DEC 4 2018 (UPDATED TO NOV 30) Daniel E. Chornous, CFA Chief Investment Officer [email protected] Eric Savoie, MBA, CFA Senior Analyst, Investment Strategy [email protected] THE GLOBAL INVESTMENT OUTLOOK – NEW YEAR 2019 RELEASE U.S. 10-year T-Bond yield S&P 500 equilibrium Global purchasing managers' indices Equilibrium range Normalized earnings & valuations The S&P 500 Nov. '18 Range: 2141 - 3563 (Mid: 2852) is slightly below 65 16 5120 equilibrium (i.e. the band’s ISM Peak Aug 2018: 61.3 Our equilibrium model suggests an Nov. '19 Range: 2218 - 3691 (Mid: 2954)midpoint), and many Previous ISM Peak Feb 2011: 59.2 14 upward bias to interest rates for a very Current (30-November-18): 2760 other markets continue 60 long time into the future should 2560 to show significant discounts to their fair value. A significant rise in inflation and interest rates 12 inflation premiums and real rates of will eventually reduce the sustainable 55 interest ultimately return to their long- 1280 level for valuations, but normalizing 10 term norms. P/E’s and corporate profitability to Last Plot: 2.99% reflect current levels for these 50 8 Current Range: 2.12% - 3.90% (Mid: 3.01%) 640 critical variables suggests % stock market valuations are reasonable, but 45 6 320 certainly not Solid gains in “cheap” in all revenues and earnings 4 Led by the U.S., PMIs remain at 160 locations. propelled U.S. stocks in 40 particular, but threats to levels consistent with expansion, 2 But in the near-term, the pressure but the trend everywhere is both are accumulating. JPMorgan Global Mfg. PMI on yields to move higher is 80 35 moderating. U.S. ISM Mfg. PMI 0 China Mfg. PMI alleviated by valuations. Euro Area Mfg. PMI 30 -2 40 2008 2010 2012 2014 2016 2018 2020 1980 1985 1990 1995 2000 2005 2010 2015 2020 1960 1970 1980 1990 2000 2010 2020 Source: RBC GAM, RBC CM Source: RBC GAM Source: Haver Analytics, RBC GAM KEY CONCLUSIONS > REDUCING BOND UNDERWEIGHT/MAINTAINING MILD OVERWEIGHT IN STOCKS AS YIELDS CLIMB, CYCLE MATURES The global economy slowed in the second half of 2018, a trend that is expected to extend into 2019 amid tighter financial conditions and increased protectionism. Although leading indicators continue to signal expanding economic activity, they peaked in most major regions in late 2017/early 2018. The U.S. economy has been particularly resilient, supported by large-scale tax cuts and increased government spending. But the boost from U.S. fiscal stimulus will fade in 2019 and may even become a drag in 2020. For both the U.S. and global economy, we continue to forecast decent growth for 2019, but at a slightly reduced pace from 2018. Protectionism is among the gravest risks to growth, especially with respect to the relationship between the world’s two largest economies. Tariffs between the U.S. and China now cover hundreds of billions of dollars of trade and, while most trade models suggest the current damage from protectionism is fairly small, uncertainty over potential additional tariffs is likely exerting a greater drag. That said, tensions between the U.S. and China may have eased somewhat after Trump and Xi agreed to a temporary 90-day cease-fire in the trade war. There is no guarantee of a resolution, however, and trade skirmishes could flare up again as the end of the 90-day period draws nearer. Within North America, the signing of the USMCA has curbed the most immediate threat from protectionism. While the new NAFTA is arguably suboptimal, the possibility of a disruptive outcome has now been removed. A variety of other risks are constantly evolving. In Europe, the Brexit situation has yet to be resolved and Italy’s populist government is a constant source of uncertainty. Tightening financial conditions represent a challenge for private-sector debt, which has ballooned in size and deteriorated in quality after an extended period of ultra-low interest rates. And, as before, China’s slowing economy is particularly important because the country accounts for a third of global growth. Fortunately the Chinese government is stepping in with various stimulus measures to support the economy and prevent a hard landing. Although the economy is facing a number of headwinds, sustained economic growth and relatively firm inflation are encouraging central banks to dial back monetary accommodation. The Fed is the furthest along, having delivered several rate hikes and now shrinking its balance sheet. The Fed may soon slow its pace of tightening as interest rates approach the long-term neutral rate. We look for 3 more rate hikes in the U.S. over the next 12 months. Other major central banks have also joined the tightening trend, but at a slower pace, including the BOC and BOE. Central banks in Europe and Japan, though, are