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INVESTMENT
OUTLOOK
RBC GAM Investment Strategy Committee
FALL 2016
THE RBC GAM INVESTMENT
STRATEGY COMMITTEE
The RBC GAM Investment Strategy Committee From this global forecast, the RBC GAM
consists of senior investment professionals Investment Strategy Committee develops
drawn from across RBC Global Asset specific guidelines that can be used to manage
Management. The Committee regularly receives portfolios.
economic and capital markets related input
These include:
from internal and external sources. Important
guidance is provided by the Committees the recommended mix of cash, fixed income
regional advisors (North America, Europe, instruments, and equities
Far East), from the Global Fixed Income & the recommended global exposure of fixed
Currencies Subcommittee and from the global income and equity portfolios
equity sector heads (financials and healthcare, the optimal term structure for fixed income
consumer discretionary and consumer staples, investments
industrials and utilities, energy and materials,
the suggested sector and geographic make-up
telecommunications and technology). From this
within equity portfolios
it builds a detailed global investment forecast
looking one year forward. the preferred exposure to major currencies
The Committees view includes an assessment Results of the Committees deliberations are
of global fiscal and monetary conditions, published quarterly in The Global Investment
projected economic growth and inflation, as well Outlook.
as the expected course of interest rates, major
currencies, corporate profits and stock prices.
CONTENTS
the euro. Meanwhile, the pound will still powerful downward forces on yields quarters, given that a number of
be dogged by questions surrounding at work. indicators suggest equities are now
the countrys exit from the EU. expensive. However, the average of the
Many international bodies continue to
Canadas economic adjustment has eight valuation measures that we look
call for a new round of fiscal stimulus
been only slight thus far, and we at indicates that stocks are roughly in
as a means of taking pressure off over-
expect further loonie weakness. line with the historical norm and we
worked central bankers. We support
therefore do not share the markets
any such effort, so long as the stimulus
Inflation to edge higher view that equities are expensive.
is implemented in areas with high
Global inflation remains low by fiscal multipliers such as infrastructure While there is still some room for an
historical standards. But this is at least spending. upward move in valuations, earnings
partially an illusion, as it represents growth will be critical to sustaining
the remnants of the commodity shock Continue to forecast any meaningful advance in stocks.
depressing headline inflation rates. rising yields Fortunately, the two largest headwinds
Core inflation levels are much closer to corporate profits since the end of
The world remains trapped in an
to normal, as they are better able to 2014 the collapse in oil prices and
extraordinarily low interest-rate
convey general economic conditions. the strengthening U.S. dollar have
environment given the slow economic
We anticipate a gradual normalization moderated and should allow for
growth and low inflation, as well as
of headline-inflation rates as they corporate profit growth to resume in the
an aging population, high income
shake off the prior effects of the coming quarters.
inequality, elevated debt loads and a
commodity shock and converge toward
shortage of safe assets. Global bond
current core inflation readings. With
yields fell to record lows during the
No change to asset mix
this forecast, we are a little above the We have opted to maintain our
quarter, with some bond markets
market consensus. recommendation for a moderately
characterized by negative yields even
at the longer end of the yield curve. overweight equity allocation. This is
Central banks still front and Our models project that yields should motivated primarily by the superior
centre rise from these unusually low levels, valuations of equities over bonds, and
The U.S. Federal Reserve (Fed) but any near-term adjustment will be secondarily by our belief that further
continues to press forward with its plan constrained by the current low speed economic advances remain more likely
to nudge the fed funds rate higher. limit on economic growth. While a bit than not, especially as downside risks
A rate hike is considered more likely of extra inflation and a Fed rate hike or have declined slightly. Even slow
than not by the end of 2016. While we two could prompt bond yields to move economic growth will be sufficient to
believe a modicum of Fed tightening is higher, a return to historically normal allow for a modest increase in interest
justified and thus at worst benign for rates appears quite unlikely over the rates, which will act as a headwind for
risk assets, we must not completely forecast horizon. fixed-income investments. Coupons
forget that the financial markets are so low that they do little to cushion
struggled in the months after the last Stocks extend gains against capital losses resulting from
rate increase. even a slight increase in yields. We
We saw further gains in global
forecast negative total returns for
Globally, many central banks are equities over the quarter, supported
10-year sovereign bonds across all
still focused on delivering prior by improving credit markets, better-
major developed regions over the
quantitative-easing commitments, and than-expected economic data and low
year ahead and remain underweight
some are continuing to build on those interest rates, and it was these factors
fixed income as a result. For a
promises. The Bank of England has that allowed stocks to mostly shrug
balanced, global investor, we currently
been buying corporate bonds anew off what many investors had assumed
recommend an asset mix of 60%
since Brexit, while the Bank of Japan would be the widespread negative
equities (strategic neutral position:
increased the clip of its asset buying in impact of Brexit.
55%), and 37% fixed income (strategic
the spring. The European Central Bank Investors have voiced surprise at the neutral position: 43%), with the
is also pressing forward with its own stock markets buoyancy in recent balance in cash.
bond-buying program. Thus, there are
Asset mix the allocation within portfolios to stocks, expectations for the major asset classes. These weights
bonds and cash should include both strategic and are further divided into recommended exposures to the
tactical elements. Strategic asset mix addresses the blend variety of global fixed income and equity markets. Our
of the major asset classes offering the risk/return tradeoff recommendation is targeted at the Balanced profile where
best suited to an investors profile. It can be considered the benchmark setting is 55% equities, 43% fixed income,
to be the benchmark investment plan that anchors a 2% cash.
portfolio through many business and investment cycles,
independent of a near-term view of the prospects for the A tactical range of +/- 15% around the benchmark
economy and related expectations for capital markets. position allows us to raise or lower exposure to specific
Tactical asset allocation refers to fine tuning around asset classes with a goal of tilting portfolios toward
the strategic setting in an effort to add value by taking those markets that offer comparatively attractive near-
advantage of shorter term fluctuations in markets. term prospects.
Every individual has differing return expectations and This tactical recommendation for the Balanced profile can
tolerances for volatility, so there is no one size fits all serve as a guide for movement within the ranges allowed
strategic asset mix. Based on a 40-year study of historical for all other profiles.
returns1 and the volatility2 of returns (the range around The value-added of tactical strategies is, of course,
the average return within which shorter-term results dependent on the degree to which the expected
tend to fall), we have developed five broad profiles and scenario unfolds.
assigned a benchmark strategic asset mix for each. These
profiles range from very conservative through balanced to Regular reviews of portfolio weights are essential to
aggressive growth. It goes without saying that as investors the ultimate success of an investment plan as they
accept increasing levels of volatility, and therefore greater ensure current exposures are aligned with levels of
risk that the actual experience will depart from the longer- long-term returns and risk tolerances best suited to
term norm, the potential for returns rises. The five profiles individual investors.
presented below may assist investors in selecting a
strategic asset mix best aligned to their investment goals. Anchoring portfolios with a suitable strategic asset mix,
and placing boundaries defining the allowed range for
Each quarter, the RBC GAM Investment Strategy tactical positioning, imposes discipline that can limit
Committee publishes a recommended asset mix damage caused by swings in emotion that inevitably
based on our current view of the economy and return accompany both bull and bear markets.
1. Average return: The average total return produced by the asset class over the period 1976 2016, based on monthly results.
2. Volatility: The standard deviation of returns. Standard deviation is a statistical measure that indicates the range around the average
return within which 2/3 of results will fall into, assuming a normal distribution around the long-term average.
REGIONAL ALLOCATION
North America 36.9% 18% 40% 37.5% 37.7% 38.2% 37.0% 36.9%
Europe 39.4% 32% 56% 40.7% 45.3% 39.9% 35.3% 34.4%
Asia 23.8% 17% 35% 21.8% 17.0% 21.9% 27.7% 28.8%
Note: Past Range reflects historical allocation from Fall 2002 to present.
North America 61.7% 51% 61% 58.2% 58.0% 59.2% 60.2% 60.0%
Europe 19.9% 21% 35% 22.9% 23.5% 22.2% 21.6% 20.5%
Asia 11.1% 9% 18% 11.4% 11.0% 11.1% 10.8% 12.0%
Emerging Markets 7.3% 0% 8.5% 7.5% 7.5% 7.5% 7.5% 7.5%
Our asset mix is reported as at the end of each quarter. The mix is fluid and may be adjusted within each quarter, although we do not always report
on shifts as they occur. The weights in the table should be considered a snapshot of our asset mix at the date of release of the Global Investment
Outlook.
MSCI** RBC GAM ISC RBC GAM ISC CHANGE FROM WEIGHT VS.
AUG. 2016 SUMMER 2016 FALL 2016 SUMMER 2016 BENCHMARK
Balanced to Aggressive Growth.
