THE GLOBAL INVESTMENT OUTLOOK RBC GAM Investment Strategy Committee

NEW YEAR 2018 THE RBC GAM INVESTMENT STRATEGY COMMITTEE

The RBC GAM Investment Strategy Committee These include: consists of senior investment professionals ●●the recommended mix of cash, fixed income drawn from all areas of RBC GAM. The Committee instruments, and equities regularly receives economic and capital ●●the recommended global exposure of fixed markets related input from internal and external income and equity portfolios sources. Important guidance is provided by the Committee’s regional equity advisors (North ●●the optimal term structure for fixed income America, Europe, Asia, Emerging Markets) and investments from the Global Fixed Income & Currencies ●●the suggested sector and geographic make-up sub-committee. From this, the Committee builds within equity portfolios a detailed global investment forecast looking one ●●the preferred exposure to major currencies year forward. Results of the Committee’s deliberations are The Committee’s view includes an assessment published quarterly in The Global Investment of global fiscal and monetary conditions, Outlook. projected economic growth and inflation, as well as the expected course of interest rates, major currencies, corporate profits and stock prices.

From this global forecast, the RBC GAM Investment Strategy Committee develops specific guidelines that can be used to manage portfolios. CONTENTS

EXECUTIVE SUMMARY 2 CURRENCY MARKETS 52 The Global Investment Outlook Dagmara Fijalkowski, MBA, CFA – Head, Global Fixed Income and Currencies, Eric Savoie, MBA, CFA – Senior Analyst, Investment Strategy, RBC Global Asset Management Inc. RBC Global Asset Management Inc. Daniel Mitchell, CFA – Portfolio Manager, Daniel E. Chornous, CFA – Chief Investment Officer, RBC Global Asset Management Inc. RBC Global Asset Management Inc.

REGIONAL EQUITY MARKET OUTLOOK ECONOMIC & CAPITAL MARKETS FORECASTS 4 RBC GAM Investment Strategy Committee United States 60 Brad Willock, CFA – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc. RECOMMENDED ASSET MIX 5 RBC GAM Investment Strategy Committee Canada 62 Irene Matsyalko, CFA – Portfolio Manager, RBC Global Asset Management Inc. CAPITAL MARKETS PERFORMANCE 10 Sarah Neilson, CFA – Portfolio Manager, Milos Vukovic, MBA, CFA – V.P. & Head of Investment Policy, RBC Global Asset Management Inc. RBC Global Asset Management Inc. Europe 64 GLOBAL INVESTMENT OUTLOOK 13 James Jamieson – Portfolio Manager, RBC Global Asset Management (UK) Limited Secular stagnation ebbs Eric Lascelles – Chief Economist, Asia 66 RBC Global Asset Management Inc. Derek Au – Research Analyst, Eric Savoie, MBA, CFA – Senior Analyst, Investment Strategy, RBC Investment Management (Asia) Limited RBC Global Asset Management Inc. Daniel E. Chornous, CFA – Chief Investment Officer, Emerging Markets 68 RBC Global Asset Management Inc. Richard Farrell, CFA – Portfolio Manager, Emerging Market Equities GLOBAL FIXED INCOME MARKETS RBC Global Asset Management (UK) Limited The bond-market outlook 46 FEATURED ARTICLE Soo Boo Cheah, MBA, CFA – Senior Portfolio Manager, RBC Global Asset Management (UK) Limited Should indexes have a conscience? 70 The tragedy of Venezuela prompts a rethink of how Taylor Self, MBA – Analyst, RBC Global Asset Management (UK) Limited emerging-market bond indexes are constructed Jane Lesslie, MSc, CFA – V.P. & Senior Portfolio Manager, Direction of rates 49 Fixed Income and Currencies – Emerging Markets Soo Boo Cheah, MBA, CFA – Senior Portfolio Manager, RBC Global Asset Management Inc. RBC Global Asset Management (UK) Limited Earl D’Almeida, MBA, CFA – Analyst, Suzanne Gaynor – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc. RBC Global Asset Management Inc. RBC GAM INVESTMENT STRATEGY COMMITTEE 84

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 1 EXECUTIVE SUMMARY

Global expansion gains to rising interest rates. Canada’s Eric Savoie, MBA, CFA momentum housing market is also susceptible to Senior Analyst, Investment Strategy higher borrowing costs, as are a variety We are increasingly of the view that RBC Global Asset Management Inc. of exotic investment instruments that the secular stagnation that held back rely on leverage to boost returns in Daniel E. Chornous, CFA economic growth for much of the past a low-yield world. Fortunately, the Chief Investment Officer decade may be finally fading as the RBC Global Asset Management Inc. current environment also features a bad memories of the financial crisis number of positive developments. recede, a new generation of business These are related to fading concerns leaders rises to power, animal spirits surrounding secular stagnation, Global economic growth revive and business investment picks structural factors inhibiting an up. Also buoying the economy is the is running at its fastest unwelcome surge in inflation and the fact that financial conditions remain potential for governments to deploy friendly thanks to still-low government clip in seven years thanks fiscal stimulus, particularly in the U.S. bond yields, narrow credit spreads, to a number of positive rising equities and oil prices in a sweet Post-U.S. election optimism factors. The expansion is spot that supports global growth without punishing oil exporters. persists increasingly broad-based Looking forward, we anticipate further The election of President Trump a and signs of weakness strong, above-consensus GDP growth year ago appeared to have had a and rising, above-consensus inflation. significantly positive effect on global in the economy are not Our global GDP forecast is for 3.8% confidence. The rationality of this yet in evidence. Robust growth in 2018 – an upward revision optimism is debatable – Trump’s from the prior estimate. Growth in proposed policies have at best confidence measures 2018 should just surpass 2017, itself mixed implications, few have been and risk appetite are also the fastest pace in several years. implemented so far, and fewer still would appear to benefit any country fueling macroeconomic Challenges remain, but upside but the U.S. Nevertheless, we potential exists too cannot ignore that consumers and strength. There are a number of risks that businesses both began to feel much could challenge our above-consensus more confident about their economic view. The business cycle is aging, prospects immediately after the protectionism is on the ascent and election, and this positive sentiment international relations have become can boost economic growth. precarious in several pockets of the world. After dodging several U.S. dollar bull market populist threats, European politics maturing now face another onslaught of We’re nearing the end of the U.S. challenges in the form of elections, dollar upswing, but it’s a process that independence movements and will take time, possibly years. Patience nationalist governments. Chinese risks is now required as the environment have shrunk given stabilizing growth is one where foreign-exchange and improving debt metrics, but the fluctuations are no longer driven country’s economy is still likely to predominantly by the direction of the decelerate over time and the highly U.S. dollar, but rather by the relative indebted corporate sector is vulnerable merits of each currency. Differences

2 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Executive Summary | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

in growth and balance-of-payments will likely be gradual and occur over the U.S. could provide an additional dynamics are likely to be the key a period spanning many years. Our boost to profits, though at least some factors going forward and, with that fixed-income models suggest that portion of the anticipated changes has in mind, we expect the euro and the real (after-inflation) interest rates already been priced in. Given current yen to fare better than the pound and are currently too low. Some of the valuations, stocks would be vulnerable Canadian dollar. factors that have been depressing if earnings underwhelm and/or real interest rates include unorthodox Congress fails to enact the proposed Firming inflation may be monetary policy and a heightened tax changes. limited by structural forces demand for safe-haven assets. But Several factors suggest higher inflation in an environment where economic Asset mix: maintaining over the next year. Commodity prices growth is gaining momentum and overweight stocks, have rebounded, developed-world secular stagnation may be starting underweight bonds to lessen its grip, we would expect economies are approaching their In our base case scenario of improving real interest rates to ultimately rise full potential and we detect rising economic growth and firming inflation, back towards their long-term average wages amid an increasingly tight prospective returns for sovereign as investors (savers) at some point labour market. Counteracting these bonds are especially unattractive. demand a true after-inflation payment positives are some structural pressures The capital loss from rising yields is to defer consumption. Our models that may limit how quickly inflation likely to offset any income earned from assume this reversion occurs over the can rise. The constraints include coupon payments, resulting in low or next five years, though we would place adverse demographics, the effects of even negative returns for sovereign emphasis on the direction rather than globalization and some technology- bonds, perhaps over many years. In the exact timing. induced deflation. To be clear, inflation comparison, stocks continue to offer can still accelerate and likely will, but Global equities narrow superior total-return potential. We not by quite as much as traditional recognize, however, that the deep models might indicate. discount to fair value, become discounts available at earlier stages more dependent on earnings of the bull market have been erased Central banks continue to growth to sustain the bull and that further gains for equities dial back accommodative market will depend on earnings growth. We policies in response to firming Global stock markets continue to be are watching ever more diligently for economic backdrop supported by the synchronized global signs of a top in equity markets, but we are not seeing an abundance of As growth has picked up, economic expansion and better-than-expected signals that would indicate the end of slack diminishes and inflation begins corporate profit growth around the the cycle. We had been reducing risk edging higher, central banks are world, but the recent rally has pushed exposure in our asset mix over the past responding with a slow pivot away equities closer to fair value. The S&P several quarters, but have opted to from extreme monetary stimulus. The 500, in particular, hovers just below pause this quarter given the absence U.S. Federal Reserve (Fed), the Bank of the midpoint of its fair-value band of technical deterioration, the ongoing Canada (BOC) and the Bank of England and, while our model doesn’t suggest strength in profits and the increased (BOE) have all begun travelling down stocks are as expensive as some possibility of meaningful U.S. this tightening path, with the Fed other popular metrics, we recognize corporate-tax cuts coming to fruition. leading the way. Others, such as the it may be prudent to lower total- As a result, we have maintained a European Central Bank (ECB), are still return expectations and consider the moderate overweight in stocks and some distance away but are beginning potential for higher volatility in the underweight in fixed income. For a to at least reduce their rate of stimulus months ahead. Without support from balanced, global investor, we currently delivery. rising valuations, further gains in stocks will likely be paced by corporate recommend an asset mix of 58% profit growth. Earnings have indeed equities (strategic neutral position: Global bond yields remain too 55%) and 39% fixed income (strategic low according to our models been coming through and analysts are optimistic that the positive trend neutral position: 43%), with the We expect bond yields to continue can persist. Corporate tax cuts in balance in cash. moving higher, but that the pace

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 3 ECONOMIC & CAPITAL MARKETS FORECASTS

ECONOMIC FORECAST (RBC GAM INVESTMENT STRATEGY COMMITTEE)

UNITED UNITED EMERGING STATES CANADA EUROPE KINGDOM JAPAN CHINA MARKETS* Change Change Change Change Change Change Change from from from from from from from New Year Fall New Year Fall New Year Fall New Year Fall New Year Fall New Year Fall New Year Fall 2018 2017 2018 2017 2018 2017 2018 2017 2018 2017 2018 2017 2018 2017 REAL GDP 2016A 1.60% 1.43% 1.68% 1.85% 0.99% 6.73% 4.99% 2017E 2.25% N/C 3.00% 0.25 2.25% 0.25 1.50% N/C 1.75% N/C 6.75% N/C 5.50% N/C 2018E 2.75% 0.25 1.50% N/C 2.00% 0.25 1.50% N/C 1.50% 0.50 6.00% N/C 5.50% N/C CPI 2016A 1.28% 1.41% 0.25% 0.65% 0.77% 2.12% 3.66% 2017E 2.00% N/C 1.50% N/C 1.50% N/C 2.75% N/C 0.50% N/C 1.50% (0.25) 2.50% N/C 2018E 2.00% N/C 2.00% (0.25) 1.50% N/C 2.75% N/C 1.25% N/C 2.25% (0.25) 3.00% (0.25) A = Actual E = Estimate *GDP Weighted Average of China, India, South Korea, Brazil, Mexico and Russia.

TARGETS (RBC GAM INVESTMENT STRATEGY COMMITTEE)

FORECAST CHANGE FROM 1-YEAR TOTAL RETURN NOVEMBER 2017 NOVEMBER 2018 FALL 2017 ESTIMATE* (%) CURRENCY MARKETS AGAINST USD CAD (USD–CAD) 1.29 1.37 N/C (6.0) EUR (EUR–USD) 1.19 1.12 0.05 (7.8) JPY (USD–JPY) 112.54 110.00 N/C 0.5 GBP (GBP–USD) 1.35 1.15 N/C (15.9) FIXED INCOME MARKETS U.S. Fed Funds Rate** 1.25 1.88 0.25 N/A U.S. 10-Year Bond 2.41 2.75 N/C (0.5) Canada Overnight Rate 1.00 1.50 0.25 N/A Canada 10-Year Bond 1.89 2.25 0.15 (1.3) Eurozone Deposit Facility Rate -0.40 -0.40 N/C N/A Germany 10-Year Bund 0.37 0.90 0.15 (4.7) U.K. Base Rate 0.50 0.75 0.25 N/A U.K. 10-Year Gilt 1.33 1.75 0.25 (2.5) Japan Overnight Call Rate -0.06 -0.10 N/C N/A Japan 10-Year Bond 0.04 0.10 N/C (0.6) EQUITY MARKETS S&P 500 2648 2800 175 7.6 S&P/TSX Composite 16067 16350 250 4.6 MSCI Europe 130 139 5 10.0 FTSE 100 7327 7700 (150) 9.2 Nikkei 22725 25000 3500 11.7 MSCI Emerging Markets 1121 1215 40 10.9 *Total returns are expressed in local currencies with the exception of MSCI Emerging Markets whose return is expressed in USD. **The FOMC raised the target range for the federal funds rate to 1.25% - 1.50%, a 25-basis-point increase from the prior range, on December 13, 2017. Source: RBC GAM

4 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 RECOMMENDED ASSET MIX

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 investor’s 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. 1 2 returns and the volatility 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 1977 – 2017, 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.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 5 Recommended Asset Mix

GLOBAL ASSET MIX BENCHMARK PAST NEW YEAR SPRING SUMMER FALL NEW YEAR POLICY RANGE 2017 2017 2017 2017 2018 CASH 2.0% 1.0% – 16% 1.0% 2.0% 3.0% 3.0% 3.0%

BONDS 43.0% 25.0% – 54.0% 38.0% 38.0% 38.0% 39.0% 39.0%

STOCKS 55.0% 36.0% – 65.0% 61.0% 60.0% 59.0% 58.0% 58.0% Note: Effective September 1, 2014, we revised our strategic neutral positions within fixed income, lowering the ‘neutral’ commitment to cash from 5% to 2%, and moving the difference to bonds. This takes advantage of the positive slope of the yield curve which prevails over most time periods, and allows our fixed income managers to shorten duration and build cash reserves whenever a correction in the bond market, or especially an inverted yield curve, is anticipated.

REGIONAL ALLOCATION CWGBI* PAST NEW YEAR SPRING SUMMER FALL NEW YEAR GLOBAL BONDS NOV. 2017 RANGE 2017 2017 2017 2017 2018 North America 39.6% 18% – 44% 38.1% 44.2% 44.3% 34.1% 37.1% Europe 40.6% 32% – 56% 33.5% 36.4% 34.1% 40.4% 38.1% Asia 19.7% 17% – 35% 28.4% 19.5% 21.6% 25.5% 24.7%

Note: Past Range reflects historical allocation from Fall 2002 to present.

MSCI** PAST NEW YEAR SPRING SUMMER FALL NEW YEAR GLOBAL EQUITIES NOV. 2017 RANGE 2017 2017 2017 2017 2018 North America 60.8% 51% – 61% 60.3% 60.8% 59.9% 59.9% 60.0% Europe 20.5% 20% – 35% 20.3% 20.3% 21.3% 20.6% 20.6% Asia 11.4% 9% – 18% 11.9% 11.4% 11.4% 12.0% 11.9% 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.

GLOBAL EQUITY SECTOR ALLOCATION MSCI** RBC GAM ISC RBC GAM ISC CHANGE FROM WEIGHT VS. NOV. 2017 FALL 2017 NEW YEAR 2018 FALL 2017 BENCHMARK Energy 6.27% 4.95% 4.37% (0.59) 69.7% Materials 5.19% 5.98% 6.09% 0.11 117.3% Industrials 11.49% 12.42% 13.29% 0.87 115.7% Consumer Discretionary 12.06% 11.27% 14.06% 2.78 116.6% Consumer Staples 8.87% 9.49% 8.87% (0.62) 100.0% Health Care 11.95% 12.95% 12.85% (0.10) 107.5% Financials 18.02% 18.13% 18.02% (0.10) 100.0% Information Technology 17.18% 18.15% 19.18% 1.03 111.6% Telecom. Services 2.71% 2.00% 0.71% (1.29) 26.3% Utilities 3.15% 3.25% 1.25% (2.00) 39.7% Real Estate 3.12% 1.41% 1.32% (0.10) 42.2% *Citigroup World Global Bond Index **MSCI World Index Source: RBC GAM Investment Strategy Committee

6 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Recommended Asset Mix

At RBC GAM, we have a team dedicated to setting and reviewing the strategic asset mix for all of our multi-asset solutions. With “an emphasis on consistency of returns, risk management and capital preservation, we have developed a strategic asset allocation framework for five client risk profiles that correspond to broad investor objectives and risk preferences. These five profiles range from Very Conservative through Balanced to Aggressive Growth. ”

VERY CONSERVATIVE Very Conservative investors will BENCH- LAST CURRENT 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% 74.1% 74.1% capital growth, and be comfortable with Total Cash & Fixed Income 80% 65-95% 77.0% 77.0% small fluctuations in the value of their Canadian Equities 10% 5-20% 10.6% 10.6% investments. This portfolio will invest U.S. Equities 5% 0-10% 5.9% 6.0% primarily in fixed-income securities, and International Equities 5% 0-10% 6.5% 6.4% 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% 23.0% 23.0% against inflation. Investors who fit this profile generally plan to hold their RETURN VOLATILITY investment for the short to medium term 40-Year Average 8.7% 5.5% (minimum one to five years). Last 12 Months 4.8% 3.7%

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 7 Recommended Asset Mix

CONSERVATIVE Conservative investors will pursue BENCH- LAST CURRENT ASSET CLASS MARK RANGE QUARTER RECOMMENDATION modest income and capital growth with Cash & Cash Equivalents 2% 0-15% 2.9% 2.9% reasonable capital preservation, and be Fixed Income 63% 40-80% 59.0% 59.0% comfortable with moderate fluctuations Total Cash & Fixed Income 65% 50-80% 61.9% 61.9% in the value of their investments. The Canadian Equities 15% 5-25% 15.6% 15.6% portfolio will invest primarily in fixed- U.S. Equities 10% 0-15% 10.9% 11.0% income securities, with some equities, to International Equities 10% 0-15% 11.6% 11.5% achieve more consistent performance and Emerging Markets 0% 0% 0.0% 0.0% provide a reasonable amount of safety. Total Equities 35% 20-50% 38.1% 38.1% The profile is suitable for investors who

RETURN VOLATILITY plan to hold their investment over the 40-Year Average 9.0% 6.5% medium to long term (minimum five to Last 12 Months 7.0% 3.8% 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% 39.0% 39.0% preservation, with a secondary focus on Total Cash & Fixed Income 45% 30-60% 42.0% 42.0% modest income, and who are comfortable Canadian Equities 19% 10-30% 19.5% 19.5% with moderate fluctuations in the value U.S. Equities 20% 10-30% 20.8% 20.9% of their investments. More than half the International Equities 12% 5-25% 13.4% 13.3% portfolio will usually be invested in a Emerging Markets 4% 0-10% 4.3% 4.3% diversified mix of Canadian, U.S. and Total Equities 55% 40-70% 58.0% 58.0% global equities. This profile is suitable

RETURN VOLATILITY for investors who plan to hold their 40-Year Average 9.4% 7.7% investment for the medium to long term Last 12 Months 10.3% 4.2% (minimum five to seven years).

8 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Recommended Asset Mix

GROWTH Investors who fit theGrowth profile BENCH- LAST CURRENT ASSET CLASS MARK RANGE QUARTER RECOMMENDATION will seek long-term growth over capital Cash & Cash Equivalents 2% 0-15% 3.0% 3.0% preservation and regular income, and Fixed Income 28% 5-40% 23.9% 23.9% be comfortable with considerable Total Cash & Fixed Income 30% 15-45% 26.9% 26.9% fluctuations in the value of their Canadian Equities 23% 15-35% 23.5% 23.5% investments. This portfolio primarily U.S. Equities 25% 15-35% 25.8% 25.9% holds a diversified mix of Canadian, U.S. International Equities 16% 10-30% 17.4% 17.3% and global equities and is suitable for Emerging Markets 6% 0-12% 6.4% 6.4% investors who plan to invest for the long Total Equities 70% 55-85% 73.1% 73.1% term (minimum seven to ten years).

RETURN VOLATILITY 40-Year Average 9.6% 9.4% Last 12 Months 12.7% 4.6%

AGGRESSIVE GROWTH Aggressive Growth investors seek BENCH- LAST CURRENT ASSET CLASS MARK RANGE QUARTER RECOMMENDATION maximum long-term growth over capital Cash & Cash Equivalents 2% 0-15% 2.0% 2.0% 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% 2.0% 2.0% in the value of their investments. The Canadian Equities 32.5% 20-45% 31.8% 31.8% portfolio is almost entirely invested in U.S. Equities 35.0% 20-50% 34.8% 34.9% stocks and emphasizes exposure to International Equities 21.5% 10-35% 22.2% 22.1% global equities. This investment profile Emerging Markets 9.0% 0-15% 9.2% 9.2% is suitable only for investors with a high Total Equities 98% 80-100% 98.0% 98.0% risk tolerance and who plan to hold their

RETURN VOLATILITY investments for the long term (minimum 40-Year Average 10.3% 12.1% seven to ten years). Last 12 Months 17.0% 5.5%

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 9 CAPITAL MARKETS PERFORMANCE

continued subdued inflation and Over the past year, growth stocks in Milos Vukovic, MBA, CFA modest economic growth. The FTSE the U.S. significantly outperformed V.P. & Head of Investment Policy TMX Canada Universe Bond Index, value stocks – the Russell 3000 RBC Global Asset Management Inc. Canada’s fixed-income benchmark, Growth Index gained 30.3%, while dropped 2.2% in U.S. dollar terms. the Russell 3000 Value Index returned only 14.7%. The U.S. dollar appreciated against Global equities surged during two of the four major currencies the three-month period, as All of the 11 global equity sectors during the three-month period strengthening economic growth recorded gains during the quarter ended November 30, 2017, falling around the world pushed earnings ended November 30, 2017. The only against the British pound. The higher. The S&P 500 Index rose best-performing sector was Energy greenback rose 3.3% versus the 7.7% and the MSCI Japan gained with a return of 11.0%, followed by Canadian dollar and 2.4% versus 9.9%. The MSCI Germany climbed Information Technology, which rose the yen, while finishing essentially 8.5%, while the MSCI U.K. returned 9.5%, and Financials with a 7.8% unchanged against the euro and 4.1%. Over the 12-month period, gain. The worst-performing sector declining 4.4% against sterling. For the S&P 500 gained 22.9% and the over the three-month period was the latest 12-month period, the U.S. MSCI Japan rose 24.3%. In Europe, Telecommunication Services, which dollar declined against all four major the MSCI Germany returned 36.6%, returned 1.5%. currencies, falling 11.0% versus the the MSCI France gained 36.1% and euro, 7.5% versus the pound, 4.0% the MSCI U.K. returned 21.3%, all against the Canadian dollar and in U.S. dollar terms. The S&P/TSX 1.6% against the yen. Composite Index gained 3.0% in U.S. dollar terms during the three Major fixed-income markets were months. For the 12-month period, mixed during the three-month the S&P/TSX benchmark index period, with the U.S. and Japan down gained 14.1%. slightly versus gains in Europe amid

10 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Capital Markets Performance | Milos Vukovic, MBA, CFA

EXCHANGE RATES Periods ending November 30, 2017 Current 3 months YTD 1 year 3 years 5 years USD (%) (%) (%) (%) (%) USD–CAD 1.2902 3.32 (3.91) (3.96) 4.09 5.37 USD–EUR 0.8402 0.02 (11.56) (10.96) 1.49 1.79 USD–GBP 0.7394 (4.38) (8.87) (7.48) 4.96 3.45 USD–JPY 112.5450 2.37 (3.70) (1.63) (1.75) 6.42 Note: all changes above are expressed in US dollar terms CANADA Periods ending November 30, 2017 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 TR (2.16) 7.13 6.65 (1.15) (2.19) 1.09 2.43 2.90 U.S. Periods ending November 30, 2017 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 TR (0.54) 3.11 3.24 2.12 1.98 2.75 (0.84) 6.29 Barclays Capital Agg. Bond Index TR (0.55) 3.07 3.21 2.11 1.98 2.75 (0.87) 6.29 GLOBAL Periods ending November 30, 2017 USD CAD 3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years Fixed Income Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%) Citigroup WGBI TR (0.11) 7.09 6.74 1.61 0.81 3.20 2.51 5.77 Citigroup European Government TR 1.33 13.56 13.78 0.58 2.13 4.69 9.28 4.70 Citigroup Japanese Government TR (2.41) 3.95 1.01 3.89 (3.85) 0.83 (2.98) 8.14 CANADA Periods ending November 30, 2017 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 2.96 12.19 14.11 1.85 3.25 6.37 9.60 6.01 S&P/TSX 60 3.99 12.98 14.88 2.30 3.94 7.44 10.33 6.48 S&P/TSX Small Cap 0.82 4.24 8.32 2.05 (0.08) 4.16 4.04 6.22 U.S. Periods ending November 30, 2017 USD CAD 3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years Equity Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%) S&P 500 TR 7.65 20.49 22.87 10.91 15.74 11.22 18.01 15.45 S&P 400 TR 10.17 15.99 18.53 11.37 15.46 13.83 13.84 15.93 S&P 600 TR 12.56 13.83 17.66 13.25 16.87 16.29 13.01 17.88 Russell 3000 Value TR 7.14 11.76 14.70 8.53 14.16 10.69 10.17 12.97 Russell 3000 Growth TR 8.56 28.65 30.25 12.95 17.03 12.16 25.10 17.58 NASDAQ Composite Index TR 6.93 27.69 29.12 12.78 17.96 10.47 24.01 17.40 Note: all rates of return presented for periods longer than 1 year are annualized Source: Bloomberg/MSCI

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 11 Capital Markets Performance | Milos Vukovic, MBA, CFA

GLOBAL Periods ending November 30, 2017 USD CAD 3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years Equity Markets: Total Return (%) (%) (%) (%) (%) (%) (%) (%) MSCI World TR * 6.43 20.77 23.66 8.19 11.75 9.37 18.48 12.68 MSCI EAFE TR * 5.14 23.06 27.27 5.97 8.24 8.03 21.94 10.37 MSCI Europe TR * 4.01 23.64 30.12 4.61 7.64 6.88 24.67 8.96 MSCI Pacific TR * 7.25 22.56 23.12 8.88 9.51 10.21 17.97 13.40 MSCI UK TR * 4.06 16.51 21.33 1.54 4.63 6.93 16.25 5.76 MSCI France TR * 6.10 29.04 36.14 8.69 9.77 9.02 30.44 13.20 MSCI Germany TR * 8.45 27.66 36.56 7.15 9.53 11.44 30.85 11.60 MSCI Japan TR * 9.85 23.13 24.32 10.83 12.16 12.88 19.12 15.43 MSCI Emerging Markets TR * 3.30 32.53 32.82 6.15 4.61 6.15 27.26 10.55

