THE GLOBAL INVESTMENT OUTLOOK (SPRING 2016) by Rockstone Research

THE GLOBAL INVESTMENT OUTLOOK

RBC GAM Investment Strategy Committee

SPRING 2016

THE RBC GAM INVESTMENT STRATEGY COMMITTEE The RBC GAM Investment Strategy Committee consists of senior investment professionals drawn from across RBC Global Asset Management. 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 (financials 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.

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

The Committee’s view includes an assessment of global fiscal and monetary conditions, projected economic growth and inflation, as well as the expected course of interest rates, major currencies, corporate profits and stock prices.

Results of the Committee’s deliberations are published quarterly in The Global Investment Outlook.

These include: the recommended mix of cash, fixed income instruments, and equities the recommended global exposure of fixed income and equity portfolios the optimal term structure for fixed income investments the suggested sector and geographic makeup within equity portfolios the preferred exposure to major currencies

CONTENTS

EXECUTIVE SUMMARY

The Global Investment Outlook

RBC GAM Investment Strategy Committee

RECOMMENDED ASSET MIX

4 REGIONAL EQUITY MARKET OUTLOOK 5

RBC GAM Investment Strategy Committee

CAPITAL MARKETS PERFORMANCE

Milos Vukovic, MBA, CFA – V.P. & Head of Investment Policy, RBC Global Asset Management Inc.

GLOBAL INVESTMENT OUTLOOK

Eric Lascelles – Chief Economist, RBC Global Asset Management Inc. Eric Savoie, MBA, CFA – Senior Analyst, Investment Strategy, RBC Global Asset Management Inc. Daniel E. Chornous, CFA – Chief Investment Officer, RBC Global Asset Management Inc.

Soo Boo Cheah, MBA, CFA – Senior Portfolio Manager, RBC Global Asset Management (UK) Limited Suzanne Gaynor – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

United States Raymond Mawhinney – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc. Brad Willock, CFA – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

Canada Stuart Kedwell, CFA – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

Asymmetric risks

GLOBAL FIXED INCOME MARKETS

Dagmara Fijalkowski, MBA, CFA – Head, Global Fixed Income and Currencies (Toronto and London), RBC Global Asset Management Inc. Daniel Mitchell, CFA – Portfolio Manager, RBC Global Asset Management Inc. Taylor Self, MBA – Analyst, RBC Global Asset Management Inc.

Sarah Riopelle, CFA – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc. Daniel E. Chornous, CFA – Chief Investment Officer, RBC Global Asset Management Inc.

ECONOMIC & CAPITAL MARKETS FORECASTS

CURRENCY MARKETS

Europe Dominic Wallington – Chief Investment Officer, RBC Global Asset Management (UK) Limited

Asia Mayur Nallamala – Head & Senior Portfolio Manager, RBC Investment Management (Asia) Limited

Emerging Markets Guido Giammattei – Portfolio Manager, RBC Global Asset Management (UK) Limited

47 RBC GAM INVESTMENT STRATEGY COMMITTEE

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 1

EXECUTIVE SUMMARY Downside risks have increased Sarah Riopelle, CFA V.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

Daniel E. Chornous, CFA Chief Investment Officer RBC Global Asset Management Inc.

Global economic growth has clearly been sluggish and, while we don’t see a recession on the horizon, the risks to our outlook have increased. Central banks are engaging in a familiar attempt to revive growth and enthuse financial markets via additional monetary stimulus. But they are encountering less success than usual, failing to distract financial markets from the reality of subpar economic growth, low bond coupons and stagnant earnings. In this difficult environment, risk assets such as equities and corporate bonds have suffered.

The world is grappling with an unusually large number of downside risks and challenges. A familiar set of headwinds – debt excesses, the resource shock, the emerging-market slowdown and a grab-bag of Chinese imbalances – continues to brew. Newly added to this list of concerns are rising geopolitical risks, an aging business cycle and fresh worries about the banking sector. China remains a key market focus for a mix of reasons. Structurally, Chinese economic growth is now several times more important for global growth than any other country, and so merits attention even when all appears fine. Cyclically, China now demands even more scrutiny given a raft of complications that relate to its currency, stock market, debt excesses and economic deceleration. But we do not see evidence of a so-called “hard landing,” and it is worth noting that China has not completely lost its growth engines. The long-sought transition to a more consumer- and service-oriented economy appears to be happening, with the service sector now representing more than half of the country’s economic output.

Lowering our economic forecasts, but not forecasting a recession Economic growth has again slowed, and the bulk of the world’s countries are suffering unusually tepid expansions. It is somewhat disconcerting that economic growth in the developed world has been so 2 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

sluggish over the past year despite the theoretical tailwinds of ultra-low interest rates, low oil prices and weak exchange rates. There is a risk that growth could look even worse as those tailwinds eventually fade. Our economic projections have been almost universally scaled back. The developed world is now expected to grow by just 1.5% in 2016 – putting it on track for the worst performance since 2013, and notably less than 2015 growth of 1.9%. The 2016 emerging-market outlook has also been lowered, with the year now also set for less growth than 2015. That said, there is a gaping difference between lowering growth forecasts and forecasting a recession. Despite rumours to the contrary, the world is not obviously descending into a recession right now.

U.S. dollar bull market is not over yet We don’t think the current dollar bull market is quite ready to meet its end. The Bank of Japan (BOJ) and European Central Bank (ECB) are pursuing easier policy stances, valuations are not yet a constraint and a generational shift is occurring in global reserve balances. These factors are all serving to perpetuate the current dollar cycle. We expect the euro and the yen to lead the charge lower versus the U.S. dollar over the next 12 months. We are relatively more constructive on the pound, though the referendum run-up could be trying. The loonie will likely weaken further as Canada’s economic rebalancing continues. All things considered, we are somewhere in the middle-to-late innings of the current U.S. dollar cycle.

Executive Summary | Sarah Riopelle, CFA | Daniel E. Chornous, CFA

Inflation starting to move higher

close to all-time lows given the Fedâ&#x20AC;&#x2122;s foray into higher policy rates.

economy expands as we expect and corporate-profit growth rebounds.

With the exception of the Eurozone, inflation is now running a little bit higher than in prior quarters as the most extreme declines in commodity prices fall out of the one-year rolling window. Looking to the future, we suspect inflation can rise a little further, though it should remain low by most standards. The gains should come mainly from a modest recovery in commodity prices.

In our view, economic conditions, including the benign environment for inflation, should be sufficiently sluggish to allow for a gradual normalization of interest rates. This should result in very low total returns for sovereign bonds. There is a chance that consensus expectations for the economy prove too conservative, which would create conditions for a more rapid recovery in yields and lead to negative total returns for the fixed income asset class.

A little less overweight equities

More monetary stimulus likely The BOJ has joined a handful of central banks, among them the ECB, in dropping its policy rate below zero. The bulk of the worldâ&#x20AC;&#x2122;s major central banks will likely deliver additional stimulus over the next year. The one exception is the Fed. The recent period of heightened market volatility and rising economic uncertainty is likely to cause the Fed to proceed more cautiously in raising rates than previously expected. The Fed continues to reiterate that future rate hikes will be dependent on economic data and that the path to higher rates is likely to be a gradual one.

Gradual rise in yields expected A large portion of the worldâ&#x20AC;&#x2122;s bonds now trade at negative yields and remain near all-time lows in jurisdictions where yields are in positive territory. Government-bond yields in Europe and Japan have fallen sharply in the past quarter, spurred by renewed risk aversion, disappointing economic growth and another round of monetary stimulus. While U.S. Treasury yields are lower than several months ago, they are not particularly

Good long-term potential for stocks Reflecting the increasing risks to the global economy, global stock markets have undergone a significant downward adjustment. Many regional equity indexes entered bear markets in early 2016 and moved stocks in those regions to unusually attractive valuation levels. Our global equityvaluation composite indicates good long-term potential for stocks should our favoured scenario of sluggish but sustained growth, low inflation, gradually rising interest rates and solid corporate profitability prove accurate. Equity indexes around the world are now well below fair value, largely due to a lack of corporate-profit growth over the last year. In the U.S., S&P 500 earnings peaked in December 2014 and analyst expectations have been constantly revised downward since then. The negative impact on earnings from the strong U.S. dollar and falling oil prices should begin to recede and we should not ignore the upside potential for stocks if the

Following a downward adjustment in price, the long-term return potential for stocks has become more attractive, but we have to balance this against an increase in the downside risks. Should the economy perform in line with our expectations, corporate profits will gain traction (especially if the low print for oil is now behind) and stocks will likely post solid gains through the months ahead. However, further deterioration in global growth and/or corporate revenues and profits will almost certainly challenge already tenuous investor confidence and open up the possibility of additional downside for equity markets. We lean to the positive and maintain an overweight in equities in our recommended asset mix, but trimmed the position through the recent rally. Although economic conditions are likely to remain uninspiring, they should still allow for a gradual normalization of interest rates. From these low levels, even a modest increase in yields acts as a significant headwind for fixed-income returns. The expectation of higher yields causes total-return estimates to be especially unattractive for sovereign bonds and we therefore maintain an underweight position in fixed income. For a balanced, global investor, we currently recommend an asset mix of 60% equities (strategic neutral position: 55%), and 37% fixed income (strategic neutral position: 43%), with the balance in cash.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 3

ECONOMIC & CAPITAL MARKETS FORECASTS ECONOMIC FORECAST (RBC GAM INVESTMENT STRATEGY COMMITTEE) UNITED STATES

CANADA

EUROPE

UNITED KINGDOM

JAPAN

EMERGING MARKETS1

CHINA

Change Change Change Change Change Change Change from from from from from from from Spring New Year Spring New Year Spring New Year Spring New Year Spring New Year Spring New Year Spring New Year 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016 REAL GDP 2015A

2.38%

2016E

1.75%

(0.75)

1.20% 1.00%

(0.50)

1.49% 1.50%

(0.50)

2.19% 2.00%

(0.50)

0.47% 1.00%

(0.50)

6.91% 6.00%

N/C

4.71% 4.75%

(0.25)

2017E

2.25%

N/C

1.75%

N/C

2.00%

N/C

2.25%

N/C

0.75%

N/C

5.75%

N/C

5.00%

N/C

CPI 2015A

0.12%

2016E

1.00%

(0.50)

2.25%

0.50

0.50%

(0.50)

0.75%

(0.75)

0.50%

(1.00)

1.75%

(0.50)

3.50%

(0.25)

2017E

1.75%

N/C

2.50%

N/C

1.25%

N/C

1.75%

N/C

2.25%

N/C

2.25%

N/C

3.50%

N/C

A = Actual

1.09%

E = Estimate

0.03%

0.05%

0.77%

1.54%

4.17%

GDP Weighted Average of China, India, South Korea, Brazil, Mexico and Russia. Actual 2015 GDP uses an estimate for Russia.

TARGETS (RBC GAM INVESTMENT STRATEGY COMMITTEE) FEBRUARY 2016

FORECAST FEBRUARY 2017

CHANGE FROM NEW YEAR 2016

1-YEAR TOTAL RETURN ESTIMATE (%)

CAD (USD–CAD)

1.35

EUR (EUR–USD)

1.09

1.53

0.13

(11.0)

0.95

(0.05)

(13.4)

112.71

133.00

1.39

1.35

N/C

(16.2)

(0.16)

(3.2)

U.S. Fed Funds Rate

0.50

0.75

(0.25)

N/A

U.S. 10-Year Bond

1.70

2.25

(0.25)

(3.2)

Canada Overnight Rate

0.50

0.25

(0.25)

N/A

Canada 10-Year Bond

1.19

1.35

(0.40)

(0.3)

Eurozone Policy Rate

0.05

(0.20)

(0.10)

N/A

Germany 10-Year Bund

0.11

0.50

N/C

(3.7)

U.K. Base Rate

0.50

(0.50)

N/A

U.K. 10-Year Gilt

1.34

1.75

(0.65)

(2.4)

Japan Overnight Call Rate

0.00

(0.20)

(0.25)

N/A

(0.06)

0.00

(0.50)

(0.7)

1932

2125

(150)

12.3

12860

14400

(100)

15.3

1392

1530

(220)

13.9

CURRENCY MARKETS AGAINST USD

JPY (USD–JPY) GBP (GBP–USD) FIXED INCOME MARKETS

Japan 10-Year Bond EQUITY MARKETS S&P 500 S&P/TSX Composite MSCI Europe FTSE 100 Nikkei MSCI Emerging Markets Source: RBC GAM

4 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

6097

6600

(200)

12.7

16027

17700

(4300)

12.5

740

820

(80)

13.9

RECOMMENDED ASSET MIX Asset mix – the allocation within portfolios to stocks, bonds and cash – should include both strategic and tactical elements. Strategic asset mix addresses the blend of the major asset classes offering the risk/return tradeoff best suited to an investor’s profile. It can be considered to be the benchmark investment plan that anchors a portfolio through many business and investment cycles, independent of a near-term view of the prospects for the economy and related expectations for capital markets. Tactical asset allocation refers to fine tuning around the strategic setting in an effort to add value by taking advantage of shorter term fluctuations in markets.

expectations for the major asset classes. These weights are further divided into recommended exposures to the variety of global fixed income and equity markets. Our recommendation is targeted at the Balanced profile where the benchmark setting is 55% equities, 43% fixed income, 2% cash.

Every individual has differing return expectations and tolerances for volatility, so there is no “one size fits all” strategic asset mix. Based on a 35-year study of historical returns1 and the volatility2 of returns (the range around the average return within which shorter-term results tend to fall), we have developed five broad profiles and assigned a benchmark strategic asset mix for each. These profiles range from very conservative through balanced to aggressive growth. It goes without saying that as investors accept increasing levels of volatility, and therefore greater risk that the actual experience will depart from the longerterm norm, the potential for returns rises. The five profiles presented below may assist investors in selecting a strategic asset mix best aligned to their investment goals.

This tactical recommendation for the Balanced profile can serve as a guide for movement within the ranges allowed for all other profiles.

Each quarter, the RBC GAM Investment Strategy Committee publishes a recommended asset mix based on our current view of the economy and return

A tactical range of +/- 15% around the benchmark position allows us to raise or lower exposure to specific asset classes with a goal of tilting portfolios toward those markets that offer comparatively attractive nearterm prospects.

The value-added of tactical strategies is, of course, dependent on the degree to which the expected scenario unfolds. Regular reviews of portfolio weights are essential to the ultimate success of an investment plan as they ensure current exposures are aligned with levels of long-term returns and risk tolerances best suited to individual investors. Anchoring portfolios with a suitable strategic asset mix, and placing boundaries defining the allowed range for tactical positioning, imposes discipline that can limit damage caused by swings in emotion that inevitably accompany both bull and bear markets.

1. Average return: The average total return produced by the asset class over the period 1981 – 2016, based on monthly results. 2. Volatility: The standard deviation of returns. Standard deviation is a statistical measure that indicates the range around the average return within which 2/3 of results will fall into, assuming a normal distribution around the long-term average.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 5

Recommended Asset Mix

GLOBAL ASSET MIX BENCHMARK POLICY

PAST RANGE

SPRING 2015

SUMMER 2015

FALL 2015

NEW YEAR 2016

SPRING 2016

CASH

2.0%

1% – 16%

1.0%

2.0%

1.0%

3.0%

BONDS

43.0%

25% – 54%

38.0%

36.0%

37.0%

STOCKS

55.0%

36% – 65%

61.0%

60.0%

62.0%

60.0%

Note: Effective September 1, 2014, we revised our strategic neutral positions within fixed income, lowering the ‘neutral’ commitment to cash from 5% to

2%, and moving the difference to bonds. This takes advantage of the positive slope of the yield curve which prevails over most time periods, and allows our fixed income managers to shorten duration and build cash reserves whenever a correction in the bond market, or especially an inverted yield curve, is anticipated. REGIONAL ALLOCATION CWGBI* FEB. 2016

PAST RANGE

SPRING 2015

SUMMER 2015

FALL 2015

NEW YEAR 2016

SPRING 2016

North America

38.2%

18% – 40%

36.4%

36.9%

37.5%

37.7%

38.2%

Europe

39.9%

32% – 56%

40.5%

40.7%

45.3%

39.9%

Asia

21.9%

17% – 35%

23.1%

22.4%

21.8%

17.0%

21.9%

GLOBAL BONDS

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

MSCI** FEB. 2016

PAST RANGE

SPRING 2015

SUMMER 2015

FALL 2015

NEW YEAR 2016

SPRING 2016

North America

60.5%

51%– 61%

59.2%

58.6%

58.2%

58.0%

59.2%

Europe

21.2%

21% – 35%

22.8%

22.4%

22.9%

23.5%

22.2%

Asia

11.1%

9% – 18%

10.5%

11.5%

11.4%

11.0%

11.1%

Emerging Markets

7.3%

0% – 8.5%

7.5%

GLOBAL EQUITIES

Our asset mix is reported as at the end of each quarter. The mix is fluid and may be adjusted within each quarter, although we do not always report on shifts as they occur. The weights in the table should be considered a snapshot of our asset mix at the date of release of the Global Investment Outlook. GLOBAL EQUITY SECTOR ALLOCATION MSCI** FEB. 2016

RBC ISC NEW YEAR 2016

RBC ISC SPRING 2016

CHANGE FROM NEW YEAR 2016

WEIGHT VS. BENCHMARK

Energy

6.31%

6.18%

6.31%

0.13

100.0%

Materials

4.18%

3.56%

3.68%

0.12

88.0%

Industrials

10.63%

12.16%

9.63%

(2.53)

90.6%

Consumer Discretionary

13.22%

14.36%

14.72%

0.36

111.3%

Consumer Staples

11.09%

9.00%

12.59%

3.59

113.5%

Health Care

13.28%

14.12%

13.78%

(0.33)

103.8%

Financials

19.97%

20.15%

17.97%

(2.18)

90.0%

Information Technology

14.29%

16.19%

16.29%

0.10

114.0%

Telecom. Services

3.61%

2.66%

3.61%

0.94

100.0%

Utilities

3.42%

1.62%

1.42%

(0.20)

41.5%

*Citigroup World Global Bond Index **MSCI World Index

6 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Source: RBC GAM Investment Strategy Committee

Recommended Asset Mix

â&#x20AC;&#x153;

At RBC GAM, we have a team dedicated to setting and

reviewing the strategic asset mix for all of our multi-asset solutions. With an emphasis on consistency of returns, risk management and capital

preservation, we have developed a strategic asset allocation framework for five client risk profiles that correspond to broad investor objectives and risk preferences. These five profiles range from Very Conservative through Balanced to Aggressive Growth.

VERY CONSERVATIVE BENCHMARK

RANGE

0-15%

1.2%

2.9%

Fixed Income

78%

55-95%

73.1%

72.6%

Total Cash & Fixed Income

80%

65-95%

74.3%

75.5%

Canadian Equities

10%

5-20%

11.5%

11.4%

U.S. Equities

0-10%

5.9%

International Equities

0-10%

8.3%

7.2%

Emerging Markets

0.0%

20%

5-35%

25.7%

24.5%

RETURN

VOLATILITY

ASSET CLASS

Cash & Cash Equivalents

Total Equities

LAST CURRENT QUARTER RECOMMENDATION

35-Year Average

9.0%

5.9%

Last 12 Months

(1.8%)

3.2%

â&#x20AC;?

Very Conservative investors will seek income with maximum capital preservation and the potential for modest capital growth, and be comfortable with small fluctuations in the value of their investments. This portfolio will invest primarily in fixed-income securities, and a small amount of equities, to generate income while providing some protection against inflation. Investors who fit this profile generally plan to hold their investment for the short to medium term (minimum one to five years).

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 7

Recommended Asset Mix

CONSERVATIVE ASSET CLASS

Cash & Cash Equivalents

BENCHMARK

RANGE

0-15%

LAST CURRENT QUARTER RECOMMENDATION

1.1%

2.9%

Fixed Income

63%

40-80% 57.5%

57.3%

Total Cash & Fixed Income

65%

50-80% 58.6%

60.2%

Canadian Equities

15%

5-25%

16.7%

16.5%

U.S. Equities

10%

0-15%

11.1%

11.0%

International Equities

10%

0-15%

13.6%

12.3%

0.0%

20-50% 41.4%

39.8%

Emerging Markets Total Equities

35%

RETURN

VOLATILITY

35-Year Average

9.2%

7.1%

Last 12 Months

(2.7%)

4.3%

BALANCED ASSET CLASS

Cash & Cash Equivalents

BENCHMARK

RANGE

0-15%

LAST CURRENT QUARTER RECOMMENDATION

1.0%

3.0%

Fixed Income

43%

20-60% 37.0%

37.0%

Total Cash & Fixed Income

45%

30-60% 38.0%

40.0%

Canadian Equities

19%

10-30% 20.7%

20.4%

U.S. Equities

20%

10-30% 21.1%

20.9%

International Equities

12%

5-25%

15.5%

14.2%

0-10%

4.7%

4.5%

40-70% 62.0%

60.0%

Emerging Markets Total Equities

55%

RETURN

VOLATILITY

35-Year Average

9.1%

8.5%

Last 12 Months

(3.9%)

5.9%

8 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Conservative investors will pursue modest income and capital growth with reasonable capital preservation, and be comfortable with moderate fluctuations in the value of their investments. The portfolio will invest primarily in fixedincome securities, with some equities, to achieve more consistent performance and provide a reasonable amount of safety. The profile is suitable for investors who plan to hold their investment over the medium to long term (minimum five to seven years).

The Balanced portfolio is appropriate for investors seeking balance between long-term capital growth and capital preservation, with a secondary focus on modest income, and who are comfortable with moderate fluctuations in the value of their investments. More than half the portfolio will usually be invested in a diversified mix of Canadian, U.S. and global equities. This profile is suitable for investors who plan to hold their investment for the medium to long term (minimum five to seven years).

Recommended Asset Mix

GROWTH BENCHMARK

RANGE

0-15%

1.0%

3.0%

Fixed Income

28%

5-40%

21.4%

21.7%

Total Cash & Fixed Income

30%

15-45%

22.4%

24.7%

Canadian Equities

23%

15-35%

24.8%

24.4%

U.S. Equities

25%

15-35%

26.3%

26.0%

International Equities

16%

10-30%

19.7%

18.3%

0-12%

6.8%

6.6%

70%

55-85%

77.6%

75.3%

RETURN

VOLATILITY

35-Year Average

9.0%

10.6%

Last 12 Months

(4.9%)

7.1%

ASSET CLASS

Cash & Cash Equivalents

Emerging Markets Total Equities

LAST CURRENT QUARTER RECOMMENDATION

AGGRESSIVE GROWTH BENCHMARK

RANGE

Cash & Cash Equivalents

0-15%

1.0%

Fixed Income

0-10%

0.0%

Total Cash & Fixed Income

0-20%

1.0%

Canadian Equities

32.5% 20-45%

32.4%

32.6%

U.S. Equities

35.0% 20-50%

34.3%

34.4%

International Equities

21.5% 10-35%

23.3%

22.7%

9.0% 0-15%

9.0%

9.3%

80-100% 99.0%

99.0%

ASSET CLASS

Emerging Markets Total Equities

98%

LAST CURRENT QUARTER RECOMMENDATION

RETURN

VOLATILITY

35-Year Average

8.9%

13.1%

Last 12 Months

(6.9%)

9.2%

Investors who fit the Growth profile will seek long-term growth over capital preservation and regular income, and be comfortable with considerable fluctuations in the value of their investments. This portfolio primarily holds a diversified mix of Canadian, U.S. and global equities and is suitable for investors who plan to invest for the long term (minimum seven to ten years).

Aggressive Growth investors seek maximum long-term growth over capital preservation and regular income, and are comfortable with significant fluctuations in the value of their investments. The portfolio is almost entirely invested in stocks and emphasizes exposure to global equities. This investment profile is suitable only for investors with a high risk tolerance and who plan to hold their investments for the long term (minimum seven to ten years).

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 9

CAPITAL MARKETS PERFORMANCE

Milos Vukovic, MBA, CFA V.P. & Head of Investment Policy RBC Global Asset Management Inc.

