THE GLOBAL INVESTMENT OUTLOOK RBC Investment Strategy Committee
SPRING 2009
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 1 THE RBC INVESTMENT STRATEGY COMMITTEE
The RBC Investment Strategy Committee consists of senior investment professionals drawn from individual client focused business units within RBC Financial Group. The Committee regularly receives economic and capital markets related input from internal and external sources. Important guidance is provided by the Committee’s regional advisors (North America, Europe, Far East), from the Global Fixed Income & Currencies Subcommittee and from the global equity sector heads (fi nancials and healthcare, consumer discretionary and consumer staples, industrials and utilities, energy and materials, telecommunications and technology). From this it builds a detailed global investment forecast looking one year forward.
The Committee’s view includes an assessment of global fi scal and monetary conditions, projected economic growth and infl ation, as well as the expected course of interest rates, major currencies, corporate profi ts and stock prices.
From this global forecast, the RBC Investment Strategy Committee develops specifi c guidelines that can be used to manage portfolios.
These include: the recommended mix of cash, fi xed income instruments, and equities the recommended global exposure of fi xed income and equity portfolios the optimal term structure for fi xed income investments the suggested sector and geographic make-up within equity portfolios the preferred exposure to major currencies
Results of the Committee’s deliberations are published quarterly in The Global Investment Outlook.
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THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE CONTENTS
EXECUTIVE SUMMARY 2 The Global Investment Outlook Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Asset Management Inc. ECONOMIC & CAPITAL MARKETS FORECASTS 4 RBC Investment Strategy Committee RECOMMENDED ASSET MIX 5 RBC Investment Strategy Committee CAPITAL MARKETS PERFORMANCE 8 Milos Vukovic, MBA, CFA – V.P. Investment Policy, RBC Asset Management Inc. GLOBAL ECONOMIC OUTLOOK 10 Patricia Croft, Chief Economist – RBC Global Asset Management GLOBAL INVESTMENT OUTLOOK 14 Capitalism Is Down But Not Out Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Asset Management Inc. and Phillips, Hager & North Investment Management Ltd. Andrew Mitchell, CFA – V.P. & Institutional Portfolio Manager, Phillips, Hager & North Investment Management Ltd. GLOBAL FIXED INCOME MARKETS 40 Robin Gullason, CFA – V.P., Fixed Income Portfolio Advisory Group, RBC Dominion Securities Inc. CURRENCY MARKETS 47 Dagmara Fijalkowski, MBA, CFA – V.P. & Senior Portfolio Manager, RBC Asset Management Inc. REGIONAL EQUITY MARKET OUTLOOK United States 54 Raymond Mawhinney – Senior V.P., U.S. & Global Equities, RBC Asset Management Inc. Brad Willock, CFA – V.P. & Senior Portfolio Manager, RBC Asset Management Inc.
Canada 56 Stuart Kedwell, CFA – Senior V.P. & Senior Portfolio Manager, RBC Asset Management Inc.
Europe 58 Dominic Wallington – Chief Investment Offi cer, RBC Asset Management UK Limited
Asia 61 Yoji Takeda – Director & V.P., Asian Equities, RBC Investment Management (Asia) Limited RBC INVESTMENT STRATEGY COMMITTEE 62 DISCLAIMER 65
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE DANIEL E. CHORNOUS, CFA Chief Investment Offi cer – RBC Asset Management Inc. and Phillips, Hager & North Investment Management Ltd.
ANDREW MITCHELL, CFA V. P. & Institutional Portfolio Manager – EXECUTIVE SUMMARY Phillips, Hager & North Investment Management Ltd.
ECONOMY: CAPITALISM IS Looking beyond the fi rst quarter, particularly damaging for an indebted DOWN BUT NOT OUT the onset of a U.S. economic economy since it raises the infl ation- recovery is getting pushed further adjusted cost of servicing or repaying In the midst of all the bad news and out. The most recent economic outstanding debt. Simply put, each fear that surrounds us, it is important data suggests that we are now dollar of unpaid debt becomes a to consider that the pendulum often essentially looking at a 2010 story. bigger dollar. A bout of mild defl ation overshoots in both directions. Free However, keep in mind that we are is a real possibility, but should prove markets have proven time and again approaching the spring of 2009 transitory. The Fed is responding to that they are incredibly resilient and markets are forward-looking. this concern by fl ooding the system and effi cient. They remain the best In the meantime, there is virtually with money, but the velocity of money means for fostering economic growth no good news on the economy has plummeted, as much of it is being and productivity. The dysfunctional anywhere in the world. A late start hoarded by banks rather than working credit and banking systems have to monetary easing in Europe, where its way into lending. Our forecast exposed weaknesses that will need the fi nancial system is particularly for U.S. infl ation falls to -1.0% from to be dealt with through an updated vulnerable, and a combination 0.5%, refl ecting continued weakness global regulatory framework, and of export dependence and strong in the global economy, while in the that will take time to fall into place. currency appreciation in Japan, are Eurozone, the forecast is unchanged Uncertainty will be with us for the likely to prolong their recessions. at 0.50%. We forecast Canadian CPI foreseeable future, and sustainable We forecast a 2.7% contraction in at 0.75%, while in Japan, infl ation of growth is unlikely to re-emerge until U.S. GDP for 2009, with Canada -0.75% is expected. Infl ation in the confi dence is restored, housing begins experiencing a decline of 2.2%. In U.K. is forecast at 0.75%. (See page 27) to stabilize, credit channels begin to Europe, we look for a 2% decline in function more normally and lending the economy and a 2.8% drop for FED TAKING MULTIPLE STEPS begins to re-accelerate. Nonetheless, the U.K. In Japan, GDP is forecast TO ENSURE THAT THE CREDIT we believe that policymakers, working to fall 3.25% in 2009. (See page 14) alongside the private sector and CRISIS EVENTUALLY PASSES investors, will ultimately succeed in INFLATION FEARS HAVE The Fed’s powers are not pinned to stemming the slide. As confi dence interest rates alone. Monetary-policy returns, markets will eventually MORPHED INTO FEARS OF responses to the fi nancial crisis have move back toward equilibrium. DEFLATION been innovative and aggressive. We Infl ation fears have morphed into would not be surprised to see a host GLOBAL ECONOMY IN fears of defl ation. Headline CPI of new programs added to the list DEEP RECESSION peaked at 5.6% in July 2008 as the before this crisis has passed into price of oil approached $150 per the history books. Since there are The combination of a coordinated barrel. In sharp contrast, the January few constraints on how large the global contraction and intense risk 2009 fi gure was essentially fl at, as Fed’s balance sheet can become, aversion suggests that the depth and energy-price relief continues to affect the Fed is creating cash and using it duration of this recession will be far year-over-year comparisons. Infl ation to fund a multitude of new lending worse than any we have experienced expectations buried in the pricing facilities to help ease stress in credit in generations. A seriously weak of CPI index-linked bonds remain markets. As part of that effort, the economy is apparent in the U.S. nearly non-existent, indicating an Fed continues to move toward a new First-quarter growth for this year expectation that a severe recession program to purchase long-term U.S. could be as bad, or worse, than the will continue to put a lid on wages Treasuries. The intent is to bring 6.2% contraction in GDP in the and prices. With capacity utilization down the cost of debt that is priced fourth quarter of 2008. Unintended falling globally, concerns in the at a spread to long-term Treasuries inventory accumulation will reverse market have essentially shifted to such as mortgage and corporate in the fi rst half of 2009 as companies worries about defl ation, which acts debt. Other programs include a cut production to bring inventories as a disincentive to consumption. $600 billion program to purchase in line with plummeting demand. A bout of serious defl ation could be securities issued by government-
2 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE EXECUTIVE SUMMARY • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
linked mortgage fi nance companies, only three winning currencies threat of its re-emergence beyond Fannie Mae and Freddie Mac. since the crisis began, behind the forecast horizon, providing the yen and Swiss franc. This scope for low yields over the months LOW INTEREST RATES is a surprising outcome for the ahead. At the same time, fears A FIXTURE dollar considering that the U.S. have emerged that backstopping has been at the epicenter of the the fi nancial system will require Short-term interest rates are almost fi nancial crisis. Poor data from massive and frequent new issuance certain to stay at rock-bottom levels. other countries and their desire for of government bonds, forcing yields We forecast a fed funds rate of weaker currencies due to a higher higher since last fall. As a result, 0.25% one year from now, and our dependence on external trade mean the near-term risk in fi xed-income forecast for the ECB’s benchmark that dollar strength may persist markets is somewhat less than it rate is 1.00%. The Bank of Japan for the time being. During this has been. In our recommended environment of heightened volatility will target short rates at 0.10%, and asset mix, we have modifi ed our and with valuations unusually we expect the Bank of England signifi cant underweight position close to fair, we favour lower risk to set the base rate at 0.75%. In in bonds, moving exposure from Ottawa, the Bank of Canada will allocation to foreign exchange. 32.5% to 35% for a balanced keep the overnight rate at 0.50%. STOCKS SINK, ONCE AGAIN investor, against a neutral position Government bond yields are set of 40% (past range 25% - 54%). to trade in disequilibrium for a After a brief bear-market rally We recognize that the nature of prolonged period, given the severe since the last release of the Global events over the past 18 months and risk aversion dominating investor Investment Outlook, stocks have the challenges that still lie ahead for psychology, the lengthening time fallen to fresh lows and returned to policymakers and investors suggest a horizon to potential recovery in the trading at the greatest discounts to bunker mentality in equity markets economy, the small risk of a surprise fair value in more than a generation. is logical. Nevertheless, we believe uptick in infl ation and expectations Just as no major economic region that a fi x for the fi nancial system will that the Fed will buy longer-dated has been left unscathed and most ultimately emerge. Some important Treasuries. We expect that situation companies are struggling to adjust pieces have already fallen into place. to sustain itself, for now, even in the production to meet an increasingly Ultimately, investors will turn their face of growing supply concerns. grim reality, no market has been attention away from the fear and Yields need to stay low to stimulate left untouched by the collapse in confusion that has gripped markets a recovery. But when a whiff of valuations. Our models encourage and toward the opportunities that normalization ultimately appears our view that markets will ultimately exist. Stocks will eventually recover – watch out. As the crisis resolves value companies based on their and returns will be above average itself, government-bond valuations through-the-cycle earnings power, for a lengthy period as normal will be increasingly vulnerable to a not on trailing or forecast profi ts valuations are restored. The scale mean reversion in infl ation and risk generated at the trough of a severe of the decline in equity markets premiums. That should result in a recession. As the crisis clears and since last summer, the resulting sharp rise in our valuation bands confi dence is restored, investors deeply depressed valuations and and a reversion in yields toward will lengthen their time horizons, our belief that initiatives designed equilibrium valuations. (See page 42) ultimately driving stocks sustainably to right the fi nancial system and higher as prices move to refl ect force feed growth, will work, CURRENCIES: U.S. DOLLAR normal earnings power. (See page 47) encourages us to maintain our CONSOLIDATES GAINS AS overweight position in equity GLOBAL ECONOMY FALTERS ASSET MIX REMAINS TILTED markets. For a balanced investor, we TOWARD STOCKS recommend a 60% weight in stocks, Last quarter, the U.S. dollar 5% above the neutral position (past consolidated its gains, trading in The deepening recession has lowered range: 36% - 65%. (See page 39) a broad range. It remains one of expected infl ation and moved the
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 3 ECONOMIC & CAPITAL MARKETS FORECASTS
ECONOMIC FORECAST (RBC INVESTMENT STRATEGY COMMITTEE)
UNITED STATES CANADA EUROPE UNITED KINGDOM JAPAN CHINA CHANGE CHANGE CHANGE CHANGE CHANGE CHANGE FROM FROM FROM FROM FROM FROM SPRING NEW YEAR SPRING NEW YEAR SPRING NEW YEAR SPRING NEW YEAR SPRING NEW YEAR SPRING NEW YEAR 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 REAL GDP 2008A 1.10% 0.50% 1.00% 0.70% -0.70% 9.00% 2009E -2.70% (1.70) -2.20% (1.45) -2.00% (1.25) -2.80% (1.80) -3.25% (2.75) 6.00% N/A 2010E 1.00% N/C 1.20% N/C 1.20% N/C 0.50% N/C 0.75% N/C 8.00% N/A CPI 2008A 3.80% 2.40% 3.30% 3.60% 1.40% 5.90% 2009E -1.00% (1.50) 0.00% (0.50) 0.50% (0.50) 0.75% (0.25) -0.75% (1.25) 0.00% N/A 2010E 2.00% N/C 1.50% N/C 1.80% N/C 1.50% N/C 0.50% N/C 1.50% N/A A = ACTUAL E = ESTIMATE
TARGETS (RBC INVESTMENT STRATEGY COMMITTEE)
FORECAST CHANGE FROM 1-YEAR TOTAL RETURN FEB. 2009 FEB. 2010 NEW YEAR 2009 ESTIMATE (%) CURRENCY MARKETS AGAINST USD USD–CDA 1.27 1.25 N/C 1.8 EURO–USD 1.27 1.20 N/C (5.5) USD–JPY 97.67 105.00 N/C (8.0) GBP–USD 1.43 1.46 (0.04) 2.3 FIXED INCOME MARKETS U.S. Fed Funds Rate 0.25 0.25 (0.25) 0.3 U.S. 10 Year Bond 3.02 3.00 (1.00) 2.8 Canada Overnight Rate 0.60 0.50 (1.00) 0.6 Canada 10 Year Bond 3.13 3.25 (0.35) 3.0 Eurozone Repo Rate* 0.93 1.00 (1.00) 1.0 Eurozone 10 Year Bond* 3.71 3.25 (0.25) 7.7 U.K. Base Rate 1.00 0.75 (1.00) 0.9 U.K. 10 Year Gilt 3.62 3.75 0.25 3.8 Japan Overnight Call Rate 0.27 0.10 (0.20) 0.2 Japan 10 Year Bond 1.28 1.30 (0.45) 1.2 EQUITY MARKETS S&P 500 735 1000 (150) 39.9 S&P/TSX Composite 8123 10250 (1150) 30.8 MSCI Europe 874 1100 (275) 33.6 FTSE 100 3830 4500 (500) 24.0 Nikkei 7568 9000 (1500) 21.8 * GDP weighted average of Germany, France and Italy. Source: RBC AM
4 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE RECOMMENDED ASSET MIX
Asset mix – the allocation within further divided into recommended specifi c asset classes with a goal portfolios to stocks, bonds and cash exposures to the variety of global of tilting portfolios toward those – should include both strategic and fi xed income and equity markets. markets that offer comparatively tactical elements. Strategic asset mix Our recommendation is targeted attractive near-term prospects. addresses the blend of the major at the Balanced profi le where the This tactical recommendation for the asset classes offering the risk/return benchmark setting is 55% equities, Balanced profi le can serve as a guide tradeoff best suited to an investor’s 40% fi xed income, 5% cash. for movement within the ranges profi le. It can be considered to be A tactical range of +/- 15% around allowed for all other profi les. If, for the benchmark investment plan that the benchmark position allows example, the recommended current anchors a portfolio through many us to raise or lower exposure to Continued on next page... business and investment cycles independent of a near-term view of the prospects for the economy GLOBAL ASSET MIX and related expectations for capital BENCHMARK PAST SUMMER FALL REVISED NEW YEAR SPRING POLICY RANGE 2008 2008 NOV. 3, 2008 2009 2009 markets. Tactical asset allocation CASH 5.0% 1.5% – 16% 7.5% 7.5% 7.5% 7.5% 5.0% refers to fi ne tuning around the strategic setting in an effort to add BONDS 40.0 25% – 54% 32.5% 32.5% 32.5% 32.5% 35.0% value by taking advantage of shorter STOCKS 55.0 36% – 65% 60.0% 60.0% 60.0% 60.0% 60.0% term fl uctuations in markets. REGIONAL ALLOCATION Every individual has differing return CWGBI* PAST SUMMER FALL REVISED NEW YEAR SPRING GLOBAL BONDS expectations and tolerances for FEB. 2009 RANGE 2008 2008 NOV. 3, 2008 2009 2009 volatility, so there is no “one size fi ts North America 24.3% 9% – 46% 19.3% 17.6% 17.6% 18.7% 24.3% all” strategic asset mix. Based on a Europe 42.1% 40% – 90% 52.2% 51.7% 51.7% 48.6% 42.1% 35-year study of historic returns and Asia 33.6% 0% – 29% 28.5% 30.7% 30.7% 32.6% 33.6% the volatility of returns (the range Note: Based on anticipated 12-month returns in $US hedged basis around the average return within MSCI** PAST SUMMER FALL REVISED NEW YEAR SPRING GLOBAL EQUITIES which shorter-term results tend to FEB. 2009 RANGE 2008 2008 NOV. 3, 2008 2009 2009 fall), we have developed fi ve broad North America 54.8% 15% – 60% 53.0% 54.3% 55.0% 55.0% 56.0% profi les and assigned a benchmark Europe 29.7% 30% – 70% 33.0% 33.0% 31.0% 31.0% 30.0% strategic asset mix for each. These Asia 15.5% 10% – 39% 14.0% 12.8% 14.0% 14.0% 14.0% profi les range from income through balanced to aggressive growth. It GLOBAL EQUITY SECTOR ALLOCATION goes without saying that as investors MSCI** RBC ISC RBC ISC CHANGE FROM WEIGHT vs. accept increasing levels of volatility, FEB. 2009 NEW YEAR 2009 SPRING 2009 NEW YEAR 2009 BENCHMARK and therefore greater risk that the Energy 12.52% 12.75% 13.50% 0.75 107.83% actual experience will depart from Materials 6.20% 5.50% 6.25% 0.75 100.81% the longer-term norm, the potential Industrials 10.60% 9.50% 9.50% N/C 89.62% for returns rises. The fi ve profi les presented below may assist investors Utilities 5.69% 6.00% 6.00% N/C 105.45% in selecting a strategic asset mix best Consumer Discretionary 8.96% 8.00% 8.00% N/C 89.29% aligned to their investment goals. Consumer Staples 10.86% 12.00% 12.00% N/C 110.50%
Each quarter, the RBC Investment Health Care 12.36% 11.50% 13.50% 2.00 109.22%
Strategy Committee publishes a Financials 16.42% 20.00% 15.00% (5.00) 91.35% recommended asset mix based on our current view of the economy and Information Technology 11.24% 10.25% 11.25% 1.00 100.09% return expectations for the major Telecom. Services 5.15% 4.50% 5.00% 0.50 97.09% asset classes. These weights are * Citigroup World Global Bond Index **MSCI World Index Source: RBC Investment Strategy Committee
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 5 RECOMMENDED ASSET MIX
...Continued from previous page equity exposure for the Balanced The value-added of tactical strategies returns and risk tolerances best profi le is set at 62.5% (i.e.: 7.5% above its are, of course, dependent on the degree suited to individual investors. benchmark of 55% and part way toward to which the expected scenario unfolds. its upper limit of 70% for equities), that Anchoring portfolios with a suitable would imply a tactical shift of + 5.02% Regular review of portfolio weights strategic asset mix, and placing to 25.02% for the Income profi le (i.e.: is an essential part of the ultimate boundaries defi ning the allowed range for tactical positioning imposes a discipline a proportionate adjustment above success of an investment plan as it that can limit the damage caused by the benchmark equity setting of 20% ensures that current exposures are swings in emotion that inevitably within the allowed range of +/- 15%). aligned with the level of long-term accompany both bull and bear markets.
1. Average Return: The average total return produced by the asset class over the period 1973 – 2008, 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. INCOME BENCH- LAST CURRENT ASSET CLASS RANGE Income-oriented investors will seek income with MARK QUARTER RECOMMENDATION CASH & CASH EQUIVALENTS 5% 0-15% 8.3% 5.4% maximum capital preservation and the potential for modest capital growth, and be comfortable with small FIXED INCOME 75% 55-95% 67.5% 71.0% fl uctuations in the value of their investments. This TOTAL CASH & FIXED INCOME 80% 65-95% 75.8% 76.4% portfolio will invest primarily in fi xed-income securities CANADIAN EQUITIES 10% 5-20% 9.4% 11.9% and a small amount of equities to generate income while U.S. EQUITIES 5% 0-10% 9.0% 6.0% providing some protection against infl ation. Investors INTERNATIONAL EQUITIES 5% 0-10% 5.8% 5.7% who fi t this profi le generally plan to hold their investment TOTAL EQUITIES 20% 5-35% 24.2% 23.6% for the short to medium term (minimum one to fi ve years). RETURN VOLATILITY
35-YEAR AVERAGE 9.2% 6.5%
LAST 12 MONTHS AVERAGE -4.9% 6.0%
CONSERVATIVE BENCH- LAST CURRENT ASSET CLASS RANGE Conservative investors will pursue modest income MARK QUARTER RECOMMENDATION and modest capital growth with reasonable capital CASH & CASH EQUIVALENTS 5% 0-15% 7.9% 5.2% preservation, and be comfortable with moderate FIXED INCOME 60% 40-80% 51.6% 54.9% fl uctuations in the value of their investments. The TOTAL CASH & FIXED INCOME . . 65% 50-80% 59 6% 60 1% portfolio will invest primarily in fi xed-income CANADIAN EQUITIES 15% 5-25% 14.2% 17.3% securities with some equities to achieve more U.S. EQUITIES 10% 0-15% 15.2% 11.6% consistent performance and provide a reasonable INTERNATIONAL EQUITIES 10% 0-15% 11.0% 11.0% amount of safety. The profi le is suitable for investors TOTAL EQUITIES 35% 20-50% 40.4% 39.9% who plan to hold their investment over the medium
RETURN VOLATILITY to long term (minimum fi ve to seven years).