GLOBAL EQUITY SECTORS Periods ending November 30, 2017 USD CAD 3 months YTD 1 year 3 years 5 years 3 months 1 year 3 years Sector: Total Return (%) (%) (%) (%) (%) (%) (%) (%) Energy TR * 10.99 0.29 3.93 (1.02) 0.62 14.05 (0.42) 3.09 Materials TR * 6.01 24.27 26.15 8.07 5.74 8.94 20.87 12.55 Industrials TR * 7.50 23.21 24.30 10.42 13.29 10.46 19.10 15.01 Consumer Discretionary TR * 7.73 21.05 22.65 9.45 14.33 10.70 17.52 14.00 Consumer Staples TR * 2.76 14.81 18.23 6.68 9.78 5.60 13.28 11.11 Health Care TR * 2.29 19.88 21.76 5.09 13.98 5.11 16.66 9.46 Financials TR * 7.81 20.36 25.12 8.84 12.40 10.78 19.88 13.36 Information Technology TR * 9.54 38.31 40.25 16.71 19.39 12.55 34.38 21.56 Telecommunication Services TR * 1.46 4.55 10.77 2.28 7.76 4.26 6.14 6.53 Utilities TR * 2.05 19.39 24.63 5.70 9.22 4.87 19.41 10.09 Real Estate TR * 2.41 13.75 16.24 NA NA 5.23 11.37 NA

* Net of taxes Note: all rates of return presented for periods longer than 1 year are annualized Source: Bloomberg/MSCI

12 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 GLOBAL INVESTMENT OUTLOOK Secular stagnation ebbs

Eric Lascelles Exhibit 1: Global manufacturing expansion continues Chief Economist RBC Global Asset Management Inc. 57 56 Eric Savoie, MBA, CFA 55 Senior Analyst, Investment Strategy Expansion 54 RBC Global Asset Management Inc. 53

52 Daniel E. Chornous, CFA 51 Chief Investment Officer 50

RBC Global Asset Management Inc. PMI Manufacturing 49 48 47 Contraction Global economic growth is travelling 2012 2013 2014 2015 2016 2017 J.P.Morgan Global PMI Developed markets PMI Emerging markets PMI at the highest altitude in seven Note: PMI refers to Purchasing Managers Index for manufacturing sector, a measure for economic years thanks to a confluence of activity. Source: Haver Analytics, RBC GAM positive supports (Exhibit 1). The expansion is highly synchronized, Exhibit 2: Investors in risk-seeking mode encompassing the bulk of developed and many emerging-market nations. 2 Measures of confidence and risk Loving 1 appetite are also robust, benefiting Seeking from this macroeconomic strength 0 Neutral and simultaneously helping to -1 Reluctant sustain it (Exhibit 2). -2 We are increasingly of the view that Averse -3 secular stagnation – the plague of Risk appetite index (average = 0) = (average index appetite Risk fear and diminished expectations -4 1991 1998 2005 2012 2017 that enfeebled the post-crisis Note: Measures risk appetite based on 45 normalized inputs. Source: Bloomberg, BofA ML, Consensus Economics, Credit Suisse, Federal Reserve Bank of Philadelphia, Haver Analytics, NedDavis, RBC GAM period – is starting to lessen its grip. This helps to explain better growth today and offers the hope the U.S. business cycle looks to be pivot offers a few things to like, but of sustainably faster growth in at a fairly late stage, if hardly at the also a few to fret over. very end of the cycle (Exhibit 3). We the future, though not a complete For now, markets remain return to the pre-crisis trajectory are now on watch for evidence of excessive risk-taking – a classic sign preternaturally calm. There is given other headwinds still in place. some logic to this, but it is not fully Against this backdrop, our own of an economic cycle on its last legs. Tightening central banks introduce justified (Exhibit 4). Market technical growth forecasts have edged a signals are similarly stretched, with little higher and are overall above a narrative twist not experienced in over a decade. valuations across most asset classes consensus. erring on the optimistic side. At the same time, it is fair to concede U.S. protectionism is another key risk, as are several geopolitical Synthesizing these disparate that there are considerable risks to observations into a coherent this rosy narrative. Among them, considerations. China’s recent policy

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 13 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

whole, we are content to maintain a modest equity-overweight Exhibit 3: U.S. business-cycle probability position given the superior relative valuation of equities over bonds, Most likely here strong economic momentum, our Conceivably hypothesis that secular stagnation is here fading and the potential for U.S. tax cuts to provide a further push higher. A smaller risk

That said, let us acknowledge that Likelihood our tendency has been to gradually reduce this overweight over the past year – largely for business-cycle reasons – and that this trend could Start of cycle Early cycle Mid cycle Late cycle End of cycle Recession yet re-emerge in coming quarters. Note: Calculated via scorecard technique by RBC GAM. Source: RBC GAM

Macro strength persists Exhibit 4: Market volatility should be low but not this low Global economic growth continues to be quite good by post-crisis 0.8 standards. The synchronized 0.6 0.4 acceleration that began in the middle 0.2 of 2016 has mostly transformed into 0.0 -0.2 steady, robust growth. But there are -0.4 -0.6 tentative signals that it may have deviations) -0.8 -1.0 sped up again in the latter half of 2004-07 2010 2011 2012 2013 2014 2015 2016 2017

2017. Looking forward, we anticipate Z (number of score standard average External spillovers Funding and liquidity conditions further robust, above-consensus Corporate performance Macroeconomic fundamentals VIX Index Model-fitted VIX index GDP growth and rising, above- Note: IMF volatility model estimated using an ordinary least square regression with explanatory variables including U.S. GDP growth, Citi U.S. Economic Surprise Index, net income to assets and payouts to assets consensus inflation. for S&P 500 companies, TED spread, cross-currency basis swap rates, yield spreads and supply of U.S. Treasuries. Source: IMF GFSR October 2017, RBC GAM This quickening of growth was not the work of policymakers. The global fiscal impulse remains roughly flat Exhibit 5: Global macro forecast summary and several prominent central banks have begun the gradual Vs. market Key points removal of monetary stimulus. Growth •• Strong momentum Instead, we see several other factors Modestly •• Friendly financial conditions above •• Political/fiscal optimism at play (Exhibit 5). consensus •• Classic late-cycle behavior •• Secular stagnation fading? Financial conditions remain friendly thanks to still-low government Inflation •• Oil to rise slightly Modestly •• Economies tighten yields, narrow credit spreads, rising above •• Wages to rise – Phillips curve equities and oil prices in a sweet consensus •• Central banks more stimulative than policy rules suggest spot that supports global growth without punishing oil exporters. The Source: RBC GAM

14 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

fairly late point of the business cycle is also frequently associated with Exhibit 6: Global credit impulse treads lower solid economic growth.

20 The U.S. election of a year ago Credit impulse adds to GDP growth appeared to have had a powerfully 10 positive effect on global confidence. 0 The rationality of this trigger is -10 debatable – President Trump’s (ppt) proposed policies have at best -20 mixed implications, few have been Global credit impulse for -30 Credit impulse detracts implemented so far, and fewer from GDP growth private non-financial corporations -40 still would appear to benefit any 2001 2003 2005 2007 2009 2011 2013 2015 2017 Note: Credit impulse measured as year-over-year change in year-over-year change in credit country but the U.S. Nevertheless, outstanding as percentage of GDP. Source: IIF, RBC GAM it is undeniable that consumers and businesses both began to feel much more confident about their economic Exhibit 7: Keep structural headwinds to economic growth in mind prospects immediately after the election, and such sentiment can Human factors Economic structure Post-crisis boost economic growth. • Demographics: • Fading globalization • Populism/protectionism – Slower population growth • Declining creative • Secular stagnation We also continue to think, with – Rising retired % destruction – Diminished – Lower firm turnover expectations growing conviction, that the plague • Decelerating gains: – Education – Higher firm – Less business concentration investment of secular stagnation that held back – Health • Regulatory burden – Skill decay economic growth for much of the – Urbanization • Goods  services • Debt excesses • Rising complacency: past decade may finally be starting • Maturing EM economies – Servicing – Low labor mobility to fade as the bad memories of the – Deleveraging – More segregated Technology financial crisis ebb, a new generation – Less risk-taking • Running out of big new of business leaders takes the helm, • Falling societal trust innovations? animal spirits revive and business Source: RBC GAM investment picks up. A key signal of this – productivity growth – is little repercussions are visible in the just outmuscle 2017, itself the now on the upswing. This boost, if economy to date (Exhibit 6). Finally, fastest clip in several years. This genuine, would enable faster growth let’s not forget that there are many outlook means that macroeconomic on a sustained basis. reasons why future growth is unlikely factors should be supportive of Not everything is perfect, of course. to match the sustained heroics of further stock-market gains and yield The aforementioned financial earlier decades (Exhibit 7). increases. conditions, while still helpful, are no We are comfortable with an above- longer actively improving. Similarly, Economic forecast refresh consensus stance on economic the global credit impulse appears Our global GDP forecast is for a growth for a variety of reasons, most to be in negative territory, meaning 3.8% increase in 2018 – an upward discussed in the prior section. But that global credit is growing less revision from the prior estimate and a further technical consideration is quickly than before. This exerts a moderately above the consensus. that there has been a profound shift theoretical drag on growth, though If achieved, growth in 2018 should

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 15 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

in the way that consensus growth forecasts are evolving. For the great Exhibit 8: Consensus forecast starts to trend higher bulk of the post-crisis period, the consensus for each year began too l 4.5 Outlook revised steadily lower for many years...

re a 4.3 d optimistically and then tumbled l

o r ...has finally 4.1 lower until eventually matching w started to turn! of 3.9 2018: the reality of the situation. Betting 3.7% a st (%) below the consensus was reliably 3.7 2017: GD P fore c the winning strategy. That has now 3.5 3.7% sus

n 3.3

changed. Forecasters have been e

s 2012: 2014: beaten down after years of excessive o n 3.1 3.4% 2013: 3.3% 2015: 2016: C 3.2% 3.1% 3.0% optimism at the same moment that 2.9 2012 2013 2014 2015 2016 2017 growth has perked up, leaving above- Date when forecast was made consensus growth forecasts as the Source: Consensus Economics, IMF, RBC GAM new winning strategy (Exhibit 8).

The pillars of this global forecast Exhibit 9: RBC GAM GDP forecast for developed markets are a slightly greater contribution from both developed and emerging 3.5 3.00% economies. Developed countries 3.0 2.75% should collectively grow by 2.2% in 2.5 2.25% 2.25% 2018, their best in nine years, while 2.00% 2.0 1.75% emerging economies should grow by 1.50% 1.50% 1.50% 1.50% 5.4%, their best in four years. 1.5 1.0 Annual GDP growth (%) Naturally, not every country is set 0.5 to trump market expectations. The 0.0 U.S., Eurozone and Japan are the Canada U.S. Eurozone Japan U.K. 2017 2018 developed nations most capable of Source: RBC GAM besting consensus. Canada may lag the consensus for competitiveness and housing-related reasons, while Exhibit 10: RBC GAM CPI forecast for developed markets we are not far from a dreary Brexit- infused consensus for the U.K. 3.0 2.75% 2.75% (Exhibit 9). 2.5 2.00% 2.00% 2.00% Inflation to sneak higher 2.0 1.50% 1.50% 1.50% Above-consensus inflation also 1.5 1.25% seems a reasonable expectation for 1.0 2018 (Exhibit 10). Granted, optimism 0.50% CPI (YoY % change)CPI (YoY has hardly been a winning bet for 0.5 inflation during the post-crisis 0.0 U.K. U.S. Canada Eurozone Japan period. However, we detect several 2017 2018 things beginning to change in favour Source: RBC GAM

16 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

of higher inflation. First, as with the growth outlook, market expectations Exhibit 11: Phillips Curve remains and wages could accelerate are no longer being revised steadily downward from month to month. 6 Furthermore, there are several 5 positives specific to the inflation 4 outlook over the next year: 3 y = -0.5156x + 8.7242 • The commodity shock has ended 2 R² = 0.6002

and for that matter oil prices 1 y = -0.2458x + 6.1751 R² = 0.8556

have recently spurted higher, of prime-age (%) workers 0

with implications for near-term AtlantaFed median wage growth 6 8 10 12 14 16 18 inflation. Broad unemployment rate (%, 3MMA with 12-month lag) Before 2010 2010 and after • Developed-world economies Source: BLS, Federal Reserve Bank of Atlanta, Haver Analytics, RBC GAM are finally approaching their full potential. This unavoidably maps onto greater inflation pressures. Exhibit 12: Inflation barometer: shifting up toward normal inflation

• Despite claims that wages are not responding to faster economic growth, we detect rising wages Debt Large monetary Monetary erosion base policy and still believe that a declining risk/reward unemployment rate must 2 eventually lead to faster wage Inflation growth (Exhibit 11). Commodity Economic Clear inflation prices slack target Inflation 1 Pitted against these positives expectations Demographics Globalization Tech deflation are a somewhat subdued level of • Comparative • Technology prices advantage • Automation inflation expectations and some • Global Phillips curve • Industry disruption structural constraints that arguably Source: RBC GAM make it harder for inflation to rise as nimbly as one would otherwise have expected. The constraints A new project for central banks central-bank balance sheets, and the include adverse demographics, As growth has picked up, economies occasion likely also marks the end of the effects of globalization and tighten, and inflation begins a 34-year bull market in bonds. some technology-induced deflation edging higher, central banks are The U.S. Federal Reserve (Fed), the (Exhibit 12). To be clear, inflation responding with a slow pivot Bank of Canada (BOC) and the Bank can still rise and likely will, but away from extreme monetary of England (BOE) have all begun not by quite as much as traditional stimulus. This is momentous for down this tightening path. The Fed models might indicate. We are left three reasons: reversals of this leads the charge. Others, such as content with an above-consensus sort are a roughly once-a-decade the European Central Bank (ECB), inflation outlook. occurrence, this particular version is are still some distance away but are in uncharted waters given the need beginning to at least reduce their to simultaneously shrink distended rate of stimulus delivery.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 17 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

We view these monetary recalibrations as appropriate. Exhibit 13: Broadest measure of U.S. unemployment falls nicely Even if economic growth had not accelerated over the past year, 18 the gradual progress of the prior 16 seven years whittled away enough 14 economic slack to demand a shift Historical average in stance. As an illustration, the 12(%) broadest measure of the U.S. 10 unemployment rate now matches the 8 prior cycle’s low (Exhibit 13). U.S. broad unemployment rate Matches previous cycle trough 6 That said, even as monetary 1994 1998 2002 2006 2010 2014 2017 Note: Broad unemployment rate defined as U-6 unemployment rate. Historical average since 1994. stimulus starts to fade and interest Source: BLS, Haver Analytics, RBC GAM rates rise, there remains an enormous amount of stimulus. The average global policy rate is still very Exhibit 14: Global monetary-policy tightening has started low, and has increased only slightly so far (Exhibit 14). 7

The central banks that partook in 6 the extreme practice of quantitative easing – printing money and buying 5 bonds with the proceeds – are now 4 beginning to reverse themselves. 3 Since October, the Fed has allowed (%) rate policy Global its portfolio of bonds to begin 2 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 shrinking. Within several years – Note: Policy rates of the U.S., Canada, U.K., Eurozone, Switzerland, Sweden, Norway, Japan, Australia, China, India, South Korea, Russia, Brazil and Mexico aggregated and weighted by PPP-based GDP assuming no recession interrupts – share. Source: Haver Analytics, RBC GAM the Fed’s balance sheet and thus the U.S. monetary base should shrink down to a more normal size, though Exhibit 15: Fed balance sheet to return to normal growth rate significantly larger than before the crisis. The extra size is because the 500 economy is larger than before and ts

also because a capital-constrained ass e 400

l 100 ) banking sector requires a relatively = tot a 300 06 larger monetary base just to ensure nk a -2 0 b

c 200

a normal amount of money is e D t ral circulating in the economy (Exhibit ( 100 Projection 15). This balance-sheet reduction Ce n 0 should impose an upward pressure 2000 2003 2006 2009 2012 2015 2018 2021 on bond yields, though the effect Canada projection U.S. Canada Note: Projection for Bank of Canada assets based on growth rates from 2000 to 2007 and July should be surprisingly modest. 2010 to June 2017. Source: Haver Analytics, RBC GAM

18 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Risks to the base case view Exhibit 16: Macro risks: slight improvement in landscape There are a number of risks to the base case forecast (Exhibit 16). Among the negative scenarios, three are especially prominent. Aging business cycle Protectionism International relations s k i The business cycle is aging, d e r i China growth/Credit

s European populism

protectionism is on the ascent and n w international relations have become o D Higher interest rates Debt hot spots precarious in several pockets of the world. The latter two risks have Structural s k

i Fiscal stimulus worsened slightly over the past Japan reforms e r d i quarter. All three are discussed in s Secular Structurally p more detail later. U stagnation ends low inflation

Several of the lesser risks have Source: RBC GAM improved somewhat, though still remain relevant: Exhibit 17: Global fiscal impulse fairly neutral ahead

• European politics had a good year 2.0

for most of 2017, dodging several al

populist threats, but now face fis c 1.5 ural another onslaught of challenges ) 1.0 Fiscal boost pp t t ruc in the form of elections, ( 0.5 e c

independence movements o rld s 0.0 w ala n

b n

and nationalist governments i -0.5

coalescing in Eastern Europe. nge

h a -1.0 Fiscal drag • Chinese risks have shrunk given C -1.5 stabilizing growth and improving 2005 2007 2009 2011 2013 2015 2017 2019 2021 Note: Forecast from latest IMF World Economic Outlook. PPP-based country GDP as share of debt metrics, but the country is world total used as weights. Source: IMF, Haver Analytics, RBC GAM still likely to decelerate over time and sports an enormous amount of corporate debt by emerging- market, China’s aforementioned fade even more quickly than market standards. corporate debt sector, emerging- we are budgeting for, enabling market corporate debt more sustainably faster growth. • Policy tightening by a handful of generally, and a myriad of exotic • To the extent that it is now major central banks brings with investment instruments that rely harder for inflation to rise due to it the risk of a brisker increase upon leverage to boost returns in structural constraints, this might in interest rates, though it is a low-yield world. reassuring that the market extend the length of the economic Fortunately, the current environment response so far has been expansion. also reveals a number of upside measured. • Governments could opt to deploy risks: • By extension, rising interest rates fiscal stimulus, in contrast to the could at some point spell trouble • The decade-long scourge current IMF projection (Exhibit for the world’s debt hot spots. of slow post-crisis growth – 17). There is a good chance of These include Canada’s housing “secular stagnation” – could this in the U.S., it is plausible

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 19 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

in Japan, and Germany may yet Exhibit 18: U.S. business-cycle scorecard pursue a similar tack. In the U.S. economy most likely in “late cycle,” but some debate context of declining monetary Start of Early Mid Late End of stimulus, this would help to cycle cycle cycle cycle cycle Recession sustain global growth. Cycle age • Japan’s structural reforms may Economic trend be starting to gain traction, Economic slack potentially unleashing a period Sentiment of superior growth for the world’s Business investment third-largest economy. Consumer durables The latest on the business Housing cycle Loan growth Leverage The U.S. economic cycle is now Inventory ratio more than eight years old. While Employment expansions don’t die of old age, risk Prices factors do tend to accumulate over Expected market volatility time (Exhibit 18). Monetary policy Among the many factors relevant to Bonds assessing the phase of the business Credit cycle, the plurality argue for a “late- Stock direction cycle” interpretation, meaning that Equity profitability one would normally expect the next Votes for each stage of 1 2.5 11.5 13 4.5 0 recession to arrive within the next business cycle few years. Supporting factors include Note: Darker shade indicates the most likely stage of business cycle (full weight); lighter shade indicates alternative interpretation (0.5 weight). Source: RBC GAM the fact that there is essentially no economic slack remaining in the U.S. economy, consumer and business Another way of thinking about the We are on high alert for evidence confidence are high, market volatility gradually rising risk of a downturn of rising risk-taking and any side- is low, monetary policy is tightening, is in the context of economist effects that could bring the business the yield curve has flattened Hyman Minsky’s financial-instability cycle to a jarring halt. There is considerably, credit spreads are hypothesis (Exhibit 19). To starting to be some evidence of this. narrow and profit margins are summarize, a period of low volatility starting to ebb. such as the one currently underway The short and long of encourages a quest for additional In anticipation of the approaching geopolitics yield; this, in turn demands completion of this business cycle, International relations seem additional risk-taking. The extra we have gradually reduced our risk- unusually fraught with risk risk-taking eventually translates into taking over the past year by reducing (Exhibit 20). a bubble, and the bursting of the the extent of our equity-overweight bubble then spikes volatility higher In the short run, two geopolitical position and also lowering the and sends the process careening issues dominate. The first is North level of risk taken within the bond back in the opposite direction. In a Korea. The situation has undeniably portfolio. nutshell, stability begets volatility. deteriorated over the past year.

20 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

North Korean leadership has always been inclined toward uttering Exhibit 19: Minsky hypothesis: stability begets volatility threats and symbolic shows of force, but the new U.S. leadership High volatility Likely at this stage: is now retaliating in kind rather Bubble Quest for bursts than turning the other cheek. This safety • High confidence new U.S. tactic reduces the margin Bubble • Rising economy-wide Financial forms leverage for error, especially at a time when Lower instability • Inflows into riskier assets North Korea appears to have made risk-taking hypothesis Higher (EM, credit); $500B in target- significant progress in its nuclear risk-taking volatility funds, selling VIX and missile technologies. • Very low risk premiums Delevering Quest Low for yield • Pockets of rising consumer Still, we believe the basic calculation volatility defaults remains fundamentally the same Source: RBC GAM for both sides, and that war is thus unlikely (Exhibit 21). North Korea will not realistically abandon its nuclear- Exhibit 20: Geopolitical tensions heightened recently weapons program given the untimely Iraq x 600 Barcelona attacks, fate of Libyan and Iraqi leaders after invasion North Korea ICBM

Ind e Madrid similar concessions. At the same threat k 500 r bombing Russian annexation ) a London of Crimea time, North Korea will not attack m

h ISIS 10 0 bombing 400 9/11 escalation = the West given that any retaliation Iran

Ben c nuclear Syrian civil war Paris would devastate the country. The 00 9 300 escalation 2 sk tensions attacks i - R

U.S. options are similarly limited. A l Arab Spring: 00 0 a 200

2 Syrian and ( pre-emptive attack is tempting, but iti c Libyan wars 100 would yield unacceptable casualties opo l e for American allies. Recent rhetoric G 0 from President Trump seems to 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Source: Caldara, Dario and Matteo Iacoviello, “Measuring Geopolitical Risk," working paper, acknowledge this. Instead, the Board of Governors of the Federal Reserve Board, August 2017, RBC GAM U.S. is likely to remain locked in an antagonistic relationship with Exhibit 21: North Korean game theory North Korea, but without the kind of disaster that would be pivotal for the Stance Pacifism Antagonism Attack global economy or markets. • U.S. or South Korea • Sustain domestic popularity • Attacking others would might invade via us-vs-them rhetoric induce devastating retaliation Another short-term risk revolves North • North Korean leadership • U.S. or South Korea unlikely Korea would be removed to invade • North Korea would lose around Saudi Arabia. The country • Bad endings for Libya • North Korean leadership • North Korean leadership recently went through a leadership and Iraq unlikely to be removed would be ousted transition, elevating a young and • North Korea might be • Prevent North Korea from • Would win, eliminating emboldened to invade invading South Korea North Korean threat progressive new crown prince – United South Korea • Save face • Gain border with China Mohammed bin Salman – to States • North Korea sells nukes? • But U.S. and allies would effective control. This has been • Lose face suffer unacceptable losses positive from an economic This is the Nash equilibrium. The logic is only strengthened standpoint, with the rights of Source: RBC GAM by North Korea’s acquisition of nuclear capabilities

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 21 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

women expanding, the power of the religious police declining, an Exhibit 22: Geopolitical power shift after several quiet decades anti-corruption drive and a series U.S. retreats from world of economic reforms aimed at eventually diversifying the economy away from oil. • Trade tensions • Initially friendly relations However, Saudi Arabia’s political • North Korea • Russia interferes in U.S. election shift has been much more • China navy in Pacific • New multipolar world • Russia bellicose in Eastern Europe complicated from a political and • “Thucydides” Trap? foreign-policy perspective. The new • Friendlier relations leadership recently charged dozens • Natural gas deal of Saudi elites with corruption.

