Balancing Act: Weighing optimism and caution

Bruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee

June 2017

N E W T H I N K I N G

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 2

Balancing Act: Weighing optimism and caution

Over the past several months, we’ve often used a tug-of-war analogy to describe the investing backdrop as we’ve witnessed a number of competing forces at play, including optimism vs. uncertainty, cyclical growth vs. structural restraints, and high valuations vs. potential for earnings growth. After weighing a variety of factors, the TD Wealth Asset Allocation Committee (WAAC, we) decided that conditions warranted a more balanced approach, and in March 2017 we moved to a neutral position across asset classes by reducing equities and cash from overweight to neutral and increasing fixed income from underweight to neutral.

Scaling back stocksAfter being overweight equities as an asset class for several years, in February 2015 we moved to a neutral position as we felt that tailwinds were dissipating and the risk/reward dynamic was becoming less compelling. In November 2016, immediately following the U.S. presidential election, we increased our equity weighting to overweight. In the four months that followed, the S&P 500 Index rose 8% amid burgeoning investor enthusiasm about the new administration’s policies and their potential to support earnings growth. After this boost, we moved equities as an asset class back to neutral in March 2017.

Chart 1: WAAC Equity Positioning

S&P

500

Inde

x Le

vel

Source: TD Asset Management. As at: May 11, 2017.

Overweight Equities Neutral Equities

0

500

1000

1500

2500

2000

Feb. 2015

Nov. 2016

Mar. 2017

Feb. 12

June 12

June 13

June 14

June 15

June 16

Oct. 12

Oct. 13

Oct. 14

Oct. 15

Oct. 16

Feb. 13

Feb. 14

Feb. 15

Feb. 16

Feb. 17

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 3

Our decision to move equities back to neutral was based on three key factors: stretched valuations, possible policy disappointment and ongoing concerns over structural issues.

1. North American valuations are relatively high. The long-term average price earnings multiple

1 (p/e multiple) for S&P 500 stocks is 15X. When we made our shift, the average price earnings multiple was over 18X, about 20% above the long-term average. The current low bond yield environment is likely to offer support for slightly higher equity p/e multiples than we have seen historically. However, we don’t expect multiples to rise sustainably higher from here as it is likely to be challenging for businesses to further improve their margins and revenue growth is likely to be in line with GDP growth, which we expect to be modest. In addition, p/e multiples tend to be supported by low equity market volatility. With volatility near multi-decade lows, it is unlikely this factor will be a tailwind going forward.

Overall, as Chart 2 demonstrates, S&P 500 stocks are trading above our forecast. While equities may continue to move upward given current momentum, we are active investors who look for quality investments and take a disciplined approach to investing—and we believe that current valuations warrant caution.

Chart 2: TDAM S&P 500 Price Potential

0

500

1000

1500

2500

2000

S&P

500

Inde

x Le

vel

Forecast

Dec. 93

Dec. 94

Dec. 95

Dec. 96

Dec. 97

Dec. 98

Dec. 99

Dec. 00

Dec. 01

Dec. 02

Dec. 03

Dec. 04

Dec. 05

Dec. 06

Dec. 07

Dec. 08

Dec. 09

Dec. 10

Dec. 11

Dec. 12

Dec. 13

Dec. 14

Dec. 17

Dec. 15

Dec. 18

Dec. 16

Dec. 19

Source: TD Asset Management, Bloomberg Finance L.P. Data as at March 31, 2017.

TDAM S&P 500 Potential Model (current) S&P 500 Actual Price

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 4

In Canada, equities are close to their all-time highs following a strong 2016. That performance is unlikely to be repeated this year given muted economic growth prospects, weaker commodity prices and elevated levels of household debt.

2. When we moved to an equity overweight in November 2016, we expressed this as an overweight to U.S. equities. As noted above, they have experienced strong returns since the election, due in part to investor excitement over promised pro-business policies, such as lower corporate taxes and reduced regulatory burdens. We believe that the probability of these policies being passed has declined in recent months as the political climate in Washington may hamper the administration’s ability to effect legislative change. While the probability of these policies passing is certainly not zero, it is not something we are comfortable relying on.

3. The global economy has experienced something of a resurgence lately, driven in large part by cyclical factors. Growth may continue to accelerate from the very low base in Europe, which was one of the factors in our decision to move to an overweight in international equities (see “Europe: Entering the opportunity zone” for more information). However, we don’t expect sustained acceleration in North America as persistent structural problems such as high debt levels, demographics and sluggish productivity

2 remain. In addition, the U.S. economy is operating at close to full capacity with unemployment at the lowest level in years. We therefore believe that we will continue to be in a lower-for-longer growth environment. This type of environment will be particularly challenging for higher beta stocks (such as commodities), which is part of our rationale for underweighting Canada and emerging markets.

It’s important to note that our return to neutral for equities as a broad asset class does not mean that we are negative about them—we expect equities to deliver mid-single-digit returns. However, we don’t believe that investors will be compensated for taking on the additional risk of an overweight position at this time.

When investing in equities in the current environment, it is key to focus on high quality companies and to incorporate them into a portfolio that contains three key elements:

• an emphasis on risk management that helps ensure risk taking is being properly compensated;

• a high level of diversification to help mitigate the impact of market movements; and

• a focus on quality companies with strong balance sheets, high returns on capital and consistent cash flows that are positioned to prosper in a difficult environment.

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 5

Europe: Entering the opportunity zone?

From a geographic standpoint, we remained overweight U.S. equities until early May, when we reduced them to neutral and increased other international equities. Our overweight to U.S. equities was supported by our expectation that several of the new administration’s proposed policies would benefit the earnings of U.S. corporations. As noted above, the probability of these policies being passed appears to have declined recently and the uncertain environment in Washington may fuel further bouts of volatility. In addition, valuations are elevated and profit margins are close to peak levels. All of these factors led us to take a more conservative position.

Our current geographic preference is for international equities, and we have moved to a modest overweight position in them based on our expectations for outperformance in Europe. It’s no secret that the euro zone has struggled to find its footing following the financial crisis of 2008/2009—the 10-year averages for key economic indicators are weak: economic growth is a paltry 0.1%, industrial production is -0.1%, retail sales 0.3% and the unemployment is 10.1%.

However, we may have reached an inflection point, at least cyclically. Recent economic data has been more positive, with growth and inflation rising and Purchasing Managers’ Indices (which tend to be a leading indicator for stocks) showing strength. Given the region’s weak performance over the past decade, there is still plenty of slack in the economy, which means it should be able to grow without igniting inflation. This could be good news for investors as corporate sales and margins tend to accelerate during this part of the cycle.

In addition, liquidity is improving; monetary policy remains supportive, with the ECB committed to providing stimulus; and fiscal policy could potentially provide additional support for stocks. For example, France’s new government wants to reduce taxes, which would help corporate earnings. Finally, European equity returns have lagged those in North America over the past 3 years, and they are approximately 15% below their all-time highs while their North American counterparts are at or close to all-time highs, which makes relative valuations attractive.

While we are positive about Europe’s prospects currently, WAAC’s outlook horizon is only 12-18 months. We believe this is likely to be a short-term opportunity as Europe still faces significant long-term headwinds, including the viability of the euro and policy concerns (i.e. will euro zone countries address critical structural issues). In addition, the health of Italian banks is a concern, as is the potential resurfacing of political uncertainty. Currently, however, we believe that risks have been overpriced and there are opportunities in the region.

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 6

Chart 3: Structural Headwinds Hindering GDP Growth

60%

50%

100%

60%

180%

80%

140%

70%

Priv

ate

sect

or c

redi

t

(non

-fina

ncia

l) as

a %

of

GD

P

Wor

ld %

of

wor

king

age

pop

ulat

ion

1975 1985 1995 2005 2015

Source: World Private Credit to GDP: Bank for International Settlements; TD Asset Management. World % of working age population: The World Bank – World Development Indicators, as of January 2015.

World Private Credit to GDP (weighted by GDP US$) World % of working age population (RHS)

Finding Value in Fixed IncomeCoincident with moving equities to neutral, we also moved to a neutral weighting in fixed income after being underweight for several years. North American bond returns have lagged those of equities over the past 5 years, and while we expect bonds will continue to underperform equities, they are a valuable part of portfolios, offering income, stability, diversification and the potential to reduce volatility. In addition, the uptick in yields during the second half of 2016 has improved the income offered by bonds and prices are reasonably attractive.

Some people are curious about the decision to move fixed income to neutral given their assumption that yields will continue to rise, which would clearly be a headwind for bond valuations. While it’s true that short-term yields are likely to increase as the U.S. Federal Reserve (the Fed) continues to raise the federal funds rate, we don’t expect a broad increase in yields. In fact, we expect the lower-for-longer rate environment to continue for some time to come. Long-term bonds are driven by growth and inflation expectations rather than changes in the Fed’s short-term lending rate, and we anticipate that growth and inflation will moderate, which will restrain yields at the longer end of the curve. In other words, the ‘bondageddon’ some investors fear does not appear imminent.

BA L A NCING AC T: W E IGH ING O P T IM ISM A ND C AU T I O N | 7

Our viewValuations are stretched in North America, economic growth is expected to slow and the tailwinds associated with the new administration may recede, particularly given recent uncertainty in Washington—which may also fuel further episodes of volatility. In addition, difficult long-term structural issues remain unresolved. Overall, this reinforces our decision to take a more cautious approach and to have a neutral weighting across asset classes (cash, fixed income, equities). We continue to favour a diversified portfolio that includes:

• High quality equities that have the ability to increase their earnings and dividends in a low growth environment and thereby protect the real value of investors’ savings.

• An allocation to cash to provide stability and safety of capital.

• An allocation to high quality domestic government bonds and investment-grade corporate bonds to provide some income, diversification and stability.

This disciplined approach—along with a focus on the long term—should help investors navigate the challenging environment they face today.

About the authorBruce Cooper, CFA Chief Executive Officer & Chief Investment Officer, TD Asset Management Chair, TD Wealth Asset Allocation Committee

@BruceCooper_TD

About TD Asset Management

TD Asset Management (TDAM), a member of TD Bank Group, is a North American investment management firm. Operating through TD Asset Management Inc. in Canada and TDAM USA Inc. in the U.S., TDAM brings new thinking to investors’ most important challenges. TDAM offers investment solutions to corporations, pension funds, endowments, foundations and individual investors. Additionally, TDAM manages assets on behalf of almost 2 million retail investors and offers a broadly diversified suite of investment solutions including mutual funds, professionally managed portfolios and corporate class funds. Collectively, TDAM manages over C$294.6 billion in assets as at March 31, 2017.

(0617)

1 A stock’s price earnings multiple represents how much investors are willing to pay for that stock’s earnings stream. 2 For more information on productivity, please see TD Asset Management’s article The Paradox of Productivity and Monetary Policy.

Unless otherwise stated, all market statistics sourced from Bloomberg Finance L.P.

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. Index returns are shown for comparative purposes only. Indexes are unmanaged and their returns do not include any sales charges or fees as such costs would lower performance. It is not possible to invest directly in an index. The TD Wealth Asset Allocation Committee (“WAAC”) is comprised of a diverse group of TD investment professionals. The WAAC’s mandate is to issue quarterly market outlooks which provide its concise view of the upcoming market situation for the next six to eighteen months. The WAAC’s guidance is not a guarantee of future results and actual market events may differ materially from those set out expressly or by implication in the WAAC’s quarterly market outlook. The WAAC market outlook is not a substitute for investment advice. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. FTSE TMX Global Debt Capital Markets Inc. 2017 “FTSE®” is a trade mark of FTSE International Ltd and is used under licence. “TMX” is a trade mark of TSX Inc. and is used under licence. All rights in the FTSE TMX Global Debt Capital Markets Inc.’s indices and / or FTSE TMX Global Debt Capital Markets Inc.’s ratings vest in FTSE TMX Global Debt Capital Markets Inc. and/or its licensors. Neither FTSE TMX Global Debt Capital Markets Inc. nor its licensors accept any liability for any errors or omissions in such indices and / or ratings or underlying data. No further distribution of FTSE TMX Global Debt Capital Markets Inc.’s data is permitted without FTSE TMX Global Debt Capital Markets Inc.’s express written consent. Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. TWITTER, TWEET, RETWEET and the Twitter logo are trademarks of Twitter, Inc. or its affiliates. All trademarks are the property of their respective owners. ® The TD logo and other trademarks are the property of The Toronto-Dominion Bank.