The U.S. dollar rose against the British pound and the Canadian dollar between December 1, 2015, and February 29, 2016, while falling against the yen and the euro. The greenback’s rise was 8.2% against sterling and 1.3% versus the Canadian dollar. The U.S. dollar’s decline was 8.4% against the yen and 2.9% versus the euro. Over the 12-month period ended February 29, 2016, the U.S. dollar rose 10.9% against the pound, 8.2% versus the Canadian dollar and 2.8% against the euro, while declining 5.7% versus the yen. Global fixed-income markets rose modestly during the three-month period, with Japanese bonds benefiting significantly in U.S. dollar terms from the appreciation of the yen. The Barclays Capital Aggregate Bond Index, a broad measure of U.S. fixed-income performance, climbed 1.8%, while European bonds rose 3.4% in U.S. dollar terms as measured by the Citigroup WGBI – Europe Index. The Citigroup Japanese Government Bond Index

10 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

climbed 13.9% and the FTSE TMX Canada Universe Bond Index, Canada’s fixed-income benchmark, gained 0.4%. Major equity markets declined during the latest three-month period as concern about the strength of Chinese economic growth and persistently weak commodity prices led to speculation that the global economy might enter recession. The S&P 500 Index fell 6.6%, but declines were even more significant in much of Europe and Asia in U.S. dollar terms. The MSCI Germany dropped 13.6%, while the MSCI Japan and the MSCI U.K. both fell 10.5%. Over the 12-month period, the S&P 500 dropped 6.2% and the MSCI Germany dropped 19.4%. The MSCI U.K. lost 18.1%, while the MSCI Japan declined 9.9%. The S&P/TSX Composite Index declined 5.0% in U.S. dollar terms during the three months versus a 5.1% drop for the large-cap S&P/TSX 60 Index and a 1.8% decline in the S&P/TSX Small Cap Index. The MSCI Emerging Markets Index fell 8.7% during the three-month period and dropped 23.4% over the 12-month period. The S&P 400 Index, a measure of the U.S. mid-cap market, lost 8.4% in the latest three months and dropped

10.0% for the 12-month period, while the S&P 600 Index, a gauge of small-cap performance, lost 9.7% in the three-month period and 9.1% over 12 months. The Russell 3000 Growth Index lost 7.7% during the quarter versus a 7.5% decrease for the Russell 3000 Value Index. Over the 12 months, the Russell 3000 Growth Index decreased 6.0%, while the Russell 3000 Value Index lost 9.7%. Seven of the 10 global equity sectors declined during the quarter ended February 29, 2016. The bestperforming sector was Utilities with a gain of 2.6%, followed by Telecommunication Services with a rise of 1.2% and Consumer Staples with a 0.1% increase. The worstperforming sectors over the past three months were Financials, which lost 14.5%; Energy, which lost 12.6%; and Information Technology, with a 9.2% decrease. Over the 12-month period, the bestperforming sectors were Consumer Staples, Telecommunication Services and Utilities, and the worstperforming were Energy, Materials and Financials.

Capital Markets Performance | Milos Vukovic, MBA, CFA

EXCHANGE RATES Periods ending February 29, 2016 3 months YTD 1 year (%) (%) (%)

Current USD

3 years (%)

5 years (%)

8.23

9.47

6.85

USD–CAD

1.3530

1.31

(2.22)

USD–EUR

0.9192

(2.88)

(0.10)

2.87

6.27

4.88

USD–GBP

0.7185

8.21

5.92

10.92

2.91

3.16

(8.40)

(6.19)

(5.74)

6.76

6.64

USD–JPY

112.7550

Note: all changes above are expressed in US dollar terms

CANADA Periods ending February 29, 2016 USD Fixed Income Markets: Total Return FTSE TMX Canada Univ. Bond Index

CAD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

0.43

2.89

(7.91)

(5.23)

(1.76)

1.75

(0.33)

3.75

U.S. Periods ending February 29, 2016 USD

CAD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

Citigroup U.S. Government

2.83

3.00

2.82

2.08

3.49

4.19

11.28

11.75

Barclays Capital Agg. Bond Index

1.77

2.10

1.50

2.22

3.60

3.10

9.86

11.90

Fixed Income Markets: Total Return

GLOBAL Periods ending February 29, 2016 USD Fixed Income Markets: Total Return

3 months (%)

YTD (%)

CAD

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

Citigroup WGBI

3.66

3.06

0.97

0.08

1.47

5.03

9.28

9.57

Citigroup European Government

3.37

2.40

(2.26)

0.49

2.08

4.73

5.79

10.01

Citigroup Japanese Government

13.90

10.38

11.98

(3.01)

(3.11)

15.39

21.20

6.18

CANADA Periods ending February 29, 2016 USD Equity Markets: Total Return

CAD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

(5.75)

(5.40)

(3.75)

(12.93)

3.18

S&P/TSX Composite

(5.00)

1.55

(19.55)

S&P/TSX 60

(5.11)

1.47

(19.15)

(5.13)

(5.00)

(3.86)

(12.50)

3.86

S&P/TSX Small Cap

(1.84)

3.33

(21.97)

(11.00)

(12.12)

(0.55)

(15.55)

(2.57)

U.S. Periods ending February 29, 2016 USD

CAD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

S&P 500

(6.59)

(5.09)

(6.19)

10.75

10.13

(5.36)

1.53

21.24

S&P 400

(8.35)

(4.36)

(9.99)

8.19

8.27

(7.14)

(2.58)

18.44

S&P 600

(9.66)

(5.12)

(9.10)

9.02

9.33

(8.47)

(1.62)

19.35

Russell 3000 Value

(7.54)

(5.26)

(9.73)

7.95

8.52

(6.32)

(2.30)

18.18

(7.68)

(6.06)

(5.98)

12.11

10.63

(6.46)

1.75

22.73

(10.78)

(8.98)

(8.17)

12.98

10.38

(9.61)

(0.61)

23.69

Equity Markets: Total Return

Russell 3000 Growth NASDAQ Composite Index

Note: all rates of return presented for periods longer than 1 year are annualized

Source: Bloomberg/MSCI THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 11

Capital Markets Performance | Milos Vukovic, MBA, CFA

GLOBAL Periods ending February 29, 2016

Equity Markets: Total Return

3 months (%)

YTD (%)

USD 1 year (%)

3 years (%)

5 years (%)

3 months (%)

CAD 1 year (%)

3 years (%)

(8.32)

(6.68)

(11.00)

5.32

4.92

(6.74)

(3.45)

15.46

MSCI EAFE*

(10.16)

(8.93)

(15.18)

0.38

0.56

(8.61)

(7.99)

10.05

MSCI Europe*

(10.63)

(8.27)

(16.14)

0.58

0.66

(9.09)

(9.02)

10.27

MSCI World*

MSCI Pacific* MSCI UK*

(9.32)

(10.15)

(13.59)

(0.14)

0.38

(7.76)

(6.26)

9.48

(10.50)

(6.85)

(18.14)

(0.99)

0.75

(8.96)

(11.19)

8.55 11.50

(8.73)

(5.58)

(12.11)

1.71

(0.45)

(7.16)

(4.65)

MSCI Germany*

(13.62)

(11.27)

(19.35)

0.42

0.37

(12.13)

(12.51)

10.09

MSCI Japan*

(10.45)

(10.74)

(9.90)

3.89

1.11

(8.91)

(2.26)

13.90

(8.72)

(6.64)

(23.41)

(8.90)

(5.41)

(7.15)

(16.91)

(0.13)

MSCI France*

MSCI Emerging Markets*

GLOBAL EQUITY SECTORS Periods ending February 29, 2016

Sector: Total Return

3 months (%)

YTD (%)

USD 1 year (%)

3 years (%)

5 years (%)

3 months (%)

CAD 1 year (%)

3 years (%)

Energy

(0.53)

(12.58)

(3.32)

(25.09)

(9.27)

(6.81)

(11.08)

(18.73)

Materials

(8.36)

(4.47)

(24.72)

(7.14)

(7.01)

(6.78)

(18.33)

1.81

Industrials

(6.16)

(3.71)

(9.42)

5.44

4.71

(4.54)

(1.74)

15.59

Consumer Discretionary

(9.12)

(7.02)

(7.89)

10.15

9.97

(7.55)

(0.08)

20.75

0.05

(0.89)

0.28

8.28

10.87

1.77

8.79

18.71

(7.64)

(9.03)

(9.30)

12.97

14.08

(6.05)

(1.60)

23.85

(14.53)

(12.99)

(16.93)

1.30

1.52

(13.06)

(9.88)

11.06

(9.24)

(7.12)

(6.78)

12.37

8.73

(7.68)

1.14

23.19

Telecommunication Services

1.15

1.49

(1.69)

9.32

6.56

2.89

6.65

19.85

Utilities

2.57

1.05

(3.10)

6.30

2.78

4.34

5.12

16.53

Consumer Staples Health Care Financials Information Technology

* Net of Taxes

Note: all rates of return presented for periods longer than 1 year are annualized

12 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Source: Bloomberg/MSCI

GLOBAL INVESTMENT OUTLOOK Asymmetric risks

Eric Lascelles

Exhibit 1: A challenging investing environment

Chief Economist RBC Global Asset Management Inc.

Eric Savoie, MBA, CFA

Slowing growth

Rising risks

Market displeasure

Senior Analyst, Investment Strategy RBC Global Asset Management Inc.

Daniel E. Chornous, CFA Chief Investment Officer RBC Global Asset Management Inc.

Downside risks have been magnified for some time, but have arguably grown recently, leaving an appreciably higher probability of a bad surprise relative to a happy one. A familiar set of downside risks – debt excesses, the resource shock, the emerging-market slowdown and a grab-bag of Chinese imbalances – continue to brew. Newly added to this list of concerns are rising geopolitical risks, an aging business cycle and fresh worries about the banking sector. Given all of this, it is unsurprising that risk assets such as equities and corporate bonds have suffered, and that our measure of risk appetite

Exhibit 2: Unusually slow growth in most countries Fraction of countries in the decile (%)

Economic growth has again slowed, and the bulk of the world’s countries are suffering unusually tepid expansions (Exhibit 2).

Source: RBC GAM

About 70% of countries are growing at below historically normal rates

20 15 10 5 0

<=10

10-20

20-30

30-40

40-50 50-60 Growth decile

60-70

70-80

80-90

>90

Note: Decile ranking of Q3 2015 year-over-year real GDP growth of a country relative to its historical growth from 2001 to Q3 2015. A sample of 55 countries used. Source: Haver Analytics, RBC GAM

Exhibit 3: Fading risk appetite Risk appetite index (average = 0)

Having raised our alert level last quarter, we venture further down that path this quarter, modestly reducing our equity overweight position. A mix of economic, riskdistribution and financial-market considerations have motivated this shift (Exhibit 1).

Loving Seeking

Neutral

Reluctant

-1 -2

Averse

-3 -4 1991

1996

2001

2006

2011

2016

Note: Measures risk appetite based on 45 normalized inputs. Source: Bloomberg, BofA ML, Consensus Economics, Credit Suisse, Federal Reserve Bank of Philadelphia, Haver Analytics, NedDavis, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 13

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

When investing, it is not enough to have a view on the world. It is also crucial to have a sense for where market expectations lie relative to this view. While we believe the recent financial market swoon is roughly proportionate to our diminished base-case outlook, our preference is nevertheless for a slightly diminished equity allocation given the asymmetry of risks that surround this base case. Of course, even with this reduction we remain moderately overweight equities relative to our benchmark given superior valuations and positive expected returns for the coming year.

2.5 Annual GDP growth (%)

Central banks are engaging in a familiar attempt to revive growth and enthuse financial markets via additional monetary stimulus. But they are encountering less success than usual, failing to distract financial markets from the reality of subpar economic growth, low coupons and stagnant earnings.

Exhibit 4: RBC GAM GDP forecast for developed markets

2.0

2.25%

2.00%

2.00% 1.75%

1.75% 1.50%

1.5

1.00%

1.0

1.00% 0.75%

0.5 0.0

U.K. 2016

2017

U.S.

Eurozone

Canada

Japan

Source: RBC GAM

Exhibit 5: RBC GAM GDP forecast for emerging markets

Annual GDP growth (%)

has fallen below its natural “risk seeking” state (Exhibit 3).

7.50% 7.50% 6.00% 5.75%

6 4

2.75% 2.75% 2.75% 3.00%

1.00%

0.00%

0 -1.00%

-2 -4

India 2016

China 2017

South Korea

Mexico

Russia

-3.00% Brazil

Source: RBC GAM

Downgraded growth forecasts

There are two motivations for these downward adjustments.

14 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 6: Manufacturing softens in DM and goes sideways in EM 55 Manufacturing PMI

Our economic projections have been almost universally scaled back. The developed world is now expected to grow by just 1.5% in 2016 – putting it on track for the worst performance since 2013, and notably less than 2015 growth of 1.9% (Exhibit 4). The 2016 emerging-market outlook has also been lowered, with the year now also set for less growth than 2015 (Exhibit 5).

Expansion

53 52 51 50 49 48

Contraction

47 2012 2013 JP Morgan Global PMI

2014 Developed markets PMI

2015 2016 Emerging markets PMI

Note: PMI refers to Purchasing Managers Index for manufacturing sector, a measure for economic activity. Source: Haver Analytics, RBC GAM

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Second, it makes sense that growth is slowing. Financial conditions have tightened, meaning credit spreads have widened, stocks have fallen and volatility has increased (Exhibit 9). The related concept of risk appetite has also fallen (refer back to Exhibit 3), and these developments are casting a chill over business investment. Historically, wider corporate-bond spreads have anticipated a subsequent economic slowdown (Exhibit 10). Policy uncertainty has also been growing. This impediment was a central discussion point in late 2012 as the last U.S. presidential election and a “fiscal cliff” approached, but subsequently went fallow for several years. Arguably, it is again mounting. Another U.S. election beckons in late 2016, and the American political mood seems more amenable than usual to policy views that deviate

Economic Surprise Index (1 std dev=100)

120 Positive surprises

80 40 0

-40 -80

Negative surprises

-120 Oct-10

Jun-11

Feb-12

Oct-12

Jun-13

Feb-14

Source: Citigroup Economic Surprise Index, RBC GAM

Oct-14

Jun-15

Feb-16

Exhibit 8: Evolution of GDP and inflation forecast for 2016: developed markets 2.5

Consensus forecast for inflation (%)

Whereas emerging-market growth has decelerated steadily for several years – with highly tentative indications that the swoon could be starting to flatten out – the developed-world slowdown is a more recent phenomenon and is less obviously halting. It is for this reason that we are content with generally below-consensus growth forecasts for the developed world.

Exhibit 7: U.S. economic data repeatedly miss expectations

Jan-15

Feb-16

1.5

Jan-15

1.0 0.5 0.0

Jan-15

2.0

Feb-16 0.8 U.S.

Jan-15

Feb-16

1.3 1.8 2.3 Consensus forecast for GDP growth (%) Canada Eurozone U.K.

2.8 Japan

Source: Consensus Economics, RBC GAM

Exhibit 9: Financial conditions have tightened significantly 105 U.S. Financial Conditions Index

First, we can clearly observe negative momentum in the global economy. Leading indicators have steadily soured (Exhibit 6), economic data has been surprisingly poor for a sustained period (Exhibit 7), and the consensus economic forecast is itself shifting lower (Exhibit 8).

104 103 102 Index now at six-year high

101 100 99

98 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Goldman Sachs, Bloomberg, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 15

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Shifting to a slightly longer time horizon, it is somewhat disconcerting that economic growth in the developed world has been so sluggish over the past year despite the theoretical tailwinds of ultra-low interest rates, low oil prices and weak exchange rates. There is a risk that growth could look even worse as those tailwinds eventually fade.

Rising recession risk There is a gaping difference between lowering growth forecasts and forecasting a recession. Despite

16 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

-400

-300

-200

-100 0

100

-1

200

-3

300

-5 1992

1998 U.S. GDP (LHS)

2004 2010 Credit spread (RHS, inverted)

2016

400

Corporate bond credit spread (YoY change, bps)

U.S. GDP (YoY % change)

A further friction is that low oil prices do not seem to be providing as much stimulus as was once expected. Normally, the “winners” of low oil prices – consumers and non-energy businesses – spend a disproportionate share of their windfalls, while the “losers”– oil producers and their associates – do not curtail their spending by much. Thus, low oil is traditionally a substantial net positive for economic activity. However, that benefit appears to be unusually diluted this time as consumers have chosen to save much of their newfound profits, while oil producers have cancelled or delayed almost US$400 billion in projects worldwide. As a result, the countries that are normally hurt by low oil prices are pained even more than usual, and countries helped by low oil are benefiting less.

Exhibit 10: Corporate bond spread signals slower growth

Note: Credit spread measured as spread between U.S. Baa corporate bonds and U.S. 10-year Treasuries. Source: Federal Reserve Board, BEA, Haver Analytics, RBC GAM

Exhibit 11: Global trade growth slowed, but didn’t collapse 40 World exports (YoY % change)

significantly from the status quo. European politics has already veered substantially in this direction, with a growing number of far left and far right parties grasping at power.

30 20 10 0 -10 -20 -30 -40 2001

2003 2006 Nominal exports

2008 Real exports

2011

2013

2016

Note: Year-over-year % change of 3-month moving average of world exports. Nominal exports in U.S. dollars. Source: IMF, Credit Suisse, Haver Analytics, RBC GAM

rumours to the contrary, the world is not obviously descending into a recession right now. Global trade, for instance, is still growing when measured properly (Exhibit 11). However, it is undeniable that recession risks tend to rise as base-case growth prospects dim, and this is doubly true when tail risks are growing and skewed to the downside. Our suite of recession models is sending a variety of signals. At the

most alarming end of the spectrum, some indicators, such as those coming from the stocks, corporate bonds and financial-market volatility argue that likelihood of a U.S. recession risk is around 50% over the next year. Others – such as a crowd-sourced recession gauge – suggest that the risk is still fairly low (Exhibit 12). The slope of the yield curve is a classic recession gauge, and signals that the recession risk has risen

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Big risks We believe the world is grappling with an unusually large number of downside risks and challenges (Exhibit 16). Providing tentative support for this view, an unusually flat yield curve is often a harbinger of volatility ahead.

Google search volume index

100 80 60 40 20 0 2006

2008

2010

2012

2014

2016

Note: The number of Google web searches for the term relative to the total number of searches on Google over time is scaled and normalized to arrive at the Search Volume Index for each week. Shaded area represents recession. Source: Google Trends, RBC GAM

Exhibit 13: Yield curve flattening, but not negative U.S. Treasury 3M-10Y yield spread (bps)

Another way of thinking about recession risks is via the business cycle. The developed world has now enjoyed economic growth for more than 6½ years. Historically, the average expansion is actually slightly shorter. Fortunately, this is a less daunting finding than it first seems. First, post-crisis expansions tend to be longer than usual (Exhibit 14). Second, economies usually manage to grow for a few more years after their central banks initiate a tightening cycle, much as the U.S. recently did (Exhibit 15). Third, the Fed argues that “recessions don’t die of old age” – one must look at more than just the business cycle’s age to properly gauge the likelihood of a downturn.

Exhibit 12: Google for “recession”

400 300 200 100

Yield curve flattens on growth concerns

-100 2006

2008

2010

2012

2014

2016

Source : Federal Reserve Board, Reuters, Haver Analytics, RBC GAM

Exhibit 14: Current cycle growing long in the tooth 10 Expansion length (years)

materially, especially given the bullflattening nature of the movement (Exhibit 13). But the interpretation of even this time-tested indicator is subject to dispute, depending upon whether one adjusts for the fact that yield curves tend to be unusually steep when the level of interest rates is low. Collectively, our sense is that the U.S. recession risk over the next year has risen to around 25% to 30%: elevated by any standard, and at least double the usual rate. All the same, economic growth remains distinctly more likely than decline.

6.6 years and counting...

8.4 7.4 6

5.3

4.9

4 2 0

Current

Average

After no financial crisis

After financial After shallow crisis recession

Note: Historical pattern of 13 developed economies. Source: Goldman Sachs Global Investment Research, RBC GAM

After deep recession

HE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 17

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

There are still a number of debt hot spots worth watching, especially as pressure is applied by a mix of higher borrowing costs (mainly the result of wider credit spreads rather than Fed tightening), the strong U.S. dollar, low commodity prices and the emerging-market slowdown (Exhibit 17). Areas worthy of particular attention are the high-yield oil space, commodity-oriented sovereign debt, dollar-denominated external debt and emerging-market corporate debt. None aside from high-yield oil is currently experiencing material problems, but all could. Chinese risks remain enormous, particularly the excesses apparent in the countryâ&#x20AC;&#x2122;s debt market, and evidence of a slowing economy. Emerging-market growth is now far slower than during its early millennium heyday, and the repercussions of this deceleration are still playing out, especially as it pertains to emerging-market debt. Major nations such as Russia and Brazil appear to be on track for another year of economic decline. The resource shock also continues to play out on a scale far larger than initially envisioned, and the economic and financial market implications of the decline are now ricocheting into second- and thirdorder consequences. An assortment of geopolitical risks appear to be rising in importance (Exhibit 18). European politics have become more problematic, Middle East conflicts are intensifying and the U.S. presidential election threatens

18 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 15: Historical Fed tightening timeline 28 months 16 months

Median

9 months

16 months

Median

12 months 1 month From first to last hike

From last hike to recession

Note: Top and bottom of box represent 25th and 75th percentile. Source: Federal Reserve Bank of New York, Haver Analytics, RBC GAM

Exhibit 16: Substantial downside risks Debt hot spots EM slowdown Resource shock Geopolitics

China

Maturing business cycle

Fed rate hikes Deflation

Source: RBC GAM

Exhibit 17: Global debt is vulnerable to four arrows

GLOBAL DEBT

Rising rates

Rising dollar

Slowing EM

Commodity crash Source: RBC GAM

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Overblown banking concerns Lately, some have fretted about the health of the banking sector. These concerns are probably exaggerated. Undeniably, the combination of diminished economic growth, negative interest rates and lingering non-performing European loans constitute challenges. But they do not amount to anything resembling a solvency problem. Banks have steadily increased their capital ratios since the financial crisis, and now sustain quite significant cushions (though European banks have not done as much as American ones). Their contingent convertible debt can serve as a buffer in the event of an emergency, and their assets are much more liquid. Were liquidity to nevertheless become a problem, central banks have grown adept at offering well-targeted, stigmafree liquidity. The market itself recognizes that the risk of a domino effect from one bank to another is quite low today relative to the financial crisis (Exhibit 19). We believe that recent worries about banks are primarily a confidence problem ungrounded in true liquidity or solvency issues. That said, in a worst-case scenario, a confidence problem can become a liquidity

Exhibit 18: Geopolitical events and risks Military

Multi-faceted Syria (and Iraq) battle Saudi-Iran conflict, including Yemen proxy war Russian aggressions in Eastern Europe and Syria Territorial disputes in South China and East China seas

Refugees

Failed Arab Spring and Syrian war spur migration to Europe

Terrorism

ISIS terrorist threat inclines voters toward far-right politicians

Political

Voters inclined toward far-right (or far-left) parties by

Multipolar era

China challenges U.S. economic hegemony

Disease

Zika virus worries

Consequences

Substantial downside risks for investors

economic crisis, slowing globalization, wars, refugees, terrorism and U.S. retreat from global policeman role

(though geopolitical risks are rarely a central driver)

Economic drag –– Military spending diverts from more productive uses –– Worse public policy over medium run as voters flee centre –– Multipolar eras are usually worse for globalization/growth Source: RBC GAM

Exhibit 19: Interbank lending concerns remain limited 400 350 Spread (bps)

to tilt U.S. public policy away from centre. The U.K. contemplates a divorce from the EU. The Zika virus is the latest health scare. Longer-term geopolitical complications relate to a growing militarization in Asia, and a slow shift from U.S. hegemony to an unfamiliar multipolar world.

300 250 200 150 100

A small rise in spreads

50 0 2008

2010 U.S. 3M Libor-OIS spread

Source: Bloomberg, RBC GAM

2012

2014 2016 Eurozone 3M Euribor-OIS spread

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 19

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

In this context, the era of extreme monetary stimulus remains very much ongoing (Exhibit 20). This reality comes with a mixed interpretation: it is good that central banks are still providing support to economies given the evident need, but it is disappointing that the need still exists a mind-bending seven years after the crisis peaked. Not all monetary stimulus is created equal. Central banks’ latest strategy – an experiment with negative policy rates – is recording only mixed success. Borrowing costs are being successfully lowered – a significant fraction of European and Japanese bonds now trade with a negative yield (Exhibit 21) – but risk appetite has failed to revive, 20 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Change in central bank policy rates (% raising/cutting in month)

For many years, the only centralbanking theme of any note was the delivery of ever-more monetary stimulus. Last quarter, that trend was temporarily obscured by the U.S. Federal Reserve (Fed), which initiated its first new tightening cycle in 11 years. However, further Fed tightening now looks to be delayed given economic and financial market uncertainties. Simultaneously, the Bank of Japan (BOJ) has joined a small handful of central banks, among them the European Central Bank (ECB), in dropping its policy rate below zero.