If this were to backfire, it could China looks outward Russia seeks empire undermine bin Salman’s control over Source: RBC GAM the country. On the foreign-policy front, Saudi Arabia has long had an • The U.S. appears fatigued with its All the same, China’s ascent is acrimonious relationship with Iran international responsibilities and something of a headache for the as both vie for influence over the so is tilting toward isolationism. world as the country’s emergence Middle East, with an underpinning of In this environment, other powers marks a profound shift from a period religious differences. are happy to step into the void of undisputed U.S. dominance This spat has not merely spilled this creates. toward a multi-polar landscape in over into an intensification of the • Russia appears intent upon which multiple countries vie for longstanding proxy war in Yemen, rebuilding an empire of sorts for influence. Not only does Chinese and but more recently into an embargo itself, annexing territory along its Russian strength make the outlook on Qatar and now political chaos in borders, re-involving itself in the less certain, but multi-polar worlds Lebanon. Iran, for its part, is taking Middle East and currying favour tend to be associated with less advantage of the recent void created with North Korea. economic growth. Framed differently, the “Thucydides Trap” becomes by ISIS losses in Syria and Iraq to • China, which had long relevant: as global dominance has bolster its influence over the vacated punched well below its weight territory. Against a backdrop of geopolitically, has set a clear shifted from one country to the next massive oil production in the region, goal of engaging more actively over the great sweep of history, war there is the chance of an accidental with the world beyond mere has frequently resulted between the oil-supply shock, with the effect of commercial concerns. This is an ascending and descending nation. sharply higher oil prices, spiking entirely reasonable expectation Friction is likely over the coming inflation and weaker global growth. for a country with China’s generation between the U.S. and population, economy and military China. Finally, and perhaps most important, might, and one cannot deny that is a longer-term geopolitical risk. its curious blend of one-party Protectionist tendencies The power dynamic among global rule plus capitalism could prove It is not entirely fair to describe superpowers is palpably shifting an attractive model for less the current growth-impeding trend (Exhibit 22): successful nations. toward protectionism as emanating

22 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

solely from the U.S. since non- tariff barriers are rising in many Exhibit 23: Non-tariff trade barriers growing everywhere countries (Exhibit 23) and the populist attitudes that often underlie 1020000

s a protectionism have strengthened in 800 ures many places, including the U.K. and 0 3 600 Eastern Europe. However, the U.S. is mea s une

f J 400

the clear leader, outpacing the rest of tari f with its growing number of trade 200 impediments (such as on softwood Non - 0 lumber from Canada). Germany U.K. France Mexico Japan South India Canada China EU U.S. Korea 2000 Technical 2007 Technical 2017 Technical 2000 Targeted 2007 Targeted 2017 Targeted NAFTA, the longstanding free- Note: Targeted barriers include anti-dumping, countervailing, safeguards and special safeguards, tariff-rate trade agreement between the U.S., quotas, export subsidies, quantitative restrictions and state trading enterprises. Source: World Trade Organization, RBC GAM Canada and Mexico, is still being renegotiated and the goal is to finalize a new deal by the end of Exhibit 24: NAFTA renegotiation scenarios the first quarter of 2018. The early going has not been promising. Some Scenarios Odds Assumptions Economic effect minor progress has occurred but negotiators appear to be talking past • NAFTA scrapped • Problematic, resulting in • Canada and U.S. revert to higher costs, supply-chain one another on key points. Termination 40% prior trade deal, but also likely headaches, worker permit scrapped • Cdn GDP -0.8% We identify four possible outcomes • WTO default tariffs apply • U.S. GDP -0.4% (Exhibit 24). While it would be lovely for the sides to reach a technocratic • U.S. largely gets its way: NAFTA • Modest to moderate defanged negative economic solution that refreshed the deal for • Trade dispute tribunals scrapped effects, depending on a more modern age, we assign a • U.S. can impose safeguard how substantially NAFTA is undermined in practice mere 25% probability to this happy Substantial exclusions 10% outcome. Just as likely is that NAFTA changes • U.S. protects procurement • U.S. carves out minimum auto negotiators fail and the pact remains share as is. Together, then, we assign • Pact renewal necessary every a roughly 50% chance to a fairly 5 years “benign” outcome, meaning that • Some modernization with benign • Limited economic effect, North American growth avoids a new or even beneficial changes ranging from slight headwind. • Better incorporation of negative to slight positive Modest 25% intellectual property and modern depending on precise However, this leaves a 50% chance changes industries changes of a more negative outcome. • Throw a bone: accede to lesser U.S. asks One is that Canada and Mexico largely accede to U.S. demands, • Canada and Mexico run out • Short-term uncertainty; no significantly hobbling NAFTA though No change 25% the clock long-term effect not quite technically killing it. Finally • Trump policy has often fizzled is the possibility that NAFTA is killed, Source: RBC GAM with a worryingly high 40% chance.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 23 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

President Trump has repeatedly uttered this threat, though how Exhibit 25: Effect of Trump policies on U.S. GDP much represents bluff remains unclear. Simultaneously, Canada and 1.0 +0.9 Mexico have also come to recognize 0.8 that they might be better off outside 0.6 point s 0.4 +0.5 NAFTA (where modest WTO tariffs Negative economic +0.4 0.2 effect in long term and impartial rules would apply), entage c 0.0

rather than inside a bad deal. Pe r -0.2 -0.2 -0.3 -0.4 Positive economic -0.5 Given the number of plausible -0.4 effect in short term -0.5 scenarios, it is impossible to speak -0.6 with precision about the economic 2017 2018 2019 2020 2021 2022 Cumulative effect on GDP level Effect on annual GDP growth implications of NAFTA negotiations. Source: RBC GAM assumptions and calculations What we can do is estimate that a bad outcome would theoretically cast a shadow subtracting about Exhibit 26: Considerable U.S. deregulation already underway 0.8% from the Canadian economy, and around 0.4% from the U.S. Approaches to Theoretical deregulation Speed Difficulty effectiveness economy. Legislative (change laws) Slow Hard High Executive orders U.S. economy stays strong (change interpretation of laws) Medium Medium Medium As with the global economy, U.S. Change enforcement climate (lighten enforcement of laws) Instant Easy Medium GDP has continued to gallop and the country’s leading indicators remain No longer adding new rules Instant Easy High unusually strong. Confidence is high, Well underway and business investment intentions Making progress signal further health ahead. Financial Energy / Labour Health Hurricane-related depressants sector environment laws care in the third quarter were smaller Source: RBC GAM than feared, suggesting a modest rebound in the fourth quarter. The short-term effects are supported through Congress. The Senate and by the spike in confidence since the House of Representatives have In assessing the many and varied the election, growth-friendly pitched slightly different visions of economic effects of a Trump deregulation (Exhibit 26) and the the bill, and further adjustments will presidency, we continue to believe prospect of tax reform. As a result, almost certainly have to be made that the U.S. economy can grow we upgrade our 2018 U.S. GDP to accommodate a few holdout faster than otherwise in the short forecast to 2.75%, with the view Republicans who remain on the run to the tune of an extra 0.4% that inflation will remain in the fence. Time is of the essence as to 0.5% of growth per year above vicinity of 2.0%. the U.S. midterm elections are now normal, though slower over the less than a year away and betting medium run as constraints on trade At the time of writing, U.S. tax markets indicate that Democrats and immigration begin to accrue reform remains highly contentious, could take possession of the House, (Exhibit 25). though a bill is moving steadily

24 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

impeding further serious policy action for another two years. Exhibit 27: U.S. tax reform very likely

We assign an 90% chance to the Proposed size • $1.5T of additional fiscal stimulus (=net debt) passage of U.S. tax reform in (over decade) the near term (Exhibit 27). Why? • Corporate rate from 35% to 21%; territorial, repatriation Republicans almost universally like Tax cuts • Full, immediate depreciation on capital investment tax cuts and are desperate for a • Fewer and lower personal tax brackets; higher deduction political win. A key sticking issue – • Limit corporate deductions; foreign excise tax whether the tax reform will be Partially paid for via • Reduce credit for state & local taxes paid, mortgage interest allowed to increase the public debt or not has already been hashed out: Challenges • Razor thin Republican majority in Senate it will, by US$1.5 trillion. • 90% chance of 2018 U.S. tax cut Outcomes Highlights of the proposed reform • Tax reform temporary – lasts only 10 years include a substantially lower • Tax cuts = 0.6% GDP boost, spread over a few years corporate-tax rate, accelerated GDP effect = 5% to 9% boost to corporate profits depreciation on capital investments, Source: RBC GAM and several lower personal tax brackets. We estimate the U.S. economy would expand by an additional 0.6 percentage point Exhibit 28: Countries with strong currencies lose competitiveness in the event that the proposals succeed, and that after-tax corporate 30 20 earnings could rise by 5% to 9%. 10 Less competitive This boost is not yet fully priced into 0 markets, suggesting some upside -10 yet to come. -20 change, 2016) -30 More competitive On the other hand, we continue -40 Relative unit labour cost, total economy 3-year (cumulative % Italy U.K. U.S. India Chile Brazil

to point to a roughly 25% chance Spain China Japan Turkey Russia Ireland France Poland Austria Mexico Greece Finland Norway Canada Belgium Sweden Portugal Hungary Australia Denmark Germany of a U.S. recession over the next Indonesia Switzerland Czech Rep. Czech Netherlands South Africa South Korea year, motivated in large part by New Zealand Developed markets Emerging markets the late stage of the business Source: OECD, Haver Analytics, RBC GAM cycle and the high degree of policy uncertainty that exists in the U.S. The Fed raised the fed funds earlier observation that the time regarding the tax, trade and foreign- rate earlier this month, and we for below-consensus wagers on policy outlooks. There is also no expect another two rate hikes by growth, inflation and policy rates denying that the U.S. has lost a November 2018. This represents has arguably come and gone. In this fair amount of competitiveness in the continuation of a process that scenario, the U.S. dollar likely has a recent years due mainly to currency started in late 2015 and has gained bit more room left to run due to the strength (Exhibit 28). The latest IMF steam over the past year (Exhibit country’s attractive real yields, more assessment matches our recession- 29). This anticipated clip represents hawkish central banks, prospect of risk estimate. a slightly above-consensus forecast tax reform (including the repatriation on our part, meshing well with the of assets into U.S. dollars) and

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 25 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

descent into protectionism (a classic Exhibit 29: U.S. fed funds rate currency-positive force). Equilibrium range

24 U.K. challenges ahead 22 20 The British economy has exceeded 18 expectations since the surprise 16 14 Brexit vote in June 2016. The weak 12

% 10 pound has been instrumental 8 in buffering the initial negatives 6 4 associated with this British decision 2 0 to part from the European Union -2 (EU) (Exhibit 30). The actual severing 1980 1985 1990 1995 2000 2005 2010 2015 2020 won’t begin until 2019 at the Last plot: 1.16% Current range: -0.40% - 1.77% (Mid: 0.69%) earliest, but the interim uncertainty, Source: Federal Reserve, RBC GAM prospective loss of finance jobs and reduced business investment have Exhibit 30: Pound has remained weak since Brexit vote all cast a chill.

It would appear that the negatives 135 130 are starting to outmuscle the 125 positives. Various macroeconomic 120 signals in the U.K. have begun to 115 weaken even as other countries have 110 managed a coordinated economic 105 acceleration (Exhibit 31). The U.K. 100 continues to run a large current- 95 rate, rate, pound sterling (2000=100)

Nominal broad effective exchange exchange Nominal broad effective 90 account deficit, and the personal 85 savings rate has fallen sharply, 2003 2005 2007 2009 2011 2013 2015 2017 suggesting unsustainable spending. Source: J.P. Morgan, Haver Analytics, RBC GAM

We anticipate further depreciation of the pound, which should alleviate Exhibit 31: U.K. activity starting to rise less enthusiastically a portion of the economic damage. But that still leaves us with an 4 65 3 I M

underwhelming on-consensus 60 P

ion s 2 ng ) i

l 55 r forecast of just 1.5% GDP growth in en t 1 e u t v in t c e

l 0 50

2018. Normally, that kind of growth a

e r -1 45 wouldn’t cause the BOE to budge ine ss anu f sc o

-2 M (

. bu s 40 from its stimulative setting, but . K

-3 . K . 35 U prior economic progress, paired U -4 with pound-induced inflation, have -5 30 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 altered the equation. We forecast PMI (RHS) Emp., manufacturing (LHS) Emp., services (LHS) steamy 2.75% inflation for 2018 Inv., manufacturing (LHS) Inv., services (LHS) Note: U.K. business intentions in hiring and investment of manufacturing and services sectors. Scores range (Exhibit 32). In turn, the BOE has from -5 (rapid contraction) to +5 (rapid growth). Source: BoE, IHS Markit, Haver Analytics, RBC GAM

26 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

tightened its policy rate once recently and may deliver another Exhibit 32: U.K. inflation ratchets up since Brexit vote increase in the coming year. 5.5 With the added complexity of 5.0 Prior bouts of 4.5 high inflation a minority government after 4.0 hange ) c last summer’s election, Brexit 3.5 %

Y 3.0 negotiations are proving vexing. A o

Y 2.5 ( tentative agreement over British I

P 2.0 C financial obligations to the EU still . 1.5 K . 1.0 leaves very difficult negotiations U 0.5 over the Irish border and then even 0.0 more fundamental questions about -0.5 trade access. Although we ultimately 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Source: ONS, Haver Analytics, RBC GAM assume a fairly “soft” Brexit deal is reached (Exhibit 33), there is the considerable risk of negotiations and Exhibit 33: Ongoing U.K. political intrigue thus uncertainty extending beyond U.K. election chaos the original early-2019 deadline. • Mere minority for Conservatives A snap election could well add to • Fragile alliance with DUP • Risk of snap election/PM resignation the swirling uncertainty, with Prime Minister May’s party support Positive economic implications at historic lows. While this might • Minority governments tend to be more fiscally stimulative yield an even softer Brexit, the • Brexit likely to be softer, though more uncertain far-left orientation of the main opposition represents a further Soft threat to the British economy were No Brexit Hard Very hard it to gain power. Brexit Brexit Brexit Source: RBC GAM Eurozone on the ascent The Eurozone has continued to Exhibit 34: Eurozone sentiment high; manufacturing growth strong impress, clocking in at a 2%-plus

120 growth with a persistence that I 60 M 115 would have been hard to fathom P 55 110 ring

several years ago. The majority ) u l t 105 leve l e of the region’s leading economic 50

le v 100

anufa c signals are absolutely on fire, at 45 95 Inde x M

(inde x 90

least by European standards (Exhibit ea 40 r a

85 34). The breadth of the growth is 35 80 also good. The great majority of Eur o 30 75 countries have strengthened, though 2001 2003 2005 2007 2009 2011 2013 2015 2017 it is fair to concede that Catalonia’s Euro area Manufacturing PMI (LHS) Euro area Economic Sentiment (RHS) Germany ifo Business Climate (RHS) recent pursuit of independence Source: European Commission, ifo Institute, Haver Analytics, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 27 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

is likely to undermine Spanish Exhibit 35: Eurozone still has excess capacity; U.S. output gap already close growth temporarily, and that some to zero of the Italian leading indicators 4 )

are wobbling. All in all, we have P

D 3 upgraded the Eurozone 2018 outlook G 2 Europe has to 2.0% GDP growth. Inflation should 1 more upside ential

be in the vicinity of 1.5%. po t 0

f o -1

The Eurozone arguably has more (% -2 room left to run than the U.S. gap -3 put before the currency union bumps up t -4 u against capacity constraints (Exhibit O -5 -6 35). By virtue of the Eurozone’s 2007 2009 2011 2013 2015 2017 U.S. Eurozone double-dip recession, its recovery Source: IMF, Haver Analytics, RBC GAM began much later than in the U.S. This was bad news at the time, but today represents something of an Exhibit 36: Probability of a euro breakup is low by recent standards opportunity. Whereas the U.S. will

struggle to continue outpacing its 80 o 70 normal growth speed limit for much eu r

, longer, the Eurozone can sustain 60 nde x I a few more years of relatively fast ) 50 up % growth without running into trouble. ( 40 ea k r B The ECB is thus in no hurry. The area 30 uro central bank can gradually scale E 20 back its bond-buying plan, but is 10 senti x unlikely to pivot toward outright 0 tightening until 2019. We expect | Jun-12 Jul-13 Aug-14 Sep-15 Oct-16 Nov-17 Note: Index measures the percentage of investors that expect at lease one country to leave a fairly quiet euro-U.S. dollar the euro area within the next 12 months. Source: sentix GmbH, Haver Analytics, RBC GAM exchange rate.

We grant that the Eurozone is such as the U.S. are hardly pillars of is the lowest it has been in years grappling with more than its fair strength in this regard. The past year (Exhibit 36). share of banking-sector woes and has mostly been a story of trouble Looking forward, the Italian election political challenges. But both areas avoided, as populist bids to gain set to occur by next spring could have improved somewhat. Eurozone control of several major Eurozone yield a precarious outcome, in part banks are steadily increasing their nations have failed. The Dutch, because of populist forces and in capital buffers and they now benefit French and German elections all part because a stable coalition might from the ECB’s oversight. Also, kept power in centrist hands. There prove impossible to form. It is also several of the most troubled have have also been some tentative steps worth acknowledging the nationalist now been bailed out. to better integrate the continent’s military forces. It is not surprising, sentiment that has accumulated The European political environment then, that surveys show that the in the old footprint of the Austrian is imperfect, though other places perceived risk of a Eurozone breakup Empire. Voters in Poland, the Czech Republic, Slovakia, Hungary and

28 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Austria have given considerable influence to nationalist parties, Exhibit 37: East/West divide replaces core/periphery though they don’t seem inclined to exit the EU (Exhibit 37). Austrian Empire reviving? Nationalism rises in the East Japanese reforms continue • Divide between core and peripheral Europe shrinking

Like other developed nations, Japan • But political gap between west and east is growing Poland has managed to impress of late, with • Right-leaning parties with nationalist tendencies now the economy appearing to finally lead Hungary, Poland, Czech Republic, Slovakia and Czechia Austria Slovenia lock into regular, solid (at least Austia • All likely to remain in EU, but angry at open borders Hungary by Japanese standards) economic and wary of EU as “USSR-lite” growth (Exhibit 38). • Unlikely to support “more Europe” Source: RBC GAM Collective economic heft is Markets were bolstered by the bigger than Italy larger-than-expected election victory of Prime Minister Abe in the fall. Abe’s support had been lukewarm Exhibit 38: Japan on longest growth streak since 2001 at best when he called the snap 12 election, but he then managed not merely to win but to sustain his 8 Abenomics supermajority in the lower house 4 of Parliament. In turn, this political 0 clout provides considerable leeway -4 Real GDP Real GDP for the continuation of Abe’s growth- -8 friendly economic policies, including -12 the likely reappointment of Haruhiko (QoQ % change annualized) -16 Kuroda as governor of the BOJ. -20 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 We have wavered in our assessment Source: Cabinet Office of Japan, Haver Analytics, RBC GAM of Abe’s economic bona fides over the years as some of his promises – a snappy return to 2% inflation, Exhibit 39: Japanese women now in labour force most prominently – went unfulfilled. 73

But a more thoughtful analysis, 71 ate , aided by a few more years of data, r 69 argues that Abe has been a positive io n

) 67 pa t i % force for Japan. The economy has c Japan's labour market ( i 65 structure was l e a now managed its longest period of par t gradually improving... 63 m e uninterrupted growth in 16 years, f e ...Abenomics

or c 61 f has accelerated inflation has edged higher and 59 the pace wages are making cautious progress. 57 Labour The labour market has made huge 55 strides and is now the tightest in a 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 Japan U.S. quarter-century. Source: Haver Analytics, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 29 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Furthermore, Japan is starting to implement structural reforms, which Exhibit 40: Japanese corporate reforms: room for improvement theoretically increase the speed at which the economy can grow. Low Japan base = room for improvement: Amazingly, Japan’s female labour- Median % of independent corp. directors: 26% (vs 50-89% in other countries) force participation rate recently Median % of women on corp. boards: 0% (vs 22-43% in other countries) surpassed the U.S., though there are Just 8/500 Topix firms have majority independent board with 2+ women still serious constraints on women 17% of Topix firms have annual meeting on single day; 39% in same week advancing up the corporate ladder Evidence of tentative improvement: (Exhibit 39). Similarly, Japan has laid Stewardship code for investment firms passed in 2014 the groundwork for a more efficient • Asset managers have doubled their votes against company directors from 2014 to 2016 and profitable corporate sector • GPIF demanding good stewardship when allocating passive funds (Exhibit 40). We accordingly remain Corporate governance code passed in 2015 overweight Asian equities. • Requires disclosure and justification of cross-holdings • Banks have cut “strategic” cross-holdings; other firms persist Going forward, we anticipate attractive Japanese growth of 1.5% Source: Bloomberg Professional Services, RBC GAM in 2018, an upgrade from our prior forecast. Inflation should transition Exhibit 41: China’s new policy goals higher to 1.25% for the coming year. Until inflation seriously challenges Goals Main points Implications the 2.00% target, however, it is unlikely that the BOJ will let its foot • No explicit growth target, suggesting • Ultimately, a positive pivot slower growth to come • Begins to reduce Chinese debt risks off the monetary accelerator. From Growth quality • Focus instead on quality of growth: • Nevertheless, expect a bit less steady- a currency perspective, the yen is over quantity • Less reliance on credit state growth from China • Address inequality quite cheap. Thus, in contrast to the • Environment depreciating trend anticipated for • Sharp reversal from prior plan • Easier to implement policy agenda several other currencies, we expect Central role for • Market forces lose, gov’t control wins • Hard to boost productivity and profits the yen to hold its own versus the state • Ruling party wary of losing control without market influence greenback. • Xi consolidates power • Autocracy bad for long-run growth

• China has long punched below weight • Implications mainly over long run China sets a new course in foreign policy, now finally engaging • Marshall Plan for Asia and Africa Outward • Rising global leadership (i.e. Davos) The Chinese economy remains a focus • Thucydides Trap = friction with U.S. • One Belt One Road plan builds central consideration for investors, • From hegemonic to multipolar world = influence, foreign supply & demand slightly slower global growth generating as it does nearly a third of global growth. Fortunately, the Source: RBC GAM country has been cruising along at a remarkably steady clip over the past deteriorating competitiveness (refer regarding China’s intended path 18 months, exceeding expectations. back to Exhibit 28) and a shifting forward (Exhibit 41). One relates to We anticipate a moderate slowdown policy emphasis. the country’s aspiration for greater to a below-consensus 6.0% of international clout, as discussed growth in 2018 for a mix of reasons The latest Chinese National earlier in the geopolitical risk including a naturally maturing Congress, held every five years, section. economy, U.S. protectionism, clarified three main themes

30 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Another is a pivot toward prioritizing the quality of economic growth over Exhibit 42: China’s debt growth has accelerated since 2010 the quantity. This development is a welcome one, as China’s past 280

D P 260 obsession with maximizing GDP 240 o- G t growth led it down an undesirable - 220 deb t ) 200 %

path, resulting in an excessive or ( 180 t

c o i e 160 reliance on credit as a driver of s

ra t 140 ia l growth and overcapacity in certain 120

industries. The shift portends inan c 100 80

less economic growth, but it is a Non f 60 worthwhile trade in the name of 1990 1995 2000 2005 2010 2012015 6 sustainability. Advanced economies EM economies ex China China Note: Nonfinancial sector debt of G20 countries includes government, household and nonfinancial corporation debt. Source: IMF GFSR October 2017, RBC GAM The final theme is an elevated role for the state in the direction of the economy. We view this in a Exhibit 43: China’s credit and GDP growth finally converging mostly negative light. Previously, the expectation was that China 40 Credit boom would allow market forces to nudge 35 during last lumbering state-owned enterprises 30 slowdown toward greater efficiency. The 25 hang e c country now appears to be defending 20 Gap narrowing %

nicely the centrality of the Communist Y 15 o Y Party in guiding the economy. It is 10 hard to fathom this being as efficient 5 a process as if market forces were 0 involved. 2007 2009 2011 2013 2015 2017 Total social financing Nominal GDP Source: China National Bureau of Statistics, PBoC, Haver Analytics, RBC GAM The centralization of power is actually operating at two levels. Not China’s biggest risk has long been • The stock of China’s long fretted- only is the party seeking to regain its its heavy debt load (Exhibit 42). over Wealth Management economic influence, but President Xi Fortunately, our concerns are Products recently recorded their himself is consolidating power within lessening thanks to several welcome first quarterly decline in years. the party. It is increasingly likely that developments: he will opt to stay on past the normal • Local governments continue end of his presidency in five years. to be reined in, reducing their • The overall rate of credit growth A more autocratic structure might longstanding debt risks. has converged downward toward make it easier to implement policy the rate of economic growth Emerging-market expansion in the short run, but tends to be a (Exhibit 43). intact negative over the long run as policy errors gradually stack up. • Heavy industries are reducing The emerging-market story is their excess capacity and in also a positive one, though the so doing cutting their non- acceleration in growth has been less performing loans (Exhibit 44). pronounced than in the developed

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 31 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

world (Exhibit 45). Nevertheless, the positive readings from emerging- Exhibit 44: Chinese heavy industries no longer expanding rapidly market leading indicators confirm that a prior multi-year swoon has 230 definitively ended. 210 190 Broad-based tailwinds for emerging 170 markets include the strong 150 expansion of global demand and 130 “risk-on” market sentiment that 110 90

tends to translate into inflows for China's output (million tons) emerging-market assets. 70 2007 2009 2011 2013 2015 2017 Steel Cement On the other hand, a few broad- Note: Steel output includes steel, steel products and corrugated steel bars. based headwinds include our Source: CNBS, Haver Analytics, RBC GAM forecast for a moderately stronger U.S. dollar, the prospect of central- Exhibit 45: Slightly faster growth in emerging markets bank tightening and the possibility that a deleveraging China might compromise demand for emerging- 10 markets products and services from 8 other Asian countries. 6

Of course, individual emerging 4 market nations vary significantly from one another (Exhibit 46). 2 We continue to believe that China 0 could underperform growth (%) growth realGDP EM-6 annual 2000 2003 2006 2009 2012 2015 2018 RBC GAM forecast expectations for reasons discussed Note: EM-6 includes Brazil, China, India, Mexico, Russia and South Korea. earlier. On the other hand, Brazil Source: Haver Analytics, RBC GAM and Russia both look capable of exceeding expectations due Exhibit 46: Varied EM economic drivers to their substantially improved competitiveness and sensitivity Common tailwinds: Strong global demand growth, “Risk on” Common headwinds: Rising USD, CB tightening, China to delever? to rebounding commodity prices (Exhibit 47). Outlook for: China India Korea Brazil Mexico Russia Structural reforms + + + 0 + + 0 A promising structural trend is that Competitiveness – – 0 – + ++ ++ a number of emerging markets with U.S. protectionism – – 0 – 0 – – – a history of chronically high inflation Credit – – – 0 – 0 0 have made progress toward solving Commodities – – – + + 0 + + this problem (Exhibit 48). Russia, Brazil and India are prominent Geopolitics 0 0 – – – 0 0 beneficiaries and their economic Overall – – O – + O + Note: + means positive, – means negative, O means neutral. Source: RBC GAM

Source: RBC GAM

32 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

speed limits could increase accordingly. Exhibit 47: RBC GAM GDP forecast for emerging markets

8 7.25% Canadian moderation ahead 6.75% 7 6.00% The Canadian economy is on track 6.00% 6 to record its most impressive 5 performance in seven years for 4 3.25% 2017, growing by roughly 3.0%. 2.75% 2.75% 2.75% 3 2.50% 2.25% This white-hot performance was 2.00% 2 sustained by strong global demand, 1.00% Annual GDP growth (%) rising commodity prices, generous 1 0 government spending and monetary- China India South Korea Mexico Russia Brazil policy support. 2017 2018 Source: RBC GAM The oil shock of 2014-2016 concluded more quickly than prior downturns due to the remarkable Exhibit 48: EM inflation structurally falling – a big positive nimbleness with which U.S. shale- 9 oil producers cut their production 8 (Exhibit 49). In turn, the Canadian 7 economy was able to rebound Inflation rising in 6 traditionally low sooner than in prior commodity inflation countries 5 cycles. However, while oil prices may 4 advance a little further in the short 3 run, rising U.S. crude production (%) years past five 2 Inflation falling in traditionally high hints that the equilibrium price for Latest core CPI change vs. 1 inflation average core CPI change over over change core CPI average countries oil is likely no higher than US$45 0 Russia Brazil India Indonesia Mexico China Poland to US$50 per barrel – a downgrade Note: Latest core CPI YoY % change versus average core CPI YoY % change over past from current levels and a constraint five years. Source: Haver Analytics, RBC GAM on additional Canadian economic growth. Exhibit 49: U.S. shale producers boost production We can already see that the Canadian economy is starting to 9.7 decelerate, both in terms of GDP and 9.5 our own leading indicator (Exhibit 9.3 50). The BOC has raised rates twice 9.1 and fiscal spending will no longer actively add to growth in 2018. As a 8.9 result, the country is likely to settle (millionbbl/day) 8.7 back into a more subdued rate of U.S. crude production 8.5 growth, with a below-consensus 8.3 1.5% gain in 2018. Inflation should Apr-15 Sep-15 Feb-16 Jul-16 Jan-17 Jun-17 Nov-17 alight around 2.0%. Source: EIA, Haver Analytics, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 33 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Supporting this cautious Canadian outlook, the country’s competitive Exhibit 50: Canadian growth to dip landscape is arguably deteriorating vis-a-vis the U.S., and there are, of 2 course, ever-present housing risks. 1