35-YEAR AVERAGE 9.4% 7.9%
LAST 12 MONTHS AVERAGE -10.9% 7.5%
6 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE RECOMMENDED ASSET MIX
BALANCED BENCH- LAST CURRENT ASSET CLASS RANGE The Balanced portfolio is appropriate for investors MARK QUARTER RECOMMENDATION seeking balance between long-term capital growth CASH & CASH EQUIVALENTS 5% 0-15% 7.5% 5.0% and capital preservation, with a secondary focus on FIXED INCOME 40% 20-60% 32.5% 35.0% modest income, and who are comfortable with moderate TOTAL CASH & FIXED INCOME 45% 30-60% 40.0% 40.0% fl uctuations in the value of their investments. More than CANADIAN EQUITIES 20% 10-30% 19.1% 22.1% half the portfolio will usually be invested in a diversifi ed U.S. EQUITIES 20% 10-30% 25.3% 22.1% mix of Canadian, U.S. and global equities. This profi le is INTERNATIONAL EQUITIES 15.6% 15.8% 15% 5-25% suitable for investors who plan to hold their investment TOTAL EQUITIES % 55% 40-70% 60.0 60.0% for a medium to long-term (minimum fi ve to seven years). RETURN VOLATILITY
35-YEAR AVERAGE 9.3% 9.3%
LAST 12 MONTHS AVERAGE -18.0% 9.3%
GROWTH BENCH- LAST CURRENT ASSET CLASS RANGE Investors who fi t the Growth portfolio profi le will MARK QUARTER RECOMMENDATION seek long-term growth over capital preservation CASH & CASH EQUIVALENTS 5% 0-15% 4.1% 3.0% and regular income, and be comfortable with FIXED INCOME 25% 5-40% 19.5% 21.2% considerable fl uctuations in the value of their TOTAL CASH & FIXED INCOME 30% 15-45% 23.6% 24.2% investments. This portfolio primarily holds a CANADIAN EQUITIES 25% 15-35% 23.8% 27.4% diversifi ed mix of Canadian, U.S. and global equities U.S. EQUITIES 25% 15-35% 31.7% 27.3% and is suitable for investors who plan to invest for INTERNATIONAL EQUITIES 20.8% 21.1% 20% 10-30% the long term (minimum seven to ten years). TOTAL EQUITIES 70% 55-85% 76.4% 75.8%
RETURN VOLATILITY
35-YEAR AVERAGE 9.2% 11.6%
LAST 12 MONTHS AVERAGE -23.4% 10.6%
AGGRESSIVE GROWTH BENCH- LAST CURRENT ASSET CLASS RANGE Aggressive growth investors seek maximum long-term MARK QUARTER RECOMMENDATION growth over capital preservation and regular income, CASH & CASH EQUIVALENTS 5% 0-15% 3.3% 3.0% and are comfortable with signifi cant fl uctuations FIXED INCOME 0% 0-10% 0.0% 0.0% in the value of their investments. The portfolio is TOTAL CASH & FIXED INCOME 5% 0-20% 3.3% 3.0% almost entirely invested in stocks and emphasizes CANADIAN EQUITIES 35% 20-50% 34.3% 36.1% exposure to international equities. This investment U.S. EQUITIES 30% 15-45% 33.1% 31.3% profi le is suitable only for investors with a high risk INTERNATIONAL EQUITIES % % 30% 15-45% 29.2 29.6 tolerance and who plan to hold their investments TOTAL EQUITIES % % 95% 80-100% 96.7 97.0 for the long term (minimum seven to ten years). RETURN VOLATILITY
35-YEAR AVERAGE 9.0% 14.2%
LAST 12 MONTHS AVERAGE -32.0% 12.6%
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 7 MILOS VUKOVIC, MBA, CFA CAPITAL MARKETS PERFORMANCE V.P. Investment Policy – RBC Asset Management Inc.
Over the latest three-month period, EXCHANGE RATES (USD RETURNS) the U.S. dollar rose against all PERIODS ENDING FEBRUARY 28, 2009 major currencies, including the Current 3 months YTD 1 year 3 years 5 years USD (%) (%) (%) (%) (%) yen. The greenback’s biggest gain USD–CAD 1.2729 2.77 4.66 29.51 3.85 -0.98 was against the British pound, at 7.6%. The dollar strengthened USD–EUR 0.7892 0.20 10.20 19.77 -2.02 -0.29 2.1% against the yen and 2.8% USD–GBP 0.6988 7.63 1.93 38.81 7.01 5.45 against the Canadian dollar. In the USD–JPY 97.5065 2.13 7.57 -6.06 -5.53 -2.18 one-year period ended March 1, Note: all changes above are expressed in US dollar terms 2008, the dollar appreciated most CANADA (CAD $ BASIS) against the pound, rising 38.8%. PERIODS ENDING FEBRUARY 28, 2009 3 months YTD 1 year 3 years 5 years In that period, the greenback rose Fixed Income Markets: Total Return (%) (%) (%) (%) (%) 19.8% versus the euro and 29.5% DEX Overall Universe Bond Index 2.60 -0.27 4.08 4.65 4.94 versus the Canadian dollar, while dropping 6.1% against the yen. U.S. (USD $ BASIS) PERIODS ENDING FEBRUARY 28, 2009 3 months YTD 1 year 3 years 5 years Global equity markets continued Fixed Income Markets: Total Return (%) (%) (%) (%) (%) to post signifi cant losses, and Citigroup US -0.28 -3.57 5.90 7.32 5.18 government fi xed-income securities LB Aggregate Bond Index 2.43 -1.26 2.06 4.95 4.00 provided shelter against the volatility. The DEX Universe Bond GLOBAL (USD $ BASIS) Index, a measure of the performance PERIODS ENDING FEBRUARY 28, 2009 of the broad Canadian bond market, 3 months YTD 1 year 3 years 5 years Fixed Income Markets: Total Return (%) (%) (%) (%) (%) returned 2.6% the past three Citigroup WGBI 0.86 -5.15 -3.19 5.67 4.21 months. Over the same period, the Citigroup World Government Bond Citigroup Europe -0.17 -8.54 -13.35 4.59 4.08 Index gained 0.9% in U.S. dollar Citigroup Japan -0.68 -7.37 8.96 8.28 3.75 terms. All other major bond regions Note: all rates of return presented for periods longer than 1 year are annualized Source: Bloomberg/MSCI were almost fl at for the period. Japan lost 68 basis points, measured by the capitalization, were modest at month period, the Russell 3000 Citigroup Japan Total Return Index, 1.0%, while the largest companies Value Total Return Index fell 22.2%, while Europe declined 17 basis in the index posted a decline of compared with a 10.6% loss for the points measured by the Citigroup 12.3% as measured by the S&P/TSX Russell 3000 Growth Total Return Europe Total Return Index, in U.S. 60 Index. The S&P 500 Composite Index. The Russell value-tilted dollar terms. U.S. bonds, measured Index also fell signifi cantly, losing index underperformed its growth by the Citigroup U.S. Total Return 17.3% over the three-month period counterpart on a one-year basis, Index, lost 0.28%. On a one-year and 43.3% for the year. The period with the growth index recording basis, U.S. and Japanese bonds from December, 1 2008, to February a loss of 40.2%, compared with a outperformed, gaining 5.9% and 28, 2009, wasn’t any easier for U.S. 47.0% drop for the value measure. 9.0% respectively, in U.S. dollar mid cap and small cap stocks. terms. In the same period, European The S&P 400 index, a measure of All major global equity indices fi xed income markets lost 13.4%. mid cap performance, lost 12.2% continued to experience losses during this period, while the S&P through the winter. The MSCI The S&P/TSX Composite Index 600 index, a gauge of small cap World Index declined 15.5% for declined 11.5% in the three months performance, dropped 18.5%. the three months ended February ended February 28, 2009. Losses Since March 1, 2008, the S&P 400 28, 2009. MSCI declines for major in the smallest companies in has fallen 42.0%, and the S&P 600 world regions ranged from 10.9% the index, measured by market has declined 42.5%. For the three- in Asia-Pacifi c to 15.9% for Europe.
8 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE CAPITAL MARKETS PERFORMANCE • MILOS VUKOVIC, MBA, CFA
The worst performer among major CANADA (CAD $ BASIS) European markets was Germany, PERIODS ENDING FEBRUARY 28, 2009 3 months YTD 1 year 3 years 5 years where the MSCI Germany Total Equity Markets: Total Return (%) (%) (%) (%) (%) Return Index lost 17.9%. Emerging S&P/TSX Composite -11.48 -9.09 -38.20 -8.95 0.80 markets, measured by MSCI, S&P/TSX 60 -12.28 -9.16 -36.63 -7.33 2.12 lost 4.9% over the three-month S&P/TSX Small Cap -1.04 -7.06 -48.62 -18.45 -8.51 period, outperforming developed- market indexes. Between March U.S. (USD $ BASIS) 1, 2008, and February 28, 2009, PERIODS ENDING FEBRUARY 28, 2009 the MSCI Germany Total Return 3 months YTD 1 year 3 years 5 years Index declined 54.9% measured Equity Markets: Total Return (%) (%) (%) (%) (%) in U.S. dollars, while the MSCI S&P 500 -17.31 -18.18 -43.32 -15.11 -6.64 Emerging Markets fell 56.2%. S&P 400 -12.17 -16.23 -42.00 -15.38 -4.43 For the same period, the MSCI S&P 600 -18.47 -23.15 -42.54 -17.32 -5.20 Japan index lost 39.8%. RUSSELL 3000 Value -22.21 -23.56 -47.02 -17.43 -6.65 RUSSELL 3000 Growth -10.55 -12.36 -40.16 -13.67 -6.38 All 10 global equity sectors have NASDAQ Composite Index -10.27 -12.63 -39.34 -15.46 -7.45 fallen since the last publication of the Global Investment Outlook. GLOBAL (USD $ BASIS) Information Technology PERIODS ENDING FEBRUARY 28, 2009 outperformed other sectors, losing 3 months YTD 1 year 3 years 5 years 6.6%, followed by Health Care Equity Markets: Total Return (%) (%) (%) (%) (%) and Materials, which lost 8.9% MSCI World* -15.47 -18.10 -47.12 -15.22 -5.02 and 9.2%, respectively. The worst MSCI EAFE* -14.20 -19.07 -50.22 -15.30 -3.27 performer was the Financials sector, MSCI Europe* -15.90 -20.09 -52.96 -15.13 -3.71 which lost 30.5%, amid continued MSCI Pacifi c* -10.90 -17.11 -44.25 -15.85 -2.45 weakness in the world’s banks and MSCI UK* -16.37 -13.90 -51.36 -15.75 -4.97 insurers. Industrials and Energy MSCI France* -15.80 -22.42 -50.77 -14.42 -3.32 lost 19.6% and 15.3%, respectively. MSCI Germany* -17.94 -27.25 -54.89 -12.75 -1.61 Since March 1, 2008, the Financials sector performed worst, with a MSCI Japan* -11.70 -18.34 -39.84 -17.34 -3.37 decline of 64.6%, followed by MSCI Emerging Markets* -4.85 -11.73 -56.17 -11.91 3.36 Materials, with a 57.5% fall, and * Net of Taxes Industrials, which declined 53.2%. GLOBAL EQUITY SECTORS (USD $ BASIS) PERIODS ENDING FEBRUARY 28, 2009 3 months YTD 1 year 3 years 5 years Sector: Total Return (%) (%) (%) (%) (%) Energy -15.32 -12.32 -42.93 -7.21 5.99 Materials -9.20 -14.02 -57.47 -11.61 0.87 Industrials -19.55 -23.41 -53.16 -17.15 -4.85 Utilities -13.49 -17.20 -36.40 -3.75 5.94 Consumer Discretionary -9.93 -14.96 -46.16 -17.61 -8.06 Consumer Staples -12.24 -14.12 -29.97 -2.94 0.94 Health Care -8.93 -15.20 -29.14 -9.21 -2.94 Financials -30.45 -31.67 -64.59 -30.56 -14.97 Information Technology -6.62 -9.26 -40.83 -14.34 -7.69 Telecommunication Services -10.02 -14.71 -34.11 -3.32 -1.29 Note: all rates of return presented for periods longer than 1 year are annualized Source: Bloomberg/MSCI
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 9 PATRICIA CROFT, GLOBAL ECONOMIC OUTLOOK Chief Economist – RBC Global Asset Management
GLOBAL ECONOMY EXHIBIT 1. Leading Economic Indicators IS DEEP IN RECESSION OECD & Selected Non-OECD
The world economy is deeply 104 mired in recession amidst a 102 rare synchronized downturn in 100 economic activity. We estimate that 98 world GDP will grow by less than 96 1% this year with the probability Index 94 of an outright decline in economic * Trade-weighted average of China, India, Brazil, Russia, 92 Indonesia & South Africa activity rising – this would mark the fi rst decline in world output in over 90 Source: Organization for Economic Cooperation & Development, PH&N 60 years. The negative impact of the 88 credit crisis has spilled over into the 1998 2000 2002 2004 2006 2008 2010 real economy, exacerbating already OECD Non-OECD* weak economic conditions. To date this so-called negative feedback loop EXHIBIT 2. G7* Real Central Bank Policy Rate has overwhelmed the massive policy response. Nonetheless, we remain of the view that with a lag, the 6 unprecedented fi scal and monetary 5 *GDP weighted average of US, Japan, Eurozone, policy measures taken to date UK & Canada target interest rates minus inflation will support a modest recovery in 4 February 2009 is an estimate economic activity later this year that 3 will become evident in the reported % 2 economic data at that time or in 1 the months to follow (Exhibit 1). 0 Tumbling energy prices and -1 Source: National Central Banks, National Statistical Agencies, PH&N growing output gaps have resulted -2 in headline infl ation readings 1980 1985 1990 1995 2000 2005 2010 swooning the world over. Defl ation is coming to North America, but importantly, not at the level of THE DOWNSIDE OF of globalization, particularly in core or underlying infl ation. Core GLOBALIZATION China where exports are roughly infl ation will remain subdued 40% of GDP. The Chinese economy Leading indicators of economic however, refl ecting the growing slowed to its weakest pace of activity are signaling tough times slack in labour markets and the growth in seven years in late 2008 as ahead. Through trade linkages, sharp drop in operating capacity exports and imports plunged with emerging-market economies are utilization rates. Defl ation on a U.S. consumers embarking on a contracting sharply. The downturn buyers strike of unknown duration. sustained basis is a low-probability is worse for the world’s most open Developed economies that are large outcome given the prompt policy economies such as Singapore, exporters of capital goods, cars response, as central bankers where exports equal over 180% of and electronics have been severely have driven interest rates to GDP – in the fourth quarter of 2008, impacted as well. Japan’s economy essentially zero in the U.S. and the island economy contracted at a shrank at a whopping 12.7% annual Japan and 2% or lower in other massive 17% annual rate. Economic rate in the fourth quarter of 2008, G-7 economies (Exhibit 2). stalwarts such as China and India the worst performance since the are also experiencing the downside deep recession of the early 1970s
10 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL ECONOMIC OUTLOOK • PATRICIA CROFT
while Germany’s economy plunged EXHIBIT 3. U.S. Household Net Worth at an 8% annual rate late last year. Year-over-Year Change
US RECESSION LONGEST OF 8,000 POST-WAR PERIOD 6,000 4,000 The U.S. economy and fi nancial 2,000 markets remain at the epicenter of the credit and economic crisis -
that has rippled across the world. $US Billions -2,000 The U.S. is now 14 months into a -4,000 recession that began in December 2007. The average length of post- -6,000 Source: U.S. Federal Reserve, Merrill Lynch war recessions in the U.S. is about -8,000 10 months – the current recession 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 will likely be the longest in post-war history. We estimate the recession EXHIBIT 4. US Household Debt Relative to Disposable Income will last 20 to 24 months before the economy begins to post positive quarterly growth rates. In the interim, 150 we expect the unemployment rate to climb to 10% – 2.6 million jobs 130 Household deleveraging will were lost in the four-month period 110 be a drawn-out process ending January 2009 alone and labour market indicators suggest % 90 further sizeable losses lie ahead. Amid massive layoff announcements, 70 a record 5.1 million people are 50 receiving unemployment insurance Source: U.S. Federal Reserve Flow of Funds benefi ts on an ongoing basis. 30 However, the unemployment rate 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 is a lagging indicator and will rise even as signs of an improvement in the U.S. economy begin to emerge. rise further to 8% as the negative U.S. economy. Positive signs are wealth effect of tumbling equity emerging as the enormous inventory The U.S. consumer has experienced and home prices crimps consumer overhang is beginning to subside an enormous hit to their balance spending (exhibits 3 and 4). and affordability has soared to its sheet, with household net worth best level in decades, while housing down by over $10 trillion from its HOUSE PRICES REMAIN starts have plunged over 80% to a recent peak. Real consumer spending A KEY RISK TO THE OUTLOOK record low thereby reducing new is set to contract sharply this year supply. However, we feel house as the U.S. consumer has shunned House prices are now down 27% prices could fall a further 10% conspicuous consumption for from their peak in 2006 – this to 15% as momentum in prices thrift – at least for now. Consumers is a key signpost we monitor, as remains negative and excess supply are paying down debt for the fi rst stability in the housing market is persists. Nonetheless, we expect time in 56 years as the personal critical in order for us to become to see signs of greater stability in savings rate has climbed from more optimistic about the outlook housing supply/demand dynamics negative territory to close to 5% – for the U.S. consumer and the within the next three to six months. we estimate the savings rate will
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 11 GLOBAL ECONOMIC OUTLOOK • PATRICIA CROFT
Weakness in the U.S. economy EXHIBIT 5. Canadian Real GDP Growth extends beyond the consumer as exports have slumped, capital spending is plummeting and 4.5 industrial production, particularly auto-related, is in the doldrums. 3.5 Car sales have slumped to below 2.5 10 million units, the weakest in
25 years, and sales in China are % 1.5 outpacing those in the U.S. for the 0.5 fi rst time ever. The U.S. economy contracted 6.2% in the fourth -0.5 Source: Statistics Canada quarter of 2008, and the current -1.5 quarter’s GDP decline will also rank 2006 2007 2008 2009 2010 among the worst in recent decades. Month-over-month Year-over-year
MODEST RECOVERY LATER THIS YEAR news is grim with record job losses government moves back into defi cit in January, plummeting wholesale, position for the fi rst time in 11 years The policy response to the U.S. and retail sales and sharply weaker with a $40 billion package of tax downturn has been massive in scale. exports and manufacturing cuts and infrastructure spending. The U.S. budget defi cit will likely top shipments and orders. The impact As well, a weaker Canadian dollar $1.75 trillion this year, equivalent to of lower commodity prices is will help cushion the blow of roughly 12% of GDP, including the just beginning to be felt, creating the onset of recession. However, $787 billion fi scal stimulus package. signifi cant headwinds for the Canada is a small open economy GDP. Recently announced efforts provinces of Alberta and British with considerable exposure to the to stem the tide of homeowners Columbia in particular. Capital- U.S. economy, our largest trading entering foreclosure will hopefully spending plans are being scaled partner now deep in recession. bear fruit later this year. The U.S. back sizably in the energy, mining Canada is also leveraged to the Federal Reserve has slashed interest and manufacturing sectors. The global commodity price cycle, and rates to zero and embarked on a divergence of performance across depressed prices will result in a rare path of credit easing, providing provincial economies will narrow decline in nominal GDP this calendar vital support through various credit sharply this year with the Canadian year. While Canadian consumers are facilities to circumvent the broken economy expected to contract arguably in better fi nancial shape banking system and provide credit by 2.2%, the fi rst recession in 17 then their U.S. counterparts, the to the economy at a reasonable years, with a modest recovery negative wealth effect will be felt price. These efforts should put a envisioned for 2010 (Exhibit 5). here as well, as house prices are fl oor under the U.S. economy, setting set to fall by an estimated 10% this the stage for a modest recovery Canada is well positioned in a global year while the unemployment rate later this year and into 2010. context, however, as our banking is expected to climb to at least 9%. system remains the envy of most CANADIAN ECONOMY other nations. The Bank of Canada OUTSIDE OF NORTH NOW IN RECESSION has cut interest rates to just 0.5% AMERICA, RECESSION FEARS (with a strong likelihood of further The deterioration in the Canadian unprecedented monetary policy WILL DOMINATE IN 2009 economic landscape has been steps ahead) and has taken steps Europe’s economy is in recession remarkable both in terms of its to ensure credit continues to fl ow. led by Germany – the peripheral size and speed. The latest economic Fiscal policy has eased as the federal countries such as Spain, Greece and
12 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL ECONOMIC OUTLOOK • PATRICIA CROFT
Portugal are under pressure with EXHIBIT 6. China Real GDP Growth credit rating downgrades at hand. Concern is growing with respect to European banks' exposure to faltering 14 Eastern European economies, as Source: National Bureau of Statistics of China, PH&N 12 the credit crisis and evaporating trade fl ows exact a toll. The U.K. 10 economy is also in recession with 8 rising unemployment, falling house prices, an overly indebted consumer 6 and problems in the banking system. 4 Japan’s downturn is particularly 2 acute owing to its reliance on exports and growing ties to China, whose Cumulative % Change/QoQ Annualized 0 economic fortunes have also faltered. 1994 1996 1998 2000 2002 2004 2006 2008 2010
KEY TO THE OUTLOOK: CHINA EXHIBIT 7. China Merchandise Trade Growth in the Chinese economy slowed markedly at the end of 2008, with real GDP growth falling to 6.8% 60 year over year, implying virtually 50 40 zero growth on a quarterly basis. 30 Exports and imports have slumped 20 as the defunct U.S. consumer has 10 resulted in the shuttering of many 0 exporting and manufacturing -10 facilities. An estimated 20 million -20 migrant workers have been forced -30 Source: National Bureau of Statistics of China -40 to return to rural areas, creating Year-over-year % Change, 3 Mth Avg. signifi cant potential for political 1998 2000 2002 2004 2006 2008 2010 unrest. The Chinese government has Exports Imports reacted forcefully to the economic slowdown, pledging a massive closely monitor Chinese indicators involving government guarantees $586 billion U.S. in fi scal stimulus, to gauge the success of initiatives and additional capital infusions equivalent to roughly 14% of the taken to date (exhibits 6 and 7). from central authorities but the economy. Unlike the U.S., China problem is exceedingly complex has the ability to readily fi nance RESOLUTION OF CREDIT and patience will be required. A such aggressive policy measures, as CRISIS ESSENTIAL recovery in world economic activity the debt-to-GDP ratio is just 19%, later this year is predicated on and foreign-exchange reserves, at We must see stability in the world a healthier banking system and over US$1.3 trillion, are equal to fi nancial system as a key condition the lagged stimulative impact a noteworthy 45% of GDP. As well, for a recovery in the world economy. of policy initiatives undertaken the Chinese banking system is in Adverse negative feed back loops to date. Risks to the outlook are relatively good shape and credit are well entrenched in economies skewed to the downside. Key appears to be readily available. such as the U.S. We appear to be signposts to monitor include U.S. The key to a recovery in the world inching our way towards some form house prices, Chinese economic economy lies in China, and we will of resolution to the credit crisis indicators and credit spreads.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 13 DANIEL E. CHORNOUS, CFA Chief Investment Offi cer – RBC Asset Management Inc. and Phillips, Hager & North Investment Management Ltd.