VERY CONSERVATIVE
BENCH- LAST CURRENT
Very Conservative investors will
ASSET CLASS MARK RANGE QUARTER RECOMMENDATION seek income with maximum capital
Cash & Cash Equivalents 2% 0-15% 2.9% 2.9% preservation and the potential for modest
Fixed Income 78% 55-95% 72.6% 72.6% capital growth, and be comfortable with
Total Cash & Fixed Income 80% 65-95% 75.5% 75.5% small fluctuations in the value of their
Canadian Equities 10% 5-20% 11.4% 11.0% investments. This portfolio will invest
U.S. Equities 5% 0-10% 6.4% 6.0% primarily in fixed-income securities, and
International Equities 5% 0-10% 6.7% 7.5% a small amount of equities, to generate
Emerging Markets 0% 0% 0.0% 0.0% income while providing some protection
Total Equities 20% 5-35% 24.5% 24.5%
against inflation. Investors who fit
this profile generally plan to hold their
RETURN VOLATILITY investment for the short to medium term
40-Year Average 9.0% 5.9% (minimum one to five years).
Last 12 Months 6.0% 2.8%
CONSERVATIVE
BENCH- LAST CURRENT
Conservative investors will pursue
ASSET CLASS MARK RANGE QUARTER RECOMMENDATION modest income and capital growth with
2% 0-15%
Cash & Cash Equivalents 2.9% 2.9% reasonable capital preservation, and be
Fixed Income 63% 40-80% 57.3% 57.3% comfortable with moderate fluctuations
Total Cash & Fixed Income 65% 50-80% 60.2% 60.2% in the value of their investments. The
Canadian Equities 15% 5-25% 16.5% 16.1%
portfolio will invest primarily in fixed-
U.S. Equities 10% 0-15% 11.6% 11.2%
income securities, with some equities, to
International Equities 10% 0-15% 11.7% 12.5%
achieve more consistent performance and
Emerging Markets 0% 0% 0.0% 0.0%
provide a reasonable amount of safety.
Total Equities 35% 20-50% 39.8% 39.8%
The profile is suitable for investors who
RETURN VOLATILITY plan to hold their investment over the
40-Year Average 9.5% 7.2% medium to long term (minimum five to
Last 12 Months 6.1% 4.0% seven years).
BALANCED
The Balanced portfolio is appropriate
BENCH- LAST CURRENT
ASSET CLASS MARK RANGE QUARTER RECOMMENDATION for investors seeking balance between
Cash & Cash Equivalents 2% 0-15% 3.0% 3.0% long-term capital growth and capital
Fixed Income 43% 20-60% 37.0% 37.0% preservation, with a secondary focus on
Total Cash & Fixed Income 45% 30-60% 40.0% 40.0% modest income, and who are comfortable
Canadian Equities 19% 10-30% 20.4% 20.0% with moderate fluctuations in the value
U.S. Equities 20% 10-30% 21.5% 21.1% of their investments. More than half the
International Equities 12% 5-25% 13.6% 14.4% portfolio will usually be invested in a
Emerging Markets 4% 0-10% 4.5% 4.5% diversified mix of Canadian, U.S. and
Total Equities 55% 40-70% 60.0% 60.0% global equities. This profile is suitable
RETURN VOLATILITY
for investors who plan to hold their
40-Year Average 9.7% 8.5% investment for the medium to long term
Last 12 Months 7.0% 6.0% (minimum five to seven years).
GROWTH
BENCH- LAST CURRENT
Investors who fit the Growth profile
ASSET CLASS MARK RANGE QUARTER RECOMMENDATION will seek long-term growth over capital
2% 0-15%
Cash & Cash Equivalents 3.0% 3.0% preservation and regular income, and
Fixed Income 28% 5-40% 21.7% 21.7% be comfortable with considerable
Total Cash & Fixed Income 30% 15-45% 24.7% 24.7% fluctuations in the value of their
Canadian Equities 23% 15-35% 24.4% 24.0%
investments. This portfolio primarily
U.S. Equities 25% 15-35% 26.6% 26.2%
holds a diversified mix of Canadian, U.S.
International Equities 16% 10-30% 17.7% 18.5%
and global equities and is suitable for
Emerging Markets 6% 0-12% 6.6% 6.6%
investors who plan to invest for the long
Total Equities 70% 55-85% 75.3% 75.3%
term (minimum seven to
RETURN VOLATILITY ten years).
40-Year Average 10.0% 10.6%
Last 12 Months 7.2% 7.6%
AGGRESSIVE GROWTH
BENCH- LAST CURRENT
Aggressive Growth investors seek
ASSET CLASS MARK RANGE QUARTER RECOMMENDATION maximum long-term growth over capital
2% 0-15%
Cash & Cash Equivalents 1.0% 1.0% preservation and regular income, and are
Fixed Income 0% 0-10% 0.0% 0.0% comfortable with significant fluctuations
Total Cash & Fixed Income 2% 0-20% 1.0% 1.0% in the value of their investments. The
Canadian Equities 32.5% 20-45% 32.6% 31.9% portfolio is almost entirely invested in
U.S. Equities 35.0% 20-50% 35.3% 34.6%
stocks and emphasizes exposure to
International Equities 21.5% 10-35% 21.8% 23.2%
global equities. This investment profile
Emerging Markets 9.0% 0-15% 9.3% 9.3%
is suitable only for investors with a high
Total Equities 98% 80-100% 99.0% 99.0%
risk tolerance and who plan to hold their
RETURN VOLATILITY
investments for the long term (minimum
40-Year Average 10.2% 13.2% seven to ten years).
Last 12 Months 7.8% 10.6%
EXCHANGE RATES
Periods ending August 31, 2016
Current 3 months YTD 1 year 3 years 5 years
USD (%) (%) (%) (%) (%)
USDCAD 1.3114 0.00 (5.23) (0.32) 7.59 6.02
USDEUR 0.8965 (0.25) (2.57) 0.60 5.82 5.19
USDGBP 0.7615 10.30 12.26 16.86 5.68 4.34
USDJPY 103.4650 (6.57) (13.92) (14.66) 1.76 6.20
Note: all changes above are expressed in US dollar terms
CANADA
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Fixed Income Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
FTSE TMX Canada Univ. Bond Index 2.72 10.81 6.10 (1.41) (1.24) 2.72 5.76 6.07
U.S.
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Fixed Income Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
Citigroup U.S. Government 2.04 5.15 5.07 3.59 2.53 2.05 4.74 11.46
Barclays Capital Agg. Bond Index 2.32 5.86 5.97 4.37 3.24 2.33 5.63 12.30
GLOBAL
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Fixed Income Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
Citigroup WGBI 2.91 8.70 8.08 2.57 1.16 2.91 7.74 10.35
Citigroup European Government 2.43 8.17 5.89 2.03 1.60 2.44 5.55 9.77
Citigroup Japanese Government 6.21 22.57 25.55 2.32 (2.73) 6.21 25.15 10.09
CANADA
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Equity Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
S&P/TSX Composite 4.54 20.74 9.04 0.43 (0.15) 4.54 8.69 8.06
S&P/TSX 60 4.47 19.85 8.10 0.94 0.31 4.47 7.75 8.61
S&P/TSX Small Cap 7.14 37.42 23.08 (1.27) (4.85) 7.15 22.69 6.22
U.S.
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Equity Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
S&P 500 4.10 7.82 12.55 12.30 14.69 4.11 12.19 20.83
S&P 400 5.25 13.12 12.33 11.45 14.07 5.25 11.97 19.92
S&P 600 7.16 13.15 13.26 11.03 15.18 7.17 12.90 19.45
Russell 3000 Value 4.87 10.55 12.98 10.51 14.24 4.88 12.61 18.90
Russell 3000 Growth 4.04 5.65 9.99 12.94 14.60 4.04 9.64 21.51
NASDAQ Composite Index 5.36 4.11 9.14 13.24 15.11 5.36 8.79 21.84
Note: all rates of return presented for periods longer than 1 year are annualized Source: Bloomberg/MSCI
GLOBAL
Periods ending August 31, 2016
USD CAD
3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years
Equity Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%)
MSCI World* 3.14 4.99 6.68 7.39 9.51 3.45 5.20 15.49
MSCI EAFE* 1.61 0.49 (0.12) 2.48 5.00 1.92 (1.50) 10.20
MSCI Europe* (0.15) (0.86) (3.14) 1.48 4.81 0.15 (4.48) 9.13
MSCI Pacific* 4.92 3.24 6.01 4.24 5.39 5.24 4.54 12.10
MSCI UK* (0.76) (0.21) (3.96) (0.35) 3.85 (0.46) (5.29) 7.17
MSCI France* (1.13) 0.61 (1.93) 1.28 4.01 (0.83) (3.29) 8.92
MSCI Germany* 3.35 0.88 1.94 2.98 6.94 3.66 0.52 10.75
MSCI Japan* 4.25 0.93 2.85 5.57 6.66 4.57 1.43 13.53
MSCI Emerging Markets* 11.94 14.55 11.83 1.12 (0.42) 12.28 10.28 8.74
Manufacturing PMI
Senior Analyst, Investment Strategy 53
RBC Global Asset Management Inc. 52
51
Daniel E. Chornous, CFA
50
Chief Investment Officer
RBC Global Asset Management Inc. 49
48
Contraction
47
2012 2013 2014 2015 2016
As we reflect back on a quarter that JP Morgan Global PMI Developed markets PMI Emerging markets PMI
contained one of the most surprising Note: PMI refers to Purchasing Managers Index for manufacturing sector, a measure for economic activity.