Canadian competitive headwinds 0 appear to be forming (Exhibit 51). -1 From the perspective of businesses -2

choosing where to expand their historical norm) -3 operations, Canada now suffers (standard deviations from -4 several disadvantages versus Canadian Economic Composite -5 the U.S. including moral suasion 2001 2003 2005 2007 2009 2011 2013 2015 2017 Note: Composite constructed using four leading indicators from surveys on Canadian businesses. from the White House, a sharp Source: CFIB, Haver Analytics, RBC GAM increase in Canadian minimum wages, tightening environmental rules, rising regulations and a Exhibit 51: Canadian medium-term competitiveness challenges general increase in tax rates for highly mobile workers. The U.S., by Canadian competitiveness threats versus U.S. contrast, is loosening environmental •• President Trump threatens companies that consider major Moral suasion rules and regulations, and cutting expansions outside U.S. taxes. Canada will be at a further •• Tougher labour laws in Canada (ON, AB, BC) disadvantage if the U.S. continues •• Higher minimum wage Labour to step up its imposition of tariffs on •• Easier unionization Canadian goods. •• FT/PT equivalency

Canada’s housing market also •• Canada in Paris agreement, U.S. out eventually needs to give back Environment •• New carbon taxes ramp up over next five years •• Gov’t wants more extensive resource consultation process some of its gains. The growth of household borrowing that has taken Regulations •• U.S. deregulating, Canada regulating place in recent years is well beyond Taxes •• U.S. taxes could fall, Canadian taxes have mostly risen that experienced in any other country save China (Exhibit 52), and Tariffs •• U.S. threatening tariffs on Canada (competitiveness hit) housing has expanded to occupy Source: RBC GAM an unusually large share of GDP (Exhibit 53). It is unlikely in our view that housing’s share of the economy Canada is getting a taste of the stands to reason that it could thus can continue to grow, suggesting first, but not yet enough to seriously be worse for Canada than the U.S. less support for the economy going impede residential real estate. In the present context, two further forward. Unemployment, however, remains low and probably will remain so until factors could impede the Canadian Housing booms are usually the next North American recession housing market. The first is that extinguished by one of two things: comes around. Whenever the next governments are now focused on higher borrowing costs or higher North American recession occurs, it cooling Canada’s housing market via unemployment rates (Exhibit 54). a series of targeted rule changes,

34 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

with more likely if housing does not obey. Lastly, parabolic rises in any Exhibit 52: Household debt soared with rapid home-price gains asset cannot go on forever, implying a tamer future for Toronto and ) 40 - (pp t t o 30 Vancouver home prices in particular. 6 debt -

20 1 20 to

None of this is to say that Canada o ld 10 se h

has serious trouble immediately 200 6

0 ahead of it, especially given minor ho u

in -10 fro m

e tio victories such as a new free-trade l

-20 y y a a a n a a a o l i i li a c c e n e a s a i i az i t k a an y r han g x s r I r nd i r f U.K . U.S . P r a t anc e I e u u deal with Europe, an interprovincial m r B A C Ch i Ko r s Ja p r anad a D

R T F M u e C h G t A ndone s G uth u trade deal and rising immigration. I o o S S But the overall backdrop is distinctly Countries with home price growth > 25% Countries with home price growth < 25% less friendly than it has been. In Note: Nominal home price growth from 2006 to 2016. Source: IMF GFSR October 2017, RBC GAM this environment, we anticipate no more than two BOC rate hikes over the next year. The Canadian dollar Exhibit 53: Canadian housing share of GDP is high, signalling risk should decline to partially offset the 24 brewing competitive challenges. 23 22 Flattening yield curve could 21 20 elicit volatility 19

The solid and improving economic Housing share of 18 Canadian GDP (%) BC's housing share of backdrop, combined with low 17 GDP is nearly 30% interest rates, has created a 16 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 comfortable environment for Nominal Nominal, historical average Real Real, historical average investors. Credit spreads are Note: Housing share of GDP calculated as residential construction, renovations, transfer costs, housing rent (both actual and imputed for home owners), maintenance and repair of dwellings, utilities, a housing wealth effect, plus historically narrow, liquidity is high half of furniture, textiles and appliances & equipment for house and garden. Historical average from 1990 to 2006. Source: Haver Analytics, RBC GAM and volatility has been unusually low. History, unfortunately, suggests that these favourable conditions are Exhibit 54: Threats to Canada’s housing boom unlikely to persist. Higher Parabolic One sign bumpier times may lie Economic Tighter Threat interest recession regulations home price ahead is the fact that the yield rates increase curve has reached its flattest point • Hurts • Increases • Constrains • Prices out since before the financial crisis. The affordability unemployment access to or buyers • Higher • Higher desirability of • What goes up slope of the curve, measured as mortgage mortgage home buying must come the spread between the yields on Why default rate default rate • Actions down U.S. 2-year and 10-year government • Canada’s next spanning • A bit less national and bonds, has been declining gradually recession to acute than in be extra deep? regional gov’ts 2016-H1 2017 since 2008. Such flattening is the normal experience during economic Near -term MEDIUM MEDIUM HIGH HIGH risk expansions, but we would become Source: RBC GAM concerned if the yield curve actually

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 35 inverts (i.e. slope falls below zero) Exhibit 55: U.S. Treasury yield curve because recessions often follow Spread between yield on 2-year and 10-year maturities soon thereafter (Exhibit 55). Even 4 though the curve is still 63 basis Maximum points away from inversion, the 3 historical spread: 2.81% flattening we have seen thus far 2 Average spread: 0.97% could introduce volatility into capital 1 markets. Exhibit 56 plots the CBOE

% 0 Last plot: 0.63% S&P 500 Volatility Index (VIX) -1 alongside the reverse of the yield -2 curve, advanced 30 months. The fact -3 that the yield curve has flattened 1980 1985 1990 1995 2000 2005 2010 2015 2020 by over 100 basis points since 2015 Recession Average Max Range suggests that a pick-up in volatility Source: Bloomberg, RBC GAM may lie ahead.

Expecting gradual rise in Exhibit 56: U.S. yield curve vs. VIX volatility bond yields -2% 70

Global bond yields could rise 60 -1% gradually over many years supported 50 l e by the strengthening economy and 0% v e

40 l the fact that central banks continue VIX last plot: 11.3 1% 30 moving away from the extremely Inde x 20 stimulative monetary policies 2% that have been in place since the 10 financial crisis. Yields have already 3% 0 1990 1994 1998 2002 2006 2010 2014 2018 2022 begun moving higher, but have Recession periods U.S. 10yr-2yr spread (LHS, Inv, Adv 30 months) VIX (RHS) been mostly range-bound in 2017 Source: Bloomberg, RBC GAM following a sell-off in the second half of 2016. Our models continue to its two components: an inflation according to the model could rise 60 suggest that valuation risk exists in premium and a real (after-inflation) basis points over the year ahead. A the fixed-income market, with yields rate of interest. Together, these number of structural factors have below our estimate of equilibrium in elements project a rise in yields been depressing real interest rates all major regions (Page 44). of approximately 70 basis points including unorthodox monetary Although the U.S. 10-year yield is over the year ahead. The inflation policy, heightened demand for only slightly below our estimate premium poses little threat at its safe-haven assets and an aging of equilibrium, the modelled level current level of 1.9% – our model population. But in an environment rises over time and represents indicates that is the appropriate where economic growth is gaining a potential headwind to fixed- setting for the year ahead given momentum and secular stagnation income returns for many years to our forecast for reported inflation may be starting to lessen its grip, come. Exhibit 57 breaks down our through the next two years. The we would expect real interest rates U.S. 10-year Treasury model into bigger threat to bond prices comes to ultimately move back towards from the real interest rate, which their long-term average as investors

36 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

(savers) will at some point demand a Exhibit 57: U.S. 10-year bond yield true after-inflation payment to defer Fair-value estimate composition consumption. Our models assume this reversion occurs over the next United States United States CPI Inflation Real 10-year T-bond yield five years, but the actual time frame is not as important as the direction. 16 12.0 14 10.0 12 Our forecast is for the U.S. 10-year 8.0 10 36-month Centred Last Plot: 1.9% 6.0 yield to be at 2.75% a year from now. 8 12-Month Forecast: 2.0% +1 SD %

6 % 4.0 Last Plot: 4 + 2.0 0.5% Equities: a year in review 2 0.0 0 -1 SD Average: 2.1% Global stock markets have delivered -2.0 -2 12-Month Forecast: 1.14% sizeable returns through the past -4 -4.0 1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020 year, supported by the increasingly 36-month Centred CPI Inflation Actual Monthly CPI Inflation Real T-Bond Yield Real 10-Year Time Weighted Yield Source: RBC GAM, RBC CM Source: RBC GAM, RBC CM broad-based economic expansion and better-than-expected corporate profit growth around the world. As U.S. 10-year T-bond yield of November 30, 2017, the MSCI Equilibrium range

Emerging Markets Index was up 16 30% and the S&P 500 Index had 14 risen 18% so far this year. Japanese 12 stocks, measured by the Nikkei 10 Index, were up 19% in local-currency 8 terms, benefiting from President % 6 Abe’s re-election. The victory 4 solidified his power and allowed 2 Nov. '18 Range: 2.26% - 4.04% (Mid: 3.15%) him to extend his agenda of fiscal 0 stimulus and pro-growth structural 1980 1985 1990 1995 2000 2005 2010 2015 2020 reforms. European and Canadian Last Plot: 2.41% Current Range: 1.80% - 3.58% (Mid: 2.69%) markets had more modest gains Source: RBC GAM, RBC CM because their stock indexes have minimal exposure to the strong Exhibit 58: Global stock-market composite returns delivered by the Information Equity-market indexes relative to equilibrium Technology sector. 100 80 Although stocks remain below our 60 estimate of fair value in most regions (page 45), the recent rally has 40 20 narrowed that gap on an aggregate Last Plot: -12.9% measure and reduced further upside 0 potential (Exhibit 58). The S&P 500, -20 % above/below fair fair value % above/below in particular, hovers just below -40 the midpoint of its fair-value band -60 (Exhibit 59), and it is worth taking 1980 1985 1990 1995 2000 2005 2010 2015 2020 a closer look at what this valuation Source: RBC GAM

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 37 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

implies given the importance of U.S. Exhibit 59: S&P 500 equilibrium equities on the world stage. Normalized earnings & valuations

The U.S. market, proxied by the S&P 5120 Nov. '17 Range: 2015 - 3363 (Mid: 2689) 500 Index, has spent most of the Nov. '18 Range: 2148 - 3585 (Mid: 2867) 2560 current bull market in a high-return Current (30-November-17): 2648 1280 valuation zone and, according to our model, is on the cusp of transitioning 640 into a less favourable environment. 320

Exhibit 60 illustrates this clearly by 160 plotting a standardized version of 80 our equilibrium model for the S&P 500 in which we’ve ‘stretched’ the 40 1960 1970 1980 1990 2000 2010 2020 fair-value bands horizontally. The Source: RBC GAM dotted line running through the centre of the chart is fair value – our modelled estimate of the appropriate Exhibit 60: Standardized S&P 500 fair-value bands level for stocks given today’s interest rates, inflation and corporate profitability – and the solid lines S&P 500 most represent one standard deviation overvalued 4 above and below fair value. We’ve +1 SD 3 segmented the chart into four FV zones, or buckets. The current 2 -1 SD bull market began with stocks 1 S&P 500 most situated in Bucket 1 (more than one undervalued standard deviation below fair value) but quickly graduated to Bucket 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 2020 2 (between fair value and one Source: Haver Analytics, RBC GAM standard deviation below), where it has spent the majority of the bull market except for a brief period in Exhibit 61: S&P 500 Index Return prospects by valuation zone Bucket 3 (between fair value and 1-year one standard deviation above) in Data 1-year average 1-year 2013. We ran return statistics based set average Batting return in Max return Valuation (Bucket) return average^ win* loss Std. dev. on which bucket the S&P 500 was situated in and noticed that stocks (S&P 500 most overvalued) 4 (0.7%) 48.6% 14.8% (27.5%) 17.0% have historically done very well in 1 SD Above Bucket 2 (Exhibit 61). In this zone, 3 3.5% 62.3% 13.0% (41.4%) 15.6% Equilibrium stocks have delivered average one- 2 12.1% 83.9% 16.0% (44.8%) 13.5% year returns of 12.1% and risen in 1 SD Below 83.9% of periods – with the lowest (S&P 500 most undervalued) 1 14.7% 80.2% 19.9% (12.8%) 16.3% volatility of returns in any of the *Win = Periods where returns are above 0%. ^Batting average = Incidence of winning in any four zones. Notice, though, what given period. Source: RBC GAM

38 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

happens to these statistics when Exhibit 62: S&P 500 Index stocks transition into Bucket 3. Normalized valuation metrics, as at November 2017 Returns drop to an average of 3.5% 2.5 Market is expensive over one-year periods, the batting 2.0 1.70 1.55 1.31 1.27 average falls to 62.3% and volatility 1.5 1.09 1.0 0.72 rises. While stocks haven’t crossed 0.5 Market is slightly expensive into this less attractive zone, they 0.0 -0.5 Market is slightly cheap -0.06 c or e -0.41 are awfully close and it might -1.0 -0.68 Z- s -1.5 therefore be prudent to lower total- -2.0 Market is cheap return expectations and consider the -2.5 -3.0 potential for higher volatility in the Average Market Tobin's Q Shiller P/E 12-M 12-M RBC GAM Equity Fed cap ÷ U.S. (CAPE) trailing forward fair value risk model months ahead. GDP P/E P/E premium Notes: Historical data from Jan 1956 for 12-M Trailing P/E, 12-M Forward P/E, Equity risk premium, Shiller A number of other popular valuation P/E and Fed model. Historical data from Mar 1956 for market cap ÷ U.S. GDP. Historical data from Jan 1960 for RBC GAM fair value. Source: Haver Analytics, RBC CM, RBC GAM measures suggest that stocks have been expensive for some time. Exhibit 62 plots eight valuation Exhibit 63: S&P 500 Index Simple average of valuation metrics metrics in terms of standard deviations from their historical 3.0 2.5 averages. Five of the measures 2.0 Market is expensive suggest stocks are expensive. 1.5 1.0

e Market is slightly expensive While we have long argued that r 0.5

sc o 0.0 the environment of historically low - Z -0.5 Market is slightly cheap interest rates and inflation justify -1.0 higher price-to-earnings multiples, -1.5 Market is cheap -2.0 our own multifactor model no longer 1956 1963 1970 1977 1984 1991 1998 2005 2012 2019 suggests stocks are particularly Notes: Historical data from Jan 1956 for 12-M Trailing P/E, 12-M Forward P/E, Equity risk premium, Shiller P/E, Tobin's Q and Fed model. Historical data from Mar 1956 for market cap ÷ U.S. GDP. cheap. Exhibit 63 plots a simple Historical data from Jan 1960 for RBC GAM fair value. The r-square figures used for the weighted composite are based on the relationship of each valuation indicator with S&P 500 10-year returns. average composite of the eight Source: Haver Analytics, RBC CM, RBC GAM indicators over time and shows that valuations have clearly pushed earnings growth, with the balance earnings estimates as corporate closer to expensive territory as a delivered by expanding price-to- profits continually exceeded result of the rally in equities and rise earnings ratios. Exhibit 64 plots analysts’ expectations, and that’s in interest rates since 2016. the contribution to returns from been especially true through the valuations and earnings over time. past eight months (Exhibit 65). Earnings power through Notice that expanding valuations Normally, analysts start the year too Valuations are only one part of the were a significant and constant optimistic and are forced to lower equation affecting stock returns. A source of fuel for stocks between their earnings estimates as the significant portion of the market’s 2011 and 2016, but that earnings year progresses (Exhibit 66). But gains this year has been delivered have been the key driver in 2017. estimates have moved up repeatedly through rising earnings. More than this year, a pattern that is also One of the major investment two-thirds of the S&P 500’s 18.3% reflected in the higher-than-usual themes of 2017 has been the price return from the start of the year number of companies that have constant upward revisions to to November 30, 2017, came from

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 39 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

been exceeding analysts’ estimates Exhibit 64: S&P 500 return decomposition (Exhibit 67). Such widespread Return contribution of earnings growth and multiple expansion earnings beats are unusual in the later stages of a cycle, suggesting 60% analysts have been too pessimistic 40% about corporations’ abilities to 20% increase profits. S&P 500 earnings climbed at a double-digit rate in 0% the first two quarters of 2017 and -20% at a high single-digit rate in the -40% third quarter, and current analyst -60% )

expectations suggest this trend 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 D 8 8 9 9 9 9 9 0 0 0 0 0 1 1 1 17 ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' could continue or even accelerate in ' Multiple Expansion Earnings Growth S&P500 Price Return (Y T the quarters ahead. Source: RBC GAM, RBC CM

Potentially adding to the positive earnings momentum is the chance Exhibit 65: S&P 500 Index Consensus earnings estimates of large-scale U.S. corporate-tax

cuts. The House of Representatives 170 and the Senate have both passed 160 timate s tax bills, and Congressional leaders s e 150

have vowed to have the bills to ) ngs i S President Trump for his signature n 140 ($ U ea r before the end of the year. Markets 130

have already responded positively, ensu s 120 although some legislative details Con s still need to be sorted out. Optimism 110 2011 2012 2013 2014 2015 2016 2017 2018 about impending tax cuts can be 2014 2015 2016 2017 2018 2019 observed in a comparison of the Source: Thomson Reuters, Bloomberg performance of stocks that stand to benefit most if the tax bill is enacted Exhibit 66: U.S. analyst overoptimism in S&P 500 EPS estimates (i.e. companies with high effective Monthly pattern, averages for 1985-2016 tax rates) versus those that won’t (i.e. companies with already-low tax $135 rates). Wolfe Research has identified 112 stocks that would fall in either $130 of the two camps (56 in each), and the relative performance of these $125 unweighted baskets is plotted in $120 Exhibit 68. The rising line in the chart since September reflects $115 the increasing likelihood of tax Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec cuts coming to fruition as high-tax Average Forecast Error Rebased to Feb. 2017 Forecast 2017 bottom-up consensus earnings estimate companies outperformed. Wolfe Source: Chopra, ThomsonReuters, RBC GAM

40 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Research’s analysis also suggests that every 5-percentage-point cut to Exhibit 67: Companies reporting results above consensus forecasts the corporate tax rate would boost S&P 500 earnings by 3% (Exhibit 100% 69). Thus a 15-percentage-point 90% 80% Last Plot: 73% reduction to 20% from the current port s

e 70% r

35% corporate tax rate could result s 60% u in a 9% boost to aggregate S&P n s 50% 40%

500 earnings, or roughly US$10 ons e c

30% per share. While the tax cuts would e 20% clearly be a significant tailwind Abo v 10% 0% to the stock market, the fact that 2003 2005 2007 2009 2011 2013 2015 2017 2019 the high-tax stock basket has % Greater Than Expectations Long-Term Average: 62% outperformed so strongly indicates Source: Thomson Reuters that at least a portion of the anticipated change has already been Exhibit 68: U.S. corporate tax reform long/short basket priced in. Relative performance

e 12

Gauging the potential for c n 10 a

stocks m 8 r o f

r 6

To get a sense for where stocks e (% ) p 4 could trade in the year ahead if tax ve 2 i t a cuts are passed, we ran scenarios l 0 e combining earnings estimates at R -2 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 different price-to-earnings levels. Notes: U.S. corporate tax reform long/short basket is a long-short portfolio based on Wolfe Research's Exhibit 70 outlines these scenarios outlook for corporate tax reform. The chart represents the equal-weighted net performance of being long 56 stocks poised to benefit most and 56 stocks likely to face the largest headwinds in Wolfe Research's base for 2018 with and without the impact case scenario for corporate tax reform. In the S&P 500, they identified the top/bottom ~10% of each industry group that would be most impacted under their base case of a 25% corporate rate and transfer of tax cuts. With the US$10 boost to pricing/income shifting being materially curtailed. They did not include real Estate or a border adjustment S&P 500 earnings expected from tax tax. Source: Wolfe Research, Bloomberg, RBC GAM cuts, the S&P 500 could reach 2948 by the end of next year and deliver Exhibit 69: S&P 500 EPS impact at varying U.S. corporate tax rates a total return of roughly 13% from November 30, 2017. This scenario 9% assumes the market trades at our modelled equilibrium P/E of 18.9 6% and the S&P 500 generates earnings of US$156 per share (analysts’ 4% top-down consensus estimate of 3% US$146 plus US$10 from tax cuts). In the event that the tax bill fails, the

S&P 500 would rise to only 2759, to 500 EPS changeS&P Estimated generating a lesser but still positive 20% 25% 28% 30% U.S. corporate tax rate total return of about 6%. While a Source: Wolfe Research

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 41 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

wide range of outcomes is possible, Exhibit 70: Earnings estimates and alternative scenarios for valuations and these scenarios illustrate that even outcomes for the S&P 500 Index from a starting point of relatively full Consensus + $10.00 Consensus valuations, returns can still be decent from corporate tax cuts as long as earnings come through. 2018 2018 2018 2018 Top down Bottom up Top down Bottom up Styles: value stabilizes versus P/E $146 $147 $156 $157 growth +1 Standard Deviation 23.2 $3389 $3412 $3621 $3645

Value stocks have stabilized relative +0.5 Standard Deviation 21.1 $3074 $3095 $3285 $3306 to growth stocks and may suggest Equilibrium 18.9 $2759 $2778 $2948 $2967 increasing investor confidence in the ability of Congress to implement -0.5 Standard Deviation 16.7 $2444 $2462 $2612 $2629 pro-growth policies. Coincident with -1 Standard Deviation 14.6 $2130 $2145 $2276 $2290 the Senate making progress on its Source: RBC GAM version of a tax bill, value stocks rose 1.7% relative to growth stocks Exhibit 71: Value to growth relative performance in the last few days of November S&P 500 Value Index / S&P 500 Growth Index (Exhibit 71). While this move 4% Nov 9, 2016: represents only a fraction of the e 2% Trump wins

an c U.S. election 12% relative loss for value versus 0% -2%

growth stocks since the start of the erfor m p -4% e

year, the recent stabilization in value v as a theme could signal renewed at i -6% re l -8% e confidence that the economy is v -10% at i about to accelerate. Value stocks u l -12%

u m Pre-election trough: generally outperform growth equities C -14% Trough: Jan 25, 2016 when the economy is picking up -16% Nov 27, 2017 2014 2015 2016 2017 2018 momentum because investors Source: Bloomberg, RBC GAM generally prefer cheaper stocks in an environment where earnings gains from crisis levels. Aside from rising In this improving growth are more broad-based. interest rates, other risks to our environment, it is difficult to get outlook include the ever-present excited about prospective returns Asset mix: maintaining risk of protectionism, European in sovereign fixed-income assets. overweight stocks/ politics and international relations, Yields remain extremely low underweight bonds particularly with respect to North throughout the world and a starting Nearly a decade after the financial Korea. We are cognizant that the point of low yields often leads to crisis, the economy is gaining business cycle is aging, but in low total returns over the medium momentum through a synchronized our view the balance of risks and to longer term. In the past, the yield global expansion and the forces of opportunities tilts in favour of to maturity on a 10-year T-bond secular stagnation may be beginning growth in the economy, and we are has provided a reliable forecast to fade. Inflation is firming, but not yet seeing signs of any imminent for forward 10-year total returns not yet problematic, and monetary downturn. on that bond (Exhibit 72). If this policy is appropriately moving away relationship holds, investors could

42 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

expect to earn 2.4% annualized over the next decade. As central banks Exhibit 72: U.S. 10-year Treasury note and returns continue to tighten and/or dial back 18 the stimulative monetary policies 16 that have been in place for most of 14 the post-financial-crisis era, yields 12 are likely to drift upward, acting 10 8 % as a headwind to fixed-income Correlation: 0.96 6 returns. At the current low level of 4 yields, a 13-basis-point increase 2 in the U.S. 10-year yield wipes out 0 any incremental returns to cash 1910 1930 1950 1970 1990 2010 2030 over the next 12 months (Exhibit 10y UST Yields, Advanced 10Yrs Subsequent Realized 10yr Compound Annual Nominal Returns 73). While we expect only a gradual Source: Deutsche Bank, Haver Analytics, RBC Capital Markets rise in yields over the next year, our sovereign-bond return forecasts are Exhibit 73: U.S. 10-year Treasury near zero or even slightly negative in Required move in yields for break-even return against 30-day T-Bill all major regions one year from now. 50 Compared to fixed income, stocks 45

continue to offer superior total- ) 40 bp s return prospects. We recognize, ( 35

s t however, that the deep discounts n 30 Last plot: 13 bps po i 25 available at earlier stages of the s bull market have since been erased. 20 Bas i Valuations are now more demanding 15 and further gains for equities will 10 depend on earnings growth. The 5 outlook for corporate profits is 2009 2011 2013 2015 2017 2019 Source: RBC CM, RBC GAM indeed positive, but should earnings fail to meet analysts’ expectations and/or the U.S. tax bill fails to been reducing risk exposure in our asset mix relative to our strategic go through, equities would be asset mix but have opted to pause neutral levels. For a balanced, global vulnerable given current valuations. this quarter given the absence of investor, we currently recommend an technical deterioration, the ongoing asset mix of 58% equities (strategic We are watching ever more diligently strength in profits and the increased neutral position: 55%) and 39% for signs of a top in stock markets, possibility of meaningful U.S. fixed income (strategic neutral but at this point we are not seeing corporate-tax cuts coming to fruition. position: 43%), with the balance in an abundance of signals that would As a result, we have maintained a cash. indicate the end of the cycle. Over moderate overweight in stocks and the past several quarters, we had underweight in fixed income in our

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 43 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

GLOBAL FIXED INCOME MARKETS

U.S. 10-Year T-Bond Yield Eurozone 10-Year Bond Yield Equilibrium range Equilibrium range

16 18 14 16

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: 2.41% Current Range: 1.80% - 3.58% (Mid: 2.69%) Last Plot: 0.85% Current Range: 1.46% - 2.60% (Mid: 2.03%) Source: RBC GAM, RBC CM Source: RBC GAM, RBC CM

Japan 10-Year Bond Yield Canada 10-Year Bond Yield Equilibrium range Equilibrium range

14 18

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: 0.04% Current Range: 0.18% - 1.00% (Mid: 0.59%) Last Plot: 1.89% Current Range: 1.32% - 2.86% (Mid: 2.09%) Source: RBC GAM, RBC CM Source: RBC GAM, RBC CM

U.K. 10-Year Gilt Equilibrium range

18 16 “Our models continue to 14 12 suggest that valuation risk exists 10

% in the fixed-income market, 8 6 with yields below our estimate 4 2 of equilibrium in all major 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 Last Plot: 1.33% Current Range: 1.37% - 3.12% (Mid: 2.25%) regions.” Source: RBC GAM, RBC CM