Emergingmarket led tightening

60 40

Tightening

20 0 -20 -40

Widespread easing in reaction to financial crisis

-60 -80

-100 2008

2010 % of central banks tightening Net % of banks easing

Persistent net easing

2012

Easing

2014 2016 % of central banks easing

Note: Based on policy rate for 30 countries. Source: Haver Analytics, RBC GAM

Exhibit 21: Central banks drive bond yields below zero 3 Government bond yield (%)

Central-bank stimulus

Exhibit 20: Central banks still in era of monetary easing

2 1 0 -1

3M U.S.

6M 9M Canada

3Y U.K.

5Y 7Y Germany

10Y 15Y France

20Y 25Y 30Y Italy Japan

Source: Haver Analytics, RBC GAM

Exhibit 22: Commodity supercycle 900

Commodity supply rising

800 S&P Goldman Sachs Commodity Index

problem, and a liquidity problem might eventually become a solvency problem. But such a progression is hardly automatic, and there are safeguards at every step along such a journey.

700 600

Strong EM demand growth, weak commodity supply

500 400 300 200

Financial crisis

Weakening EM demand, high commodity supply

100 0 2000

2002

2004

2006

2008

Source: S&P, Haver Analytics, RBC GAM

2010

2012

2014

2016

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

We are left with two conclusions. First, the bulk of the world’s major central banks will likely deliver additional stimulus over the next year. Second, the efficacy of that stimulus may be somewhat diluted relative to the past. The exception is the Fed, which still seeks further modest tightening in 2016 so long as the economy allows.

Exhibit 23: Disparate commodity drivers and outlook

Metal

Commodity prices remain quite low and are very volatile, but are no longer actively trending lower. Looking to the future, the specific outlook varies by commodity type. Gold occupies its own category, enjoying a temporary resurgence on renewed risk aversion. Metals prices could stay low for some time given that low prices reflect a structural hole in demand originating from China. Oil prices, on the other hand, should rebound more briskly

Demand shock

Supply shock

Poor economic signal China-driven Lengthy adjustment

Neutral economic signal OPEC/U.S. shale-driven Brisk adjustment

Source: RBC GAM

Exhibit 24: U.S. new-well productivity increased rapidly New-well oil production per rig (b/d)

Commodity supercycle The commodity supercycle came to an end over the past few years as the world transitioned from an era of unusually fast emerging-market growth and an undersupply of resources to the opposite situation on both counts (Exhibit 22). But just as the top of the commodity market proved unsustainable, today’s low prices arguably constitute an overshoot in the opposite direction.

Oil

600

Productivity growth starting to flatten

500

1500 1300

400

1100

300

900

200

700

100

500

0 2007

2010 2013 New-well oil production per rig (LHS)

Rig count (rigs)

in contrast to the great enthusiasm with which markets responded to earlier quantitative easing and ratecutting undertakings. And it is no longer automatic that a country’s currency depreciates, either.

300 2016 Rig count (RHS)

Note: Data includes 7 key regions in the U.S. which account for 92% of domestic oil production growth in 2011 to 2014. Source: EIA, RBC GAM

given oil’s roots in supply excesses that are now beginning to resolve themselves (Exhibit 23). Delving into oil prices in more detail, we can make several observations. Demand is rising nicely, and should continue to do so in response to the incentive of low prices. Current pricing is not sustainable over any sustained period of time, as it is well below the upfront cost required to justify further exploration efforts.

The U.S. remains the most likely candidate for substantially lower oil production given the sharp drop in exploration, and as outsized oilproductivity gains begin to stall (Exhibit 24). Juicing productivity by shutting down the least productive rigs was a good trick, but one that has now been largely exhausted. Working against these positive forces for oil is the fact that OPEC nations have actually increased

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 21

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

The upside risk for oil prices comes primarily from the Middle East, in two distinct forms. In one scenario, already intense conflict in the Middle East intensifies further and disrupts OPEC oil production. Given that OPEC’s excess oil supply buffer is quite low, this would quickly translate into an oil-price spike. In the other scenario, oil production is rapidly right-sized by government edict given Saudi Arabia and Russia’s recent pursuit of a coordinated production freeze. A mix of economic and financial implications extend from these market views. The economic wedge that has divided countries into oil-importing “winners” and oilexporting “losers” remains very much in place in 2016, though it should begin to ebb by the second half of the year as oil prices creep higher. For financial markets, it is a much more difficult assessment. Risk assets have lately been falling in tandem with oil prices. This seems odd. The latest bout of ultra-low oil prices was not obviously the result of problems with global demand, and even though low oil prices themselves appear to be less growth-inducing than once imagined, they are still at least a slight positive

22 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 25: China generates a dominant portion of world growth Share of world GDP growth (%)

production, with Iran set to materially boost its supply in 2016 now that it is free of sanctions. This is the main reason why the oil market’s supply-demand imbalance is unlikely to fully close in 2016. While oil prices may rise, they are unlikely to fully normalize before 2017.

45 40 35 30 25 20 15 10 5 0 1985

IMF 1990 U.S.

1995 China

2000

2005

2010

2015

2020

Note: 5-year average real GDP growth and 5-year average PPP-exchange-rate-based weights used in calculations. Source: IMF, Haver Analytics, RBC GAM

Exhibit 26: Four Chinese complications New currency regime

Stock market bubble

China worries Debt excesses

Slowing economy

Source: RBC GAM

for growth. Presuming the market interpretation becomes more logical in the future, the prospect of mildly higher oil prices would be slightly negative for global growth and thus risk assets in general.

Chinese currency concerns China remains a key market focus for a mix of structural and cyclical reasons. Structurally, Chinese economic growth is now several times more important for global growth than any other country, and

so merits attention even when all appears fine (Exhibit 25). Cyclically, China now demands doubly close scrutiny given a raft of complications that relate to its currency, stock market, debt excesses and economic deceleration (Exhibit 26). China’s currency story is not inconsequential, but neither is it as dramatic or fraught with as much risk as is generally perceived. China has allowed market forces to play

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

There is a risk that the renminbi could fall more sharply – a steeper drop would conveniently solve the country’s capital outflows and competitiveness issues in one fell swoop. But this still seems to us to be a poor bet, mainly because the government does not desire this outcome and has deployed hundreds of billions of dollars in defending the currency. China retains a reserve war chest worth trillions of dollars and so can continue in this defense for as long as it likes. Recent efforts to open up the Chinese bond market to foreign investors should encourage more inflows, and the country is clamping down on illicit outflows. China doesn’t want a weaker exchange rate for two reasons. First, the country’s diminished competitiveness is largely the result of rising Chinese wages, which also heralds the long-awaited creation of a significant domestic consumer base. Second, a significant depreciation of the renminbi would likely prompt a tit-for-tat response

RMB nominal broad effective exchange rate (2010=100)

In reality, however, there is less than meets the eye. While the renminbi has fallen by a moderate 6% versus the U.S. dollar since August, it has remained roughly flat according to the trade-weighted measure favoured by Chinese policymakers (Exhibit 27).

Exhibit 27: Chinese currency still very strong 130 125 120 115 110 105 100 95 90 85 80 2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: J.P. Morgan, Haver Analytics, RBC GAM

Exhibit 28: Stocks in mainland China trade at huge premium over identical Hong Kong shares 220

Hang Seng China A-H Premium Index

a more central role in governing its currency since August, and this has triggered large flows of money out of the country. The concern is that the renminbi could fall sharply, unleashing chaos on the world.

200 180 Mainland A-shares trade at premium

160 140 120 100 80 60 2006

Hong Kong H-shares trade at premium

2008

2010

2012

2014

2016

Source: Bloomberg, RBC GAM

from China’s neighbors, creating a problematic race to the bottom.

Chinese stocks don’t matter We continue to believe that China’s stock-market gyrations are peripheral to concerns about financial stability, and that global markets erred in responding with fear to Chinese equity-market declines earlier in the year. The weaker Chinese stock market is not a particularly useful signal of

Chinese economic troubles. It has swung between extreme strength and weakness over the past two years, never obviously reflecting any underlying trend in the domestic economy. On the contrary, the Chinese stock market seems to be embroiled in something of a speculative bubble, as demonstrated by the fact that mainland shares are roughly 40% more expensive than comparable shares available in Hong Kong (Exhibit 28).

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 23

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60 50 40 30 20 10 0 -10 -20 -30 -40 -50 -60 -70 Mar-08 Mar-10 Mar-12 NPLs YoY % change (LHS)

China’s true problems

The big question is whether these credit problems could metastasize into a full-blown financial crisis. The short answer is “probably not.” The Chinese government has the means,

24 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

6 5 4 3 2 1 Mar-14 NPLs ratio (RHS)

0 Mar-16

Note: Non-performing loans (NPLs) of commercial banks. Source: China Banking Regulatory Commission, Haver Analytics, RBC GAM

15 14 13 12 11 10 9 8 7 6 5 1995

4 3 2 1 0 -1 -2 1998 2001 GDP Growth (LHS)

2004

Economic Activity Index (standard deviations from historical norm)

Exhibit 30: China’s balancing act: slower sustainable growth

China GDP growth (YoY % change)

We have long argued that China’s credit market is far more deserving of investor concern. Analysis by the Bank of International Settlements argues that China is at the top of the list of vulnerable debtors given the astonishing rate at which the country’s private sector has leveraged up in recent years. Nonperforming loans at Chinese banks are now growing by just over 50% per year (Exhibit 29). Although the official numbers show a fairly low starting base of only 1.7% of loans in arrears, banks confess that the true figure is at least 5%. Mathematically, this would mean that Chinese banks alone are dealing with a frightening $750 billion of bad loans. Interestingly, most of these bad loans originate from heavy industrial firms grappling with lost competitiveness and excess capacity, not the much-maligned Chinese property market.

Non-performing loans ratio (%)

Exhibit 29: Non-performing loans in China rising

Non-performing loans (YoY % change)

Chinese stock-market weakness, regardless of the cause, will also impose only limited economic damage by itself. Chinese stock prices remain substantially higher than they were before late 2014, and the Chinese stock market is quite small relative to the heft of the country’s economy. This means that any negative wealth effect would deliver only a glancing blow to the economy.

-3 2007 2010 2013 2016 Economic Activity Index (RHS)

Note: Index constructed using sixteen proxies for real economic activity in China. Source: Bloomberg, Haver Analytics, RBC GAM

desire and a long history of bailing out its financial sector as the need has arisen. It has already made preparations for a similar response this time. The main consequence of these credit excesses is more likely to be the loss of economic tailwinds as credit growth ebbs and as government resources are redirected from productivity-enhancing infrastructure to bailouts. This souring of credit explains part of China’s economic deceleration

in recent years (Exhibit 30). We continue to forecast a further modest deceleration to belowconsensus growth of 6.0% in 2016 and 5.75% in 2017. But we do not see evidence of a so-called “hard landing” (defined as something on the order of a halving of Chinese growth), and it is worth noting that China has not completely lost its growth engines: the long-sought transition to a more consumer- and service-oriented economy appears to be happening, with the service

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

sector now representing more than half of China’s economic output (Exhibit 31).

Exhibit 31: China’s services sector shows strength 70

The other source of economic growth – productivity – is subject to much debate. Productivity growth is presently quite poor in most of the world. Whether it will remain perpetually weak or instead revive (Exhibit 33) was the subject of a recent Economic Compass we published that is entitled “The Future of Productivity and Innovation.” Our research concludes that productivity growth is experiencing a temporary cyclical trough that stems from lingering financial-crisis stresses. A gradual productivity revival is likely as the lingering effects of the financial crisis continue to fade. However, structural productivity considerations present a more complicated picture. A number of

60 55 % of GDP

Before venturing into the minutiae of national-level economic forecasts for 2016, let us step back for a moment and contemplate longer-term economic growth. Mathematically, economies grow by adding workers or by making workers more productive. It is widely understood that the demographic outlook has deteriorated significantly, diminishing the rate at which new workers will come on line. This has a variety of implications that range from diminished economic growth to worse fiscal prospects to low bond yields (Exhibit 32).

Services sector now accounts for over half of total GDP

Long-term asides

50 45 40 35 30 1992

1996 Services sector

2000

2004 2008 Industrial sectors

2012

2016

Source: China National Bureau of Statistics, Haver Analytics, RBC GAM

Exhibit 32: Demographic considerations for developed world Implications of demographic change – aging population + declining fertility

GDP

Roughly 1 percentage point less GDP growth per year

Fiscal

Growing fiscal imbalance that must be addressed via higher taxes or lower entitlements

Savings

Population growth shifting from “young” old (who are society’s biggest savers) to “old” old (who are significant dissavers)

Thus, demand to exceed supply Inflation

The Japanese experience argues for deflation But theory (demand > supply) argues for high inflation We split the difference and assume roughly normal inflation

Bonds

Slower economic growth and declining investor risk appetite suggest lower-than-normal bond yields

A potentially larger public debt load points in the opposite direction, but should prove the less potent factor

Equities

Slower earnings growth, slightly higher dividends and arguably similar valuations (though with considerable debate on this specific point) translate into a modestly lower equity return

Source: RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 25

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The U.S. economic outlook has undeniably dimmed, and this is reflected in the countryâ&#x20AC;&#x2122;s sour financial markets. Prominently, corporate earnings have now fallen for several consecutive quarters (Exhibit 37). The burning question

26 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

U.S. productivity growth (annual % change, 10-year average)

Railroad boom

4 3

Post-war boom

Mid-war boom

I.T. boom

1 0 -1 -2 1899

1928

1957

1986

2015

Note: Data prior to 1948 is consumption per capita growth; 1948 and later is growth of standard output per hour. Source: R. Shiller, Haver Analytics, RBC GAM

Exhibit 34: Rising intellectual property investment 28 24 Intellectual property rising as a share of capital investment

20 16 12 8 4 1954

1963

1972

1981

1990

1999

2008

2017

Note: Nominal fixed asset investment. Source: BEA, Haver Analytics, RBC GAM

Exhibit 35: Middle-income country innovation on the rise 1.5

800 700

1.2

600 500

0.9

400 0.6

300 200

0.3

100 0 1985

1989 1993 1997 Patent applications (LHS)

2001

2005 2009 2013 R&D expenditure (RHS)

Note: Patent applications and R&D expenditures of middle income countries. Source: World Bank, Haver Analytics, RBC GAM

0.0 2017

R&D expenditure (% of GDP)

U.S. dimmed but not extinguished

U.S. intellectual property investment (% of private fixed asset investment)

This analysis suggests that productivity growth should revive materially in the coming years, if not exceed the boom era of the 1980s and 1990s (Exhibit 36). While developed-world economic growth should still fall short of precrisis norms due to demographic headwinds, it need not be as poor as the recent experience. This last observation hints that the level of interest rates and the pace of corporate-earnings growth should both partially revive over time as well.

Exhibit 33: U.S. productivity waves

Patent applications (thousands)

one-time productivity tailwinds that super-charged the 20th century for the developed world are arguably fading as the positive impulses of urbanization, the widespread entry of women into the workforce and universal education have now been fully delivered. Fortunately, we think innovation itself is on the cusp of a renaissance. The queue of fascinating new scientific advances remains impressive, companies are investing in new, more productive types of capital (Exhibit 34), the internet is radically reducing the barriers to entry for clever new ideas, and middle income countries like China are beginning to join the innovation party (Exhibit 35).

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Confirming this less favourable impression, U.S. business inventories are still too high and the necessary adjustment should depress output growth for a few quarters. Recent financial tightening could chill what has otherwise been a friendly rate of credit growth. The U.S. election is also a source of unusual policy uncertainty given rising odds that the Republicans nominate the unorthodox candidate Donald Trump. But it is not all negative for the U.S. economy. On the positive side of the ledger, this year’s powerful El Nino effect promises to provide a modest boost to U.S. growth (Exhibit 39). Similarly, the U.S. job market remains solid, easily outmuscling drags in a handful of sectors (Exhibit 40). Lastly, the intensity of the dollar’s drag may be starting to fade now as its rate of ascent slows.

Contribution to GDP growth (ppt)

1.99

2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

1.75

0.09

TFP

0.36 0.44 0.04 1.10

1980-2003 Tech diffusion

0.97

0.14 0.41

0.01 0.22

0.30

0.70

0.90

2004-2014 Tech innovation Labour quality

Forecast Capital

Note: Contribution to GDP growth of thirteen major developed countries. Total factor productivity (TFP) is separated into innovation and diffusion of technology. Forecast based on RBC GAM estimates. Source: Feenstra, Inklaar and Timmer (2015), "The Next Generation of the Penn World Table" forthcoming in American Economic Review, available for download at www.ggdc.net/pwt, The Conference Board Total Economy Database, RBC GAM

Exhibit 37: S&P 500 earnings are falling

S&P 500 annual earnings per share (US$)

Until recently, our view was that the weakness in the ISM Manufacturing Index was largely a currency story, and that in contrast the non-energy, internal-facing components of the U.S. economy were still sailing along nicely (Exhibit 38). However, now the U.S. service sector hints of softness as well.

Exhibit 36: Developed-nation productivity growth should revive

Earnings hurt by oil and currency

144 72 36 18 9 1990

1993 1996 1999 Actual earnings

2002 2005 2008 Trend earnings

2011

2014

2017

Note: Y-axis in logarithmic scale. Source: RBC Capital Markets, RBC GAM

Exhibit 38: U.S. manufacturing contracting; non-manufacturing sectors still growing, but at slower rate 65 60 ISM Index

for the world’s largest economy is the extent to which this weakness is the temporary and understandable result of a strong U.S. dollar and the sharp decline in oil prices (both of which have a disproportionate effect on earnings relative to the broader economy), or instead reflects the arrival of new pernicious forces.

Expansion

55 50 45 40 35

Contraction

30 2000

2002 2004 2006 ISM Manufacturing Index

2008

2010 2012 2014 2016 ISM Non-Manufacturing Index

Source: Institute for Supply Management, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 27

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

The Fed has initiated monetary policy liftoff, but any further tightening will be ginger and as such likely no more than one or two further rate hikes over the span of the next year (Exhibit 41). We are not overly fretful that the Fed made a policy error when it raised interest rates in December. This is partially because most U.S. economic indicators support a return to cautiously positive interest rates, and partially because a single rate hike is not potent enough by itself to create serious problems for the economy (Exhibit 42).

Brexit in focus The British economy continues to follow a similar trajectory to the U.S. Both countries achieved a clear economic liftoff after the financial crisis, making them among the more successful post-crisis economies. The central banks of both countries have contemplated tightening monetary policy in recent years (though only the U.S. delivered), and both are now suffering mildly decelerating growth (Exhibit 43). There are, of course, notable differences in the factors affecting

28 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 39: Strong El Nino effect in 2015–2016 hurts Asia, helps North America El Nino effect: a warmer Pacific Ocean

Negative Drought hurts India, Indonesia, Philippines

Positive Warmer, wetter winter helps U.S., Canada

Inflation Higher food prices, slightly lower energy prices

Source: RBC GAM

Exhibit 40: U.S. job creation has been excellent despite a few lagging sectors Change in employment since July 2014 (millions)

Altogether, the new negative forces appear to outweigh the positive ones, prompting a downgrade of our U.S. 2016 growth forecast from 2.5% to just 1.75%. Whereas the old forecast was at the high end of the post-crisis experience, the new forecast is firmly at the low end. U.S. economic slack may struggle to shrink much further in this environment.

4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 Jun-14

Oct-14 Others

Feb-15 Manufacturing

Source: BLS, Haver Analytics, RBC GAM

Jun-15 Oct-15 Mining and logging

Feb-16

each economy. The U.S. grapples with a strong currency, whereas the U.K. is still embroiled in significant fiscal tightening and must now deal with the spectre of “Brexit” – the possibility that Britain will leave the EU.

right. The U.K. managed to extract more concessions from the EU than expected in recent negotiations, and the Scottish referendum of 2014 demonstrates that the status quo tends to prevail even when the polls report a dead heat.

The Brexit referendum is set for June 23. Although the polls are quite close, betting odds put the statusquo at close to twice as likely as separation. This strikes us as about

Nevertheless, Brexit is still a material risk for the U.K. The greatest consequence is likely to be in the runup to the referendum as renewed policy uncertainty impedes

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

The list of European worries is a familiar one, led by terrorism, migrants and politics. In practice, these issues are all largely one and the same: the terrorist threat and migrant influx should both be framed primarily as political issues, as they push voters toward far-from-centre political options. The consequences of this shift are medium term in

1 -1 -3

2015 -5.5

-4.5

-3.5 -2.5 -1.5 -0.5 0.5 1.5 U.S. output gap (% of potential GDP)

2.5

3.5

Note: Annual data from 1982 to 2015 shown in chart. Source: Federal Reserve Board, IMF, Haver Analytics, RBC GAM

Exhibit 42: U.S. fed funds rate Equilibrium range

24 22 20 18 16 14 12 10 8 6 4 2 0 -2

1980

1985 1990 Last plot: 0.29%

1995 2000 2005 2010 2015 2020 Current range: -1.39% - 0.79% (Mid: -0.30%)

Source: Federal Reserve, RBC GAM

Exhibit 43: U.K. economy loses steam recently U.K. real GDP (YoY % change)

Accordingly, we have downgraded our Eurozone growth expectations to 1.5% growth in 2016 and 2.0% growth in 2017.

-5 -6.5

European politics dim the medium-term view European leading indicators remain broadly favourable. Moneysupply growth signals faster economic growth (Exhibit 45), and credit growth is substantially improved (Exhibit 46). However, recent financial tightening and the newfound concerns about European banks could impede further progress.

-2

-1

-4

-2

-6 2004

2006 GDP (LHS)

2008

2010

2012

2014

-3 2016

U.K. employment (YoY % change)

We have downgraded our U.K. growth forecast to a mediocre 2.0% for 2016 and 2.25% for 2017. This is unlikely to be enough to get the Bank of England to cut rates, but any tightening is off the table for the time being as well (Exhibit 44).

Exhibit 41: Current fed funds rate is arguably a bit too low

Real fed funds rate (%)

economic activity. Were the country to opt out of the EU, it is easy to imagine a further sharp decline in the pound and intensifying risk aversion, though the U.K. would be likely to then negotiate a deal that would preserve much of the existing arrangement, akin to Norway and Switzerland.

Employment (RHS)

Note: Year-over-year percentage change of 3-month moving average of U.K. employment aged 16 and over. Source: ONS, Haver Analytics, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 29

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

30 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

1992

1998 2004 2010 2016 Current range: -1.93% - 0.65% (Mid: -0.64%)

Exhibit 45: Eurozone money supply argues for more growth 65 60 55 50 45 40 35 30 1998

2001 2004 2007 Eurozone Composite PMI (LHS)

2010

2013 Real M1 (RHS)

2016

16 14 12 10 8 6 4 2 0 -2 -4 -6 -8

Note: Real M1 has 9-month lead. Source: ECB, Markit, Haver Analytics, RBC GAM

Exhibit 46: Eurozone credit generally improving

Bank loans (YoY % change)

To be sure, there are still several indicators of relative economic success in Japan. Some progress has been made, as the Japanese labour market is now clearly tight. Also, bank lending is much improved (Exhibit 48). Structural reforms also

1986 Last plot: 0.50%

Source: RBC GAM, RBC CM

Japan goes negative The Japanese economy continues to sputter, contracting yet again in the fourth quarter (Exhibit 47). The economy has clearly not achieved the stability or velocity sought by the Abe government, and the plan for another sales-tax hike in 2017 threatens to again derail growth unless it is deferred.

18 16 14 12 10 8 6 4 2 0 -2 1980

Eurozone real M1 (YoY % change)

The ECB is clearly of the opinion that inflation and growth remain too low, and so additional stimulus is quite likely. This stimulus may be multi-faceted, coming in the form of additional quantitative easing, a deeper plunge into negative interest rates and/or an expanded set of liquidity offerings to fend off concerns about the banking sector. We still look for the euro to soften significantly further, which should provide additional economic support.

Exhibit 44: United Kingdom base rate Equilibrium range

Eurozone Composite PMI

nature, as European public policy may tilt in a less growth-friendly direction over the coming years. This political transition is arguably already underway, given Greeceâ&#x20AC;&#x2122;s far-left government, a significant tilt to the left in Portuguese politics, a leap to the far right in Poland, and a probable shift to the left in Spain in the midst of protracted party negotiations.

5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 2009

2010 Households

2011

2012 2013 Businesses

Source: European Central Bank, Haver Analytics, RBC GAM

2014

2015

2016

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Chilly Canada The Canadian economy remains weak, reflecting the continued effects of the global resource shock (Exhibit 49). The economy looks no worse than it did last year, but neither does it appear much better – particularly as consumer spending seems to now be softening. So far, low oil prices are outmuscling the benefits that theoretically accrue from a weak currency, a resilient neighbor to the south and Bank of Canada (BoC) rate cuts. This dynamic should remain in effect for much of 2016, leaving GDP growth at a below-consensus 1.0% before rebounding to 1.75% in 2017. There are still enormous regional economic variations within Canada (Exhibit 50). Our growth proxies

Real GDP (QoQ % change annualized)

12 8

Abenomics

4 0 -4 -8

-12 -16 2008

2010

2012

2014

2016

Source: Cabinet Office of Japan, Haver Analytics, RBC GAM

Exhibit 48: Japanese credit still growing decently Bank lending to private sector (YoY % change)

However, Japan’s housing market has been tepid of late, wage growth continues to underwhelm and corporate profits have tumbled now that the yen is no longer propping them up. Some of these challenges should be addressed as the BOJ delivers yet more stimulus, and we suspect the yen will begin to soften again. Altogether, we forecast that the Japanese economy will grow by an uninspired 1.0% in 2016 and 0.75% in 2017, when the tax hike is set to reduce growth and boost inflation.

Exhibit 47: Japanese growth underwhelms

4 3 2 1 0 -1 -2 -3 -4 -5 -6 2002

2004

2006

2008

2010

2012

2014

2016

Source: Bank of Japan, Haver Analytics, RBC GAM

Exhibit 49: Canadian economy still undershooting normal Canadian Economic Composite (standard deviations from historical norm)

continue, leaving some hope that the economy will be able to grow faster over the long term. Tokyo’s 2020 Olympics victory will gradually necessitate additional infrastructure in the coming years.

2 1 0 -1 -2 -3 -4 -5 2001

2004

2007

2010

2013

2016

Note: Composite constructed using four leading indicators from surveys on Canadian businesses. Source: CFIB, Haver Analytics, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 31

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Looking beyond Canada’s shortterm outlook, two thoughts occur to us. First, the prospect of higher oil prices and the beginning of the new government’s much ballyhooed infrastructure spending should permit the Canadian economy to gradually escape from present-day weakness, allowing for improved prospects in subsequent years.

Monthly GDP (YoY % change)

Ontario unusually good

8 6 4 2 0 -2 -4 -6 -8 2002

Alberta unusually weak

2004 2006 Ontario GDP proxy

2008 2010 2012 Alberta GDP proxy

2014

Exhibit 51: Canadian ex-energy exports fly on back of low loonie Prior CAD bust

Prior CAD bust Soft CAD

20 10 0 -10 -20

Ex-energy exports thrive

-30 -40 1998

2001

2004

2007

Total merchandise ex energy products

2010

2013

2016

Total merchandise

Source: Statistics Canada, Haver Analytics, RBC GAM

Exhibit 52: Canadian household debt service burden to rise Record high if rates normalize

18 16 14 12 10

8 ppt

8 6 4 2

Average effective interest rate

0 1990

1995 Principal payment

2000 2005 Interest payment

2010

2015

Note: Debt-service ratio defined as cost of interest payments on debt only. Average effective interest rate since 1995. Source: Statistics Canada, Haver Analytics, RBC GAM

32 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

2016

Note: Monthly provincial GDP estimated from available monthly economic variables, combined via principal component analysis and then regressed against annual provincial GDP. Source: Haver Analytics, RBC GAM

Canadian exports (YoY % change)

The growth outside of the oil patch is due significantly to the benefits of the weak Canadian dollar, which are now becoming more visible in the economic data. Canadian export growth excluding energy has clearly ticked higher despite the global malaise (Exhibit 51). We look for the Canadian dollar to soften further – eventually to just 1.53 versus the U.S. dollar (65 cents U.S.) – largely because of the secular uptrend in the greenback rather than Canadian-specific considerations. Amid Canada’s economic underperformance and a cacophony of other central banks delivering more stimulus, the Bank of Canada is likely to cut the overnight rate again, but probably won’t venture into outright negative interest rates as Canadian inflation is not as low as most other countries.

Exhibit 50: Alberta suffering; Ontario holding up

Debt service ratio (%)

indicate that Alberta is suffering a recession no less severe than the one that occurred in the wake of the 2008 financial crisis. In contrast, large provinces such as Ontario, Quebec and British Columbia are all clearly expanding, and arguably advancing at a slightly-better-thannormal clip.

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Emerging-market growth has slid steadily over the past several years for reasons that include weaker global demand, deteriorating productivity growth, the commodity shock and softening demographics (Exhibit 53). In aggregate, we forecast a modest further deceleration this year, motivated in significant part by the aforementioned trends. Reflecting a similar attitudinal shift in the market, consensus expectations for emerging economies have also shifted substantially lower (Exhibit 54). Some leading indicators tentatively signal that emerging-market growth could bottom in 2016, though additional confirmation is necessary before we can profess any confidence in this happening. Of course, experiences vary considerably at the national level.

CYCLICAL

COMMON

STRUCTURAL

Sluggish global demand

Slowing globalization

Debt risks

Slower productivity gains

Commodity decline

New reform era

Worsening demographics

(Exporter/Importers) INDIVIDUAL

(India, Mexico, China, Indo.)

Credit slowdown

Shifting competitiveness

(China, Brazil, etc./Others)

(China/Mexico, frontier markets)

Source: RBC GAM

Exhibit 54: Evolution of GDP and inflation forecast for 2016: emerging markets Consensus forecast for inflation (%)

Emerging economies still in slow lane

Exhibit 53: Review of EM drivers

Feb-16

9 8

Feb-16

Jan-15

Feb-16

3 2 1

Jan-15 Jan-15

-4

-3

-2

China

-1

Jan-15 Feb-16

Feb-16

0 1 2 3 4 5 Consensus forecast for growth (%)

India

South Korea

Brazil

Mexico

9 Russia

Source: Consensus Economics, RBC GAM

Exhibit 55: Investors flee emerging markets 3 Weekly EM bond fund net flows (US$ billions)

Second, Canadian household debt remains relatively high overall and has put many consumers in a precarious position. There are few signs of distress today thanks to ultra-low interest rates. However, even a moderate increase in borrowing costs would trigger an unusually high debt-servicing burden (Exhibit 52), spilling over into the housing market and likely prompting a retrenchment in consumer spending. The systemic risks are low, but this threat is likely enough to keep Canadian growth underwhelming over a five-year time horizon.

Renewed outflows

Inflow

2 1 0 -1 -2

Taper tantrum

-3 -4 -5

Outflow

-6 2010

2011

2012

2013

2014

2015

2016

Source: EPFR, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 33

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Inflation edges off the floor Inflation expectations continue to fall, raising the risk of inflation becoming stuck at a very low level (Exhibit 57). Fortunately, the decline is not quite as severe as it looks when risk premium distortions are subtracted out.

34 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Non-financial corporate debt (% of GDP)

100 95 90 85 80 75 70 65 60 55 50 2000

DM debt flattened

EM corporate debt rising rapidly

2002 2004 Developed markets

2006

Source: IIF, RBC GAM

2008 2010 Emerging markets

2012

2014

2016

Exhibit 57: U.S. inflation expectations at multi-year low U.S. 5Y5Y inflation swap forward (%)

Emerging-market debt concerns are legitimate. Substantial capital outflows are putting pressure on borrowers, though fortunately the exodus is not substantially worse than during the 2013 taper tantrum (Exhibit 55). That said, it is daunting that emerging-market corporate debt (excluding financial firms) is now larger as a share of GDP than in the developed world (Exhibit 56). The market is aware of this trend and has done a reasonable job of distinguishing between countries, but such high levels of indebtedness could yet spell trouble.

Exhibit 56: EM corporations are more indebted than their DM counterparts

3.7 3.5 3.3 3.1 2.9 2.7 2.5 2.3 2.1 1.9 1.7 2008

2010

2012

2014

2016

Source: Bloomberg, RBC GAM

Exhibit 58: RBC GAM CPI forecast for developed markets 3.0 CPI (YoY % change)

Russia and Brazil appear set for a second straight year of recession as each grapples with low commodity prices and issues of governance. Others, such as India, have sailed rather nicely around recent shoals although upward Indian growth revisions are raising eyebrows. Stylistically, we continue to believe the winners are likely to be countries that meet several of the following requirements: those that benefit from low commodity prices, those that did not extend too much credit after the financial crisis, those that have managed to sustain their competitiveness and those that are delivering substantial structural reforms.

2.5

2.25%

2.50%

2.25%

2.0

1.75%

1.5 1.00%

1.0

1.25% 0.75%

0.5 0.0

Canada 2016

U.S. 2017

Source: RBC GAM

U.K.

0.50%

Eurozone

0.50%

Japan

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Presenting an upside risk to this view, one can argue that inflation should already be higher than it currently is, based on the level of economic slack that currently prevails. For instance, the level of the U.S. unemployment rate is now sufficiently low that there should be considerably more wage growth on its way (Exhibit 59). A smattering of indicators hint that inflation pressures may be starting to catch up to the state of the economy. On the other hand, the indisputable winning strategy for inflation forecasting for several years has been to make below-consensus predictions.

Fed to proceed cautiously Some may argue that the Fed committed an error in raising policy rates in December 2015, but the Koenig-Taylor rule (Exhibit 60) – a model of the appropriate level for the fed funds rate based on inflation, growth and unemployment – suggests that the right fix for the

Subsequent year wage growth (%)

Exhibit 59: U.S. wages to grow faster in 2016 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0

Q4 2015 wage growth and unemployment rate

3.5

4.5 1985 - 2008

5.5

6.5 7.5 Unemployment rate (%) 2009 - 2015

8.5

9.5

10.5

Note: Quarterly U.S. unemployment rate and hourly earnings growth from 1985 to present. Source: Bureau of Labor Statistics, Haver Analytics, RBC GAM

Exhibit 60: Koenig Taylor rule and fed funds rate

More generally, with the exception of the Eurozone, we can celebrate the fact that inflation is now running a little bit higher than in prior quarters as the most extreme declines in commodity prices fall out of the one-year rolling window. Looking to the future, we suspect inflation can rise a little further, though it should remain low by most standards (Exhibit 58). The gains should come mainly from a modest recovery in commodity prices. Given our scaledback economic growth forecasts, we no longer anticipate significant help from a further diminishment of economic slack.

12 10 8 6 4 2 0 -2 -4 -6 -8 1990

1995 Fed Funds Rate

2000

2005

2010

2015

2020

Predicted Fed Funds Rate (Koenig Taylor Rule)

Source: Federal Reserve Bank of Dallas, RBC GAM

fed funds rate has been above zero since the spring of 2014. The latest reading of this rule suggests that a fed funds rate above 100 basis points is warranted today. That said, the recent period of heightened market volatility and rising economic uncertainty is likely to cause the Fed to proceed more cautiously in raising rates than previously expected. Prices on fed funds futures contracts suggest that the market expects at most one

more rate hike in 2016 versus the four hikes telegraphed in the Fed’s projections (Exhibit 61). The market has been right in predicting a lowerfor-longer scenario, as the Federal Open Market Committee (FOMC) has been ratcheting its fed funds rate projections downward quarter after quarter. The Fed continues to reiterate that future rate hikes will be dependent on economic data and that the path to higher rates is likely to be a gradual one. At the

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 35

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

same time, the Fed doesn’t want to fall behind the curve, placing itself in a situation where it would have to hike aggressively. As a result, the actual path to higher rates probably lies somewhere between the FOMC projections and what the market is pricing in.

36 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Nov-17

Sep-17

Jul-17

May-17

Mar-17

Jan-17

Nov-16

Jul-16

May-16

Mar-16

Jan-16

Nov-15

Sep-15

Sep-16

FOMC median projections as of Sep 2014 FOMC median projections as of Mar 2015 FOMC median projections as of Sep 2015

Source: Bloomberg, U.S. Federal Reserve, RBC GAM

Exhibit 62: U.S. 10-year bond yield Fair-value estimate composition United States Real 10-year T-bond yield

United States CPI Inflation 12.0

16 14

36-month Centred

10.0

Last Plot: 0.9% 12-Month Forecast: 1.2%

8.0

10 8

6 4 2

6.0 %

4.0

0.0 -2.0

-4

1960 1966 1973 1980 1986 1993 2000 2006 2013 2020 36-month Centred CPI Inflation Source: RBC GAM, RBC CM

Actual Monthly CPI Inflation

+1 SD

Last Plot: 0.8%

2.0

-2

-1 SD

Average: 2.1%

12-Month Forecast: 1.25% -4.0 1960 1970 1980 1990 2000 2010 2020 Real T-Bond Yield Real 10-Year Time Weighted Yield Source: RBC GAM, RBC CM

U.S. 10-year T-bond yield Equilibrium range

16 14 12 10 8 %

Although sovereign-bond yields are well-below our modeled equilibrium levels in many regions, the U.S. 10-year bond yield is trading close to where we would expect and is likely to move higher over the long term (page 45). Exhibit 62 shows the breakdown of our equilibrium model for the U.S. 10-year yield, which is composed of an inflation premium and real rate of interest. The inflation premium embedded in the model is based on a 36-month centered moving average of annual changes in CPI to smooth out short-term effects. While the inflation premium remains low, it has stopped falling and is expected to rise over the coming quarters as the disinflationary

Market-implied forecast as of February 29, 2016 FOMC median projections as of Dec 2014 FOMC median projections as of Jun 2015 FOMC median projections as of Dec 2015

Government-bond yields in Europe and Japan have plunged, spurred by renewed risk aversion, disappointing economic growth and another round of monetary stimulus. A large portion of the world’s bonds now trade at negative yields, and even jurisdictions where yields remain in positive territory are near alltime lows. An exception is U.S. Treasury yields which, while lower than several months ago, are not particularly close to all-time lows given the Fed’s foray into higher policy rates.

Jul-15

Ultra-low yields persist

350 300 250 200 150 100 50 0

May-15

Basis points (bps)

Exhibit 61: Implied fed funds rate 12-months futures contracts

6 4 2 0

1980

1985 1990 Last Plot: 1.70%

Source: RBC GAM, RBC CM

1995

2000 2005 2010 2015 2020 Current Range: 0.91% - 2.70% (Mid: 1.81%)

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

The pace of increase in bond yields may be limited through the near term as there are major global forces keeping them low. Investors’ appetite for yield remains elevated, in part because increasingly accommodative monetary policy from the ECB and the BOJ has reduced the appeal of fixed-income assets in those regions. In Germany, 10-year government bonds offer very little return if held to maturity and yields are now negative in Japan (Exhibit 63). U.S. 10-year Treasuries appear quite attractive on this basis and are actually among the highest-yielding government bonds in the developed world. As a result, demand for U.S. Treasuries from global investors is likely to remain elevated and keep a lid on how high Treasury yields can go. As long-term yields remain depressed and short-term rates have risen, the yield curve is now at its flattest level since the 2008/2009 financial crisis and indicates that

Exhibit 63: Global bond yields 10-year government bonds 1.70

1.8

1.53

1.6

1.42

1.4

1.34

1.2

1.19

1.0 0.8 0.6 0.4

0.11

0.2 0.0 -0.2

U.S.

Spain

Italy

U.K.

Canada

Germany

-0.06 Japan

Source: Bloomberg, RBC GAM

Exhibit 64: U.S. Treasury yield curve Spread between yield on 10-year and 2-year maturities 4

Maximum historical spread: 2.81%

3 2 1 %

impact of falling energy prices fades. The second component of the model, the real rate of interest, could also contribute to rising nominal yields. Through the use of a trailing 10-year time-weighted average, we have tried to reflect investors’ “adaptive expectations” bias, giving a larger weight to more recent history. As a result, the more recent experience of negative real rates in 2011-2013 has pulled our modeled level lower. That said, the eventual normalization of the economy and passage of time should eventually lead to real rates rising towards their long-term average.

0 -1 -2 -3 1980

1986

1992

Recession

1998

2004

2010

2016

Max Range

Source: Bloomberg, RBC GAM

the risk of recession may have increased. Exhibit 64 shows that the yield curve, as measured by the spread between 10-year and 2-year yields, usually inverts prior to a recession. A slowdown in the economy would cause the Fed to delay monetary tightening or even reduce short-term rates, so investors have priced in this possibility through lower long-term bond yields. While the curve remains far from inversion, past flattening trends have brought about increased volatility

in equity markets with a 30-month lag (Exhibit 65). A steepening of the yield curve and subsequent calming of market volatility will likely occur if economic growth improves.

Signs of stress Credit spreads have ballooned over the past year as the price of oil – arguably the world’s most important commodity – has collapsed. The Energy sector was the first area of the market to feel the stress of the oil collapse as revenues declined

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 37

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

38 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

70 50

VIX last plot: 19.5

40 30

Index level

-1%

3% 1990

1994 1998 Recession periods VIX (RHS)

2002 2006 2010 2014 2018 U.S. 10yr-2yr spread (LHS, inv, adv 30 months)

Source: Bloomberg, RBC GAM

Exhibit 66: BofAML U.S. High Yield Master II Index Government option adjusted spread HY Energy peak (2016/02/11): 1984 last plot: 1609

2000 1800 1600

HY Index peak (2016/02/11): 887 last plot: 775

1400 1200 1000 800 600

Long-term average: 580 bps HY ex Energy

400 200 Dec-13

peak (2016/02/11): 746 last plot: 671

May-14

HY Index

Oct-14 HY Energy

Mar-15

Aug-15

HY ex Energy

Jan-16

Jun-16

Long-term average

Source: BofAML, RBC GAM

Exhibit 67: Corporate bond spread and U.S. leading economic indicators 20

-400

-300

-200

-100

-5

100

-10

200

-15

300

-20 1980

1984 1988 1992 1996 2000 2004 2008 2012 2016 U.S. LEI Index (LHS) Baa Corporate yield minus 10-year T-bond yield (inverted, RHS)

Source: The Conference Board, RBC GAM, ISI

400

Y/Y change (basis points)

Corporate credit spreads can also be useful in forecasting equity-market movements. Exhibit 69 illustrates how corporate-bond spreads trade closely with the inverse of the S&P 500 Index. Through both the bursting of the technology bubble in 2000-2002 and the global financial crisis in 2008-2009, credit spreads widened as the S&P 500 Index declined, and narrowed as equities and the economy recovered. The relationship appears intact, with stress in credit markets anticipating the recent volatility in stocks. An

-2%

Basis points (bps)

The damage to credit markets is consistent with slowing economic data and deteriorating corporate profits. Exhibit 67 plots the yearover-year change in the U.S. Leading Economic Indicator Index against the year-over-year change in corporatebond spreads. The U.S. LEI Index slowed at the same time as the widening in spreads. A similar relationship is observed between corporate-bond spreads and S&P 500 corporate-profit growth (Exhibit 68). To generate a sustained turn in credit spreads, a better tone to economic and corporate-earnings data is essential.

Exhibit 65: U.S. yield curve vs. VIX volatility

Y/Y % change

and balance sheets became stretched. Funded largely through credit markets, this sector made up as much as one-fifth of the U.S. high-yield market in 2014 and concern about the sectorâ&#x20AC;&#x2122;s solvency has dragged down the BofA Merrill Lynch US High Yield Index (Exhibit 66). The erosion of high-yield credit spreads was initially isolated to energy but has more recently extended to other sectors.

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

The S&P 500 Index is now decidedly below fair value, largely due to a lack of corporate-profit growth over the past year. Exhibit 71 shows a standardized version of our fairvalue model. The midpoint of the chart is the product of our measures of â&#x20AC;&#x153;normalizedâ&#x20AC;? earnings and an equilibrium P/E (exhibits 72 and 73). These two factors are a function of 12 equations that combine actual and forecast interest rates, inflation, and corporate profitability. While the current 12-month trailing P/E is slightly above equilibrium, stocks are currently below fair value because reported earnings have fallen well below normalized earnings. Without earnings growth,

Basis points

200 300 400 500 600 700 800 1980

1984 1988 1992 1996 2000 2004 2008 2012 2016 Baa Corporate yield minus 10-year T-bond yield (inverted, LHS) S&P 500 earnings (RHS)

100 80 60 40 20 0 -20 -40 -60 -80 -100

Source: RBC CM, RBC GAM

Exhibit 69: Corporate bond spread and S&P 500

Basis points

Reflecting the increasing risks to the global economy and the worsening conditions in credit markets, global stock markets have undergone a significant downward adjustment. Many regional equity indexes (including Canada, Europe, U.K., Japan, emerging markets) entered bear markets in early 2016, with peak-to-trough declines in excess of 20%, and moved stocks in those regions to attractive valuation levels (page 46). As a result, our global stock-market equilibrium composite extended its distance below fair value to levels not seen since mid2012 (Exhibit 70).

0 100

700

-400

600

500

400

800

300

1200

200

1600

100 0 1998

2000 2001

2004

2007

2010

2013

2016

Baa Corporate yield minus 10-year T-bond yield (LHS) - Last plot: 358 S&P 500 (inverted, RHS) - Last plot: 1932

Source: RBC GAM, ISI

Exhibit 70: Global stock market composite Equity market indexes relative to equilibrium 100 % above/below fair value

Stock market malaise

Exhibit 68: Corporate bond spread (inverted) vs. S&P 500 earnings

YoY % change

improvement in credit conditions, indicated by a durable narrowing of credit spreads, is among the factors that would help sustain a turnaround in equity markets.

80 60 40 Last plot : -20.6%

20 0 -20 -40 -60 1980

1985

Source: RBC GAM

1990

1995

2000

2005

2010

2015

2020

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 39

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

S&P 500 earnings peaked in December 2014 and analyst expectations have been constantly revised downward since then (Exhibit 74). The strengthening U.S. dollar and the fall in oil prices were responsible for approximately onethird and two-thirds, respectively, of the reduction in S&P 500 earningsper-share estimates. Our view is that the negative impact on earnings of the strong U.S. dollar and falling oil prices will begin to recede. The U.S. dollar has actually traded sideways since March 2015 versus a basket of other major currencies (Exhibit 75), and any further appreciation in the dollar should take place at a slower pace than has been the case since 2014. As for the Energy sector, the bulk of the impact on S&P 500 earnings from the declines in Energy sector profits may be over, since the group now makes up a much smaller portion of the earnings pool. According to consensus estimates, the Energy companies are now expected to contribute only US$2.30 to S&P 500 EPS in 2016, down about 80% from US$12.50 in 2014 (Exhibit 76). Should oil form a bottom and stabilize going forward, there is a possibility that Energy company earnings could even surprise to the upside.

Potential outcomes for stocks Investors, of course, could lose confidence in the absence of a rebound in corporate earnings, potentially leading to further 40 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 71: Standardized S&P 500 fair value bands

S&P 500 most overvalued

+1 SD FV -1 SD

S&P 500 most undervalued

1960

1967

1974

1981

1988

1995

2002

2009

2016

Source: Haver Analytics, RBC CM, RBC GAM

Exhibit 72: S&P 500 earnings comparison 256 128 64 32 16

Current Reported Earnings: $104.81 Current Trendline Earnings: $116.08 Current Normalized Earnings: $126.82

8 4

2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Trendline Earnings Actual Earnings Normalized Earnings Source: RBC GAM, RBC Capital Markets

Exhibit 73: S&P 500 Index Normalized (equilibrium) price/earnings ratio 35 30 25 X

it will be difficult for stocks to get back to or above fair value.

20 15 10 5 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 +/- 1 Standard Deviation from Equilibrium P/E P/E on Trailing 12 Mths Earnings +/- 2 Standard Deviations from Equilibrium P/E Source: Bloomber, RBC GAM

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Potential returns for the S&P 500 span a wide range in this unstable investing environment. Exhibit 79 presents the possible outcomes for the S&P 500 based on various earnings estimates and P/E scenarios. With trailing 12-month earnings at US$104.80 and, assuming the market trades at ¾ of a standard deviation below equilibrium P/E as in an average bear-market scenario outlined above, the S&P 500 would reach 1535.96 for a further decline of approximately 20% based on February’s closing level. However, we should not ignore the upside potential for stocks if the economy expands as we expect and corporate-profit growth rebounds. In this scenario, P/E ratios would

Consensus earnings estimates ($US)

Exhibit 74: S&P 500 Composite Index Consensus earnings estimates 160 155 150 145 140 135 130 125 120 115 110 2011

2012

2013

2014

2015

2016

2017

Source: Thomson Reuters, Bloomberg

Exhibit 75: U.S. trade weighted major currency dollar 100 95 90 85 80 75 70 65 2010

2011

2012

2013

2014

2015

2016

2017

Source: Bloomberg, RBC GAM

Exhibit 76: S&P 500 Energy earnings Actuals and bottom-up consensus estimates Contribution to S&P 500 EPS ($)

declines in equity valuations. We conducted an analysis of S&P 500 P/E multiples during previous bear cycles to gauge what a more meaningful downturn in the S&P 500 might look like. Dating back to January 1960, there have been 14 bear-market cycles (Exhibit 77). On average, bear cycles start with normalized P/Es around ½ of a standard deviation above equilibrium and, while the current cycle started a bit lower than that, P/Es did reach ½ of a standard deviation above equilibrium in late2015 (Exhibit 78). Should the S&P 500 undergo a similar bear scenario, the normalized P/E would fall to ¾ of a standard deviation below equilibrium from the current level of ¼ of a standard deviation, resulting in lower stock prices.

12.5

12 10 8

2.3

2 0

5.4

5.0

2013

2014

2015

2016

Note: actual data for 2015 and prior, consensus estimates for 2016 onward. Source: Bloomberg, RBC GAM

2017

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 41

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

trade closer to equilibrium and could even expand with a pick-up in risk appetite. Assuming that the market generates the consensus 2016 top-down earnings estimate of US$121.70 and trades at an equilibrium multiple of 17.7, the S&P 500 would reach 2155.94 by yearend, which would represent a total return of 14% based on the index close on February 29, 2016. Should risk appetite increase and valuations expand to ½ of a standard deviation above equilibrium, the market could rise to 2403.86 for a total return of 26% over the next 10 months!

Are the new styles here to stay? The recent correction in equities has triggered a style rotation. Investors have positioned their portfolios defensively and market breadth has narrowed since early 2015. As a result, large and mega-cap stocks had consistently outperformed small- and mid-cap stocks since that time (Exhibit 80). The concentration in a few mega-cap stocks provided support to the S&P 500 while the S&P 600 and S&P 400 indexes both entered bear markets. In recent weeks, we have seen a reversal of the trend, with small/mid-cap stocks outperforming mega caps. A rotation from growth into value may also be underway. For most of the past two years, growth stocks have outperformed value stocks (Exhibit 81), as investors favoured companies that have demonstrated the ability to consistently deliver earnings growth in a challenging 42 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 77: S&P 500 P/E during bear cycles All bear cycles

Assume current cycle started May 2015

Average normalized P/E at start of cycle (SD)

0.57

0.21

Average normalized P/E at end of cycle (SD)

-0.75

0.18

Average change in normalized P/E from start to end of cycle (SD)

-1.32

-0.04

Number of cycles

Note: Based on monthly data since January 1960. SD = standard deviations from equilibrium. Source: RBC CM, RBC GAM

Exhibit 78: S&P 500 Index Normalized (equilibrium) price/earnings ratio +2 SD +1 SD +½ SD EQ -½ SD -1 SD

-2 SD

2005

2007

2009

2011

2013

2015

2017

Source: RBC CM, RBC GAM

Exhibit 79: E arnings estimates & alternative scenarios for valuations and outcomes for the S&P 500 Index CONSENSUS

+1 Standard Deviation

ACTUAL

2016 Top down

2016 Bottom up

Trailing 12 months

P/E

$121.7

$119.6

$104.8

21.8

2651.8

2604.7

2283.0

+0.75 Standard Deviation

20.8

2527.8

2483.0

2176.3

+0.5 Standard Deviation

19.7

2403.9

2361.2

2069.6

Equilibrium

17.7

2155.9

2117.7

1856.1

-0.5 Standard Deviation

15.7

1908.0

1874.2

1642.7

-0.75 Standard Deviation

14.7

1784.1

1752.4

1536.0

13.6

1660.1

1630.7

1429.2

-1 Standard Deviation

Source: Bloomberg, Thomson Reuters, RBC GAM

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

Global economic growth has been sluggish and, while we donâ&#x20AC;&#x2122;t see a recession on the horizon, the risks to our outlook have increased. Credit spreads are wider than normal, U.S. lending conditions are tightening and the downward trend in corporateprofit estimates has yet to stabilize. In this environment, we recognize the need to be more cautious and have lowered our economic growth forecasts accordingly. Highly accommodative central-bank policies have pushed bond yields in many regions near historic lows â&#x20AC;&#x201C; even breaking the zero bound in a growing number of cases. Although economic conditions are likely to remain uninspiring, they should still allow for a gradual normalization in interest rates. From these low levels, even a modest increase in yields acts as a significant headwind for fixed-income returns. The capital loss from a mere 15-basis-point increase in the U.S. 10-year yield would offset coupon income and any further increases would generate negative total returns over the next year (Exhibit 82). Our fixed-income models reinforce a bleak picture of expected returns

105 104 103 102 101 100 99 98 97 96 95 Jan-15

Apr-15 Jul-15 S&P 100 Mega Cap Index S&P 400 Mid Cap Index

Oct-15 Jan-16 Apr-16 S&P 600 Small Cap Index

Source: Haver Analytics, RBC GAM

Exhibit 81: Growth to value relative performance S&P 500 Growth Index / S&P 500 Value Index Cumulative relative performance

Asset Mix

Exhibit 80: Relative strength to S&P 500 Index Rebased to 100 as of Jan 1, 2015

16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% 2013

2014

2015

2016

Source: Bloomberg, RBC GAM

Exhibit 82: U.S. 10-year Treasury Required move in yields for break-even return against 30-day T-bill 50 45 Basis Points (bps)

economic environment. During the recent correction, however, there has been a shift from growth to value. While it is too early to tell whether this is sustainable, a shift to value stocks could signal that investors are more confident that economic growth will improve.

40 35 30

Last Plot: 15

25 20 15 10 2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: RBC CM, RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 43

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

EXHIBIT 83: Asset-class forward returns

Asset class

Current return1

U.S. Treasury Bill

0.11%

1-year forward return

2-year* forward return

3-year* forward return

5-year* forward return

10-year* forward return

U.S. 10 Year Treasury Bond

(0.93%)

(3.49%)

(2.33%)

(1.69%)

(0.56%)

0.35%

Canada 10 Year Government Bond

(11.92%)

(14.52%)

(8.21%)

(5.50%)

(3.04%)

(1.09%)

U.S. Investment Grade Bond**

15-year* forward return

20-year* forward return

3.53%

3.25%

2.21%

2.12%

2.61%

3.06%

Canada Investment Grade Bond**

(5.44%)

(6.01%)

(2.62%)

(0.98%)

0.58%

1.83%

U.S. High Yield Bond***

17.98%

24.81%

15.73%

13.16%

11.64%

10.72%

U.S. Stocks (S&P 500) Total Return

16.17%

37.03%

23.72%

18.03%

14.11%

11.25%

10.29%

9.81%

Canadian Stocks (TSX) Total Return

38.95%

47.04%

27.38%

17.87%

14.06%

11.20%

10.22%

9.71%

If market moves to equilibrium. *Annualized returns **Bank of America ML Indexes, assuming long-term reversion to normal spread to T-bond, evenly through to end date Source: RBC GAM, Bloomberg 1

in government debt. Exhibit 83 shows prospective forward returns for various asset classes based on the assumption that they return to our estimate of equilibrium over the specified time frames. The expectation of higher yields causes total-return estimates to be especially unattractive for sovereign bonds. We maintain an underweight position in fixed income as a result. Following a downward adjustment in price, the long-term return potential for stocks has become more attractive, but we have to balance this against an increase in the downside risks. Equities remain below our estimate of fair value in the U.S. and, on this same

44 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

basis, stocks are considerably more attractive in Canada, Europe, the U.K. and in emerging markets. Should the economy perform in line with our base case scenario, corporate-profit growth is likely to resume and stocks should move higher in the months and quarters ahead. However, we cannot ignore the damage that has been done to economic data, credit spreads, earnings and market breadth. Until we see an improvement in these indicators, the risk of a further decline in stocks is elevated, and some factors could darken the outlook further (China, Europe, weak corporate earnings). For these reasons, we have maintained our

overweight in equities, but reduced the allocation by 2 percentage points, moving the proceeds to cash as a buffer in this time of heightened volatility and uncertainty. For a balanced, global investor, we currently recommend an asset mix of 60% equities (strategic neutral position: 55%), and 37% fixed income (strategic neutral position: 43%), with the balance in cash.

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

GLOBAL FIXED INCOME MARKETS U.S. 10-Year T-Bond Yield Equilibrium range

Eurozone 10-Year Bond Yield Equilibrium range 18

12 10

2 0

1980

1985

1990

Last Plot: 1.70%

1995

2000

2005

2010

2015

2020

Current Range: 0.91% - 2.70% (Mid: 1.81%)

1980

1985

Source: RBC GAM, RBC CM

1995

2000

2005

2010

2015

2020

Current Range: 0.95% - 2.12% (Mid: 1.54%)

Source: RBC GAM, RBC CM

Japan 10-Year Bond Yield Equilibrium range

Canada 10-Year Bond Yield Equilibrium range

14 12

10 %

6 4

8 6

0 -2

1990

Last Plot: 0.58%

1980

1985

1990

Last Plot: -0.06%

1995

2000

2005

2010

2015

2020

Current Range: 0.78% - 1.64% (Mid: 1.21%)

Source: RBC GAM, RBC CM

1980

1985

1990

Last Plot: 1.19%

1995

2000

2005

2010

2015

2020

Current Range: 1.74% - 3.36% (Mid: 2.55%)

Source: RBC GAM, RBC CM

U.K. 10-Year Gilt Equilibrium range 18 16 14 12 %

10 8 6 4 2 0

1980

1985

1990

Last Plot: 1.34%

1995

2000

2005

2010

2015

2020

“The eventual normalization of the economy and passage of time should eventually lead to real rates rising towards their long-term average.”

Current Range: 0.06% - 2.07% (Mid: 1.06%)

Source: RBC GAM, RBC CM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 45

Global Investment Outlook | Eric Lascelles | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

GLOBAL EQUITY MARKETS S&P 500 Equilibrium Normalized earnings and valuations

S&P/TSX Composite Equilibrium Normalized earnings and valuations

Feb. '16 Range: 1649 - 2754 (Mid: 2201)

5120 2560

Feb. '16 Range: 13962 - 20924 (Mid: 17443) Feb. '17 Range: 14786 - 22158 (Mid: 18472) Current (29-February-16): 12860

25600

Feb. '17 Range: 1947 - 3251 (Mid: 2599) Current (29-February-16): 1932

12800

1280

6400

640

3200

320 160

1600

800

40 1960

1970

1980

1990

2000

2010

400 1960

2020

Source: RBC GAM

1970

1980

1990

2000

2010

2020

Source: RBC GAM

Japan Datastream Index Normalized earnings and valuations

Eurozone Datastream Index Normalized earnings and valuations

1040

520

5760

Feb. '16 Range: 1689 - 3635 (Mid: 2662) Feb. '17 Range: 1802 - 3878 (Mid: 2840)

2880

Current (29-February-16): 1351

1440 720

260

360 130

Feb. '16 Range: 291 - 855 (Mid: 573)

180

Feb. '17 Range: 308 - 906 (Mid: 607) Current (29-February-16): 415

65 1980

1985

1990

1995

2000

2005

2010

2015

90 1980

2020

Source: Datastream, Consensus Economics, RBC GAM

U.K. Datastream Index Normalized earnings and valuations 26880 13440

1985

1990

1995

2000

2005

2010

2015

2020

Source: Datastream, Consensus Economics, RBC GAM

Emerging Market Datastream Index Normalized earnings and valuations

Feb. '16 Range: 5292 - 10146 (Mid: 7719) Feb. '17 Range: 6294 - 12067 (Mid: 9180) Current (29-February-16): 4582

Feb. '16 Range: 239 - 434 (Mid: 336) 640

6720

320

3360

160

1680

Feb. '17 Range: 250 - 453 (Mid: 351) Current (29-February-16): 200

840

420 210 1980

1985

1990

1995

2000

2005

2010

Source: Datastream, Consensus Economics, RBC GAM

46 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

2015

2020

20 1995

2000

2005

Source: Datastream, RBC GAM

2010

2015

2020

GLOBAL FIXED INCOME MARKETS

V.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

Global government bond yields have been heading lower, with US$5.1 trillion, or one-quarter, of the high-quality government fixedincome market trading at negative yields (Exhibit 1). While many commentators attribute the latest rally to a temporary flight to quality, our belief is that low yields have become a semi-permanent feature of developed-market economies. Central banks have, since the financial crisis, prescribed endless doses of ultra-accommodative monetary policy in an effort to restore the economic successes characteristic of the period between 1980 and 2007. Global growth, however, has been on the low side of historical averages (Exhibit 2) and disinflation pressures continue to climb (Exhibit 3). Our view is that central banks will continue to intervene so long as disinflation pressures remain. The latest sign that disinflation continues to stump central banks occurred on January 29, when the Bank of Japan (BOJ) followed the European Central Bank (ECB) in implementing negative interest rates, buckling under pressure to revive growth and inflation. We are sceptical that negative-interest-rate

% of bonds with negative yields

Suzanne Gaynor

100 90 80 70 60 50 40 30 20 10 -

100

57 45

$5.1 trillion

Switzerland Germany

Japan

Sweden

Denmark

Source: Citigroup WGBI, March 4, 2016

Europe Developed (ex-Germany) World

Exhibit 2: Growth in advanced economies is slower than in the past 6 Advanced economies GDP y/y %

Senior Portfolio Manager RBC Global Asset Management (UK) Limited

Exhibit 1: US$5.1 trillion/25% of government bonds are trading at negative yields

1980-2007 average 2.9%

4 3 2

2011 onwards average 1.6%

1 0 -1 -2 -3 -4 1980

1985

1990

1995

2000

2005

2010

2015

Source: Haver Analytics

Exhibit 3: Disinflation pressures are building 5.0% Advanced economies CPI y/y

Soo Boo Cheah, CFA

4.0% 3.0% average: 1.8%

2.0% 1.0% 0.0% -1.0% -2.0% 1994

1997

2000

2003

2006

2009

2012

2015

Source: Haver Analytics

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 47

Global Fixed Income Markets | Soo Boo Cheah, CFA | Suzanne Gaynor

The question then becomes: why are central banks continuing to pursue ultra-loose monetary policies? We see two reasons. First, high private-sector debts built up over the past two decades threaten to destabilize the banking system and choke off credit (Exhibit 5), and these developments could lead to bankruptcies, high unemployment and a loss faith in the monetary system. The second reason for central-bank vigilance is the refusal of governments to enlist fiscal tools, such as infrastructure spending and tax reform, that would help create the economic growth needed to support high debt levels. Until political constraints to such measures can be overcome, central banks will continue to try to hold down interest rates. Investors recognize the limits of monetary policy to engineer an exit from the low-growth, low-inflation conundrum, and rightly expect a bumpy ride for asset prices over the next 12 months. Charles Gave of Gavekal, a research firm in Hong Kong, contends that the extended period of low interest rates 48 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 4: NIRP brings down bond yields

10-year bond yields (%)

3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 Jul-2013

Japan

Jan-2014 Jul-2014 Jan-2015 Denmark Germany

Jul-2015 Sweden

Jan-2016 Switzerland

Source: Haver Analytics

Exhibit 5: More painful adjustments to come after years of prosperity via borrowed money 350 Debt built-up (2000=100)

policies (NIRP) in Japan and Europe will be any more successful than the U.S. Federal Reserveâ&#x20AC;&#x2122;s (Fed) eightyear experiment with near-zero rates. Relying on monetary tools alone to generate growth is the triumph of hope over experience. The only thing that ultra-low rates achieve is to put downward pressure on bond yields across all maturities (Exhibit 4), which while making debt loads easier to carry, delays the likely onset of a broad deleveraging.

300 250 200 150

Outstanding Domestic Debt (trillion) Local Ccy. ($) 2000 2015 2015 U.S. 25.9 59.5 59.5 U.K. 3.0 8.7 12.8 Euro-area 22.7 47.7 51.8 Canada 2.5 6.5 4.7 Japan 2,755 3,254 27.1

100 50 0 1996

1998 U.S.

2000 2002 2004 2006 2008 U.K. Euro-area Canada

2010 2012 Japan

2014

Source: Haver Analytics

is not the cure for the developed worldâ&#x20AC;&#x2122;s malaise. He instead argues in a somewhat extreme view that ultra-low rates are the very thing holding back the global economy. Gave borrows from the 19th-century Swedish economist Knut Wicksell, who theorized that excessively low interest rates prompt investors to direct capital away from promising long-term investments toward ventures that rely on the too-low rates for their success. According to this theory, low rates will lead

to lower productivity over time, and a lower rate of economic growth, disinflation and the further accumulation of unproductive debts. Unfortunately, the easy-money policies of the developed world were exported around the globe in the wake of the financial crisis, endangering the economies of countries and regions less prepared to deal with the fallout. Freeflowing, low-cost capital found its way into emerging economies,

Global Fixed Income Markets | Soo Boo Cheah, CFA | Suzanne Gaynor

The endless tide of low interest rates and central-bank asset purchases has also made a mess of the financial systemâ&#x20AC;&#x2122;s plumbing, increasing its vulnerability to wider swings in asset prices. The foundation of modern developed-market banking systems is the willingness of banks to accept high-quality collateral such as government bonds and mortgagebacked securities in exchange for short-term financing. To keep a lid on interest rates, central banks are buying up these high-quality bonds at the same time as new regulations prompt banks to scale back overnight lending in the repo market. The effect is a potential overall decline in the availability of market collateral and subsequent decrease in the amount of financing available in the event of a financial crisis. A widespread shortage of collateral creates an environment where big asset-price declines are required to get trades completed. Perhaps we are at the stage where weak economic growth and disinflation have become structural issues that central banks can no

Exhibit 6: Japanese employers have had a hard time filling job vacancies

Job on offers to applicants ratio

3.0 Smoothed: 6-month average

2.5 2.0 1.5 1.0 0.5 2001

2003

2006

2008

2010

2013

2015

Source: Haver Analytics

Exhibit 7: Japan cannot generate wage inflation despite a tight labour market 2

Smoothed: 3-months average

1 Wage growth yoy %

where cheap debt funded rapid economic expansion and predictable overinvestment. These economies now have excess capacity that has driven down prices of goods and commodities. Investors fear that the number of defaults in these economies will escalate, imperilling the global credit system and inviting further policymaker intervention, and reinforcing the global disinflation cycle.

0 -1 -2 -3 -4 -5 -6 2001

2004

2007

2010

2013

2016

Source: Bloomberg

longer address by themselves. Fiscal policy may be needed to pick up the slack, as a historically low U.S. unemployment rate of 4.9% masks what is happening under the surface in labour markets. With official unemployment so low, wage pressures should be creating inflation at this stage of the business cycle. The opposite is true, as economy-wide spending is reduced by a falling labour-participation rate and the substitution of low-paying service jobs for relatively high-wage

union jobs in manufacturing. Japan is a good example of how strong demand for labour and weak wage growth can co-exist: employers have for years had a hard time filling job vacancies and expect the situation to worsen (Exhibit 6). At the same time, those employers have found it strangely unnecessary to raise wages (Exhibit 7). If Japan, one of the worldâ&#x20AC;&#x2122;s most services-oriented economies, cannot wring inflation from extremely tight labour markets, can others be expected to?

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 49

Global Fixed Income Markets | Soo Boo Cheah, CFA | Suzanne Gaynor

Global central banks are clearly unsettled by the fact that their intervention has so far failed to ward off disinflationary pressures, and, in our view, could be sowing the seeds of financial instability. Negative interest rates should, in theory, pressure savers to take their money from the bank and either spend it on goods and services or invest it in higher-risk assets such as stocks and corporate bonds. The goal is to get money circulating so it can stimulate economic activity. For this to work, central banks must be willing to penalize savers to such a degree that it becomes uneconomical to save, and assumes that any political backlash would not be too severe. But have central banks thought about the potential fallout if negative interest rates fail? Another financial meltdown and ensuing bailout would be measured in trillions of dollars of new government bonds – bonds that almost certainly would be issued with significantly negative coupons.

Direction of rates Volatility in government-bond markets rocketed last year to levels experienced only a few times since the 1980s. Such volatility is psychologically exhausting for fixedincome investors, who are receiving minimal nominal returns from their investments while being forced to endure significant market swings. The investor earning 7% on a bond in a tempestuous market is less likely to fret than the investor who is earning 1%. When markets unexpectedly fall, the 1% investor instantly feels the pain of loss. 50 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

In the short term, we expect government-bond yields to bottom out and then move somewhat higher as volatility subsides. However, yields should trade at the lower end of recent ranges over 2016 as central banks in Europe and Japan reinforce their commitment to holding down yields, and their easing policies weaken the Fed’s resolve to extend interest-rate hikes. The BOJ’s decision to implement negative-interest-rate policy prompts us to trim our bond-yield forecasts across the board. We expect funding costs in Japan and Europe to go further into negative territory over our forecast horizon. We expect the Fed to continue tightening, albeit at a much slower pace. The Bank of England (BOE) is likely to leave interest rates where they are given the ECB’s preference for negative rates and concerns surrounding the possibility that Britons will vote to leave the EU in a referendum. We expect the ECB and BOJ to extend their asset-purchase programs and further cut policy rates. We look for the Bank of Canada (BOC) to cut its benchmark interest rate by a further 25 basis points. Assuming that volatility settles down in the shorter term, investors will likely take time to re-assess their devotion to government bonds, which while offering capital gains and safety in times of financial distress, also represent a nearguaranteed loss of purchasing power at current yields if held to maturity. We like government bonds for their

safety in a crisis, but recognize that any normalization of economic conditions would likely make them among the worst-performing investments as rising yields would wipe out their meagre coupon income. Government bonds, then, may not be the “risk-free” assets that they appear to be. U.S. – We expect the Fed to continue to message a higher fed funds rate, based on a new model that suggests the short-term rate is too low for an economy operating at full capacity and with inflation of at least 2%. The model, which has been cited to justify the Fed’s tightening bias, was developed by Thomas Laubach, a director of the Fed board of governors, and John Williams, president of the San Francisco Fed regional bank. To maintain confidence, the Fed will continue to assure investors that it plans to keep the size of its balance sheet unchanged. We are reducing our 12-month fed funds rate forecast to 0.75% from 1.00%. That suggests one or two rates hikes over the next 12 months instead of the two or three we had expected. This revision recognizes that aggressive easing by other major central banks in effect tightens Fed policy. Negative interest rates around the world are adding to the allure of Treasuries, attracting capital from investors in the Eurozone and Japan seeking relatively safe assets with a positive yield. Our outlook is for 2.25% on the 10-year bond in a year’s time, 25 basis points lower than our previous forecast.

Global Fixed Income Markets | Soo Boo Cheah, CFA | Suzanne Gaynor

Germany – Bund yields should stay near historical lows as inflation remains subdued and the ECB signals policy-rate cuts further into negative territory. The interestrate differential between 10-year Treasuries and bunds should rise to 175 basis points in favour of Treasuries from the current 150. Bunds will continue to be supported by ECB asset-buying and the fiscal surplus in Germany, which does not have to issue net new debt. We are reducing our policy-rate forecast to -0.20% from -0.10%. Our forecast for the 10-year yield stays at 0.50%. Japan – The BOJ shocked the market with its announcement of negative interest rates in January, as it had consistently denied that it intended to act in such a way. In practice, however, the BOJ’s version of negative interest rates is a compromise, as it applies only to new bank reserves created by central-bank bond purchases and will not penalize existing deposits, which make up about half of household financial assets. While the BOJ will not immediately penalize savers, we fear that the plan may backfire by encouraging the Japanese, already renowned for their propensity to stash cash, to save even more given expectations of falling interest income. Moreover, negative interest rates will have little impact on Japanese corporations because it has been the poor economic outlook, not the lack of funding or the cost thereof, that has damped capital spending.

INTEREST RATE FORECAST: 12-MONTH HORIZON Total Return calculation: February 24, 2016 – February 25, 2017 U.S.

3-month Base

2-year

5-year

10-year

Horizon 30-year return (local)

0.75%

1.30%

1.75%

2.25%

3.00%

(0.25%)

(0.20%)

(0.25%)

(0.10%)

High

1.50%

2.20%

2.65%

3.00%

3.60%

(4.74%)

Low

0.13%

0.25%

0.80%

1.25%

2.10%

4.44%

Change to prev. quarter

(0.98%)

Expected Total Return US$ hedged: (0.81%) GERMANY

3-month

2-year

5-year

10-year

Horizon 30-year return (local)

Base

(0.20%)

0.00%

0.05%

0.50%

1.05%

Change to prev. quarter

(0.10%)

(0.01%)

(0.05%)

0.00%

(0.10%)

(2.36%)

High

0.05%

0.50%

0.75%

1.25%

1.65%

(8.13%)

Low

(0.50%)

(0.25%)

0.00%

0.40%

3.66%

Expected Total Return US$ hedged: (1.51%) JAPAN

Horizon 30-year return (local)

3-month

2-year

5-year

10-year

Base

(0.20%)

(0.10%)

0.00%

1.15%

Change to prev. quarter

(1.57%)

(0.25%)

(0.30%)

(0.25%)

(0.50%)

(0.35%)

High

0.05%

0.10%

0.50%

0.75%

1.70%

(8.13%)

Low

(0.50%)

(0.35%)

(0.20%)

0.60%

4.82%

Expected Total Return US$ hedged: (0.54%) CANADA

3-month Base

2-year

5-year

10-year

Horizon 30-year return (local)

0.25%

0.50%

0.80%

1.35%

2.25%

(0.25%)

(0.40%)

(0.25%)

High

0.75%

1.25%

1.50%

2.25%

3.00%

(7.39%)

Low

0.00%

0.20%

0.25%

1.25%

7.94%

5-year

10-year

Change to prev. quarter

(1.19%)

Expected Total Return US$ hedged: (1.51)% U.K.

3-month Base

2-year

Horizon 30-year return (local)

0.50%

0.60%

1.20%

1.75%

2.50%

(0.50%)

(0.80%)

(0.65%)

(0.30%)

High

1.25%

1.60%

2.25%

2.75%

(5.58%)

Low

0.00%

0.40%

1.00%

2.00%

6.19%

Change to prev. quarter

(0.79%)

Expected Total Return US$ hedged: (0.43%) Source: RBC GAM

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 51

Global Fixed Income Markets | Soo Boo Cheah, CFA | Suzanne Gaynor

We are decreasing our yield forecast for the 10-year JGB to 0%, 50 basis points lower than our previous forecast. Our policy-rate forecast declines to -0.20% from the current level of -0.10%. Canada – The BOC’s decision to leave interest rates unchanged in January surprised some investors and pushed up the Canadian dollar. Governor Stephen Poloz said the decision was based primarily on concern that recent Canadian-dollar weakness could lead to excessive inflation. Poloz is lucky to be able to take his foot off the monetary pedal, since Prime Minister Justin Trudeau has promised a federal fiscal stimulus package in the new budget slated for presentation on March 22. Since any fiscal stimulus would take some time to work its way through the economy, we expect one more rate cut within the next 12 months. Our expectation for one BOC rate cut – while the Fed could hike once or twice – means that Canadian yields should fall while U.S. yields rise, resulting in Canadian bonds outperforming. Moreover, international demand for Government of Canada bonds should remain strong as the country offers safety with its AAA sovereign credit rating, stable political climate and strong financial system. We are reducing our forecast for the 10-year government-bond yield to 1.35% from 1.75% last quarter. The forecast for the policy rate declines to 0.25% from 0.50%.

52 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 8: Yields are decent around the world for U.S. dollar investors CURRENCY HEDGED YIELD

10-Year yield

Local yield Feb-24

US$ Investors

JPY Investors EUR Investors

C$ Investors

U.S.

1.71

0.45

1.63

U.K.

1.37

1.57

0.32

1.49

Canada

1.10

1.18

(0.07)

1.10

Japan

(0.06)

1.20

(0.06)

1.12

Germany

0.15

1.34

0.08

1.26

France

0.51

1.70

0.44

1.62

Spain

1.62

2.81

1.56

2.74

Italy

1.54

2.73

1.47

2.65

Denmark

0.48

1.74

0.48

0.55

1.66

Swiss

(0.41)

1.57

0.30

0.36

1.49

Source: RBC GAM

U.K. – BOE Governor Mark Carney has said explicitly that a rate hike is off the table for 2016. We take Carney at his word, since the ECB is contemplating further rate cuts and there is uncertainty surrounding whether the country will choose to remain in the EU. Any indication that Britons will vote to pull out would tend to push yields lower because of concern that a withdrawal could lead to safe-haven demand, at least initially, as well as a short-term negative effect on U.K. economic growth. In the overnight derivative market, investors are looking for a rate cut from the BOE in 2016 and no hike until 2020. We are reducing our 12-month forecast for the 10-year gilt to 1.75%, 65 basis points lower than in the previous quarter. Our policy-rate

forecast is marked down by 50 basis points to the current 50 basis points, reflecting the reversal that has taken place since last quarter.

Regional preferences We recommend that fixed-income investors remain neutral in their regional allocations, as it appears likely that coupon returns on Treasuries will be matched by capital gains on Japanese government bonds and Eurozone bonds when yields fall further in those areas. While yields are negative or low on an absolute basis in Japan and the Eurozone, yields are still decent for investors whose returns are hedged into U.S. dollars (Exhibit 8). This group of investors benefits from negative funding rates, while the U.S. is offering a higher absolute and relative re-investment rate.

CURRENCY MARKETS Dagmara Fijalkowski, MBA, CFA Head, Global Fixed Income & Currencies (Toronto & London) RBC Global Asset Management Inc.

Daniel Mitchell, CFA Portfolio Manager RBC Global Asset Management Inc.

Taylor Self, MBA Analyst RBC Global Asset Management Inc.

Exhibit 1: U.S. dollar cycles 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 -1,000

You don’t know where you’re going until you know where you’ve been. It has now been almost five years since the start of the U.S. dollar bull market and, by and large, this cycle is following a similar script to previous ones (Exhibit 1). In a typical bull market, the U.S. dollar appreciates 40% to 60% over a span of seven years or so. This cycle has now met the lower end of the historical range in terms of magnitude, but has yet to grow long in the tooth. We expect further strength from the greenback. On a trade-weighted basis, the U.S. dollar is only mildly overvalued (Exhibit 2). As a result, valuations should not yet pose too stiff a headwind to further greenback appreciation. As investors, we remember that richer levels for the U.S. dollar mean diminished long-term return potential, and this correspondingly lowers our appetite for currency risk. At this point, we would continue to use countertrend moves to add to long dollar positions, but recognize that trades need to be smaller and more tactical,

-500

1978 - 1985

500 1,000 1,500 Days into USD Bull Market 1994 - 2002 2011 - Present

2,000

2,500

Sorce: Bloomberg

Exhibit 2: U.S. dollar purchasing power parity 150 140 130 120 110 100 90 80 70 60

U.S. Trade-Weighted Dollar

00 PPP

20% Bands

Source: Deutschebank

reflecting the worsened risk-reward on offer. Another factor we consider is that while bottoms of dollar cycles have been long and drawn out, the tops have tended to be left behind almost as quickly as they were made and were far less predictable. In both previous tops, interventions were involved. Insofar that much has been made of the impact of a stronger U.S. dollar

on everything from S&P 500 profits, to the costs of servicing emergingmarket corporates’ dollar debts, to, closer to home, near-usurious prices for cauliflower, we don’t think similar intervention is imminent. To be sure, while the tops of dollar cycles can be quick, we don’t think the current bull market is quite ready to meet its end. All things considered, we are somewhere in the middle-to-late innings.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 53

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Beyond the dollar, the preeminent concern in currency markets is the outlook for the renminbi. The view that China might significantly devalue the renminbi has become increasingly commonplace after policymakers tentatively loosened their grip on the currency back in the summer. To be fair, the 1.5% one-day move in August that precipitated this concern was poorly communicated and jarred global financial markets. However, that same move would hardly bear mentioning against the January gyrations of the euro, yen and pound. It is not clear that China is facing the pressures necessary to prompt a more significant devaluation. While the oft-highlighted pace of financial outflows is substantial, so is China’s current-account surplus. The trump card, moreover, is China’s stock of international reserves, which is large by almost any measure. The view that a substantial devaluation is in the offing has stubbornly gained steam despite the renminbi being recommended to become the fifth member of the IMF’s Special Drawing Right in November and the paramount desire of policymakers for stability. Some have speculated that a sudden, one-off devaluation would let China “get ahead” of depreciatory pressures on the renminbi. Others believe that it could provide a

54 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 3: Chinese capital flows 100

Capital inflows

50 USD Billions

The rise of the “redback”

0 -50 -100

Capital outflows

-150 Jul-10 May-11 Mar-12 Capital Flow Estimate*

Jan-13

Nov-13

Sep-14

Jul-15

May-16

*Net FX Settlements by banks on behalf of clients. Source: National Bureau of Statistics of China

much-needed recapturing of competitiveness for the export sector, which until only recently was suffering from having the renminbi pegged to a rising dollar. We don’t believe the calculus is quite so clear-cut. Any advantage gleaned from a competitive devaluation is likely to be erased quickly as most of the country’s regional competitors would follow suit. More broadly speaking, a significant devaluation by China would not be inconsequential. Considering the tempest created last August, we think such a step would be more of a case of mutually assured economic destruction than the unilateral achievement of a sustainable competitive advantage. Rightly or wrongly, the apparent threat of devaluation has caused capital to flee the country (Exhibit 3). The fact that Chinese citizens are shipping money out of China is hardly a new development – we have long heard and read about

persistent Chinese demand for real estate in Sydney and Vancouver. However, August’s sudden devaluation has caused the flows to both broaden and accelerate. Local businesses, for example, are finding inventive ways to keep or move money offshore, such as through loans to subsidiaries or by inflating invoices for imported goods and services. They are also repaying their foreign-currency loans, fearful that the servicing of these debts will become only more onerous. This acceleration in capital flows presents a policy dilemma for Chinese authorities. While they are committed to gradually moving towards a more freely floating currency and wish to bolster the renminbi’s credentials as a reserve currency, they are also greatly inclined towards maintaining stability – a goal that is not entirely divorced from the first two commitments.

Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA | Taylor Self, MBA

The laws of finance dictate that a country cannot guarantee a fixed currency while also maintaining free movement of capital and independent control of monetary policy. China is no different. This so-called “impossible trinity” is such that only two of the three may be chosen. In other words, if China were to fix its exchange rate and allow free capital flows, then it would lose the ability to set monetary policy according to the needs of the domestic economy. We consider a return to a pegged currency arrangement to not be a palatable option. Once re-pegged, reserve managers could effectively trade renminbi exposures for U.S. dollars and bear none of the then even-greater devaluation risk. On the flipside, an outright devaluation of any significant size would also indubitably impair the adoption of the renminbi among global reserve managers – as much so or more than a re-pegging. We are optimistic that China, in moving toward a more freely floating currency, chose the best course from a list of difficult options. We would be very surprised if the People’s Bank of China (PBOC) raised interest rates in order to defend the currency, a move that would put a damper on growth at a time when stimulus is a much more fitting policy response. It is also unlikely that policymakers will unravel much of their financial liberalization efforts by re-introducing too-strict capital controls. In fact, they are doing the

Exhibit 4: China’s new currency basket 110 105 100 95 90 85 Mar-14

Sep-14 CFETS Band

Mar-15 CFETS Basket

Sep-15

Mar-16

Source: China Foreign Exchange Trade System

opposite. As we went to press, the PBOC announced the opening up of the Chinese bond market to foreign institutional investors. Immediately, the move reinforced the argument that reform efforts remain a priority, and the long-term implications of the decision will be significant. China possesses the second-largest bond market globally. In a world where about US$5 trillion of sovereign bonds trade at negative yields, there should be significant interest in Chinese bonds from institutional asset managers such as pension funds, mutual funds and insurance companies, which collectively manage US$107 trillion. The opening of China’s bond market is the best step that policymakers could have made to earn the renminbi true reservecurrency status. The end result of all of the above is a policy choice to permit an increasingly flexible exchange rate. This is consistent with the change

in currency regime to a managed float against a basket, which was formally unveiled in December. A consideration of the renminbi’s stability against the basket suggests that this policy change actually occurred much earlier in the year (Exhibit 4).

So where does that leave us? In the long term, we expect persistent capital outflows from China to be the norm. When official reserves are excluded, the country has very few international assets compared with other emerging- and developed-market countries. This largely reflects the legacy of capital controls. As these are loosened, Chinese businesses and households are expected to continue to increase their holdings of international assets. The flows will not be one way, and foreign investors will continue to be attracted to China. In the near term, however, authorities are faced with difficult choices about how to manage their

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desire for stability and greater internationalization of the renminbi against the reality of substantial capital outflows. In our view, the current mismatch between significant Chinese outflows and foreign inflows that face slowly receding impediments to entry will be plugged by a combination of the current-account surplus and continued drawdowns of international reserves. However, the outward pace will eventually slacken while greater inward flows should start to materialize. Longer term, we are certain that the foreign-owned share of the Chinese bond market will be higher than current estimates of 2%. To summarize, we find ourselves observing a nascent elevation of the renminbi to international reservecurrency status that, while rocky, continues to proceed apace. Calls for the “redback” to challenge the U.S. dollar as the reserve currency of choice are obviously overblown in the near term, and the selling of Chinese reserves necessary to maintain stability in the face of the current outflows ironically will extend the bull run of the greenback. Looking back over the 2003 to 2013 period, we see that the era of dramatic growth in the stock of global reserves coincided with a long period of U.S. dollar weakness (Exhibit 5). This relationship illustrates the powerful influence on currencies from reserve managers selling dollars to diversify into other reserve currencies such as the euro,

56 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 5: U.S. dollar and global reserve growth 105

40%

100

30%

20%

10%

80 75

-10%

-20%

65 2003

2005 2007 2009 Trade Weighted U.S. Dollar (LHS)

-30% 2011 2013 2015 Reserve Growth (12m Chg, RHS)

Source: Bloomberg, IMF COFER

yen and pound. Now, as China draws down its reserves, this process is happening in reverse. With the decline in global foreign-exchange reserves, we can expect persistent selling pressure on other reserve currencies – a necessary action to prevent their weight within the reserve pool from rising. This at least partially explains why, even though the U.S. dollar cycle technically turned upwards in 2011, it was not until reserves started contracting in earnest in 2015 that the dollar uptrend really gained steam. So even though valuations for the U.S. dollar are stretching into overvalued territory, there is still room for dollar appreciation as long as reserves continue to decline and, if we’re right about China, this is not going to change anytime soon.

The euro We cannot say the same thing about appreciation prospects for the euro. Since the last Global Investment

Outlook, the single currency has frustrated our call for an eventual move to parity against the U.S. dollar. The strength of the euro has not been driven by a fundamental improvement in the fortunes of the Eurozone. Instead, periods of euro strength have coincided with riskoff sentiment, as illustrated by the currency’s negative correlation to U.S. equities. This relationship may seem to run counter to the idea that the single currency’s status as a safe haven was permanently marred by the multiple chapters of the Eurozone debt crisis. However, it is a function of the fact that being short the euro is a popular trade and equity investors have increasingly hedged their European exposure. When riskoff sentiment hits, investors trim their largest positions – in this case euro shorts. At the same time, they must reduce the size of their hedges by buying back euros in step with falling equities.

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We have written extensively about the outlook for both continued and greater easing from the ECB and our view remains the same. After disappointing markets in December with less-than-expected easing, the ECB left policy unchanged at its January meeting. However, the door behind which further easing resides clearly lies more than slightly ajar. The pause in the easing cycle fulfilled two purposes for ECB President Mario Draghi. For one, it served to placate some of the more reticent members of the Governing Council. It will also permit Draghi to arm himself with new staff forecasts in time for the March meeting where he can use them to drive home his desire to do more. And more is exactly what we expect from the ECB. In January, Draghi referred to the fact that, even compared with early December, the expected path of inflation had shifted “significantly lower.” Moreover, inflation dynamics in the Eurozone were markedly “weaker

Exhibit 6: Expected paths of Federal Reserve and European Central Bank

Normalized to Current Policy Rate

To be sure, we continue to expect that the combination of policy divergence between the European Central Bank (ECB) and the U.S. Federal Reserve (Fed), capital outflows and the decline in global reserves mentioned above will conspire to guide the euro lower versus the greenback. With this in mind, stronger risk correlations afford us opportunities to add to short euro positions during riskoff episodes.

3.0

Fed Funds rate path - 3m ago

2.5 2.0 1.5

Current Fed Funds rate path

1.0

ECB deposit rate path - 3m ago Current ECB deposit rate path

0.5 0.0 Feb-16

May-16

Aug-16

Nov-16

Feb-17

May-17

Aug-17

Source: Bloomberg

than expected.” This reflects external factors such as renewed weakness in oil prices, softening external demand, as well as the appreciation of the euro on a tradeweighted basis. While the impact of oil and currency movements would not normally attract the concern of policymakers attending to an inflation target in the medium term, the increased volatility of market-based measures of inflation suggests that expectations are becoming divorced from the ECB’s inflation goal of “below, but close to, 2%.” With the ECB’s policy rate already well into negative territory, deviations from the ECB’s inflation target present a particular pickle. When interest rates start to reach their effective lower bounds, the room for a central bank to effect an easing of policy is afforded not by ever-more rate cuts but by the degree to which policymakers can raise expectations of future inflation.

So, while the ECB can reasonably be encouraged by the improvement in the Eurozone’s economic prospects, the nearly unabated march lower of inflation expectations leads us to believe that the next move for the Governing Council is almost inexorably towards further easing in some form. Additional easing should return some impetus to growing the policy divide between the ECB and the Fed. We can observe that the expected path of policy rates for the latter has been dramatically affected over the past quarter (Exhibit 6), with markets pricing essentially no hikes from the Federal Open Market Committee (FOMC) until sometime in 2017. This change in sentiment has, if only temporarily, taken some of the wind out of the sails of policy divergence. Nevertheless, little if anything in Fed Chair Yellen’s Congressional testimony or in U.S. economic data suggests that expectations should have been revised down so sharply. So, while an adjustment in the path

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In addition to the impact on policyrate differentials, the ECB’s easing should prompt continued financial outflows from the Eurozone as foreign and domestic investors balk at the paltry rates offered on European fixed-income instruments. Such portfolio outflows, which are running near a €500 billion annual pace, are necessary to counteract the Eurozone’s large current-account surplus (Exhibit 7). Looking ahead, we expect this important source of capital flows to persist as European investors shift their portfolios abroad in search of higher returns, while the ECB continues to purchase large quantities of assets. The decline in international reserves is also an important factor leading the euro lower. As reserve managers sell assets, they must also sell euros in order to keep their currency allocations unchanged. We know from IMF data that the euro’s share of reserves is around 25%, meaning that if reserves fall by about US$1 trillion, euro selling would be in the range of €250 billion – not an insignificant sum. What is more, reserve managers have been reducing their allocations to the single currency, adding to the need to sell euros (Exhibit 8). In summary, we do not think that the euro’s recent resilience has unseated

58 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 7: Eurozone basic balance of payments 5% Percentage of GDP

of the ECB is likely to be minimal, the prospect of this divergence widening again as the Fed’s rate path is moved higher should provide enough material to spur a weaker euro.

3% 1% -1% -3% -5% 2003

2005 2007 Portfolio Investment Current Account Balance

2009

2011 2013 Direct Investment Basic Balance of Payments

2015

Source: Eurostat

Exhibit 8: Euro share of global reserves 30%

25%

20%

15% 1999

2001

2003

2005

2007

2009

2011

2013

2015

Source: COFER

fundamental arguments for a weaker euro. We expect the single currency to move towards parity with the U.S. dollar over the next year.

The yen In a startling move in January, Japan became a card-carrying member of the negative-interest-rate club, joining the Eurozone, Denmark, Sweden and Switzerland. We have long maintained that the Bank of Japan (BOJ) would eventually need to

push forward with more aggressive easing in order to meet its inflation target. However, we thought any easing would first occur in the form of increased asset purchases – not least because Governor Kuroda had repeatedly ruled out any consideration of negative rates. The abrupt change of heart reminds us strongly of what transpired before the Swiss National Bank shocked markets by dropping the franc’s floor about a year ago.

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Turning to valuations, the yen remains very cheap, even after accounting for the currency’s recent rally (Exhibit 9). However, as long as the BOJ maintains its distinct easing bias, we are willing to downgrade the importance of valuations.

Exhibit 9: USDJPY purchasing power parity 350 300

JPY cheap

250 200

The adoption of negative rates is all but an official admission by the BOJ that the use of quantitative easing alone to generate higher inflation has failed. The presupposed primary transmission channel of negative rates is through currency weakness. In Japan, we feel it might be slightly different due to the high level of cash holdings in the economy. These holdings may be relatively immune to the impact of lower bond yields and high stock prices caused by BOJ purchases of government bonds and equity ETFs. The threat of negative deposit rates gives Governor Kuroda a much more powerful tool.

2017 and this level of participation is already reducing liquidity in the country’s government-bond market. Meanwhile, the BOJ has effectively been forced to abandon its timeframe for a return to 2% inflation, something it has failed to achieve since announcing the explicit target more than three years ago.

The move to cut interest rates into negative territory by another major central bank has raised wider concerns regarding both the consequences of such policies and the simple fact they were required due to the inability of policymakers to generate meaningful inflation. The BOJ has now purchased over ¥200 trillion of government bonds since April 2013 and owns around 37% of the Japanese government bond (JGB) market, raising the prospect that quantitative easing may be reaching its technical limits. At the current rate of purchases, the BOJ will own more than 50% of the JGB market by the end of

The BOJ may not be able to generate inflation, but lower Japanese bond yields should continue to spur financial outflows from Japan. As in the Eurozone, such outflows are necessary to counter a large and growing current-account surplus. The impact of the US$1.2 trillion Government Pension Investment Fund’s (GPIF) rapid rebalancing into foreign assets has been almost exhausted. But follow-on flows from other asset managers could eventually dwarf those of the GPIF, while occurring at a more moderate pace. Investment mandates can be slow to change, and developing the capabilities and infrastructure

150 JPY expensive

100 50

79 82 USDJPY

88 91 PPP

00 03 20% Bands

Source: Deutschebank

required to manage significant overseas assets will take time. Outside of the monetary-policy realm, Japan’s economy faces rising headwinds in the shape of stalling reform momentum. Prime Minister Abe’s “three arrows” suffered a fresh setback in January as the policy’s chief architect, Economy Minister Akira Amari, was forced to resign due to a bribery scandal. Amari’s resignation comes at an inauspicious time for the government, as the country is scheduled to head for important elections this summer. All told, impetus for further reform efforts is likely to slow down. Softening economic data through the end of last year has stirred speculation that the already once-delayed consumption-tax hike scheduled for April 2017 should be postponed yet again. This lack of meaningful reform progress will keep the prerogative for supporting growth firmly with the BOJ.

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Given the current backdrop, we continue to expect a weaker yen and forecast a level of 133 against the U.S. dollar in 12 months. The currency’s sharp rally has disquieted policymakers in Japan and even raised the spectre of direct intervention in the currency market by the Ministry of Finance. We would forecast an even weaker yen, but we are wary of already stretched valuations. Far from instilling confidence that policy will remain accommodative, Governor Kuroda’s latest salvo in his bid to generate 2% inflation – at some point – has instead served to undermine the confidence of investors in the BOJ. What we do know is that central-bank policymakers have demonstrated their resolve to do “whatever it takes” and, unlike their counterparts at the ECB, appear keen to retain the power to surprise.

Sterling One of the reasons that we had been more constructive on the British pound was that the Bank of England (BOE) has been riding the coattails of the Fed on the path towards policy normalization. Indeed, over the past couple of years, the U.K. was arguably closer at times to tightening than any major central bank, including the Fed. While we still believe the BOE to be nearest the Fed in terms of position in the policy cycle, BOE Governor Mark Carney and the rest of the Monetary Policy Committee (MPC) have clearly

60 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 10: Market-implied months until first rate hike for BOE and Fed 60 50 40 30 20 10 0 2013

2014 Fed: 0.0 months

2015

2016

BoE: 38.2 months

Source: Morgan Stanley

fallen off the pace set by Chair Yellen (Exhibit 10). Part and parcel of the widening gulf between the BOE and Fed has been the fact that inflation in the U.K. has remained stubbornly low, tamped down by falling oil prices and also from cheaper imports given the pound’s strength. This disinflation dividend has created cover for the MPC to keep policy looser for longer. The sectoral composition of job creation has also prevented wage growth from accelerating markedly, even as the labour market has consistently outpaced the central bank’s forecasts. In any case, more pressing considerations have moved onto the BOE’s policy horizon. The first of these considerations is the impending EU referendum, which is due to be held in June of this year. Prime Minister David Cameron returned from a European Commission meeting in mid-February with a deal that granted significant concessions to the U.K.’s original

membership obligations, particularly on the sensitive issue of workplace benefits for immigrants. With a deal agreed upon, attention is turning to what will almost certainly be an acrimonious referendum campaign. The referendum will pit as many as half of the members, including many cabinet members, of Mr. Cameron’s ruling Conservative party against the official government position. Polls suggest that the opposing sides of the issue are basically in a dead heat (Exhibit 11), although the percentage of uncommitted voters is high at about 15%. In an early setback to the “in” campaign, influential Tory politician Boris Johnson stated that he would oppose the deal. While the inner workings of British politics are beyond the scope of this article, the gyrations of the referendum campaign will certainly impinge on sterling’s prospects should the experience resemble the run-up to last year’s Scottish referendum. If anything, the question being put to Britons is

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In addition, the U.K. is faced with one of the heaviest fiscal drags in the Organization for Economic Cooperation and Development due to the government’s continued efforts to roll back public expenditures. This fiscal retrenchment will present a clear headwind to economic activity. The BOE is again likely to err on the side of easier rather than tighter monetary policy in order to cushion the blow. In the longer term, we believe a weaker pound will be necessary to balance the U.K.’s external accounts. Britain is running a historically large current-account deficit, which is composed mostly of the negative income balance (Exhibit 12). What this represents is the U.K. paying out greater returns on foreigners’ assets in the U.K., while the income U.K. investors receive on their assets abroad has fallen. Recent research has examined this phenomenon, which seems to be the result of the U.K.’s external assets being concentrated in resource extraction and financial services, both of which have struggled in recent years.1

Exhibit 11: U.K. referendum polls 50 45 40 35 30 25 20 15 10 5 0 Apr-14

Remain

Leave

Undecided

Jul-14

Oct-14

Jan-15

Apr-15

Jul-15

Oct-15

Jan-16

Source: Yougov

Exhibit 12: U.K. current-account balance 4% Percentage of GDP

even more existential to the U.K.’s economic and financial standing. The uncertainty generated by the possibility of a fundamental redrafting of the relationship with the U.K.’s most important trading partner, the EU, will likely not manifest itself positively.

