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THE REGIME SHIFT COMETH

Q4 REVIEW AND OUTLOOK

THE GREAT FACTOR UNWINDBROKEN RECORD, OR BROKEN TREND?RISKS TO THE RECOVERY

THE GREAT ROTATION?BLAST FROM THE PAST (A CAUTIONARY TALE)SECTOR OUTLOOKS

2 | PICTON MAHONEY Q4 OUTLOOK 2016

Lower for longer continues to play out as OPEC keeps pumping to keep share while US producers cut costs. Still searching for a bottom, which should be determined in Q1 2016.

Global Real GDP BelowChina and LatAm remain challenged and will continue to weight down on global growth even as the US remains a pillar and the rest of the world, particualrly Europe, stabilizes.

Risk

View PMAM vs. Consensus

Below2016 should bring some more certainty to markets as we get past the first Fed hike, China hard landing risks subside, and EU breakdown risks resolve.

US Real GDP SameWeakness in exports and energy are offset by accelerating wage growth, a full labor market, increasing household formations and an investment cycle that is just beginning.

Canada Real GDP LowerA second round of weakness from the energy fallout will hit growth, while higher domestic inflation from a weak currency may limit the BOC's ability to help.

US Equities BelowLeadership has been narrow. Margins are at peak while sales growth potential is low, so valuations need to expand for stocks to rise, although they are not so cheap on a historical basis.

European Equities AboveECB remains accomodative, the weaker Euro should act a tailwind, the fiscal drag is fading more, economic recovery on track, and not a crowded trade.

Canadian Equities BelowA second round of weakness from the energy fallout will limit Canadian equities (outside of a recovery bounce). A weaker domestic consumer will not help much, though US exposed equities should do better.

Treasuries (US 10 yr) BelowTightening cycles will see higher rates, but the biggest shift initially is in the curve, as short rates rise fastest. Fed will raise rates very slowly and talk down the long end of the curve.

Investment Grade Corp AboveHigher govt rates will push yields higher as spreads are past the narrowest point in cycle. Very little coupon protection could lead to relative underperformance amongst bonds.

High Yield Corp AboveWe except default rates to keep climbing as more energy/materials companies run out of time. Still, current high yield spreads provide adequate coupon protection.

Crude Oil Below

EPS Growth (S&P 500) BelowExpect continued headwinds a strong USD, margin pressures, rising wages and round two of energy weakness. Global growth will stabilize but remain lower than trend.

P/E (S&P 500) Above With anemic EPS growth, modest equity gains need to come from higher P/E. At these levels equity yields are still more attractive than bonds.

US Inflation AboveRebound from the basing effect of oil will be felt for a few month, but fade into mid-2016. Upside can come from pent up housing/rental demand from higher household formations and wage pressure.

Macroeconomic

Equity Returns

Bond Yields

Other

$50-$60 is an achievable target next year, close to the long-term futures price of $57, and slightly higher than current expectations of $49. Higher prices following the OPEC cuts will likely be met with more production and investment, thus capping oil price growth for some time.

Global Real GDP HigherG3 growth surprised to the upside in Q4 and has room to run higher in Q1 2017. Emerging Markets monetary policy easing will provide further upside in 2017.

Risk

View PMAM vs. Consensus

LowerRisk aversion steadily fell in 2016, and with the US presidential election behind us it should fall further in Q1. However, the European election cycle later in 2017 will likely cause macro risk to rise once again.

US Real GDP HigherBoth consumer and corporate confidence have surged to new cycle highs after the election results and will create a virtuous cycle of investment and spending. A tight labor market and cycle high wage growth will provide the US consumer with further ammo.

Canada Real GDP LowerPolitical attempts to contain the housing bubble have succeeded (ex-Toronto), with prices in the West not just stabilizing but falling, which will have repercussion for the financial sector. Weak resource investment will continue to be a headwind.

US Equities BullishUS stock indices have surged to new highs and we expect the rotation from equities into bonds to reverse and provide more fuel to the fire. Valuations may be stretched but growth estimated may be too low.

European Equities BearishThere are too many risks in Europe in 2017 to recommend much exposure: A calendar full of risky elections, an unresolved banking crisis, and a refuge crisis that is getting worse. ECB QE tapering will likely cause them to have their own taper tantrum, which, along with a stronger currency, will tighten financial conditions.