maintaining negative interest rates to fuel inflation which remains stubbornly low in those regions. That said, the ECB has taken steps to dial back the degree of accommodation, and is expected to halt bond purchases at the end of 2018, setting up for potential rate hikes in the second half of 2019. Bond yields retreated in most major regions after having risen to multi-year highs earlier in the quarter. The moderating outlook for growth boosted the demand for safe-haven assets, and the steep decline in oil since the beginning of October also weighed on the inflation premium embedded in nominal bond yields. Our models suggest that yields on 10-year government bonds in the U.S. and Canada are near equilibrium, but also that yields in other regions remain unsustainably low and are therefore at a greater risk of upward adjustment. Our models continue to forecast higher yields over the longer term in all regions, paced by a gradual increase in real rates of interest to their historical norms, although the near-term need for that adjustment has lessened considerably in North America especially. After rallying to a new high in September, the S&P 500 Index declined along with other risk assets as higher interest rates, political uncertainty and slowing global growth shook investor confidence. Emerging- market equities were particularly hard hit, with the MSCI Emerging Markets Index down more than 26% from its January peak. In aggregate, global equities offer more attractive total-return potential following the sell-off, but within regions the U.S. continues to trade at a premium relative to other markets. The price-to-earnings ratio on the S&P 500 remains above its long-term norm even after the recent correction, and rising interest rates and firming inflation are likely to limit gains from expanding valuations. Earnings growth will be critical to pushing stocks higher and, although profits have been growing quickly in 2018, they are expected to slow going forward. Earnings surged 28% on a year-over-year basis in the third quarter on sales growth of 8.6%. But without the boost from tax cuts in 2019 and moderating global growth, analysts expect earnings growth to slow to high-single-digit rates. We expect the global economy to continue expanding over our forecast horizon, but we also recognize that growth is slowing as the cycle matures. Rising rates will continue to act as a headwind to fixed income returns, but yields in North America have reset considerably over the past year and bonds also offer protection in balanced portfolios during an economic/equity-market downturn. We maintain a slight underweight position in fixed income, but have taken advantage of the increase in yields earlier in the quarter to add one percentage point to our bond allocation, sourced from cash. Prospective returns for equities remain higher than those for fixed income should the economy continue to grow as we expect. As a result, we continue to maintain an above-benchmark exposure to equities to benefit from potential upside in corporate profits, but given we are in the later stages of the business cycle and that the risk of recession is rising according to our indicators, the size of our overweight is less aggressive than it has been. Our current recommended asset mix for a global balanced investor is 58% equities (strategic: “neutral”: 55%), 41% bonds (strategic “neutral”: 43%) and 1% in cash. RBC GAM INVESTMENT STRATEGY COMMITTEE ECONOMIC FORECASTS – NEW YEAR 2019 RBC GAM Investment Strategy Committee - Economic Forecasts Actual Forecast Forecast Actual Forecast Forecast Real GDP 2017 2018 Change 2019 Change CPI 2017 2018 Change 2019 Change United States 2.27% 2.75% N/C 2.50% N/C United States 2.14% 2.50% N/C 2.25% N/C Canada 3.00% 2.00% N/C 1.75% 0.25 Canada 1.61% 2.25% N/C 2.00% N/C Europe 2.50% 2.00% N/C 1.50% N/C Europe 1.53% 1.75% N/C 1.75% N/C United Kingdom 1.85% 1.25% N/C 1.50% N/C United Kingdom 2.68% 2.50% N/C 2.25% N/C Japan 1.71% 1.00% (0.25) 1.00% (0.25) Japan 0.44% 1.00% N/C 1.25% (0.25) Emerging Markets* 5.41% 5.50% N/C 5.25% (0.25) Emerging Markets* 2.51% 3.25% N/C 3.50% 0.25 RBC GAM Investment Strategy Committee - Capital Markets Forecasts Forecast 1 Year Est. Forecast 1 Year Est. Central Bank Policy Rates 30-Nov-18 Nov-19 Change Total Ret.% Equity Markets 30-Nov-18 Nov-19 Change Total Ret.%^ United States 2.25 3.00 0.25 N/A S&P 500 S&P 500 2760 2875 (125) 6.1 Canada 1.75 2.25 0.25 N/A S&P/TSX ComS&P/TSX Composite 15198 16350 (650) 10.8 Europe** -0.40 -0.20 N/C N/A MSCI EuropeMSCI Europe 121 131 (6) 12.2 United Kingdom 0.75 1.00 N/C N/A FTSE 100 FTSE 100 6980 7500 (500) 12.2 Japan** -0.06 -0.10 N/C N/A Nikkei Nikkei 22351 24500 100 11.6 MSCI EmergiMSCI Emerging Markets 995 1085 (40) 12.1 Forecast 1 Year Est.