2% 0% -2% -4% -6% -8% 1960

1965

1970

Income Balance

1975

1980

1985

1990

1995

Goods and Services Balance

2000

2005

2010

2015

Current Account Balance

Source: Office for National Statistics

The net effect of the deterioration in the current account is that the pound is more subject to the “swing” factor of portfolio flows, which can be fickle. For now, the funding of the current account is not of paramount concern as the U.K. has been a major beneficiary of the flows forced out of Europe by the ECB and, along with strong direct investment, has left

the basic balance of payments well inside positive territory (Exhibit 13). However, barring an adjustment in the external accounts, the necessary rebalancing will be through a weaker pound. The stage is therefore set for softer sterling. With this in mind, we are lowering our forecast for the pound to 1.35 from 1.51. The considerable

Hamroush, S., Hendry, R., Hardie, M. (2016): “An analysis of Foreign Direct Investment, the main driver of the recent deterioration in the UK’s Current Account”, Office for National Statistics

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 61

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The Canadian dollar We are increasingly being asked whether the loonie is due for a continued rebound as it has already strengthened in recent weeks from below 69 U.S. cents. We cannot rule out Canadian-dollar strength in the middle of a U.S. dollar bull market – currency markets are no different than others in that they can have significant countertrend moves. Nevertheless, we continue to see fundamental reasons for the currency to trade lower. Before constructing our outlook for the Canadian dollar, we feel we must confront the popular idea that as goes oil, so goes the loonie. We believe that the Canadian dollar could easily reach new lows even if oil prices start to recover. Our opinion is built on a simple analysis of history and our own experience. Significant periods of time have passed where the loonie either moves in the opposite direction to

62 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Exhibit 13: U.K. basic balance of payments

Percentage of GDP

uncertainty generated by the referendum means the pound could even descend near the 1.20 level before rebounding towards our forecast, assuming the “ins” have it on referendum day. Once longerterm forces prevail, the fact that the MPC and Governor Carney are still closest to the Fed in terms of policy normalization than any other major central bank should secure the pound’s outperformance on a relative basis, particularly versus the euro.

25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% 1999

2003 Portfolio Investment Current Account Balance

2007

2011 Direct Investment Basic Balance of Payments

2015

Source: Office for National Statistics

Exhibit 14: USDCAD purchasing power parity 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80

USDCAD

PPP

20% Bands

Source: Deutschebank

crude, or even exhibits little to no relationship at all. The loonie is undervalued but not yet at the extremes (Exhibit 14). The Canadian currency occupies what we consider to be a valuation “no man’s land” – cheap, but not cheap enough. Currencies tend to overshoot to extreme overvalued and undervalued levels, and it is at these points that the attraction of fair value, and thus our confidence in

such measures, rises. Now is not one of the times when valuation matters, and we will surely revisit extremely undervalued levels before the end of this dollar cycle. Turning to monetary policy, the Bank of Canada (BOC) is faced with a twospeed economy. The economies of provinces primarily occupied with the extraction of commodities are, at best, stuck in neutral but, more realistically, plunging. For the rest

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All the while, expectations for further easing from the Canadian central bank are quite high. BOC Governor Stephen Poloz indicated late last year that the effective lower bound for Canada might not be zero, as previously suggested, but negative 0.50%. Negative interest rates in the Eurozone and Japan have raised the possibility that Canada may not be far behind. However, barring a more drastic downturn in the economy, we expect that they are happy to remain on hold for the time being. One of the reasons for standing pat is that, relative to the Eurozone and Japan, which are battling deflation risks, Canada enjoys a relative surfeit of inflation. Both headline and core price measures continue to bump up against the BOC’s target (Exhibit 15). PriceStats, a daily measure of inflation provided by State Street, suggests that inflation could head higher still. The other reason is the loonie, which has weakened a lot without the Governing Council having to do very much. Currency weakness acts as the classic shock absorber for Canada by improving the competitiveness of firms in foreign markets and shifting consumer demand from imports towards domestically produced goods. However, insofar as this easing can offset some of the economic pain

Exhibit 15: Inflation in Canada 5% 4% 3% 2% 1% 0% -1% -2% 2000

2002

2004

2006

Headline Inflation

2008

2010

Core Inflation

2012

2014

2016

Target

Source: Statistics Canada

Exhibit 16: Canadian dollar and manufacturing employment 2,500

Thousands

of the country, a weaker currency and loose policy from the BOC is beneficial, but slow to provide stimulus.

1.75

2,300

1.60

2,100

1.45 1.30

1,900

1.15

1,700

1.00

1,500

0.85

1,300 1976

1981

1986

1991

1996

2001

Manufacturing Employment, 2 year lag (LHS)

2006

2011

0.70 2016

USDCAD (RHS)

Source: Bank of Canada, Statistics Canada

felt in the oil sector, its effects will manifest at a much slower pace (Exhibit 16). This adjustment is not automatic. Canada lost not only competitiveness during the “strongloonie” years, but also suffered the destruction of capacity as businesses either closed outright or moved production abroad. An illuminating statistic is the share of U.S. automotive imports provided

by Canada and Mexico through time. In the 1990s, Canada clearly outstripped Mexico in importance. By 2015, the roles had been reversed (Exhibit 17). The BOC will be keen to see if some of this lost capacity will start to return, buoyed by newfound competitiveness. However, these trends are hard to reverse. Take the example of shifting an automobile factory to Mexico. The movement of such an

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64 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

35% 30% 25% 20% 15% 10% 5% 0% 1990

1993 Mexico

1996

1999 Canada

2002

2005

2008

2011

2014

Source: Haver Analytics

Exhibit 18: Canada basic balance of payments 8% 6% 4% 2% 0% -2% -4% -6% -8% 1999

2003 Portfolio Investment Current Account Balance

2007

Source: Statistics Canada

2011 Direct Investment Basic Balance of Payments

2015

Exhibit 19: Central government debt Percentage of GDP 250% 200% 150% 100%

Norway

Canada

Sweden

France

Germany

Source: Haver Analytics

U.K.

U.S.

50% Italy

The Governing Council’s hand was also stayed by the expected federal fiscal-stimulus measures due to be announced in this year’s budget. This budgetary boost should provide a more targeted, and effective, tailwind to economic activity than would the relatively blunt tool of monetary policy. There is obviously some concern that a larger-thanexpected federal deficit may

40%

Japan

Related to this hollowing-out of the non-energy export sector, a major factor underpinning our expectations for a lower loonie is the state of the balance of payments. Canada still has a sizeable current-account deficit, most of which is financed via relatively flighty portfolio investment and cross-border loans (Exhibit 18). Flows related to outward foreign direct investment (FDI) are also running at a significant clip, averaging $29 billion per quarter over the past year, nearly twice as fast as previous years. Just recently we started to see some FDI into Canada, but these decisions take time and currency weakness must become entrenched to entice more buyers of Canadian assets.

Exhibit 17: Share of U.S. automotive imports: Canada versus Mexico

Percentage of GDP

“anchor” facility prompts ancillary businesses, such as parts suppliers, to shift their operations to nearby sites. This is why the persistence of a weaker loonie is more important than the absolute magnitude of its fall. Longer-term weakness in the loonie would give exporters the confidence to invest in new capacity in Canada and others the impetus to create new businesses.

Currency Markets | Dagmara Fijalkowski, MBA, CFA | Daniel Mitchell, CFA | Taylor Self, MBA

contribute to negative sentiment towards government bonds and perhaps undercut some of the demand for Canadian securities that has been funding the trade deficit. This is not much of a concern at present, since many other countries are carrying higher debt loads than Canada (Exhibit 19). A lower loonie resolves economic imbalances for Canada. The boost to non-energy exports should start to narrow the trade gap on the one hand and, on the other, entice buyers of Canadian assets, firming

up the deficit’s funding. Again, this will not happen quickly.

Summary To be sure, while the tops of U.S. dollar cycles can reverse quickly, we don’t think the current bull market is quite ready to meet its end. Two major central banks not governed by Chair Yellen are pursuing easier policy stances, valuations are not yet a constraint, and a generational shift is occurring in global reserve balances. These factors are all serving to perpetuate the current dollar cycle.

We expect the euro and the yen to lead the charge lower versus the U.S. dollar over the next 12 months. We are relatively more constructive on the pound, though the referendum run-up could be trying. The loonie will likely weaken further as Canada’s economic rebalancing continues. All things considered, we are somewhere in the middle-to-late innings of the current U.S. dollar cycle.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 65

REGIONAL OUTLOOK â&#x20AC;&#x201C; U.S. UNITED STATES RECOMMENDED SECTOR WEIGHTS

Ray Mawhinney Senior V.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

RBC INVESTMENT STRATEGY COMMITTEE February 2016

Brad Willock, CFA V.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

Energy

7.0%

6.79%

Materials

3.0%

2.79%

Industrials

The U.S. stock market has had a rough ride the past three months. In the quarter ended February, the S&P 500 declined approximately 5% and volatility increased substantially, particularly since year-end. In our opinion, the poor returns have been the result of a slowdown in global growth, especially in China, which has increased investor anxiety about the U.S. economic outlook. Signals from fixed-income markets, commodity prices and the stock market all appear to suggest that there is a reasonably high probability that the U.S. could experience a recession this year. However, if one considers fundamental data from the jobs and housing markets, bank-lending statistics, retail sales and consumer confidence, one would likely conclude that the odds of a recession seem rather remote. Recessions are notoriously hard to predict, but what we know for sure is that investors are positioned as if the odds of a recession are very high, and that if one is avoided, several areas of the market offer opportunities for above-average returns. Of course, a recession is just one of the possible outcomes among

66 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

BENCHMARK S&P 500 February 2016

9.5%

10.10%

Consumer Discretionary

13.5%

12.92%

Consumer Staples

11.0%

10.55%

Health Care

14.0%

14.57%

Financials

15.0%

15.85%

Information Technology

21.5%

20.40%

Telecommunication Services

3.0%

2.77%

Utilities

2.5%

3.27%

Source: RBC GAM

S&P 500 EQUILIBRIUM

Normalized earnings and valuations 5120 2560

Feb. '16 Range: 1649 - 2754 (Mid: 2201) Feb. '17 Range: 1947 - 3251 (Mid: 2599) Current (29-February-16): 1932

1280 640 320 160 80 40 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: RBC GAM

many that could unfold over the coming year. The important thing for investors is to consider all scenarios, the likelihood of each of them occurring and to then determine to what degree they appear to be priced into markets. Given the recent rallies in gold (up 16%) and U.S. Treasury yields (down almost 20%) during the three-

month period and the six-month outperformance of high-yielding, less economically sensitive sectors such as Telecommunication Services (+9%), Utilities (+11%) and Consumer Staples (+13%), it seems clear that most investors are placing very high odds on a negative scenario. In fact, investors have been voting with their feet, as U.S. equity funds

Regional Outlook â&#x20AC;&#x201C; U.S. | Ray Mawhinney | Brad Willock, CFA

have seen outflows in 12 of the past 13 weeks, a longer stretch than at any time during the 2007-2009 bear market. Considering this backdrop, it seems appropriate to consider opportunities in compelling valuebased strategies; companies with some exposure to foreign markets; and greater exposure to sectors that are economically sensitive. With respect to value-based strategies, it might seem obvious that one should always buy the cheapest stocks. However, when economic growth is below trend, as it has been for the past several years, stocks with the best growth prospects and/or the most steady earnings tend to outperform. Over the past two years, stocks with these characteristics outperformed by almost 35%, and in 2015, experienced their best year since the mid-1980s. By year-end, these stocks had become very expensive compared with the market average, and particularly relative to the cheapest cohort of stocks. The current difference between the most expensive quintile of stocks and the market average has only been greater in 5% of months since 1957 and the cheapest quintile of stocks have a free-cashflow yield of at least 7.5%. The price of future growth and steady earnings have become historically expensive while economically sensitive stocks have become cheap enough to warrant an increased allocation within portfolios.

A major concern of investors has been that the collapse in commodity prices, and oil in particular, would rattle credit markets and pressure the real economy. Thus far, the price declines and the deterioration in credit markets has had limited effects on the broad U.S. economy. In the fourth quarter of 2015, earnings of energy and industrial commodity companies were down by 60% while the rest of the market was up about 3.5%. One risk to the status quo is that higher corporate borrowing costs could lead to a drop in capital spending in the non-energy and mining sectors. In the latest quarter, capital spending by commodity companies sank by one-third while spending by the rest of the market was up roughly 5%. However, the longer corporate-bond yields remain elevated, the more likely it is that capital spending across the economy will be curtailed. Of note, corporate-bond markets recently began to rally just as the growth in U.S. oil inventories appears to have peaked, sparking a rebound in the price of crude oil. Oil prices, based on the West Texas Intermediate benchmark, are now up roughly 32% from their low on February 11, 2016, but a substantial move from current levels will have several hurdles to overcome, including bloated inventories, which will likely keep increasing into early next year. Current estimates suggest U.S. oil inventories could be over 1 billion barrels above normal

by year-end. The prospect of this overhang is likely to moderate any further price increases unless there is a coordinated production cut by OPEC. We are monitoring a number of data points to gauge the state of the economic cycle. In China, growth in exports plus a slowdown in the amount of capital leaving the country would help ease fears of a rapid and sizeable depreciation in the renminbi. The capital flight reflects a loss of confidence in the Chinese system and must be controlled to reduce the odds of a crisis. In the U.S., the trajectory of the U.S. dollar and the change in oil inventories are likely to play a large role in how the cycle ultimately plays out. If the U.S. dollar remains stable versus the countryâ&#x20AC;&#x2122;s major trading partners and oil inventories decline, one would expect anxiety in credit markets to dissipate, the economic cycle to continue to trudge forward and stock markets to post modest gains for the remainder of the year. However, if the U.S. dollar is stronger than expected, the price of oil refuses to rally, and/or Chinese authorities fail to restore confidence in their system, U.S. markets are likely to experience negative returns from current levels.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 67

REGIONAL OUTLOOK â&#x20AC;&#x201C; CANADA Stuart Kedwell, CFA

CANADA RECOMMENDED SECTOR WEIGHTS

Senior V.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

The S&P/TSX Composite Index declined in the latest three-month period, but outperformed its global counterparts due to a very strong first two months of 2016. Total returns for the S&P/TSX were down 3.75%, versus a 6.6% drop in the S&P 500 and an 8.3% decrease in the MSCI World Index, both in U.S. dollar terms. The decline in the Canadian dollar moderated, down 1.3%, and therefore did not have much impact on returns. This is not to say that the Canadian market did not exhibit the same jaw-dropping volatility seen elsewhere. At its worst, the Canadian market was down 12% during the quarter before recovering in mid-January along with the Canadian dollar and crude oil. Interestingly, the price of West Texas Intermediate crude oil fell to a cycle low of US$26.21 in mid-February, but the performance of the Canadian stock market and currency showed significant divergence as neither looked back from the January lows. Gold stocks were the bestperforming segment of the S&P/ TSX, finishing the quarter up more than 40% on a 16% increase in bullion prices. Later in the quarter, other commodities began to recover, and while down in absolute terms, ended the period well above their lows. The Financials sector lagged the index due to company-specific and macroeconomic concerns.

68 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

RBC INVESTMENT STRATEGY COMMITTEE February 2016

BENCHMARK S&P/TSX COMPOSITE February 2016

Energy

19.0%

18.83%

Materials

11.0%

11.39%

Industrials

7.5%

8.10%

Consumer Discretionary

7.0%

6.64%

Consumer Staples

5.5%

4.70%

Health Care

0.5%

2.05%

37.0%

37.14%

Information Technology

4.0%

3.12%

Telecommunication Services

6.0%

5.65%

Utilities

2.5%

2.37%

Financials

Source: RBC GAM

S&P/TSX COMPOSITE EQUILIBRIUM

Normalized earnings and valuations 25600

Feb. '16 Range: 13962 - 20924 (Mid: 17443) Feb. '17 Range: 14786 - 22158 (Mid: 18472) Current (29-February-16): 12860

6400

1600

400 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: RBC GAM

Globally, the sector struggled as investors worried about the impact of low or negative interest rates on net interest margins. Meanwhile, the earnings headwinds that could result from credit provisions linked to energy lending were a frequent topic of discussion. The performance of the Canadian benchmark was also held back by a further 25% drop in shares of Valeant, which remains a benchmark heavyweight.

We continue to believe that the Canadian economy will deliver modest growth, but that domestic growth will lag the U.S. expansion. While the weakening Canadian dollar will provide a tailwind in British Columbia, Ontario and Quebec, the currency is not likely to be enough to drive a meaningful acceleration in growth. The Canadian dollar could rebound with crude prices, but longer-term we are skeptical

Regional Outlook – Canada | Stuart Kedwell, CFA

that it can sustain its advance. Purchasing power parity for the Canadian dollar is $1.25, and we would be surprised if a rebound in the Canadian dollar breached this level. We note that our one-year forecast is $1.53. Longer term, the pace of U.S. interest-rate increases is expected to be faster than Canada’s. The domestic economy’s reliance on housing and questions about the ability of consumers to maintain their spending are likely to be points of discussion. While a rebound in the price of oil would bring a welcome boost in Canadians’ purchasing power, the price of crude must move significantly higher to justify restarting massive oil-sands developments. The consensus estimate for S&P/ TSX composite earnings for 2016 has dropped steadily with declining energy estimates. Benchmark estimates for 2016 are about $825, with a considerable uptick for 2017 to more than $900. Embedded in these estimates are fairly reasonable broad market growth and Energy sector earnings above those generated in 2015. On a forward 12-month basis, both the S&P 500 and S&P/TSX carry similar valuations. Broadly speaking, financial stocks are attractively valued relative to history, but not outliers when compared to North American sector valuations, while the non-financial, non-energy sectors are slightly more fully valued and in line to slightly above their North American peers. As a result, the Canadian stock market will have trouble outperforming the U.S.

absent sustained gains in energy prices. Canadian banks’ valuations have fallen both in terms of price-toearnings ratios and price-to-book. Earnings estimates have been pressured by weaker capitalmarkets activity and rising loanloss provisions for both energy and consumer lending in energyexposed provinces. Under stressed scenarios, there is no question that earnings would weaken, but not to the point where capital- or dividendcoverage issues would arise. As bank stocks grind through this tough environment, we continue to believe that they offer attractive value and dividend yields, and we assume modest payout growth. Both of Canada’s major railways are managing through a period of difficult shipment volumes via a combination of price increases and cost discipline. Canadian Pacific has made headlines in recent months with indications of interest in acquisitions that would further consolidate the North American railway industry. While any acquisition would face regulatory hurdles, we see a great opportunity for Canadian Pacific’s management approach to create significant shareholder value. Oil prices remain difficult to forecast in the short run, although a supply response does appear to be in the cards. While OPEC has made no mention of cutting production, the impact of low oil prices has been felt in credit markets. Declining access to capital coupled with fast-decreasing

rates of marginal production should stabilize prices above recent lows. Longer-term discussions about carbon emissions and electric cars complicate investor appetite for a sector that continues to look quite interesting on a valuation basis. Large companies with long-life reserves and strong balance sheets are set to deliver attractive levels of free cash when crude prices bounce back to the US$65-US$70 level. The price of natural gas has not received the same attention as oil, but it is also important to the Canadian Energy sector. The warm winter has pushed the price of natural gas to a multi-year low and made only the most robust liquids-rich gas economic to produce. Emerging-market economic growth in general, and Chinese economic growth in particular, have a significant impact on resource prices and have therefore been topics of discussion among Canadian investors. While the challenges to growth remain, some signs of improvement at the margin could lead to a sizable expansion in valuations in the Materials sector. The combination of depressed valuations relative to net asset value, considerable balance-sheet leverage in some companies and the removal for now of a worst-case commodity scenario could lead to strong performance from many companies in the sector. Given the recent valuation expansion in both gold and basic-materials companies, further underlying commodity-price gains will be important for the sector.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 69

REGIONAL OUTLOOK â&#x20AC;&#x201C; EUROPE Dominic Wallington

EUROPE RECOMMENDED SECTOR WEIGHTS

Chief Investment Officer RBC Global Asset Management (UK) Limited

Global stock markets have started the year poorly and the investment community is engaged in the debate of trying to establish why. We believe the most plausible answer can be found in the Bank of America Global Wave, a composite leading indicator for the global economy. According to this indicator, the global economy is at risk of turning down and this coincides with weakness in high-yield bond markets that has pushed up funding cost. These observations have led many investors to take profits from equities that have done well and to continue abandoning sectors and stocks that have not. Europeâ&#x20AC;&#x2122;s economy actually appears to be quite robust relative to much of the globe, and leading indicators still suggest continued improvement. The credit mechanism continues to work effectively and points to a potential pickup in loan growth. Given these positive factors, it is important to remember that Europe depends on international trade for a significant portion of its GDP. This is a good thing in that it demonstrates that the benefits of global growth can easily be tapped through European companies. But it can also be a disadvantage because the region cannot remain insulated from concerns elsewhere if they are serious enough. Given that Eurozone economic activity appears to be gently rebounding, valuations look attractive, especially relative to the U.S., and because the 70 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

RBC GAM INVESTMENT STRATEGY COMMITTEE February 2016

BENCHMARK MSCI EUROPE February 2016

Energy

6.5%

6.57%

Materials

6.5%

6.83%

Industrials

11.0%

11.56%

Consumer Discretionary

12.5%

11.99%

Consumer Staples

16.0%

15.37%

Health Care

13.8%

13.45%

Financials

20.0%

21.04%

Information Technology

5.0%

4.17%

Telecommunication Services

5.0%

5.09%

Utilities

3.5%

3.95%

Source: RBC GAM

EUROZONE DATASTREAM INDEX EQUILIBRIUM Normalized earnings and valuations 5760

Feb. '16 Range: 1689 - 3635 (Mid: 2662) Feb. '17 Range: 1802 - 3878 (Mid: 2840)

2880

Current (29-February-16): 1351

1440 720 360 180 90 1980

1985

1990

1995

2000

2005

2010

2015

2020

Source: Datastream, Consensus Economics, RBC GAM

economies we cover look broadly decent, we think the region still looks attractive on a relative basis. Moreover, the ECB is expanding its balance sheet at a time when the Fed seems to be tightening. Further monetary easing is likely if the current downturn in the global economy leads to inflation continuing to lag targets. Despite strength relative to the Canadian dollar, the euro remains near its 12-month low

versus the U.S. dollar, and this acts as a tailwind for European companies that are competing internationally with U.S. companies. Finally, the stress points in the Eurozone seem to be under control as evidenced by falling credit spreads in peripheral countries. The backdrop is sufficiently positive overall for Europe to merit significant exposure. As usual, there are political problems on the horizon. The British prime

Regional Outlook â&#x20AC;&#x201C; Europe | Dominic Wallington

minister, David Cameron, has suggested the referendum on Britain remaining in the EU may well take place by June 2016, giving the government little time to put a positive case forward. The risk of Brexit has therefore grown. In Europe itself, a number of countries have re-established national borders to control the refugee crisis. This is being marketed as a temporary step, but freedom of movement is so key to the idea of the Eurozone that it suggests escalating political risks. The best counterpoint we can offer is that, from a political perspective, German Chancellor Angela Merkel is more alert to the problems than before, while from an investment perspective, we see little risk to the types of companies we invest in. Another longer-standing negative is that earnings revisions, while improving in Europe, have not been in positive territory for some time. This is partly a result of sector bias, with U.K. companies having undergone earnings downgrades because of that marketâ&#x20AC;&#x2122;s large exposure to oil and gas, as well as to metals and mining. These are typically not areas of interest to us given generally low levels of profitability and their cyclicality, and given that other sectors of the U.K. market have been more robust, such as Consumer Staples. The Eurozone has less exposure to the worst-hit sectors, and it is possible that the pace of Eurozone earnings revisions will beat the U.S. for a second straight year. Having been partial to the Consumer Discretionary sector for some time,

we lowered our weight in mid2014. However, we have lately been selectively adding to holdings in this area. Our focus has been media and gaming. We are committed to the structural dynamics of media, especially to companies that have reduced their capital intensity and broadened their Internet exposure. We have also been adding exposure in luxury goods. Consumer Staples continues to be a natural home for us given the highquality companies in the sector, but valuations have been somewhat challenging. We are focused on beverages, food ingredients and household goods because these areas offer the best mix of growth and valuation. We remain underweight food manufacturing. Most of our exposure to this sector is in companies with the global reach to capitalize on the growing middle class in emerging markets. We have been concerned for some time about capital-spending increases in the Energy sector. While management teams are reversing this trend, many projects will generate very low returns at current oil prices. Valuations are at almost unprecedentedly low levels, both in absolute and relative terms, but have not fallen enough to offset the fundamental backdrop. Dividend yields are high, but for many independent oil companies, high capex levels mean that they are only just covered by cash flow. We retain our preference for Health Care and recently added to our

holdings on weakness in the sector. Valuations are attractive and recent M&A and asset swaps represent progress toward creating an industry with focused, high-return franchises. Strong balance sheets, robust cash flows, low earnings volatility and a focus on capital returns make the sector attractive. In the Financials sector, the performance of the banks, and in particular Eurozone banks, has moved in line with macroeconomic data, but was hit recently as the market weakened. A tighter regulatory backdrop means that the sector is unlikely to return to profitability levels seen before the financial crisis, and many banks struggle to generate returns above their cost of equity. Our preference continues to be for banks with high returns on equity and strong balance sheets. This results in a bias towards the Nordic region and away from the Eurozone. Over the last year, Telecommunication Services has been one of the bestperforming sectors in Europe. This has been driven by an improvement in traditional telecom operators and the improving regulatory backdrop. We still view the Materials sector unfavourably. Mining stocks have ceded the growth valuations acquired over a decade. They are now value stocks, with dividend yields slightly higher than the market average. Our preference is for specialty chemicals as well as the niche areas of enzymes and flavours and fragrances, where we see high barriers to entry and good growth and returns.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 71

REGIONAL OUTLOOK – ASIA ASIA RECOMMENDED SECTOR WEIGHTS

Mayur Nallamala Head & Senior Portfolio Manager RBC Investment Management (Asia) Limited

RBC GAM INVESTMENT STRATEGY COMMITTEE February 2016

Energy

3.0%

2.88%

Materials

5.5%

5.95%

Industrials

12.5%

13.10%

Consumer Discretionary

13.5%

13.01%

7.5%

6.92%

A sluggish outlook for global growth, led by renewed concerns regarding the state of China’s economy, has led to sustained weakness in equity and currency markets across the region. Stock markets in Asia excluding Japan fell significantly during the period, again led by China, where headlines have begun to have a significant impact on other regional markets. These equity-market declines were due in part to the unwelcome repeat over the past three months of Chinese policy missteps made during the summer of 2015. The most concerning issue regarding Chinese equity markets remains the apparent policy flip-flopping of the government, be it efforts to control the value of the renminbi or regulate domestic equity markets. Meanwhile, the Japanese benchmark extended its decline from the previous period amid concerns about the potential for slowing global growth, driving the yen higher against the U.S. dollar and exerting further downward pressure on Japanese equities.

the country’s central bank to boost monetary stimulus.