44 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

GLOBAL EQUITY MARKETS

S&P 500 Equilibrium S&P/TSX Composite Equilibrium Normalized earnings and valuations Normalized earnings and valuations

5120 Nov. '17 Range: 2015 - 3363 (Mid: 2689) 25600 Nov. '17 Range: 13799 - 20905 (Mid: 17352) Nov. '18 Range: 2148 - 3585 (Mid: 2867) Nov. '18 Range: 14010 - 21225 (Mid: 17617) 2560 Current (30-November-17): 2648 12800 Current (30-November-17): 16067 1280 6400 640 3200 320

1600 160

80 800

40 400 1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020 Source: RBC GAM Source: RBC GAM

Japan Datastream Index Eurozone Datastream Index Normalized earnings and valuations Normalized earnings and valuations

Nov. '17 Range: 1675 - 3763 (Mid: 2719) 1040 3200 Nov. '18 Range: 1788 - 4018 (Mid: 2903) Current (30-November-17): 1704 1600 520 800

260 400

200 130 Nov. '17 Range: 287 - 896 (Mid: 592) Nov. '18 Range: 302 - 941 (Mid: 621) 100 Current (30-November-17): 559 65 50 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

U.K. Datastream Index Emerging Market Datastream Index Normalized earnings and valuations Normalized earnings and valuations

26880 Nov. '17 Range: 6280 - 13145 (Mid: 9713) Nov. '17 Range: 236 - 441 (Mid: 339) Nov. '18 Range: 6994 - 14638 (Mid: 10816) 640 Nov. '18 Range: 253 - 474 (Mid: 364) 13440 Current (30-November-17): 5504 Current (30-November-17): 271

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

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 45 GLOBAL FIXED INCOME MARKETS The bond-market outlook

Soo Boo Cheah, MBA, CFA Exhibit 1: Underlying inflation pressures are higher Senior Portfolio Manager RBC Global Asset Management (UK) Limited 3.5% ea r y -

Taylor Self, MBA n 3.0% o Analyst 2.5% ear - y RBC Global Asset Management (UK) Limited e 2.0%

1.5% chan g

e g

a 1.0% A global economic upswing is t n e

c 0.5% eliminating what slack remains in r e developed and emerging economies, P 0.0% while major central banks have 2012 2013 2014 2015 2016 2017 Underlying inflation gauge Core PCE inflation either begun or are expected to Source: Federal Reserve Bank of New York, Bureau of Economic Analysis, Bloomberg begin tightening monetary policy for the first time in several years. far by raising interest rates over the Investors expect Bank of Japan In addition to rate hikes, central past two years. The Fed’s ability (BOJ) Governor Haruhiko Kuroda to banks are slowing asset purchases to raise rates amid a backdrop continue his efforts to fix the yield in another likely harbinger of higher of steady economic growth has on the 10-year Japanese government yields. By the second half of 2018 – encouraged the U.S. central bank to bond (JGB) at 0%, as inflation has and for the first time in a decade – also begin reducing the size of its not reached the central bank’s target net purchases by global central balance sheet. The Fed started this of 2%. We note that it is getting banks will not be adding liquidity to process in October, with little market easier for the BOJ to achieve this the global financial system. impact, and its actions in this area goal because, as the central bank’s The reaction of central banks speak to its success so far in guiding share of the JGB market approaches to accelerating global economic market expectations. 50%, smaller amounts of bond purchases are required to maintain growth is the most important factor In the Eurozone, Mario Draghi, currently affecting fixed-income bond-yield levels under the BOJ’s president of the European Central “yield-curve control” program. We markets, and investors are sanguine Bank (ECB), has also won the hearts in their belief that central banks foresee a slight risk that the BOJ of investors, as expectations for could adjust its policy framework, can tighten monetary policy without ECB rate actions almost exactly much jeopardizing economic growth. especially surrounding yield-curve match those laid out by the ECB. control. Both the bond market and central The ECB’s plans and the evolution banks foresee a gradual path toward of economic data look strikingly One global condition that has policy normalization, and investors’ similar to the Fed and the U.S. enabled central banks to keep rates faith in the ability of central banks to economy in the first quarter of 2014, low is persistently benign inflation, deliver at least a few more years of at which point the first hike for the and it is therefore faster inflation economic growth and relatively low Fed was about 18 months away. For that would most likely undermine the inflation has never been greater. the time being, bond yields across current mood in the market. Another The U.S. Federal Reserve (Fed) Europe still depend significantly on possible culprit is a withdrawal of was the first central bank to begin the ECB’s bond-purchase program, central-bank liquidity that is faster gradually withdrawing stimulus – so which Draghi has said will last until than the economy can tolerate. September 2018.

46 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Fixed Income Markets | Soo Boo Cheah, MBA, CFA | Taylor Self, MBA

The challenge, therefore, will be for Exhibit 2: Central-bank quantitative easing and global government-bond central banks to contain deflationary supply pressures while withdrawing stimulus, and hope meanwhile that 2,500 il )

B Projection a tight U.S. labour market leads 1,500 (US$ to higher wages. A new inflation

measure released by the Fed’s New su m 500 York branch suggests that underlying onths -500 m inflation pressures are higher than 2 1 more widely followed indicators -1,500 li ng l suggest (Exhibit 1). Moreover, with o R -2,500 unemployment so low, history 2011 2012 2013 2014 2015 2016 2017 2018 suggests that faster wage growth Global QE demand Bond supply Net should follow. Source: BoE, BoC, ECB, Fed, BOJ, U.S. Treasury, Ministry of Finance (Japan), SNB

With central banks hiking and removing liquidity over the next Exhibit 3: The yield curve flattens while the Fed tightens policy year, we expect investors to be more discriminating in assessing 300 risks than they were over the past 250 year, when asset prices benefited 200 significantly from quantitative 150 easing that exceeded the supply of 100 50 government bonds (Exhibit 2). Now Forecast that central banks are less involved, 0 private investors will have more 2-10s Curve Treasury U.S. -50 influence on prices than they have -100 1987 1991 1995 1999 2003 2007 2011 2015 had since central banks became Fed tightening such important buyers, and the yield Source: RBCGAM, Bloomberg, November 2017 curve should be more responsive to market preferences. belief that central-bank support in between 2-year and 10-year bonds the form of asset purchases and has narrowed to 60 basis points and The slowdown in central-bank asset a gradual tightening of financial our forecast is for further flattening purchases and a possible comeback conditions would buoy asset prices. to 35 basis points in the next 12 of inflation will not only affect yields months (Exhibit 4). The concern for on higher-quality bonds. A sell-off The recent flattening of the yield investors is that the U.S. 10-year in the government-bond market curve has attracted a lot of attention bond yield is now lower than it was will almost certainly reverberate in (Exhibit 3). Investors are worried in December 2015, around the time markets for more risky assets such about a possible inversion of the that the Fed was beginning to raise as equities and higher-yielding curve down the road, which would rates. Since then, the Fed has raised fixed-income investments. Investors mean that short-term yields rise rates four times, pushing up short- have spent recent years chasing all above long-term yields. This rare term yields. So, why haven’t long- forms of risky investments to boost occurrence has historically been a term rates risen as well? portfolio returns, confident in their harbinger of recession. The spread

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 47 There are several forces at work. The first is market expectations that Exhibit 4: Yield curve is expected to flatten to 35 basis points inflation will stay low even with the 250 near-record-low unemployment rate. 2004 Tightening Cycle The Phillips-curve assumption that 200 12 months Forecast Yield Curve = 35bps Forecast for inflation rises as the unemployment Fed Funds = 1.875% 150 Current Cycle rate falls appears to have broken down, and the thinking these days 100 is that today’s economy is subject 50 to structural influences such as 0 technology and demographics that US Treasury Curve 2-10s (bps) Curve 2-10s US Treasury -50 will limit inflation for the foreseeable 0123456 future. Fed Funds Rate % Source: RBCGAM, Bloomberg, November 2017 The other factor affecting the yield curve is the Fed itself, whose long- term forecast for the policy rate has dropped to 2.75% recently from 3.50% in December 2015. We believe that these Fed projections are a powerful influence on long- term bond yields. It is worth noting, however, that this long-run policy rate is less a trading signal, and more of a long-term valuation guidepost. In conclusion, we think that bond yields will go higher, but most likely not too much higher. We will elaborate in the Direction of Rates article that follows.

48 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 GLOBAL FIXED INCOME MARKETS Direction of rates

induced by higher bond yields. half of 2018, pushing the German Soo Boo Cheah, MBA, CFA Investors may have to abandon bund yield higher and away from Senior Portfolio Manager risky strategies pursued to boost today’s extremely rich level. As the RBC Global Asset Management (UK) Limited portfolio returns in recent years ECB buys fewer bunds, the cost of Suzanne Gaynor now that the cost of financing has borrowing bunds should decline and V.P. & Senior Portfolio Manager risen and global liquidity is less demand ebb for the limited supply of RBC Global Asset Management Inc. plentiful. While yields have been bunds, allowing breathing room for rising as a result of Fed tightening, yields to rise. they could reverse to the benefit of We expect bond yields to rise Treasury prices when investors seek Using a fair-value model based on over the next 12 months, with safety during periods of heightened historical trends of economic growth short-term yields rising faster volatility. and short-term bond yields, the than those on longer-term bonds. 10-year bund yield could be trading The global economy continues Our core scenario envisages the close to 0.90% in 12 months absent to expand at a healthy pace, the Fed continuing to tighten policy via ECB intervention (Exhibit 1), 0.15% odds of recession are remote and rate hikes and a shrinking balance higher than our previous forecast. the direction of monetary policy is sheet. Assuming that economic Our projection for the policy rate gradually changing. Concerted policy growth remains stable and inflation remains at negative 0.40%. tightening by major central banks rises gradually, Treasury yields is expected to gather pace over the should rise. We expect the 10-year Japan – The Japanese central bank is next year and is likely to push bond yield to rise to 2.75% over the likely to keep holding down the yield yields higher. Moreover, a decrease next 12 months, and factoring our on the 10-year Japanese government in asset purchases by central expectations of higher asset-price bond (JGB) so long as inflation banks should start to exert upward volatility, we see the range for the remains below 2%. However, we pressure on yields. next 12 months to be between see a possibility, when yields on 1.90% and 3.25%. The fed funds U.S. Treasuries and German bunds U.S. – The U.S. Federal Reserve rate will rise to 1.88% from about start to rise, that the Bank of Japan (Fed) raised the fed funds rate 1.13% currently, in our view. (BOJ) shifts its policy focus to target earlier this month, and we expect yields on shorter-maturity JGBs another two rate hikes by November Germany – The European Central instead of 10-year bonds. We believe 2018. Meanwhile, the Fed should Bank (ECB) bond-purchase program that Japanese economic growth proceed with plans to scale back has been keeping pressure on is strong enough and the labour reinvestments in its portfolio of government-bond yields across market tight enough to justify higher Treasuries and mortgage-backed Europe at levels that are too low government-bond yields. The BOJ securities. We believe the risk of given the positive outlook for may allow short-term rates to climb significantly higher longer-maturity economic growth and inflation. over the next 12 months, implying a bond yields should be contained As long as financial conditions higher ceiling for 10-year JGB yields. as long as inflation stays within remain supportive and inflation This scenario depends on both the the Fed’s desired range and its rises gradually, we believe the ECB Fed and the ECB making progress long-range policy-rate forecast will remain on the path to policy with their plans to scale back bond stays between 2.75% and 3.00%. normalization. We think, therefore, purchases. However, there is a short-term risk of that investors will be forced to price higher volatility across asset prices in higher ECB policy rates in the first We expect the BOJ to keep its official target on the 10-year JGB at

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 49 Global Fixed Income Markets | Soo Boo Cheah, MBA, CFA | Suzanne Gaynor

0.00%, but to allow it to stray higher than the assumed ceiling of 0.10% Exhibit 1: Bund yield should revert to fair value absent ECB intervention observed since the launch of yield- Fair Value Model: 10-year German Bund Yield curve control policy. We maintain 12 our deposit-rate forecast at negative 10 0.10% over the next 12 months. 8 Canada – After surprising the market 6 with a rate hike in September, Actual the Bank of Canada (BOC) has 4 since adopted a more cautious 2 tone. The BOC recently said that Model 0.92 the outlook “remains subject to 0 0.35 substantial uncertainties about -2 geopolitical developments and Model minus Actual about fiscal and trade policies” and 3 that policymakers “continue to be 2 Fair Value preoccupied with the downside risks 1 to inflation.” While the BOC was 0 delivering a dovish message, the -0.58 federal government delivered lower- -1 than-expected budget deficits and -2 third-quarter growth underwhelmed 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 expectations, as growth slowed from Source: RBC GAM, Gavekal, Macrobond the torrid pace of the first half of the year. These factors make Canada’s months. The BOC’s cautious stance but wage gains and productivity bond market quite attractive to on rates, offset by another U.S. have been weak. Even prior to the international investors. rate increase this month, should referendum to leave the EU in June continue to support the relative 2016, U.K. household finances had Provincial bonds have enjoyed near-term performance of Canadian been deteriorating. particular attention outside Canada. bonds. We expect Canadian yields to The country’s AAA credit rating and move higher in 2018 in conjunction Household savings have been relatively high liquidity are fostering with our view of rising yields in declining, while unsecured demand from international investors, the U.S. We forecast an increase borrowings to maintain consumption who face a reduced global supply of in the BOC policy rate of 50 basis have tracked higher. None of government and quasi-government points to 1.50% over the 12-month these trends speaks well for the bonds due to the EU’s quantitative- horizon. Our forecast for the 10-year long-term health of the economy. easing program. Moreover, strong government bond rises to 2.25%, a Chancellor Philip Hammond, in his global demand for longer-dated 15-basis-point increase. recent budget speech, said the bonds aligns with the longer potential for a slowdown in U.K. duration of provincial issues. U.K. – For more than a year, the growth has increased and showed a narrative has been about economic willingness to expand fiscal policy to Our preference for Canadian uncertainty linked to Brexit. cushion Brexit headwinds, implying government bonds over U.S. fixed Employment continued to improve, higher government borrowing. In income worked well in recent

50 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Global Fixed Income Markets | Soo Boo Cheah, MBA, CFA | Suzanne Gaynor

our opinion, higher government INTEREST RATE FORECAST: 12-MONTH HORIZON borrowing does not automatically Total Return calculation: Nov. 24, 2017 – Nov. 23, 2018 lead to higher gilt yields given U.S. that slower economic growth will Horizon typically lead to lower yields. Under 3-month 2-year 5-year 10-year 30-year return (local) these circumstances, the Bank of Base 1.88% 2.40% 2.60% 2.75% 3.10% (1.67%) England would most likely ease Change to prev. quarter 0.25% 0.40% 0.10% 0.00% (0.15%) monetary policy, or at the very least High 2.38% 3.00% 3.15% 3.25% 3.60% (4.37%) stay on hold, while other major Low 1.38% 1.50% 1.70% 1.90% 2.40% 2.78% central banks are tightening. Expected Total Return US$ hedged: (1.50%)

We expect the U.K. to be negotiating GERMANY the terms and timeline of Brexit Horizon 3-month 2-year 5-year 10-year 30-year return (local) for a good part of our forecast Base (0.40%) 0.00% 0.35% 0.90% 1.50% (3.14%) horizon. Even with the talks’ Change to prev. quarter 0.00% 0.10% 0.10% 0.15% 0.20% increasing frailty, we have penciled High (0.20%) 0.40% 0.75% 1.25% 1.75% (5.86%) in a 25-basis-point BOE rate hike Low (0.40%) (0.50%) (0.25%) 0.25% 0.90% 2.96% premised on the extension of the Expected Total Return US$ hedged: (1.20%) global economic expansion. We are raising the 10-year gilt yield forecast JAPAN to 1.75%, a 25-basis-point increase. Horizon 3-month 2-year 5-year 10-year 30-year return (local) Regional preferences Base (0.10%) (0.05%) 0.00% 0.10% 0.90% (0.08%) Change to prev. quarter 0.00% 0.00% 0.02% 0.00% (0.10%) We are reducing our underweight High 0.00% 0.10% 0.10% 0.25% 1.10% (2.70%) exposure to the U.S. by half to Low (0.10%) (0.10%) (0.10%) (0.10%) 0.60% 3.94% 2.5 percentage points from 5 Expected Total Return US$ hedged: 1.90% percentage points and initiating a 2.5-percentage-point underweight CANADA position in German bunds. We Horizon 3-month 2-year 5-year 10-year 30-year return (local) maintain our 5-point overweight in JGBs. We expect bond returns Base 1.50% 1.90% 2.05% 2.25% 2.60% (1.17%) Change to prev. quarter 0.25% 0.40% 0.25% 0.15% 0.00% in most regions to underperform High 2.00% 2.30% 2.60% 2.75% 3.00% (4.72%) cash. JGBs are the exception, after Low 0.75% 1.00% 1.10% 1.30% 1.70% 7.31% factoring in returns from currency Expected Total Return US$ hedged: (0.50%) hedging. U.K. Horizon 3-month 2-year 5-year 10-year 30-year return (local) Base 0.75% 1.00% 1.30% 1.75% 2.15% (3.17%) Change to prev. quarter 0.25% 0.25% 0.30% 0.25% 0.15% High 1.00% 1.25% 1.65% 2.00% 2.25% (4.87%) Low 0.25% 0.25% 0.30% 0.75% 1.50% 6.92% Expected Total Return US$ hedged: (1.20%) Source: RBC GAM

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 51 CURRENCY MARKETS

Dagmara Fijalkowski, MBA, CFA Exhibit 1: Long-term cycles in U.S. trade-weighted dollar Head, Global Fixed Income & Currencies RBC Global Asset Management Inc. 150 8 yrs 6 yrs 10 yrs 7 yrs 9 yrs 6.5 yrs Daniel Mitchell, CFA 140 -26% +67% -47% +43% -40% +42% Portfolio Manager 130 RBC Global Asset Management Inc. 120 110 100 42% 90 U.S. dollar cycle becomes 80 extended 70 60 We have long held that cyclical 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 movements in the trade-weighted U.S. Trade-weighted dollar U.S. dollar offer a useful tool for Source: U.S. Federal Reserve, Bloomberg gauging the currency-investing landscape. Our analysis usually begins with these longer-term cycles Exhibit 2: Purchasing power parity (U.S. trade-weighted dollar) before considering the shorter-term 150 factors of individual currencies. 140 130 A glance at Exhibit 1 suggests that 120 the current U.S. dollar upswing may 110 have run its course now that the 100 rally has matched what is typical 90 in both length and magnitude. 80 However, there are good arguments 70 60 why this cycle could run longer than 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 average and why the inevitable USTW$: 88.68 [Nov. 24, 2017] PPP: 80.88 [Nov. 2017] 20% Band : [64.70, 97.05] reversal will not be as sudden as Source: U.S. Federal Reserve, Bloomberg, RBC GAM peaks in 1985 and 2001, when policymakers reacted to excessive 3). We conclude that this process result in meaningful demand for U.S. dollar gains that had disrupted can take several years to unfold, the greenback as U.S. corporate global markets. We believe that especially in the absence of policy earnings are repatriated. Finally, similar intervention is less likely intervention. protectionism could give the U.S. in 2018 because the U.S. dollar is dollar a boost by prompting trade not as expensive as it was at the What could lead the U.S. dollar to partners to weaken their currencies time of the previous tops (Exhibit strengthen in 2018? Three points to maintain competitiveness. So, 2). In addition, closer examination come to mind. First, the U.S. Federal while 2017 has largely been a year of the prior peaks shows that, even Reserve (Fed) continues to hike of U.S. dollar weakness, we expect in those sharp reversal episodes, it rates while other central banks this combination of factors to drive a took time for turning points to occur are still pushing bond yields lower rebound next year toward the highs as the greenback made highs versus via quantitative easing. Second, previously seen in 2016. currencies at different times (Exhibit the passage of tax reform could

52 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

Greater dispersion of currency returns Exhibit 3: U.S. dollar peaks against major currencies The maturing stage of the U.S. dollar 1985 peak cycle leads us to examine some of 150 the fundamental factors that drive CHF EUR GBP NZD SEK 140 returns of individual currencies, 130 and in doing so we find that these JPY 120 CAD elements support improved outlooks 110 AUD for the euro and yen but signal 100 (1973 = 100) deteriorating trends in the U.K. and 90 4 yrs Canada. Our forecasts reflect this 80 U.S. U.S. weighted trade dollar divergence and assume that, while 70 the U.S. dollar may have already 60 peaked against the yen and euro, it 1980 1980 1981 1982 1983 1984 1985 1985 1986 1987 1988 1989 1990 has room to strengthen against the Source: U.S. Federal Reserve, Bloomberg other two major developed-market 2001 peak currencies discussed here. 120 115 GBP CAD It is the nature of foreign-exchange lar 110 CHF EUR SEK do l markets that different factors can 105 NZD AUD ed JPY be driving currencies at any given 100 )

gh t 100 i = e time. These are easy to spot after w 95 1973

the fact. The trick to successfully ( ade 90 r t trading currencies, however, lies in . 85 3.5 yrs S . anticipating the rotation of driving U 80 factors. In today’s environment of 75 improving global growth, it seems 70 1990 1991 1992 1993 1995 1996 1997 1998 2000 2001 2002 2003 2005 logical that economic trends drive Source: U.S. Federal Reserve, Bloomberg currency performance. This has certainly been the case over the past year, when currency movements Exhibit 4: FX returns versus economic data have corresponded to the degree of economic improvement (Exhibit 4). 20.0% Recent trends of economic data in Canada and the U.K. suggest that 15.0% these countries may experience 10.0% weaker growth than others going 5.0% forward – a dynamic we expect to persist as both struggle to negotiate 0.0% -5.0% with key trading partners. 1-year FX spot returns

-10.0% Looking forward, we ask ourselves -300 -200 -100 0 100 200 300 400 500 which factors will dominate in 2018. Citigroup data change measure vs U.S. We think current-account balances Source: Citibank, Bloomberg

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 53 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

will begin to draw more attention as the macroeconomic landscape Exhibit 5: Current-account balances (% GDP) shifts to one marked by central- bank liquidity withdrawal which 10 8 may upset investor complacency. 6 It is now quite clear that central 4 2 banks are transitioning away from 0

providing liquidity: the Fed will of % GDP -2 continue to shrink its balance sheet -4 -6 over the course of the year while the -8 European Central Bank (ECB) and N.Z. U.K. U.S. India Brazil China Korea Switz. Japan Philip. Indon. Russia Turkey Poland

Bank of Japan (BOJ) purchase Mexico Norway S.Africa Canada Sweden Hungary Australia Malaysia Colombia Eurozone fewer assets. C/A Balance, % of GDP 2 years ago Source: Bloomberg Meanwhile, central banks in Canada, China, Sweden and the U.K. are also which has broadened to include which goes to the euro. Given that tightening policy. The combined southern Europe. Two other factors foreign-exchange reserves total effect of these actions on financial also deserve elaboration. more than US$11 trillion (Exhibit 6) – markets has so far been limited, but these flows could offer significant as more tightening occurs we would The first is a diminishing tendency support for the single currency. expect greater market volatility and for Europeans to invest abroad. a tougher environment for countries Portfolio outflows from the Eurozone The reason we aren’t definitively needing to fund large current- peaked at 550 billion euros in 2016 optimistic about the euro is because account deficits. Some, including but have fallen to levels that may no we think its current exchange emerging-market countries, have longer weigh on the euro. Looking rate more than reflects these made improvements in recent years. forward, the improved balance improvements. A comparison of Canada and the U.K., however, of capital flows should persist the exchange rate with interest- stand out for their lack of progress given that the ECB will be placing rate differentials, a reliable guide (Exhibit 5). less downward pressure on bond historically to the euro’s value, yields. The second euro-positive indicates that the currency should Euro development is the resumption of be trading closer to parity than to growth in global foreign-exchange its current level of 1.19 (Exhibit 7). We have raised our 12-month euro reserves. These are mostly U.S. Moreover, the ECB understands forecast this quarter to 1.12 per dollar assets accumulated by the risk that an elevated currency U.S. dollar from 1.07, reflecting countries trying to prevent strength can pose to growth and inflation. a still-bearish outlook from the in their own currencies, and such This is why ECB President Mario current level of 1.19 but recognizing stockpiles would expand if the Draghi cited his concerns about improvements in the longer-term Trump administration continued its foreign-exchange movements in drivers of the currency. These protectionist tendencies. As a way a September press conference include reduced political risk, with of ensuring a more balanced pool and why the ECB has indicated to less-dramatic-than-feared outcomes of assets, reserve managers tend investors that it will be keeping in Spain’s Catalonia region, as well to sell U.S. dollars for other major negative interest rates for some as French and German elections; and currencies, the largest share of time. Recent euro strength seems a brisk pace of economic growth,

54 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

inconsistent with money-market expectations that interest rates Exhibit 6: Global foreign-exchange reserves will remain negative until the fall of 2020. Short-term factors, like the 14 currency’s negative cost of carry and 12 overbought positioning, also suggest 10 that further gains are limited. Global FX 8 reserves are growing again Japanese yen 6 Similar to the Eurozone, Japan is 4 enjoying stronger economic growth 2 Internationalreserves ( $ trillions) and positive net capital inflows, 0 and these flows indicate improving 2003 2005 2007 2009 2011 2013 2015 2017 demand for the yen. The so-called Source: Bloomberg basic balance, which combines the current account, foreign direct Exhibit 7: U.S., Euro 2-year spread vs. EURUSD investment and portfolio flows, is in positive territory for the first 300 1.60 time since 2014 (Exhibit 8). The improving basic balance of payments 200 1.50 magnifies another important long- 100 1.40 term support for the yen – its 0 1.30 persistent undervaluation. The yen bps EURUSD has been one of the few extremely -100 1.20 undervalued currencies based on -200 1.10 all long-term metrics that we follow. -300 1.00 These metrics, which suggest the 2008 2010 2012 2015 2017 Japanese currency is 20%-25% EURUS 2Yr spread (LHS) EURUSD Spot Rate (RHS) undervalued, are consistent with the Source: Bloomberg BOJ’s own estimates.

Reviewing the yen’s typical drivers, Exhibit 8: Japan’s basic balance of payments we see that the currency has 40 historically moved in unison with 30 bond yields and Japanese equities. 20 These relationships are now 10 breaking down. Perhaps this hints 0 -10 at a lack of faith in ”Abenomics,” -20 the set of policies put forth by Trillions(Yen) -30 Prime Minister Shinzo Abe to revive -40 the Japanese economy, and lower -50 Jan-04 Dec-05 Nov-07 Oct-09 Sep-11 Aug-13 Jul-15 Jun-17 expectations that the BOJ’s policies Net portfolio flows Current account will continue to exert downward Net foreign direct investment Basic balance of payments Source: Bank of Japan, Macrobond pressure on the yen. In any case,

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 55 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

the yen has had difficulty weakening beyond 114 per dollar (Exhibit Exhibit 9: USDJPY spot exchange rate 9), even after Abe’s mandate was strengthened following his landslide 118 victory in October elections and as 117 116 U.S. Treasury yields trended higher. 115 The final element that feeds our 114 113 more optimistic stance on the yen 112 is its safe-haven status. Japan has 111 USDJPY rate USDJPY exchange had a positive net international 110 investment position for many years – 109 which is to say that its government 108 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 and citizens own more assets abroad Source: Bloomberg than foreigners do in Japan. This investment balance matters more during periods of markets stress, Exhibit 10: U.K. retail sales (ex autos & fuel) when foreign assets tend to be liquidated and cash is brought home 10 to Japan. It is at these times that 8 the yen tends to perform best, even

) 6 Y if the uncertainty is caused by a o Y 4 Japanese event as was the case after ( 2 the 2011 Fukushima earthquake and change

0 tsunami. While we can’t forecast % earthquakes, we are wary of the -2 low levels of volatility in global -4 asset markets, as well as exuberant -6 1989 1992 1995 1998 2001 2004 2008 2011 2014 2017 investor behavior. As a result, we Source: U.K. Office for National Statistics, Macrobond like owning yen in our portfolios as insurance against such risks one that is bound to precipitate a celebrations will be short-lived. The and forecast the yen to strengthen more painful adjustment at a time new trade relationship between the toward 110 per U.S. dollar over the when Brexit negotiations are creating EU and the U.K. will form the second coming 12 months. business uncertainty. phase of the negotiations, and these are set to be far more complex than British pound Foreign-exchange markets, so the earlier round of talks. We have referred before to the far, do not reflect this reality. The gloomy outlook for U.K. consumers. British pound has rallied 10% this Recent economic data releases Disposable incomes have been year and now sits near its post- are now showing some weakness squeezed by high inflation, savings Brexit highs. This is due, in part, to in household spending (Exhibit rates have collapsed to multi-decade bearish positions being unwound 10). What’s more, U.K. consumer lows and households have been on speculation of progress in sentiment seems to be faltering borrowing to maintain consumption. negotiations toward a divorce bill most in the lower quartile of the This model is unsustainable, and with the EU. However, we think these income distribution (Exhibit 11).

56 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

This is the segment that is most sensitive to changes in economic Exhibit 11: U.K. consumer confidence by income quartile conditions because a large portion of what they earn is spent rather 15 than saved. It is for this reason 10 that we find it odd that the Bank 5 0 of England (BOE) chose to begin -5 raising interest rates last month. The -10 Level BOE’s move was especially puzzling -15 because the inflation-targeting -20 central bank should also be aware -25 that the temporary effect on inflation -30 1st Quartile 2nd Quartile 3rd Quartile 4th Quartile from currency weakness has now End of 2015 Before Brexit Current passed (Exhibit 12). All this is to say Source: U.K. Office for National Statistics, Macrobond that we expect the BOE to be more cautious going forward. Combining the U.K.’s sluggish growth outlook Exhibit 12: GBP performance and U.K. imported inflation with its large current-account deficit 20% -30% and slow-to-tighten central bank, -25% 15% our 1.15 forecast suggests a much -20% weaker pound in the year ahead. 10% -15% -10% 5% Canadian dollar -5% 0% 0%

The loonie has fallen 6.5% since YoY (% change) YoY (% change) 5% early September, partly reversing -5% 10% summer gains from two rate hikes -10% 15% in response to economic growth 2006 2007 2009 2011 2013 2015 2017 exceeding 4%. Our 12-month GBP trade weighted index, inverted rhs Consumer goods import prices (excl. cars), lhs Source: Bloomberg, UK Office for National Statistics forecast of 1.37 is premised on a slower pace of economic growth in rapidly changing economic-policy • Rising taxes for small-business the year ahead, a widening interest- environment could have more owners, with more stringent rate gap with the U.S. and poor influence than it did in the past. In treatment of passive income and competitiveness that will widen this section, we focus on Canada’s income splitting; Canada’s current-account deficit. poor competitiveness and explain • Tighter housing regulations, Shorter-term factors such as the how Canada’s currency will need stricter mortgage rules and movements in the price of crude oil to cheapen to offset some of the stress tests to be implemented in often distract Canadians from what economic headwinds that lie ahead. January 2018; is really important to the direction There is no shortage of • Stronger unions than south of the of currencies over the long term. developments that are complicating border; We observe that the currency’s the landscape for Canadian correlation to crude is far from • Tougher environmental businesses: constant (Exhibit 13) and that the standards, including carbon levies;

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 57 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

• Provincial opposition to pipelines, preventing crude oil from moving Exhibit 13: CADUSD correlation with crude oil east and west from land-locked western Canada; 1.0 0.8 • President Trump’s protectionist 0.6 tendencies, with moral suasion 0.4 to “Buy American” and risks to 0.2 NAFTA; 0.0 -0.2 • Significant increases in minimum -0.4 wages. 26 week correlation -0.6 -0.8 Given that small businesses are -1.0 responsible for a large share 1989 1993 1997 2001 2005 2008 2012 2016 of employment growth, these Source: Bloomberg, RBC GAM developments form a hurdle for the economy. A recent survey Exhibit 14: Top cost constraints for Canadian businesses by the Canadian Federation of Independent Business found that 70 its members expect taxes and wages to be their greatest cost 60 constraints (Exhibit 14), and such 50 concerns appear to be increasing, 40 thanks to recent initiatives by the 30 federal and provincial governments. 20 For example, a carbon tax of $10 of concernLevel 10 per tonne will be introduced in 0 2018 and rise by $10 per tonne in Taxes, Wages Fuel, Insurance Banking Product Foreign Occupancy Borrowing Capital Regulations Energy inputs Currency costs equip., each of the following four years. Oct-16 Oct-17 Tech. Some provinces, keen to collect the Note: Data from business barometer survey. Source: CFIB, Macrobond additional revenue have already imposed the tax earlier than Exhibit 15: Tax revenue generated from carbon levies mandated (Exhibit 15). Minimum wages are set to rise to $15/hour in 6

Alberta next year and to the same 5 level in Ontario over two years. 4 This sizable increase from current wage rates of $11.60 in Ontario and 3 $12.20 in Alberta may be tough 2 1 for businesses to absorb. Studies Revenue (billionsCAD) of past wage hikes in Ontario 0 have shown a negative impact on employment among 15-24-year-olds 07-08 08-09 09-10 10-11 11-12 12-13 13-14 14-15 15-16 16-17 17-18 18-19 BC AB ON QC as businesses hire fewer but better Source: Government of B.C., Alberta, Ontario & Quebec, RBC Economics skilled workers.

58 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA

These measures further dent Canadian competitiveness, and Exhibit 16: Canada balance of payments (as % of GDP) mean the country will likely be 8 plagued by trade and current- 6 account deficits for many years to 4 come (Exhibit 16). As investors, we 2 would prefer that these deficits be 0 funded by stable inflows such as -2 % of % of GDP foreign direct investment (FDI) – -4 purchases of physical assets like -6 factories, for example. But FDI is -8 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 actually going in the wrong direction Current account Net foreign direct investment as foreign investment dries up Net portfolio flows Basic balance of payments and Canadian firms continue to Source: Statistics Canada, Macrobond seek better opportunities abroad. Canada still enjoys portfolio inflows To summarize U.S. dollar, but rather by the relative in the form of foreign purchases We’re nearing the end of the dollar merits of each currency. Differences of Canadian government and upswing, but it’s a process that will in growth and balance-of-payments corporate bonds, but these flows take time, possibly years. Patience dynamics are likely to be the key can be a fickle source of funding and is now required as the environment factors going forward, and with that represent heightened vulnerability is one where foreign-exchange in mind, we expect the euro and the for the loonie. fluctuations are no longer driven yen to fare better than the pound predominantly by the direction of the and Canadian dollar.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 59 REGIONAL OUTLOOK – U.S.

UNITED STATES RECOMMENDED SECTOR WEIGHTS Brad Willock, CFA V.P. & Senior Portfolio Manager RBC GAM INVESTMENT BENCHMARK RBC Global Asset Management Inc. STRATEGY COMMITTEE S&P 500 Nov. 2017 Nov. 2017 Energy 4.9% 5.9% The U.S. stock market recorded Materials 2.9% 2.9% returns that were well above average Industrials 11.0% 10.0% over the past three months, rising Consumer Discretionary 12.7% 12.1% 7.7%, on the back of solid returns Consumer Staples 8.1% 8.1% from cyclical sectors such as Health Care 14.1% 14.1% Financials, Information Technology, Financials 16.0% 14.8% Energy and Materials. Returns were Information Technology 25.0% 23.9% pressured by weak performance from Telecommunication Services 1.0% 2.0% the bond-proxy sectors, including Utilities 2.0% 3.1% Real Estate, Utilities, Consumer Real Estate 2.0% 2.9% Staples and Telecommunication Source: RBC GAM Services. The strong overall performance was driven by the continuation of the synchronized S&P 500 EQUILIBRIUM global economic expansion, still Normalized earnings and valuations accommodative global central-bank 5120 Nov. '17 Range: 2015 - 3363 (Mid: 2689) policy and low market interest rates Nov. '18 Range: 2148 - 3585 (Mid: 2867) 2560 and inflation, which drove better- Current (30-November-17): 2648 than-expected financial performance 1280 for most U.S. companies. Improving 640 prospects for tax reform also helped 320 to lift investor sentiment. 160 The U.S. economic backdrop 80 remained solid, as real GDP growth has been roughly 3% in the last 40 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 two quarters compared with the 2% Source: RBC GAM trend seen since the global financial network reached record highs in to support consumer spending, and crisis. Growth appears to have had recent weeks. According to the the housing market in particular. decent momentum into the fourth Federal Reserve Bank of Atlanta, real During the quarter, sales of new quarter as surveys of economic GDP growth for the current quarter homes rose over 6% year over year activity, which correlate well with is rising at a 3.4% pace. In addition, to a level not seen since October GDP, have been coming in above the Conference Board’s Consumer 2007, and a survey of homebuilder trend. Business-activity indicators Confidence Survey recently hit a optimism touched the second- such as the American Trucking 17-year high. The unemployment highest reading since 2005 – the Association’s tonnage index sit at a rate in November was unchanged at midst of the housing bubble. The low four-year high, and volumes carried 4.1%, the lowest since 2000, helping unemployment rate and improving by intermodal cars on the railroad

60 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Regional Outlook – U.S. | Brad Willock, CFA

availability of mortgage credit are 15% above the market average activity, dividends or buybacks; should support further growth in the and year-over-year revenue gains and consumer spending will likely housing market, but affordability is that are more than double the rest improve. While all of this would becoming stretched as home prices of the market. Looking forward, likely push the stock market higher have risen much faster than wages. earnings growth is expected to in the short term, we recognize that accelerate to 11% in the fourth expectations for a tax bill to make it The S&P 500 is up almost 20% quarter, above the long-term trend through Congress have been rising over the past year, driven primarily of 7%, as activity rebounded after since early September. by solid corporate fundamentals. the hurricanes and energy prices After three years of essentially flat continued to rise. Our base case While our base case is for stocks earnings, the S&P 500 is expected assumption is that the economy to rise modestly over the next year, to generate roughly 11% earnings continues to expand and that short- there are several scenarios that growth in 2017. The drop in the term interest rates rise slowly over could lead to declines, including oil price from mid-2014 until early the next year. With respect to the an escalation of tensions with 2016, plus the 20% rally in the stock market, we must recognize North Korea, a policy mistake by trade-weighted U.S. dollar over that asset prices have gone up the U.S. Federal Reserve (Fed) a similar period, depressed the substantially, and that the tailwinds or protectionist trade moves by earnings of the Energy sector and of low corporate borrowing costs, the Trump administration. Stock large multinational producers. The falling energy prices and inflation, markets would become more negative effects of the U.S. dollar and low short-term interest rates volatile and likely fall under any and oil prices started to wane a are no longer incrementally helping of these scenarios. However, any year ago and earnings growth has or are likely to turn into headwinds pullback would probably be minor rebounded strongly, although in in the year ahead. However, we are and short-lived unless a recession the most recent quarter earnings comforted by the solid economic ensued. Our indicators suggest growth decelerated due to hurricane- backdrop, the good corporate that the odds of a recession remain related losses. Despite this, financial performance and the fairly low, but with valuations at an profitability remains exceptional optimism of management teams. eight-year high and the Fed intent as net profit margins were roughly on normalizing interest rates, the 13% and the incremental margin It is too early to turn completely risks have increased. As a result, on a dollar of new sales was 17%, defensive given that prospects we have adjusted our portfolios to similar to percentages in the prior for tax reform have become more be somewhat more defensive by three quarters. The remarkable likely. If the tax bill is signed into raising our stake in the Health Care profitability is being driven by law, corporate earnings could and Utilities sectors and trimming manufacturers of capital goods and be revised higher by 5%-9% in some of our overweight exposure software. These highly profitable 2018; repatriated foreign earnings to the most cyclical parts of the companies sport profit margins that could lead to increased merger Information Technology sector.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 61 REGIONAL OUTLOOK – CANADA

Irene Matsyalko, CFA CANADA RECOMMENDED SECTOR WEIGHTS Portfolio Manager RBC Global Asset Management Inc. RBC GAM INVESTMENT BENCHMARK STRATEGY COMMITTEE S&P/TSX COMPOSITE Sarah Neilson, CFA Nov. 2017 Nov. 2017 Portfolio Manager Energy 18.5% 19.7% RBC Global Asset Management Inc. Materials 11.0% 11.1% Industrials 10.5% 9.4% Canadian stocks rose 6.4% in the Consumer Discretionary 6.5% 5.5% most recent quarter, but remain Consumer Staples 4.0% 3.7% one of the worst-performing Health Care 0.5% 0.7% developed markets so far in 2017. Financials 36.5% 35.1% As of November 30, the S&P/TSX Information Technology 3.5% 3.2% Composite Index had returned 7.8% Telecommunication Services 4.0% 4.9% in 2017, compared with returns of Utilities 3.0% 3.8% 15.8% for the S&P 500 Index and Real Estate 2.0% 2.9% 16.6% for the MSCI World Index, Source: RBC GAM both in Canadian dollars. The comparison is particularly notable considering that Canada’s first-half S&P/TSX COMPOSITE EQUILIBRIUM Normalized earnings and valuations GDP was one of the highest among G10 countries. The Canadian index 25600 Nov. '17 Range: 13799 - 20905 (Mid: 17352) was held back by the Energy sector, Nov. '18 Range: 14010 - 21225 (Mid: 17617) appreciation in the Canadian dollar Current (30-November-17): 16067 and concern that the economy lacks 6400 a growth driver for the slowing housing market. Market sentiment continues to be hurt by looming 1600 uncertainty regarding NAFTA, as the U.S. has taken a tougher-than- anticipated stance in negotiations. 400 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: RBC GAM Our expectations for economic growth remain healthy, with U.S. GDP forecast to grow 2.25% in 2017 of Canada (BOC), following two Analysts’ consensus estimates for and 2.75% in 2018. Faster-than- interest-rate hikes earlier this year, S&P/TSX Composite earnings are expected growth in Canada over chose to leave its overnight rate $935 in 2017 and $1,021 in 2018, the first half of the year has pushed unchanged in October, while noting representing annual increases of our 2017 GDP forecast to 3.0%, that economic slack will act as an 13% and 9%, respectively. While but fading tailwinds from stronger offset to potential inflation concerns. market valuations for both the S&P/ oil prices and competitiveness We are monitoring the impact of TSX and the S&P 500 are somewhat concerns result in a much weaker higher interest rates given the elevated relative to history, S&P/TSX 1.5% forecast for 2018. The Bank economy’s reliance on residential valuations are lower than they are for real estate and consumer spending. the S&P 500. This difference seems

62 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Regional Outlook – Canada | Irene Matsyalko, CFA | Sarah Neilson, CFA

justified given the dependence of Consumer Discretionary has been construction are set to benefit from the Canadian market on commodity- the best-performing sector so far this economic growth and a recovery price increases and the size of year. The outperformance came from in capital spending by commodity financial earnings in the domestic stocks like Dollarama, Restaurant producers. market’s overall profit pool. Brands, Cogeco Communications, Martinrea and Linamar. After months Energy has been the worst- The Financials sector drove a of concern about a slowdown in performing TSX sector in 2017, significant amount of the Canadian North American vehicle production mainly because of volatility in crude- index’s recent performance, with and NAFTA risks, automotive oil prices. Crude has rebounded bank stocks climbing roughly 9% suppliers have posted double-digit recently, creating a favourable since the end of August. Bank shares returns and are no longer trading at outlook for sector earnings in 2018. are trading slightly above their depressed valuations. The industry Momentum has been driven by historical average of 11.7 times the is changing rapidly in part due solid demand growth and continued forward P/E multiple, boosted by the to the emergence of self-driving confidence in OPEC’s willingness to BOC’s more hawkish rate outlook. technologies, and Magna is among cut global inventories by maintaining As banks benefit from higher those well positioned to adapt. lower output levels into 2018. borrowing rates, their net interest The resilience of growth in global margins will stabilize and gradually Grocers continued to weigh on the demand and production by U.S. rise. Regulatory conditions that take Consumer Staples sector due to shale producers will help determine effect January 1, 2018, are expected concerns about competitive pressure whether crude prices can rise to slow house-price appreciation from online retailers such as further. and new mortgage originations, Amazon, as well as higher minimum as all borrowers will be required to wages, NAFTA and falling prices The Materials sector is up less than qualify at higher mortgage rates. for generic drugs. Valuations have 2% so far this year as price increases However, most banks have said they compressed as a result after several for copper, zinc and precious believe the impact on earnings will years of robust performance. The metals have failed to translate into be minimal. grocers continue to generate solid significant stock-market gains. Gold free cash flow and demonstrate equities, which make up roughly half The outlook for life-insurance the capacity to return capital to of the sector’s weight, have retreated companies remains positive. Higher shareholders through dividends and amid uncertainty in the outlook interest rates and a leadership share buybacks. for gold prices given the potential change at Canada’s largest insurer, for rising interest rates, a stronger Manulife, have driven solid Canadian National and Canadian U.S. dollar and a relatively stable outperformance since the end of Pacific have contributed significantly geopolitical backdrop. Base-metals August. We believe there is more to TSX performance and profit companies comprise about 15% of room for gains as the insurers trade growth in 2017, benefiting from solid the sector and rallied recently to at reasonable multiples of price rail volumes and pricing. However, reflect rising prices supported by to book value and their returns on they face tougher year-over-year solid demand growth in China. This equity are set to benefit from rising comparisons and already trade scenario bodes well for the cyclically rates. In additional, both Manulife at the upper end of the historical skewed Canadian stock market. and Sunlife generate about 40% of valuation range. Other Industrials revenue in the U.S. and are poised sector constituents such as to benefit from lower corporate tax heavy-equipment distributors and rates.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 63 REGIONAL OUTLOOK – EUROPE

James Jamieson EUROPE RECOMMENDED SECTOR WEIGHTS Portfolio Manager RBC Global Asset Management (UK) Limited RBC GAM INVESTMENT BENCHMARK STRATEGY COMMITTEE MSCI EUROPE Nov. 2017 Nov. 2017 Energy 6.3% 7.3% After a robust first six months Materials 9.0% 8.1% of 2017, the European equity Industrials 14.5% 13.2% market consolidated through the Consumer Discretionary 12.0% 10.5% summer as strength in the euro Consumer Staples 13.8% 13.8% lowered earnings estimates and Health Care 12.5% 12.3% the escalation of tensions in North Financials 20.0% 20.9% Korea reduced demand for risky assets. Both of these issues have Information Technology 6.0% 5.0% subsided in recent months, and Telecommunication Services 3.0% 3.8% the wider picture continues to look Utilities 2.5% 3.7% positive. But we remain mindful that Real Estate 0.5% 1.3% structural and cyclical uncertainties Source: RBC GAM remain, and that these potential disruptions could come back to the EUROZONE DATASTREAM INDEX EQUILIBRIUM fore at some point. Normalized earnings and valuations

We have passed through the big Nov. '17 Range: 1675 - 3763 (Mid: 2719) event-risk peak in European politics, 3200 Nov. '18 Range: 1788 - 4018 (Mid: 2903) Current (30-November-17): 1704 at least for this year. In 2017, 1600 a crescendo of major elections 800 occurred, with the Netherlands, the U.K., France and Germany voting 400 to deliver favourable results for EU 200 continuity and the stock market. 100 However, the middle ground of politics is less secure, and this 50 backdrop poses a risk further down 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: Datastream, Consensus Economics, RBC GAM the road. The next big risk on the horizon is the Italian general election standpoint, these talks are crucial make concessions. The average set for some time in the first half of given that the U.K. represents about trade deal takes 2.8 years to 2018. This vote is important given one-third of Europe’s stock-market complete, so the two-year window Italy’s position as the third-largest capitalization, but also as a roadmap is invariably optimistic and likely to economy in the Eurozone, the rise of should comparable situations arise create volatility as the negotiations Euroscepticism and the complexity elsewhere. A stronger EU recovery ebb and flow. of the region’s political ecosystem. could serve Britain well during the bargaining because representatives There is also the issue of EU The unprecedented Brexit integration. German Chancellor negotiations are set to begin of a more prosperous single market would likely have some leeway to Angela Merkel supports efforts properly in 2018. From an equity by French President Emmanuel

64 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Regional Outlook – Europe | James Jamieson

Macron to foster a reinvigorated headroom given the sizeable utilization above the cycle average sense of European unity at this devaluation of the pound. It is also at 83%, such spending is well vulnerable time. However, she will worth noting that ECB President supported assuming financing have increasing difficulty making Mario Draghi’s eight-year term as conditions remain favourable. concessions on financial transfers chief ends in October 2019. The The robust pick-up in investment from richer EU countries to poorer search for Draghi’s successor will also signals an uptick in European ones (the transfer union) after she begin in 2018, so the equity market corporate risk appetite, a trend forms what is certain to be a more will be discounting the news through that looks set to continue given fragmented governing coalition. next year. that the cost of credit for European Getting the go-ahead for a Eurozone- businesses has never been lower. wide budget, a Brussels-based Aside from inflation, key Encouragingly, rising capital finance minister and collective macroeconomic indicators in Europe expenditures have not come at military will be a hard-sell for continue to look sound, although the expense of cash returns to voters in Germany, where there is the marginal rate of progress has shareholders as evidenced by the much less discussion than in other lessened. It is possible we are fact that dividends are back near countries about the benefits of EU gently nearing the “slowdown” pre-crisis levels. membership. phase of the economic cycle but, importantly, key economic metrics In spite of the recent progress, As in the U.S., low inflation in appear to provide a solid foundation European equities still appear cheap Europe doesn’t appear to concern for a continuation of corporate profit compared with other stock markets. the European Central Bank (ECB), growth. Growth in the money supply European equities also offer value which has just announced that it remains at a decently positive level. on a yield basis relative to other will begin reducing asset purchases The dynamics of growth may change income-producing assets amid the beginning early next year. As when tightening comes through, improving profitability of companies expected, tightening will begin with but the trend should remain intact. in the region and the decline in QE tapering, followed by rate hikes Europe’s manufacturing purchasing political risk. further down the road. The U.K.’s managers’ index rests at cycle highs, need to control inflation following while unemployment in the Eurozone For the first time in many years, sterling’s decline prompted the Bank continues to move steadily lower and consensus earnings estimates for of England to raise the policy rate in now sits below the average in place 2017 are holding up, so absolute November, the first hike since 2007. over the course of the current cycle. valuations look well supported. It is unclear how the mechanics of Importantly, EPS momentum is these central-bank interventions will After a depressed 2016, the value now being driven by revenue work through the system, but we of Western European merger-and- growth for the first time since 2011, expect the tightening to be gradual acquisition activity was up more compounding the positive impact enough for stock markets to absorb than 90% for the period between of cost-cutting and the adoption of them without great shocks. January and late October. Much of technology. Furthermore, a likely this is due to vertical integration rebound in buybacks would enhance Ultimately, near-term decisions to drive efficiency. The U.K. is earnings. made by central banks in Europe will dominating takeover activity, with depend on currency movements, 50% of the total, as the currency All in all, the outlook is positive. and policymakers are very aware collapse has made U.K. assets Volatility remains depressed on a of the impact that their actions can more attractive. Cyclical indicators long-term basis, although we may have on foreign-exchange rates. The of Eurozone capital expenditures still see some oscillations around U.K. looks to have more tightening are also picking up. With capacity the risks raised above.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 65 REGIONAL OUTLOOK – ASIA

Derek Au ASIA RECOMMENDED SECTOR WEIGHTS Research Analyst RBC GAM INVESTMENT BENCHMARK RBC Investment Management (Asia) Limited STRATEGY COMMITTEE MSCI PACIFIC Nov. 2017 Nov. 2017 Energy 2.5% 3.1% Asia-Pacific markets rallied during Materials 6.5% 6.7% the period, adding to the strong Industrials 13.0% 12.3% year-to-date gains that have Consumer Discretionary 13.5% 12.7% propelled the region’s indexes to the Consumer Staples 5.5% 6.1% leadership position in global equity Health Care 5.0% 4.8% performance. The region largely shook off the U.S. Federal Reserve’s Financials 22.0% 21.0% commitment to balance-sheet Information Technology 22.0% 21.3% reduction, as tensions on the Korean Telecommunication Services 3.5% 4.4% peninsula eased. Earnings growth Utilities 2.0% 2.4% supported cyclical sectors such as Real Estate 4.5% 5.4% Industrials and Financials against a Source: RBC GAM backdrop of inexpensive currencies and a strong technology cycle. JAPAN DATASTREAM INDEX EQUILIBRIUM Normalized earnings and valuations China was again the biggest outperformer, as investor sentiment 1040 improved on the back of stabilizing economic indicators and rising 520 corporate-earnings expectations. The MSCI China Index has soared 260 49% this year, easily outpacing the regional benchmark. In Japan, equity 130 Nov. '17 Range: 287 - 896 (Mid: 592) markets advanced 10.9% in U.S. Nov. '18 Range: 302 - 941 (Mid: 621) dollar terms on generally supportive Current (30-November-17): 559 65 macroeconomic data and a rosier 1980 1985 1990 1995 2000 2005 2010 2015 2020 corporate earnings outlook. Further, Source: Datastream, Consensus Economics, RBC GAM a resounding election victory for Prime Minister Shinzo Abe in October relatively soft earnings. Indonesia Utilities and Telecommunication provided a tailwind for the economy, was the laggard during the period, as Services underperformed. and the Bank of Japan (BOJ) is well its central bank and government are positioned to continue with monetary running out of policy options to fire Japan easing. Elsewhere, the strongest- up the economy after six interest-rate Japanese equities soared to their performing markets in the region cuts last year. highest levels since December 1996, were Hong Kong and Thailand. The reflecting the market’s optimism that Indian market, where valuations were Across the region, the best- domestic companies will continue expensive at the start of the year, performing sectors were Financials, to increase earnings as business fared surprisingly well, even amid Information Technology and Consumer Discretionary, while sentiment improves, as well as the

66 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Regional Outlook – Asia | Derek Au

supportive political backdrop. A On the economic front, China by wealth-management products. decline in the Japanese yen against continued on a firm footing despite While we believe these provisions the U.S. dollar during the period also GDP growth slowing marginally to should be stronger, they lead us to supported the rally. 6.8% in the third quarter. That said, expect further reforms to address the broad trend of moderation in excessive leverage. The task of The ruling Liberal Democratic Party economic growth remains intact China’s central government in the gained a decisive victory in snap for now. Industrial production years ahead will be to pursue orderly elections, enabling Abe to remain in accelerated somewhat in recent financial-market deleveraging and office until 2021. While Abe’s primary months while the services sectors prevent systemic risk. mandate is reforming the constitution continue to shoulder much of the to allow for the strengthening of growth in the Chinese economy. Elsewhere in the region, India’s Japan’s military, the market’s focus During the twice-a-decade party macroeconomic outlook has will be on the likely re-appointment congress, the central government weakened because of the of BOJ Governor Haruhiko Kuroda abandoned its GDP growth target, as after-effects of the country’s for a second term. Kuroda’s the world’s second-largest economy demonetization program as well continuation in the post would pledges to focus on the quality of as challenges implementing a allow for the expansion of the BOJ’s economic growth over the long term. goods and services tax (GST). While accommodative policies, exerting The shift away from ambitious official inflation remained healthy amid downward pressure on the yen and growth targets would be a departure rising food and housing prices, Japanese government-bond yields, from past practice. second-quarter GDP growth slipped while providing further support for to 5.7%, the slowest since 2014. stocks. Not everyone is convinced Regarding China’s banking Corporate profits declined in most that Abe’s victory will be constructive sector, outstanding assets under sectors, likely as a result of GST for Japanese equities. The prime management of Chinese bank’s implementation. These near-term minister has indicated that he would wealth-management products disruptions are not serious enough like to raise the national sales tax to slowed during the quarter, perhaps to change our belief that India has 10% in October 2019, a move that signalling progress in financial- taken the measures necessary to could push Japan back into recession market deleveraging. Having increase the country’s long-run as the previous increase, to 8%, did grown exponentially in the past productivity. in 2014. five years, banks have become increasingly cautious on the market Advances in Australian equities were Asia Pacific ex-Japan for these off-balance-sheet loans roughly on par with the rest of the region, although gains were skewed Risk-on sentiment was in full force as China’s banking regulator tightened rules. A tighter grip has towards the Health Care sector. during the period as Asian equities In contrast to the hawkish shift in marched higher into unchartered channeled investment allocations to more diversified instruments commentary from major central territory amid easing geopolitical banks, the Reserve Bank of Australia tensions. Chinese markets were such as money-market instruments and bonds, which we view as maintained its neutral policy stance. driven by a rally in information The labour market continues to show technology, real estate, insurance an encouraging sign for Chinese banks. More encouragingly, Chinese resilience as unemployment ticked and automotive. Stellar performances lower to 5.5% in September, driven due in part to cyclicals resulted from regulators released draft rules in November governing the asset- by job creation in health care and a renewed reform push outlined by construction. President Xi Jinping during China’s management industry that propose national congress in late October. ending the implicit guarantee offered

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 67 REGIONAL OUTLOOK – EMERGING MARKETS

EMERGING MARKET DATASTREAM INDEX EQUILIBRIUM Richard Farrell, CFA Normalized earnings and valuations Portfolio Manager – Emerging Market Equities RBC Global Asset Management (UK) Limited Nov. '17 Range: 236 - 441 (Mid: 339) 640 Nov. '18 Range: 253 - 474 (Mid: 364) Current (30-November-17): 271 After five years of underperformance, 320 emerging-market equities 160 outperformed developed-market stocks in 2016 by 3.7 percentage 80 points and have continued to 40 outperform this year as emerging- market economic growth picked up. 20 The MSCI Emerging Markets Index 1995 2000 2005 2010 2015 2020 Source: Datastream, RBC GAM fell 7.5% in the week following last year’s shock election of President Trump in a very short-term reaction on emerging markets over the next emerging-market economic outlook to concern about U.S. policy 12 months is predicated on the will, in our view, continue to be uncertainty. The turnaround since continued improvement in this trend. driven by Asia. then in emerging markets, where We have long argued that the main In the longer term, we expect higher the 30%-plus return in 2017 has driver of returns on equity over the returns for emerging markets to be outperformed developed markets, short to medium term is changes supported by a shift in the make-up is justified in our view because of in profit margins, which along with of the asset class. Emerging markets improving returns on equity and a asset-use efficiency and financial in Asia now make up 73.5% of the stabilizing Chinese economy. leverage constitute the three main MSCI Emerging Markets Index, up Emerging-market equities remain components of a DuPont analysis of from 52.5% 10 years ago. This shift attractive given a current price- returns on equity. In recent years, is positive because Asian companies to-book ratio of 1.8 and a current profit margins have contributed tend to have higher returns on return on equity of 11.4%, up much more to changes in returns equity than the emerging-market from 10.2% 12 months ago. In on equity, with the recent pick-up in average. Another shift is being contrast, the price-to-book ratio for returns due mainly to a rise in net- driven by expanding middle classes developed markets is 2.4 and the profit margins to 9.3% from 7.8%. in emerging-market countries, return on equity 11.3%, meaning Asset turns and financial leverage generating faster growth in sectors that emerging markets trade at a have been a net drag during that with higher-than-average returns. 27% discount to developed markets, period. These sectors are centred on but offer slightly higher and rising domestic consumption and include The rise in profit margins is due returns. While emerging markets Information Technology, Consumer mostly to a pick-up in industrial have been trading at a significant Staples, Health Care and, to a lesser production, particularly via output discount to developed markets extent, Financials. increases in China, India, South for a number of years, the notable Korea, Taiwan and, to a lesser We are also more confident about change is that emerging markets extent, commodity-exporting China’s economic stability. The now have positive momentum economies such as Brazil, Malaysia latest data from the People’s in terms of earnings growth and and Russia. This improvement in the Bank of China showed that the returns on equity. Our positive view

68 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Regional Outlook – Emerging Markets | Richard Farrell , CFA

country’s foreign-exchange reserves activities were broadly unregulated, rebalancing, come expanding middle increased in September for the but Chinese banking regulators have classes and their higher pay checks. eighth consecutive month, the been requiring banks to gradually The latest data show that this longest stretch since 2014. The bring these assets on balance sheet rebalancing is actually accelerating, reserves now sit at US$3 trillion, a and to start accounting for them a trend that gives us confidence that 3% increase since January of this more in line with traditional bank the Chinese economy can continue year, but below the US$3.9 trillion assets. Regulators have also capped to shift away from excessive peak of June 2014. This trend implies interbank liabilities at 1/3 of total investment-led growth and toward that capital outflows are stabilizing liabilities. consumption-led growth, which we after a government crackdown on believe is more sustainable in the illegal capital flight, and is a positive Another positive for China’s long term. for China’s economic stability economic stability are reforms following the mismanaged renminbi that have reduced production in Certainly, the Chinese economy devaluation of August 2015. sectors that were borrowing and faces a number of significant issues, producing more than the economy particularly with regard to potential One key advantage of the receding needed. After years of talking loan losses in the banking sector. capital outflows is that Chinese about supply cuts in a number However, in contrast to Japan’s authorities can continue to slow of oversupplied sectors, there is zombie-bank crisis or the U.S. sub- credit growth by tightening evidence of action. Data so far prime crisis, Chinese authorities regulation with less risk of creating this year point to continued cuts are very aware of the build-up of a renminbi shortfall in the short- in capacity in industries such as risks in the financial system and are term money and interbank markets. steel, where output has been cut implementing reforms to address China, with banking assets totalling by about 12% since 2014, and coal, them. In our view, the reforms have 228 trillion renminbi (US$33 trillion), where the decline is about 10%. stopped these risks from increasing, overtook the Eurozone in 2016 as These reductions have bolstered but initiatives are still required to the world’s largest banking system pricing power and profit margins, reduce banking-sector risk over the for the first time due to huge enabling overleveraged industrial next few years. Overall, we believe growth in credit. The tightening of companies to lower their borrowing that the odds of a Chinese financial financial regulations can be seen and reducing stress on their balance crisis, which was the largest risk in the flattening of growth in off- sheets. of investing in emerging markets balance-sheet loans such as social in recent years, have declined financing and wealth-management Growth in real disposable income significantly. products. Estimates of these assets remains robust for people in both are between 65 trillion and 70 urban and rural areas. That’s in part trillion renminbi. Until recently, these because, along with the economic

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 69 Should indexes have a conscience? The tragedy of Venezuela prompts a rethink of how emerging-market bond indexes are constructed

Much of this debate for RBC GAM’s appropriate to invest in tobacco Jane Lesslie, MSc, CFA emerging market bond team has companies? Or in companies V.P. & Senior Portfolio Manager, Fixed Income surrounded Venezuela over recent that sell guns to drug gangs?... and Currencies – Emerging Markets, RBC Global Asset Management months. The country has recently Nowadays, it is emerging markets announced a restructuring of its as an asset class that should Earl D’Almeida, MBA, CFA debt. In mid-November it began make people morally queasy. Analyst, RBC Global Asset Management partially defaulting on bond Should decent people put their payments. This followed decades money in emerging-market bond of economic mismanagement under funds?” Emerging market former President Hugo Chavez and countries, by their very his handpicked successor, President How to blow a trillion dollars Nicolas Maduro. definition, are those with Perhaps it is first worth asking how weaker institutions and Last May, Professor Ricardo Venezuela, the wealthiest country Hausmann, head of the Centre in Latin America with a credit rating governance, which lack for International Development of Aaa in 1976, became the Caa3 checks and balances on at Harvard and himself a former rated pariah of today?2 How did power and which suffer Venezuelan planning minister, asked this happen to the country with the the following question in an article world’s largest proven oil reserves?3 from poor transparency. entitled “The Hunger Bonds” on the How did Venezuela see its oil Investor focus on these Project Syndicate website:1 production decline 31% from 1998 features ebbs and while production elsewhere in the “Investing often creates moral world was sky-rocketing (Exhibit 1)? flows with liquidity dilemmas over goals: Should we and headlines. The aim to do well or to do good? Is it vast majority of active 1Ricardo Hausmann, The Hunger Bonds, 2Moody’s Investor Service investors will screen for a Project Syndicate, May 26, 2017 3BP Statistical Review of World Energy, 2016 broad variety of economic Exhibit 1: Venezuelan oil production has fallen even as global and valuation factors. But production has risen at what point do “social

3.5 Chavez 100

inagurated ) y values” indicators make a n on

) 3.0 95 /d a ct i o a y duct i country un-investable? d /

2.5 90 od u rrels pr o a p r

b rrel s Chavez

a 2.0 85 ude of r b dies c cr ud e of

ons a

l 1.5 80 bal o l u e ion s (mill i G e z 1.0 PDVSA strike 75 (mil l e n 19,000 employees fired V 0.5 70 1999 2002 2005 2008 2011 2014 2017 Venezuela crude production (LHS) Global crude production (RHS) Note: Data as of Jul. 31, 2017. Source: Bloomberg, RBC GAMource: Bloomberg, RBC GAM

70 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

Why, over the last twenty years, when Norway, Saudi Arabia and Exhibit 2: Venezuela’s squandered oil wealth Russia were building up enormous sovereign wealth funds, did 100 1,000 ) 90 900 llion s i

Venezuela run steadily growing ) 80 800 b

70 700 ($

budget deficits and sextuple its ion s

bil l 60 600 foreign currency debt, even as oil enue $ ( 50 500 re v prices touched US$145? The country,

40 400 e with a population of 31 million, 30 300 ulati v Revenue 20 200 received an estimated $1 trillion in m u oil revenues over the last 18 years 10 100 C 0 - (Exhibit 2). 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Yearly revenue (LHS) Cumulative revenue (RHS) At the moment, 25% of Venezuelan Note: Data as of Aug. 31, 2017. Petroleos de Venezuela crude oil basket used for oil price. Crude production is an average of DOE and OPEC data. Source: Bloomberg, RBC GAM production goes to domestic sales at wildly subsidized prices. All Venezuelans, whether wealthy or Exhibit 3: Chavez’s regime accompanied a historic boom in oil poor, pay less than 1 cent per litre for gasoline. This is a dramatic 160 incentive to smuggle it across r ice p

80 borders into Colombia and Brazil. I T

Another 25% goes to China and W rrel) Russia as debt repayments. Where ed 40 / b a jus t Mar '13 d Chavez dies

does the rest of it go? a ($

20

atio n Jan '99 l Chavez An oil boom masquerading In f inagurated 10 as a “Bolivarian Socialist 1959 1973 1987 2001 2014 Revolution” Note: Data as of Jun. 30, 2017. Price data adjusted using PCE deflator (2009 = 100). Source: Bloomberg, Bondlab, RBC GAM In politics, timing is everything. Hugo Chavez had the luck to be elected wheeling spending programs for the dismantling of the country’s president – with 56% of the vote on healthcare, food and education institutions. The judiciary came a voter turnout of 63%4 – near the for the poor. Similar programs had under presidential control as did post-Asia-crisis nadir in oil prices in been successfully enacted in Mexico the country’s electoral council that December 1998 (Exhibit 3). and Brazil. Yet the Venezuelan oversaw the legitimacy of elections. An electorate embittered by an programs came at a price. Within a Press freedom was muzzled. indifferent oligarchy voted for his year of President Chavez’s election, Reporters without Borders ranked anti-corruption and social inclusion Freedom House5 had downgraded the Venezuela 137 out of 180 countries platform. He promised them a country from “free” to “partly free” in 2015. Mexico and Brazil had “Bolivarian Socialist Revolution.” following a referendum that began managed to successfully introduce Venezuelans were understandably poverty alleviating programs without enamoured of Chavez’s free- 5Freedom House is a U.S. based NGO conducting research and advocacy on 4Election Guide – Democracy Assistance & democracy, political freedom and human Election News rights. It is funded by the U.S. government.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 71 Emerging Markets | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

making the institutional sacrifices Venezuela was seeing. Higher Exhibit 4: PDVSA’s CAPEX skyrocketed even as production collapsed spending was accompanied by far 30 14 lower transparency. Corruption began to skyrocket. Veteran Venezuela 25 12 analyst Siobhan Morden of Nomura 10 20 estimates corruption and capital 8 15 flight have cost the country $300 6 CAPEX billion over the past 17 years. 10 4

Crime increased; most notably the CAPEX (USD billions)

5 per produced Barrels dollar of homicide rate which tripled from 2 1998 to 2015, from 19 per 100,000 0 0 2003 2005 2007 2009 2011 2013 2015 people to 57, making Venezuela the Barrels per $ of CAPEX (RHS) CAPEX (LHS) third most dangerous country in the Note: Data as of Jan. 31, 2017. Source: Macrobond, Bloomberg, RBC GAM world.6 Expropriations and political President Chavez began to seize An economic travesty has interference have caused domestic more direct control of national become a social tragedy production of goods to slump and oil company PDVSA, which until The country is a text-book case of capital to flee. The country must then had operated in a reasonably economic mismanagement. GDP has now import virtually everything it independent and professional plunged more than 40% since 2013. requires, particularly food, prompting manner, in the first years of the The minimum wage has collapsed intense competition for scarce new century. Ultimately this led to more than 88% measured at the dollars. Even refined gasoline is a strike at PDVSA in 2002 which black-market foreign exchange rate. imported. Yet as local production prompted Chavez to fire 40% of People are picking through garbage of goods has cratered, imports too the company’s staff, many of them in search of food. In-patient mortality have collapsed, falling 75% from oil industry experts. Most of them has risen 10-fold while the death 2012 to 2016. Analysts estimate they fled the country and their energy of newborns in hospitals is up 100- contracted another 15% to the end expertise went with them. They were fold.7 of August this year. Basic products replaced by people whose principal are imported, the government qualification was loyalty to the Multiple exchange-rate regimes establishes artificially low regulated president. The country’s barrels of permit those with privileged access prices for them and they are production per dollar of capex fell to buy dollars from the central bank distributed to stores by the military. from 13 in early 2003 to as low as at advantageous prices and then A military general is Minister for 1.14 per dollar in 2014 (Exhibit 4). sell them at vast multiples on the black market. Two years ago the Food. A bakery will pay 2 cents per Yet Venezuelans re-elected President black market rate to buy one dollar pound for sugar and then 60 cents Chavez in 2000, 2006 and 2012. was 467 bolivares. At the beginning for the same pound, separately, as As luck would have it, he would die of December it took more than a kickback.9 Estimates are that half in 2013 just as the China-driven oil 100,000.8 of imports are appropriated for the price boom was coming to a close.

7 Ricardo Hausmann, Venezuela’s 9Hannah Dreier and Joshua Goodman, Unprecedented Collapse, Project Syndicate Venezuela military trafficking food as country August 18,2017 goes hungry, Associated Press, December 28, 6After El Salvador and Honduras, World Bank 8www.dolartoday.com 2016

72 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

black market, much of which is sold government or trading new bonds current Vice President, Tarek El in neighbouring countries. in the secondary market. Treasury’s Aissami, to the list. On November OFAC10 must issue a license to permit 2, President Maduro appointed El For years PDVSA has made “social investment banks to participate Aissami as chief debt negotiator for contributions” to the government. in a restructuring. It will not issue the government. In its recent annual report the a license if a restructuring is not company noted that from 2015 to approved by Venezuela’s National Perhaps what is most disheartening 2016 these contributions plunged Assembly. is that despite all of the burdens from US$9.2 billion to US$1 billion that have befallen Venezuelans, as a consequence of buckling oil Confusing as it is the U.S. exports ineffective and infighting opposition revenues. both gasoline and light crude to groups have been unable to arrive Venezuela. Venezuela requires at anything resembling a coherent In late July, despite four months light crude to mix with its heavy collective strategy. of street protests, the Venezuelan crude permitting the latter to government held elections for a new be transported. In turn, close to Venezuela is depending on the constituent assembly to rewrite the 500,000 barrels of Venezuelan oil “kindness of strangers” constitution. This was viewed as a go to U.S. refiners each day. This Venezuela was able to meet external broadside against the opposition puts considerable leverage in U.S. debt payments last spring only controlled National Assembly. The government hands, but using it through the “good graces” of Russian election was widely regarded as comes at a cost. The introduction state-owned oil company Rosneft. fraudulent. Twelve nations from the of sanctions has been used as There is little transparency regarding Americas, including Canada, refused “evidence” by the Venezuelan the terms of the transactions with to recognize any decision taken by government that the country is Russia, which amount to some US$6 the constituent assembly and further failing, not due to its own ineptitude billion. Similarly, we lack information condemned the government for not but as a consequence of a conspiracy on the estimated US$19 billion in accepting foreign donations of food by the “Imperialist Americans.” funding the country has outstanding and medicine. President Maduro’s approval rating with Chinese development banks. rose from 17% to 23% following the The UN recently issued a scathing The country has been shut out of U.S. decision.11 report charging the government issuance in international capital with human-rights abuses and Similar “Imperialistic” cries have markets for some time due to its torture by Venezuelan security been raised as the U.S. brought economic deterioration. Instead, the forces. Opposition leaders have indictments for drug trafficking government has relied on selling been jailed. Close to 5,000 people against the former head of the dollar-denominated debt to locals at have been detained for participating intelligence service, former anti- an advantageous foreign exchange in demonstrations, and 124 drug officials, the former Minister of rate only to have the bonds then leak demonstrators have been killed Defense and the former head of the into international secondary markets this year. National Assembly, accusing them at deeply discounted prices. of partnering with Colombian and The U.S. Treasury subsequently On August 30, Hausmann published Mexican drug cartels. In February introduced sanctions, banning a new article on Project Syndicate. this year, the U.S. added Venezuela’s U.S. banks from participating in Here he castigated Goldman Sachs new issues by the Venezuelan Asset Management for reportedly 10Office of Foreign Assets Control, enforces economic and trade sanctions 11Reuters World News, October 2, 2017

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 73 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

purchasing US$2.8 billion in “hunger Exhibit 5: Venezuela contributes an ever larger part of index yield as the bonds” from the Venezuelan national country approaches collapse oil company at a deep discount from 8 1.0 already low market prices. Hausmann 0.9 challenged the morality of purchasing 7

0.8 ) 6 % ( such bonds even as the country’s 0.7 e economy collapsed.12 5 0.6 en c r (% )

4 0.5 e f d f l i e d Clearly, Venezuelans have been i 3 0.4 Y

0.3 eld 2 i desperately-ill served by their Y 0.2 government. What has happened to 1 0.1 investors? 0 0.0 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017 EM (LHS) EM ex Venezuela (LHS) Yield Difference (RHS) Investors answer the “siren Note: Data as of Nov. 2, 2017. Source: Macrobond, JPMorgan, RBC GAM call of the interest carry” From a post oil crash low in January the Venezuelan subindex fell 29%. and how much Venezuela contributed 2015 to early March this year, the The cost to the overall emerging to this yield. Venezuela sub index of the EMBIGD market bond index was 41 basis rose more than 150%. Government points. Despite this, the overall index Why we found it hard to officials, in order to maintain their still turned in a modest +0.05% jettison Venezuela return for the month of November. grip on power, have chosen to pay Why don’t we just ignore Venezuela? bond holders for fear of the steps In his original May article for Project In part it is driven by that cost of investors might take to seize the Syndicate, Hausmann observed carry, or loss of yield. To try to replace proceeds of oil exports, thus bringing that Venezuela represented “only” Venezuela’s 30%+ yield contribution dollar inflows to a halt. 5% of the JPMorgan EMBI+ (one to the index at the end of October would have required, for example, As October came to a close, widely followed EM bond index) but increasing the allocation to single Venezuelan bonds had fallen 17% accounted for 20% of the index’s B-rated bonds from 21% of the from their early spring peak. The total yield. We employ the JPMorgan benchmark index to 45% (employing 12-month return on the Venezuela Emerging Market Bond Index Global the 6.28% yields prevailing on sub-index was -1.4%. However, Diversified (EMBIGD) which limits the single B sector at the end of investors looking more closely would individual country weightings. October).13 We believed it too late see that while bond prices were Venezuela accounted for only in the credit cycle to so dramatically down 18.3% over the previous year, 1.42% of our index at the end of increase the allocation to riskier interest returns were positive, nearly October. However, with the country’s bonds. Many single B rated bonds 21%. Bond holders had been playing bonds carrying yields of more than are trading near 100 cents on the the equivalent of Russian roulette 30%, this small part of the index dollar. Many of these countries with the Venezuelan government. On contributed nearly 10% of the index’s also have fundamentals that are November 13, with the first defaults, 5.10% yield. Exhibit 5 illustrates the deteriorating. Countries in this group, the chamber was finally found to be difference between the yield on the including Angola, Iraq and Pakistan, loaded. For the month of November index, with and without Venezuela, display social challenges and

12Ricardo Hausmann, Ugo Panizza, Odiousness Ratings for Public Debt, Project Syndicate, 13According to Bloomberg Port analytics August 30, 2017

74 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

indicators that are equal to or worse With the sovereign bonds trading at Furthermore, countries can make than those faced by Venezuela. 21 to 25 cents on the dollar at the use of restructuring tools that To eliminate the yield differential end of November, our team would align the interests of investors and would have dramatically reduced argue that both restructuring and citizens. These include warrants both the average credit quality havoc have largely been priced in. that pay out when GDP growth rises and qualitative, or social values, The country has been unable to above a certain threshold or when measures for our EM investments access international capital markets oil prices or oil production rise overall. In addition to this, we have for some time. It has been receiving above a particular level. Essentially investment policy limits on how no foreign direct investment. What the country pays more to holders much our average credit quality can the market finds enormously difficult of restructured bonds (who have be below its benchmark. Lastly, to price is how events will unfold absorbed principal losses) when it is measurements of our active risk following the default – most critically, in a better position to do so. relative to the benchmark (tracking with or without more violence and error) would increase significantly with or without the existing regime. The historical average recovery value were we to have simply eliminated following sovereign defaults was Venezuela on its own. Thus while we With a coherent economic policy, 65 cents on the dollar from 1998 15 have been under weight Venezuela international support from to 2016 according to Moody’s. for years, except for a brief period multilateral lenders, aid to the many When re-weighted for the size of the following Hugo Chavez’s death when vulnerable in the economy and, yes, issued debt, this falls to 46 cents we hoped policies might change, a debt restructuring, both citizens on the dollar thanks to Argentina, we nonetheless have maintained and investors could do well. In fact, Greece and Russia. Ecuador and an allocation. We have emphasized analysis by our team shows outsize Argentina, two serial defaulters, bonds with the lowest price as all returns by countries as they emerge have seen recovery rates as low bonds tend to trade at similar levels from restructurings. as 26 and 27 cents respectively. as defaults unfolds. From 2015 Exhibit 6 illustrates the impact Why is this? Well, they exit with on the Venezuelan sub index and on we assumed there would be a lower debt burdens, lower interest restructuring. During an investor trip broad index returns using these costs and maturities extended, thus historic recovery values. Attractive? to Venezuela in 2015 we advised one overall reduced refinancing risk. opposition leader on how they might The catch: will this restructuring They have generally adopted better occur within the next 12 months or constructively begin preparing for public policies and benefit from this. will it take 15 years as it did with IMF oversight. (Venezuela has not Argentina? And during this time – undergone an IMF Article IV “audit” Putting a price on havoc however long – you receive no since 2004). With this improved interest payments and lose the effect In his article Hausmann argued: outlook and generally high exit yields of compounding on those interest in line with vulnerable countries, “Analysts who are bullish on payments. A second catch: if the bonds of restructured countries current government were to achieve Venezuelan debt have been become comparatively attractive.14 lobbying the government and a restructuring without the consent opposition leaders with an of the National Assembly, then a new implied threat. Even considering government would likely choose to 14The obvious question would be why repudiate the restructured debt. And the restructuring of your bonds, don’t more countries restructure? Markets demanding higher risk premiums for countries they point out, will allow those that default, the risk of having assets seized managing your assets (sic) to by creditors, as well as the loss of access to 15Moody’s Investor Service, Sovereign Default funding both for the sovereign and its banks – and Recovery Rates,1983-2016, June 30, 2017 cause havoc in Venezuela.” all act as deterrents.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 75 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

what investor would trust the existing government to change its economic Exhibit 6: Impact of a Venezuela restructuring spots to stripes? Impact of a Venezuela restructuring on the index under different Hausmann has demanded that recovery values, assuming an average price for index bonds of 23.5 cents JPMorgan eject Venezuela from its 26 cents 46 cents 65 cents Weighted various indexes. Unlike many bond (Ecuador) ($ wtd. avg.) (issuer avg.) average Venezuela indexes, the JPMorgan EMBIGD does +10.6% +95.9% +176.6% +94.2% not use credit ratings to determine Sub-Index Return membership but instead employs Impact on Index 4 bps 96 bps 177bps 92 bps a Gross National Income (GNI) per- Note: Data as of Nov. 30, 2017. Return refers to the price impact only, assumes a neutral weighting of capita ratio measure from the World 1% and no accrued interest. Recovery values from Moody’s. Source: RBC GAM Bank. To be eligible, countries must have an adjusted GNI below particular countries or does it lie, as companies and six “stewardship” a prescribed level for a minimum of we believe, with the index itself? principles for U.S. investors. three years. Potential members are also screened for whether pricing Can national governments be The challenge is that sovereign is available daily from a third-party governments are not corporations. judged on their “corporate vendor. The minimum-issue size for Equity investors have the right to a bond to be included in the index is governance”? vote on corporate management’s US$500 million. Even countries that Even as the popularity of emerging- decisions or the composition of a default are not sent into exile. These market investments has grown, so company board. Sovereign investors criteria lead to the amazing result too has the interest of investors in do not. Corporate bond investors can that Mozambique, which defaulted the social impact of the investments take management to court or seize in 2016, delivered returns on its they make. Consequently, debates assets should a company default. sub-index of well over 15% from about social values in emerging If a sovereign government defaults, January 1 to November 30 in 2017. markets are destined to increase. In the ability of investors to confiscate Very strong inflows to EM bonds, August 2015, RBC GAM became a assets in order to be repaid is very particularly by passive investors who signatory to the UN’s Principles for constrained. Most notably, foreign are called upon to simply replicate Responsible Investment. The UN PRI investors cannot seize central bank the benchmark, pushed up the price is recognized as the leading global foreign exchange reserves. Investors of the bonds despite Mozambique network for investors committed to are buying a sovereign government’s making no interest payments. integrating environmental, social track record and promises. and corporate governance (ESG) JPMorgan quietly introduced an considerations into investment RBC GAM’s emerging-market alternative benchmark, the practices and ownership policies. bond team considers five broad EMBIGD – ex Venezuela index, in RBC GAM is also a founding member themes when analyzing the 70+ August. But the random elimination of the Canadian Coalition for Good countries that we follow. Together, of one country from an index does Governance and has recently these themes comprise our Global not answer the underlying question become a founding member of the Fundamental Model (GFM). Among of whether there are minimum U.S. Investor Stewardship Group, these themes is a 20% weighting qualitative standards countries providing a set of six corporate- in qualitative factors, as opposed should meet. Venezuela is not the governance principles for U.S. to economic or other quantitative only “offender.” Is the problem with measures. While the team had

76 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

long considered public policy and small firms, are those that political risk consultants, the governance risk in its analysis, encourage investment, and Eurasia Group, which has we refined this approach further therefore economic growth. developed a political-risk rating in 2015. We believe the best based on six-month and two- • The United Nations Human year views. We have adapted this opportunities lie in countries that Development Index (HDI) was analysis to develop a proprietary are on an improving path. We are based on the work of Nobel scoring model. not looking for “the best,” as risk Laureate Amartya Sen, a premiums will be low, but we ARE development economist. We look • Transparency International’s looking for “the getting better.” So to this measure to ask: Is the Corruptions Perceptions Index we review both current measures country improving the quality is published annually. The CPI and their trends. of life for its citizens? The HDI employs 13 surveys from index measures such things as 12 institutions. The current components of our life expectancy at birth, expected • The MSCI Environmental team’s qualitative basket are as years of schooling for children, Score assesses the extent to follows: average schooling of adults and which a country’s long-term income per capita. In 2015, the competitiveness is affected by its • The World Bank’s Ease of Doing UN took a new step, adjusting “ability to protect, harness and Business Survey is published this last indicator for income supplement its natural resources, annually. The focus of the survey inequality within countries. and to manage environmental is a country’s regulatory system, Note that under both UN scores, vulnerabilities.” Data comes from government efficiency and Venezuela ranks above median the Energy Information Agency, quality of business governance. (Exhibit 7). Countries that create a legal and the Central Intelligence Agency regulatory framework fostering • We employ The Eurasia Group’s and the UN, as well as proprietary private enterprise, especially political trajectory from our work done by MSCI.