ANDREW MITCHELL, CFA V. P. & Institutional Portfolio Manager – GLOBAL INVESTMENT OUTLOOK Phillips, Hager & North Investment Management Ltd.
CAPITALISM IS DOWN BUT NOT OUT
OBAMA’S INITIAL POLICY as Citigroup and Bank of America Following the collapse of Lehman FORAYS FAIL TO INSPIRE off life support. The equity markets Brothers in mid-September, the have fi lled the information void economy fell off a cliff. The fact EQUITIES by focusing on dismal economic that the seeds for such a severe Nineteen months into the crisis, data, which have sparked growing global recession were not apparent credit losses and the potential concerns that the recession may to policymakers as late as the fall for further writedowns have extend deeper into 2009 than of 2008 can be traced to its unique kept risk premiums elevated, many had considered possible. roots. This was not a recession gummed up lending and blunted that resulted from tight monetary the impact of monetary policy. FREE MARKETS WILL PROVE policy – arguably the cause of every Strain on the global economy THEIR METTLE OVER TIME postwar recession. Somewhat is acute and deepening. ironically, overconfi dence bolstered At the same time, there are still by exceptional liquidity and After a brief reprieve brought on by notable positives percolating expectations of a sustained low- anticipation that the new Obama under all the dark news. While infl ation environment set the stage. administration would be able to barely visible on the surface, some Of the three traditional imbalances restore confi dence and implement relief in credit markets, energy that have sparked recessions in the new policy approaches, intense costs, and policy stimulus suggest past – excess housing construction, risk aversion has returned to that a modest recovery should be excess inventories and excess most capital markets. A renewed visible on the horizon later this capital investment – only home plunge in bank shares over the year. Credit markets, for example, construction was present at the past few weeks indicates that have actually charted a different outset. the crisis is still developing, and course than equities over the past that concerns have resurfaced. few weeks. Even in the face of the The stunning speed in the swing broad disappointments with the from overconfi dence and a sound Simply put, the market was new administrations initial policy economic footing to intense fear underwhelmed by the Obama forays, issuance and liquidity in and a sharp downturn in growth, administrations broad policy commercial paper and investment- combined with the weaknesses intentions. While the programs grade credit has remained on exposed in banking system, led to appear to be constructive and a gradual recovery path. a sharp loss of confi dence in some hopeful on the surface, the latest of the structures underpinning pronouncements undermined the Part of the explanation for the our fi nancial system. In the midst fragile support that had recently stubborn loss of confi dence across of all the bad news and fear that returned to most capital markets. the capital markets lies in the surrounds us, it is important to The 5% sell-off in equities following economy’s shocking reversal in consider that the pendulum often Treasury Secretary Geithner’s a few brief months. Economic overshoots in both directions. February 10 announcement was growth broke down in the face of Free markets have proven time sparked by the lack of detail the common wisdom that we were and again that they are incredibly regarding implementation and in a unique period of stability, and resilient and effi cient. They remain timing. Another concern was that growth of free markets would the best means for fostering whether it adequately addressed foster sustainable wealth creation economic growth and productivity. how to get major global banks such and lower poverty globally.
14 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
The dysfunctional credit and EXHIBIT 1. U.S. Manufacturers' Inventories to Shipments Ratio banking systems have exposed weaknesses that will need to be dealt with through an updated 1.8 global regulatory framework, and that will take time to fall into place. 1.6 Uncertainty will be with us for the foreseeable future, and sustainable growth is unlikely to re-emerge 1.4 until confi dence is restored, housing begins to stabilize, credit channels 1.2 begin to function more normally Source: RBC AM and lending begins to re-accelerate. 1.0 Nonetheless, we believe that 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 policymakers, working alongside Inventory/Sales Ratio Regressed trend the private sector and investors, will ultimately succeed in stemming the slide. As confi dence returns, EXHIBIT 2. Weighted Average Consensus Real GDP markets will eventually move Growth Estimates For Major OECD Nations back toward equilibrium levels. 4.0 BATTLE BETWEEN DEEPENING 3.0 RECESSION… 2.0 1.0 The combination of a coordinated 0.0 global recession and intense risk aversion suggests that the depth and -1.0
duration of this recession will be Avg % Chg on Previous Yr -2.0 Source: Consensus Economics far worse than we have experienced -3.0 in generations. A seriously weak 2004 2005 2006 2007 2008 2009 2010 2011 2012 economy is apparent in the U.S. 2006: 2.9% 2007: 2.4% 2008: 1.1% 2009: -2.2% 2010: 1.4% First-quarter growth for this year could be as bad or worse than the 6.2% contraction in GDP in the to bring inventories in line with anywhere in the world (Exhibit 2). fourth quarter of 2008. The current plummeting demand (Exhibit 1). A late start to monetary easing in quarter is also likely to be one of the Europe, where the fi nancial system worst on record with similar themes Looking beyond the fi rst quarter, is particularly vulnerable, and a playing out – rapid adjustments to a the onset of a U.S. economic combination of export dependence sea change in consumer spending, recovery is getting pushed further and strong currency appreciation from plummeting production to out. The most recent economic in Japan are likely to prolong inventory destocking. In a nutshell, data suggests that we are now recessions in those places. A year we are setting up for a very weak essentially looking at a 2010 story. ago, it was possible to consider the start to 2009. The extent of the However, keep in mind that we are possibility that the fallout from the unintended inventory accumulation approaching the spring of 2009 U.S. fi nancial crisis would be less prior to the back half of the fourth and markets are forward-looking. severe elsewhere, and might be quarter will reverse in the fi rst half In the meantime, there is virtually resolved without the damage we are of 2009 as companies cut production no good news on the economy now facing if Asia and Europe had
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 15 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
managed to stay out of recession. EXHIBIT 3. Global Fiscal Policy Response Unfortunately, the rest of the world has not only caught up quickly with COUNTRY PACKAGE SIZE % OF GDP the economic environment facing ($US Billion) the U.S. but appears to be faring CHINA 586 14.0% even worse. Industrial production UNITED STATES 787 5.5% in most economies outside North UNITED KINGDOM 50 2.5% America is falling even faster than INDIA 26 2.4% it is in the U.S. The depth and uniformity of the contraction in CANADA 34 2.0% global industrial production has few JAPAN 85 1.7% comparisons in modern history. EUROZONE 260 1.5% GERMANY 39 1.3% …AND UNPRECEDENTED GLOBAL TOTAL $2,292 2.8% STIMULUS GOES GLOBAL Source: RBC AM, PH&N Key policy actions that will ultimately EXHIBIT 4. Global Short-Term Interest Rate Composite help the economy heal are beginning Short-Term Interest Rates Relative to Equilibrium to fall into place. Virtually every major economy is simultaneously 100 pulling out all the stops in monetary 80 and fi scal policy while inventing a 60 few new policies along the way. 40 20 There are well telegraphed fl aws 0 in a number of the stimulus -20 plans that have been announced, -40 including the $787 billion U.S.
% Above/Below Equilibrium -60 version (Exhibit 3). Nonetheless, in -80 Source: RBC AM Last Plot: -69.3% total, the global fi scal response is -100 unprecedented in both its magnitude 1980 1984 1988 1992 1996 2000 2004 2008 2012 and the breadth of participation.
The major central banks have rates on related debt. These moves confi rm that the bottom is behind rapidly followed the Fed’s lead by have lessened the risk of a new leg in us until long after it has been driving down short-term rates to the crisis as mortgages roll off teaser discounted by stock markets. The rock-bottom levels (Exhibit 4). They rates negotiated when the housing good news is that all these efforts are also broadening their efforts to bull market was in full swing. are already percolating in the global blend traditional policy responses economy, and the momentum will with new tools that include providing We should not anticipate increase as the recently enacted liquidity directly to key credit markets instantaneous results. Stimulus takes round of additional fi scal stimulus such as commercial paper, while time to work, and patience will be work their way into the pipeline. keeping a lid on long-term rates by required. In fact, the fi rst sign that purchasing longer-maturity bonds. these measures are working will NEGATIVE FEEDBACK LOOPS The latter is particularly important not actually be a recovery in many ARE STILL INTENSIFYING… to U.S. housing, where the direct of the economic indicators that are purchase of mortgage-backed currently transfi xing investors. Most As optimistic as we remain that securities has brought down interest economic indicators are unlikely to the economy and capital markets
16 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
will eventually begin to function EXHIBIT 5. U.S. Subprime Loan Delinquencies more normally, we remain realistic As % of Subprime Loans Outstanding that policy responses have yet to produce bottoms for the housing 22 and lending markets (Exhibit 5). Source: Mortgage Bankers Association, ISI 20 Real estate prices are still falling, sparking an uninterrupted global 18 fl ow of asset writedowns, bank
failures and the intensifying fear of % 16 bank nationalizations. The collateral 14 damage from this uninterrupted fl ow of falling asset values is still 12 broadening across global capital markets from its epicenter. The 10 vicious cycle of bank writedowns 1998 2000 2002 2004 2006 2008 2010 triggering fi nancial institutions to deleverage and tighten lending MARK-TO-MARKET standards continues to intensify. ACCOUNTING MAY HOLD A KEY up that “if the assets trading way below economic value have …AS WE WORK THROUGH to be recognized as immediate OUR FIRST REAL-TIME One debilitating issue that losses, then it does not take a swept rapidly, and somewhat rocket scientist to fi gure out the RECESSION uncontrollably, through the capital banking system is bankrupt.” The markets was the interaction unintended consequence has been Aggravating these negative feedback between mark-to-market further restrictions on the ability loops is the reality that we are accounting and securitization. of fi nancial institutions to initiate working through our fi rst severe The adoption of mark-to-market new loans and support old ones. recession in real-time. Never before accounting in 1999 was intended In essence, balance-sheet health have businesses and consumers to enhance transparency and is understated when it is needed entered as severe a recession with it has been successful on that most. Consequently, fi nancial comparable breadth of real-time front. However, it is also central conditions have stubbornly resisted economic data and information to the negative feedback loops policy efforts to date, and the credit technology at their fi nger tips that have exacerbated the crunch has continued to blunt – allowing them to adjust their fi nancial crisis. Mark-to-market the transmission of stimulative behavior almost instantaneously. accounting requires that where policy to broader lending rates. We hope that we will look back market prices are available, one day and discover that the real- they must serve as the basis for The Senior Loan Offi cer Opinion time linkages in this crisis may carrying values of all similar Survey on bank lending is a key case have actually led to a sharper and securities – regardless of whether in point. It continues to signal that shorter trough than might have the holder wishes to transact. lending standards on all major loan otherwise transpired. However, categories are still rising, albeit at a the pitch of the economy’s descent The result has been massive diminishing rate, even though policy is steepening, and we have yet balance-sheet writedowns that makers are trying to stimulate freer to implement an effective circuit refl ect marginal and distressed fl owing credit (Exhibit 6). Nearly breaker for the vicious housing- transactions rather than 48% of mortgage offi cers and 64% of lending spiral that began in 2006. nonperformance or impairment. A respondents cited tighter standards recent Credit Suisse report summed for commercial and industrial
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 17 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
loans. At the same time, funding EXHIBIT 6. Senior Loan Offi cer Survey on Bank Lending Practices costs are improving, but they are Loan Offi cers Reporting Tightening Standards still well above pre-crisis levels, which has raised debt-servicing 90 costs for new loans (Exhibit 7). 70
What is fairly apparent is that 50 banks should recapture a large 30 portion of the writedowns and 10 bolster their balance sheets with QoQ % Change reversals of mark-to-market hits -10 when markets thaw and prices Source: Federal Reserve -30 are restored to refl ect the value of 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 securities not traded in distress. However, it is unclear if the Mortgage Loans to Individuals Commercial & Industrial Loans ultimate thaw will arrive quickly enough to prevent the unintended EXHIBIT 7. United States Bond Yields damage from reverberating deeper Corporate, U.S. 10-Year Treasury and 30-Year Mortgage Rates into otherwise healthy balance sheets. One potential circuit 20 breaker could be a modifi cation 18 of mark-to-market accounting. 16 14 …AS NEW APPROACHES TO 12
% 10 LENDING COME INTO PLAY 8 6 Although the market’s 4 negative reaction to the initial 2 Source: Moody's, Haver Analytics lack of specifi cs on the new 0 administration’s fi nancial stability 1980 1985 1990 1995 2000 2005 2010 plan seems reasonable, there is Moody's BAA Corporate 10Y U.S. T-Bond Yield 30Y Mortgage Rates room for cautious optimism.
The Obama team has gathered an markets has created a logjam in the the biggest banks have suffi cient impressive team of fi nance experts credit pipeline as capital has been capital. At $500 billion to $1 trillion, ranging from former Federal Reserve tied up and cannot be released the Public-Private Investment Fund Chairman Paul Volcker to Former by transferring the risk. That has (PPIF) may be too small to get the Treasury Secretary Larry Summers, aggravated the tightening of lending job done, but it is also a start down and they are just getting started. standards in the consumer and a reasonable path to help clear other sectors. So, TALF is a critical to credit channels by getting toxic The Term Asset-Backed Loan unclogging the lending pipeline. The assets off bank balance sheets. We Securities Facility (TALF) is expansion of TALF to $1 trillion from are encouraged to see the Treasury essentially a mechanism designed $200 billion is coming at a critical and the Fed continue take an to provide investors with cheap time to stem rollover risk in areas innovative and fl exible approach fi nancing to purchase asset-backed such as commercial real estate debt. to fi nding the best combination of securities in the hope that they will prescriptions to spark the healing restart the securitization market. A new Capital Assistance program process. Interestingly, Ben Bernanke The collapse of securitization is also being created to ensure that pointed out in his 1999 assessment
18 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
of the Great Depression that “many EXHIBIT 8. U.S. Consumer Balance Sheets – Net Worth of Roosevelt’s policies did not work Households and Nonprofi t Organizations as intended, but in the end FDR deserves great credit for having 70 the courage to abandon failed 60 paradigms and to do whatever 50 needed to be done.” In short, this is something of a trial-and-error 40 process that will demand patience, 30 and we are confi dent that it will $ Trillions eventually lure back borrowers. 20 That, in turn, should help banks 10 to shrink their leverage ratios, as Source: Federal Reserve much by a recovery in asset values 0 as by creating a more orderly market 1980 1985 1990 1995 2000 2005 2010 for dispersing illiquid assets.
EXHIBIT 9. U.S. Initial Unemployment Claims Filed CONSUMERS GRAPPLE WITH Four Week Moving Average PLUMMETING NET WORTH… AND EMPLOYMENT 650 600 Last Plot: 639
The challenge that bank balance 550 sheets face from the negative 500 feedback loops are mirrored in 450 household balance sheets, as forced 400 selling fuels declines in consumers’ Median: 353 nest eggs. Falling home prices and 350 plunging capital markets have 300 Source: BLS, Haver Analytics wiped out $7 trillion, or 11% of U.S. 250 household net worth (Exhibit 8). 1990 1995 2000 2005 2010
At the same time, mounting unemployment shows few signs of jumped to an average of 70,900 still employed are just coming to falling from levels that are already per month over the last three terms with the realization that worse than the last recession. The months. Sadly, unemployment is their nest egg has taken a major hit. unemployment rate has climbed to a lagging indicator. As a result, the Unfortunately, the fi rst response, 8.1% from 4.9% a year ago, easily weakness in leading indicators even among households that can surpassing the 6.3% peak of the 2001 globally and inventory cuts needed easily afford a major hit to their recession. Total job losses now stand to adjust to high U.S. inventories net worth, will likely be to cut at 4.4 million in the U.S., while the in the fourth quarter suggest that spending and ramp up savings. four-week moving average of initial the peak for unemployment will Lower energy prices, tax cuts, and jobless claims has spiked to its not be in view for some time. interest rates can only soften the highest level since 1982 (Exhibit 9). blow at the outset. It will take time Consequently, consumers are for individual households to return In Canada, the employment being hit with a barrage of bad to a more optimistic footing. rate has climbed to 7.2% from news, and will be for some time. 6.2% in September as job losses Even the vast majority who are
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 19 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
HOUSING DATA REMAINS EXHIBIT 10. U.S. Housing – New Private Housing Units Started BLEAK Total Starts Including Farm Housing
Housing is at the root of the 2.4 crisis that we fi nd ourselves in. Presumably, we will need to stem 2.0 the bleeding in housing before being confi dent of further and tenable 1.6 progress in credit conditions. 1.2 Million Units It is easy to build a case for an extension of the deep consumer- 0.8 led recession that we are now Source: Census, Housing Starts confronting based on the most 0.4 recent housing data. There is no 1980 1985 1990 1995 2000 2005 2010 question that the data are seriously ugly, at least on the surface. Housing EXHIBIT 11. U.S. Housing – Months Supply of Homes on the Market starts have fallen to their lowest Existing Single Family Homes level in more than a quarter-century (Exhibit 10), and existing home 12.0 sales are still very weak and stuck in negative year-over-year territory. Last Plot: 9.2 Mths 10.0 Subprime delinquencies continue to climb, and have moved beyond 8.0 20% of subprime loans outstanding.
Even in the upper end of the market, Months 6.0 jumbo mortgages (home loans of at least $417,000), delinquencies are on 4.0 the rise as job losses and the sharp Source: National Association Of Realtors decline in net worth take their toll. 2.0 In fact, approximately 20% of U.S. 1990 1994 1998 2002 2006 2010 households now fi nd themselves in a position where their house is worth less than their mortgage. As shocking as the data are, the fi nal chapter of this unprecedented sharp fall-off in housing starts decline in residential real estate …BUT THERE MAY FINALLY BE suggests that we are not bringing prices, but it could be a long SOME LIGHT AT THE END OF as much new supply on stream. For chapter. We need to see inventories example, the 245,000-unit level of fall faster than sales to shorten THE TUNNEL single-family starts in January was the months supply (Exhibit 11). 25% below the latest data point we While the housing crisis is not over, have for new home sales. It is also The fair-value, or equilibrium, ratio it is possible to argue that we have approximately 50% below potential that we look at also shows that the worked through a signifi cant portion homeowner demand of 520,000 units, rate of descent may be slowing as of the repair that needs to happen, based on household formation. As the normal balance is being restored and that the credit crisis may now a consequence, home inventories between prices and incomes (Exhibit be on the path to stabilization. fell further – down 3% in January 12). Between 1986 and the early – and have fallen 29% year-over- years of this decade, homes sold for year. So, we may be entering the about 2.9 times household income.