Japan – Japanese equities mirrored the broad-based sell-off in Asia, with a particularly sharp decline in February due to the negative effect of the strengthening yen, as investors flocked to assets perceived as offering a degree of safety. Weakerthan-expected GDP data signaled that Japan is on the brink of falling into a recession and increased pressure on

Concerns about China’s economic slowdown and a stronger yen will continue to largely determine the direction of Japanese markets. The outlook for supportive policies remains intact, as the low-inflation environment supports the Bank of Japan’s case for negative interest rates, quantitative easing and sustained fiscal stimulus.

72 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

BENCHMARK MSCI PACIFIC February 2016

Consumer Staples Health Care

6.0%

5.72%

Financials

27.0%

28.17%

Information Technology

15.0%

15.00%

Telecommunication Services

6.0%

5.83%

Utilities

3.0%

3.43%

Source: RBC GAM

JAPAN DATASTREAM INDEX EQUILIBRIUM

Normalized earnings and valuations

1040 520 260 130

Feb. '16 Range: 291 - 855 (Mid: 573)

65 1980

Feb. '17 Range: 308 - 906 (Mid: 607) Current (29-February-16): 415

1985

1990

1995

2000

2005

2010

2015

2020

Source: Datastream, Consensus Economics, RBC GAM

China – After a series of ad hoc measures taken to halt the collapse in the stock market last summer, Chinese policymakers have again resorted to an aggressive stance on equity-market intervention amid concerns that the weakening renminbi will accelerate capital outflows. In January, policymakers banned stock sales by large shareholders and introduced a ‘circuit breaker’ to prevent markets from falling too

Regional Outlook – Asia | Mayur Nallamala

steeply on any single day. Despite its intentions to tame market volatility, regulators ended up suspending the circuit-breaker mechanism after trading was halted twice in four days. Unfortunately, intervention seems to have perpetuated the market selloff as investors worry about policy unpredictability. The same uncertainty now afflicts China’s policy on its currency. The recent August devaluation and the lower renminbi fixes in early 2015 have sent tremors through global equity markets. With the renminbi now qualified for inclusion in the basket of major currencies known as special drawing rights (SDR), the People’s Bank of China (PBOC) had moved to push the renminbi lower against the U.S. dollar (we note that the renminbi has barely moved against a basket of major currencies). To counter offshore speculative attacks on the currency, Chinese regulators changed course and began defending the renminbi. They have done this in part by driving up the cost of borrowing renminbi offshore to reduce the attractiveness of betting on declines in the currency. Other measures include mandating that banks hold more reniminbi and, most recently, warning against unauthorized and excessive foreigncurrency purchases domestically. Given the general level of confusion regarding policy intent on the part of the PBOC and the government, it is worth considering the underlying reasons for the recent depreciation. While China still enjoys a healthy trade surplus, struggling exporters are likely to be happy about the

improved competitive positioning that a falling currency provides. More likely is that the PBOC wishes to rein in, and ultimately reverse, a multiyear accumulation of U.S.-dollar debt that now rests in a leveraged Chinese corporate sector, as companies availed themselves of the solid returns provided by the renminbi carry trade. With a diminished interest-rate differential – onshore rates are being cut in response to a cooling economy – the PBOC has made it clear that it will not make it easy for speculators who have looked to profit quickly from a reversal in the trend of the Chinese currency. Companies, of course, are responding and there has been a shift in U.S. dollar borrowing into local currency. The bubbly domestic bond market has made this action relatively painless, particularly for more reputable companies, but also for lower-quality corporates. Perhaps the major miscalculation was that a herd-like rush for the exit doors from so-called hot money would happen. Retail investors are prone to such behaviour and the massive capital flight that has characterized the last six months could be easily explained by a significant swing in sentiment against holding a depreciating currency. India – The domestic policy environment in India remains mixed as key market reforms are stalled in Parliament. After a disappointing winter, the budget session in February will have likely shed some light on the progress of the GST Bill, which will provide needed simplification of tax policy (we expect

little or no progress) and fiscal deficit targets for the coming year. The country’s economic backdrop has been one of modest growth and low inflation, but we expect the sharp fall in global crude-oil prices to boost corporate profits. Structurally, the long-term positive outlook on the country’s consumer, Information Technology and Health Care sectors remains intact on the back of India’s favourable demographic profile and growing domestic demand for such products and services. Australia – The Reserve Bank of Australia (RBA) expressed optimism about the domestic outlook given a falling jobless rate, low inflation and lower currency, as well as evidence that the transition away from a reliance on mining has started to take hold. Despite holding the benchmark interest-rate steady, the RBA maintained its dovish bias by signaling that there is further scope for easier policy to lend support for the current low-inflation environment. That said, the outlook for China continues to be a key source of uncertainty for Australian companies. Australian equities outperformed the region despite declines in Energy and Materials stocks. The Health Care and consumer sectors performed well given the improving outlook for employment, as well as increased tourism. While plunging oil prices have damaged the balance sheets of global giants like BP and Royal Dutch Shell, the RBA believes lower oil prices will continue to support the growth of Australia’s major trading partners.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 73

REGIONAL OUTLOOK – EMERGING MARKETS EMERGING MARKET DATASTREAM INDEX EQUILIBRIUM

Guido Giammattei

Normalized earnings and valuations

Portfolio Manager RBC Global Asset Management (UK) Limited

Feb. '16 Range: 239 - 434 (Mid: 336) Feb. '17 Range: 250 - 453 (Mid: 351) Current (29-February-16): 200

640

After a promising start to 2015, the MSCI Emerging Markets Index ended the year down 17%. It was the fifth-worst performance in 30 years and the fifth consecutive year of underperformance versus developed markets, as the headwinds of a strong U.S. dollar and weak commodity prices took their toll. These same headwinds contributed to extending the weakness in emerging-markets stocks into 2016. Despite the disappointing performance at the index level, there were clear winners and losers in 2015: the MSCI Latin America index underperformed the MSCI Asia by 22%. In terms of investment style, quality stocks outperformed value stocks by 25%. Stocks in Latin America and value equities underperformed the broad index for the fifth straight year. There are at least three interrelated headwinds that have been negatively impacting recent emerging-market performance: the U.S. Federal Reserve’s (Fed) December rate hike and associated credit fears; China growth concerns; and weakness in overall emergingmarket earnings. We believe that the negative impact of these headwinds will be reduced in 2016. While the start of U.S. monetary tightening has raised fears of a

74 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

320 160 80 40 20 1995

2000

2005

2010

2015

2020

Source: Datastream, RBC GAM

negative impact on risk assets, there has not been a strong historical link between Fed hikes and the performance of emerging-market equities. In two of the past three cycles, in fact, emerging-market stocks have performed well. Additionally, any Fed rate-hike cycle is likely to be modest given the recent deterioration in the outlook for U.S. and global growth. The deceleration in Chinese economic growth and depreciation in the country’s currency have also raised concerns. The government’s efforts to rebalance the economy from investment to domestic consumption continue, and this shift is in our view the main cause of China’s recent economic slowdown. Large-scale reforms initiated by the government for this purpose will produce lower but more stable, higher-quality growth in the future. Given China’s strategic goal, it follows that the government should be unwilling to engage in a large-

scale devaluation of the currency since such a step would reduce consumers’ purchasing power. The lack of earnings growth has been a key issue for emerging markets but the worst is likely behind us. Earnings have been downgraded in each of the past five years and the magnitude of downgrades has risen each year. The resources sectors and commoditylinked countries such as Russia and Brazil have accounted for all of the decline in profits since 2010. Looking ahead, the fact that commodities now account for a much smaller portion of the index means that year-over-year comparisons should be much more favourable. Moreover, the overcapacity that has plagued emerging markets in recent years has started to abate in many countries and should provide a boost to corporate profit margins. We believe the key factor driving emerging-market equity

Regional Outlook – Emerging Markets | Guido Giammattei

underperformance since the financial crisis has been a slowdown in the relative growth rates of emerging markets compared with developed markets. There is, in fact, a close relationship between relative growth rates and relative equity-market performance. Faster growth has historically been the key reason for investing in emerging markets and has driven long-term performance. Since 1968, there have been three bull cycles and three bear cycles, and the change in relative growth rates has been the main driver of performance over that time. With this paradigm in mind, having a view on the expected growth differential is critical for forecasting emergingmarket performance. In the short term, economic indicators point to an improvement in emerging-market momentum. A slowdown in the rate of decline of emerging-market GDP growth, coupled with a decrease in the expected GDP growth rate of developed markets, signals that the growth differential between the two has already started to stabilize. Equally important for our outlook is an assessment of whether the geographic and style winners of recent years – Asia and quality – can continue to outperform. While a modest recovery in emerging-market growth and earnings in 2016 suggest that the outperformance of quality as

a factor may diminish, the fact that growth will be subdued tells us that the market will remain challenging for value stocks and that investors will continue to reward profitability, growth and low earnings risk. In essence: quality. Viewing the performance of emerging-market equities from a regional perspective over the past five years shows that the one standout feature has been Latin America’s systematic underperformance. The MSCI index that tracks Latin America has lagged its Asian counterpart by over 50% after underperforming the latter every year since 2010. Latin America has performed poorly as a whole in an environment characterized by the strong U.S. dollar and declining commodities prices. Brazil, which is a big producer of iron ore and agricultural commodities, has accounted for the lion’s share of this dramatic underperformance. Peaks and troughs are difficult to identify, but taking a long-term view during 2015 led us to increase our exposure to Brazilian highquality franchises based on their very attractive valuations and our trust in management’s ability to eventually find micro-level solutions to macro-level problems. We expect country performance to continue to vary widely in 2016, although the

underperformance of Latin America should diminish given how far valuations have fallen and the fact that currencies in the region are now very cheap. That means that, in terms of country allocation, Brazil is the one market for which we have changed our weighting to a more neutral stance from underweight. Otherwise, we continue to maintain overweight positions in India, the Philippines, South Africa and frontier markets such as Nigeria, driven by attractive bottom-up opportunities. In sector terms, we believe there are two key reasons to add more cyclicality to the portfolio. The first is valuation, as emerging-market valuations in cyclical sectors are at the lowest levels we have seen over the past 20 years relative to defensive sectors. The second is the tendency for cyclical stocks to outperform when the Fed begins a tightening cycle, which is currently the case. However, given that we are still expecting subdued economic growth in 2016, this factor will be less influential. Given this backdrop, the portfolio manager has a favourable view of the Industrials and Information Technology sectors. We also believe that, while the credit cycle has yet to bottom, value is emerging in high-quality banks.

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RBC GAM INVESTMENT STRATEGY COMMITTEE Members Daniel E. Chornous, CFA Chief Investment Officer RBC Global Asset Management Chair, RBC GAM Investment Strategy Committee Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc., which has total assets under management of $383 billion. Mr. Chornous is responsible for the overall direction of investment policy and fund management. In addition, he chairs the RBC GAM Investment Strategy Committee, the group responsible for global asset-mix recommendations and global-fixed income and equity portfolio construction for use in RBC Wealth Management’s key client groups including retail mutual funds, International Wealth Management, RBC Dominion Securities Inc. and RBC Phillips, Hager & North Investment Counsel Inc. He also serves on the Board of Directors of the Canadian Coalition for Good Governance and is Chair of its Public Policy Committee. Prior to joining RBC Asset Management in November 2002, Mr. Chornous was Managing Director, Capital Markets Research and Chief Investment Strategist at RBC Capital Markets. In that role, he was responsible for developing the firm’s outlook for global and domestic economies and capital markets as well as managing the firm’s global economics, technical and quantitative research teams.

Dagmara Fijalkowski, MBA, CFA Stephen Burke, PhD, CFA Vice President and Portfolio Manager RBC Global Asset Management Stephen is a fixed-income portfolio manager and Head of the Quantitative Research Group, the internal team that develops quantitative research solutions for investment decision-making throughout the firm. He is also a member of the PH&N IM Asset Mix Committee. Stephen joined Phillips, Hager & North Investment Management in 2002. The first six years of his career were spent at an investment-counselling firm where he quickly rose to become a partner and fixed-income portfolio manager. He then took two years away from the industry to begin his Ph.D. in Finance and completed it over another three years while serving as a fixed-income portfolio manager for a mutual-fund company. Stephen became a CFA charterholder in 1994.

Head, Global Fixed Income & Currencies (Toronto and London) RBC Global Asset Management As Head of Global Fixed Income & Currencies at RBC Global Asset Management, Dagmara oversees 15 investment professionals in Toronto and London, with more than $40 billion in assets under management. In her duties as a portfolio manager, Dagmara looks after foreign-exchange hedging and active currency-management programs for fixed-income and equity funds, and co-manages several of the firm's bond portfolios. Dagmara chairs the RBC Fixed Income & Currencies Committee. She is also a member of the RBC GAM Investment Policy Committee, which determines the asset mix for RBC balanced products, and the RBC GAM Investment Strategy Committee, which establishes global strategy for the firm.

Stuart Kedwell, CFA Senior Vice President and Senior Portfolio Manager RBC Global Asset Management Stu began his career with RBC Dominion Securities in the firm’s Generalist program and completed rotations in the Fixed Income, Equity Research, Corporate Finance and Private Client divisions. Following this program, he joined the RBC Investments Portfolio Advisory Group and was a member of the RBC DS Strategy and Stock Selection committees. He later joined RBC Global Asset Management as 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 Global Asset Management’s Canadian Equity Team.

76 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

Eric Lascelles Chief Economist RBC Global Asset Management Eric is the Chief Economist for RBC Global Asset Management Inc. (RBC GAM) and is responsible for maintaining the firm’s global economic forecast and generating macroeconomic research. He is also a member of the RBC GAM Investment Strategy Committee, the group responsible for the firm’s global asset-mix recommendations. Eric is a frequent media commentator and makes regular presentations both within and outside RBC GAM. Prior to joining RBC GAM in early 2011, Eric spent six years at a large Canadian securities firm, the last four as the Chief Economics and Rates Strategist. His previous experience includes positions as economist at a large Canadian bank and research economist for a federal government agency.

RBC Global Asset Management

Ray Mawhinney Hanif Mamdani Head of Alternative Investments RBC Global Asset Management Hanif Mamdani is Head of both Corporate Bond Investments and Alternative Investments. He is responsible for the portfolio strategy and trading execution of all investment-grade and high-yield corporate bonds. Hanif is Lead Manager of the PH&N High Yield Bond Fund and the PH&N Absolute Return Fund (a multi-strategy hedge fund). He is also a member of the Asset Mix Committee. Prior to joining the firm in 1998, he spent 10 years in New York with two global investment banks working in a variety of roles in Corporate Finance, Capital Markets and Proprietary Trading. Hanif holds a master's degree from Harvard University and a bachelor's degree from the California Institute of Technology (Caltech).

Senior Vice President and Senior Portfolio Manager RBC Global Asset Management Ray leads the U.S. Equity team in Toronto and brings a wealth of expertise to his role, having specialized in U.S. equities since 1984. He joined the firm in 1992 and is involved in managing several of the firm's U.S. equity funds. Ray is also a member of the RBC GAM Investment Policy Committee, which determines asset mix for balanced products, and the RBC GAM Investment Strategy Committee, which establishes a global asset mix covering mutual funds, as well as portfolios for institutions and high-net-worth private clients. Ray graduated from the University of Manitoba with a bachelor's of commerce degree in finance, with honours.

Martin Paleczny, CFA

Sarah Riopelle, CFA

Vice President and Senior Portfolio Manager RBC Global Asset Management

Martin Paleczny, who has been in the investment industry since 1994, began his career at Royal Bank Investment Management, where he developed an expertise in derivatives management and created a policy and process for the products. He also specializes in technical analysis and uses this background to implement derivatives and hedging strategies for equity, fixed-income, currency and commodity-related funds. Since becoming a portfolio manager, Martin has focused on global allocation strategies for the full range of assets, with an emphasis on using futures, forwards and options. He serves as advisor for technical analysis to the RBC GAM Investment Strategy Committee.

Since 2009, Sarah has managed the entire suite of RBC Portfolio Solutions, including the RBC Select Portfolios, RBC Select Choices Portfolios, RBC Target Education Funds and RBC Managed Payout Solutions. Sarah is a member of the RBC GAM Investment Strategy Committee, which sets global strategy for the firm, and the RBC GAM Investment Policy Committee, which is responsible for the investment strategy and tactical asset allocation for RBC Funds’ balanced products and portfolio solutions. In addition to her fund management role, she works closely with the firm’s Chief Investment Officer on a variety of projects, as well as co-manages the Global Equity Analyst team.

William E. (Bill) Tilford Head, Quantitative Investments RBC Global Asset Management Bill is Head, Quantitative Investments, at RBC Global Asset Management and is responsible for expanding the firm’s quantitative-investment capabilities. Prior to joining RBC GAM in 2011, Bill was Vice President and Head of Global Corporate Securities at a federal Crown corporation and a member of its investment committee. His responsibilities included security-selection programs in global equities and corporate debt that integrated fundamental and quantitative disciplines, as well as management of one of the world’s largest market neutral/overlay portfolios. Previously, Bill spent 12 years with a large Canadian asset manager, where he was the partner who helped build a quantitative-investment team that ran core, style-tilted and alternative Canadian / U.S. funds. Bill has been in the investment industry since 1986.

THE GLOBAL INVESTMENT OUTLOOK Spring 2016 I 77

RBC Global Asset Management

GLOBAL EQUITY HEADS >> Paul Johnson

>> Ray Mawhinney

>> Dominic Wallington

V.P. & Senior Portfolio Manager, Global Equities RBC Global Asset Management Inc.

Senior V.P. & Senior Portfolio Manager, U.S. & Global Equities RBC Global Asset Management Inc.

Chief Investment Officer, RBC Global Asset Management (UK) Limited

>> Philippe Langham

>> Mayur Nallamala

Senior Portfolio Manager, Emerging Markets RBC Global Asset Management (UK) Limited

Head & Senior V.P., Asian Equities RBC Investment Management (Asia) Limited

GLOBAL EQUITY ADVISORY COMMITTEE >> Stuart Morrow, CFA

>> Kent Crosland, CFA

>> John Richards, CFA

Portfolio Manager, U.S. Equities & Vice President Global Equity Research RBC Global Asset Management Inc.

Analyst, Global Equities (Semis/Tech Hardware, Commercial Services) RBC Global Asset Management Inc.

Analyst, Global Equities (Banks) RBC Global Asset Management Inc.

>> Martin Paleczny, CFA

>> Sean Davey, CFA

V.P. & Senior Portfolio Manager, Asset Allocation & Derivatives RBC Global Asset Management Inc

Analyst, Global Equities

>> Hakim Ben Aissa, CFA

>> Matt Gowing, CFA

>> Angelica Uruena

Senior Analyst, Global Equities (Energy) RBC Global Asset Management Inc.

Analyst, Global Equities (Telecommunications, Software, Utilities) RBC Global Asset Management Inc.

Analyst, Global Equities (Consumer Discretionary) RBC Global Asset Management Inc.

>> Rob Cavallo, CFA

(Consumer Staples) RBC Global Asset Management Inc.

>> Joe Turnbull, CFA Analyst, Global Equities (Industrials ex Commercial Services, Building Products) RBC Global Asset Management Inc.

Senior Analyst, Global Equities (Health Care) RBC Global Asset Management Inc.

GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE >> Dagmara Fijalkowski, MBA, CFA

>> Soo Boo Cheah, MBA, CFA

>> Eric Lascelles

Head, Global Fixed Income & Currencies (Toronto and London) RBC Global Asset Management Inc.

Senior Portfolio Manager, Global Fixed Income & Currencies RBC Global Asset Management (UK) Limited

Chief Economist RBC Global Asset Management Inc.

>> Suzanne Gaynor V.P. & Senior Portfolio Manager, Global Fixed Income & Currencies RBC Global Asset Management Inc.

78 I THE GLOBAL INVESTMENT OUTLOOK Spring 2016

DISCLOSURE This report has been provided by RBC Global Asset Management Inc. (RBC GAM Inc.) for informational purposes only and may not be reproduced, distributed or published without the written consent of RBC GAM Inc. In the United States, this report is provided by RBC Global Asset Management (U.S.) Inc., a federally registered investment adviser founded in 1983. In Europe and the Middle East, this report is provided by RBC Global Asset Management (UK) Limited, which is authorised and regulated by the Financial Conduct Authority. RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, RBC Alternative Asset Management Inc., and BlueBay Asset Management LLP, which are separate, but affiliated corporate entities. This report is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. Due to the possibility of human and mechanical error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC GAM is not responsible for any errors or omissions contained herein. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information. Any investment and economic outlook information contained in this report has been compiled by RBC GAM from various sources. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any other person as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any errors or omissions. All opinions and estimates contained in this report constitute our judgment as of the indicated date of the information, are subject to change without notice and are provided in good faith but without legal responsibility. To the full extent permitted by law, neither RBC GAM nor any of its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the outlook information contained herein. Interest rates and market conditions are subject to change. A note on forward-looking statements This report may contain forward-looking statements about future performance, strategies or prospects, and possible future 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 about 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. 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.

100537 (03/2016) ÂŽ/TM Trademark(s) of Royal Bank of Canada. Used under licence. ÂŠ RBC Global Asset Management Inc. 2016.