Exhibit 7: Excerpts from UN Human Development Index (HDI) Report 2016

Avg. ann. % inc. HDI rank Inequality adjusted Index score in score Chg- HDI rank Country End 2015 HDI Rank 2015 1990 to 2015 2010-2015 Norway 1 1 0.949 0.45% 0 Singapore 5 5 0.925 1.02% 0 Canada 10 12 0.920 0.32% 1 USA 10 20 0.920 0.27% -3 UK 16 17 0.909 0.64% -4 Russia 49 48 0.804 0.37% 5 Venezuela 71 82 0.767 0.76% -4 Mexico 77 89 0.762 0.65% -5 Brazil 79 98 0.754 0.85% 7 China 90 NA 0.738 1.57% 11 India 131 127 0.624 1.52% 4 Rwanda 159 158 0.498 2.89% 4 Note: 188 countries, to be above median, must have a rank of 1-94. Looks at three dimensions of human development – long and healthy life, knowledge and decent standard of living. Source: UN HDI

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 77 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

The challenges in scoring Exhibit 8: Venezuela’s qualitative rankings relative to 69 peers social values EM Country Universe

But a closer look at these indicators Overall Global Fundamental Rank 65 / 70 betrays their weaknesses and thus Qualitative Ranking Only 65 / 70 the difficulty in trying to “score” or Comprised of: “rank” countries on a social-values scale. One problem is the frequency World Bank Ease of Doing Business rank 70 / 70* with which data are published – Transparency International Corruptions Perception Index 67 / 69 usually only once a year. Then there is the lag between the time the data UN Inequality – Adjusted Human Development Index 29 / 62 is collected and when it is released. MSCI Environmental Risk rank 26 / 70 For example, in 2017, we are working Eurasia Group Political Trajectory Rank 55 / 55** with reports based on data from Note: Data as of Oct. 17, 2017. *Joint with two other countries. **Joint with eight other countries. the end of 2015 for the UNHDI. Source: RBC GAM While Venezuela has been steadily deteriorating for some time, the UN Bank Ease of Doing Business Survey. drew on the writings of Alexander survey pre-dates the precipitous It qualitatively leaves regional peer Sack, a Russian legal theorist who decline of the past 18 months. (and oil blessed) Nigeria in its developed the concept of “odious Another issue is subjectivity. dust. What if a country is engaged debt” in 1927 following the First Transparency International’s index in a civil war? Does one invest in World War. measures the “perception” of Colombia, which has long been Sack argued: corruption and is based on opinion in the index but only in the last surveys rather than hard data. twelve months emerged from a “If a despotic power incurs a Furthermore, not all countries are decades-long conflict with FARC debt not for the needs or in covered and in some cases the data guerrillas? Does a country have to the interest of the State, but to histories are quite short. We also be a democracy? If so, what do you strengthen its despotic regime, to need to assess how reliable the data do with China, the world’s second- repress its population that fights is and whether the supplier of the largest economy? What do you do against it, this debt is odious for data has a political bias/agenda. Do with countries where democracy is the population of the State…The we ignore U.S. think-tank Freedom deteriorating, such as Poland and debt is not an obligation for the House, which measures levels of Hungary? nation; it is a regime’s debt, a democracy, freedom and human In Exhibit 8 we provide Venezuela’s personal debt of the power that rights, because it is funded by a overall GFM rank as well as the has incurred it.” national government? qualitative rank alone. What However, as some academics have How does one measure a country qualitative score or rank should asked, at what point is a regime such as Rwanda? It has a leader with make a country “un-investable”? determined to be “despotic?”16 authoritarian leanings but ranks, Venezuelans elected Chavez in according to the UNHDI report, An Odious Index? 1998, affirmed his policies in a among the countries most rapidly In August this year, Hausmann 16 improving its citizens’ well-being. argued that countries should Applied Legal History: Demystifying the Doctrine of Odious Debts, Sarah Ludington It is in the top quartile of countries carry not only credit ratings, but (Campbell University, Mitu Gulati (Duke University) and Alfred Brophy (University of worldwide, out of 190, in the World “odiousness ratings” as well. He North Carolina at Chapel Hill ).

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1999 referendum and repeatedly Exhibit 9: Venezuela in crisis – Markets and rating agencies slow to react to re-elected him until his death in democratic decline 2013. And yet Freedom House had been downgrading the country since 3,500 Not Partly Partly free 1999 (Exhibit 9). 3,000 Free free

) free BB 2,500 (bp s Lee Buchheit, one of the best B+ attorneys and legal scholars on u m 2,000 B

r em i B-

p 1,500 the subject of sovereign debt CCC+ is k 1,000 restructurings, poses another R CCC 17 question : 500 CCC- 0 SD “Someone must assume the task 1993 1997 2001 2005 2009 2013 2017 of painting a scarlet letter “O” Risk premium (LHS) S&P credit rating (RHS) Note: Data as of Sep. 1, 2017. Source: Bloomberg, RBC GAM on a great many regimes around the world. Who will make this assessment of odiousness and on Exhibit 10: Cumulative returns (%) what criteria?” Crisis Who indeed would undertake this After onset of QE Pre crisis peak (peak to trough) Solomon-like decision? Rating Mar. 2009 - Jun. 2007 - Jun. 2007 - Credit Quality Nov. 30, 2017 Nov. 30, 2017 Mar. 2009 Agencies? The UN Security Council? A 69.9 84 8.3 The UN Human Rights Council? Past members of the UNHRC have BBB 95.6 99.39 1.9 included Saudi Arabia and Libya BB 150.9 139.4 -4.6 under Muammar Gaddafi! B 216.3 122.2 -29.7

CCC-C 114.5 -71.9 -86.9 Do investors care about social values? Venezuela 102.5 41.29 -30.2 Perhaps the most fundamental EMBIGD 119.8 111.2 -3.9 question Hausman posed in “The Source: RBC GAM Hunger Bonds” was: Do investors really care about social values? At first glance, the answer seems to be Exhibit 10 illustrates in the first before the financial crisis at the end “no” for many investors. column the returns on various credit of June 2007, when risk premiums quality tiers for the period from the were at historic lows? Exhibit 9 shows the risk premium low of March 2009 when quantitative was falling during the second period easing began in earnest to the end Total returns for B rated bonds the country was declared “partly of November this year. Poorer quality and below are materially reduced. free” by Freedom House. Similarly, bonds have generally outperformed Venezuela’s is reduced by 60% and rating agencies ignored this the broad index. CCC and below falls into negative democratic decline. territory. The index by comparison Now what if we look through the sees its total return reduced from 17Lee Buchheit, Mitu Gulati, Robert Thompson, financial cycle from immediately 119.8% to 111.2%. In the second The Dilemma of Odious Debt, Duke University Law Journal, March 2007.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 79 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

column the BB sector with a Exhibit 11: Comparison of RBC GAM Global Fundamental Model (GFM) score return of 139.4% is the standout to qualitative score only throughout this period. Overall Qualitative (GFM) score score only Now let’s look at the magnitude of the decline from the June 2007 peak AA & A 6.10 7.10 prior to the financial crisis to its BBB 5.04 5.60 depths in March 2009 in the third column. The index is down 3.9% BB 4.67 4.95 through the period, while Venezuela is down 30.2%. Single B’s broadly B 3.90 4.03 are down 29.7%, while CCC’s and ≤ CCC 3.80 4.13 below are down 86.9%. When times are tough, quality counts. Note: Data as of Oct. 17, 2017. Source: RBC GAM

Clearly these returns are not about qualitative indicators alone. Exhibit 12: A growing number of bonds have negative yields However, looking at our Global

Fundamental Model scores and 60 our Qualitative scores in Exhibit 50 11 it is intriguing to observe that the difference between the AA&A 40 rated bucket and the bottom credit 30 bucket is more pronounced for the 20

Qualitative score alone than for the USD (trillions) broader GFM score alone. 10 0 Four strong winds: EM bond 2014 2015 2016 2017 2018 Bonds trading at positve interest rates Bonds trading at negative interest rates investors are being herded by Note: Data as of Nov. 30, 2017. Source: Bloomberg, Deutsche Bank, RBC GAM liquidity So investors don’t care? In fact we in bonds around the world, or have been shielded by waves would argue that dedicated active nearly 23% of all outstanding of Chinese state-owned bank EM investors like ourselves who bonds, were trading at negative lending as the country sought to would otherwise decline to own yields (Exhibit 12). According to secure commodity supplies and fixed-income securities issued by JPMorgan, total investment flows increase its geopolitical reach. countries such as Venezuela are into emerging-market investments Russia has acted similarly. Official being thwarted by four key factors: to the end of November have sector lenders such as the IMF amounted to more than US$170 normally impose “conditionality” 1. Waves of quantitative easing by billion – multiples of last year for or require policy changes multiple central banks since late the same period. to improve the economy’s 2008 have left government-bond recovery chances in exchange yields negative in many countries 2. Issuers that would have been for loans. No such demands are and investors grasping for yield. penalized by markets for poor in evidence with these bilateral As of November 30 US$9.2 trillion economic and social policies

80 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

loans. Chinese loans now dwarf Exhibit 13: Chinese state-owned banks fund growth in developing countries those from official sector lenders with fewer restrictions (Exhibit 13). Both Russia and China Development Bank & China have recently rescheduled Export Import Bank of China their loans to Venezuela. World Bank 3. Passive indexes, which account Asian Development Bank Inter American for a significant share of inflows Development Bank to EM bonds, do not employ European Investment Bank any screening, much less European Bank for Reconstruction and Development screen for social shortcomings. African Development Bank If Venezuela makes up 5% of the EMBI+ index, passive ETF 0 200 400 600 Global assets ($ bn) investors will invest that same Note: Data as of May, 2016. Source: Boston University – Global Economic Governance Initiative, RBC GAM percentage automatically. The effect is particularly pronounced on smaller country issuers. In a Exhibit 14: Net declines in “freedom” scores have outnumbered gains recent report, Citigroup noted that passive investment in emerging- 75 70 market assets has grown from just es 65 over 12% two years ago to nearly ntr i 60 o u c

19% today. f 55 o

50 4. Lastly, markets have come to be r m 45 u

believe that the IMF will lend N 40 under virtually any circumstances. 35 Traditionally, the IMF was seen 30 as a task master demanding 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Improved Declined stringent conditions in exchange Note: Data as of Dec. 31, 2016. Source: Freedom House, RBC GAM for loans. However, the fund lost credibility with markets in Russia seized the Crimea region Some social values indicators recent years after it continued of southern Ukraine. Markets under stress, even as to lend to Greece and Ukraine now seem to “assume” that all débutante issuers multiply amid unsustainable conditions, a countries seeking IMF support will Social value indicators are under breach of its own guidelines. The receive it. threat in many emerging markets. IMF may have done so in Greece These successive waves of liquidity, Freedom House’s report18 of a trend out of fear for Europe’s financial real or expected, have propped up away from democracy over the last system and potential contagion riskier bets in emerging markets, 10 years is particularly striking risk. For Ukraine the decision was postponing the day of reckoning for (Exhibit 14). complicated by geopolitics after poor policy choices.

18Freedom In The World 2017, Populists and Autocrats: The Dual Threat to Democracy, Freedom House

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 81 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

A look at the Emerging Market Bond Index suggests overall sovereign Exhibit 15: Quality breakdown of EMBI global diversified credit quality has been falling (Exhibit 15). However, there are two 100% 90% forces at work. It’s true that credit 80% quality has been declining with 70% some countries, such as Brazil and 60% Turkey losing their investment-grade 50% 40% status. However, at the same time 30% Weight in index it is worth considering the growth 20% in the sheer number of issuers in 10% recent years, most of which have 0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 been poorer-quality governments. AA A BBB BB B CCC and below At the end of 2007 the number of Note: Data as of Nov. 30, 2017. Source: JPMorgan, RBC GAM countries in the EMBIGD index was 38. Today it is 67. Similarly, the number of sovereign governments Exhibit 16: Distribution of foreign ratings from 1995 to 2016 (%) covered by Moody’s grew from 71 in 1996 to 132 by the end of 2016.19 Rating 1995 2005 2016 Aaa 18% 20% 9% Strong commodity markets and Aa 24% 7% 12% abundant liquidity warranted A 18% 22% 13% increased investor attention to many new issuers. Many African Baa 18% 14% 16% countries and some Latin American Ba 16% 16% 12% countries were newly rated having B 5% 16% 31% undergone Highly Indebted Poor Caa-C 0% 5% 7% Country (HIPC) debt relief from the Investment Grade 78% 63% 50% official sector. Here lenders such as Speculative Grade 22% 37% 50% the IMF and World Bank forgave debt in exchange for improved economic Source: Moody’s investor services, RBC GAM policies, notably an increase in spending on poverty-reduction rating. Single B countries now that for emerging-market bonds measures. This was enacted as part represent 31% of rated sovereigns, (JPMorgan EMBIGD). In the case of of the United Nations’ Millennium the single largest credit tier in the the equity index, close to 62% of Development Goals. sovereign spectrum as Exhibit 16 the index carries a credit rating of A illustrates. or above, with more than 80% rated A recent long-term default study investment grade (Venezuela is not from Moody’s determined that the This is not to criticize emerging- part of the EM equity index). By median rating of countries one year markets generally. It is worth contrast, only 48% of the EM bond prior to default was B2, five notches comparing the quality of the most index is rated investment grade below the lowest investment-grade widely followed emerging-market (Exhibit 17). equity index (MSCI EM Equity) versus 19Moody’s Investor Service, Sovereign Default and Recovery Rates, 1983-2016, June 30, 2017

82 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

A “doing well by doing good” Exhibit 17: Country level credit rating comparison of EM bonds (EMBIG div. benchmark? Index) and EM equities (MSCI EM Index)

So what have we determined? Well, 40 34.9 35.9 we know that default rates are 35 sharply higher for countries rated B2 30 28.2 25.5 and below relative to their higher- 25 22.8 rated brethren and that single-B- 20 18.3 18.1 rated countries have proliferated. 15 12.3

We have seen that the sweet spot (%) weight index 10 5 3.4 through a cycle has been in the 0 0.5 0.0 BB area; and drawdowns are less 0 AA A BBB BB B < B & not pronounced in bad times for those EM bonds EM equities rated rated BB and above. We also know Note: Data as of Nov. 30, 2017. The same methodology used to construct EMBIG Div credit buckets that there is an association between was used for the MSCI index. Source: JP Morgan, MSCI, S&P, Moodys, Fitc higher qualitative or social ratings and higher credit quality. these countries’ decisions and Once it could credibly be created, are driven by widely referenced a DEM index would guide investors Hausmann has recommended that benchmarks against which they and toward countries making decisions JPMorgan introduce a “Decent their peers are measured. Passive with the well-being of their citizens Emerging Markets Index,” or “DEM investors simply amplify the effect. in mind. It would also incentivize Index adhering to minimal standards countries with lower levels of social of respect for (EM country) citizens.” However, given the challenges we capital to improve outcomes for In principle, we agree with him. The have noted in applying indicators their citizens in order to be included existing index is indiscriminate. It that measure social values, the in such an index and thereby gain does not serve investors in the long path to such an index is by no access to additional international term and it is certainly not serving means clear. Perhaps, as qualitative funding. the interests of EM country citizens. indicators mature and there is In the meantime, international sufficient data to infer sound Or as Hausmann puts it: “You could investors have little leverage over conclusions, this will come about. do well, without feeling bad.”

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 83 RBC GAM INVESTMENT STRATEGY COMMITTEE Members

Daniel E. Chornous, CFA Chief Investment Officer RBC Global Asset Management Chair, RBC GAM Investment Strategy Committee

Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc., which has total assets under management of approximately $403 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 Management’s 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 firm’s outlook for global and domestic economies and capital markets as well as managing the firm’s global economics, technical and quantitative research teams.

Stephen Burke, PhD, CFA Dagmara Fijalkowski, MBA, CFA Vice President and Portfolio Manager Head, Global Fixed Income & Currencies RBC Global Asset Management RBC Global Asset Management Stephen is a fixed-income portfolio manager and Head of the Quantitative As Head of Global Fixed Income and Currencies at RBC Global Asset Research Group, the internal team that develops quantitative research Management, Dagmara leads investment teams in Toronto, London and solutions for investment decision-making throughout the firm. He is also Minneapolis in charge of almost $100 billion in fixed income assets. In a member of the PH&N IM Asset Mix Committee. Stephen joined Phillips, her duties as a portfolio manager, Dagmara heads management of several Hager & North Investment Management in 2002. The first six years of his bond funds, manages foreign-exchange hedging and active currency career were spent at an investment-counselling firm where he quickly rose to overlay programs across a number of funds. Dagmara chairs the Fixed become a partner and fixed-income portfolio manager. He then took two years Income Strategy Committee. She is also a member of the Investment Policy away from the industry to begin his Ph.D. in Finance and completed it over Committee, which determines asset mix for balanced and multi-strategy another three years while serving as a fixed-income portfolio manager for a products, and the RBC Investment Strategy Committee. In 2016, she was mutual-fund company. Stephen became a CFA charterholder in 1994. appointed to the RBC GAM Executive Committee. Dagmara, who began her investment career in 1994, holds an MBA from the Richard Ivey School of Business in Canada and a Master’s degree in economics from the University of Lodz in Poland. Dagmara has been a CFA charterholder since 1997.

Stuart Kedwell, CFA Senior Vice President and Eric Lascelles Senior Portfolio Manager Chief Economist RBC Global Asset Management RBC Global Asset Management Stu co-leads the North American Equity team and is a member of the RBC Eric is the Chief Economist for RBC Global Asset Management Inc. (RBC GAM) GAM Investment Strategy Committee, which is responsible for establishing and is responsible for maintaining the firm’s global economic forecast and the firm-wide global asset mix for mutual funds and for institutional and high generating macroeconomic research. He is also a member of the net worth private clients. Stu began his career in 1996 with RBC Dominion RBC GAM Investment Strategy Committee, the group responsible for the firm’s Securities in the firm’s Generalist program, a two-year internship in which global asset-mix recommendations. Eric is a frequent media commentator participants rotate through different areas of the firm. In 1998, he joined the and makes regular presentations both within and outside RBC GAM. Prior RBC Investments Portfolio Advisory Group, which provides investment ideas to joining RBC GAM in early 2011, Eric spent six years at a large Canadian and recommendations to RBC DS Investment Advisors. He was also a member securities firm, the last four as the Chief Economics and Rates Strategist. His of the RBC DS strategy & focus list committees. Stu has been with the firm previous experience includes positions as economist at a large Canadian since 2002 and is a CFA charterholder. bank and research economist for a federal government agency.

84 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 RBC Global Asset Management

Martin Paleczny, CFA Hanif Mamdani 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 Martin Paleczny, who has been in the investment industry since 1994, began Investments. He is responsible for the portfolio strategy and trading execution his career at Royal Bank Investment Management, where he developed an of all investment-grade and high-yield corporate bonds. Hanif is Lead Manager expertise in derivatives management and created a policy and process for the of the PH&N High Yield Bond and Alternative strategies, including a multi- products. He also specializes in technical analysis and uses this background strategy hedge fund. He is also a member of the Asset Mix Committee. to implement derivatives and hedging strategies for equity, fixed-income, Prior to joining the firm in 1998, he spent 10 years in New York with two global currency and commodity-related funds. Since becoming a portfolio manager, investment banks working in a variety of roles in Corporate Finance, Capital Martin has focused on global allocation strategies for the full range of assets, Markets and Proprietary Trading. Hanif holds a master's degree from Harvard with an emphasis on using futures, forwards and options. He serves as University and a bachelor's degree from the California Institute of Technology. advisor for technical analysis to the RBC GAM Investment Strategy Committee.

Sarah Riopelle, CFA Vice President and William E. (Bill) Tilford Senior Portfolio Manager Head, Quantitative Investments RBC Global Asset Management RBC Global Asset Management Since 2009, Sarah has managed the entire suite of RBC Portfolio Solutions. Bill is Head, Quantitative Investments, at RBC Global Asset Management and Sarah is a member of the RBC GAM Investment Strategy Committee, which sets is responsible for expanding the firm’s quantitative-investment capabilities. global strategy for the firm, and the RBC GAM Investment Policy Committee, Prior to joining RBC GAM in 2011, Bill was Vice President and Head of which is responsible for the investment strategy and tactical asset allocation Global Corporate Securities at a federal Crown corporation and a member of for RBC Funds’ balanced products and portfolio solutions. In addition to her its investment committee. His responsibilities included security-selection fund management role, she works closely with the firm’s Chief Investment programs in global equities and corporate debt that integrated fundamental Officer on a variety of projects, as well as co-manages the Global Equity and quantitative disciplines, as well as management of one of the world’s Analyst team. largest market neutral/overlay portfolios. Previously, Bill spent 12 years with a large Canadian asset manager, where he was the partner who helped build a quantitative-investment team that ran core, style-tilted and alternative Canadian / U.S. funds. Bill has been in the investment industry since 1986.

Brad Willock, CFA Milos Vukovic, CFA Vice President and Vice President, Investment Policy Senior Portfolio Manager RBC Global Asset Management RBC Global Asset Management Milos, who joined RBC in 2003, oversees investment-management activities Brad Willock joined RBC Global Asset Management in July 2002 and is a including new-fund launches, performance analytics and trade-cost analysis. Senior Portfolio Manager and CFA charterholder. In his current role, Brad has He is also responsible for developing and monitoring investment mandates responsibility for RBC Global Asset Management’s core and income-oriented and implementing tactical asset allocation for the RBC GAM investment U.S. equity strategies. He joined RBC in May 1996 after receiving a bachelor’s solutions. Milos earlier worked for a Big 4 accounting firm and two top-tier of commerce degree with distinction from the University of Calgary. Prior to securities firms. He earned an MBA at the Schulich School of Business and that, Brad obtained a bachelor’s of science degree at the University of British has held the CFA designation since 2004. He is a board member of both the Columbia and represented Canada at the 1992 Barcelona Summer Olympics Canadian Buy-Side Investment Management Association and the Canadian in volleyball. Advocacy Council for Canadian CFA Institute Societies, and recently joined IIROC’s Market Structure Advisory Committee.

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 85 RBC Global Asset Management

GLOBAL EQUITY ADVISORY COMMITTEE

>> Philippe Langham >> Mayur Nallamala >> Dominic Wallington Head & Senior Portfolio Manager, Head & Senior V.P., Asian Equities Head, European Equities & Emerging Market Equities RBC Investment Management (Asia) Senior Portfolio Manager, RBC Global Asset Management (UK) Limited RBC Global Asset Management (UK) Limited Limited >> Martin Paleczny, CFA >> Brad Willock, CFA V.P. & Senior Portfolio Manager, V.P. & Senior Portfolio Manager, Asset Allocation & Derivatives North American Equities RBC Global Asset Management Inc. RBC Global Asset Management Inc.

GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE

>> Dagmara Fijalkowski, MBA, CFA >> Suzanne Gaynor >> Eric Lascelles Head, Global Fixed Income & Currencies V.P. & Senior Portfolio Manager, Global Chief Economist RBC Global Asset Management Inc. Fixed Income & Currencies RBC Global Asset Management Inc. RBC Global Asset Management Inc. >> Soo Boo Cheah, MBA, CFA Senior Portfolio Manager, Global Fixed Income & Currencies RBC Global Asset Management (UK) Limited

86 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018 DISCLOSURE

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