Canadian Equities Neutral

Treasuries (US 10 yr) SameThe Fed hiked rates in Q4 and the bond market has fully priced this in. Further ECB tapering may give rates another leg up, though that is likely to be focused within European yields which are still far too low.

Investment Grade Corp SameThe combination of higher rates and spread compression should result in flat IG bond yields.

High Yield Corp LowerDespite higher government rates, spread compression is likely given better economic outlook and credit conditions.

WTI Crude Oil Higher

EPS Growth (S&P 500) SameGrowth expectations in the US are already factoring in a recovery from energy companies; further upside could come from better productivity as a result of higher investment, but this will take time.

P/E (S&P 500) Lower Higher interest rates and a fading bid from foreigners should weight on broad equity valuations.

US Inflation HigherHousing inflation and rent growth are hitting cycle highs and higher mortgage rates have not yet done much to ease the pressure. The Fed is still behind the curve and is letting inflation run hot.

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The 21.1% total return for the TSX Index in 2016 will likely not be repeated in 2017 given economic headwinds, though 10% may be achievable from piggy-backing off stronger US trade and consumer spending.

Consensus based on Bloomberg avg. estimates

PICTON MAHONEY Q4 OUTLOOK 2016 | 3


THE REGIME SHIFT COMETH MANY GLOBAL EQUITY MARKETS DELIVERED SOLID RETURNS IN 2016; HOWEVER, A LOOK UNDER THE SURFACE OF THE MARKET AVERAGES SHOWED THAT 2016 WAS A HEAD-SPINNING YEAR, STARTING WITH THE UNWINDING OF EXTREMELY CROWDED TRADES AND ENDING WITH A MASSIVE REGIME CHANGE AS INVESTORS EMBRACED CYCLICALITY AT THE EXPENSE OF YIELD CHASING.


SECTION 1(RECAP): THE GREAT FACTOR UNWIND

One of the most intriguing aspects of 2016 was the extremely volatile performance of certain “factors” (stock-specific traits, like “value,” “momentum” and “residual volatility”) as they went from being over-crowded to being caught in mean reversion counter-trend moves. Growth and momentum factors bore the brunt initially as capital rushed to more defensive themes (ie interest rate-sensitive stocks with lower volatility traits). By mid-year, falling bond yields and the thirst for safety had S&P 500 Telecoms and Utilities on pace for >50% annualized returns, trouncing the rest of the market. Another atypical unwind was the simultaneous rally in cyclicals and heavily-shorted stocks. As represented by the Goldman Sachs “Most Shorted Basket,” stocks that had been the market’s whipping boys of 2015 had a rally on par with that of 2009 (Fig 1). It is not often that the most and least economically sensitive areas of the market outperform at the same time.

Perhaps these unusual occurrences are the result of some (temporary?) change in the structure of equity markets where, increasingly, individual stocks trade more on their current factor traits or inclusion in some other basket of similar stocks instead of on their company-specific fundamentals. The growth in passive management, ETFs and “smart” beta products combined with the era of rampant central bank money creation may be contributing to this phenomenon.

Another manifestation of this market structure change is the higher correlation of stocks within the overall market. Cambridge Associates and others have highlighted this issue by observing the higher frequency of “all or nothing” days in the S&P 500 Index, when more than 80% of the index constituents move in the same direction on a given day. There has been a marked increase in these “all or nothing” days over the past decade (Fig 2).

This factor-driven, high correlation environment made 2016 a difficult year in which to outperform. That said, we think that the investing environment in 2017 may provide some real opportunities for investors to differentiate themselves and perhaps benefit from these changes in the market structure.

SECTION 1

Fig 1: 2016’s “Most Shorted Basket” rally echoes 2009

Source: Bloomberg, PMAM Research

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SECTION 2: BROKEN RECORD, OR BROKEN TREND?

Since the Global Financial Crisis, investors have begun each new year with renewed optimism that the economy will accelerate and interest rates will rise. 2017 appears no different, particularly given recent improvements in the global economy and the potential for significant fiscal stimulus in the Trump presidential era. Are we primed for disappointment yet again? Will the secular trend of stagnant growth and underlying deflationary forces continue to provide a long hangover from the bursting of the global debt bubble back in 2008? We posit that this year may, in fact, be different, resembling something closer to a more typical economic recovery occurring later in a more typical cycle.

Even before capital markets faced the reality of a Trump win, global economic activity was improving and bond yields were rising. Sure, we’ve seen a number of positive spikes in global economic activity this cycle that only proved to be fleeting. But there are some key differences that could make this recovery different.

Global trade recovery

Global trade data is telling a new tale of recovery. Looking at the sum of US imports and exports as a proxy for global trade in Fig 3, it appears that the downtrend has been broken: total trade volume has recently ticked positive. The world suffered a “trade recession” for much of 2015 and well into 2016, where a strong and fluid free flow of goods was a key missing ingredient in global economic growth. A significant inventory de-stocking (largely in the US) appears to have ended, placing the overall economy on better footing than a year ago.

EM easing

While the US Central Bank has just increased short term interest rates, there are now emerging market central banks that are in easing mode. This is a sharp contrast to this time last year, when many emerging market central banks were still tightening and battling falling currencies. Brazil is the poster child, having cut interest rates twice recently and appearing ready to ease much more in 2017. Chinese currency is weaker (though not spooking the market as it did this

time last year), supporting export-led strength in the world’s largest contributor to economic growth.

US economic strength

In the all-important US economy, we believe that the US labour market has finally been substantially healed, leaving the Fed with a tenuous argument for keeping interest rates as artificially low as they have. After a false start in the first half of the year, US breakeven inflation rates (Fig 4) have been ramping higher since the end of June, breaking a downtrend in place since at least 2013.

SECTION 2

WE POSIT THAT THIS YEAR MAY, IN FACT, BE DIFFERENT, RESEMBLING SOMETHING CLOSER TO A MORE TYPICAL ECONOMIC RECOVERY OCCURRING LATER IN A MORE TYPICAL CYCLE.

Fig 3: Global trade recovery has begun


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SECTION 2

Fig 4: US breakeven inflation on the rise


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Fig 5: US Homebuilder sentiment is bullish


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US homebuilder sentiment is bullish (plotted with Consumer Confidence in Fig 5), indicating supply may come to market in 2017 and beyond. Perhaps the pace of housing-related inflation may moderate, but growth should continue as existing home inventory remains tight. On the demand side, the unemployment rate for 20-35 year olds has fallen sharply from 13% to 6%. This key demographic for household formation may have pent-up demand for up to one million homes and affordability remains a tailwind, as long as mortgage rates do not ratchet significantly higher.

Of course there are pockets of weakness in the US that are a concern. The “all-in” nature of global monetary policy to date, aided by the global thirst for yield, pushed interest rates to successive new lows. This process pulled forward a significant amount of demand for credit-financed purchases, like autos, where markets are now soft and incentives are remarkably high. However, surveys of senior loan officers (those responsible for approving consumer / commercial loans) have been cautious for some time now, suggesting there is still ample room to increase credit formation at the median consumer level. There is also a renewed prevalence of shadow banking entities, ready and willing to relax standards with such a low cost of capital on offer.

ANIMAL SPIRITS ALIGHT

While these are important signs that the recent economic uptick might have more to it than prior false starts, the real game changer could be that “animal spirits” are finally coming to life, especially in the US. That “spontaneous urge to action rather than inaction” that Keynes had in mind when he coined the term could help unleash a more vigorous recovery than we have become accustomed to. Years of unconventional monetary policy have reflated asset prices, but Trump’s election and the higher likelihood of a handoff from monetary policy to significant fiscal stimulus bears promise for the average American household. Though the proposed tax cuts seem far less populist than first blush and the benefits of large-scale infrastructure spending will come mostly in the “out years” of his term, Trump’s appeal

thus far is palpable. The “average” small business owner certainly seems to be invigorated.

The most recent survey (Dec 2016) from the National Federation of Independent Business reflects a surge in small business confidence in the wake of the election, with the headline measure leaping 3.5 pts to 98.4 (Fig 6). Most of the specific component questions of the survey registered improvement: respondents who “Expect Better Economy” swung hard from -7% to +12%, matching cycle highs in late 2014 and 2010.

Small businesses don’t get much airtime in the financial press, but they should, because they are disproportionately responsible for job growth and investment. The small business survey results show that confidence is booming, which should lead to higher growth and investment—especially as the new US administration delivers on its promised tax incentives.


SECTION 2

Fig 6: Small US businesses confident in wake of election


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THE REAL GAME CHANGER COULD BE THAT “ANIMAL SPIRITS” ARE FINALLY COMING TO LIFE


SECTION 3: RISKS TO THE RECOVERY

SECTION 3

THE PBOC HAS BEEN MICRO-MANAGING LIQUIDITY THIS YEAR LIKE NO OTHER TIME IN THE CURRENT CYCLE—PERHAPS A SIGN OF HOW MUCH EFFORT IT HAS TAKEN TO KEEP THINGS LOOKING “CALM AND STEADY” BEHIND THE SCENES.


CHINA: SOURCE OF RISK, OR SO FAR, SO GOOD?

For now, China is “ok”. Though the currency weakening is reminiscent of last year’s crisis, there are some stark and critical differences between now and then:

• China’s PPI hit a multi-decade low of -5.9% a year ago; now it is surging (last reading was +3% and accelerating). This improvement reflects much stronger export demand (probably a result of weaker currency).

• Last year, Alternative GDP was at cycle low of 1.2%; it has since surged to over 10%

• Freight traffic volume hit a multi-decade low-19% last year; since then it has surged to over 10% (last reading was 10.7%)

• Electricity production went from negative to +7%

However, Chinese monetary policy has shifted from easy to neutral and there are some signs of stress within the Chinese banking system. Fig 7 shows The People’s Bank of China’s open market operations. The PBOC has been micro-managing liquidity this year like no other time in the current cycle—perhaps a sign of how much effort it has taken to keep things looking “calm and steady” behind the scenes.

Rolling asset bubbles have plagued China’s economy and monetary policy application. The latest round of tightening in their housing market comes as the economy reaps the benefit of a global inventory rebuild. China’s struggle to achieve sustainable growth without driving speculative excesses internally is real. The latest big fiscal stimulus impulse for infrastructure spending has potentially played out and it is not clear what the next lever of growth will be.

Of course, ignoring China’s reliance on global trade could be perilous. President-elect Trump’s protectionist stance could pose a real risk to China (and the rest of the world, for that matter). We don’t think this will be an issue in the early stages of 2017, but it may become increasingly concerning as 2018 approaches.

SECTION 3

FIGHTING THE DOLLAR…AGAIN?

In the past, we have highlighted the US dollar’s role as the linchpin in many different risk trades. Continued strength in the greenback could be destabilizing as central banks in countries bearing large USD-denominated debt are thwarted from cutting interest rates to stimulate their economies.

Despite headlines of the USD reaching multi-year highs, we don’t believe the impact will be as damaging as it was in 2015. In terms of momentum, the yearly pace of dollar appreciation so far has only reached a high of 5%: in 2015, it peaked at 25%. If we truly believe that we are embarking on an era of lower taxes and higher deficit spending, the USD should actually fall instead of rise in 2017, as the direction of the budget deficit is ultimately the primary driver for the USD (Fig 8).

Fig 8: US Budget deficit primary driver for USD


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Fig 7: PBOC micro-managed liquidity in 2016


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SECTION 4: THE GREAT ROTATION?

Reflation appears to be taking hold. Rising interest rates are helping reinforce the view that the cycle is picking up steam and pushing deflation fears to the side. The potential repositioning required in investor portfolios for this new environment is significant. For example, over US $1 trillion has flowed into bond funds this cycle (Fig 9). If it has to reverse, it will drive a “Great Rotation” into equities.

But how far can rates move higher before equity markets get concerned? After all, the equity risk premium embedded in valuations has been the beneficiary of progressively lower interest rates for much of the past 30+ years. Fig 10 shows the relationship of US equity P/E ratios to various government bond yields. It appears that as bond yields fall, P/Es rise; however, once bond yields fall below 4% (due to concerns about deflation), P/Es also start to fall. Given how low rates are now, as deflationary pressures abate, rising bond yields may not immediately lead to falling P/E multiples. If the market P/E remains stable, rising earnings growth should lead to rising stock prices.

SECTION 4

Fig 10: P/E ratios start to fall when bond yields dip below 4%

Source: Robert Shiller

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Fig 9: Will US $1 Tr bond fund flows redirect into equities?


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SECTION 5: BLAST FROM THE PAST (A CAUTIONARY TALE)

SECTION 5

WE ARE IN A MARKET THAT APPEARS POISED TO “INFLATE ‘TIL IT BREAKS.”

