slowing down consumption for cyclical metals this year. We have trimmed exposures accordingly.

Geopolitical risk also appears to be rising, following a mining code revision in the Democratic Republic of Congo that resulted in higher royalties. (Mali is also reportedly contemplating carrying out similar measures.) On a company level, Zambia recently slapped First Quantum Ltd. (FM) with an egregious tax assessment, which made investors more jittery about investing in companies that operate in risky geopolitical regions.

Rising political tensions, as exhibited by trade frictions between the U.S. and China, could help gold break the humdrum that it has had in place since 2016. We continue to believe that high-quality gold producers such as Agnico Eagle Mines Ltd. (AEM) are best positioned for this potential commodity price rally and provide portfolio construction benefits at this point in the cycle.

ENERGY

We continue to believe that crude oil (WTI) prices remain range bound for the foreseeable future, with a $45/bbl to $60/bbl range, but that improving fundamental data should support prices in Q1 2018 near the top end of this expected range.

Overall compliance with OPEC quotas has remained very strong through Q1 2018, while members Venezuela, Angola and Algeria continue to see production declines. Against this cohesive OPEC backdrop, oil market fundamentals are still improving, pushing OECD commercial petroleum stocks toward their five-year average (a 200 mm bbls since peaking in January 2017). With globally synchronous economic growth enduring, and oil prices well below historical highs, we project that we should see another year of more than 1.5 mb/d demand growth this year.

We currently own energy companies that generate free cash flow at our targeted crude price, while also delivering positive operational change, such as Canadian Natural Resources (CNQ) and Encana Corp. (ECA). On the pipelines side, we see Pembina Pipeline Corp. (PPL) as a unique opportunity to benefit from a good combination of growth and commodity leverage at a reasonable valuation.

FINANCIALS

We believe that the global banking sector has reached an inflection point in which profitability is set to continue to improve and capital returns will ratchet higher as the decade-long headwinds—brought on by low rates, increased liquidity, de-leveraging and elevated regulatory spending—are set

to become tailwinds, particularly in the U.S. Additionally, the signing of the Tax Cut and Jobs Act in the U.S. provides an immediate improvement to profitability while we watch for signs of improved corporate confidence kick-starting balance sheet growth at the banks.

We remain a bit more cautious on the outlook for the Canadian banks and mortgage finance companies, given housing policy changes in Ontario and B.C. and the new B20 guidelines that became effective January 1, 2018. First-quarter results were generally better than expected for Canadian banks, characterized by continued strength in the banks’ domestic banking and wealth management franchises, and a seasonally strong quarter in wholesale banking. Key themes continue to be the ongoing benign credit environment and healthy (albeit slowing) balance sheet growth. We like banks with leverage to improved U.S. growth, higher rates and market-sensitive revenue streams. Our core Canadian bank holdings include Royal Bank of Canada (RY) and The Toronto-Dominion Bank (TD).

In the life insurance space, we continue to favour Sun Life Financial Inc. (SLF), as we believe its relative capital strength will become a clear differentiator as life insurers begin to report under their new capital regime in Q1 2018 (LICAT). In the asset management space, Brookfield Asset Management Inc. (BAM/A) remains a core holding, as we see continued double-digit growth in BAM/A’s fee-related earnings and believe investors are getting a free call option on future carry at current valuations.

HEALTH CARE

Headlines on the upcoming drug pricing proposals from the Trump administration, potential generic/biosimilar competition and margin pressure have led to the underperformance of the biopharma subsector. In the generic drug space, sentiment remains low despite stabilization of price deflation. The drug supply sector sell-off has continued with concerns on multiple fronts, such as drug price control, the momentum behind Intermountain Healthcare’s generics initiative, Amazon.com Inc.’s push into Health Care and questions about the strategic merit and the Department of Justice risks to the potential vertical integration of CIGNA Corporation and Express Scripts Holding Co. Top-performing subsectors are medical devices, life science tools and managed care—even in light of rich valuations— because they are largely sheltered from the current political environment. In addition, the recent increase in the National Institute of Health funding supports continued sustained growth of the tools subsector.

Sector performance in the near future is likely to remain choppy, with vague health care policies, pronouncements from Washington and upcoming mid-term elections in November that could change the majority in Congress.


STAPLES

The Staples sector continues to grapple with various structural headwinds that have emerged in recent years. In the U.S., food retailers continue to see headline risk from the Amazon.com Inc. / Whole Foods Markets Inc. combination. In response to the Amazon.com Inc. threat, retailers are looking to establish e-commerce platforms, expand their private-label offerings and provide better customer service. In doing so, they are shifting pressure onto their vendors to reduce prices, remove less profitable categories from shelves, replace them with higher-growth/better-margin categories, destock inventory and face more stringent penalties for late deliveries. In addition to the retailer pressure, packaged food and home and personal care companies are facing higher freight and commodity costs and increased competition from private label (retailer brands), along with changing consumer preferences, driven by millennials who desire more natural, organic and local products. Because of the significant headwinds and muted outlook for 2018, we remain underweight in the sector.

The Canadian Staples space faces similar hurdles, with additional pressures from minimum wage and drug reforms. That being said, Empire Co. Ltd. (EMP/A CN) remains our top pick in the sector: the company continues to execute its cost-cutting initiatives and deliver relatively strong margin growth in a tough retail environment.

UTILITIES

We remain underweight in the Utilities sector, as it continues to face two large short-term headwinds: near record-high valuations (both on a P/E, and FCF yield basis) and a period of rising North American interest rates, pointing to potentially continuing negative macro headwinds.

Against these near-term headwinds, there are some longer-term tailwinds developing that we are monitoring. We believe that the widespread adoption of electric vehicles will create unprecedented global electricity demand growth for the next 10+ years, and could boost the fortunes of well-positioned electric utility companies. To handle this increase in demand, up to $3 trillion will need to be spent over the next three decades on infrastructure to support low-carbon economy growth globally. Much of this growth will be low-risk “rate-base” growth captured by the previously sleepy utilities. In such an environment, many electric utilities could become solid growth stories, especially if they have a higher renewables component.

REITs

The fourth quarter of 2017 was another lacklustre quarter, with earnings growth for the group coming in at -3% year-over-year. Against this backdrop, our favourite name continues to be Colliers International Group Inc. (CIGI-TSX). Colliers was one of the handful of names that beat estimates, and did so by a wide margin (adjusted EPS bettered consensus by 16%, and this was

driven by a healthy top-line beat of +12%).

Taking a step back, we like the real estate brokerage business in this environment. Historically, brokerage businesses have been GDP+ growth types of businesses from the standpoint of revenue growth. As it is now, brokerage businesses are capital-light, have the ability to adjust their commissions and benefit when credit is readily available for transactions. The other important favourable development is the consolidation that is happening in the real estate brokerage industry. This industry is very fragmented, with the top five players garnering about 20% market share. Colliers International is one of the consolidators, and with net debt/EBITDA of about 1x, it is in an excellent position to execute its roll-up strategy.

TELCO

There is no change to our underweight positioning in the Telco sector, which is premised on a lack of compelling growth, particularly when juxtaposed with current valuation. The good news is that the competitive environment remains largely rational and disciplined, and the CRTC has maintained its support for facility-based competition, but did not walk down the path of enabling mobile virtual network operators (MVNOs) (by allowing them to utilize wholesale rates).

Our top holding continues to be Telus Corp. (T-TSX). Telus.com’s 2018 guidance of 4–6% revenue growth and 4–7% EBITDA growth puts it at the top of its peers in Canada. Also, we like the fact that capex intensity has peaked (both in intensity and dollars), and that should result in a positive inflection in Telus.com’s free cash flow. Meanwhile, the company is currently trading at approximately 8x EV/EBITDA, in line with its larger peers. We believe that Telus.com’s superior growth profile and its excellent competitive positioning should result in superior returns, especially now that the heavy lifting for bringing fibre optic to the home is completed.

THINK AHEAD. STAY AHEAD.

General inquiries [email protected]

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Telephone: 416.955.4108 Toll free: 1.866.369.4108

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www.pictonmahoney.com

PMAM-OUT-HR-Q1-2018

This report is published by Picton Mahoney Asset Management (PMAM) on April 12, 2018, and and is intended primarily for institutional investors. It is provided as a general source of information and should not be relied upon as investment advice, a forecast or research, and is not a recommendation, offer or solicitation to buy or sell securities in any jurisdiction or to adopt any investment strategy. The information contained in this report has been obtained from sources believed reliable; however, the accuracy and/or completeness of the information is not guaranteed by PMAM, nor does PMAM assume any responsibility or liability whatsoever. All opinions expressed are subject to change without notification. PMAM funds may currently hold long and/or short positions in the securities of the companies mentioned in this report. Past performance is not indicative of future performance.

This report may contain “forward-looking information” that is not purely historical in nature. Forward-looking statements are not guarantees of future performance and involve inherent risks and uncertainties about general economic factors. There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements, as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statements, as made. This report may not be reproduced, distributed or published without the written consent of PMAM.

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