20 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
That range was likely the result of EXHIBIT 12. Home Prices as a Multiple of Median Household Income banks’ longstanding leverage limits Existing House Price Divided by Median Income and risk-management practices. 4.5 Then the appearance of the Peak of Housing Market Median Price $230,900 subprime and other new types of housing loans in the early years of 4.0 this decade very rapidly blew that ratio out to almost 4.5 times. The 3.5 correction in home prices, coupled X 20% Below peak housing price 3.0 with modest income growth, has 27% Correction required pulled the ratio down 27% over to achieve average ratio Average Ratio 1986-2001: 2.85 30% Below peak housing price the past four and a half years, 2.5 40% Below peak housing price moving it back to its equilibrium Source: National Association of Realtors level. Interestingly, that is very 2.0 closely aligned with an IMF study 1986 1989 1992 1995 1998 2001 2004 2007 2010 suggesting that house prices tend to fall 30% during periods combining EXHIBIT 13. U.S. Housing a housing bust with a recession. Affordability Index
There is no law that housing prices 170 must stop falling once the prior Last Plot: 167 160 income-equilibrium ratio is restored. This market changed very radically 150 in a very short period of time, and 140 deleveraging could force the market 130 down further. Although fear now
Index Level 120 abounds, not all families have Average: 124 tight balance sheets and some will 110 undoubtedly capitalize on improved 100 Source: National Association of Realtors, Existing Home Sales housing affordability (Exhibit 13). 90 With the pipeline shutting down, 1990 1994 1998 2002 2006 2010 sales no longer in freefall, inventory starting to get worked down and housing prices now well supported by The fi nger-pointing in this crisis Housing Act, which mandated rising current incomes, housing could begin has been mostly directed at quotas for low-income mortgages. to heal. That would surely help to commercial banks and Wall Street, By 1997 Fannie Mae and Freddie restore confi dence and work its way which played a willing, and initially Mac were required to devote 42% of into other areas of the credit crisis. profi table, role in packaging and their mortgage underwriting to low- distributing mortgage securities. and moderate-income American THE ILLS OF A FAILED However, they were part of an households. In the end, subprime SOCIAL POLICY unhealthy confl uence of events mortgages ballooned to 20% of the and motivations that politicized mortgage market in 2006 from 4.5% The ills of a failed social policy home ownership in the U.S. A in 1994, precisely – and sadly – what to put Americans in their own series of laws that started with the policymakers had hoped for. It homes suggest that U.S. lawmakers Community Reinvestment Act of stands to reason that if you start may need to revisit current 1977 encouraged lenders to make to set quotas on lending, risk is housing legislation to ensure risky home loans, and culminated going to be mispriced. Former we build a lasting resolution. in the 1992 Urban Development & U.S. Senator Phil Gramm said in a
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 21 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
recent Wall Street Journal editorial EXHIBIT 14. U.S. Consumer Debt that loose money and politicized Seasonally Adjusted Annual Rates mortgages are among the villains. 16000 CONSUMER DEBT CHALLENGE 14000 MAY BE MORE ABOUT WHERE 12000 IT’S CONCENTRATED 10000 8000
Much attention has been drawn to $ Billions 6000 consumer-debt levels, which have 4000 steadily climbed at a compound 2000 growth rate of 8.6% over the past Source: Federal Reserve Board quarter-century (Exhibit 14). We 0 think this has led some to draw 1980 1985 1990 1995 2000 2005 2010 the somewhat fl awed conclusion that U.S. households have been on a debt-fuelled spending binge interest rates. For example, the U.S. be commonly believed. The caveat to for decades and have amassed household debt/net worth ratio that argument is that policymakers untenable debts. To be fair, this has steadily climbed, but remains must avert a downward spiral in argument essentially hinges on manageable at 24.6% (Exhibit 15). jobs, incomes and asset values four indisputable facts – nominal While true that net worth is now that would essentially infl ate the household debt has climbed steadily declining sharply, debt renegotiation nominal value of each dollar of debt. over the past couple of decades, and forgiveness may become a household debt has steadily climbed surprising offset in time (more on …AND DOUBLE-ENTRY as a percentage of income, the that later). It is important to consider BOOKKEEPING SHOULD LEND U.S. household savings rate had that these are aggregate ratios and fallen to nearly non-existent levels the most indebted households are A HELPING HAND until recently, and robust gains in unfortunately either on their way consumer spending during the most to being wiped out and falling out The relationship between the recent expansion were supported of the averages, or having their sharp deterioration in consumer by home equity drawdowns. debt load marked down to a more net worth, initially sparked by manageable level. Consistent housing, and historic bank losses The U.S. savings rate is rising, and with the politicizing of home is broadly apparent. However, Patti Croft, the chief economist of ownership in the U.S. over the past double-entry bookkeeping is not RBC Global Asset Management, two decades, outsized subprime just about the asset side of the predicts that the rate will climb mortgage debt was taken on by the ledger for consumers and banks. higher. An increased savings rate lower tiers of the income spectrum, The implication is that bank credit will, at least initially, dampen the particularly those households in losses will eventually fi lter into debt strength of the recovery. However, the lowest 20% of incomes. Not renegotiation ("cramdowns") and the idea that we may be pricking surprisingly, debt-to-income ratios debt forgiveness (via foreclosure) a U.S. household-debt bubble is rose modestly over the past few on the consumer side of the ledger less than compelling based on our years elsewhere in the income has gained far less attention. This work, for a few reasons. The growth spectrum. So, the households that should be especially true for U.S. in household debt was closely are mostly likely to survive this crisis mortgage holders, who are in the aligned with the robust growth in and fuel a recovery in consumer unusual position of having almost U.S. consumer net worth and the spending appear to have far more no legal recourse for delinquent sharp decline in real and nominal manageable debt loads than might borrowers beyond renegotiating
22 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
better terms or foreclosing on the EXHIBIT 15. U.S. Consumer Debt as % of Net Worth home. Borrowers are generally Seasonally Adjusted Annual Rates shielded from any further claims on their assets for losses suffered 26 beyond the net market value 24 of a residential property. 22
We anticipate a lag effect on the 20 transmission of bank writedowns % 18 to consumer debt forgiveness, suggesting that benefi t will remain 16 somewhat invisible for the moment. 14 There are also too many moving Source: Federal Reserve Board parts to determine how signifi cantly 12 it will slow deterioration in U.S. 1980 1985 1990 1995 2000 2005 2010 household debt ratios, since the current economic fallout will EXHIBIT 16. TED Spread and LIBOR Spread impact the debt-ratio denominators 3-Month TED and 3-Month LIBOR Minus the $US OIS Rate (net worth, income etc.). Yet, it is important not to overlook this link 500 as a helpful counter-balancing 450 Source: RBC AM, Haver Analytics mechanism. A substantial portion 400 of the trillions that are now being 350 written off by banks and investors 300 globally should eventually 250 200 materialize as a positive surprise in Basis Points 150 the U.S. consumer debt story. The 100 implications could be particularly 50 benefi cial to U.S. household debt 0 ratios when employment and Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 income growth begin to recover. U.S. 3-Month LIBOR minus 3-month T-Bill U.S. 3-Month LIBOR minus Overnight Indexed Swap Rate After all, mortgage debt is the largest component of U.S. household debt and debt forgiveness is a permanent market. It also promotes greater Since those unsettling events, win for U.S. consumers, whereas job stability in other key markets such as LIBOR-OIS spreads have fallen to losses and reductions in net worth money markets and foreign exchange. 1.0% from their 3.6% post-Lehman are generally temporary losses. bankruptcy peak, 90-day asset- Policymakers’ concerted efforts to backed commercial paper rates are INTERBANK SPREADS rebuild liquidity and confi dence down to 0.7% from 5.25%, and the HAVE VASTLY IMPROVED in credit market continue to show TED spread has retreated 360 basis progress. The exogenous shocks points to 1.0% from 4.6% (Exhibit We are seeing tentative signs of a triggered by Lehman’s bankruptcy 16). Commercial-paper issuance thawing of the credit crunch and a in September triggered an has also enjoyed a resurgence, return to more normal functioning unprecedented spike in rates and refl ecting the success of the Fed’s in money markets. That is a loss of liquidity, refl ecting a deep commercial-paper program. critical component to putting the loss of confi dence in the solvency economy on a recovery track and of banks and all but the 15 top- to normalizing prices in the stock rated issuers of commercial paper.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 23 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
THAW GRADUALLY SPREADING EXHIBIT 17. United States TO HIGH GRADE CORPORATES Corporate Bond Issuance
There are also notable signs the 120 thaw is gradually working its way 100 into the corporate-debt market. 80 60 Corporate-debt spreads have 40 tightened materially and the 20 progress continued into the New 0 Year despite the sharp reversals -20 YoY % Change in the equity markets. Liquidity -40 is also recovering in high-grade -60 corporate debt markets. Recent -80 Source: Bloomberg issuance activity was actually -100 up strongly year-over-year for Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 January and February (Exhibit 17). In fact, February ranks as the EXHIBIT 18. U.S. ISM Manufacturing Index and the Fed Funds Rate ninth-largest month on record in Fed Funds Inverted and Advanced Six Months issuance of investment-grade debt in the U.S. Renewed liquidity and 70 0 appetite for debt issues has been 65 1 gradually spreading from Triple 60 2 A-rated debt to Single A-rated debt. 55 3 A “NEW NORMAL” 50 4 % FOR SPREADS? 45 5 40 6 Tight bid/ask spreads and ballooning 35 7 Source: Institute for Supply Management volumes across most fi nancial 30 8 markets characterized the unusually 1998 2000 2002 2004 2006 2008 2010 strong liquidity experienced ISM Diffusion Index (LHS) Fed Funds Rate (Inverted, Adv 6 Months) (RHS) during the most recent economic expansion. It became apparent that portions of the debt markets were worst is behind us, we should also to those drivers. Tighter credit not appropriately pricing risk when prepare ourselves for a “new normal” regulation, including tighter spreads on unsecured high-yield for interbank and credit spreads. regulation of the ratings agencies, is bonds traded below secured bank The exceptional liquidity that began likely to prevent a similar experience debt for some issuers. The fl ight to to disappear from risky markets from occurring for some time. We quality has caused the pendulum to in 2007 appears to have been see spreads gradually narrowing overshoot in the other direction, as primarily fostered by a powerfully as the economy begins to heal, but liquidity dried up in many markets virtuous circle of low interest rates, not to the levels of the most recent and credit spreads widened to a glut of global savings looking for cycle, and it will take time. Interbank previously unheard-of levels. a home in “A” -rated U.S. fi nancial lending rates, for example, will assets, the advent of securitization remain elevated as long as concern However, we believe that investors and nearly unrestricted credit. exists that the balance sheets of should take a balanced view. While some big banks are impaired. we expect spreads to gradually With the exception of low interest However, spreads do not have to tighten as the markets sense the rates, this crisis has dealt a blow
24 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
tighten to the levels of the past cycle EXHIBIT 19. U.S. ISM Non-Manufacturing Index & the Fed Funds Rate for the system to function normally. Fed Funds Inverted and Advanced Six Months
THE POINT OF MAXIMUM 70 0 PAIN COULD BE AROUND 65 1 60 2 THE CORNER 55 3 50 4 % Exhibits 18 and 19 show a strong correlation between the level of 45 5 the fed funds rate and economic 40 6 activity, and have been useful 35 7 Source: Institute for Supply Management roadmaps in past economic cycles. 30 8 In each exhibit, the fed funds rate 1998 2000 2002 2004 2006 2008 2010 (dotted line, inverted and advanced ISM Diffusion Index (LHS) Fed Funds Rate (Inverted, Adv 6 Months) (RHS) six months on the charts) is plotted overtop of the ISM Manufacturing EXHIBIT 20. United States and Non-Manufacturing diffusion Non-Farm Employment and the Fed Funds Rate indices (solid lines on charts). Both lines trace each other very 0.0 6.0 closely, suggesting that Fed policy 2.0 has been effective at laying a path 4.0 4.0 for the economy to follow, with an approximate six-month lag. 6.0 2.0
% 8.0 Similar to exhibits 18 and 19, Exhibit 10.0 0.0 YoY % Change 20 tracks the fed funds rate (dotted 12.0 -2.0 line on the chart, inverted and 14.0 Source: ISI Portfolio Strategy advanced 18 months) overtop of 16.0 -4.0 non-farm employment growth. Non- 1970 1976 1982 1988 1994 2000 2006 2012 farm employment tracks changes in Fed Funds Rate (Inverted, Adv 18 Mos) Non-Farm Employment (RHS) the fed funds rate closely, but with a lag of about 18 months. Exhibit 21 shows the contemporaneous EXHIBIT 21. United States relationship between changes Real Consumer Spending and Non-Farm Employment in non-farm employment and 8.0 consumption. For the nearly 70% of GDP that comes from consumer 6.0 spending, the initial impact of 4.0 lower rates should begin to reach maximum intensity over the next 2.0 few months. With the credit crunch intensifying the effect of low rates YoY % Change 0.0 on the economy, however, improving -2.0 consumption is still a ways off. Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Citigroup -4.0 These indicators of economic 1970 1975 1980 1985 1990 1995 2000 2005 2010 Non-Farm Employment Real Personal Consumption activity usually respond on a six-
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 25 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
month lag to changes in interest EXHIBIT 22. United States Money Supply Growth rates. However, our outlook for the Monetary Base (M0), M2 & MZM economy is far more dependent on developments in the credit markets 120 Source: Federal Reserve than in prior cycles. Despite massive 100 and rapid expansion of the money 80 supply (Exhibit 22) and historic lows in interest rates, velocity, the 60 speed with which money moves 40 through the economy, has slowed Change YoY % 20 to a crawl (Exhibit 23). These 0 supply factors, combined with a precipitous decline in demand for -20 borrowed funds due to consumer 1980 1985 1990 1995 2000 2005 2010 deleveraging and extreme risk Monetary Base (M0) M2 MZM aversion, have prevented traditional monetary easing from stimulating EXHIBIT 23. United States Money Velocity economic activity as we would Nominal GDP Divided by Monetary Base (M0) normally expect. Ultimately it does not matter how low you push interest rates if people do 25 not want to lend or borrow. 20 Our forecast assumes a sustained thawing in credit. Despite being 15 knocked out of sync with historical time patterns, these indices should re-conform to Fed policy 10 measures as the credit crisis is Nominal GDP/Monetary Base (M0) Source: Haver Analytics, RBC AM resolved. For that to happen, we 5 need to see money starting to 1980 1985 1990 1995 2000 2005 2010 fl ow out of the banking system. The new administration is clearly focused on making that happen, Quantitative easing describes the mechanism. Furthermore, the Fed but setbacks still appear to be adoption of unconventional policy has already essentially pulled down outweighing progress to date. measures to avert the threat of a short interest rates as far as it can. liquidity trap or to correct major FED REMAINS DETERMINED failings in the fi nancial system. Since there are few constraints on TO FLOOD THE SYSTEM Whereas interest-rate targeting how large the Fed’s balance sheet can works in combination with a well become, the Fed is creating cash and The Fed’s powers are not pinned to functioning banking system to using it to fund a multitude of new interest rates alone. Monetary-policy “encourage” changes in market lending facilities to help ease stress in responses to the fi nancial crisis have dynamics, quantitative easing credit markets. As part of that effort, been innovative and aggressive. “forces” these dynamics when the Fed continues to move toward a We would not be surprised to see the system proves unresponsive new program to purchase long-term a host of new programs added to more traditional means. Banks U.S. Treasuries. The intent is to bring to the list before this crisis has continue to hoard cash, which has down the cost of debt that is priced passed into the history books. effectively sterilized the lending at a spread to long-term Treasuries
26 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
such as mortgage and corporate debt. EXHIBIT 24. Implied Long-term Infl ation Premium Other programs include a $600 billion Breakeven Infl ation Rate: Nominal vs. 10-year Real Return Bond program to purchase securities issued by government-linked mortgage 5.0 fi nance companies – Fannie Mae Canada: 1.37% and Freddie Mac. The Fed is also 4.0 3.15% U.S.: 1.00% providing up to $200 billion of fi nancing to investors purchasing 3.0 securities tied to consumer debt % 2.0 such as car loans and credit cards. 1.0 INFLATION HITS THE Source: Bloomberg, RBC Capital Markets, RBC AM BACK BURNER... 0.0 2000 2002 2004 2006 2008 2010 Infl ation has suddenly vanished. Canada U.S. Trailing 5-yr Avg U.S. CPI Headline CPI peaked at 5.6% in July as the price of oil approached $150 by fl ooding the system with money, With most asset markets still under per barrel. In sharp contrast, the but the velocity of money has severe strain and the economy January fi gure was essentially fl at, plummeted, as much of it is being showing few signs of stabilizing, we as energy-price relief continues to hoarded by banks rather than continue to expect central banks to affect year-over-year comparisons. working its way into lending. provide whatever relief is available. Infl ation expectations buried in The ECB has been reluctant to cut the pricing of CPI index-linked At the same time, long-term debt rates, but its bias will be toward bonds remain nearly non-existent, markets are worried that the Fed’s catching up with further reduction. indicating an expectation that a programs might be too stimulative, severe recession will continue to put resulting in a resurgence in Our valuation models (exhibits a lid on wages and prices (Exhibit 24). infl ation. Although that is a risk, 25-29) indicate that policy rates lie the Fed has the ability to shrink well below their equilibrium levels ...AND SHOULD REMAIN its balance sheet relatively quickly in every major economic region THERE DESPITE MASSIVE as a substantial portion of the we follow with the exception of assets that the Fed holds – loans Japan. At the bands’ midpoints, STIMULATION to banks, swaps and commercial the trend-setting interest rate is With capacity utilization falling paper – are short-term in nature fi xed to provide the normal real globally, concerns in the market and can be allowed to run down (after-infl ation) cost of funding at have essentially shifted to worries as the programs are pared back. the 90-day maturity, plus an offset for expected infl ation. Pushing about defl ation. Defl ation acts as PAVING THE WAY FOR a disincentive to consumption, short-term rates below the lower and a bout of serious defl ation A SUSTAINED PERIOD boundary indicates an aggressive could be particularly damaging OF LOW RATES easing of interest rate policy as for an indebted economy since it the real cost of funding has been raises the infl ation-adjusted cost of Since September, we have seen all driven to extraordinarily low levels. servicing or repaying outstanding of the major central banks slash debt. Simply put, each dollar of interest rates. The Fed cut rates by We think that the major central unpaid debt becomes a bigger nearly 200 basis points to between banks will view a resurgence in dollar. A bout of mild defl ation is 0.0% and 0.25%, the U.K. by 450 infl ation as unlikely for some time a real possibility, and it is already basis points to 0.50%, the ECB and deem some infl ation preferable evident in many asset prices. The by 275 basis points to 1.5%, and to defl ation, in any event. The Fed Fed is responding to this concern Canada by 250 basis points to 0.5%. would also probably prefer to err on
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 27 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
the side of overexpansion with its EXHIBIT 25. U.S. Fed Funds quantitative-easing program than Equilibrium Range risk a long battle with defl ation. The major central banks are likely 24 to continue to hold rates at record 20 lows and not look to return to a more neutral setting until there are fi rm 16 signs that the economy has healed.
% 12
GOVERNMENTS WILL REMAIN 8
EXPENSIVE NEAR-TERM, BUT 4 Source: Federal Reserve, RBC AM ARE VULNERABLE LONG-TERM 0 1980 1984 1988 1992 1996 2000 2004 2008 2012 In the last Global Investment Last Plot: 0.25% Current Range: 0.92% - 3.10% (Mid: 2.01%) Outlook, we expressed concern that risk aversion had moved EXHIBIT 26. Canada Overnight Rate government-bond yields well below Equilibrium Range their normal valuation bands. That signaled a growing risk that we 25 could see yields rise signifi cantly in the long end of the bond market 20 as the economy stabilized. 15
As with our short-term equilibrium % 10 models, the midpoint of each of our valuation bands indicates the 5 level of yields that provides the Source: RBC AM “normal” real rate of interest at 0 that maturity, plus an offset for 1980 1984 1988 1992 1996 2000 2004 2008 2012 expected infl ation. Below that level, Last Plot: 0.60% Current Range: 1.37% - 3.47% (Mid: 2.42%) valuations provide a progressively smaller cushion against any change in the outlook as the infl ation EXHIBIT 27. Eurozone Repo Rate premium, real rate, or both of Equilibrium Range these critical factors are situated below their longer-term norms. 20
16 Our concern that long government bonds are overvalued has been 12
softened by two important shifts in % the market. First, our government- 8 bond valuation bands across most regions are down sharply 4 because of a collapse in expected Source: Bloomberg, Consensus Economics, RBC AM 0 infl ation. Second, we have seen a 1980 1984 1988 1992 1996 2000 2004 2008 2012 signifi cant rebound in government- Last Plot: 0.93% Current Range: 1.80% - 3.49% (Mid: 2.65%) bond yields, with an uptick of as
28 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
much as 100 basis points in the EXHIBIT 28. Japan Overnight Call Rate U.S., for example. Our models for Equilibrium Range the largest global bond markets (exhibits 30-34) show that bond 14 yields essentially bounced off the 12 bottom of their bands and now 10 generally trade close to the midpoint 8 of their equilibrium channels.
% 6 Similarly, technical underpinnings are still weak, but have bounced 4 off extremely overbought levels. 2 0 Source: Bloomberg, Consensus Economics, RBC AM When a whiff of normalization -2 appears – watch out. As the crisis 1980 1984 1988 1992 1996 2000 2004 2008 2012 resolves itself, government-bond Last Plot: 0.27% Current Range: 0.06% - 1.04% (Mid: 0.55%) valuations will be increasingly vulnerable to a mean reversion in EXHIBIT 29. United Kingdom Base Rate infl ation and risk premiums. That Equilibrium Range should result in a sharp rise in our valuation bands and a reversion in 18 yields toward equilibrium valuations. 16 14 Government bond yields are set 12 to trade in disequilibrium for a 10 % prolonged period, given the lack of 8 an immediate answer to the severe 6 risk aversion dominating investor 4 psychology, the lengthening time 2 Source: RBC AM horizon to potential recovery in 0 the economy, the small risk of a 1980 1984 1988 1992 1996 2000 2004 2008 2012 surprise uptick in infl ation and Last Plot: 0.50% Current Range: 2.95% - 4.66% (Mid: 3.81%) expectations that the Fed will buy longer-dated Treasuries. We expect that situation to sustain itself, for EXHIBIT 30. U.S. 10-Year T-Bond Yield now, even in the face of growing Equilibrium Range supply concerns. Yields need to stay low to stimulate a recovery. 16 14 CORPORATE BONDS 12 REMAIN ATTRACTIVE 10
% 8 Corporate-bond spreads generally 6 trade very closely with stocks. 4 Both rallied from extremes in the 2 summer of 2008 and then sold off Source: Bloomberg, Bureau of Labour Statistics, RBC AM hard as fi nancial losses mounted 0 and a prolonged recession became 1980 1984 1988 1992 1996 2000 2004 2008 2012 evident. Interestingly, the corporate- Last Plot: 3.02% Current Range: 2.30% - 4.13% (Mid: 3.22%)
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 29 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
bond market has diverged from EXHIBIT 31. Canada 10-Year Bond Yield equities recently. Even as stocks Equilibrium Range have been hitting fresh lows, U.S. investment-grade credit has rallied 18 from a spread of 622 basis points 16 in December to just over 500 basis 14 points. At that level, corporate 12 spreads remain well past levels seen in the aftermath of the any of the % 10 recent crises over the past couple 8 of decades, but the relief is material 6 and looks to be durable (Exhibit 35). 4 Source: Bloomberg, RBC AM There are a variety of indicators 2 suggesting that move may be 1980 1984 1988 1992 1996 2000 2004 2008 2012 Last Plot: 3.13% Current Range: 2.78% - 4.48% (Mid: 3.63%) sustainable. Leading indicators have ticked up modestly and key leverage ratios such as corporate debt/equity EXHIBIT 32. Eurozone 10-Year Bond Yield and interest coverage remain healthy Equilibrium Range (Exhibit 36). We are also approaching 30 months since the yield curve 18 began to normalize. Based on historic 16 relationships, spreads should start 14 to narrow in May (Exhibit 37). 12
As the credit crunch clears and % 10 the economy gets back on a 8 better footing, there appears to 6 be a tremendous opportunity for 4 Source: Bloomberg, Consensus Economics, RBC AM capital appreciation in corporate 2 bonds, and the attractive yields are 1980 1984 1988 1992 1996 2000 2004 2008 2012 essentially paying you to be patient. Last Plot: 3.71% Current Range: 3.27% - 4.53% (Mid: 3.90%) The corporate market is still far from normal, and companies tapping the market with new issues have EXHIBIT 33. Japan 10-Year Bond Yield generally been at least A-rated with Equilibrium Range balance sheets built to withstand a drawn-out recession. However, 14 Source: Bloomberg, Consensus Economics, RBC AM the revitalization in liquidity and 12 confi dence should gradually spread 10 from A-rated issuers to Triple B-rated. 8
HIGH YIELD STILL HAS % 6 LOTS OF BAD NEWS TO 4 WORK THROUGH 2
The probability of a short, sharp 0 cycle in high-yield defaults looks 1980 1984 1988 1992 1996 2000 2004 2008 2012 to be low and declining. After Last Plot: 1.28% Current Range: 1.35% - 2.22% (Mid: 1.78%)
30 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
benefi ting from the recent rally EXHIBIT 34. United Kingdom 10-Year Gilt in investment grade debt, high- Equilibrium Range yield spreads are beginning to widen out again. According to 18 the Merrill Lynch Global High 16 Yield Index, the average yield for 14 junk bonds is 20.1%, below its 12 recent highs of 22.7% but far from
% 10 healthy. Furthermore, high-yield spreads remain under severe 8 strain at 16.4% (Exhibit 35). 6 4 Source: RBC AM We still believe that some 2 outstanding opportunities will 1980 1984 1988 1992 1996 2000 2004 2008 2012 materialize in the high-yield Last Plot: 3.62% Current Range: 2.82% - 4.93% (Mid: 3.88%) debt market, but it is too early to become aggressive. High-yield EXHIBIT 35. U.S. Corporate Spreads debt is still severely challenged Moody's BAA and Merrill Lynch High Yield minus 10-Year T-Bond and looks set to remain that way for some time. Capital structures 7.0 20.0 became extremely top heavy in Source: RBC AM the most recent cycle with large 6.0 15.0 secured bank or investment-grade 5.0 debt sitting above high yield.