Our macro distance model (which seeks the “rhymes” in market history) suggests that the current environment has many similarities to the mid-1980s, specifically late 1986. Reagan’s 1986 tax cuts occurred when the output gap was already positive, similar to today’s cyclically robust employment picture that is about to get a further boost from “trumponomics”. The bond market (crowded to the tune of $1 trillion as noted above) may face outflows that push yields higher, as occurred in 1986 through 1987. Investors are likely to ignore tightening financial conditions in the near term, driving share prices higher and betting that tax cuts and infrastructure spending will work their trickle-down magic to boost the economy and earnings growth. However, there is the potential that the US Fed will hike more aggressively in this scenario, that bond yields overshoot on the upside and that share prices eventually have a significant pullback. Should an equity pullback occur, we hope it is much less traumatic than the pullback of 1987. Should history repeat, we would face an epic macro event—one to which we are keenly attuned to minimizing risks in.

CONCLUSION

To the extent that tightening financial conditions (ie continued USD strength) and continued geopolitical uncertainty offer pullbacks in equity prices, we believe these pullbacks should be bought in the near-term. However, if rising interest rates outpace economic growth, we will likely shift to a “sell the rally” mindset. If the Fed has any credibility, perhaps the biggest surprise of 2017 will be the market buying into the “dots” plotted by Fed governors as the most likely path of future interest rates. Under that scenario, the US 10-Year Treasury could reach 3% relatively quickly and cause problems for equity prices. 2016 was a good year to be nimble and should prove to have been great training for the year ahead, as 1986 was for the fall of 1987. We are in a market that appears poised to “inflate ‘til it breaks.”


THE ELECTION FACTOR

While growth and momentum factors found their footing over the summer months, the US election has thrown another “factor” into the mix: tax rates. With the surprising Trump sweep, his economic policy platform was quickly priced-in by the market. As Fig 11 demonstrates, US companies with the highest tax rates are outperforming those companies with the lowest tax rates by a notable margin.

While this was just the latest factor rotation to take place in 2016, our portfolios remain positioned in more cyclical industries where earnings acceleration is more apparent relative to the more crowded interest-sensitive areas of the market.

FINANCIALS

Globally, the financial sector has rallied in line with the sharp move higher in rates and a steepening of the yield curve, as reflation begins to emerge in the wake of President-elect Trump’s anticipated pro-growth policies. Positive sentiment around an improved economic outlook, de-regulation and tax reform bodes well for the US financial services sector. Many of the asset-sensitive names, including US regional banks and lifecos, have been clear beneficiaries of the curve steepening and increased probability of multiple Fed rate hikes.

In Canada, recent results continue to support the notion that the banks have put energy provisioning behind them and the market has begun to re-focus on earnings growth prospects while trying to factor in the repercussions from the recent changes to the mortgage finance landscape. Heading into 2017, we continue to see an environment characterized by slowing domestic loan growth. We favour banks with strong core deposit franchises, domestic scale and a proven ability to drive efficiencies. Additionally, as the economic outlook continues to improve in the US, we like banks with leverage to improved US growth and higher rates. Our favourite names in the space are Royal Bank of Canada and Toronto Dominion Bank.

We have become more constructive on the life insurance space in the quarter, as the macro backdrop continues to improve with long-term interest rates trending higher in both Canada and the US. We prefer lifecos with leverage to growth outside of the Canadian market and higher long-term rates. Our preferred names include Manulife Financial Corp and Sun Life Financial Inc.

ENERGY

We remain constructive on the outlook for the Energy sector for 2017 and believe that the recent announcement by OPEC/non-OPEC crude producers to cut production will accelerate the commodity’s inevitable balance into Q1/2017. We continue to follow the 1987/89 road-map

SECTOR OUTLOOKS

Fig 11: The tax rate “factor”

Source: Evercore ISI

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as a guide to today’s Energy markets, and believe we are likely to enjoy a constructive environment for Energy equities over the next year as crude prices drift up toward $US 60/bbl, global inventories draw down, and the market balance remains tight. We are overweight energy producers and underweight integrated oil companies. We are particularly focused on Montney plays in Western Canada, given the strong economics of those projects in today’s pricing environment and own positions in companies such as ARC Resources Ltd. and Seven Generations Energy Ltd.

INDUSTRIALS

The unbridled rally in deep industrial cyclicals shifted a few gears following the US election. This indiscriminate push was fueled by hopes of a large infrastructure stimulus, corporate tax reform, and commodity price increases. The macro data has indeed gotten better since the election, with business confidence surveys and freight volumes on the uptrend. However, many of the equities in the sector have already baked-in a full-fledged acceleration in the global economy in 2017.