Source: Haver Analytics, RBC GAM
and consequential geopolitical
shocks in years the U.K. vote to
leave the European Union (EU) it Exhibit 2: Significant but slightly shrinking risks
is remarkable that financial markets
managed to deliver handsome gains Maturing
to investors and exuded calm. business cycle
Debt hot spots
This improbable outcome was China
thanks to three other developments.
First, economic data flitted
pleasantly higher over the summer. Geopolitics
EM slowdown
Second, global downside risks
shrank somewhat. Third, the decline
in bond yields over the period
Resource shock Fed rate hikes
seemed to strengthen the search
for yield mentality, resulting in Source: RBC GAM
narrower credit spreads and higher
stock valuations. particularly welcome, coming as it debt risks remain enormous, but
does after years of downgrades. dont appear on the cusp of being
The improved macroeconomic triggered. Most evidently, the risk
trend is most easily observed via Sifting through the most prominent of further downside from emerging-
the recent increase in purchasing threats to growth (Exhibit 2), it market economies or commodity
manager indexes (Exhibit 1). Global strikes us that several have been prices has been progressively fading
economic surprises have also been shrinking recently. Business-cycle for several quarters.
largely positive. Corporate earnings, risks are still front and centre,
long mired in a slump, are hinting but perhaps a bit less acute than Of course, the task at hand is
at green shoots, and global trade is before. Chinese downside risks anticipating the future performance
no longer decelerating. A tentative remain sizeable, but our concerns of financial markets, not admiring
uptick in emerging-market growth is for the countrys housing and debt recent gains. On this front, one
markets have shrunk slightly. Global source of mild trepidation is that
Estimate
95 95.6
9.5
18 17.9 90 9.5 9.5
reasonable to budget for something 85 9.0
16
a little bumpier, especially with the 80
8.5
79.4
many event risks approaching over 14 14.1 75 8.4
71.2 8.0
14.1 70
the fall. 12 65 7.5
Bonds
Equities Currencies
Latest Median
Additionally, we suspect the recent Note: Top and bottom of box represent the 75th and 25th percentiles for CBOE Market Volatility Index and Merrill
Lynch Option Volatility Estimate since 1990; and for Deutsche Bank Currency Volatility Index since 2001.
trend of unexpectedly happy Source: Bloomberg, RBC GAM
economic data may be starting
to fade. Economic surprises are
beginning to drift back down to a Exhibit 4: S&P 500 now diverging from economic surprises
more neutral reading (Exhibit 4)
and the autumns first smattering 50
2200
Weighing these considerations, Exhibit 5: Markets have rebounded from post-Brexit extremes
we have opted to maintain our
recommendation for a moderately 8 80
6
Yield/spread change
60
overweight equity allocation within 4
(basis points)
40
Price change (%)
2
a balanced investment portfolio. 0 20
-2 0
This is motivated primarily by the -4 -20
-6 -40
superior valuations of equities over -8
-10 -60
bonds, and secondarily by our belief -12 -80
-14 -100
that further economic advances
All Share
GBPUSD
IG credit
S&P 500
dollar
10yr yield
10yr yield
HY credit
EM credit
U.S.
spread
spread
spread
FTSE
U.K.
U.S.
Brexit aftermath
Exhibit 6: Marked U.K. economic hit from Brexit
The U.K. publics surprise vote to
bolt from the EU has so far proven
20 63
less problematic for markets and 61
(% balance)
reacted quite negatively to the news, -10
55
they have since more than fully 53
-20 51
recovered (Exhibit 5). The pound
49
remains significantly weaker than -30
47
before Brexit and government yields -40 45
have fallen both clear markers of 1986 1992 1998 2004 2010 2016
Consumer confidence (LHS) Composite PMI (RHS)
Brexits vestigial effects. Fortunately,
Source: Haver Analytics, RBC GAM
however, both serve to improve
U.K. financial conditions rather than
undermine them.
Exhibit 7: U.K. in modest recovery
The odds of a U.K. recession
European U.K. Pre-Brexit
following Brexit have also fallen, 6 Initial recovery renaissance Medium-run
GDP growth (QoQ % annualized)
debt worries
crisis under
with the initial probability of 60% 4 performance
now down to no more than 40%. 2
0
This is partly because of the
-2
aforementioned improvement in Post-Brexit
-4 recession?
financial conditions, and partly -6
because we can already see that -8
economic activity has dipped by -10
Recession Forecast
less than feared in the months after -12
2008 2010 2012 2014 2016 2018
Brexit. The short-term economic
Source: ONS, Haver Analytics, RBC GAM
implications were always something
of a guessing game given that the
main channels are via confidence The Bank of England (BOE) certainly yet to be activated, meaning formal
and expectations rather than hasnt let its guard down, having negotiations are some distance
specific economic hurdles. Let us be responded to the shock with a off. The U.K. is busy adjusting to
clear: we still expect some negative measured 25-basis-point rate cut new Prime Minister Theresa May
consequences given the material and a new round of credit-oriented and must also ramp up its trade-
decline in consumer and business quantitative easing (Exhibit 8). negotiating capabilities a branch
confidence already demonstrated Additional fiscal stimulus is also of the civil service that had withered
(Exhibit 6), and we still budget for expected in the upcoming budget. given the EUs dominion over
weaker-than-normal U.K. economic trade. We expect Article 50 will be
performance over the next year Of course, nothing has changed yet activated in 2017, allowing a multi-
(Exhibit 7) with 1.5% growth in 2016 regarding the U.K.s relationship year negotiation process to begin.
and just 0.75% growth in 2017. with the EU. The clause governing That said, there is still perhaps a
the exit of a member country has 25% chance that Brexit never takes
CEPR
CBI/PwC
Bertelsmann
Oxford
Econ.
OECD
Treasury
Open
U.K.
IEA
Updated forecasts
Exhibit 13: Slow growth in three buckets
Our growth forecasts remain
heavily informed by the experience
1 2 3
of the post-financial-crisis era.
Central to this, the speed limit for STRUCTURAL CRISIS-INDUCED RECENT SHOCKS
recession.
Another indicator of rising recession Exhibit 17: U.S. yield curves flattening
risk is the recent flattening (and
unusual flatness) of the yield curve 120 107.7
(Exhibit 17). The credit cycle also
10-year and 2-year bonds (bps)
Difference in yields between
100
continues to age, with potential 82.1
implications for the broader 80 74.2
(Exhibit 19).
9
2. Global trade appears to be
stabilizing, if in a position of 6
two candidates. 30
20
At the time of writing, betting 10
markets have assigned the 0
Democrats Hillary Clinton a nearly -10
-20
80% chance of victory, while the
-30
Republicans Donald Trump trails
-40
well behind with just over a 20% 2001 2004 2007 2010 2013 2016
likelihood (Exhibit 22). Nominal exports Real exports
Note: Year-over-year % change of 3-month moving average of world exports. Nominal exports in U.S.
dollars. Source: IMF, Credit Suisse, Haver Analytics, RBC GAM
We believe the race is marginally
closer than this, as Brexit
demonstrated that populist
inclinations are now unusually Exhibit 21: Temporary employment signal not great
strong. Trump has repeatedly
125 3.0
exceeded expectations in his short
temporary help services (millions)
Temporary
Nonfarm payroll employment,
2.8
Nonfarm payroll employment,
120 employment
political career to date and now
total private (millions)
wavering 2.6
115
appears to be belatedly tacking 2.4
110 2.2
somewhat closer to the political
105 2.0
centre where many voters sit.
100 1.8
Moreover, it is not unreasonable 1.6
95
to believe that his supporters are 1.4
90 1.2
being undercounted in the polls
85 1.0
due to a mix of bashfulness and 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
media distrust, and any bout of bad Total private (LHS) Temporary help services (RHS)
economic news or sour financial Source: BLS, Haver Analytics, RBC GAM
60%
60
From an economic perspective, his
promise of a large infrastructure- 50
(US$ trillions)
8
broadening wage pressures. Second, QE3
SNB
BoJ
6 intervention
the Fed has now clearly signaled its Fed Fed begins
4 QE2
tightening intention in speeches by QE1 BoE
Chair Yellen and Vice Chair Fischer. 2 QE
is somewhat understandable: -1
consumers have already restored
-2
their savings rates to respectable
levels and are now deploying the -3 wages < productivity
1990 1995 2000 2005 2010 2015
2016
proceeds of strong hiring and
Note: YoY % change of 4-quarter moving average. Source: Haver Analytics, RBC GAM
improving wage growth. In contrast,
business investment is undermined
by the drop in oil-related capital Exhibit 27: U.S. consumer spending remains solid while business
expenditures, generally weak foreign investment fades
demand and uncertainty about the 15
path for public policy going forward. 10
Looking ahead, the gap between
5
YoY % change
12
Japan is all about the yen
(QoQ % change annualized)
8
Japan remains a country of Abenomics
100
question is whether he will deploy
100
his newfound political capital in 90
110
that direction, or instead focus on 80
120
re-militarization.