Debt multiples at the secured % 4.0 10.0 % level were stretched and leave 3.0 little to no asset value supporting 5.0 many of the restructurings 2.0 that are already underway. 1.0 0.0 1990 1995 2000 2005 2010 That is putting pressure on Moody's BAA 10-year T-Bond Spread (LHS) Merrill Lynch High Yield Spread (RHS) expectations for default and recovery rates. Moody’s expects default rates to rise to the EXHIBIT 36. Corporate Bond Spread and U.S. Leading Economic Indicators 16%-to-17% range, above default rates of all comparable cycles including 2001, 1991, and even the 20 -400 15.4% record in 1933. However, it 15 -300 appears to be more rational than 10 -200 it initially looked. The recovery 5 -100 rate, which generally has bigger 0 0 implications for valuations, is -5 100 expected to fall to approximately Y/Y % Change -10 200
10% from the 25% to 30% range Y/Y Basis Point Change -15 Source: The Conference Board, RBC AM, ISI 300 experienced in prior cycles. -20 400 1980 1985 1990 1995 2000 2005 2010 In short, the journey will require U.S. LEI Index (LHS) Baa Corporate Yield minus 10-year T-Bond Yield (Inverted, RHS) substantial restructuring and
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 31 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
reorganization of the high-yield EXHIBIT 37. U.S. Yield Curve vs. Investment Grade Spreads market for the next two years or longer, and we are probably only a fi fth of the way through. -2.0 7.0 Source: RBC AM 6.0 STOCKS MAKE FRESH LOWS -1.0 5.0 AS RECOVERY STRETCHES OUT 0.0
% 4.0 % After a brief bear-market rally 1.0 since the last release of the Global 3.0 Investment Outlook, stocks have 2.0 2.0 fallen to fresh lows and returned to trading at the greatest discounts to 3.0 1.0 fair value in more than a generation. 1990 1995 2000 2005 2010 2015 Just as no major economic region U.S. 10-2 Spread (Lt, Inv, Adv 30 Months) Moody's BAA-10 year T-bond Spread (Rt) has been left unscathed and most companies are struggling to adjust EXHIBIT 38. S&P 500 Equilibrium production to meet an increasingly Normalized Earnings & Valuations grim reality, no market has been left untouched by the collapse in 2512 Feb '09 Range: 979 - 1580 (Mid: 1280) valuations (exhibits 38 through 42). 1585 Feb '10 Range: 992 - 1602 (Mid: 1297) 1000 Current (27-Feb-09): 735 Our equilibrium models establish 631 fair value for equity- market indexes (i.e.: the bands’ midpoint) as a 398 function of normalized earnings and 251 valuations. Normalized earnings 158 and valuations are particularly 100 63 useful during periods of stress or Source: Bloomberg, RBC AM distortion. Rather than basing a 40 view on cyclically depressed or 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 infl ated earnings, or on error-prone forecasts, we calculate the earnings that would be produced if returns EXHIBIT 39. S&P/TSX Composite Equilibrium on equity were at their long-term Normalized Earnings & Valuations average after adjusting for changes 15849 in infl ation and interest rates. 10524 Feb '09 Range: 8369 - 12474 (Mid: 10421) Similarly, the normalized p/e ratio Feb '10 Range: 9450 - 14084 (Mid: 11767) refl ects the history of valuations at 6989 Current (27-Feb-09): 8123 all levels of interest rates, infl ation 4642 and returns on equity. The North 3082 American and U.K. models draw 2047 on over 50 years of history. Data 1359 availability limits the history for the 903 Japanese and Eurozone to 35 years, 600 but that’s still a substantial amount. Source: Bloomberg, RBC AM 398 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
32 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
The models refl ect our view that EXHIBIT 40. Eurozone Datastream Index markets will ultimately value Normalized Earnings & Valuations companies based on their through- the-cycle earnings power, not on 3162 Feb '09 Range: 1511 - 2395 (Mid: 1953) trailing or forecast profi ts, and that 2132 Feb '10 Range: 1823 - 2890 (Mid: 2357) the valuations assigned to these 1438 Current (27-Feb-09): 775 will be moved up and down by 970 changes in the levels of infl ation 654 and interest rates. Recognizing that 441 markets swing far above and below 297 fair value over time, we have built a band to capture the normal range of 201 135 movement through the past decades. Source: Datastream, Consensus Economics, RBC AM
Two additional factors will impact 1980 1985 1990 1995 2000 2005 2010 where indexes sit relative to fair value. First is the secular backdrop. EXHIBIT 41. Japan Datastream Index During long periods of low infl ation Normalized Earnings & Valuations and mild interest rates, like the 1960s or 1990s, stocks have seldom fallen 1000 below the bands’ midpoint, and 717 when they have, didn’t stay there 514 long. During the unstable 1970s, though, the indexes almost always 368 hovered below fair value. Long 264 periods of stability add to valuations 189 while an inability to predict the 136 Feb '09 Range: 291 - 698 (Mid: 494) Feb '10 Range: 319 - 766 (Mid: 543) future detracts. Second, our positive 97 Current (27-Feb-09): 235 outlook and consistent overweight 70 Source: Datastream, Consensus Economics, RBC AM in equities since 2002 was very much 50 infl uenced by the U.S. market’s 1980 1985 1990 1995 2000 2005 2010 proximity to fair value in light of our contention that the secular backdrop created conditions for valuations EXHIBIT 42. United Kingdom Datastream Index to hold above the bands’ midpoint. Normalized Earnings & Valuations We considered the midpoint to be the minimum sustainable valuation 11482 Feb '09 Range: 4230 - 6946 (Mid: 5588) 7338 level, given the mild interest rates Feb '10 Range: 4197 - 6893 (Mid: 5545) and low infl ation of the period. 4689 Current (27-Feb-09): 2652 2997 This framework has generally 1915 provided a powerful tool in tactical 1224 asset mix, allowing for a comparison of current valuations to those of 782 the postwar era, and doing so after 500 319 making the kinds of adjustments Source: Bloomberg, Datastream, Consensus Economics, RBC AM required to limit distortion. 204 Emotional baggage is minimized. 1980 1985 1990 1995 2000 2005 2010
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 33 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
PENDULUM SWINGS EXHIBIT 43. Bull Markets: Valuations vs 1st Year Recovery FROM UNDERPRICING TO First Year Returns as a Function of Valuations at Onset OVERPRICING RISK -60% Fundamental to this type of 1978 1982 analysis is the assumption of -40% “mean reversion.” We assume 2002 1987 1970 1974 that subsequent plots will, over -20% 1960 time, converge on the long-term 196 1990 average. For markets, that means 0% 1966 of Bull Market that investors will ultimately pay 20% 1998 the same price for every dollar Source: RBC AM of earnings and dividends, after 40% S&P 500 Under/Overvaluation at Onset making the necessary adjustments, 0% 5% 10% 15% 20% 25% 30% to refl ect differences in the levels Total % Increase over 1st Year of Bull Market of infl ation and interest rates.
EXHIBIT 44. Relative Strength The nearly unparalleled shocks the Philadelphia Banks Index Relative to S&P 500 global economy has endured since mid-September have cast aside 1.4 most statistical relationships in the capital markets and mean reversion 1.2 has been turned on its head. As Warren Buffet noted in Berkshire 1.0 Hathaway’s recently released annual 0.8 report, “the investment world has gone from underpricing risk to 0.6 overpricing it. This change has not been minor; the pendulum has 0.4 Source: RBC AM, RBC CM covered an extraordinary arc.” 0.2 2002 2003 2004 2005 2006 2007 2008 2009 2010 Putting aside fundamentals for a moment, the very fact that “risky” assets, such as equities, is a powerful force aligned on Exhibit 43 relates valuation levels have fallen to levels that have left the side of mean reversion. to the size of bull markets over the them underperforming their “risk- past half-century. Specifi cally, we free” comparisons over long time …CREATING CONDITIONS compared the level of the S&P 500 frames, such as government bonds, FOR SHARP RECOVERY to its fair value (i.e.: the midpoint is not a sustainable relationship. of the band on Exhibit 38) at the After all, a free-market framework We have looked at the stability of start of all 11 bull markets since is fundamentally designed to these “mean reverting” relationships 1956 (vertical axis, inverted scale) encourage risk-taking. While risk in both bull and bear markets. Our against the climb in the S&P 500 can be overpriced for an extended research shows that falling markets in the fi rst year of the bull phase. period when exogenous shocks are much more vulnerable to being materialize, investors’ long- sideswiped by huge shifts in risk We have fi t a line to the data and the term desire to achieve a positive preference, and that can dominate expected relationship is confi rmed real return on their investments valuations, at least for a time. – bull markets that begin with
34 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
deeply depressed valuations show EXHIBIT 45. CDX North America Investment Grade Index particularly strong gains in their fi rst year. Those that begin with more full valuations are less impressive, at least 300 through their initial rally. Further analysis of the data confi rms that the 250 “best-fi t” line is signifi cant for bull 200 markets: statistical analysis confi rms that the degree of undervaluation at 150 the start of a bull has an important impact on fi rst-year gains. 100
Although emotion is a recurring 50 Source: Bloomberg theme in steep bear-market sell- 0 offs, mean reversion to rational Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 valuation appears to be restored rapidly in the ensuing recovery. So, although, the market appears to be EXHIBIT 46. U.S. Analyst Revision Estimates paying little attention to valuations Downward Revisions as a Percent of Total Revisions at the moment, fundamentals will return to the forefront when the -20 pitch of the economy’s current freefall begins to fl atten out. Further, -40 the best opportunities should exist in markets where valuations lie furthest below equilibrium, such % -60 as the Eurozone and S&P 500.
-80 RENEWED WEAKNESS IN FINANCIALS Source: ThomsonReuters -100 1985 1990 1995 2000 2005 2010 Although the valuations already look washed out, two indicators suggest that we are still a long way from being Credit is the essential lubricant for the SHARP EARNINGS out of the woods. Exhibit 44 illustrates economy. Investors need confi dence DETERIORATION… the renewed turmoil that we are that big U.S. banks and credit overall seeing in the fi nancials. Following will begin to function more normally, Since peaking 19 months ago at a solid recovery during the summer so that investors can again have $92.09, S&P 500 earnings have fallen and early fall, U.S. bank stocks have confi dence buying risky assets. 31%. Exhibit 46 shows that, at the fallen to fresh lows relative to the S&P end of January, 82% of estimate 500. It would be possible to argue Exhibit 45 sends an eerily similar revisions were negative – slightly up that the good news is that the U.S. message. It illustrates the CDX North from the worst we have seen so far. fi nancials now account for less than American Investment Grade index, There is a glimmer of hope there, 10% of the index. While that implies which essentially depicts the cost but it is far too early to get excited. that the continued implosion of the of insurance and fear of insolvency Recent economic data certainly bank sector has less bearing on the for investment-grade debt. After a appears to be confi rming that the direction of the S&P 500, this is not a period of moderation earlier this severity of the current earnings thought that gives us great comfort. year, the crisis still has claws. recession for the S&P/TSX is going
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 35 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
to be deep and enduring. As the EXHIBIT 47. S&P 500 Index fi nancials have shown, the depth Normalized Price/Earnings Ratio of this recession brings challenges for debt-heavy companies and for 35 Feb '09 Range: 2 Std. Dev.: 9.4x - 25.2x (Mid: 17.3x) industries with high fi xed costs. 30 Feb '10 Range: 2 Std. Dev.: 9.1x - 24.4x (Mid: 16.8x) Current: 11.6x 25 Regardless, we are looking at the 20
second-deepest collapse in S&P 500 X earnings of the postwar era. Bottom- 15 up earnings estimates have fallen 10 back to $63.12 for 2009 and $79.84 5 for 2010. That is 46% below the peak Source: RBC AM 0 estimate reported by Thomson 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 last year. It is also 31% below the P/E on Trailing 12 Months Earnings Upper & Lower Limits of Normalized P/E actual trailing earnings peak of 2 Standard Deviation Limits of Normalized P/E $92.09 this cycle. Turning to the S&P/TSX, the 2009 earnings growth EXHIBIT 48. S&P 500 Recurring Earnings that analysts were anticipating All Earnings Peaks Associated with Periods of Recession has now reversed sharply, with analysts expecting a drop of 17% 120 for 2009, a full 27% below forecasts Source: RBC AM as recently as November. 110 100 …IS ALREADY DISCOUNTED 90 80 Equity analysts have been playing Earnings Level Median Months: 70 catch-up with earnings estimates Earnings Peak to Earnings Trough: 19 months (Current Period since July '07 Earnings Peak: 19 months) to adjust to the jarring declines 60 Earnings Level as % of Cycle Peak in stock indexes, and they have -6 0 6 12 18 24 30 36 42 48 54 60 Months Prior to & Following Peak in Earnings further to go. However, earnings Current Cycle 1957-1958 1960-1961 1969-1970 1973-1975 revisions are essentially a lagging 1980 1981-1982 1990-1991 2001 indicator, and are not a particularly useful in deciding whether to sell equities once you are already deep its normalized value. For those into a bear market. We think it is in an environment of collapsing comfortable with statistics, that’s +/- far more useful to understand the confi dence. Exhibit 47 plots the 1 standard deviation. The midpoint extent of the earnings collapse current p/e multiple for the S&P of the band is now 17.3x earnings. that the 50%-plus plunge in equity 500 based on trailing 12-month If investors were confi dent enough indices is already discounting. reported earnings (boldface line on to capitalize profi ts at their average Making that judgment requires a chart) against its equilibrium range. long-term level (as established view on the appropriate p/e ratio. The band’s midpoint represents the by our normalized estimate), market’s average p/e ratio through the S&P 500 would essentially be Our fair-value models for the indices the past half-century, after adjusting discounting an earnings drop of (exhibits 38 through 42) were to refl ect prevailing levels of 56% from their July 2007 peak. calculated based on normalized infl ation, interest rates and returns valuations, which always make on equity. The bands capture the a lot of sense to us as a basis for normal distance that the multiple valuing stocks, but especially so tends to wander above and below
36 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
IS THAT OUR WORST EXHIBIT 49. S&P 500 CASE OUTCOME? Normalized and Recurring Earnings
In the current environment of 100 intense fear, though, the bottom 68 of the normalized p/e band may 46 represent a better estimate for 31 the appropriate multiple. Using 21 a multiple of 13.4x, equities are EPS 14 already discounting a 43% drop 10 7 from peak earnings. It could, 4 of course, get worse. There is Source: RBC AM, RBC CM 3 a signifi cant chance earnings 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 could fall as much as 50%. If we Normalized Earnings Predicted by Model Actual Recurring Earnings traded at 13.4x earnings down Geometric Trendline Earnings (6.7%) 50%, that would imply we could see the S&P 500 trough at 617. of 13.5%. High levels of infl ation in have compounded at a 6.7% rate over It is possible to paint scenarios 1974 and 1980 limited the nominal multiple decades. That is the natural where we could see even dollar decline in earnings through growth rate of the earnings stream further downside. If we go two those recessions and probably still you are buying when you purchase standard deviations below mean added some buoyancy through a well diversifi ed equity portfolio. p/e valuations, you could only the deep recession of 1981-1982, accommodate a 15% decline in so those periods aren’t much use We have seen periodic variance profi ts. The current cycle is all in scaling the current threat. The in both directions in the 1970s, about what statisticians refer recession following the Tech Wreck 1980s and 1990s. The 1990s Tech to as “tail risk” – the threat that was about average in duration, but Boom is the most memorable the least likely outcomes unfold. the S&P earnings pool dropped recent experience. During that That last point is not particularly 36% below its peak in the worst period earnings were compounding reassuring, and while anything decline of the postwar era. Using at a rate that went far beyond is possible in an environment the normalized multiple as the long-term normal profi t growth. where confi dence has been swept appropriate valuation statistic, In that case, as with every into a vacuum, it is important the decline in stocks refl ects a other example, we have seen a to remember that the market is view that the drop in earnings relatively rapid correction and a forward-looking machine. will be at least as large this time. restoration of trend growth.
More importantly, we consider the WHAT IS THE UPSIDE Consequently, we believe that best starting point in analysis to OPPORTUNITY FROM 6.7% is a good estimate of S&P be knowledge of the past. Exhibit profi t growth through a full cycle, 48 details the downside of S&P HANGING ON? regardless of the swings that occur 500 earnings cycles through the in between. Extrapolating the past half-century. Different from We think that normalized earnings natural course of the market using Canada where cyclical components are especially useful for estimating that analysis, the current number of the pool distort the profi t cycle, the potential recovery path of the is $80 for 2009 (the intercept for S&P 500 earnings show an average market when reported earnings 6.7% CAGR in 2009). If you apply a peak-trough decline of only 13.8% are expected to move far above or conservative 13-14x p/e multiple on through the eight recessions over below trend. Exhibit 49 illustrates that trend-earnings expectation, the period, and a median decline that trend-level earnings for the S&P it would imply an underlying S&P
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 37 GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
target of nearly 1100. Even applying EXHIBIT 50. S&P 500 Equilibrium a 10x p/e multiple, which is two Technical Support Levels standard deviations below the norm (which should be seen about 2% 2512 of the time), would result in a 800 1053 S&P Projections (Avg. Growth at 6.85%) 2009: 611 target for the S&P. Keep in mind 441 2010: 653 that we based those S&P targets on 185 2015: 910 the 2009 intercept. Looking toward 77 2020: 1267 2010, the intercept crosses through 32 $91. We conclude that we should be 14 looking at double-digit returns for equities for a number of years as 6 2 the economy heals and appropriate Source: Bloomberg, RBC AM risk premiums are restored. Even 1 though economic problems may 1926 1936 1946 1956 1966 1976 1986 1996 2006 persist, stocks rebounded strongly from similar levels of valuation EXHIBIT 51. S&P 500 without resolution to the economic Percentage of Issues with Rising Long-Term Price Momentum woes in the 1930s, 1970s and 1980s. At a minimum, we certainly expect 249 MONTHS S&P 500 TPL (Q1+Q2) MAY88 - FEB09 30.00 0.00 that equities will be substantially -30.00 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 higher a year from now. S&P 500 TPL (Q1+Q2)
80.00 TECHNICAL INDICATORS 60.00
ALSO SUGGEST WE ARE 40.00
NEAR THE BOTTOM 20.00
S&P 500 TPL (Q1+Q2) Rel. S&P 500 0.30 0.20 Exhibit 50 illustrates the trend 0.10 30000 line linking the trough for extreme 20000 10000 bear markets of the past century. 0 Source: RBC CM
The slope of that trend line rises at 6.9% per year – very close to the 6.7% lessons from the past suggest that 10% of S&P 500 stocks (Exhibit 51) long-term normal quarterly rate for you do not want to let the current have positive price momentum. earnings. Using the trend line of past momentum be your guide. Market bottoms tend to form with support levels to project a technical this statistic below 20%, a level support level for the current bear The internals of this market remain fi rst achieved way back in the fall market indicates a downside trough weak. Yet, a variety of technical of 2007. There is also a tremendous level for the S&P 500 would occur indicators have moved to levels amount of cash on the sidelines and in the 600 range. That suggests that consistent with a reversal in the it continues to mount by the day. It you could see another 100-point trend, or at least indicating the is only a matter of time before part decline in the S&P 500 from current likelihood of a sustainable rally. of this money will become impatient levels, but we would not expect Momentum readings suggest the with the guarantee of little more that to hold for long. Admittedly, it S&P 500 is as oversold as it has than zero percent real returns, at is hard to know where the market ever been. The only comparable best, and push back into risky asset could stop falling giving the deep experiences in the annals of history classes. The resurgence of corporate evaporation in confi dence, but the are 1974 and 1932. In fact, less than bonds is a recent case in point.
38 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • ANDREW MITCHELL, CFA
Importantly, other key markets allowing our equity exposure in We recognize that the nature of have not followed equities to new balanced portfolios to drift as much events over the past 18 months and lows. Corporate bonds have rallied, as 5% below the targeted amounts the challenges that still lie ahead foreign exchange is more stable, before re-committing funds. for policymakers and investors and interbank lending is well off suggest a bunker mentality in equity the panic extremes we visited last ASSET MIX markets is logical. Nevertheless, we fall. This is also the deepest decline RECOMMENDATION believe that a fi x for the fi nancial the S&P has experienced in any system will ultimately emerge. six-month period over the past 100 The past quarter saw more body Some important pieces have already years by a signifi cant margin. In blows to the fi nancial system and fallen into place. Our models, fact, we are in the midst of a fi fth deep, persistent deterioration which help us compare current sell-off wave – usually the last wave in the economy. The complexity valuations to those of all periods down in a bear market. Sentiment of putting banks on a fi rmer through the past half-century, indicators, too, indicate few bulls foundation, and recognition that indicate little confi dence, perhaps are still standing. The contrarian without a stable fi nancial system the least confi dence, of the period. signals are not as strong as we saw the economy can’t begin the process Ultimately, investors will turn their last fall, but they are not far off. of repair, has pushed expectations attention away from the fear and for recovery to late 2009 or early confusion that has gripped markets Rather than ignoring these and in 2010. The gloom is pervasive. and toward the opportunities that other studies that have offered exist. Stocks will eventually recover useful and unemotional signals The deepening recession has and returns will be above-average of tops and bottoms in the past, lowered expected infl ation and for a lengthy period as normal we still need to see the trend must moved the threat of its re-emergence valuations are restored. The scale reverse before we can rely on their beyond the forecast horizon, of the decline in equity markets effi cacy. Specifi cally, we still want providing scope for low yields since last summer, the resulting to see strong, broad stock-market over the months ahead. At the deeply depressed valuations and rallies that are closely followed by same time, fears have emerged our belief that initiatives designed more of the same. A good measure that backstopping the fi nancial to right the fi nancial system of this are rallies where over 90% system will require massive and force-feed growth will work of individual stocks and volumes and frequent new issuance of encourages us to maintain our are to the upside in a single day, government bonds, forcing yields overweight position in equity followed by one or two more of these higher since last fall. As a result, markets. For a balanced investor, within a 10-day span. Common the near-term risk in fi xed-income we recommend a 60% weight to bear markets, there have been markets is somewhat less than it in stocks, 5% above the neutral plenty of explosive rallies (17 of the has been. In our recommended position (past range: 36% - 65%) best 20 rally days have occurred asset mix, we have modifi ed our within bear markets, and seven of signifi cant underweight position these are from the current cycle). in bonds, moving exposure from 32.5% to 35% for a balanced Respecting that, we have learned investor, against a neutral position to avoid rebalancing too quickly, of 40% (past range 25% - 54%).