We continue to prefer names with a higher degree of firm-specific risk where positive fundamental changes are readily apparent. Air Canada outperformed nicely in the last quarter: we still believe there remains plenty of upside before the market fully prices-in the sustainability of the airline’s through-cycle profitability, as well as its normalized free cash flow generation. Waste Connections Inc.’s synergies from the acquisition of Progressive continue to surprise to the upside, and we believe this trend will continue while volumes benefit from the stronger economy.

CONSUMER DISCRETIONARY

The Canadian Consumer Discretionary sector performed well in 2016, led by growthier names rallying strongly off their February lows. Following a series of impressive third quarter results, management teams generally remain upbeat about the prospects for household spending, despite some ongoing oil-related weakness in Alberta. We are constructive on the group, but are monitoring a growing number of potential headwinds that could impact consumer stocks going forward: a weakening Canadian dollar, changes to the NAFTA trade agreement, rising auto incentives in the US, and more expensive valuations. Against this backdrop, we believe that stock selection will become even more important as companies are only rewarded for best-in-class execution.

Our favorite name in the space remains Canadian Tire Corp. Ltd, an under-appreciated stock which continues to deliver better than expected earnings supported by a robust balance sheet. The stock has resumed its upward trend since reporting strong 3Q16 results, but the retail business still trades at under 5.5x EV/EBITDA despite better comps than its US mass retail peers (Target and Wal-Mart on 7.5x and 8.0x respectively). We believe there may be upside to earnings as the company laps last year’s unseasonably warm winter and management continues to drill deeper into its cost structure. Spin Master Corp. also surprised positively last quarter, with full-year guidance raised

to reflect the launch of its latest hit toy, Hatchimals, and accelerating international sales penetration. In addition to the sizeable organic revenue opportunity, we believe that Spin Master’s robust free cash flow generation and clean balance sheet will allow management to enhance shareholder returns either through acquisitions or dividends/buybacks.

TECHNOLOGY

Myriad risks have come to the forefront in the Technology sector since the US election, including higher interest rates (which negatively impact the DCF valuations of high-growth companies), a stronger USD, increasingly uncertain access to talent (given immigration policy rhetoric), and international trade retaliation risk. Upside risks for the sector include stronger macro trends, a tax holiday on repatriation of capital held internationally, and a more conciliatory tone from the Trump administration.

We have reduced our overall Technology exposure, but added to select names this quarter such as Open Text Corp. Recent acquisitions provide significant synergy opportunities for Open Text while the competitive landscape is softening and the company’s solutions are improving from a diverse set of stand-alone products into a more integrated platform. We have also initiated a position in Mastercard (MA US), a high-quality payment network operator that benefits from the secular adoption of digital payments and e-commerce. The company is showing positive operational leverage following two years of elevated investments and is positioned to benefit from regulatory changes in Europe in the coming years.

MATERIALS

The Materials sector continues to exhibit strong momentum traits, although it may be due for a pause following a broad-based recovery in the underlying metal complex. A potential overheating in the Chinese property market has led to improved demand for cyclical raw materials, but the emergence of less accommodative policy from Beijing in an attempt to begin tackling egregious macro imbalances could cause some volatility in the sector in 2017. We remain constructive on Trevali Mining Corp. due to its favourable exposure to zinc and its growing production profile in a supply-constrained market. We also prefer best-in-class, low-cost metal producers such as Lundin Mining Corp.

We are currently neutral on Precious Metals and continue to focus on unique positive change stories such as Silver Standard Resources Inc. We are looking to increase positions in a number of precious metal exploration companies which could become the target of major producers facing growing challenges to replace reserves.

HEALTH CARE

Health Care sector performance continues to be choppy and one of the worst performers. Thanks to the clean Republican sweep, 2017 will likely bring major health care policy changes that will influence most health care sub-industries. The most significant impact will likely be the

SECTOR OUTLOOKS


repeal of significant portions of the ACA (Obamacare), including health exchange subsidies, Medicaid expansion, numerous tax provisions, and the individual and employer mandates. However, the partial repeal via the budget reconciliation process is going to happen well before any replacement is implemented (full repeal would require approval through the legislative process). This environment of uncertainty could drag through much of 2017, as there is no coherent health care policy from Trump and only broad brush stroke “replace” policy from the Republican Congress. Implementing reduced coverage (20 million of incremental covered lives that have gained coverage under the ACA) will be bad for hospitals and the provider sectors. With delayed “replace” policy, the insurers (particularly Medicaid & ACA-leveraged) face significant uncertainty in the near-term, but Republican initiatives seem to be long-term positive (particularly Medicare Advantage).

Drug pricing is increasingly becoming a bipartisan issue, but will likely be less of a headwind than it would have been under a Clinton presidency. The offset to this headline risk is an industry-friendly Republican-controlled congress that supports a favorable regulatory and reimbursement environment, which should help innovative biopharma companies.

STAPLES

Staples underperformed materially in the fourth quarter. As rate expectations began to rise following the Trump election, the crowded low volatility trade rapidly unwound. Canadian Staples in particular have faced additional headwinds. For instance, the recovery in the price of oil is a fundamental negative for Alimentation Couche-Tard Inc., the largest constituent of the Canadian Staples index. Rising oil prices result in higher prices at the gas pump, which typically results in lower fuel margins for the retailer and less savings for the consumer to spend in store. Gas margins also have a material impact on cash flow generation and, as result, could put a crimp on M&A activity for the company.

Another factor weighing on the larger cap Canadian Staples is retail deflation. Canadian food CPI transitioned from low-to-mid-single digit inflation to deflation in September 2016. While most analysts expected inflation to slow, most did not envision deflation—certainly not so soon. It is unclear whether the recent deflation will spark a price war, but the downside risk is material should one arise.

We continue to prefer food manufacturer Saputo Inc, given the margin expansion they have been delivering despite the soft commodity environment. We believe there is additional upside from the improved balance of supply and demand for global dairy commodities as well as M&A activity.

REITs

It has been an interesting year for Canadian REIT investors, with an abrupt performance reversal, fundamental deterioration and a GICS sector classification. Fundamentally, the second half of 2016 has been one of the most difficult operational periods for Canadian REITs since

2009. Sector earnings (FFOPU) growth was negative in Q3, the first YoY decline in six years, resulting in the largest negative earnings revision (-1.8%) in more than four years.

It is also worth noting that fundamental weakness is not simply a byproduct of Alberta-related pressure: a number of “non-Alberta” portfolios have seen sizeable earnings misses and downward revisions over this time frame. Going forward, we expect aggregate earnings growth to continue to be challenging as management teams are forced to invest more heavily to achieve any sort of meaningful rental growth and/or offer discounts to maintain occupancy. As for Alberta, despite a lift in energy prices and a recent bout of outperformance from Alberta-centric names, we expect property fundamentals to remain quite challenging in the region as unemployment continues to rise and new supply comes online. Sector valuations are generally fair, on average, with earnings multiples in line with historical norms and a NAV discount in the low single digit range.

Within the Canadian REIT universe, we prefer names that have superior balance sheets and lower payout ratios (as these names should be able to drive NAV and distribution growth in the face of rising rates and slower same property revenue growth). Another key consideration is market exposure, as foreign institutional capital continues to flow into major markets at a record pace. Going into 2017, we continue to like Chartwell Retirement Residences, the largest retirement care platform in Canada. Chartwell continues to consolidate the secularly growing market niche. They are business operators as well as property owners (unlike triple-net lease REITs), giving them a more robust growth profile that is not subjected to rent controls like most other apartment operators.

UTILITIES

We continue to be positioned defensively in the Utilities sector. If interest rates in the US continue to grind higher next year, history shows that this interest rate-sensitive space’s valuations will compress (on avg. 2.5 to 3x EV/EBITDA compression) from current all-time highs. Even if interest rates stay low, we believe the sector will still be weak, as it is priced to perfection with yields at record lows, valuations at all-time highs, and pricing pressure on the regulated sector’s ROEs. Our top two holdings are TransAlta Corp. (under-valued turn-around) and Emera Inc.(best growth profile at reasonable value).

TELECOM

We are underweight the Telecom sector given stalled earnings momentum combined with some of the highest valuations in the world. The Shaw Communications Inc. purchase of Wind Mobile should create the first legitimate competitor to the cozy oligopoly that exists in the Canadian telecom market, eventually leading to competitive pricing pressures. We continue to favour Quebecor Inc., given its continued healthy fundamentals and improving focus on proper capital allocation within the company.

SECTOR OUTLOOKS

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-Q4-2016

This report is published by Picton Mahoney Asset Management (PMAM) on Jan 3, 2017. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. 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.

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