130 70
We have left our Japanese growth 140 60
forecasts unchanged at 0.50% for 2000 2002 2004 2006 2008 2010 2012 2014 2016
USD-JPY spot exchange rate (LHS) Nominal effective exchange rate (RHS)
2016 and 1.00% for 2017. The Source: J.P. Morgan, Haver Analytics, RBC GAM
positive influences of a recently
announced fiscal-stimulus program
and additional monetary stimulus are Exhibit 33: Prices in Japan have risen in recent years
roughly offset by a more muscular
currency. The delay of Japans next 101
Japan core CPI (2000=100)
100
sales-tax increase to 2019 from 2017 2.6% higher since
99
is one reason that we are able to the trough
98
anticipate a growth uptick in 2017. 97
96
For all of the public criticism of 95
94
Japans inflation-revival efforts, it 93
must be acknowledged that the 92 3.4% higher
since the trough
country has at least achieved a 91
2000 2002 2004 2006 2008 2010 2012 2014 2016
partial victory. The rate of inflation Core CPI, adjusted for tax hikes Core CPI
remains well shy of +2% per year, but Note: CPI adjusted to exclude the estimated effect of sales tax hikes. Source: BoJ, Ministry of
Internal Affairs and Communication, Haver Analytics, RBC GAM
core prices have at least escaped
historical norm)
sustained now that the yen is no 2
(YoY % change)
11
longer providing artificial assistance. 1
10
We are monitoring a slight decline in 9 0
prices in 2016, but pencil in a 1.0% 8 -1
7
increase for 2017. -2
6
5 -3
China finds its feet 1995 1998 2001 2004 2007 2010 2013 2016
GDP Growth (LHS) Economic Activity Index (RHS)
As the generator of roughly one-third Note: Index constructed using sixteen proxies for real economic activity in China.
Source: Bloomberg, Haver Analytics, RBC GAM
of global economic growth, China
matters hugely. For years, we have
looked for and gotten a steady
Exhibit 35: Chinese trade is finally flattening out
deceleration in Chinese economic
growth as the country loses prior
70
important tailwinds such as its high 60
level of competitiveness and the 50
China trade in goods
40
(YoY % change)
Much as global trade now looks Exhibit 36: Chinese consumer spending still slower than usual
to be flattening after a period of
deceleration, Chinese trade has 5
(standard deviations from
4
Consumer Activity Index
may actually have too few homes 29% of housing 2% Sold and occupied
71%
even after factoring in the high stock is Sold but unoccupied
unoccupied 20% Completed but unsold
initial vacancy rate.
Excess under construction
As such, Chinas housing market
constitutes a real risk, but perhaps
Note: Share of Chinese housing (in units) by status in 2015. Completed but unsold unavoidably includes both
a slightly less worrying one than we new and existing units for sale. Excess under construction (in units) measured as floor space under
construction less floor space completed estimated based on the historical relationship of housing under
had previously assumed. construction and completion. Source: China Household Finance Survey, Credit Suisse, CICC, Haver
Analytics, RBC GAM
Chinas main problem is its high
and rising debt load. While this
is partially a function of the Exhibit 39: Potential Chinese bank losses worrisome
aforementioned housing market, it is
just as crucially linked to struggling 3.5 28% 30
$3.2T
heavy industries, an underdeveloped
(% of bank assets / GDP)
3.0
Potential bank losses
25
Potential bank losses
4 2.75% 2.75%
Fortunately, recent government 2.75% 2.75%
2 1.5%
statements have suggested that 1.0%
Emerging markets stabilize Exhibit 41: Brazils economic malaise may be bottoming
Emerging-market leading indicators
3
have improved somewhat over
Number of standard deviations
(million barrels)
and increasing their ability to 2800
4.8
valuations remain cheap, 4.6
motivating our own equity 4.4
(million b/d)
8 Ontario faring
slightly diminish the pain of the oil 6 well
We anticipate a gradual
normalization of headline-inflation
rates as they shake off the prior Higher
effects of the commodity shock
Mutually
inflation
and converge toward current core compatible
inflation readings (Exhibit 50). when
With this forecast, we are a little potential
above the market consensus. This Poor
growth rate
expectation is grounded in our economic very low
outlook for moderately higher oil growth
prices, in our belief that economic Source: RBC GAM
Nov-15
Dec-15
Jan-16
Jun-16
Jul-16
Nov-16
Dec-16
Jan-17
Jun-17
Jul-17
Nov-17
Dec-17
May-15
Aug-15
Sep-15
Aug-16
Sep-16
Oct-15
Feb-16
Mar-16
Apr-16
May-16
Oct-16
Feb-17
Mar-17
Apr-17
May-17
Aug-17
Sep-17
Oct-17
an extraordinarily low interest-
rate environment given the slow Market-implied forecast as of August 31, 2016 FOMC median projections as of Sep 2014
FOMC median projections as of Dec 2014 FOMC median projections as of Mar 2015
economic growth and low inflation FOMC median projections as of Jun 2015 FOMC median projections as of Sep 2015
FOMC median projections as of Dec 2015 FOMC median projections as of Mar 2016
discussed above, as well as an aging FOMC median projections as of June 2016
Source: Bloomberg, U.S. Federal Reserve, RBC GAM
population, high income inequality,
elevated debt loads and a shortage
of safe assets. Seven years following
Exhibit 52: Central banks and uncertainty drive yields lower
the financial crisis, investors are
perhaps starting to realize that the 3
slow-growth, low-inflation world
Government bond yield (%)
%
move higher with time, as the model 4
2.0
0.5%
2
begins to incorporate higher inflation 0 0.0
-1 SD Average: 2.1%
and a return in the real rate of -2 -2.0
12-Month Forecast: 1.26%
-4
interest to its long-term average by 1960 1966 1973 1980 1986 1993 2000 2006 2013 2020
-4.0
1960 1970 1980 1990 2000 2010 2020
36-month Centred CPI Inflation Actual Monthly CPI Inflation Real T-Bond Yield Real 10-Year Time Weighted Yield
the end of 2020. In our view, bond Source: RBC GAM, RBC CM Source: RBC GAM, RBC CM
yields are not likely to rise as quickly
as the model suggests, at least in
the short term. While a bit more
U.S. 10-year T-bond yield
inflation and a Fed rate hike or two 16 Equilibrium range
could prompt bond yields to move 14
higher, a return to historically normal 12
rates appears quite unlikely over the 10
forecast horizon. 8
6
%
Z-score
we are not surprised that equity 0.0
-0.5 Market is slightly cheap -0.22
valuations have risen, and point -1.0
-1.5 -1.00
out that some of the most popular -2.0 Market is cheap
metrics for valuing stocks ignore the -2.5
-2.36
-3.0
critical inverse relationship between Average Market Tobin's Q 12-M 12-M Shiller P/E RBC GAM Equity risk Fed
cap U.S. trailing forward (CAPE) fair value premium model
interest rates and inflation, on the GDP P/E P/E
one hand, and the present value of Notes: Historical data from Jan 1956 for 12-M Trailing P/E, 12-M Forward P/E, Equity risk premium,
Shiller P/E and Fed model. Historical data from Mar 1956 for market cap U.S. GDP. Historical data
future earnings, on the other. Exhibit from Jan 1960 for RBC GAM fair value. Source: Haver Analytics, RBC CM, RBC GAM
Y/Y % change
of equities in the current 300 20
Basis points
suggest that the bull market in Exhibit 63: Relative strength to S&P 500 Index
equities still has some momentum. Rebased to 100 as of Jan. 1, 2015
105
U.S. election market impact
104
103
We mentioned earlier that the
102
November U.S. presidential election 101
could have a significant impact 100
on financial markets over the next 99
98
few months. A look at how stock
97
markets performed during past U.S. 96
elections may provide a basis as 95
for what to expect this time around. Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16
S&P 100 Mega Cap Index S&P 600 Small Cap Index S&P 400 Mid Cap Index
The average performance of the Dow
Source: Haver Analytics, RBC GAM
Jones Industrial Average Index (DJIA)
going back to 1900 and covering
29 presidential cycles suggests Exhibit 64: U.S. presidential election year
that markets perform better in Dow Jones Industrial Average
election years when the incumbent 20%
party wins (Exhibit 64). So far this
Cumulative price return
15%
year, markets are tracking the 10%
favoured scenario (for equity market 5%
performance) of an incumbent 0%
party win by Hillary Clinton, the -5%
Democratic Party candidate. -10%
Further analysis breaks down the -15%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
performance of stocks depending 2016 2017
on which party controls the White Current cycle (2016) Average of all election years
Average of years when incumbent party wins Average of years when incumbent party loses
House and Congress (Exhibit 65).