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 39 ROBIN GULLASON, CFA V.P., Fixed Income Portfolio Advisory Group – GLOBAL FIXED INCOME MARKETS RBC Dominion Securities Inc.
Global bond markets have made EXHIBIT 1. United States a hasty retreat from the extreme 12-Month Yield Forecasts valuations seen at year end. As the global recession takes its toll, 27-FEB-09 BASE WORST BEST administered interest rates have room to come down in countries 3mo 0.26% 0.25% 2.00% 0.00% not already sitting at or near zero. While supply headwinds could 2yr 0.98% 1.00% 3.00% 0.25% pressure some markets, a demand for safety and low infl ation should 5yr 1.99% 2.00% 3.75% 0.75% keep longer-term yields in check. 10yr 3.02% 3.00% 4.50% 1.50% UNITED STATES 30yr 3.71% 3.80% 5.00% 2.50% Last year came to a spectacular end Source: RBC AM for government bond investors, who rushed to stuff their portfolios with EXHIBIT 2. United States the most secure of assets. The safe- Yield Curves: Current and 12-Month Forecast Levels haven bid that began in Treasury bills shifted further out the curve, 6.0% as expectations that the Fed would Source: RBC AM, Consensus Economics embark on quantitative easing 5.0% spread through the market. Longer- term bond yields plummeted to 4.0% levels not seen in generations. Risk 3.0% aversion and the fear of looming defl ation became the dominant 2.0% 27-Feb-09 Consensus issues for bond investors. Base 1.0% Worst We expect the fed funds rate to Best 0.0% remain in the 0%-0.25% range 3m 2y 5y 10y 30y currently pegged by the Federal Reserve, a 25-basis-point reduction from last quarter’s outlook. The fl at January’s sharp sell-off in 10-year term. Foreigners, driven by risk outlook for rates stems from the bonds raised yields to 3%, which aversion and lack of alternatives, weak economy and the fact that is our new 12-month forecast. continue to buy longer-dated the Fed “continues to anticipate This is 100 basis points lower Treasuries. Domestic investors that economic conditions are than last quarter. Our reduced should contribute to the demand likely to warrant exceptionally forecast is driven by persistently as U.S. savings rates increase and low levels of the federal funds weak economic data, a lack of investors who are getting almost no rate for some time.” Barring an infl ation and the possibility that income on their short-term holdings extraordinary recovery in economic the safe-haven bid continues to gravitate to longer maturities. Last, growth or substantial upsurge hold yields artifi cially low. While but not least, the Federal Reserve in infl ation, extremely low short- the stimulus-driven supply of U.S. has indicated that it is prepared to term rates look to be with us for Treasuries is large, it seems that we buy longer-term Treasury debt if some time (exhibits 1 & 2). need not worry about the market’s required, and this implied support ability to absorb it in the near should put a ceiling on yields.
40 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL FIXED INCOME MARKETS • ROBIN GULLASON, CFA
Risks to our yield forecasts are EXHIBIT 3. Europe mostly to the downside, as a lack 12-Month Yield Forecasts of economic recovery and outright 27-FEB-09 BASE WORST BEST defl ation could push 10-year yields even lower. On the other hand, our forecast could prove 3mo 0.91% 1.00% 3.00% 0.50% to be too optimistic if the Fed backs off quantitative easing and 2yr 1.32% 1.50% 3.10% 0.50% outright Treasury purchases. 5yr 2.27% 2.50% 3.50% 1.50% EUROZONE 10yr 3.12% 3.25% 4.00% 2.00% The effect of the fi nancial crisis on the European economy has 30yr 3.81% 3.80% 4.25% 3.00% deepened, as European banks suffer from high leverage and exposure Source: RBC AM to Eastern Europe, and sovereign EXHIBIT 4. Europe downgrades erode confi dence. The Yield Curves: Current and 12-Month Forecast Levels ECB cut rates 50 basis points in January but held tight in February, 4.5% though it did acknowledge 4.0% Source: RBC AM, Consensus Economics expectations of future rate cuts. 3.5% After an ill-timed rate hike in 2008 it is apparent that the ECB must still 3.0% cut rates more. With European GDP 2.5% expected to contract at the same 2.0% 27-Feb-09 rate as in the U.S., the gap between 1.5% Consensus U.S. and Eurozone benchmark rates 1.0% Base Worst should narrow in the year ahead. 0.5% Best 0.0% We expect the ECB to reduce rates 3m 2y 5y 10y 30y by 100 basis points to 1.0%, half our previous forecast, but still the highest in the regions covered. given that governments in the JAPAN Economic conditions call for lower region probably won’t need to base rates, and infl ation is unlikely issue bonds at the same levels The Japanese economy has fallen to be a problem. This should give as in the U.S. (exhibits 3 & 4). into a serious recession, with fourth- the ECB some breathing room from quarter growth collapsing at a their infl ation-driven mandate of Risks to our forecast continue 12.7% annual rate, while industrial keeping infl ation just below 2.0%. to be on the downside for both production has fallen to 1987 levels. Eurozone 10-year bond yields should short- and longer-term yields. Japan’s export-driven economy be largely unchanged at 3.25% and Signifi cant weakness in growth has been deeply wounded by the trade at a small premium to the and infl ation in the next year fi nancial crisis. A steep decline in U.S. Should global bond yields rise could lead to lower-than-expected demand for the country’s exports higher than expected due to an short-term rates set by the ECB, has been driven in part by a strong oversupply of U.S. Treasuries, we and longer-term rates would also yen, which has appreciated 40% would expect Europe to outperform likely follow lower in this scenario. on a trade-weighted basis since the crisis began. Japan’s economic
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 41 GLOBAL FIXED INCOME MARKETS • ROBIN GULLASON, CFA
minister has described the EXHIBIT 5. Japan situation as the “worst economic 12-Month Yield Forecasts crisis in the post-war era.” 27-FEB-09 BASE WORST BEST With rate hikes all but out of the question, we see Japanese short 3mo 0.28% 0.10% 0.50% 0.00% rates steady at 0.1%. The BOJ continues to use other monetary 2yr 0.41% 0.40% 1.00% 0.10% tools, including the payment of interest on excess reserves (0.10%, 5yr 0.71% 0.75% 1.50% 0.30% same rate as the overnight call rate). They have also decided to increase 10yr 1.28% 1.30% 2.00% 0.60% outright purchases of JGBs to 1.4 trillion yen (about US$14 billion) a 30yr 1.96% 2.00% 2.50% 1.00% month from 1.2 trillion, expanded the range of JGBs accepted in these Source: RBC AM purchases, and agreed to buy as EXHIBIT 6. Japan much as 1 trillion yen of equities Yield Curves: Current and 12-Month Forecast Levels held by Japanese banks to stabilize the Financials sector. As with other 3.0% regions, we see lower bond yields Source: RBC AM, Consensus Economics than previously expected. We now 2.5% forecast the Japanese 10-year bond yield at 1.30% (down from 2.0% 1.75% previously) in 12 months, 1.5% the lower end of the 1.2%-2.0% 27-Feb-09 trading range that JGBs have been 1.0% Consensus in for the last fi ve years, and a test Base of 1.20% is likely (exhibits 5 & 6). 0.5% Worst Best 0.0% The risk to Japanese rates is to the 3m 2y 5y 10y 30y downside. Infl ation is unlikely to be an issue and the economy will have diffi culty bottoming without EXHIBIT 7. Canada a fi llip from either a weaker yen or 12-Month Yield Forecasts a rebound in global growth. The 27-FEB-09 BASE WORST BEST Bank of Japan could be tempted to take short rates back to zero, and 3mo 0.61% 0.50% 2.00% 0.00% a return to defl ation would likely take longer-term yields lower still. 2yr 1.15% 1.25% 2.50% 0.75% CANADA 5yr 2.05% 2.25% 3.25% 1.25% The past quarter has seen sustained weak economic data from Canada, 10yr 3.12% 3.25% 4.25% 2.25% further proof that it is not immune to the problems facing its largest 30yr 3.70% 4.00% 4.80% 3.00% trading partner. The recent jump in Source: RBC AM
42 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL FIXED INCOME MARKETS • ROBIN GULLASON, CFA
unemployment and poor holiday EXHIBIT 8. Canada retail sales confi rms that the Yield Curves: Current and 12-Month Forecast Levels Canadian economy is suffering along with the rest of the world without the 6.0% support of high commodity prices. Source: RBC AM, Consensus Economics 5.0% As such, our economic forecast refl ects a deeper recession, and we 4.0% see correspondingly lower rates. 3.0% Our forecast for the Canadian 27-Feb-09 2.0% overnight rate is 0.5%, down 100 basis Consensus Base points from last quarter’s forecast 1.0% Worst and 50 basis points below the current Best setting. Soft growth should counter 0.0% the effects of a weaker loonie, keeping 3m 2y 5y 10y 30y infl ation well under control and even temporarily pushing it below the EXHIBIT 9. United Kingdom lower limit of the Bank of Canada’s 12-Month Yield Forecasts 1%-3% target. The Bank of Canada has indicated that headline infl ation 27-FEB-09 BASE WORST BEST will likely drop below zero for two quarters this year (exhibits 7 & 8). 3mo 0.63% 0.75% 2.50% 0.00%
Our Canadian 10-year bond forecast 2yr 1.46% 1.50% 2.75% 0.75% refl ects a more sanguine view for U.S. Treasuries, and we see the 5yr 2.62% 2.75% 3.50% 1.50% 10-year Canada yield at 3.25% one year out, a small premium to 10yr 3.62% 3.75% 4.75% 2.50% the U.S. While Canada’s issuance calendar is much lighter than 30yr 4.35% 4.50% 5.00% 3.25% that of the U.S. on a relative basis, smaller infl ationary pressures Source: RBC AM and the possibility of Fed support should keep U.S. rates among the EXHIBIT 10. United Kingdom lowest in the developed world. Yield Curves: Current and 12-Month Forecast Levels
The main risk to our forecast is to 6.0% Source: RBC AM, Consensus Economics the downside on benchmark rates 5.0% and bonds. Should the economy contract more than expected or 4.0% defl ation persist, the Bank of Canada may deem it necessary to push rates 3.0% closer to zero. A retest of the recent 27-Feb-09 2.0% Consensus lows in the U.S. bond market would Base 1.0% Worst drag Canada yields lower as well, Best though we would expect Canadian yields to fall less in this scenario. 0.0% 3m 2y 5y 10y 30y
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 43 GLOBAL FIXED INCOME MARKETS • ROBIN GULLASON, CFA
UNITED KINGDOM England will be unlikely to resist if EXHIBIT 11. Expected Return infl ation undershoots expectations 12 Months The decline of the U.K. economy and all central banks push policy LOCAL U.S. is similar to the U.S. in that rates toward zero. Another round CURRENCY HEDGED housing and the Financials sector of a global fl ight to safety would U.S. played large roles. However, U.K. counter the upward pressure 3MO 0.3% 0.3% policymakers have an additional from gilt issuance and result in 2YR 1.2% 1.2% factor to consider – the weakness yields retesting cycle lows. 5YR 3.0% 3.0% of the pound. The currency’s steep 10YR 4.8% 4.8% fall against the dollar and the euro RETURNS AND 30YR 3.7% 3.7% ALL 2.8% 2.8% has implications for U.K. infl ation RECOMMENDATIONS and longer-term bond yields, EUROPE which we expect to be the highest Our expected country returns are 3MO 1.0% 0.7% 2YR 1.3% 1.0% in the fi ve regions we cover. listed in Exhibit 11. Returns for most 5YR 2.6% 2.3% major government bond markets 10YR 3.7% 3.4% Our forecast for the BOE’s base rate are forecast to be near the coupon 30YR 5.3% 5.0% is 0.75%, 100 basis points lower than rate. Though forecast returns ALL 3.2% 2.9% last quarter’s forecast and 25 basis are lackluster, we favour neutral JAPAN points below the current setting. duration given the uncertainty 3MO 0.2% 1.2% While U.K. infl ation is on the that currently dominates markets 2YR 0.6% 1.5% decline, it is set to trough at a higher and the perceived support for 5YR 0.9% 1.9% level than other nations due to the government bonds from quantitative 10YR 2.0% 3.0% steep sell-off in the pound, which easing. Though there is risk of 30YR 3.4% 4.4% will raise import prices and limit the a sharp unwind of the fl ight-to- ALL 1.5% 2.5% downside to rates. This phenomenon safety trade, the possibility of Fed CANADA should also help growth as exports participation in the U.S. Treasury 3MO 0.6% 0.3% become more competitive. Yield market makes us reluctant to be 2YR 1.4% 1.1% premiums on 10-year gilts relative short duration as such a move 5YR 2.5% 2.2% to 10-year Eurozone debt will settle could place a cap on yields. 10YR 3.8% 3.5% at 50 basis points, based on our 30YR -0.1% -0.4% gilt forecast of 3.75% in 12 months. Our forecasts indicate that few ALL 1.7% 1.4% Like the U.S., gilt issuance will be relative-value opportunities exist U.K. heavy in the year ahead, providing between different regions and they 3MO 0.7% 0.2% a headwind to relative performance are predicated on government 2YR 1.8% 1.3% with the Eurozone (exhibits 9 & 10). intervention in the bond market. As 5YR 3.8% 3.3% such, we prefer to be neutral in our 10YR 4.5% 4.0% We see downside risk across the regional allocation. A summary of 30YR 4.0% 3.5% U.K. yield curve as the Bank of our analysis is posted in Exhibit 12. ALL 3.7% 3.2% Source: RBC AM
44 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE GLOBAL FIXED INCOME MARKETS • ROBIN GULLASON, CFA
EXHIBIT 12. Scenario Analysis – 12 Months Barbell vs. Bullet (Duration Weighted) 2/10-Year vs. 5-Year EXPECTED BASE WORST BEST LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED U.S. 2yr – 10yr 2.57% 2.57% 2.17% 2.17% -8.67% -8.67% 16.99% 16.99% 5yr 4.81% 4.81% 4.73% 4.73% -6.82% -6.82% 17.10% 17.10% EUROPE 2yr – 10yr 3.29% 3.00% 2.94% 2.65% -1.79% -2.06% 11.21% 10.90% 5yr 3.68% 3.39% 3.29% 3.00% -2.69% -2.96% 13.14% 12.83% JAPAN 2yr – 10yr 1.85% 2.84% 1.21% 2.19% -3.90% -2.96% 12.75% 13.85% 5yr 2.03% 3.02% 2.05% 3.04% -3.83% -2.89% 7.77% 8.82% CANADA 2yr – 10yr 2.45% 2.13% 2.47% 2.15% -1.64% -1.94% 6.40% 6.07% 5yr 2.50% 2.18% 2.58% 2.26% -1.49% -1.79% 5.84% 5.52% U.K. 2yr – 10yr 3.04% 2.52% 2.94% 2.42% -1.11% -1.61% 8.03% 7.49% 5yr 3.79% 3.27% 3.71% 3.19% 0.27% -0.23% 7.95% 7.40%
2/30-Year vs. 10-Year EXPECTED BASE WORST BEST LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED U.S. 2yr – 30yr -7.30% -7.30% -7.77% -7.77% -13.32% -13.32% 2.45% 2.45% 10yr -3.73% -3.73% -4.07% -4.07% -11.00% -11.00% 6.31% 6.31% EUROPE 2yr – 30yr -1.88% -3.58% -1.92% -3.62% -7.17% -8.78% 3.75% 1.95% 10yr 1.70% -0.07% 2.16% 0.39% -6.80% -8.41% 6.45% 4.60% JAPAN 2yr – 30yr -0.05% 1.82% -0.35% 1.51% -1.67% 0.17% 4.01% 5.95% 10yr -0.34% 1.52% -0.69% 1.17% -2.73% -0.91% 4.82% 6.79% CANADA 2yr – 30yr 0.68% 0.36% 0.41% 0.10% -6.21% -6.50% 9.71% 9.37% 10yr 3.77% 3.45% 3.70% 3.38% -3.80% -4.10% 11.91% 11.56% U.K. 2yr – 30yr 2.68% 2.17% 2.10% 1.59% -2.03% -2.52% 12.05% 11.48% 10yr 4.51% 3.98% 4.19% 3.66% -2.80% -3.29% 14.33% 13.75% Source: RBC AM
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46 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE DAGMARA FIJALKOWSKI, MBA, CFA CURRENCY MARKETS V.P. & Senior Portfolio Manager – RBC Asset Management Inc.
After three months of consolidation, EXHIBIT 1. Average Daily EUR Range the dollar is hanging on to the Before and After Lehman Collapse extraordinary gains made since last fall. Moreover, it remains 4.0% one of three winning currencies since the crisis began, behind the 3.0% yen and Swiss franc. Not many investors would have forecast such an outcome for the dollar 2.0% considering that the U.S. has been at the epicenter of the fi nancial 1.0% crisis, and we note that the market is not entirely comfortable with Source: Bloomberg the dollar’s strength. Opinions 0.0% remain polarized, as illustrated Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 by much higher volatility in the euro-dollar exchange rate since EXHIBIT 2. USD vs. Purchasing Power Parity the Lehman Brothers bankruptcy (Exhibit 1). Despite appreciating 20% in six months, the dollar is still 160 undervalued based on purchasing 150 power parity (Exhibit 2), while the 140 euro is the most overvalued major 130 currency (Exhibit 3). However, the 120 extent of the valuation mismatch 110 is not extreme for any of the 100 major currencies against the 90 dollar, and Exhibit 4 shows that 80 the G10 currencies collectively Source: Deutsche Bank, Bloomberg 70 trade unusually close to fair 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 value – unlike stocks, government PPP Average DXY 20% bands bonds and credit spreads.
MONETARY AND FISCAL EXHIBIT 3. Valuations According to PPP DRIVERS % Over/Undervalued – February 27, 2009 20.0 Typically, differences in central- bank interest rates affect currency 12.0 10.5 10.0 moves. However, after multiple 2.8 1.6 reductions by every major central bank, short-term rates 0.0 -0.2 are clustered between 0% and -2.6 -4.8 -4.8 -5.5 2%, and considering that markets -10.0 have already priced in further cuts, interest rates are generally -20.0 -28.4 neutral in their effect (Exhibit 5). Source: Deutsche Bank The same holds for bonds, as yield -30.0 differences on 10-year bunds, EUR CHF JPY NOK CAD AUD GBP USD NZD SEK
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 47 CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
Treasuries and Canadian bonds are EXHIBIT 4. G10 Currencies Absolute Deviation From PPP negligible. While all countries are throwing money at the crisis, not all of them can afford to do so to 40% the same extent. The U.S., the U.K. 35% and Canada were in the best fi scal 30% condition among major economies 25% in December 2007 (Exhibit 6), based on debt-to-GDP ratios, and it is those 20% countries that are now spending the 15% most (Exhibit 7). The ones that were 10% already heavily indebted – Japan 5% and most of Europe – have been Source: RBC CM spending less. Our general view is 0% that currencies will perform better 1973 1978 1983 1988 1993 1998 2003 2008 in countries where governments are in the best fi scal position to take up EXHIBIT 5. 1-Month Yields the economic slack. In the longer term, the textbook outcome of a combination of easy monetary and 5.0% fi scal policies is a weaker currency. Source: Bloomberg The real-life scenario seems to 4.0% mostly confi rm that relationship (as shown on Exhibit 8). Still, lags of 3.0% 12-18 months would be possible, and the outcome is less certain in cases 2.0% where all major economies engage in fi scal and monetary largesse. 1.0%
FOREIGN-EXCHANGE POLICY 0.0% CHF JPY USD GBP CAD EUR While successfully defending an unpopular currency is usually diffi cult to achieve, purposeful EXHIBIT 6. Government Debt (% of GDP) devaluation is usually quite December 31, 2007 easy. This is because the foreign- exchange reserves needed to defend 200% Source: Bloomberg a currency are always limited. On 160% the other hand, the printing presses can create a limitless supply of 120% paper currency, and that is why the market usually pays more attention 80% when authorities are talking their currency down. January was full of 40% such comments. First, Swiss central bank board member Thomas Jordan 0% commented that the Swiss National UK USA Canada Germany France Italy Japan Bank has tools other than interest Net Debt Gross Debt
48 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
rates to regulate the economy, and EXHIBIT 7. Fiscal Spending Since Beginning of Credit Crisis that currency is one of them.1 Not to be left behind, former Japanese PACKAGE SIZE % OF GDP Ministry of Finance offi cial Eisuke Sakakibara, known as “Mr. Yen,” US $787 billion 5.5% threatened intervention if the U.S. dollar falls below 85 yen. While UK $50 billion 2.5% refraining from direct comments on the euro, French Finance Minister CANADA $34 billion 2.0% Christine Lagarde commented that the U.K. should take steps JAPAN $85 billion 1.7% to strengthen the pound. The immediate response from the Bank EUROZONE $260 billion 1.5% of England was that the bank’s GERMANY $39 billion 1.3% mandate concerns infl ation, not the value of the currency. These Source: RBC AM, PH&N are just a few examples illustrating EXHIBIT 8. United States' Debt Load vs. EUR-USD Exchange Rate that, with economies more wobbly than ever, politicians see export growth through currency 30% 1.6 devaluation as an easy solution 25% 1.5 to their domestic economic woes. 20% 1.4 Robust trade is particularly critical for countries that derive a large 15% 1.3 portion of GDP from exports 10% 1.2 and have large current-account 5% 1.1 EUR spot surpluses. Japan’s exports accounted 12m chg in US debt 0% 1.0 for 18% of output last year. -5% 0.9 Source: TD Securities, Bloomberg -10% 0.8 “A STRONG DOLLAR IS 88 90 92 94 96 98 00 02 04 06 08 IN AMERICA’S NATIONAL 12m chg in Federal debt (lhs) EUR/USD (rhs) INTEREST” of the U.S. First, a strong dollar is currency or higher interest rates, Interestingly, we haven’t heard much associated with weak commodities the U.S. could attract foreign capital from the new Obama administration and vice versa. An argument can by supporting economic growth. about the dollar beyond the routine then be made that the U.S. and the Relatively strong growth conditions recitation of the above quote. With world would prefer a stronger dollar translate into relatively attractive its large current-account defi cit, for now since it comes with cheaper investment opportunities. Fourth, doesn’t the U.S. also have to cheapen commodity prices. Second, does a starting from an undervalued the dollar to attract investment and weak currency really serve the goal base, the dollar can actually afford bolster exports? Let us play Devil’s of attracting capital? Foreigners are some appreciation unlike other Advocate for a moment to consider already heavily invested in the U.S. major currencies. Finally, because whether a strong dollar might and they don’t want to see losses on currencies affect international actually be in the best interests these investments. Both Chinese trade with a lag, a stronger dollar and Japanese offi cials have recently would offset some of the feared made comments to that effect. future infl ationary pressures 1 Jan 15, 09, speech delivered in Weinfelden Third, rather than resort to weaker stemming from extraordinary fi scal
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 49 CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
and monetary stimulus thrown EXHIBIT 9. Euro & Gold: Weaker Correlation at the crisis. The global nature of this crisis means that the tried- and-true template of currency 1.70 1100 weakness may not be the right 1.60 1000 solution. So while Geithner’s "strong 900 dollar" comment didn’t sound like 1.50 anything more than a mantra, its 800 1.40 fulfi llment may actually end up 700 being the lesser evil for all involved. 1.30 600 EURO IS SUFFERING FROM A 1.20 500 Source: Bloomberg FEAR OF HEIGHTS 1.10 400 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 The euro, the natural anti-dollar, EUR/USD Spot (lhs) Gold (rhs) has been weighed down by its own set of problems. Lower commodity prices mean lower foreign-exchange which have been increasing in the growth expectations. We’ll be reserves accumulated by commodity euro’s favour this year without watching commodity prices and exporters, and a consequent lack giving any lift to the single currency. weekly U.S. leading indicators for of diversifi cation demand for the Could it be that these broken signs of a rebound before becoming euro. Economic stress in peripheral relationships refl ect doubts about more bullish on the currency. In euro countries such as Greece and euro’s status as a dollar alternative? the meantime, we could see the Ireland, highlighted by widening Canadian dollar weaken beyond spreads on national bonds and THE CANADIAN DOLLAR IS C$1.30 (77 U.S. cents), which would credit-default swaps, have put in TAKING THE BAD NEWS IN provide a good hedging opportunity question the Eurozone’s longer-term to take advantage of a recovery survival, particularly since EU law STRIDE later. Our one-year forecast is doesn’t contain a mechanism for fairly stable at US1$ - C$1.25. national “bail-outs.”2 The euro’s The Canadian dollar has been continued overvaluation based on trading between C$1.18 to C$1.30 IS THAT ALL THERE IS FOR THE PPP and real effective exchange against the U.S. dollar for over YEN? rates is also negative for the euro, three months. The worsening and additional pressure came amid global growth outlook, refl ected The Japanese economy has disclosures about the exposure of in declining commodity prices, weakened more than most analysts Western European banks to euro is weighing on the currency. The anticipated. The signifi cant and Swiss-franc mortgages taken out Bank of Canada still has room to appreciation in the yen (40% on by Eastern European homeowners. cut rates, which could translate a trade-weighted basis since the Interestingly, the tendency for the into additional weakness from crisis started) has contributed to euro and gold to rise in tandem has an interest rate perspective but a collapse in exports (down 45.7% broken down since the beginning of underpin the currency from a year-over-year in January), which the year (Exhibit 9). The same goes growth perspective. Fiscal policy is combined with lackluster domestic for real interest-rate differentials, a positive for the Canadian dollar, demand and an aging population, is as the country’s nine consecutive going to weigh on Japan’s economic budget surpluses and relatively low recovery. In the meantime, the two debt-to-GDP ratio can well afford a drivers of yen strength – the decline 2Although Article 100.2 allows aid in "exceptional circumstances," it is certainly stimulative budget. To appreciate, in global interest rates to Japanese less available than in the U.S. the “loonie” needs a turn in global levels and the U.S. economy hurtling
50 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
into recession – are substantially as some claim, but rather closer our 12-month forecast horizon. priced in. Now that the global to 8%, according to Goldman In the meantime, convictions are decline in interest rates is complete Sachs3. Finance is more important low, risk appetites even lower, and and the U.S. economy expected to to Switzerland’s economy (9% of we expect signifi cant volatility to bottom in the fi rst quarter, support GDP), which hasn’t prevented the continue in the currency markets. for the yen should start to wane. franc from being the second-best- The possibility that the Bank of performing currency in this crisis. That our forecasts appear close to Japan will intervene to weaken Third, the U.K. is in a better fi scal current spot rates is a bit deceptive the yen if the yen strengthens position to provide a meaningful for we expect signifi cant volatility. below 85 to the dollar may also spending boost than the Eurozone. Our 12-mth forecast for EUR is 1.20, lead to further dollar strength. According to credit default swaps, GBP 1.46, CAD 1.25 and JPY 105. half of the Eurozone’s members IS THE 'POUNDING' OVER? are now at greater sovereign credit risk than the U.K. Finally, the Bank It’s no wonder that Britain’s of England is clearly on the right currency has fallen off a cliff. track by lowering rates below those Signifi cant budget and trade defi cits, in the Eurozone. We assume that an economy heavily exposed to the pound will fl uctuate versus fi nancials, and consumers who are the dollar in line with the euro, among the world’s most indebted although it should outperform created the ideal conditions for the euro in the longer term. currency depreciation. A few things are worth remembering, CONCLUSION however. First, the massive depreciation works to the benefi t Last quarter, the U.S. dollar of U.K. exporters and encourages consolidated its gains trading in investors to buy U.K. assets. The a broad range, despite continued Eurozone is the U.K.’s primary weakness in housing, increasing trading partner, so the pound’s 30% unemployment, growing losses collapse against the euro is even by fi nancial institutions and more relevant than the weakness escalating costs of the “solution’’ to against the dollar. The pound’s the fi nancial crisis. Poor data from decline below the PPP "line in the other countries and their need for sand" level of 20% versus the euro weaker currencies due to a higher at the end of December suggests dependence on external trade mean that the pound will strengthen in that, at least for now, the world the not-too-distant future. Second, would probably be better off with a while the fi nancial industry is very stronger dollar. Dollar strength may important to the U.K. economy, it persist for the time being, pushing does not amount to a third of GDP any signifi cant depreciation beyond
3UK Economic Analyst, Economics Research from Goldman 360, Issue No: 08/11
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 51 CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
THE CURRENCY OUTLOOK: KEY FACTORS EURO >> SUPPORTIVE NEGATIVE • Trading above technical support level of US$1.23- • Banking sector overleveraged and overexposed to US$1.25. emerging markets. • Market belief in a dollar-debasement theme for 2009. • Untested bankruptcy procedures. • Combination of loose fi scal and monetary polices • European recession is deepening. weighing on the dollar. • Lower commodity prices weaken diversifi cation • Yield advantage as the ECB is reluctant to cut rates as demand for euro from reserve managers. aggressively as other central banks. • ECB intent on slow and measured monetary response • Market expectations of Fed hikes within 12 months will and is likely to be forced to cut more than the market is likely be pushed further out. pricing in. • Inability of the Eurozone to respond with one fi scal policy, and of nations to even respond individually. • Continuous improvement of the U.S. current-account and trade defi cits since the end of 2005. • Overvalued based on purchasing power parity. • Talk about the potential for a law that again lets U.S. companies repatriate profi ts (Homeland Investment Act II).
12-MONTH FORECAST: 1.20. YEN >> SUPPORTIVE NEGATIVE • Continued risk reduction, deleveraging. • Domestic economy in recession. • Potential of tax breaks for Japanese corporations to • Export growth collapsing as recession spreads; trade repatriate overseas retained earnings. surplus deteriorating rapidly into defi cit. • Lower oil prices. • G7 statement warns against excessive yen volatility. • Narrowing yield disadvantage versus euro, sterling • Worst gross debt/GDP of any major economy. and commodity currencies. • Threat of intervention if yen strengthens below 85 per US$1. • The yen a favourite short when risk aversion/volatility eases. • Risk of U.S. trade protectionism in 2009.
12-MONTH FORECAST: 105.
52 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA
CANADIAN DOLLAR >> SUPPORTIVE NEGATIVE • Aggressive fi scal and monetary responses to the • Budget defi cit in 2009 to end a string of surpluses. crisis. • Vulnerable to further weakness in energy prices and • Oil prices close to the lower end of the range. deepening global recession (risk of new oil sands • Housing market and fi nancial sector in better shape projects being halted if oil remains below US$70). than their U.S. counterparts (deposits, trading • Weak U.S. economy expected to weigh on Canadian volumes will gravitate towards stable counterparties). exports. • Entered recession with low unemployment and • Negative sentiment. healthy fi scal situation. • Minority government results in slow/less effective • Technical resistance at C$1.30 (77 U.S. cents). policy creation/adoption. • Risk of U.S. trade protectionism in 2009.
12-MONTH FORECAST: 1.25. POUND STERLING >> SUPPORTIVE NEGATIVE • Contrarian bet as sentiment and positioning are • Bank of England in full-scale easing mode. extremely negative. • Worries about recession, housing, health of domestic • Technically oversold; 30%-plus decline in six months. banks and private debt to GDP levels. • Increased competitiveness of exports to Europe and • Signifi cant vulnerability to global fi nancial-system revenues from tourism. stress. • Gross debt/GDP at 47.5% is lower than EU or Japan. • Budget defi cit forecast at over 5% of GDP for 2008. • Current-account defi cit narrowing (from 4.3% in June • Bank of England expected to engage in quantitative 2008 to 1.6% in September 2008). easing to boost infl ation. • PMI services improving since Nov 08 (usually a good indicator for real GDP growth).
12-MONTH FORECAST: 1.46.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 53 RAY MAWHINNEY – Senior V.P., U.S. & Global Equities RBC Asset Management Inc.
BRAD WILLOCK, CFA – V.P. & Senior Portfolio Manager REGIONAL OUTLOOK – U.S. RBC Asset Management Inc.
ECONOMIC BACKDROP UNITED STATES RECOMMENDED SECTOR WEIGHTS
Since touching their 2009 high RBC INVESTMENT BENCHMARK on January 6, U.S. equity markets STRATEGY COMMITTEE S&P 500 FEB. 2009 FEB. 2009 moved sharply lower through late ENERGY 14.5% 13.7% February as economic news and company earnings failed to meet MATERIALS 3.0% 3.2% already lowered expectations. While INDUSTRIALS 9.0% 10.2% the fourth quarter of 2008 was awful UTILITIES 5.0% 4.5% by any measure, it appears that the CONSUMER DISCRETIONARY 7.0% 8.1% fi rst quarter of 2009 may turn out CONSUMER STAPLES 14.5% 13.3% to be worse. U.S. consumers are HEALTH CARE 18.0% 16.8% spending less and trying to reduce their debt. Businesses are liquidating FINANCIALS 8.0% 9.2% inventories, reducing production, INFORMATION TECHNOLOGY 17.0% 17.1% cutting investment in new capacity TELECOMMUNICATION SERVICES 4.0% 3.9% and eliminating jobs to try and Source: RBC AM survive the downturn. Even exports, which helped to offset U.S. domestic S&P 500 EQUILIBRIUM weakness the past two years, have Normalized Earnings & Valuations begun to decline as the rest of the world joins the U.S. in the most 2512 severe global economic contraction 1585 Feb '09 Range: 979 - 1580 (Mid: 1280) Feb '10 Range: 992 - 1602 (Mid: 1297) since the Great Depression. 1000 Current (27-Feb-09): 735 631 While it is clear that the situation is 398 dire, policymakers are taking action 251 to help the economy. Investors 158 must keep in mind, however, that 100 it will take time for the stimulus 63 package, housing plan and bank Source: Bloomberg, RBC AM 40 rescue to begin turning the tide. 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 The hole in the U.S. economy left by the collapse in consumer and business spending is too big for the the decline in house prices appears attractive and the magnitude of the government to fi ll in the near term, to be nearing an end. Still, it is market’s decline suggests a great deal making a recovery more likely in important to recognize that the seeds of negative news is already priced in. late 2009 or the fi rst half of 2010. of recovery are being sown. Fiscal and monetary responses to the crisis SECTOR ANALYSIS Given the poor and still deteriorating have been sizable and should lead to global economic backdrop, it is not an improvement in economic activity The ENERGY sector has modestly surprising that corporate earnings over time. In addition, commodity underperformed the broader market remain under tremendous pressure, prices are down substantially, over the past three months. Demand and that stock markets have fallen inventories have been well managed, for energy has been lower than to the lowest levels in more than a and outside of the Energy, Industrials expected, and while companies are decade. We, therefore, continue to and Materials sectors, capital cutting capital spending to reduce maintain a defensive position until spending has been prudent. Stock supply, the impact is not likely to the Financials sector stabilizes and valuations appear historically be felt for several quarters. While
54 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE REGIONAL OUTLOOK – U.S. • RAY MAWHINNEY • BRAD WILLOCK, CFA
demand will likely remain soft over the The INDUSTRIALS sector has over the past quarter. It appears near term, we may see a rebound in experienced a signifi cant decline that pragmatic management teams prices later this year as the economy because investors consider the have positioned their companies stabilizes and supply growth begins group susceptible to the economic well for the downturn. They have to wane. Consequently we remain downturn. Aerospace, agriculture and maintained relatively high levels of overweight the group and remain machinery have been hit particularly cash, and relatively low debt and ready to add to our Energy holdings hard. Even transportation, which inventories, while not overspending as demand begins to stabilize. had been a leader in the autumn, on new capacity as they did before has come under pressure despite the technology bubble burst in The CONSUMER STAPLES sector collapsing energy prices. We 2000. While valuations remain remains fairly valued, though some maintain an underweight for the attractive for the sector, we are companies are benefi ting from sector as a whole and believe that concerned the time horizon for the the drop in commodity prices. transportation will be one of the recovery may be longer than many We continue to like certain food fi rst areas of the market to rebound. investors anticipate. For now, we stocks that have a global footprint keep our market weight position. and expansion opportunities. The continued pressure on U.S. As a result, we are retaining an FINANCIALS is one of the biggest The TELECOMMUNICATION overweight position in the group, concerns facing investors. It is clear SERVICES sector continues to which has proven a safe haven that confi dence in the system is of undergo considerable turmoil, during rough market periods. the utmost importance, and that as weaker low-cost competitors However, we expect to move cash restoring that confi dence will be and cable companies threaten out of the sector as the market a monumental task. It is also clear industry profi tability by using anticipates an economic recovery. that banks will require signifi cantly low prices to gain market share. more capital to remain solvent. The However, valuations are near We think the recent outperformance of government has proposed a bank historic lows and dividend the CONSUMER DISCRETIONARY sector rescue, but details remain sketchy. yields are attractive and appear was premature. While lower energy We believe that it is prudent to sustainable. As such, we maintain prices have helped to cushion some lower our view to underweight from a market weighting in the sector. of the decline in consumer spending, neutral until this sector stabilizes. falling stock markets, sliding house We remain relatively optimistic prices and dimming employment Surprisingly, the MATERIALS sector on the UTILITIES sector, as both prospects will keep consumer has outperformed the market the traditional regulated utilities spending under pressure. We maintain recently as surging steel, gold and merchant-power utilities have our underweight position, as we and packaging companies have defensive characteristics and safe- expect the consumer to save more and overshadowed continued weakness haven appeal. Over the intermediate spend less for an extended period. from the forestry and chemicals term we still like the merchant-power industries. We expect numerous producers and companies that The HEALTH CARE sector has false-start rallies in the group, as have both a regulated and a market outperformed recently as the investors try to anticipate the component (integrated producers) Obama Administration focuses recovery of the North American and because we think power will be a on dealing with the fi nancial and global economies, and intend to play scarce resource as the economy economic crisis, putting health-care this volatility on a tactical basis. Our recovers. The long-standing themes reform on the back burner. Large stance remains slightly underweight. remain: the replacement of an aging pharmaceutical companies continue power infrastructure, a signifi cant to do well, while biotechnology and Despite weak demand, the need for more power-generation medical-technology companies INFORMATION TECHNOLOGY sector capacity and an increasing focus remain outperformers. We maintain has outperformed signifi cantly on clean, renewable energy. an overweight stance on the group.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 55 STUART KEDWELL, CFA – Senior V.P. & Senior Portfolio Manager REGIONAL OUTLOOK – CANADA RBC Asset Management Inc.
ECONOMIC BACKDROP CANADA RECOMMENDED SECTOR WEIGHTS
Peak-to-trough losses for the RBC INVESTMENT BENCHMARK Canadian equity market approached STRATEGY COMMITTEE S&P/TSX COMPOSITE FEB. 2009 FEB. 2009 50% by the end of February after ENERGY 28.5% 27.4% another period of heavy selling. In the most recent three months, MATERIALS 20.5% 21.5% weakness in the Financials and INDUSTRIALS 6.0% 5.8% Energy sectors weighed on the UTILITIES 2.0% 1.9% index. Losses for the S&P/TSX CONSUMER DISCRETIONARY 5.0% 4.7% were mitigated to some degree CONSUMER STAPLES 4.5% 3.8% relative to other global markets HEALTH CARE 0.0% 0.5% by gains in gold stocks fueled by a 17% surge in the gold price during FINANCIALS 24.0% 24.2% the quarter to US$952 an ounce. INFORMATION TECHNOLOGY 4.0% 4.0% TELECOMMUNICATION SERVICES 5.5% 6.2% Expectations for the economy Source: RBC AM have declined markedly, as GDP contracts substantially faster S&P/TSX COMPOSITE EQUILIBRIUM than forecasters have been able to Normalized Earnings & Valuations keep up with. The ingredients for 15849 recovery are in place save for one – 10524 Feb '09 Range: 8369 - 12474 (Mid: 10421) confi dence. Of note, a substantial Feb '10 Range: 9450 - 14084 (Mid: 11767) 6989 stimulus package is on its way in Current (27-Feb-09): 8123 Canada and the U.S., Canadian 4642 bank-funding rates have improved 3082 signifi cantly from last fall, and the 2047 banking systems ability to provide 1359 credit is intact. On the negative 903 side, housing transactions have 600 slowed, and uncertainty over the Source: Bloomberg, RBC AM fate of the automotive industry and 398 the direction of commodity prices 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 continue to infl uence the behaviour of investors and consumers. The stock-market correction has by banks and insurers in recent pushed the Canadian equity market months have weighed on the sector. Currency markets remained below our estimate of fair value. Nevertheless, the largest constituent volatile. The Canadian dollar was We continue to believe equity of the sector, Canadian banks, no exception, moving in the $0.78 markets will provide attractive continue to weather the storm to $0.85 range, with a number of returns in the intermediate term. better than their global peers. The trading days witnessing greater than earnings power of the banks should 1% movements. While fundamentals SECTOR ANALYSIS be suffi cient to cushion what will are broadly supportive for the likely be a nasty credit cycle. Even Canadian dollar relative to its We are maintaining our neutral if new equity is required – some global peers, we continue to expect stance on the Canadian FINANCIALS of which will be raised through volatile range-bound trading. sector. Earnings headwinds and a dividend reinvestment plans, the fl urry of common-equity issuance intermediate return potential is
56 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE REGIONAL OUTLOOK – CANADA • STUART KEDWELL, CFA
attractive. Canadian insurance intermediate term, we believe valuations and high levels of companies are dependent on the marginal cost of production free cash fl ow in the sector. recovery in both credit and equity is higher than the current price markets for their earnings to regain level, while valuation levels offer an The INFORMATION TECHNOLOGY momentum, and for their current inexpensive option on higher prices. sector has been lowered to market capital bases to prove adequate. Whether it be from stabilized and weight from overweight. Sector growing demand, or diminished heavyweight Research In Motion We continue to recommend supply, the clearing price for energy has posted strong subscriber an underweight stance in the will be higher in our opinion. growth, although operating profi t MATERIALS sector, with a neutral margins have disappointed some position in basic materials and The stance towards INDUSTRIALS investors. The global smartphone chemicals, and an underweight moves to slightly overweight from market remains in its infancy, position in the gold subsector. After underweight. The slowing economy and the opportunity is robust. a strong period of performance, presents earnings challenges, Research In Motion, with its gold-stock valuations may be yet a number of well managed hardware and subscription business overextended. Gold demand Canadian bellwethers stand ready model, combines attractive and is coming increasingly from to benefi t when the turn arrives. rising levels of free cash fl ow investors, leaving the commodity with a strong balance sheet. vulnerable to a sharp reversal We retain our underweight stance should confi dence in mainstream on the TELECOMMUNICATION asset classes stabilize. SERVICES sector, refl ecting the importance for now of Our rating for the ENERGY sector slowing growth and increased remains at overweight. In the competition relative to reasonable
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 57 DOMINIC WALLINGTON – Chief Investment Offi cer REGIONAL OUTLOOK – EUROPE RBC Asset Management UK Limited
ECONOMIC BACKDROP EUROPE RECOMMENDED SECTOR WEIGHTS
The past quarter was another period RBC INVESTMENT BENCHMARK of profound economic weakness, STRATEGY COMMITTEE MSCI EUROPE FEB. 2009 FEB. 2009 as problems in the Banking sector ENERGY 14.0% 13.1% continued to feed through to the broader European economy. MATERIALS 7.2% 7.4% Since December, investors had INDUSTRIALS 9.2% 9.8% been trying to look through the UTILITIES 7.7% 7.6% problems towards an economic CONSUMER DISCRETIONARY 7.0% 8.0% recovery in the second half of this CONSUMER STAPLES 13.0% 12.2% year. European markets had rallied HEALTH CARE 13.0% 11.7% as a consequence, but the move upwards has now been exhausted FINANCIALS 17.5% 18.9% by a constant stream of bad news. INFORMATION TECHNOLOGY 3.2% 3.2% TELECOMMUNICATION SERVICES 8.2% 8.2% It is clear that the industrialized Source: RBC AM economies are in recession or heading towards it. A severe EUROZONE DATASTREAM INDEX EQUILIBRIUM contraction is now spreading across Normalized Earnings & Valuations Europe, although it is possible that 3162 the worst has already occurred. Feb '09 Range: 1511 - 2395 (Mid: 1953) 2132 Surveys suggest that global growth Feb '10 Range: 1823 - 2890 (Mid: 2357) has also fallen dramatically. In 1438 Current (27-Feb-09): 775 response, the U.K. is expected to 970 cut its benchmark interest rate 654 to 1% and the European Central 441 Bank to 1.5%. Under quantitative 297 easing, we are likely to witness U.S. 201 government stimulus equivalent to 135 4% of GDP, and similar measures Source: Datastream, Consensus Economics, RBC AM will be seen in Europe even if we cannot be sure of the scale. 1980 1985 1990 1995 2000 2005 2010 One of the problems that we are facing is that the banks have still year. Our expectation is that the The focus of our strategy remains not returned to lending and seem downturn will be longer rather towards good quality, high-return intent on building their reserves. than shorter, but we believe that businesses with strong dividend It seems likely that quantitative enough is being done to ensure that support because quantitative easing itself will not be enough, and an upturn ensues. We hope to see work demonstrates that these that central governments will have some early signs of stabilization companies tend to outperform to resort to other policies such as by the middle of this year. the broader market during a buying sovereign bonds. Interest downturn. We are interested in rates are likely to stay low for a Valuations look very attractive companies that are less affected very long time. There have been in Europe but we need to see a by the economic cycle, either more than 200 recessions in the bottoming-out of analyst earnings because of their scale and product big Western economies since 1870. forecasts before markets show diversity, or because the industries Two thirds lasted only a year and any sustained strength. that they operate within generally a further 22% ended in the second prove resilient in a downturn.