Note: based on daily data back to Jan 1, 1900. Source: Ned Davis Research, Bloomberg, RBC GAM
The best gains, on average, occur
when the U.S. government was
made up of a Democratic president, Exhibit 65: U.S. government composition and performance of Dow Jones
Industrial Average
Republican House of Representatives
and Democratic Senate. While a Control of Control of % gain/ % of
President
House Senate annum time
Clinton victory appears to be priced
Republican Republicans Republicans 7.03 22.5
into markets, we acknowledge that
Republican Democrats Democrats 2.44 19.1
a Trump win is a real possibility and
Republican Republicans Democrats (10.68) 1.7
that it could have potential negative
consequences for financial markets. Republican Democrats Republicans (2.92) 8.7
Democrat Republicans Republicans 8.72 10.1
Democrat Democrats Democrats 7.17 34.6
Democrat Republicans Democrats 10.37 3.5
Democrat Democrats Republicans N/A 0.0
Notes: based on daily data back to January 1, 1900. Source: Ned Davis Research
U.S. 10 Year Treasury Bond -3.46% -7.22% -4.44% -2.83% -1.24% -0.01%
Canada 10 Year Government Bond -10.96% -13.50% -7.82% -5.30% -3.04% -1.26%
German 10 Year Government Bond -9.96% -11.52% -7.28% -5.78% -4.22% -2.98%
U.S. Investment Grade Bond** -4.38% -6.32% -3.08% -1.36% 0.31% 1.61%
Canada Investment Grade Bond** -7.64% -8.47% -4.24% -2.26% -0.46% 0.97%
Europe Investment Grade Bond** -9.58% -9.98% -5.82% -4.32% -2.76% -1.47%
U.S. High Yield Bond*** -4.23% -0.97% 2.24% 3.86% 5.36% 6.50%
U.S. Stocks (S&P 500) Total Return 7.35% 22.09% 17.69% 13.76% 11.77% 10.22% 9.64% 9.33%
Canadian Stocks (TSX) Total Return 33.20% 26.95% 14.45% 12.83% 11.20% 9.88% 9.37% 9.10%
1
If market moves to equilibrium. *Annualized returns **Bank of America ML Indexes, assuming long-term reversion to normal spread to T-bond, evenly through to end date.
***Credit Suisse High Yield Index STW, assuming long-term reversion to normal spread to T-bond, evenly through to end date
Source: RBC GAM, Bloomberg
12 14
10 12
10
8
%
%
8
6
6
4
4
2
2
0 0
1980 1985 1990 1995 2000 2005 2010 2015 2020 1980 1985 1990 1995 2000 2005 2010 2015 2020
Last Plot: 1.58% Current Range: 1.07% - 2.85% (Mid: 1.96%) Last Plot: 0.35% Current Range: 1.02% - 2.18% (Mid: 1.60%)
Source: RBC GAM, RBC CM Source: RBC GAM, RBC CM
12 16
10 14
12
8
10
6
%
8
%
4
6
2
4
0 2
-2 0
1980 1985 1990 1995 2000 2005 2010 2015 2020 1980 1985 1990 1995 2000 2005 2010 2015 2020
Last Plot: -0.06% Current Range: 0.07% - 0.91% (Mid: 0.49%) Last Plot: 1.02% Current Range: 1.45% - 3.06% (Mid: 2.25%)
8
6 adjustment will be limited given
4
2 the current low speed limit on
0
1980 1985 1990
Last Plot: 0.64%
1995 2000 2005 2010 2015 2020
Current Range: 0.37% - 2.37% (Mid: 1.37%)
economic growth.
Source: RBC GAM, RBC CM
1280
6400
640
3200
320
160 1600
80 800
40
400
1960 1970 1980 1990 2000 2010 2020
1960 1970 1980 1990 2000 2010 2020
Source: RBC GAM Source: RBC GAM
520
1440
720
260
360
130 Aug. '16 Range: 294 - 875 (Mid: 584)
Aug. '17 Range: 304 - 906 (Mid: 605) 180
Current (31-August-16): 422
65 90
1980 1985 1990 1995 2000 2005 2010 2015 2020 1980 1985 1990 1995 2000 2005 2010 2015 2020
Source: Datastream, Consensus Economics, RBC GAM Source: Datastream, Consensus Economics, RBC GAM
6720 320
3360 160
1680
80
840
40
420
210 20
1980 1985 1990 1995 2000 2005 2010 2015 2020 1995 2000 2005 2010 2015 2020
Source: Datastream, Consensus Economics, RBC GAM Source: Datastream, RBC GAM
% of Japan GDP
RBC Global Asset Management Inc.
150
100
Economists have long associated
rising fiscal stimulus with 50 Household
higher bond yields as increased Debt
0
government spending generally 1995 1999 2003 2007 2011 2015
leads to faster economic growth, Source: IIF
rising inflation and higher debt
levels. Higher fiscal spending is also
tools have become lasting features The heavy and prolonged
thought to have a crowding-out
of todays debt-dependent economy. intervention by global central banks
effect whereby large government
Interest rates near zero have allowed has driven up the wealth of people
borrowings shrink the availability
private borrowers to service their who hold stocks, bonds and real
of capital for private borrowers,
debt loads, while quantitative easing estate. But critics have blamed
forcing them to pay relatively
has propped up asset prices and central-bank policies in part for the
high interest. These days, with
prevented a deflationary spiral. populism and anti-establishment
investors turning more strident in
views that led U.K. voters to cut
their criticism of monetary policy The U.S. Federal Reserve (Fed) ties with the EU in a referendum
and major elections in the U.S. and ceased bond purchases in October during the summer and Republicans
Germany taking place against a 2014, but has since managed to to choose Donald Trump as their
backdrop of social discontent, the raise its policy rate only once and presidential candidate. Regardless
pressure is on governments to rev up also refrained from attempting to of whether Trump or Democrat
fiscal spending. Now is the time to shrink its US$4.4 trillion balance Hillary Clinton wins the presidency,
examine what impact a jump in fiscal sheet. The European Central Bank we expect fiscal spending in the
stimulus could have on bond yields. (ECB) also succumbed to the U.S. to escalate to address social
appeal of asset purchases when discontent and economic inequality.
Lets start with a review of how
Eurozone deflationary risks jumped In Europe, most governments have
monetary policy fell out of favour. In
in recent years. The ECB embarked been backing away from the fiscal
the 10 years preceding the financial
on quantitative easing in March austerity in place since the financial
crisis, economic growth relied on
2015 and the program has been crisis, and this shift in attitude
ever-expanding private debt, so the
extended through March 2017 to has been contributing to economic
collapse of private-sector balance
include purchases of corporate growth in the region since 2014.
sheets in 2008 made central-bank
bonds. Countries including Japan, Further government spending across
purchases of financial assets
Switzerland and Sweden are major economies could help reverse
necessary to prevent the implosion
experimenting with negative interest slow economic growth around the
of the banking system.
rates on deposits in an effort to globe and aid in calming the rise of
However, what were at the time stimulate lending and spending. political populism.
considered temporary monetary
(bps)
of GDP and governments have -100
-200
been borrowing to keep economies
-300
expanding, albeit weakly. Signaling -400
a similar trend, our research shows -500
-8 -7 -6 -5 -4 -3 -2 -1 0
that 10-year Treasury yields have U.S. Government incremental spending % GDP
frequently fallen in periods when 12-mos change in Budget Balance % GDP (1970 - 2016)
1970 - 1999 2000 - 2016
governments went on borrowing Source: Bloomberg
2
Direction of rates
1
The focus of financial markets over
the next year will likely shift to fiscal 0
area, we believe the ECB will step INTEREST RATE FORECAST: 12-MONTH HORIZON
back from policies that have in some Total Return calculation: Aug. 24, 2016 Aug. 23, 2017
cases pushed interest rates deep U.S.
into negative territory. Banks are Horizon
also a consideration for the ECB, as 3-month 2-year 5-year 10-year 30-year return (local)
negative interest rates are making Base 0.75% 1.20% 1.60% 2.00% 2.60% (0.70%)
it almost impossible for weaker Change to prev. quarter (0.25%) (0.40%) (0.30%) (0.25%) (0.30%)
banks to weather high levels of non- High 1.25% 1.75% 2.25% 2.50% 3.00% (3.54%)
performing loans. We raise our ECB Low 0.38% 0.50% 0.60% 1.00% 1.70% 5.18%
deposit-rate forecast to negative Expected Total Return US$ hedged: (0.40%)
0.40%, compared with our previous
GERMANY
forecast of negative 0.50%. Our
Horizon
forecast for the 10-year yield falls to 3-month 2-year 5-year 10-year 30-year return (local)
0.30%, a 0.20% reduction from our Base (0.40%) (0.20%) 0.10% 0.30% 0.60% (2.73%)
previous forecast of 0.50%. Change to prev. quarter 0.10% (0.10%) 0.00% (0.20%) (0.50%)
High 0.00% 0.40% 0.60% 0.75% 1.25% (8.73%)
Japan We expect the BOJ to
Low (0.50%) (0.50%) (0.75%) (0.50%) (0.16%) 1.80%
continue engaging in asset
Expected Total Return US$ hedged: (1.66%)
purchases and stay put on deposit
rates, leaving them at negative JAPAN
0.10%. Prime Minister Abe recently Horizon
3-month 2-year 5-year 10-year 30-year return (local)
announced a 28 trillion (US$280
billion) stimulus package. The Base (0.10%) (0.10%) (0.05%) 0.00% 0.45% (0.32%)
Change to prev. quarter 0.30% 0.25% 0.25% 0.20% 0.15%
amount was impressive on the
High 0.00% 0.05% 0.10% 0.20% 0.80% (4.75%)
surface, but in reality only 7.5
Low (0.20%) (0.20%) (0.25%) (0.25%) 0.25% 2.71%
trillion represented new spending.
Expected Total Return US$ hedged: 1.00%
JGB yields rose after a combination
of the fiscal disappointment; the fact CANADA
that the government said it would Horizon
finance the spending with longer- 3-month 2-year 5-year 10-year 30-year return (local)
term bonds, for which demand is Base 0.50% 0.90% 1.00% 1.50% 2.00% (2.20%)
relatively low; and the intention Change to prev. quarter 0.00% (0.10%) (0.25%) (0.25%) (0.35%)
of the BOJ to suspend, at least High 0.75% 1.25% 1.50% 2.00% 2.40% (5.93%)
temporarily, its pursuit of even more- Low 0.00% 0.00% 0.10% 0.50% 1.15% 6.69%
aggressive easing. At this time, JGBs Expected Total Return US$ hedged: (1.90%)
may be the only major bonds that U.K.
are fairly priced.
Horizon
3-month 2-year 5-year 10-year 30-year return (local)
We are increasing our yield forecast
Base 0.25% 0.50% 0.75% 1.00% 1.60% (3.95%)
for the 10-year JGB to 0.00% from
Change to prev. quarter (0.50%) (0.50%) (0.75%) (1.00%) (1.10%)
negative 0.20%.
High 0.25% 0.75% 1.25% 1.50% 2.00% (9.31%)
Canada The Canadian economy Low 0.00% 0.00% 0.10% 0.25% 1.25% 1.94%
clearly stumbled in the second Expected Total Return US$ hedged: (3.12%)
due to wildfires in Alberta and a nowhere close to raising rates. The that the BOE will lower rates again
surprise drop in exports leading to tone from the BOC suggests a high in the near term given that fiscal
a decline in GDP. Rebuilding efforts threshold for further easing, and stimulus is probably in the pipeline.
in Alberta should provide a boost in markets currently have priced in We expect gilt yields to rise from
the third quarter, but the Canadian no chance of a rate cut over the their current rich valuations, and our
economy is growing modestly at next year. 12-month forecast for the 10-year
best. We dont expect to see any gilt is at 1.00%, a big drop from
Bank of Canada (BOC) rate hikes We have lowered our expectations 2.00% last quarter before Brexit.
until the end of 2017, and the BOC for the 10-year government bond We forecast that the BOE policy rate
might even lower rates sometime to 1.50% from 1.75% while leaving remains unchanged at 0.25% over
this year if the economic rebound our forecast for the BOC policy rate the next 12 months.
is weaker than expected. The BOC unchanged at 0.50%.
has been worried about overheated U.K. The BOE, aware that the U.K. Regional preferences
housing markets in Vancouver and decision to leave the EU has left We are maintaining our
Toronto, but a new tax imposed on the domestic economy vulnerable, recommendation from previous
Vancouver property buyers from lowered its policy rate on August 4 quarter to overweight Japanese
abroad should help cool prices. while committing to the purchase government bonds by five
Canadian bonds continue to attract of 60 billion (US$79 billion) of percentage points and underweight
foreign money due to the allure government bonds and 10 billion of German bunds by a similar amount.
of Canadas stable financial and corporate bonds. BOE Governor JGBs are neutrally priced, while
political system, good market Mark Carney also launched a German bunds do not yet reflect the
liquidity and relatively high yields. program making it easier for banks rising odds that the ECB will scale
We expect Canadian bonds to to lend to small and medium-sized back purchases of German bonds
outperform U.S. fixed income since businesses. and pause on driving short-term
we continue to believe that the Fed interest rates further into negative
In response, longer-dated gilt yields territory. Our view on the U.S.
will hike rates at least once in the fell to historically low levels. We
next 12 months, while the BOC is remains neutral.
are skeptical of the markets view
10%
The euro
0%
It has been over a year and
Indonesia
S. Africa
Mexico
India
Brazil
Malaysia
Thailand
Korea
China
a half since the euro traded
meaningfully outside the 1.05 to
Source: J.P. Morgan
1.15 range against the U.S. dollar
(Exhibit 6). The primary reason
for the euros inertia may be that
Exhibit 6: EUR-USD exchange rate
investors are underestimating
the risks that continue to reside 1.45
in Europe. Correspondingly, the 1.40
monetary machinations of the 1.35
European Central Bank (ECB) and 1.30
ECB President Mario Draghi have 1.25
1.20
retreated from the front pages. Even
1.15
when concerns about the future
1.10
of Europe have come to the fore, 1.05
as was the case during the U.K. 1.00
referendum on EU membership, 0.95
Jan-12 Sep-12 May-13 Jan-14 Sep-14 May-15 Jan-16 Sep-16
they have quickly retreated. The
Source: Bloomberg
40
driven mostly by changes in the
20
nature of the outflows. However,
0
experience has shown us that
there is a meaningful risk that the -20
Belgium
Japan
Russia
Ireland
Turkey
Indonesia
Italy
Norway
Brazil
Colombia
Australia
S.Africa
Portugal
Hungary
Germany
Netherlands
U.K.
Mexico
India
Poland
Spain
Malaysia
China
Sweden
U.S.
Korea
Switzerland
Taiwan
Singapore
Philippines
Concerns about inflation, which
had previously preoccupied several
members of the Monetary Policy Source: Bloomberg
Committee have been relegated to
the sidelines by the more pressing
issue of supporting economic Exhibit 12: U.K.s basic balance of payments
activity. Comments by BOE Governor
25%
Carney that inflation will be of
4-quarter rolling sum, % of GDP
20%
secondary concern in coming months 15%
will likely be negative for the pound. 10%
5%
0%
The other thing that the vote to
-5%
leave the EU has brought to the -10%
fore is the U.K.s yawning current- -15%
-20%
account deficit. At over 5% of GDP,
-25%
the deficit is worse than those of 1987 1990 1993 1996 1999 2002 2004 2007 2010 2013 2016
serial deficit-runners Turkey and Net porfolio flows Current account
Net foreign direct investment Basic balance
South Africa, and is almost as bad Source: Office for National Statistics
as Colombias (Exhibit 11). It is
important to recognize that not all
arrive (Exhibit 12) and may be more against its U.S. counterpart over the
current-account deficits are created
fickle as a result of the vote. next year. The expected benefits of a
equal. What is often more important
lower Canadian dollar have, by
than the magnitude of a deficit is Going forward, we expect the and large, not yet materialized,
how it is funded. We are generally prospect of further easing to keep leaving economic activity mixed
less concerned with countries that the pound on a depreciatory path at best. In addition, the funding
fund deficits with incoming foreign as the BOE battles lacklustre of the current-account deficit is a
direct investment, which tends to be economic growth. We forecast the risk to the loonie, and a worsening
a long-term capital flow. The U.K., in pound to decline to 1.25 over the trade balance is doing nothing to
contrast, has been relying heavily on next 12 months. ameliorate the situation.
what Carney has referred to as the
kindness of strangers. These are The loonie This lack of adjustment leads us to
inward portfolio-investment flows believe that the loonie is just not
We continue to forecast that the
that can leave as quickly as they cheap enough to spur the necessary
Canadian dollar will lose ground
given the favourable setup for legs. These stocks suffered through Another sector that presents an
housing and the prospects for future an 18-month period of U.S. dollar opportunity is Financials, where
wage growth, it does not appear strength that began in mid-2014 as recent relative returns have been
that the end of the economic cycle commodity prices turned down and 60% correlated with changes in
is imminent. In fact, according to the global growth slowed. This group interest rates, a relationship that has
Federal Reserve Bank of Atlantas trades at an average P/E of 12.5 and emerged just twice since the Great
real-time GDP forecast, the U.S. has staged a bit of a recovery since Depression. Of note, the largest
is on track to produce growth of February, when expectations of a regulated financial companies sport
about 3.5% in the current quarter, slower pace of rate hikes by the a total shareholder yield (dividends
exceeding that of most other U.S. Federal Reserve caused the U.S. plus buybacks) of between 6%
developed economies. dollar to weaken and commodity and 8% compared to the market
prices to stabilize and recover average of 4%. If interest rates move
The S&P 500 currently trades at somewhat. What is clear is that the higher, these stocks have significant
roughly 17 times 12-month forward U.S. dollar is a key determinant potential for higher valuations, but
earnings estimates, in line with of the markets future. Assuming patience will be required.
our estimate of fair value. While the greenback remains range-
many investors are arguing over bound, value stocks could stage a While we may be late in the business
whether the overall market is significant rally. cycle, we believe that the global
cheap or expensive, we believe economy and markets should
the discussion should focus on the We see a number of opportunities continue to trudge forward with the
distribution of stock valuations. The among value stocks. The most strength of the U.S. just enough to
most expensive stocks have steady obvious are in the Energy sector, offset the weakness of Japan and the
and predictable earnings, offer where a historic bust has resulted Eurozone. The worlds central banks
high dividend yields, exhibit low in industrywide writedowns of more have done most of the heavy lifting
price volatility and trade like bond than 10% greater than during the during the recovery and there is now
proxies (their prices rise when bond mid-1980s oil crash. The sector is speculation that fiscal authorities
yields fall). These stocks have been cheap and there was fortunately a may become more engaged in
in high demand because of aging supply response last year, when the the fight to promote economic
demographics, too much debt and rig count and production were cut. growth. If this trend catches on,
too little growth. In a world where Globally, the supply of and demand the business cycle should continue
over half of all government debt for oil should come into balance later and value stocks would have their
yields less than 1%, these stocks this year. While inventories are high, day. However, if the politicians
are seen as a good source of income the price of oil should gradually disappoint, investors should
despite trading at an average P/E of climb, pulling energy stocks with it. expect mid-single digit earnings
22. On the other hand, the cheapest Most energy companies have done growth to drive modest returns over
stocks are mostly drawn from what they can to adapt, but some the next year.
cyclical sectors, where the worry is help from OPEC would really boost
that the economic cycle is on its last the odds of success.
weakness is not likely to be enough hopes for Canadian stock-market from raising prices as readily as they
to drive a meaningful acceleration outperformance rest with further did last year. This development could
in growth. strength in energy prices. The sector lead to lower profit margins and
is aided by current pricing still below valuations, and eventually to stock
We continue to believe that there will the marginal cost of new supply, underperformance. The same could
be more Canadian-dollar weakness while the case for prices exceeding be said in the Telecommunication
over the intermediate term. Even in the marginal cost of production is not Services sector, where strong share
the near term, the desire of the U.S. as robust. gains mean that investors are
Federal Reserve to increase interest required to pay healthy valuations
rates and uncertainty regarding oil After a strong period of performance, for businesses that may experience
prices suggest that the Canadian the focus for bank investors continues pressures on free cash flow.
dollar wont strengthen much beyond to shift towards the drivers of growth.
the $1.25 level of purchasing power While energy losses could continue, Oil prices remain difficult to forecast
parity. The domestic economys they have likely crested as a point in the short run but are still below our
reliance on housing and questions of concern. Looking into 2017, estimate of the marginal cost. Large
about the ability of consumers to consensus estimates target 4%-5% companies with long-life reserves
maintain their spending remain key profit growth, which is reasonable and strong balance sheets are set to
points of discussion. Furthermore, we for the environment we envision. deliver attractive levels of free cash if
have not seen any significant upturn Slowing loan growth, net-interest- and when crude prices bounce back
in manufacturing, and the price of margin pressure and regulatory to the US$65-US$70 level.
crude must move significantly higher impacts continue to be headwinds.
In this environment, reasonable Many commodity sectors have
to justify restarting massive oil-sands
dividend yields coupled with modest stabilized or rallied so far this
developments.
dividend growth are attractive to year. One area that has remained
S&P/TSX earnings estimates for longer-term investors. The focus subdued is agriculture, with the price
2017 are now over $900, which is on the housing market is likely to of corn falling again this quarter.
a considerable uptick versus 2016. intensify in the coming months given In Canada, fertilizer companies
Key to this increase is a substantial the acceleration in house-price gains have been the most impacted with
improvement for the Energy and and government scrutiny. In the latest Potash Corp. prudently cutting its
Materials sectors, with expectations quarter, some banks struck a note of dividend for the second time given
for the remainder of the earnings caution and began to pull back from the protracted bottoming process
pool in line with historical levels. the housing market. in the potash cycle. That said, the
Importantly, in the last three months, companys current share price trades
the estimate for 2017 earnings has Valuations in some sectors that at a meaningful discount to the
flat-lined after a period of steady traditionally exhibit stable earnings replacement cost of its assets, and
decline. Looking to 2017, both the have reached levels that would be potash gross margins are at cyclically
S&P 500 and S&P/TSX carry similar near the top end of historical ranges. low levels relative to history. With
valuations. Broadly speaking, For example, profit margins and a dividend more in line with cash
Canadian financial stocks are earnings multiples in the Consumer flow, the ingredients for a longer-
attractively valued but not outliers Staples sector have risen, suggesting term investment in Potash Corp. look
when compared to U.S. sector it is time for selectivity. Grocery interesting. Mergers often happen at
valuations. The non-financial, non- companies dominate the Consumer the tops and bottoms of cycles, and
energy sectors have valuations that Staples sector in Canada, and there so it wasnt surprising that late in the
are slightly elevated relative to their are signs that competition and a period Agrium and Potash Corp. said
U.S. peers. As has been the case, stronger loonie are preventing them they had held merger discussions.
180
Ordinarily, currency moves would not
serve as our first point of reference, 90
but the impact of extreme foreign- 1980 1985 1990 1995 2000 2005 2010 2015 2020
Source: Datastream, Consensus Economics, RBC GAM
exchange fluctuations on investment
flows and earnings-per-share
revisions make it an appropriate With U.K. equities instantly and first time in three years. The only
place to begin. The 12% drop in significantly cheaper for U.S. dollar significant signs of post-Brexit stress
sterling since the Brexit vote is not investors, buying support entered have occurred in the real estate
so surprising. But the relatively small the market quickly after the June market, where redemptions have
3.5% drop in the euro versus the 23 vote. The MSCI Europe has been suspended by some property
U.S. dollar is interesting because recovered almost all of the losses companies, and in Italian banking,
it is in part this stability that leads incurred after the vote in euro terms. which initially came under pressure
Europeans to be supportive of the However, allocations to Europe have ahead of the July stress tests by the
common currency. The problem is not returned to pre-Brexit levels, European Central Bank.
that you cant have the euro without and global asset allocators are
further integration of the EU. now underweight Europe for the
From a top-down perspective, the Brexit brings a future wracked policies decided in Brussels. In the
consequences of the U.K.s vote to with uncertainty. As one would same month, Italians will decide
leave the EU are not yet visible in the expect, the reaction to this new whether to approve the
regional statistics, with measures of environment has resulted in higher most extensive changes to the
economic activity largely unchanged equity-risk premiums in the U.K., countrys constitution in seven
since the referendum. For example, with the extent of the change decades. The significance of the
money-supply indicators remain a function of financial leverage Italian vote is more subtle, but
healthy, while the composite and return profiles. In spite of perhaps carries even higher stakes,
Purchases Managers Index indicates high contagion risk, Europes because its failure could culminate
that GDP growth continues to be risk premium excluding the U.K. in the resignation of Prime Minister
stable for now. However, it should be continues to fall on a relative basis. Renzi and would likely lead to the
noted that measures of expectations We think Europe should face a higher populist Eurosceptic 5* Movement
have begun to turn down, and we hurdle rate and have adjusted our coming to power.
therefore find ourselves waiting for analysis accordingly.
some guidance on the direction of Our investment process attempts
economic data. The important point The good news is that European to identify high-return businesses
is that it is not just the investment equities were cheap before and they that exhibit stability across the
community that is waiting for cues remain cheap, even when revised economic cycle. Such companies are
on where the European economy is to discount lower corporate profits. predominantly global leaders with
headed. So, too, are corporations, The equity-to-bond yield spread has the culture and financial resources
which want more visibility to inform widened further, which signifies the to expand through time. The
their capital-allocation decisions, relative value of European equities multinational operations of these
and governments and central banks, versus bonds. businesses provide diversification
which are searching for guidance to in a portfolio sense, but also the
Apart from the Bank of England last flexibility to manage cyclicality by
inform their policy decisions. month, there has been an absence allocating capital to the parts of the
Regional earnings revisions of policy response following Brexit. world where returns are highest.
after Brexit have been driven However, expectations of stimulus
predominantly by foreign-exchange have increased, which is serving to The consistency of this approach
shifts, and do not yet reflect the support the stock market. We can means that Brexit has not
dampening effect that Brexit have no idea what shape or form or culminated in high levels of turnover
could have on economic activity. size such initiatives would take as in the portfolios. Instead, trading
Companies relying on domestic decision makers will have to react has occurred at the edges in an
growth have been harder-hit based on economic conditions. attempt to position for medium-term
than their internationally focused developments rather than chase
Several events on the horizon short-term gains. To this end, we
counterparts, which will benefit could give a clue to the direction of
from the drop in sterling. As a result, have reduced our already small
European politics, and therefore the exposure to mid-cap stocks and
many of the market drivers have regions economies. Hungarians will
followed currency patterns, with concentrated our banking exposure
vote October 2 on whether to accept entirely back into Scandinavia.
domestically focused mid-cap stocks EU-dictated migrant quotas, and the
underperforming international vote is an important read on member
equities. Meanwhile, valuations have states willingness to fall in line with
come back into greater focus.
After buying up a significant portion January, when a modest devaluation India has announced a replacement
of the Japanese government-bond almost led to a panic. In addition for the well regarded outgoing
market, the BOJ is expanding its to fund flows being supportive for Reserve Bank of India Governor
ownership of local equities via financial markets, there has been Raghuram Rajan. The new governor,
ETF purchases. The program itself reasonably supportive economic and Urjit Patel, is an able technocrat who
began in 2010, but ETF purchases policy newsflow from Asias largest will likely cause few ripples among
have continued to sharply increase economy, further allowing the ruling-party elite, but is also
over time and are now slated to for markets to grind higher over likely to maintain recent central-
rise to 6 trillion yen (US$60 billion) the period. bank mandates aimed at tackling
annually in the year ended July. It inflationary threats to the economy.
is easy to wonder about how long While reform efforts continue, Financial markets have continued
extraordinary monetary measures on-the-ground progress remains to perform reasonably well, helped
will continue and what the end slow, and the way forward is fraught by the first decent monsoon in
game is, but for now the government with danger in an environment three years. The rains have helped
is making increasingly desperate where global growth continues to rural incomes and consumption to
attempts to keep a semblance of be weak. Turning off the credit taps recover.
optimism in place regarding the by imposing more stringent loan
efficacy of Abenomics. standards could cause a significant In Australia, Prime Minister Malcolm
market disruption. However, there Turnbulls plan to buttress his
We are increasingly concerned are encouraging noises being coalition majority by dissolving
about the outlook for Japan. There made about the removal of excess both houses of parliament the
remain significant risks that the capacity in heavy industry, as well first double dissolution since
extremely positive changes that as a cleaning-up of bad loans. More 1987 - backfired as the ruling party
have happened over the past few encouragingly, new-credit formation eked out a one-seat majority in
years will not be enough to bolster has slowed in recent months, and a the House of Representatives. The
inflation or lead to more robust continuation of this trend would be a country has continued to struggle
economic growth, especially in the long-term positive in addressing the with political deadlock since the end
face of a sharply appreciating yen. massive leverage issue that exists. of John Howards tenure as prime
Among the positive changes have minister in 2007. Mining stocks
been significantly higher female Southeast Asian markets have continue to perform well, bolstering
participation in the labour force, continued to perform well given a overall market returns. The Reserve
a necessity given the countrys weaker trade-weighted U.S. dollar, Bank of Australia cut its benchmark
rapidly aging population; improved as well as increasingly supportive interest rate to a record low of 1.50%
corporate governance; and economic monetary policy from the regions in early August. The move aided
incentives offered under Abes central banks. In Indonesia, a stocks in the interest-rate-sensitive
reforms. decision by the president to include Financials sector, as most banks
opposition politicians in the cabinet have bolstered net interest margins
and the start of a tax-amnesty
Asia-Pacific excluding Japan by declining to pass on lower rates
program have revived animal to customers.
Brexit has distracted from a renminbi spirits and strengthened consumer
depreciation that has occurred confidence. Elsewhere, Thais voted
largely under the radar. The Chinese in a referendum to approve a new
currency now trades lower against constitution that will usher in a new
the U.S. dollar than it did in early election process.
performance.
40
markets starting this year, driven by The fall in the U.S. dollar since the The consumer and Industrials
an improvement in growth in most beginning of the year has been sectors are attractive given their
areas other than China. a positive for emerging-market dependence on emerging-market
equities. Valuations of emerging- domestic economic growth. On the
Central-bank policies could also market currencies are cheap and other hand, we are less optimistic
have a positive impact on emerging- most countries have built up about companies in the Energy
market equities. First, inflation foreign-exchange reserves to cover and Materials sectors, which tend
has been slowing across emerging short-term financing needs. Only to have relatively poor corporate
markets, which could allow for more the Chinese renminbi still appears governance and invest in low-return
accommodative policies. Moreover, expensive. Looking ahead, any projects. We are taking a more
interest rates in many emerging further U.S. dollar strength will likely positive view of cyclical areas based
markets (unlike developed markets) be against other developed-market on relatively attractive valuations
are higher than inflation, which gives currencies rather than emerging- and expectations that countries
their central banks added flexibility market ones. will shift their emphasis to fiscal
to lower rates. Even if the U.S. measures from monetary policy to
Federal Reserve does raise interest One outlier is the Chinese renminbi. stimulate economies.
rates this year, we would expect the Notwithstanding the fact that the
increases to be gradual and not have currency has slipped to its lowest Positioning among countries is
a significant negative impact on level against the U.S. dollar since broadly neutral with the exception
emerging markets. mid-2010, the renminbi still looks of underweight positions in China,
expensive on an inflation-adjusted, South Korea and Russia, where
Valuations for emerging-market trade-weighted basis. To be sure, corporate governance tends to be
equities have increased, but remain widespread concerns surrounding relatively poor, and an overweight
relatively supportive even after the a sharp devaluation of the Chinese position in India, where we find
strong rally in the first half of the currency have subsided. The forces many high-quality companies with
year. The price-to-book ratio has driving the rapid rundown of Chinas good corporate governance.
risen to 1.50 from 1.33 at the end of foreign-exchange reserves in
January, but the current valuation is 2015 and early 2016, such as the
still well below the 10-year mean of repayment of foreign-currency debt
1.90. Valuations are also supportive by onshore corporations, seem to
compared with those for developed- have been largely exhausted. Going
market equities, with the emerging- forward, we expect the renminbi to
market P/B ratio at a more than 30% experience a gradual and managed
discount to developed markets, depreciation.
compared with the average discount
of 17% since 2000.
Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc., which has total assets under management of $378 billion. Mr. Chornous is
responsible for the overall direction of investment policy and fund management. In addition, he chairs the RBC Investment Strategy Committee, the group responsible
for global asset-mix recommendations and global-fixed income and equity portfolio construction for use in RBC Wealth Managements key client groups including
retail mutual funds, International Wealth Management, RBC Dominion Securities Inc. and RBC Phillips, Hager & North Investment Counsel Inc. He also serves on the
Board of Directors of the Canadian Coalition for Good Governance and is Chair of its Public Policy Committee. Prior to joining RBC Asset Management in November
2002, Mr. Chornous was Managing Director, Capital Markets Research and Chief Investment Strategist at RBC Capital Markets. In that role, he was responsible for
developing the firms outlook for global and domestic economies and capital markets as well as managing the firms global economics, technical and quantitative
research teams.
Ray Mawhinney
Hanif Mamdani Senior Vice President and
Head of Alternative Investments Senior Portfolio Manager
RBC Global Asset Management RBC Global Asset Management
Hanif Mamdani is Head of both Corporate Bond Investments and Alternative Ray leads the U.S. Equity team in Toronto and brings a wealth of expertise to
Investments. He is responsible for the portfolio strategy and trading execution his role, having specialized in U.S. equities since 1984. He joined the firm
of all investment-grade and high-yield corporate bonds. Hanif is Lead Manager in 1992 and is involved in managing several of the firm's U.S. equity funds.
of the PH&N High Yield Bond Fund and the PH&N Absolute Return Fund (a Ray is also a member of the RBC GAM Investment Policy Committee, which
multi-strategy hedge fund). He is also a member of the Asset Mix Committee. determines asset mix for balanced products, and the RBC GAM Investment
Prior to joining the firm in 1998, he spent 10 years in New York with two global Strategy Committee, which establishes a global asset mix covering mutual
investment banks working in a variety of roles in Corporate Finance, Capital funds, as well as portfolios for institutions and high-net-worth private clients.
Markets and Proprietary Trading. Hanif holds a master's degree from Harvard Ray graduated from the University of Manitoba with a bachelor's of commerce
University and a bachelor's degree from the California Institute of Technology degree in finance, with honours.
(Caltech).
>> Philippe Langham >> Stuart Morrow, CFA >> Martin Paleczny, CFA
Senior Portfolio Manager, Portfolio Manager, U.S. Equities & V.P. & Senior Portfolio Manager,
Emerging Markets Vice President Global Equity Research Asset Allocation & Derivatives
RBC Global Asset Management (UK) RBC Global Asset Management Inc. RBC Global Asset Management Inc.
Limited
>> Mayur Nallamala >> Dominic Wallington
>> Ray Mawhinney Head & Senior V.P., Asian Equities Chief Investment Officer,
Senior V.P. & Senior Portfolio Manager, RBC Investment Management (Asia) RBC Global Asset Management (UK)
U.S. & Global Equities Limited Limited
RBC Global Asset Management Inc.
>> Dagmara Fijalkowski, MBA, CFA >> Suzanne Gaynor >> Eric Lascelles
Head, Global Fixed Income & Currencies V.P. & Senior Portfolio Manager, Global Chief Economist
(Toronto and London) Fixed Income & Currencies RBC Global Asset Management Inc.
RBC Global Asset Management Inc. RBC Global Asset Management Inc.