58 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE REGIONAL OUTLOOK – EUROPE • DOMINIC WALLINGTON
SECTOR ANALYSIS We remain underweight the at the top end of their valuation INDUSTRIALS sector and are skewed range. We expect power prices We have lowered our rating on the to defensive, less cyclical companies to follow the oil price down and FINANCIALS sector to underweight with stable returns and sound this will weigh on expectations. from neutral. A crisis that started balance sheets. We are underweight with the banks has mushroomed, capital-goods stocks and remain We remain overweight the CONSUMER and lasted much longer than many concerned about the outlook for STAPLES sector, although some investors expected. It is clear that the global growth. Our focus has been valuations here continue to look quite banks are not lending to each other on industrial service companies rich. The majority of our exposure is because they do not trust each other’s and arms manufacturers. within the Food Retail sector where balance sheets and because they have we see a greater level of resilience. lost faith in the mechanisms used to We also remain neutral on value their assets. While this scenario INFORMATION TECHNOLOGY. We are still neutral on the continues it remains a substantial This is a small sector in Europe TELECOMMUNICATION SERVICES impediment to the rest of the and is dominated by a handful sector. We believe that valuations economic landscape. Governments of companies. We are avoiding continue to look reasonably on both sides of the Atlantic have semiconductor makers as demand attractive and the sector’s begun to effectively nationalize falls. On a positive note, companies in relatively stable cash fl ows support troubled banks to try to unblock the sector tend to have robust balance attractive dividend yields. credit channels, and increases risk sheets and high-quality earnings. that bank-shareholder stakes will be While the sector has been hurt by diluted to nothing as governments We maintain our underweight the decline in the global economy, boost their equity interests. We are stance on the MATERIALS sector. the effect has been less than for underweight the banks, and our It is clear that companies in this many other sectors. The sector tends exposure to the sector is through sector are run with much better to underperform in the fi rst half the largest, lowest-risk companies. fi nancial discipline than they were of the year, but the degree of the 10 years ago, and we therefore dislocation elsewhere in the market Our underweight position in the believe they will show sustainably may prevent this happening in 2009. CONSUMER DISCRETIONARY sector higher profi t margins. Moreover, remains. While we believe that the sector has fallen a long way, HEALTH CARE is a sector where we household wealth will continue and looks more attractively valued. remain overweight. The sector to fall across Europe, the effect on Having said this, it is clear that the had been very unpopular with consumer-related companies may sector is a proxy for global growth, investors for a long time but has be less than expected because profi t and it appears that economies performed well for almost a year now. growth has already been below- around the world continue to Management teams are reducing trend for a while. Much of our deteriorate. The big infrastructure costs, and it’s possible that we exposure is to service companies plans announced by the U.S. and may see a few positive surprises in and media companies that tend to Chinese governments may offset pharmaceutical-company pipelines. focus on areas of the economy that most of the declines in consumer The sector remains attractively are more resilient in recessions. In spending, but are unlikely to create priced offers good dividends yields. retail, a wave of store closures may incremental levels of growth. create expansion opportunities We remain overweight the ENERGY and bolster profi ts at survivors that Our rating on the UTILITIES sector sector. While expectations of a fall in face reduced competition. We have drops to neutral from overweight the oil price have led us to reduce our no exposure to the automotive because we see much better exposure to oil-services companies, industry because we believe the potential returns in other defensive we like the Blue Chip oil companies major operators here have been sectors such as Health Care and that have attractive valuations dependent on fi nancing for growth. because Utilities appear to be and excellent dividend yields.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 59 YOJI TAKEDA – Director & V.P., Asian Equities REGIONAL OUTLOOK – ASIA RBC Investment Management (Asia) Limited
ECONOMIC BACKDROP ASIA RECOMMENDED SECTOR WEIGHTS
Asian economies have been severely RBC INVESTMENT BENCHMARK affected by the unprecedented global STRATEGY COMMITTEE MSCI PACIFIC FEB. 2009 FEB. 2009 deterioration in credit conditions and consumer spending, which ENERGY 2.6% 2.1% are worsening as the fi rst quarter MATERIALS 10.2% 10.4% progresses. While the current analyst INDUSTRIALS 14.5% 15.3% consensus is that Asia will experience UTILITIES 7.5% 7.1% a cyclical recovery in the second half CONSUMER DISCRETIONARY 13.3% 14.2% of 2009, that scenario will depend on CONSUMER STAPLES 7.6% 6.4% the ability of companies to work down inventories and obtain funding in tight HEALTH CARE 7.0% 5.9% loan markets. The Chinese economy, FINANCIALS 24.1% 25.0% with its political and fi scal muscle, INFORMATION TECHNOLOGY 9.3% 9.2% may be the fi rst one to show signs of TELECOMMUNICATION SERVICES 3.9% 4.4% bottoming, possibly in the second half. Source: RBC AM But other Asian economies arguably depend even more heavily on how JAPAN DATASTREAM INDEX EQUILIBRIUM the U.S. economy and global credit Normalized Earnings & Valuations markets hold together. Consider 1000 that Japan’s economy contracted Source: Datastream, Consensus Economics, RBC AM 12.7% in the fourth quarter, the 717 most in more than three decades, 514 and that Taiwan’s exports declined 368 by a record 44% in January. 264 189 In Japan, a sharp fall in exports 136 has ignited big cuts in industrial 97 Feb '09 Range: 291 - 698 (Mid: 494) production, plant closures and Feb '10 Range: 319 - 766 (Mid: 543) 70 layoffs. Machine-tool orders in Current (27-Feb-09): 235 50 January declined 84.4% year over 1980 1985 1990 1995 2000 2005 2010 year, refl ecting the virtual stoppage in global capital investment, and capacity utilization has fallen to the this year but may make no more than 2009 before making an attempt at lowest level on record. Even Toyota, 7 million. We expect another year of recovery in the second half on the Japan’s most profi table company falling corporate profi ts, and this could back of infrastructure spending in 2007, has said it will post its fi rst disappoint the market later in the year. by the government. In December, operating loss in seven decades, hurt The government is putting together a exports contracted by a surprisingly by lower car sales and a strong yen. stimulus package of at least 10 trillion large 2.8%, and growth in industrial Assuming that inventories improve in yen ($130 billion), but the timing and production was 5.4% – a 10-year low. the coming months, Japan’s industrial fi nal size of the program are up in Rising factory closures and job losses production could begin to rise. But the air because of political disarray will weigh on private consumption. A capacity must decline to meet the that is likely to continue at least until proposed multiyear fi scal expansion new lower level of demand, and this this summer’s general election. plan amounts to 18% of the country’s process could take three years. For 2007 GDP, compared with 1.2% example, Toyota was planning capacity In China, GDP growth is likely of GDP during the Asian fi nancial of more than 9 million cars globally to bottom out in the fi rst half of crisis. This signals the government’s
60 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE REGIONAL OUTLOOK – ASIA • YOJI TAKEDA
determination to maintain growth dependence on exports means a since the fourth quarter of 2008 near its 8% target. The government recovery will have to wait for demand has caused factory use to fall to has been pushing banks to increase to pick up in China and the U.S. historically low levels. However, any loans since late 2008, and loan growth signs that inventories are stabilizing in January was 20.4% year over SECTOR COMMENTS would be benefi cial to the sector. year. Nevertheless, macroeconomic data is expected to remain negative We are cutting our weighting in the We maintain an underweight position in the coming months, and the FINANCIALS sector to underweight on the MATERIALS sector. Although government is likely to launch from neutral. The economic backdrop prices for some commodities seem additional measures to support continues to worsen, as credit losses to have stabilized, thanks to China, the economy. China is still one of expand and net interest margins weak markets elsewhere are likely the few economies with suffi cient contract. The insurance industry to cap any upside. A new round of excess savings to comfortably is suffering from low returns on industry consolidation may help support a big fi scal stimulus. fi xed-income investments and stabilize commodity prices. losses on stock portfolios, and In Australia, the economy contracted premium revenue remains weak. We remain overweight on the 0.5% in the fourth quarter of 2008, A decrease in capital-markets CONSUMER STAPLES sector. Demand and GDP is also likely to fall in the fi rst activity is hitting brokerages and for food manufacturing and other quarter of 2009 before stabilizing in investment banks and real estate- necessities makes this one of the the second quarter, albeit modestly. related companies are subject to few areas with relatively stable Household spending will decline as falling land prices in all regions. demand and decent profi tability. unemployment climbs and the savings rate rises. Business investment will Our rating on the CONSUMER The rating for TELECOMMUNICATION contract as exports weaken and credit DISCRETIONARY sector remains SERVICES moves lower to is constrained. Against this backdrop, underweight amid weak global underweight from neutral. Growth the government announced fi scal consumer demand. Car sales are in China is slowing and will stimulus packages designed to boost losing momentum in emerging not be enough to offset mature GDP by as much as 2%, and a budget markets, following declines in the markets in Japan and Australia. surplus gives the government plenty U.S. Demand for digital cameras is of room for additional measures also weaker. Retail sales in Asia show Our weighting on the UTILITIES to boost spending. Moreover, the marked weakness as unemployment sector stays at overweight. The Reserve Bank of Australia has cut its increases. The sector could stabilize cost to produce electric power has benchmark interest rate to 3.25%, if efforts by companies to work fallen sharply in recent months, and with more cuts coming, thanks to off inventories start to succeed. dividend yields remain attractive. a fall in infl ation. Australia exports commodities to China, where demand Our weighting in the INDUSTRIALS In HEALTH CARE, the weighting remains should pick up once companies sector remains underweight. Capital at overweight. Sales at Japanese work down their inventories. investment is slowing the most since pharmaceutical and health-care- World War II amid excess capacity equipment businesses are generally Korea and Taiwan are struggling with in many industries and tighter stable, although a stronger yen is a sharp fall in exports. Factories in credit. Bulk shipping could benefi t causing overseas revenue to stagnate. the electronics industry are operating from a recovery in China. Railroads at historically low levels, particularly and trucking companies may also The weighting on the ENERGY sector ones that produce semiconductors see some volume weakness. remains overweight. Weaker crude- and LCD panels, and high credit costs oil prices are benefi ting Asian and weaker currencies are added We remain slightly overweight on refi ners and distributors, where burdens. Governments are devising the INFORMATION TECHNOLOGY efforts to cut production are starting stimulus packages, but the economies’ sector. The collapse in demand to halt the fall in gasoline prices.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 61 RBC INVESTMENT STRATEGY COMMITTEE
MEMBERS
DANIEL E. CHORNOUS, CFA CHIEF INVESTMENT OFFICER, RBC ASSET MANAGEMENT INC. AND PHILLIPS, HAGER & NORTH INVESTMENT MANAGEMENT LTD. CHAIR, RBC INVESTMENT STRATEGY COMMITTEE Dan Chornous is Chief Investment Officer of RBC Asset Management, Canada’s largest single mutual fund family, with over $81 billion in domestic and global equity and fixed income mandates, including the Royal Mutual Funds group of products. Effective May 1, 2008, Dan was also named Chief Investment Officer, Phillips, Hager & North following its merger with RBC AM, a combination that boosted total assets under management to $141 billion. Dan 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 Investments’ key client groups including RBC Funds, International Wealth Management, RBC Dominion Securities and RBC Private Counsel. Dan serves on the Board of Directors of the Canadian Coalition for Good Governance and is also chair of its Public Policy Committee.
JIM ALLWORTH PATRICIA CROFT PORTFOLIO MANAGER, CHIEF ECONOMIST, RBC ASSET MANAGEMENT INC. RBC GLOBAL ASSET MANAGEMENT Jim has been in the investment business for 38 years, as both a Patti’s experience in the investment-management industry spans research analyst and portfolio strategist. He is currently a director almost three decades. She spent 16 years on the sell side, and was a top- of RBC Investments and also Vice-Chair of the RBC Capital Markets ranked sell-side economist before joining Canada Trust in 1996 as Chief Investment Strategy Committee. Through his 33 years at RBC Economist and member of the firm’s asset-allocation strategy committee. Dominion Securities (and predecessors), Jim has played a key role in In 1998, Patti joined Sceptre Investment Counsel as Chief Economist. In developing investment policy for the firm and translating that into this role, she managed portfolios for private and institutional clients, and solutions for individual clients. He presents extensively on the topic. later became head of the firm’s asset-mix committee. In 2004, Patti joined PH&N as Chief Economist. She is responsible for global macroeconomic research and outlook, is part of the asset-mix team overseeing $15 billion in balanced mandates and manages institutional portfolios. She is a frequent public speaker and commentator on economic issues, and is quoted regularly in print and electronic media.
JANET L. ENGELS DAGMARA FIJALKOWSKI, MBA, CFA SENIOR V. P. AND DIRECTOR, V. P. & SENIOR PORTFOLIO MANAGER, PRIVATE CLIENT RESEARCH GROUP GLOBAL FIXED INCOME & CURRENCIES RBC WEALTH MANAGEMENT RBC ASSET MANAGEMENT INC. Janet has more than 26 years of experience in the securities industry. Dagmara joined RBC Asset Management's Global Fixed Income & She joined Tucker Anthony, later RBC Dain Rauscher, in 1982. Over the Currencies Team in 1997, and has been a portfolio manager since course of her career, she has held the positions of Director of Equity 2000. During her tenure, Dagmara has developed an expertise in Research for Sutro & Co. and Director of Equity Strategies for Tucker currency management. Today she oversees foreign-exchange hedging Anthony. In 2002 she was named Director of the Private Client Group and active currency-management programs for RBC AM's fixed- at RBC Dain Rauscher, now RBC Wealth Management, where she is income and equity funds, and co-manages several of the firm’s bond also a member of the Director’s Circle and the RBC Investment Strategy portfolios. Dagmara has been a member of RBC AM’s Investment Committee. Policy Committee, a key forum for the discussion and implementation of North American investment policy, since 2003. She is also a member of the RBC Investment Strategy Committee.
62 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE MEMBERS
STUART KEDWELL, CFA ANDREW MITCHELL, CFA SENIOR V. P. & V. P. & INSTITUTIONAL SENIOR PORTFOLIO MANAGER, PORTFOLIO MANAGER, RBC ASSET MANAGEMENT INC. PHILLIPS, HAGER & NORTH INVESTMENT MANAGEMENT LTD. Stu Kedwell began his career with RBC Dominion Securities in the Andrew is an institutional portfolio manager at Phillips, Hager & North, firm’s Generalist program and completed rotations in the Fixed Income, and a member of the firm's Canadian Equity Team. Prior to joining Equity Research, Corporate Finance and Private Client divisions. PH&N in 2008, Andrew spent 12 years as a Canadian equity analyst Following this program, he joined the RBC Investments Portfolio at Scotia Capital, where he rose to the level of Managing Director. Advisory Group and was a member of the RBC DS Strategy and Stock Andrew holds an MSc from the London School of Economics. He was Selection committees. He later joined RBC Asset Management as appointed to the RBC Investment Strategy Committee in 2009. a senior portfolio manager and now manages the RBC Canadian Dividend Fund, RBC North American Value Fund and a number of other mandates. He is co-head of RBC Asset Management’s Canadian Equity Team and a member of the firm’s Investment Strategy Committee.
MARTIN PALECZNY, CFA GEORGE RILEY, FSI V. P. & SENIOR PORTFOLIO MANAGER, HEAD GLOBAL INVESTMENT SOLUTIONS, RBC ASSET MANAGEMENT INC. RBC INTERNATIONAL WEALTH MANAGEMENT Martin Paleczny, with 15 years of experience in the investing field, George has more than 30 years experience in the Financial sector, with began his career at Royal Bank Investment Management, where he over 18 years of investment experience. He is a Fellow of the Securities developed an expertise in derivatives management and created a policy and Investment Institute. Prior to joining RBC, he worked with Lloyds and process for the products. He also specializes in technical analysis Bank International in their trust businesses in the British Isles and and uses this background to implement derivatives and hedging Monaco. George joined Royal Bank of Canada in 1985 and moved to strategies for equity, fixed income, currency and commodity-related Guernsey where he was appointed Director of Royal Bank of Canada funds. Since becoming a portfolio manager, Martin has focused on Investment Management (Guernsey) Limited in 1993. In March 2000, global allocation strategies for the full range of assets, with an emphasis he moved to Geneva, Switzerland, where he was appointed Chief on using futures, forwards and options. He also serves as advisor to the Investment Officer of Royal Bank of Canada (Suisse) in June 2002. RBC Investment Strategy Committee for technical analysis. In January 2006 George was appointed Head, Global Investment Solutions and relocated to Guernsey.
JASON STORSLEY, CFA PRESIDENT & CEO, RBC DIRECT INVESTING
Jason joined RBC Direct Investing on Feb. 1, 2009, and is responsible for developing strategy, growing assets under administration, and expanding revenue and market share. He was previously head of RBC AM's institutional investment-management business and Director of Global Equity Research. Jason's career at RBC Financial Group dates from 1998, when he joined RBC DS. In 2001, he moved to the Fixed Income Portfolio Advisory Group, where he was in charge of structuring portfolios for high- net-worth clients and formulating trade recommendations. Jason was elevated to Vice President in 2003, when he assumed leadership of the portfolio advisory group, and the retail bond sales and trading desks. He is a member of the RBC Investment Strategy Committee.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 63 RBC INVESTMENT STRATEGY COMMITTEE
GLOBAL EQUITY HEADS
Ray Mawhinney Senior V.P., U.S. & Global Equities RBC Asset Management Inc. Yoji Takeda Director & V.P., Asian Equities RBC Investment Management (Asia) Limited Dominic Wallington Chief Investment Offi cer & Chief Executive Offi cer RBC Asset Management UK Limited Paul Johnson V.P. & Senior Portfolio Manager, Global Equities RBC Asset Management Inc.
GLOBAL EQUITY ADVISORY COMMITTEE
Chris Beer, CFA V.P. & Senior Portfolio Manager, Canadian & Global Equities RBC Asset Management Inc. Cameron Hurst Associate Portfolio Manager, U.S. Equities (Financials) RBC Asset Management Inc. Henry Kwok Senior Analyst, Global Equities (Health Care & Consumer Staples) RBC Asset Management Inc. Stuart Morrow, CFA Manager, Global Equities Research RBC Asset Management Inc. Martin Paleczny, CFA V.P. & Senior Portfolio Manager, Asset Allocation & Derivatives RBC Asset Management Inc. Cameron Scrivens V.P. & Senior Portfolio Manager, U.S. Equities (Health Care & Technology) RBC Asset Management Inc. Robert Silgardo, CFA Senior Analyst, Global Equities (Telecommunications & Technology) RBC Asset Management Inc. Janice Wong, CA, CFA Senior Analyst, Global Equities (Industrials & Utilities) RBC Asset Management Inc.
GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE
Soo Boo Cheah, MBA, CFA Portfolio Manager, Global Fixed Income & Currencies RBC Asset Management Inc. Patricia Croft Chief Economist RBC Global Asset Management Dagmara Fijalkowski, MBA, CFA V.P. & Senior Portfolio Manager, Global Fixed Income & Currencies RBC Asset Management Inc. Suzanne Gaynor V.P. & Senior Portfolio Manager, Global Fixed Income & Currencies RBC Asset Management Inc. Robin Gullason, CFA V.P., Fixed Income Portfolio Advisory Group RBC Dominion Securities Inc.
64 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE This information has been provided by RBC Asset Management Inc. and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, fi nancial or other advice and such information should not be relied upon for providing such advice. RBC Asset Management takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed.
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A NOTE ON FORWARD-LOOKING STATEMENTS This report may contain forward-looking statements about the Fund, its future performance, strategies or prospects, and possible future Fund action. The words “may,” “could,” “should,” “would,” “suspect,” “outlook,” “believe,” “plan,” “anticipate,” “estimate,” “expect,” “intend,” “forecast,” “objective” and similar expressions are intended to identify forward-looking statements.
Forward-looking statements are not guarantees of future performance. Forward-looking statements involve inherent risks and uncertainties, both about the Fund and general economic factors, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made in relation to the Fund. These factors include, but are not limited to, general economic, political and market factors in Canada, the United States and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological changes, changes in laws and regulations, judicial or regulatory judgments, legal proceedings and catastrophic events.
The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith but without legal responsibility.
THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 65 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE ® Registered trademark of Royal Bank of Canada. RBC Asset Management is a registered trademark of Royal Bank of Canada. Used under license. © RBC Asset Management, Inc. 2009. All rights reserved.
4 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE