global investment outlook english

The Global InvesTmenT ouTlookRbC Investment strategy Committee

NEW YEAR 2012

The RbC InvesTmenT sTRaTeGy CommITTee

The RBC Investment Strategy Committee consists of senior investment professionals drawn from individual client focused business units within RBC. 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.

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.

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

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 make-up within equity portfolios

� the preferred exposure to major currencies

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

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THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE New Year 2012 I 1

EXECUTIVE SUMMARY 2 The Global Investment Outlook

Sarah Riopelle, CFA – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

Eric Lascelles – Chief Economist, RBC Global Asset Management Inc.

Allan Seychuk, CFA – V.P., Economics & Institutional Portfolio Management, RBC Global Asset Management Inc.

Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Global Asset Management Inc.

ECONOMIC & CAPITAL MARKETS FORECASTS 4 RBC Investment Strategy Committee

RECOMMENDED ASSET MIX 5 RBC Investment Strategy Committee

CAPITAL MARKETS PERFORMANCE 8 Milos Vukovic, MBA, CFA – V.P. Investment Policy, RBC Global Asset Management Inc.

GLOBAL INVESTMENT OUTLOOK 10 Under pressure

Eric Lascelles – Chief Economist, RBC Global Asset Management Inc.

Allan Seychuk, CFA – V.P., Economics & Institutional Portfolio Management, RBC Global Asset Management Inc.

Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Global Asset Management Inc.

GLOBAL FIXED INCOME MARKETS 36 Soo Boo Cheah, CFA – Senior Portfolio Manager, RBC Asset Management UK Limited

Suzanne Gaynor – V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

CURRENCY MARKETS 43 Dagmara Fijalkowski, MBA, CFA – Head, Global Fixed Income and Currencies (Toronto and London),

RBC Global Asset Management Inc.

REGIONAL EQUITY MARKET OUTLOOK

United States 54 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 56 Stuart Kedwell, CFA – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

Europe 58 Dominic Wallington – Chief Investment Offi cer & Chief Executive Offi cer ,

RBC Asset Management UK Limited

Asia 60 Yoji Takeda – Director & V.P., RBC Investment Management (Asia) Limited

Emerging Markets 62Philippe Langham – Senior Portfolio Manager, RBC Asset Management UK Limited

RBC INVESTMENT STRATEGY COMMITTEE 64

CONTENTS

2 I THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE New Year 2012

EXECUTIVE SUMMARY

Muddle-through economic

scenario still our base case

The current investment environment is characterized by two divergent potential outcomes. Our base case scenario has Europe muddling its way through the current crisis. Any fi x will not likely be a perfect long-term solution, but rather one that persuades markets that a collapse is off the table. We expect any recession in Europe to be relatively mild and for recession in North America to be avoided. Global conditions should remain modest but positive, buoyed by fi rmer economic growth outside developed markets. The alternate outcome is for Europe’s crisis to escalate dramatically, with negative consequences for risk assets and further declines in bond yields.

The Eurozone has continued to deteriorate, engulfi ng erstwhile bystanders such as Italy, and knocking on the doors of Spain and Belgium. Unfortunately, politicians are stuck in reactive mode. They require market stress to secure the public support needed to implement bailouts. The ECB is doing a wonderful job of providing unlimited liquidity to European banks, but even unlimited liquidity has its limits when banks begin to run out of acceptable collateral. The most likely course of events for the Eurozone is that policymakers take several more months to arrive at a coherent and truly

workable solution. Bouts of volatility and pessimism are probable until this proper fi nal fi x is struck.

Our models indicate that the U.S. is not presently in a recession, but is at risk of tumbling into one within the next year. The threat comes less from domestic U.S. conditions, and more from the possibility of a European misstep with global consequences. Even absent a recession, growth prospects remain uninspiring. America is still riddled with dysfunctions, and these are holding back a proper economic recovery. The housing sector remains stubbornly resistant to signifi cant improvement, but we are increasingly of the mind that the stage is being set for a halting, modest housing recovery. The labour market is also misbehaving. Job growth now looks to be picking up moderately, but it will struggle to eat into the overhang of unemployment.

Canada continues to appear more sprightly than most. The combination of credit growth, job growth, and high and steady commodity prices are the ticket for ensuring ongoing economic gains. However, it remains highly unusual for Canada's economy to signifi cantly decouple from the U.S., especially given the Canadian dollar’s tendency to act as a shock absorber. As such, we forecast a downshift in economic growth in Canada in 2012.

Dollar a safe haven when risk

aversion returns

We cannot know yet whether the U.S. dollar lows last summer marked the bottom of the dollar bear market, or whether the 8% bounce since is merely a safe-haven rally. We can assert, however, that the European crisis, like the fi nancial-system collapse of 2008, has made it obvious that the greenback remains a safe-haven currency, and that all other currencies are secondary when risk aversion takes hold of the market. With a number of unresolved issues in Europe and critical funding needs concentrated in the fi rst quarter of next year, the spreading crisis will eventually weigh down the euro. With regard to other currencies, the past year's ‘currency impasse’ characterized by volatility in foreign-exchange values without sustainability, may very well extend into 2012. We want to take advantage of the volatility and favour establishing or adding to U.S. dollar exposure during its sell-offs in the belief that the volatility will eventually be resolved to the upside.

Benign infl ation and short

rates remain low

Global infl ation is still a bit high due to the lingering effects of higher commodity prices from the spring of 2011, but this infl uence is rapidly ebbing. The likely trajectory for infl ation is down to normal,

The global economy continues to eke out growth despite repeated market shocks and political earthquakes. These rumblings have not been entirely costless. Several fi ssures have begun to form, presenting threats to the recovery. The risk that Europe goes badly off the rails has grown over the past several months. Politicians and policymakers hold in their hands the capacity to avoid this worst-case scenario, but have so far displayed questionable dexterity. Political dysfunction has damaged confi dence and fi scal drags are beginning to bite. It is increasingly clear that this economic cycle is little different from recoveries that have followed fi nancial crises in the past. Simply put, the road back to normal is invariably long and slow.

Sarah Riopelle, CFAV.P. & Senior Portfolio Manager RBC Global Asset Management Inc.

Eric Lascelles Chief Economist RBC Global Asset Management Inc.

Allan Seychuk, CFAV.P., Economics & Institutional Portfolio Management RBC Global Asset Management Inc.

Daniel E. Chornous, CFAChief Investment Offi cer RBC Global Asset Management Inc.


EXECUTIVE SUMMARY • Sarah Riopelle, CFA • Eric Lascelles • Allan Seychuk, CFA • Daniel E. Chornous, CFA

or even sub-normal, levels given the substantial global economic slack that persists. The modus operandi for the world’s central banks remains to keep the pedal to the metal. For countries like the U.S., the U.K. and Japan, this means unchanged policy rates since their accelerators are already pressed against the fl oor. European Central Bank President Mario Draghi seems more willing to deliver monetary stimulus than his predecessor, likely translating into further policy easing in the coming months.

Signifi cant upside risks to

bond yields

Most major countries continue to enjoy near-record-low bond yields despite the unfolding crisis. The reasons that yields remain so low are simple: the short end of the yield curve is being pulled lower by stimulative central banks, and investors chasing yield have compressed the premium required for holding longer-term bonds. Growth prospects are limited, constraining the real bond yield, while infl ation looks to be mostly contained, holding down the infl ation component of the yield. Elevated risk aversion is boosting demand for bonds, and several central banks are actively engaged in quantitative easing, creating an additional major source of demand for their own sovereign bonds. The combination translates into extremely, and persistently, low bond yields.

It isn’t clear how long this perfect storm depressing yields will last. It will be hard for yields to move sustainably lower from here unless the feared collapse of the Eurozone becomes a reality, whereas the scope for eventual increases is much greater as the crisis fades and growth in Europe resumes. We do not need a “solution” to Europe’s crisis to drive yields higher. Rather, a “fi x” that allows

progress would be suffi cient for bond yields to begin their return to normalcy.

Equities struggle to look

beyond crisis

Global equity markets have exhibited unusually high volatility since mid-summer. Periods of optimism have been followed by offsetting periods when fear and risk aversion have dominated. Equity investors have been forced to balance this near-term uncertainty against historically attractive valuations, and at times, uncertainty has won out. During this period, equity markets have been trading in a well-defi ned range. Our view remains that it will be diffi cult for stocks to rise above the top end of the recent range without a signifi cant breakthrough in the European sovereign-debt crisis. Similarly, equities are unlikely to decline into the bottom half of the range unless we see an intensifi cation of the various crises confronting the global economy, an increase in the risk of recession, or falling profi ts.

While markets have recovered since early 2009, valuations remain attractive. Today’s depressed P/E multiples suggest investors are sceptical earnings growth can be sustained given the risk that Europe’s fi scal crisis will trigger a broader recession. With the benefi t of hindsight and sustained economic growth, and the restoration of investor confi dence, these valuation levels may one day seem outlandishly low.

Corporate profi tability and fundamentals are extremely healthy. It has been well documented how aggressively fi rms cut costs during the 2008-2009 fi nancial crisis, and how reticent they have been to resume hiring as growth recovered. This caution has helped direct a near-record share of each dollar of sales to the bottom line. There is little to suggest

that purse strings will be loosened appreciably in the near future, and so as long as modest growth prevails, margins should be maintained and overall earnings can continue to rise.

Asset mix – modestly

overweight stocks,

underweight bonds

While risks to growth are easy to enumerate, a durable solution to Europe’s fi scal crisis is a work-in-progress that should, over the coming months, provide investors with greater certainty that a worst-case outcome will be averted. Today’s extremely low yields on U.S., Canadian and U.K. government bonds will be diffi cult to sustain in any environment that includes modest economic growth and progress toward crisis resolution. We are also closely monitoring evidence that the global economy is still expanding at a decent pace. This, too, will help confi dence recover. As that happens, bond yields will likely rise from current ultra-low levels and result in capital losses for bond holders. Given this view, and its implied risk of higher bond yields, we remain underweight fi xed income. Within equities, we are maintaining our modest overweight position. Although growth next year will remain weak, severely depressed equity-market valuations provide upside potential. As long as growth is sustained, normalizing valuations will ultimately drive future returns. However, our overweight stance is relatively modest in recognition of the fl uid situation in Europe and unusually wide divergence between the potential outcomes of the crisis. For a balanced global investor, we recommend an asset mix of 57.5% equities (benchmark: 55% within an allowed range of 40% to 70%), 35.0% bonds (benchmark: 40% within an allowed range of 30% to 60%), with the balance of 7.5% in cash.


TARGETS (RBC INVESTMENT STRATEGY COMMITTEE)

NOVEMBER 2011FORECAST

NOVEMBER 2012CHANGE FROM

FALL 20111-YEAR TOTAL RETURN

ESTIMATE (%)

CURRENCY MARKETS AGAINST USD

USD–CAD 1.02 1.04 0.02 (1.5)

EUR–USD 1.34 1.25 N/C (6.2)

USD–JPY 77.61 80.00 (5.00) (3.5)

GBP–USD 1.57 1.60 (0.04) 2.7

FIXED INCOME MARKETS

U.S. Fed Funds Rate 0.25 0.25 N/C N/A

U.S. 10 Year Bond 2.05 3.00 (0.25) (3.7)

Canada Overnight Rate 1.00 1.00 (0.50) N/A

Canada 10 Year Bond 2.15 3.00 (0.50) (3.4)

Eurozone Policy Rate 1.25 0.50 (1.00) N/A

Germany 10 Year Bund 2.28 3.00 (0.50) (2.6)

U.K. Base Rate 0.50 0.50 N/C N/A

U.K. 10 Year Gilt 2.31 2.75 (0.50) 0.6

Japan Overnight Call Rate 0.10 0.10 N/C N/A

Japan 10 Year Bond 1.07 1.50 N/C (1.2)

EQUITY MARKETS

S&P 500 1247 1375 50 12.4

S&P/TSX Composite 12204 13500 N/C 13.5

MSCI Europe 1276 1400 (100) 14.6

FTSE 100 5505 5750 N/C 8.5

Nikkei 8630 9750 (750) 15.3

Source: RBC GAM

ECONOMIC & CAPITAL MARKETS FORECASTS

ECONOMIC FORECAST (RBC INVESTMENT STRATEGY COMMITTEE)

UNITED STATES CANADA EUROPE

UNITED KINGDOM JAPAN CHINA

EMERGING MARKETS1

New Year2012

Change from Fall

2011New Year

2012

Change from Fall

2011New Year

2012

Change from Fall

2011New Year

2012

Change from Fall

2011New Year

2012

Change from Fall

2011New Year

2012

Change from Fall

2011New Year

2012

Change from Fall

2011

REAL GDP

2010A 2.80% 3.10% 1.70% 1.30% 4.00% 9.80% 8.50%

2011E 1.75% N/C 2.25% (0.25) 1.50% (0.50) 1.00% (0.25) (0.50%) N/C 9.25% 0.25 6.75% N/C

2012E 2.00% (0.50) 2.00% (0.50) 0.00% (1.50) 1.00% (1.00) 2.25% (0.50) 8.25% (0.25) 6.50% N/C

CPI

2010A 1.60% 1.80% 1.60% 3.30% (0.80%) 3.20% 5.50%

2011E 3.00% 0.25 2.75% N/C 2.50% N/C 4.25% N/C (0.25%) (0.50) 5.75% 0.50 6.50% 0.50

2012E 1.75% N/C 2.00% (0.25) 1.50% (0.25) 2.50% 0.25 0.25% N/C 4.50% 0.50 5.50% 0.25

A = Actual E = Estimate1 GDP Weighted Average of China, India, Brazil, Russia, South Korea and Mexico


GLOBAL ASSET MIX

BENCHMARK POLICY

PAST RANGE

NEW YEAR2011

SPRING2011

SUMMER2011

FALL2011

NEW YEAR2012

CASH 5.0% 1.5% – 16% 5.0% 2.5% 5.0% 7.5% 7.5%

BONDS 40.0% 25% – 54% 35.0% 37.5% 36.5% 35.0% 35.0%

STOCKS 55.0% 36% – 65% 60.0% 60.0% 58.5% 57.5% 57.5%

REGIONAL ALLOCATION

GLOBAL BONDS CWGBI*NOV. 2011

PAST RANGE

NEW YEAR2011

SPRING2011

SUMMER2011

FALL2011

NEW YEAR2012

North America 31.2% 9% – 46% 31.5% 33.9% 33.7% 35.0% 33.7%

Europe 36.7% 40% – 90% 38.0% 32.7% 32.4% 34.5% 31.7%

Asia 32.1% 0% – 29% 30.6% 33.4% 33.9% 30.5% 34.6%

Note: Based on anticipated 12-month returns in $US hedged basis

GLOBAL EQUITIES MSCI**NOV. 2011

PAST RANGE

NEW YEAR2011

SPRING2011

SUMMER2011

FALL2011

NEW YEAR2012

North America 57.2% 15% – 60% 54.5% 55.5% 55.5% 56.0% 58.3%

Europe 24.6% 30% – 70% 30.5% 29.5% 27.0% 24.3% 23.3%

Asia 12.8% 10% – 39% 15.0% 15.0% 12.0% 13.3% 12.5%

Emerging Markets 5.5% N/A 0.0% 0.0% 5.5% 6.5% 6.0%

GLOBAL EQUITY SECTOR ALLOCATION

MSCI**NOV. 2011

RBC ISCFALL 2011

RBC ISCNEW YEAR 2012

CHANGE FROMFALL 2011

WEIGHT vs. BENCHMARK

Energy 11.71% 12.00% 12.71% 0.71 108.54%

Materials 7.62% 8.25% 7.62% (0.63) 100.00%

Industrials 10.90% 11.00% 11.15% 0.15 102.29%

Consumer Discretionary 10.38% 11.50% 11.38% (0.12) 109.63%

Consumer Staples 10.64% 10.50% 10.89% 0.39 102.35%

Health Care 10.02% 9.00% 9.52% 0.52 95.01%

Financials 18.03% 18.00% 17.03% (0.97) 94.45%

Information Technology 12.32% 13.00% 13.32% 0.32 108.12%

Telecom. Services 4.44% 3.75% 3.44% (0.31) 77.48%

Utilities 3.94% 3.00% 2.94% (0.06) 74.60%

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 profi le. 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 fi ne tuning around the strategic setting in an effort to add value by taking advantage of shorter term fl uctuations in markets.

Every individual has differing return expectations and tolerances for volatility, so there is no “one size fi ts all” strategic asset mix. Based on a 35-year study of historical returns and the volatility of returns (the range around the average return within which shorter-term results tend to fall), we have developed fi ve broad profi les and assigned a benchmark strategic asset mix for each. These profi les 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 longer-term norm, the potential for returns rises. The fi ve profi les presented below may assist investors in selecting a strategic asset mix best aligned to their investment goals.

Each quarter, the RBC Investment Strategy Committee publishes a recommended asset mix based on our current view of the economy and return expectations for the major asset classes. These weights are further *Citigroup World Global Bond Index **MSCI World Index Source: RBC Investment Strategy Committee

RECOMMENDED ASSET MIX

divided into recommended exposures to the variety of global fi xed income and equity markets. Our recommendation is targeted at the Balanced profi le where the benchmark setting is 55% equities, 40% fi xed income, 5% cash.

A tactical range of +/- 15% around the benchmark position allows us to raise or lower exposure to specifi c asset classes

with a goal of tilting portfolios toward those markets that offer comparatively attractive near-term prospects.

This tactical recommendation for the Balanced profi le can serve as a guide for movement within the ranges allowed for all other profi les. If, for example, the recommended current equity exposure for the Balanced profi le is set at 62.5%

Continued on next page...



ASSET CLASSBENCH-MARK

RANGELAST

QUARTERCURRENT

RECOMMENDATION

CASH & CASH EQUIVALENTS 5% 0-15% 7.5% 7.5%

FIXED INCOME 75% 55-95% 71.4% 71.4%

TOTAL CASH & FIXED INCOME 80% 65-95% 78.9% 78.9%

CANADIAN EQUITIES 10% 5-20% 10.8% 10.6%

U.S. EQUITIES 5% 0-10% 6.0% 6.2%

INTERNATIONAL EQUITIES 5% 0-10% 4.3% 4.3%

EMERGING MARKETS 0% 0% 0.0% 0.0%

TOTAL EQUITIES 20% 5-35% 21.1% 21.1%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 60% 40-80% 55.5% 55.5%



U.S. EQUITIES 10% 0-15% 11.5% 11.8%


EMERGING MARKETS 0% 0% 0.0% 0.0%

TOTAL EQUITIES 35% 20-50% 37.0% 37.0%

(i.e.: 7.5% above its benchmark of 55% and part way toward its upper limit of 70% for equities), that would imply a tactical shift of + 5.02% to 25.02% for the Very Conservative profi le (i.e.: a proportionate adjustment above the benchmark equity setting of 20% within the allowed range of +/- 15%).

The value-added of tactical strategies are, of course, dependent on the

degree to which the expected scenario unfolds.

Regular review of portfolio weights is an essential part of the ultimate success of an investment plan as it ensures that current exposures are aligned with the level of long-term returns and risk tolerances best suited to individual investors.

VERY CONSERVATIVE

CONSERVATIVEConservative investors will pursue modest income and capital growth with reasonable capital preservation, and be comfortable with moderate fl uctuations in the value of their investments. The portfolio will invest primarily in fi xed-income securities, with some equities, to achieve more consistent performance and provide a reasonable amount of safety. The profi le is suitable for investors who plan to hold their investment over the medium to long term (minimum fi ve to seven years).

Very Conservative investors will seek income with maximum capital preservation and the potential for modest capital growth, and be comfortable with small fl uctuations in the value of their investments. This portfolio will invest primarily in fi xed-income securities, and a small amount of equities, to generate income while providing some protection against infl ation. Investors who fi t this profi le generally plan to hold their investment for the short to medium term (minimum one to fi ve years).

RETURN VOLATILITY

35-YEAR AVERAGE 9.4% 6.2%

LAST 12 MONTHS 5.9% 1.8%

1. Average Return: The average total return produced by the asset class over the period 1976 – 2011, 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.

...Continued from previous page

Anchoring portfolios with a suitable strategic asset mix, and placing boundaries defi ning the allowed range for tactical positioning, imposes a discipline that can limit the damage caused by swings in emotion that inevitably accompany both bull and bear markets.

RETURN VOLATILITY






RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 40% 20-60% 35.0% 35.0%



U.S. EQUITIES 20% 10-30% 21.6% 22.0%


EMERGING MARKETS 3% 0-10% 3.3% 3.4%

TOTAL EQUITIES 55% 40-70% 57.5% 57.5%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 25% 5-40% 19.7% 19.7%



U.S. EQUITIES 25% 15-35% 26.7% 27.1%


EMERGING MARKETS 4% 0-10% 4.6% 5.0%

TOTAL EQUITIES 70% 55-85% 72.8% 72.8%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 0% 0-10% 0.0% 0.0%



U.S. EQUITIES 30% 15-45% 31.1% 31.6%

INTERNATIONAL EQUITIES 22.5% 10-35% 21.0% 20.9%

EMERGING MARKETS 7.5% 0-15% 7.2% 7.0%

TOTAL EQUITIES 95% 80-100% 95.0% 95.0%

BALANCED

AGGRESSIVE GROWTH

GROWTH

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 fl uctuations in the value of their investments. More than half the portfolio will usually be invested in a diversifi ed mix of Canadian, U.S. and global equities. This profi le is suitable for investors who plan to hold their investment for the medium to long term (minimum fi ve to seven years).

Investors who fi t the Growth profi le will seek long-term growth over capital preservation and regular income, and be comfortable with considerable fl uctuations in the value of their investments. This portfolio primarily holds a diversifi ed 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 signifi cant fl uctuations in the value of their investments. The portfolio is almost entirely invested in stocks and emphasizes exposure to global equities. This investment profi le 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).

RETURN VOLATILITY



RETURN VOLATILITY



RETURN VOLATILITY


LAST 12 MONTHS -1.0% 10.0%


Milos Vukovic, MBA, CFAV.P. Investment Policy RBC Global Asset Management Inc.

CAPITAL MARKETS PERFORMANCE

EXCHANGE RATES (USD RETURNS) PERIODS ENDING NOVEMBER 30, 2011

Current USD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

USD–CAD 1.0199 4.16 2.26 (0.62) (6.27) (2.22)

USD–EUR 0.7442 6.90 (0.55) (3.45) (1.88) (0.30)

USD–GBP 0.6371 3.46 (0.69) (0.95) (0.64) 4.59

USD–JPY 77.5354 1.27 (4.42) (7.25) (6.69) (7.68)

Between September 1, 2011, and November 30, 2011, the U.S. dollar rose against all four other major developed-market currencies as Europe’s sovereign-debt crisis and concern about an economic slowdown in China illuminated the safe-haven qualities of the greenback. The U.S. dollar gained 6.9% against the euro, 4.2% against the Canadian dollar, 3.5% against the British pound and 1.3% against the yen. In the latest 12-month period, the greenback dropped against all the major currencies, falling 7.3% versus the yen, 3.5% against the euro, 1.0%% against the pound and 0.6% versus the Canadian dollar.

Fixed-income markets rose in North America as Europe’s economic and political turmoil sent investors in search of bonds from regions perceived as carrying lower risks. Bond markets in Europe and Japan declined. In Canada, the DEX Universe Bond Index gained 2.2% in the three months ended November 30, 2011, making it the best performing of the major fi xed-income indexes, while the Barclays Capital Aggregate Bond Index, a broad measure of U.S. fi xed-income performance, gained 0.8%. The Citigroup World Government Bond Index lost 2.7%, and Japan’s bond market, measured by the Citigroup Japan Index, lost 1.0%. The Citigroup Europe Index declined 8.6%, as many European bond markets fell signifi cantly amid soaring yields. During the 12-month period, all fi xed-income indexes in developed markets had positive returns, led by

Source: Bloomberg/MSCI

CANADA (CAD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011

Fixed Income Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

DEX Universe Bond Index 2.22 7.86 8.03 7.68 5.85

U.S. (USD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Citigroup US TR 1.67 8.61 6.72 4.61 6.39

Barclays Capital Agg. Bond Index TR 0.75 6.67 5.52 7.69 6.14

GLOBAL (USD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Citigroup WGBI (2.71) 4.97 6.18 7.22 6.09

Citigroup Europe (8.60) 1.27 3.75 4.82 3.18

Citigroup Japan (0.97) 6.23 10.20 9.54 10.76

the Citigroup Japan Index, which rose 10.2%, helped by a strong domestic currency, followed by the DEX index, which gained 8.0%, and the Barclays Capital index, which gained 5.5%. The Citigroup Europe Index lagged with a 3.8% gain.

The U.S. stock market was the only major developed-country equity market to post gains in the latest three-month period, refl ected in a 2.9% rise for the S&P 500. In the latest 12 months, the index gained 7.8%. The S&P/

TSX Composite Index lost 3.7% in the three-month period and 3.3% for the 12-month period, dragged down by a weakening outlook for the global economy. Canadian small-cap stocks posted signifi cant losses, in contrast to the modest gains recorded by U.S. mid-cap and small-cap indexes. The S&P/TSX Small Cap Index lost 8.0% in the latest three months and 8.8% over the 12-month period. The S&P 400 Index, a measure of the U.S. mid-cap market, gained 1.4% over the latest three months, and 5.1%

Note: all changes above are expressed in US dollar terms

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


GLOBAL (USD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011

Equity Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

MSCI World* (1.65) (5.49) 1.46 12.32 (1.96)

MSCI EAFE* (5.62) (11.30) (4.12) 10.11 (3.95)

MSCI Europe* (4.71) (9.66) (2.08) 10.29 (4.30)

MSCI Pacifi c* (7.24) (13.87) (7.33) 10.05 (3.09)

MSCI UK* (0.56) (2.63) 4.47 13.80 (2.72)

MSCI France* (9.34) (14.09) (6.60) 5.63 (6.30)

MSCI Germany* (1.92) (12.34) (6.21) 10.30 (1.94)

MSCI Japan* (6.22) (15.04) (8.56) 4.06 (6.25)

MSCI Emerging Markets* (9.71) (17.43) (11.54) 23.61 3.56

CANADA (CAD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

S&P/TSX Composite (3.74) (7.13) (3.33) 12.82 1.95

S&P/TSX 60 (3.81) (7.46) (3.77) 10.31 1.57

S&P/TSX Small Cap (7.98) (14.61) (8.84) 25.87 0.77

Source: Bloomberg/MSCI

GLOBAL EQUITY SECTORS (USD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011

Sector: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Energy 2.73 0.79 10.93 11.19 2.37

Materials (8.43) (16.07) (6.55) 20.19 2.40

Industrials (1.60) (8.58) (1.00) 14.49 (0.77)

Consumer Discretionary (0.42) (2.93) 1.69 2.17 (2.10)

Consumer Staples (1.10) (4.35) 0.27 20.79 (0.64)

Health Care 1.08 6.88 12.35 14.41 6.41

Financials (0.59) 6.00 11.34 11.49 1.18

Information Technology (7.82) (18.67) (11.29) 4.31 (13.46)

Telecommunication Services 4.05 (0.95) 5.02 19.72 1.49

Utilities (0.74) 0.48 5.93 9.91 1.27

for the 12- month period, while the S&P 600 Index, a gauge of small-cap performance, gained 3.8% in three months, and 7.4% over 12 months. Value and growth stocks had similar returns in the three-month period, with the Russell 3000 Growth Index returning 2.7% and the Russell 3000 Value Index returning 2.4%. Over 12 months, however, the growth index outperformed signifi cantly, returning 8.3%, compared with a 5.7% return for the value index.

Among developed-country equity markets outside North America, the MSCI France performed worst, with a 9.3% decline in U.S. dollar terms, because of concern about French bank exposure to the European debt crisis. The MSCI Japan Index decreased 6.2% and the MSCI U.K. Index was down less than 1.0%. The MSCI World Index dropped 1.7%, while the MSCI Emerging Markets Index dropped 9.7%. In the 12-month period, the MSCI U.K. Index was the only major non-North American market to gain, adding 4.5%. MSCI Germany lost 6.2%, MSCI France lost 6.6% and MSCI Japan lost 8.6%.

Seven of the 10 global equity sectors declined over the latest three-month period. The best performing sector was Information Technology, which returned 4.1%, followed by Energy with a gain of 2.7%, and Consumer Staples, up 1.1%. The worst-performing sectors were Materials, which lost 8.4%, Financials, which fell 7.8%, and Industrials, which declined 1.6%. For the latest 12-month period, the best-performing sector was Consumer Staples, and the worst-performing sector was Financials.

* Net of Taxes

U.S. (USD $ BASIS)PERIODS ENDING NOVEMBER 30, 2011


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

S&P 500 2.90 1.08 7.83 14.13 (0.18)

S&P 400 1.40 (1.36) 5.10 21.63 3.29

S&P 600 3.82 (0.23) 7.41 18.85 1.69

RUSSELL 3000 Value 2.43 (2.04) 5.72 11.54 (2.55)

RUSSELL 3000 Growth 2.73 2.50 8.32 19.02 2.59

NASDAQ Composite Index 1.58 (1.23) 4.89 19.50 1.51

CAPITAL MARKETS PERFORMANCE • Milos Vukovic, MBA, CFA

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


Under pressure

GLOBAL INVESTMENT OUTLOOK

Divergent narratives

The global economy continues to eke out growth despite repeated market shocks and political earthquakes. Alas, these rumblings have not been entirely costless. Several fi ssures have begun to form, presenting risks to the recovery. Hairline cracks have been visible for some time within Europe, both in terms of divergent economic plights and confl icting visions for the Eurozone.

The Atlantic divide between North America and Europe looks set to drift even wider, with the Eurozone economy clearly descending into recession versus a U.S. economy that is stubbornly (if sluggishly) advancing. There is also a fascinating gap between the prospects for governments and businesses. Government revenues remain anemic and debt levels are soaring; business profi ts are robust and debt levels contained.

Lastly, there is a chasm between the two most probable global economic scenarios (Exhibit 1). Our own central forecast, and one possessing perhaps a 70% chance of attainment, involves a relatively benign outcome of cautious global economic growth and an avoidance of the trio of a major bank failure, a major sovereign default and a break-up of the Eurozone.

However, there is a non-trivial risk of something more malignant. The risk that Europe goes badly off the rails has

EXHIBIT 1. Global Scenario Redux

60

70

80

90

100

110

120

2006 2007 2008 2009 2010 2011

Inde

x

Euro Area Economic SentimentU.K. Economic Sentiment

Source: Haver Analytics, RBC GAM

EXHIBIT 2. Confi dence in Euro Area and U.K. Continues to Worsen

Eric Lascelles Chief Economist RBC Global Asset Management Inc.

Allan Seychuk, CFAV.P., Economics & Institutional Portfolio Management RBC Global Asset Management Inc.

Daniel E. Chornous, CFAChief Investment Offi cer RBC Global Asset Management Inc.

grown over the past several months. This alternate scenario would result in a serious global recession and a jarring blow to global fi nancial markets.

Handicapping these outcomes is not easy, especially because it is primarily politicians who will determine the

outcome. Politicians and policymakers hold in their hands the capacity to avoid this worst-case scenario, but have so far displayed questionable dexterity. All of this has left confi dence (Exhibit 2) and risk appetite (Exhibit 3) very low.

70%CHANCE

30%CHANCE

Sluggish global growth

Global recession

due to a combination of:

• Political dysfunction

• Major bank failure

• Major sovereign default

• Eurozone breakup

Source: RBC GAM


Fading growth forecasts

Our economic forecasts have been trimmed to refl ect newly diminished prospects. Political dysfunction has damaged confi dence, fi scal drags are beginning to bite, Europe remains messy, China’s economy appears to have crested for now, and it is increasingly clear that this economic cycle is little different from recoveries that followed fi nancial crises in the past. Simply put, the road back to normal is invariably long and slow.

The outlook for 2012 GDP is broadly lower (Exhibit 4). We have chopped around half a percentage point from U.S., Japanese and Canadian economic growth, leaving their growth rates in the range of 2.0%-2.25% for the year. For the U.S. and Canada, these rates are the defi nition of treading water. The U.K. growth forecast has been clipped by a full percentage point, to 1.0%, and the Eurozone forecast has plummeted from 1.5% to a recessionary 0.0%. Emerging-market forecasts are also diminished, but only slightly.

Even these tempered forecasts owe a debt of gratitude to the heroics of central bankers (Exhibit 5), who continue to deliver monetary stimulus. Unlike their fi scal brethren, they show the capacity for coherent, prompt and even coordinated action.

Improving data

The good news is that these economic downgrades have hopefully run their course. Outside of the Eurozone, economic data looks to have struck an infl ection point of sorts around the beginning of October. Data releases have fi nally started to come in stronger than expected instead of

GLOBAL INVESTMENT OUTLOOK • Eric Lascelles • Allan Seychuk, CFA • Daniel E. Chornous, CFA

2.25%2% 2%

0%

1%

0.0

0.5

1.0

1.5

2.0

2.5

Japan U.S. Canada U.K. Eurozone

%

Source: RBC GAM

EXHIBIT 4. RBC GAM Forecast for Developed Markets 2012 GDP Outlook

-9

-6

-3

0

3

6

9

2006 2007 2008 2009 2010 2011

Glo

bal R

isk

Appe

tite

Inde

x

Source: Credit Suisse

EXHIBIT 3. Credit Suisse Global Risk Appetite Index

-2-1012345

2000 2002 2004 2006 2008 2010

Glo

bal R

eal P

olic

y R

ate

(%)

Regions included: U.S., Canada, U.K., Eurozone, Switzerland, Sweden, Norway, Japan, Australia, China, India, South Korea, Russia, Brazil, Mexico. PPP weights by GDP share.Source: Haver Analytics, RBC GAM

EXHIBIT 5. Global Real Monetary Policy


weaker (Exhibit 6). They have begun stabilizing, or even modestly improving, on an absolute basis too (Exhibit 7). Nothing is pointing to outright strong economic growth. But increasingly it is credible to say that the U.S. economy is expanding, and more likely than not to continue growing over the coming year.

Businesses trump

governments

The main reason the stock market has remained so resilient in the face of economic weakness is that the corporate sector has done amazingly well. How has it managed this? First, many companies based in the developed world have earned profi ts from healthier emerging markets. Second, they have suppressed labour costs due to weak economic conditions, and extracted impressive productivity gains from leaner workforces.

In contrast, governments have faired especially poorly. Why? Largely because they bailed out the fi nancial sector, did their best to stimulate their economies back to life and suffered the ravages of a weak economy on their tax revenues. There is a certain irony that businesses were central benefi ciaries of the fi rst two actions.

Corporate profi ts may eventually revert to a more normal share of the economy and government defi cits have at last begun to shrink, but the main elements of this divergence are likely to persist for the immediate future (Exhibit 8). The mantra that sovereigns are always safer than corporations requires a rethink, with implications for corporate credit and equities.


-150

-100

-50

0

50

100

150

Jun-10 Oct-10 Feb-11 Jun-11 Oct-11

Inde

x, 1

Std

Dev

=100

Source: Citigroup Alpha Surprise Index, RBC GAM

Positive Surprises

Negative Surprises

EXHIBIT 6. U.S. Economic Surprises Are Turning Positive

48

50

52

54

56

Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11

PM

I Man

ufac

turin

g In

dex


EXHIBIT 7. U.S. Economy Is Reviving

ISM Manufacturing: Purchasing Managers Index

5%

21%

81%

10%

0

5

10

15

20

25

30

U.S. GovernmentReceipts

U.S. CorporateProfits

U.S. GovernmentOutstanding Debt

U.S. Non-financialand Financial

Outstanding Debt

5-Ye

ar G

row

th R

ate

(%)

0

15

30

45

60

75

90

5-Ye

ar G

row

th R

ate

(%)

Revenues (LHS) Debt (RHS)


EXHIBIT 8. U.S. Corporations Are Doing Far Better Than the Governments*

* Government includes central government, state government, and local government


Eurozone-U.S. divergence

The recent economic divergence between the Eurozone and the U.S. is curious. Both are increasingly under pressure from fi scal austerity. Surprisingly, it is the U.S. that will suffer the greater mathematical fi scal drag over the coming year.

However, there is no getting around the fact that the U.S. economy still has superior growth prospects. There are three reasons. First, the U.S. economy simply has a faster speed limit, due to better demographics and a better productivity track record. Second, confi dence is bouncing back in the U.S. more quickly than it is in Europe. Third, European banks have begun a lengthy and painful deleveraging process. This divergence looks likely to last for several years (Exhibit 9).

Eurozone recession

The Eurozone is succumbing to recession (Exhibit 10) and the unemployment rate continues to rise. This varies by country. Southern Europe is set to tumble into a serious recession, while the remainder of the Eurozone has only modest growth prospects. Meanwhile, Eurozone infl ation should waft lower to around 1.5% in 2012. The ECB is likely to deliver yet more stimulus, both in the form of traditional rate-cutting and via ever more expansive liquidity offerings. The unknown is whether the ECB can wrap its head around a bout of quantitative easing. We think and hope so. In this scenario, the euro is more likely to fall than rise.

It bears repeating that the Eurozone really could go one of two ways. The most likely direction is this middling


-6

-4

-2

0

2

4

6

2000 2002 2004 2006 2008 2010 2012

GD

P G

row

th Y

/Y (%

)

U.S.Euro Area


Growth is beginningto diverge

RBC GAM Forecast

2012 GDPForecast

Euro Area: 0%

2012 GDPForecastU.S.: 2%

EXHIBIT 9. GDP Growth Rates in the U.S. and the Euro Area Are on

Divergent Paths

1.75

-0.75-0.5 -0.5

0

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Normal GDPSpeed Limit

Fiscal Austerity

Drag

BankRecapitalization

Drag

ConfidenceDrag

2012 GDPOutlook

Source: RBC GAM

%

=-

EXHIBIT 10. European 2012 GDP Math Has Deteriorated

recession. Unfortunately, that’s about as good as it gets. The (less likely) alternative is a profoundly deep recession, brought on by political inaction or a serious policy or political misstep.

Eurozone two-step

The Eurozone has continued to deteriorate, engulfi ng erstwhile bystanders such as Italy, and knocking on the doors of Spain and Belgium (Exhibit 11). Additional countries seem to be implicated with each

passing quarter. This is worrisome and unsustainable.

Unfortunately, politicians are stuck in reactive mode. They require market distress to secure the necessary public support to implement the needed bailouts. Thus, a Eurozone two-step of sorts has developed: markets panic, policymakers respond in underwhelming fashion, and markets panic all over again. In fairness, important political progress is being made, but it is a painful way to fi x what


is fundamentally a very fi xable problem (Exhibit 12).

We cannot say with certainty that it all stops with Italy. In fact, the recent trend hints that it may not. But there are two important distinctions to be made between the countries that came before Italy (Greece, Portugal and Ireland) and the countries that may come afterwards. The fi rst three are relatively small economies, whereas the rest are worryingly much bigger. This raises the stakes. However, Italy and the other newly imperiled countries do not seem to suffer from the same insolvency that plagues Greece. Their debt loads should remain manageable, if just barely (Exhibit 13). To be sure, it would be nice to see the International Monetary Fund (IMF), the ECB or strong European nations step in more forcefully with a credible backstop. But Italy’s epitaph is not yet written, whereas Greece’s has been.

European funding stress

The good news about international funding markets is that outside of Europe they appear relatively normal. This is positive in that non-European banks and corporations can fund themselves inexpensively, and also because the market is clearly betting that the most severe problems will remain confi ned to Europe.

The bad news is that there is considerable funding stress within Europe (Exhibit 14). Short-term funding costs are high, and several European banks are on life support. European fi nancial credit default swaps show that the risk of a European bank default is elevated.


2

3

4

5

6

7

8

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

10-Y

ear B

ond

Yiel

d (%

) ItalySpainBelgium


EXHIBIT 11. Selected Euro Area 10-Year Bond Yields

Note: Liquid: capacity to raise funds in bond market Solvent: capacity to afford debt over medium to long term Competitive: economic competitiveness versus rest of Eurozone

Source: RBC GAM

EXHIBIT 12. Eurozone Is Not So Bad in the Aggregate

(% of GDP 2011 est.)

EXHIBIT 13. Parsing the Problem

Eurozone U.S.

Government Debt 89 100

Fiscal Balance (4.1) (9.6)

Current Account Balance 0.1 (3.1)

Private Debt (non-financial) 171 238

Source: IMF, RBS, RBC GAM

Country Liquid Solvent Competitive

Greece No No No

Portugal No So-So So-So

Ireland No So-So So-So

Italy So-So Yes No

Spain So-So Yes No

France Yes Yes So-So

Germany Yes Yes Yes


The stated commitment to preventing systemically important European banks from failing seems credible and the proposed bank recapitalization plan is a fi rst step, even if it looks undersized. It makes no sense to allow one of these institutions to fail. The consequences would be outsized and the cost of saving them is relatively low, especially when one considers the decent prospects of recouping the money later on.

Policymakers need to hurry up, though. The ECB is doing a wonderful job of providing unlimited liquidity to the European banks that need assistance, but even unlimited liquidity has its limits when banks begin to run out of acceptable collateral. Meanwhile, several banks face a slow-motion deposit run that can only end badly if not promptly dealt with.

Let's stay together

The most likely course of events for the Eurozone is that policymakers take several more months to arrive at a coherent and truly workable solution. Bouts of volatility and pessimism are probable until this proper fi nal fi x is struck. The endgame must, and likely will, include four central features. First, Greece needs a signifi cantly larger write-down than is currently envisioned. Second, a little help from policymakers should enable Italy and Spain to escape the gravitational pull of spooked markets. Third, the banking sector must be recapitalized, preventing European shrapnel from damaging the rest of the world. Fourth, instead of tearing itself apart, the Eurozone is likely to embrace greater fi scal union, including clear rules for fi scal conduct, a fi scal oversight agency


0

50

100

150

200

250

300

350

400

Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11

Bas

is P

oint

s

U.S. (3-Month Libor-OIS)

Eurozone (3-Month Euribor-OIS)


EXHIBIT 14. Money Market Funding Costs

United States and Eurozone

and a form of centralized eurobond. None of this mitigates the outlook for a recession in the near term and the likelihood of very slow growth over the medium term, but it avoids calamity.

Collateral damage

As Europe’s slow-motion train wreck plays out, the consequences have become deadly serious for Central and Eastern Europe. Not only are countries in this region deeply tied to the Eurozone’s sclerotic economies, but Eurozone banks are central players

in their fi nancial systems. Hungary, Slovakia, Bulgaria and Romania are especially vulnerable. Problems are beginning to pile up now that several Eurozone nations have ordered their banks to cut foreign lending. Other banks have begun to do so of their own volition. Hungary has already been hit quite hard (Exhibit 15). This could yet become quite messy unless another effort akin to the 2008 Vienna Initiative is undertaken to prevent such capital fl ight.

220

240

260

280

300

3202000 2002 2004 2006 2008 2010

Hun

garia

n Fo

rint/E

uro

(Inve

rted)


EXHIBIT 15. Hungarian Forint Is Weakening


Fortunately, emerging-market economies look to be holding up somewhat better outside of Central and Eastern Europe. Infl ation pressures are fi nally easing, allowing central banks to inject monetary stimulus. In turn, growth prospects have not diminished to the same extent as elsewhere. We look for 6.5% GDP growth across the EM-6, which includes China, India, South Korea, Russia, Brazil and Mexico. Latin American economies, in particular, continue to enjoy the benefi ts of relatively high commodity prices, while Asian economies have attractive structural characteristics such as low debt loads, robust productivity-growth rates and current-account surpluses.

A cushion for China

The shadow of past credit excesses (Exhibit 16) continues to loom over China. The consequences include an overdone housing market and excessive local government debt. The two are increasingly tangled together not just in their potentially grim consequences for Chinese banks, but also because a housing correction would sharply cut local government revenues.

However, the episode does not have to end in disaster. China has bailed out its banking sector in the past, and is likely to do so again. Certainly, it has suffi cient resources and the necessary incentives. Meanwhile, China has begun to shift its focus away from taming infl ation and back toward stoking economic growth, delivering the fi rst of what could be multiple cuts to the reserve ratio.


0

5

10

15

20

25

30

35

2000 2001 2002 2003 2004 2005 2005 2006 2007 2008 2009 2010 2010 2011

Tota

l Loa

ns Y

/Y (%

)


CreditBulge

EXHIBIT 16. Did China Extend Too Much Credit?

35

40

45

50

55

60

65

2005 2006 2007 2008 2009 2010 2011

Chin

a PM

I Ind

ex


EXHIBIT 17. China – Purchasing Managers Index

It is clear that the Chinese economy is slowing (Exhibit 17). The question is how severely. Whereas it managed 10% growth in 2010 and 9% growth in 2011, a fi gure closer to 8.25% is our call for 2012. This amounts to a soft landing. Infl ation should ebb moderately as well.

Arab Winter

After several months of relative calm, the Middle East and North Africa are back in the headlines. The new

challenges include growing tension between Iran and the West, sanctions for Syria, discontent with interim military rule in Egypt, and ongoing uncertainty in Libya and Yemen. Accordingly, oil has crept back up to $100 per barrel (Exhibit 18), sapping precious global economic growth. Commodity prices may struggle to advance much further in a sluggish growth environment, but any signifi cant deterioration in this region could lay waste to that view.


America’s recession risk

Our models indicate that the U.S. is not presently in a recession, but is at risk of tumbling into one within the next year. The odds of a stumble are currently around 40% (Exhibit 19). Accordingly, the U.S. is more likely to expand than contract, but a recession is still a very real risk and one that must be taken seriously. The threat comes less from domestic U.S. conditions, and more from the possibility of a European misstep with global consequences.

Of course, even absent a recession, growth prospects are still uninspiring for the U.S., with little more than 2.0% real GDP growth likely for 2012. This skirts recession, but fails to materially improve the woeful job market. Infl ation looks to be fl uttering lower, and should settle around 1.75% in 2012. The U.S. dollar may manage some slight appreciation on the back of euro weakness.

Not-so-super committee

The U.S. has suffered yet another fi scal setback. After narrowly averting a technical default in early August (but succumbing to a ratings downgrade nonetheless), the so-called “super committee” of politicians failed to deliver on $1.2 trillion in cuts by the late November deadline. This is clearly disappointing, and the U.S. is at risk of another debt downgrade if politicians interfere with the automatic triggers now programmed to trim the budget automatically.

Truthfully, none of this has much relevance for the near-term economic outlook. There is not much serious talk of delivering additional cuts before the 2012 election. And the bond market


continues to be blissfully unconcerned about U.S. debt levels due to the country’s privileged status as the world’s largest economy and issuer of the de facto reserve currency. Without market pressure, a comprehensive fi scal fi x requiring $5 trillion to $7.5 trillion in cuts looks rather distant.

This is not to say that the economy will be completely unaffected by fi scal developments in 2012. The rate of GDP growth is set to be around one percentage point slower due to naturally unwinding fi scal stimulus.

This could get worse if a handful of expiring measures are not extended.

U.S. dysfunction

America is still riddled with dysfunctions, and these are holding back a proper economic recovery. The two biggest are in housing and employment.

The housing sector remains stubbornly resistant to signifi cant improvement (Exhibit 20). To be sure, there are glimmers of sunlight in the form of a

75

80

85

90

95

100

105

110

115

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

Bar

rel o

f WTI

Oil,

US

$

Source: U.S. Department of Energy, RBC GAM

Peak Price

EXHIBIT 18. Oil Is Down From its Peak, but Rising Again

75%

0% 100%

50%

2

5%

10%

chan

ce

EXHIBIT 19. U.S. Recession Risk

RBC GAM Econometric Model

25% 75%

0% 100%0%0% 100%100%

40%chance

ARE WE IN RECESSION RIGHT NOW? IS A RECESSION COMING IN THE NEXT YEAR?

Source: RBC GAM


modest rise in prices for non-foreclosed homes and excellent affordability.

But equally there are big challenges such as a bloated inventory levels, and traumatized lenders and borrowers. Home buyers now recognize that home ownership is not the easy path to riches that it was once thought to be. More technical constraints are, mercifully, beginning to be addressed. For instance, a recent initiative makes it easier to refi nance an underwater mortgage, extending the benefi t of ultra-low rates to those who need it most.

We are increasingly of the mind that the stage is being set for a halting, modest housing recovery, but even this is hardly certain. What’s clear is that the usual lift from residential construction cannot be expected to jolt the economy back to life all by itself.

The labour market is also misbehaving. Even in the context of a weak economy, the U.S. shed far more jobs than it should have, and has struggled to claw them back. This struggle has several causes. One is that U.S. businesses have extracted remarkable productivity gains (Exhibit 21), temporarily postponing the need for more workers. Another is that the U.S. labour market now suffers from geographic and sectoral mismatches. It is hard to move in search of better opportunities when your mortgage exceeds the value of your home. Moreover, a disproportionate number of construction and manufacturing workers were laid off, and many of these jobs aren’t coming back. As with the housing market, there are policy proposals in place to address elements


0

500

1000

1500

2000

2500

2004 2005 2006 2007 2008 2009 2010 2011

Hou

sing

Sta

rts, T

hous

ands

100

120

140

160

180

200

220

Hom

e Pr

ice

Inde

x (H

PI)

Housing Starts (LHS)

S&P Case Shiller HPI - 20 City (RHS)

Source: Census Bureau, S&P, RBC GAM

EXHIBIT 20. U.S. Housing Can't Get Off the Floor

-8

-6

-4

-2

0

2

4

6

2005 2006 2007 2008 2009 2010 2011

%

Productivity ContributionLabour ContributionReal GDP


EXHIBIT 21. U.S. Productivity Growth Has Supplanted Job Growth

2

6

10

14

18

1994 1996 1998 2000 2002 2004 2006 2008 2010

%

Broad Unemployment Rate

Official Unemployment Rate

Source: Bureau of Labour Statistics, RBC GAM

EXHIBIT 22. U.S. Unemployment Rate Still Extremely High


of these problems, but the political will is lacking.

Job growth now looks to be picking up moderately, but it will struggle to eat into the overhang of unemployment (Exhibit 22). This sorry state is unacceptable to policymakers, and constitutes a central reason why the U.S. Federal Reserve Board should hold its target for the fed funds rate at rock-bottom levels until mid-2013 at the absolute earliest (Exhibit 23). Additional U.S. monetary stimulus is, in fact, fairly likely.

All hail QE II

The U.K. remains dead-set on solving its fi scal excesses before the bond vigilantes set in. This is proving more economically painful than expected, but the will to press ahead appears unbroken. Meanwhile, the Bank of England is doing its best to offset the resulting economic damage from this (and from worsening prospects across the English Channel) by delivering a second round of quantitative easing (QE II). This is somewhat risky in an economy that still grapples with infl ation problems, but the decision achieved a rare unanimous endorsement from the BOE’s Monetary Policy Committee.

The fi scal drag is set to outweigh the monetary boost, resulting in GDP growth that dips to just 1.0% in 2012. The British unemployment rate is already at its highest level since the 1990s, and will struggle to make progress next year.

Meanwhile, British infl ation may remain more elevated than in other countries due to the pernicious work


-2147

101316192225

1980 1985 1990 1995 2000 2005 2010 2015

%

Last Plot: 0.08%Current Range: 0.45% - 2.73% (Mid: 1.59%)

Source: Federal Reserve, RBC GAM

EXHIBIT 23. U.S. Fed Funds

Equilibrium Range

-1

0

1

2

3

4

5

6

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Y/Y

%

CPI Y/Y

5-Year Inflation Expectation


EXHIBIT 24. U.K. Infl ation Rate

of infl ationary expectations, which are at risk of unmooring after several years of excessive infl ation (Exhibit 24). A sustained period of uncomfortably high infl ation can lead workers to demand higher and higher wages, further stoking infl ation.

The Japanese recovery

Japan is in the rare position of leading 2012 economic growth in the developed world, and we forecast a 2.25% advance. This trick should be accomplished thanks to rebounding

activity after Japan’s tragic earthquake and tsunami.

Japan continues to be a country of contrasts, with the world's lowest bond yields on a nominal basis, but among the highest in the developed world on an infl ation-adjusted basis (Exhibit 25). It has the world's biggest government debt-to-GDP ratio, and yet is also the world's biggest saver when households and businesses are added to the mix. The yen looks fairly strong and has prompted the central bank to intervene


in the foreign-exchange market to keep it from appreciating any further. And yet the exchange rate looks unstretched when adjusted for infl ation (Exhibit 26).

On the back of a tightening labour market, we believe Japan could manage a slightly positive infl ation reading for 2012, constructive news for a central bank that should nonetheless continue to dribble out additional stimulus.

Canadian prospects

Canada continues to appear more sprightly than most. The combination of credit growth, job growth, and high and steady commodity prices are the ticket for ensuring ongoing economic gains. However, it remains highly unusual for Canada's economy to signifi cantly decouple from the U.S., especially given the Canadian dollar’s tendency to act as a shock absorber. In turn, we forecast a downshift in economic growth in Canada to 2.0% in 2012, just like the U.S. Infl ation in Canada may be slightly more resistant to the downward trend than elsewhere due to an abnormally low policy rate relative to economic conditions. The Canadian dollar trades near par and should stay there.

Canada continues to enjoy several structural strengths, including a relatively low government debt load and healthy banking sector. The biggest risks to the economy are those that dog the rest of the world: a possible Eurozone collapse, U.S. recession or a Chinese hard-landing. In all cases, the risk of a recession in Canada is far lower than for the Eurozone and slightly less than for the U.S. This is primarily because, in a worst-case scenario, Canada still has some wiggle room


-40-30-20-10

01020304050

1985 1986 1988 1990 1992 1993 1995 1997 1999 2000 2002 2004 2006 2007 2009

% D

evia

tion

From

Fai

r Val

ue

FixedVariable

Good Home Affordability

Poor Home Affordability

Fixed- and variable-rate mortgages fairly expensive

Source: CREA, Statistics Canada, RBC GAM

Note: Calculates the carrying cost of a home once borrowing costs have returned to normal levels, versus the historical norm.

EXHIBIT 27. Canadian Sustainable Home-Affordability Gap

0

50

100

150

200

250

300

1985 1990 1995 2000 2005 2010 2015

Spot

Exc

hang

e R

ate,

Yen

/USD

0

50

100

150

200

Rea

l Tra

de W

eigh

ted

YenYen/USD (LHS)

Real Trade Weighted Yen (Inverted, RHS)


EXHIBIT 26. Deceptive Yen

0.0

0.4

0.8

1.2

1.6

2.0

Jan. 10 Aug. 10 Mar. 11 Oct. 11

Bond

Yie

ld (%

)

5-Year Nominal Yield5-Year Real Yield

Source: Bloomberg, RBC GAM

EXHIBIT 25. Japanese Real and Nominal 5-Year Bond Yield


to deliver more fi scal and monetary stimulus.

Of course, Canada also has domestic risks, but they pale in comparison to the international ones. In particular, Canada's housing market continues to look expensive, with affordability calculations fl ashing red (Exhibit 27). A correction is unlikely until interest rates begin to normalize – a relatively distant proposition. The condo market, in particular, is diffi cult to gauge. Anecdotally, the composition of purchases seems to be shifting away from owner-occupiers and toward speculators, suggesting the potential for a pull-back.

Another major Canadian risk is the withering level of competitiveness vis-à-vis the U.S. (Exhibit 28). Part of this can be pinned on the Canadian dollar’s appreciation, but lagging productivity growth and rising labour costs have not helped.

Benign infl ation

Global infl ation is still a bit high (Exhibit 29) due to the lingering effects of higher commodity prices from the spring of 2011. But this infl uence is rapidly ebbing. It is clear that food prices, in particular, are fi nally rolling over (Exhibit 30). The likely trajectory for infl ation is down to normal, or even sub-normal, levels given the substantial global economic slack that persists.

Short-term rates

The modus operandi for the world’s central banks remains to keep the pedal to the metal. For countries like the U.S., the U.K. and Japan, this means unchanged policy rates since


-10

0

10

20

30

40

50

2005 2006 2007 2008 2009 2010 2011

Con

tribu

tion

of F

acto

rs to

Can

ada'

s Lo

ss in

C

ompe

titiv

enes

s (%

Cha

nge)

vis

-a-v

is th

e U

.S.

Relative ProductivityCanadian DollarPercentage Change in Relative Unit Labour Costs

Source: RBC GAM, Haver Analytics

EXHIBIT 28. Canada Is Losing Competitiveness Vis-à-Vis the U.S.

-2

0

2

4

6

8

10

12

2005 2006 2007 2008 2009 2010 2011 2012

%

WorldEmerging EconomiesAdvanced Economies

Source: IMF, RBC GAM

EXHIBIT 29. Global Infl ation

IMF Aggregate Region CPI

-40

-20

0

20

40

60

80

2005 2006 2007 2008 2009 2010 2011 2012

Food

Pric

e In

dex

Y/Y

(%)


EXHIBIT 30. World Food Prices

World Bank Food Price Index



their accelerators are already pressed against the fl oor. European Central Bank President Mario Draghi seems more willing to deliver monetary stimulus than his predecessor, likely translating into further monetary easing to 0.50% in the coming months.

For Canada, an unchanged policy rate is the most probable outcome (Exhibit 31), but there is a slim chance of rate cuts should the global economy seriously deteriorate, and a modest chance of rate hikes should global conditions improve. But the broad message from the world’s developed nations it that the short end of the yield curve should remain both unusually stable and astonishingly low almost everywhere.

Emerging markets are, of course, a much tougher call due to their idiosyncratic nature, their greater battles with infl ation, and the obligation to protect their currencies should global conditions worsen. China and a handful of others look to have turned the corner, and are beginning to deliver more stimulus.

Government yields remain

historically low

Most major countries continue to enjoy near-record-low bond yields despite the unfolding crisis (Exhibit 32). The reasons that yields remain so low are simple: the short end of the yield curve is being pulled lower by stimulative central banks, and investors chasing yield have compressed the premium required for holding longer-term bonds. Growth prospects are limited, constraining the real bond yield, while infl ation looks to be mostly contained, holding down the infl ation component

0

5

10

15

20

25

1980 1985 1990 1995 2000 2005 2010 2015

%

Last Plot: 0.89%

Current Range: 1.34% - 3.43% (Mid: 2.39%)

Source: RBC GAM

EXHIBIT 31. Canada Overnight Rate

Equilibrium Range

of the yield. Elevated risk aversion is boosting demand for bonds, and several central banks are actively engaged in quantitative easing, creating an additional major source of demand for their own sovereign bonds. The combination translates into extremely, and persistently, low bond yields.

European yields refl ect break-

up risk

In recent months, a few countries have defi ed this trend toward lower yields.

Italy, Spain and Belgium have been sucked into the Eurozone fi nancial crisis, resulting in marked increases in their bond yields. The German bond market had, until recently, been a bastion of safety and stability at the heart of a swirling Europe, but that has started to change. Germany's 10-year yield has climbed from an enviable level, well below the U.S. and U.K., to levels now above the U.S. and in line with the U.K. Germany can no longer be viewed through dewy eyes as a safe haven given that so many of Europe's fi nancial ills loom over its head.

1.0

2.0

3.0

4.0

5.0

6.0

2007 2008 2009 2010 2011 2012

Bon

d Y

ield

(%)

U.S.CanadaUnited KingdomGermany

Source: RBC Capital Markets, RBC GAM

EXHIBIT 32. 10-Year Sovereign Bond Yields



It isn’t clear how long this perfect storm depressing yields will last. There is a risk that the contagion continues to spread, in which case bond yields could revisit recent lows, or even more below that. However, bond-market vigilanties have made clear to lawmakers the implications for borrowing costs should they choose to ignore the realities of fi scal sustainability, and this appears to have fostered the political will required to administer an antidote. It will be hard for yields to move sustainably lower from here unless the feared collapse of the Eurozone becomes a reality, whereas the scope for eventual increases is much greater as the crisis fades and growth in Europe resumes.

Nominal yields well below

equilibrium

Europe’s debt and banking crisis, and worries associated with recession, have pulled our global bond composite well below equilibrium (Exhibit 33). To calculate the distance of bond yields from equilibrium, our models decompose nominal 10-year bond yields into their components – infl ation and real returns – and project them forward several years. Exhibits 34 and 35 show these components for the U.S. 10-year Treasury bond.

We expect infl ation to be benign over the forecast period. In terms of infl ation, the 36-month centred CPI model generates a 2.3% infl ation rate 12 months from now, but we’re expecting infl ation to come in a bit lower at 1.75%.

Our model for real yields uses a time-weighted average of the past 10 years of monthly observations. The

-40

-20

0

20

40

60

1980 1984 1988 1992 1996 2000 2004 2008 2012

% A

bove

/Bel

ow E

quilib

rium

Last Plot: -9.03%

Source: RBC GAM

EXHIBIT 33. Global Bond-Market Composite

10-Year Government Bond Yields Relative to Equilibrium

EXHIBIT 34. United States

CPI Infl ation

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

%

Real T-Bond YieldReal 10-Year Time Weighted Yield

Source: RBC GAM

+1 SD

-1 SD Average: 2.5%

Last Plot: -0.2%

12-month Forecast: 1.48%


Real 10-Year T-Bond Yield



most recent data points are weighted 10 times more heavily than those a decade ago. This way, the model provides a projection for real yields that incorporates history and learns from it. In contrast to the infl ation model, this model shows signifi cantly more dispersion among history, recent market behaviour and our projection.

As noted above, investors’ desire for safe havens has drawn billions of dollars into the government bond market. Given mild infl ation, the impact of falling nominal yields has translated directly to a decline in real yields, pulling them into negative territory. At negative 0.2%, real yields are at their lowest level since 1980, and well below the model’s predicted level of 1.5%. In our view, the collapse in real yields says less about the expected future real growth rate of the U.S. economy and much more about investors’ recent preference for U.S. government bonds above most other assets.

In order to validate the current level of real yields, we would need a U.S. recession, defl ation or the spread of Europe’s crisis across the Atlantic. These outcomes are not our base case forecast, and nor do they constitute the view of the majority of economic forecasters. Moreover, we do not need a “solution” to Europe’s crisis to drive yields higher. Rather, a “fi x” that allows progress would be suffi cient for bond yields to resume their return to normalcy.

Real yields could snap back if

a fi x is found

The path of decline in real yields from 1.5% to below zero as Europe’s crisis intensifi ed gives us some idea of the

0

2

4

6

8

10

12

14

16

1980 1985 1990 1995 2000 2005 2010 2015

%

Last Plot: 2.05%


Source: RBC GAM

EXHIBIT 36. U.S. 10-Year T-Bond Yield

Equilibrium Range

2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010 2015

%

Last Plot: 2.15%


Source: RBC GAM

EXHIBIT 37. Canada 10-Year Bond Yield

Equilibrium Range

02468

1012141618

1980 1985 1990 1995 2000 2005 2010 2015

%


Source: RBC GAM

EXHIBIT 38. United Kingdom 10-Year Gilt

Equilibrium Range


path they could follow as the pressure from the crisis is relieved. A rebound in U.S. real yields back to 1.5% could occur quite rapidly if measures currently underway in Europe succeed in restoring investor confi dence that a euro break-up, fi nancial-sector collapse or broader debt default will be avoided.

Exhibits 36 to 40 show our equilibrium models for 10-year bonds in major developed markets. Our infl ation and real-yield projections are combined to generate an estimate of equilibrium, with the upper and lower bounds of the band marked by one standard deviation above and below that point. Nominal yields in the U.S., Canada and the U.K. are currently well below the bottom of their equilibrium channels. Eurozone yields have recently climbed back to around the mid-point of their band amid acute fi scal challenges and a surge in risk premiums in Europe’s smaller nations. In Japan, government bond yields hover at the lower bound of their range.

We expect 10-year U.S. Treasury yields to rise from their current level of around 2% to 3% over the next 12 months, and potentially higher thereafter. Exhibit 41 shows our government bond-yield forecasts along with total returns available if those forecasts are achieved. With the exception of the U.K., expected total returns are negative. The table also shows the total returns that would be generated if yields rose to equilibrium over the next 12 months. In all cases, total returns are sharply negative. Bonds have become so expensive that further positive returns are becoming increasingly doubtful.


2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010 2015

%

Last Plot: 3.94%


Source: RBC GAM

EXHIBIT 39. Eurozone 10-Year Bond Yield

Equilibrium Range

0

2

4

6

8

10

12

14

1980 1985 1990 1995 2000 2005 2010 2015

%


Source: RBC GAM

EXHIBIT 40. Japan 10-Year Bond Yield

Equilibrium Range

EXHIBIT 41. 10-Year Government Bond Yields

RBC GAM Forecasts and Equilibrium Levels

CurrentYield (%)

30 Nov. 2011

RBC GAMForecast

Nov. 2012

Total Return

(Local Curr.)

Equilibrium Forecast (%)Nov. 2012

Total Return

(Local Curr.)

United States 2.05 3.00 (3.7) 3.77 (9.4)

Canada 2.15 3.00 (3.4) 4.52 (14.2)

Germany 2.28 3.00 (2.6) 4.73 (14.8)

U.K. 2.31 2.75 0.6 4.46 (15.0)

Japan 1.07 1.50 (1.2) 2.38 (8.2)

Source: RBC GAM


Equities struggle to look

beyond crisis

Global equity markets have been caught in a period of elevated volatility since mid-summer. Since August 1, 2011, the S&P 500 Index has experienced gains or losses of 1 percent or more in two of every three trading sessions (Exhibit 42). Periods of optimism have been followed by offsetting periods when fear and risk aversion have dominated. Equity investors have been forced to balance this near-term uncertainty against historically attractive valuations, and at times, uncertainty has won out.

Exhibit 43 shows the relationship between the U.S. yield curve and the Chicago Board Options Exchange Market Volatility Index, commonly known as the VIX. Normally, equity-market volatility and the slope of the yield curve move closely together. A steep yield curve usually signals stronger future economic growth, and thus has tended to accompany periods of market calm. Today, however, we see persistently elevated volatility levels despite a very steep yield curve. As the crisis in Europe moves toward some kind of resolution, the yield curve’s normal dominance in this relationship should return, with a steep curve once again indicating calmer markets ahead.

Markets caught in a range

In the last edition of the Global Investment Outlook, we forecast a near-term trading range for the S&P 500, marked by 1100 at the low end and 1300 at the top. That view has proven correct as the index touched 1100 in early October and 1300 later that month, and has been within that range


-15

-10

-5

0

5

10

15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Day

s

Source: RBC GAM

EXHIBIT 42. S&P 500 Composite Index Monthly Volatility

Number of Daily Observations Above/Below 1.0%

-2

-1

0

1

2

31990 1995 2000 2005 2010 2015

%

0

10

20

30

40

50

60

70

%

Recession PeriodsU.S. 10-Yr-2-Yr Spread (LHS, Inv, Adv 30 Months)VIX (RHS)

Source: RBC GAM

VIX Nov. 30: 27.8

EXHIBIT 43. U.S. Yield Curve versus VIX Volatility

1000

1100

1200

1300

1400

Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11Source: Haver Analytics

EXHIBIT 44. S&P 500 Composite Index


2011 Top Down

2011 Bottom Up

Trailing 12 months Recessionary*

$96.40 $97.30 $93.90 $70.40

Equilibrium P/E 16.8 1619 1636 1578 1184

1 Standard Deviation Below 12.9 1240 1252 1208 906

2 Standard Deviations Below 8.9 860 869 838 629

*Trailing 12-Month Earnings to November 2011 less 25%Source: Bloomberg, Thomson Reuters, RBC GAM


since then (Exhibit 44). This trading pattern has been broadly mirrored across most major markets.

Exhibit 45 sets out in additional detail how this trading range is derived. Along the top row we show various 2011 earnings estimates for the S&P 500, which range between $94 and $97 per share. The fi nal fi gure of $70.40 incorporates a 25% drop in earnings, which is typical of the average recession. Along the vertical column we show potential valuation levels: an equilibrium P/E ratio of 16.8 and multiples that are one and two standard deviations below equilibrium. Today’s market trades at an earnings multiple that is approximately one standard deviation below equilibrium, evidence of general uncertainty regarding the future path of earnings. If the crisis in Europe becomes acute, such as in early 2009, investors may trade the market at two standard deviations below equilibrium. We use this to generate the downside potential for the U.S. market in the unlikely, but not inconceivable, environment of recession and fi nancial crisis.

These earnings and valuation estimates produce a broad range of possible outcomes. At the current valuation of 12.9 times trailing 12-month earnings, the market should trade in a range of 1200 to 1250. The table also shows that the potential for negative returns cannot be ignored if the market chooses to price in recessionary earnings or extreme crisis valuations. In these cases, the market could trade as low as 900, or even 600 in the absolute worst case. On the other hand, the S&P 500 would exceed 1600 if investors applied equilibrium (or normal, non-crisis) valuations to 2011 earnings.

EXHIBIT 45. 2011 Earnings Estimates & Alternative Scenarios for Valuation and

Outcomes for the S&P 500

EXHIBIT 46. 2012 Earnings Estimates & Alternative Scenarios for Valuation and

Outcomes for the S&P 500

Upside break-out awaits

fi x to crisis

Our view remains that the S&P 500 will have diffi culty rising above the top end of its recent range (about 1350) without a signifi cant breakthrough in the European sovereign-debt crisis. Similarly, the index is unlikely to decline into the bottom half of its range (i.e. below 1100) unless we see an intensifi cation of the various crises confronting the global economy, an increase in the risk of recession, or falling profi ts. This period of range-bound behaviour provides opportunities both for disciplined trading and for patient equity accumulation at compelling valuations for investors with longer-term time horizons.

Exhibit 46 conducts a similar earnings and valuation exercise for 2012 and shows that additional upside potential materializes for markets in a non-recessionary environment even if valuations don’t increase. Importantly, when these consensus 2012 earnings estimates are combined with dissipating fear and higher valuations, an extremely attractive upside of 1700 is generated.

The potential for higher valuations as Europe works toward a debt resolution cannot be underestimated. Exhibit 50 shows the recent path of the P/E multiple for the S&P 500 and plots it alongside our estimate of the equilibrium valuation band. Our equilibrium band is generated by a model that regresses equity-

2012 Top Down

2012 Bottom Up

$101.50 $106.80

Equilibrium P/E 16.8 1706 1795

1 Standard Deviation Below 12.9 1306 1374

2 Standard Deviations Below 8.9 906 954

Source: Bloomberg, Thomson Reuters, RBC GAM



market valuations against normalized earnings, infl ation, and nominal and real interest rates. This model tells us what the P/E multiple should be, all else equal, given today’s levels for those variables. Equilibrium is the mid-point of the band in Exhibit 47, and the bands represent one standard deviation above and below equilibrium. Currently, the market is trading at one standard deviation below equilibrium, leaving considerable room for improvement without moving anywhere close to overvaluation.

Equities remain below

equilibrium

Exhibits 48 through 53 show our equilibrium models for the world’s largest stock markets. Strong earnings and solid balance sheets have not been enough to keep markets from trading down to, or through, the bottom end of their equilibrium bands. The U.S., Japan and the U.K. all sit right at the bottom edge of their respective channels. The Eurozone market, for obvious reasons, sits far below its band and could eventually double without breaching fair value (i.e. the mid-point of the valuation channel). While we respect the highly volatile nature of the current environment, at some point opportunities in Europe will be hard to ignore, since gains will be attractive even if markets there simply recover to their minimum expected levels. The Canadian market has declined to the middle of its channel, and even emerging markets have corrected down through fair value and the band’s mid-point.

Exhibit 54 brings all of these markets together in a global stock-market composite. While markets have

4065

106174284464759

124020263311

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Source: RBC GAM

Nov. '11 Range: 1113 - 1868 (Mid: 1491)Nov. '12 Range: 1237 - 2077 (Mid: 1657)Current (30-November-11): 1247

EXHIBIT 48. S&P 500 Equilibrium

Normalized Earnings & Valuations

398623975

15252387373458439143

1430722387

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


EXHIBIT 49. S&P/TSX Composite Equilibrium


0

5

10

15

20

25

30

35

40

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

X

P/E on Trailing 12 Months Earnings+/- 1 Standard Deviation from Equilibrium P/E+/- 2 Standard Deviations from Equilibrium P/E

Source: RBC GAM

Nov. '11 Range: 1 Std. Dev.: 12.9x - 20.7x (Mid: 16.8x)Nov. '11 Range: 2 Std. Dev.: 8.9x - 24.7x (Mid: 16.8x)Current: 13.3x

EXHIBIT 47. S&P 500 Index

Normalized (Equilibrium) Price/Earnings Ratio


141217334514792

1221188128994467

1980 1985 1990 1995 2000 2005 2010 2015Source: Datastream, Consensus Economics, RBC GAM


EXHIBIT 50. Eurozone Datastream Index



recovered somewhat since early 2009, valuations remain attractive at 27% below equilibrium. Indicative of the crisis mentality, equity valuations have fallen back to levels that appeared only during the deep bear markets of 1981-1982 and 2007-2009. With the benefi t of hindsight and sustained economic growth and restoration of investor confi dence, these valuation levels may one day seem outlandishly low.

Depressed sentiment ignoring

corporate strength

Today’s depressed P/E multiples suggest investors are skeptical that earnings growth can be sustained given the risk that Europe’s fi scal crisis will trigger a broader recession. However, Exhibit 55, which plots operating earnings for the S&P 500 alongside our modeled normalized earnings, shows that current operating earnings are in no way dangerously above trend.

Corporate profi tability and fundamentals are, in fact, extremely healthy. Exhibit 56 shows net profi t margins for U.S. and Canadian stock indexes. In both cases, profi tability is very close to all-time highs. It has been well documented how aggressively fi rms cut costs during the 2008-2009 fi nancial crisis, and how reticent they have been to resume hiring as growth recovered. This caution has helped direct a near-record share of each dollar of sales to the bottom line. While criticism has mounted in some quarters that fi rms are not doing enough to support the economy, CFOs remain extremely cautious given the uncertain landscape. There is little to suggest that purse strings will be loosened appreciably in the near future, and so as long as modest growth prevails,

507097

136189264368514717

1000



EXHIBIT 51. Japan Datastream Index


204329529851

13702205354857109190

14791



EXHIBIT 52. United Kingdom Datastream Index




margins should be maintained and overall earnings can continue to rise.

Unprecedented corporate

fl exibility being undervalued

While some of these profi ts have found their way into the hands of shareholders via share buybacks, the majority is being warehoused in corporate coffers. Exhibit 57 shows how corporate cash balances have soared in recent quarters to all-time highs in the U.S. and Canada. In the U.S. alone, corporations are holding nearly $2 trillion in cash. In Canada, the fi gure is over $500 billion. This bounty is the fl ipside of running lean operations. The accumulation of cash provides a buffer against a rerun of the last fi nancial crisis, when short-term funding markets all but disappeared, and greatly increases the ability of corporations to withstand another recession. Balance-sheet strength, shown in Exhibit 58, is part and parcel of the same set of corporate decisions. This fl exibility is being undervalued by investors.

Low returns for good stock-

picking

Exhibit 59 provides further testament to the unusual nature of the current equity-market environment. It plots the daily median correlation of movements in stocks in the S&P 500 to shifts in the overall index. Today, that correlation is at an all-time high. Only 17% of the movement in individual stocks in the index can be attributed to company-specifi c factors. The remaining 83% is simply determined by investors’ general attitude towards owning stocks on that given day. So, despite vast differences in fundamentals and

-60

-40

-20

0

20

40

60

80

100

1980 1985 1990 1995 2000 2005 2010 2015

% A

bove

/Bel

ow F

air V

alue

Source: RBC GAM

Last Plot: -27.1%

EXHIBIT 54. Global Stock-Market Composite

Equity Market Indexes Relative to Equilibrium

486281

106137179233303394513

1995 2000 2005 2010 2015Source: Datastream, RBC GAM


EXHIBIT 53. Emerging-Market Datastream Index


346

10

1624

38

6094

148

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Trendline EarningsReported EarningsNormalized Earnings

Current Reported Earnings: $93.91Current Trendline Earnings: $87.88Current Normalized Earnings: $90.30

Source: RBC GAM

EXHIBIT 55. S&P 500 Earnings Comparison



prospects at the company level, stocks continue to move together as one monolithic asset class.

As we and others have observed, the reason for this herd-like behaviour comes down to the scale of the shocks that have hit global markets in recent years, and the resulting importance of macroeconomic headlines. Positive developments generate surging demand for equities as focus is drawn to historically attractive valuations, while negative news triggers a rush out of equities and into government bonds.

Company-specifi c factors are having far less impact today than they have in the past. Exhibit 60 shows the difference in return between a hypothetical manager who owns the top 10% of stocks in the S&P 500 less the returns for a manager who owns only the worst-performing 10%. One would expect the difference to be huge, but it’s not. Recently, the quarterly returns to such “perfect foresight” have been among the lowest on record, a clear demonstration that the rewards for good stock-picking have been exceptionally poor.

Active management struggles

in Canada

The struggle for alpha generation has not been confi ned to the U.S. market. According to Russell Investments’ latest “Active Manager Report,” the environment for active investment managers in Canada in the third quarter of 2011 was one of the most challenging on record. Elevated correlations in the market made it very diffi cult for active managers to add value against the benchmark S&P/TSX Composite Index. In fact, only 40% of large-cap Canadian equity managers

2

4

6

8

10

12

1980 1985 1990 1995 2000 2005 2010 2015

%

S&P 500

S&P/TSX

Source: RBC Capital Markets, RBC GAM

EXHIBIT 56. Net Margin

0

100

200

300

400

500

600

1990 1995 2000 2005 2010 2015

Billio

n $

0.0

0.5

1.0

1.5

2.0

Trillion $

Canada (LHS)U.S. (RHS)

Source: Federal Reserve Board, Statistics Canada, Haver Analytics, RBC GAM

EXHIBIT 57. Corporate Cash Balances

Nonfarm Non-Financial Corporations (NSA)

0

20

40

60

80

100

1980 1985 1990 1995 2000 2005 2010 2015

%

0

4

8

12

16

20

24

Tim

es In

tere

st E

arne

d

Debt-Equity (LHS)Interest Coverage (RHS)

Source: Federal Reserve, Haver Analytics


Non-Financial Corporate Balance Sheets



beat the index, down from 68% in the second quarter. The report notes that for many investment managers, their performance relative to benchmarks was the worst on record.

The tripling in size of the U.S. ETF market to $1 trillion since 2005 is at least partly to blame for this myopic perspective. According to Credit Suisse, ETFs now comprise approximately 40% of all stock-trading activity. Data from the Investment Company Institute shows that individual investors have withdrawn more than $100 billion this year from mutual funds that invest in U.S. equities, perhaps refl ecting a reduced appetite for funds that invest in individual stocks, and thereby arbitrage valuation discrepancies.

But where individual investors are getting out, sophisticated investors should ultimately swoop in. When value goes unrewarded by public markets, private-equity funds crystallize that value by taking target companies private. Additionally, companies themselves have stepped up share repurchases. These actions validate our view that the longer that company-specifi c factors are ignored, the greater the valuation anomalies that develop and, ultimately, the greater the potential returns to those making choices among competing investments.

Solid balance sheets and

earnings should command a

premium

We may already be seeing the early stages of a shift toward markets that reward companies with superior long-term prospects. Very recently, the returns to perfect foresight in Exhibit 60 have increased. Additionally, the

0.0

0.2

0.4

0.6

0.8

1.0

1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012

Last Plot: 0.83

Source: Ned Davis Research

EXHIBIT 59. S&P 500 Stock Correlations

Median Correlations of S&P 500 Stocks to the S&P 500 Index

20%

30%

40%

50%

60%

70%

80%

90%

1986 1990 1994 1998 2002 2006 2010 2014

Qua

rterly

Ret

urns

Low Spreads

High Spreads

Source: Bank of America Merrill Lynch

Average: 47.8%

Foresight = 1 quarter in advance

EXHIBIT 60. S&P 500 – Returns to Perfect Foresight

Difference Between Median Performance of Top and Bottom Deciles

0.50

0.75

1.00

1.25

1.50

1996 1998 2000 2002 2004 2006 2008 2010 2012Source: RBC GAM

EXHIBIT 61. United States – Small Cap/Large Cap Performance

Russell 2000 Small Cap Index Relative to S&P 500 Index



returns to large-cap stocks relative to small-cap stocks continue to improve following a long period of dramatic underperformance (Exhibit 61). Stronger performance from large caps offers an early glimpse of investor attitudes toward “quality.” Large-cap companies have weathered several market cycles, typically have superior balance-sheet strength, and possess competitive advantages that have allowed them to grow larger over time. Smaller companies may lack some of these attributes, and so their earnings potential tends to be more volatile and more dependent on the vagaries of the economic cycle.

Time to re-emphasize large-

cap U.S. stocks

When economic growth is sluggish, as we expect it will be over the forecast horizon, companies with solid balance sheets and sustainable earnings growth should command premium valuations. A turn to a period of sustained weaker growth argues for a tilt towards quality large-cap stocks with sustainable earnings. The S&P 400, a smaller-cap index, has outperformed the large-cap S&P 500 since 2000, but as shown in Exhibit 62, the mid-cap run may be ending.

Exhibit 62 shows that a change in the relationship between mid-cap performance and large-cap performance has particular importance for Canadian investors, whose domestic market is the S&P/TSX index. The TSX is a mid-cap index in comparison to the S&P 500, the pre-eminent large-cap stock index, so if the market is indeed beginning to favour large-cap quality stocks, investors should consider whether

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1995 2000 2005 2010 20150.2

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1.4

1.6

1.8S&P 400/S&P 500 (LHS)TSX/S&P 500 (in CAD, RHS)

Source: RBC GAM

EXHIBIT 62. Mid Cap/ Large Cap Performance

Relative Strength

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1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016Source: RBC GAM

+1 SD

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Average

EXHIBIT 63. TSX Relative to S&P 500 (in Canadian Dollars)

they have suffi cient exposure to the S&P 500. If the global economy slows and sustainable growth companies command premiums, Canada’s market could very well underperform the S&P 500.

Exhibit 63 shows the performance of the TSX relative to the S&P 500 in Canadian dollar terms. Eleven years of superior gains have allowed the TSX to traverse the path of one standard deviation below the U.S. market in relative performance to one standard deviation above. But after testing

the upper reach of its normal range, the TSX has fallen back, a sign that investors may be shifting their attention to the undervalued U.S. market.

Asset mix remains unchanged

The current investment environment is characterized by a wide chasm between two alternate outcomes. Our base case scenario has Europe muddling its way through the current crisis. Any fi x will not likely be a perfect long-term solution, but rather one that persuades markets that a collapse is off the table.



We expect any recession in Europe to be relatively mild and for recession in North America to be avoided. Global conditions should remain modest but positive, buoyed by fi rmer economic growth outside developed markets.

The alternate outcome is for Europe’s crisis to escalate dramatically, with negative consequences for risk assets and further declines in bond yields. During the past few months, we have observed expensive government bond markets getting still more expensive, and cheap stocks becoming cheaper still, as investors remained generally fi xated on the negative scenario. Money is being parked in U.S. government bonds.

The gap between these two outcomes is a wide one, and investors must take a view. Our view is that the euro will remain the continent’s single currency, and that further signifi cant debt defaults will be avoided. While risks to growth are easy to enumerate, a durable solution to Europe’s fi scal crisis is a work-in-progress that should, over the coming months, provide investors with greater certainty that a worst-case outcome will be averted.

Given this view, and its implied risk of higher bond yields, we remain underweight in fi xed income. Our 35% weight in bonds (versus a 40% neutral setting for balanced investors) is unchanged from last quarter. Short-term interest rates will remain low throughout 2012, and the uncertain near-term outlook is expected to hold longer-term government bond yields at generally low levels for some time. However, today’s extremely low yields on U.S., Canadian and U.K. government bonds will be diffi cult

-200-100

0100200300400500600700

1935 1945 1955 1965 1975 1985 1995 2005 2015

Stoc

k M

arke

t Out

perfo

rman

ce %

S&P 500 10-Year Total Return minus Barclays CapitalLong-Term T-Bond 10-Year Total Return

Source: Ned Davis Research

Mean: 120.5%

+1 Std Dev

-1 Std Dev

-2 Std Dev

+2 Std Dev

EXHIBIT 64. 10-Year U.S. Stock and Bond Performance

Stock Market 10-Year Total Return Minus Long Bond Total Return

to sustain in any environment that includes modest economic growth and progress toward crisis resolution. As we saw briefl y during October, better news out of Europe can cause investor sentiment to shift quite rapidly away from risk aversion. We are also closely monitoring evidence that the global economy is still expanding at a decent pace. This, too, will help confi dence recover. As that happens, bond yields will likely rise from current ultra-low levels and result in capital losses for bond holders.

Within equities, we are maintaining our modest 2.5-percentage-point overweight position (57.5% versus a 55% neutral setting for balanced investors). Although growth next year will remain weak, severely depressed equity-market valuations provide upside potential. As long as growth is sustained, normalizing valuations will ultimately drive future returns. However, our overweight stance is relatively modest in recognition of the fl uid situation in Europe and unusually wide divergence between the potential outcomes of the crisis.

Exhibit 64 provides a visual narrative of how today’s ultra-low valuations and expensive fi xed-income markets have together made equities extremely attractive relative to bonds for investors with longer-term time horizons. The exhibit shows 10-year trailing total returns for U.S. stocks versus long-term government bonds. The regular drumbeat of fi nancial and economic shocks experienced over the past decade pulled stocks to their lowest-ever return versus bonds, beneath even the worst of the Great Depression. Despite a recent rebound, stocks remain abnormally depressed relative to bonds. As noted above, even a modest decline in risk aversion would likely send returns on stocks higher relative to bonds. Our overweight and underweight positions in stocks and bonds, respectively, are premised on that eventual outcome.

Signs over the past few weeks that investors are indeed willing to fl ock back to stocks when news in Europe improves suggest that the momentum out of bonds and into riskier assets can accelerate suddenly, and rapidly. We



are well-positioned with exposure to equities as that happens.

Exhibit 65 shows the returns available to investors if the move back to equilibrium in equity and bond markets occurs over one year, two years, and beyond. The valuation gap between stocks and bonds is so wide that tremendous relative-return differentials

exist. For example, over the next three years, a return to equilibrium means U.S. bonds lose 1.26% per annum, while U.S. stocks compound at nearly 15.9% per year – a gap of 17.2%! If it takes a decade, the return differential is still nearly 10% per year. We don’t know when these returns will materialize, but we do believe that this exercise provides a reasonable

view of market outcomes as the global economy and capital ultimately normalize following a decade of shock and disappointment. Given such a compelling story regarding potential relative returns, our strategic asset mix maintains an ongoing preference for equities over bonds, and holds an elevated cash position to facilitate tactical trades around this strategy.

Asset ClassCurrent Return

1-YearForward Return

2-Year*Forward Return




15-Year* Forward Return


U.S. Treasury Bill (0.38%)

U.S. Treasury Bond (13.12%) (11.31%) (3.00%) (1.26%) (0.05%) 0.90%

Canada Gov. Bond (15.84%) (16.70%) (8.55%) (6.19%) (2.97%) (0.33%)

Canadian Stocks (TSX) 7.47% 13.76% 9.44% 7.93% 6.53% 5.02% 4.17% 3.54%

U.S. Stocks (S&P 500) 19.56% 34.84% 20.26% 15.87% 15.06% 10.46% 8.95% 8.19%

*Annualized ReturnsSource: RBC GAM

EXHIBIT 65. Asset Class Forward Returns


Market view

Major government bond markets outside the Eurozone posted strong performance over the past quarter, driven mainly by the continued deterioration in Europe’s sovereign-debt crisis and renewed concern about the outlook for global economic growth. Further boosting the bond market was the worsening negative feedback loop between fi nancial markets and sentiment, which led investors to seek refuge in the most liquid government bonds. Risk and liquidity premiums surged in the Eurozone, while sentiment towards sovereign debt turned decidedly negative. The sell-off affected all Eurozone sovereign debt, with the peripheral nations suffering most, but even Germany has been affected recently.

The turmoil in Europe has progressed through three distinct phases this year. In the second quarter of 2011, problems emerged (or re-emerged) with Greek, Irish and Portuguese debt, setting off a round of cross-border “ring-fencing” to prevent spillover effects in other member states. Italian, Spanish and Belgian debt joined the sell-off in the third quarter after governments began exploring the possibility of forcing bond holders to mark down their assets. This situation implied that government bonds were no longer risk-free and prompted investors to liquidate non-AAA-rated sovereign debt. In the fourth quarter, the threat of changes to the treaty establishing the Eurozone exposed the links among sovereign debt, Europe’s

GLOBAL FIXED INCOME MARKETS

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0.00.51.01.52.02.53.03.54.04.5

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Citi Risk Aversion IndexUST 10-Year Yield (RHS)

Risk Appetite Bond Yield

Source: Bloomberg, Citigroup

EXHIBIT 1. Falling Risk Appetite Benefi ted UST

banking system and economic growth. Investors fl ed to the perceived safety of German Bunds, at the expense of all other Eurozone sovereign debt. The sell-off in short- and mid-maturity non-German AAA-rated sovereign debt into November was particularly worrisome, as the market starting factoring in the increased risk of a Eurozone break-up.

Debt woes are not unique to the Eurozone. Both the Japanese and American economies share similar problems, although both chose the path of further borrowing to rehabilitate their economies rather than undergo painful austerity. The American and Japanese approach will result in higher government debt burdens, which can usher in higher bond yields. But since the piper won’t have to be repaid until later, higher yields are not likely in an environment where the private sector is deleveraging and credit channels remain largely broken. The more likely result from this deleveraging is that private-sector savings will be recycled

back into government bonds in good standing. The European approach of debt reduction means that GDP will probably shrink, possibly creating the risk of a defl ationary debt spiral. The effect is an increase in risk aversion across Europe, pushing investors into the relative safety of German Bunds until some form of collectively backed eurobond arrives. Regardless of the approach, government bond yields in the U.S., Germany and Japan are expected to remain low, hovering in the range that has been established over the past two years.

In the short run, investors remain extremely risk averse, so it’s entirely possible that bond yields will fall further from their current low levels (Exhibit 1). Bad news – which would be good for bonds – could come from further economic fallout within the Eurozone, a political fi asco jeopardizing the euro, or simply a series of disappointing economic data that prompts revisions to the currently

Soo Boo Cheah, CFASenior Portfolio Manager RBC Asset Management UK Limited

Suzanne GaynorV.P. & Senior Portfolio Manager RBC Global Asset Management Inc.


GLOBAL FIXED INCOME MARKETS • Soo Boo Cheah, CFA • Suzanne Gaynor

positive (but far from robust) economic growth expectations for the U.S. and Japan.

Another area of concern that has been overshadowed by the Eurozone crisis is U.S. political brinkmanship regarding defi cit reduction. This stand-off stems from a lack of responsible political leadership and the seeming absence of sensible thought on the part of legislators. With next year’s presidential ballot drawing closer, politicians’ efforts to pander to the electorate could undermine global trade. All these short-run risks are preventing bond yields from moving higher as investors keep a defensive stance in portfolios. However, we do not expect the current crisis to last indefi nitely, and investor pessimism will reverse when the situation becomes less dire. Should the global economy grow as we expect, bond yields are expected to ascend toward fair value over our 12-month forecast horizon.

Direction of rates

Yields on U.S. 10-year Treasuries continue to look rich based on traditional valuation metrics, which imply yields should be at least 75 basis points higher. While bond yields at current levels already refl ect slow economic growth and expectations that infl ation will remain low, risk aversion has pushed yields below levels indicated by our fair-value models.

Given the current state of the global economy and poor private-sector conditions, it is reasonable to assume that major central banks will keep monetary policy accommodative to facilitate balance-sheet repair.

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Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11Source: Bloomberg

Not seeing higher rate

EXHIBIT 2. 1-Year Rate 1-Year Forward

(Proxy for Future 1-Year Rate Expectation)

In a deleveraging phase, money multipliers are not likely to rise in a way that causes signifi cant infl ationary pressures or substantial economic growth. We therefore believe most central banks will stay passive on policy rates, but active with non-traditional measures, to ease current economic transitions. The ECB is expected to cut its short-term rate to 0.5% should the crisis worsen. We are also conscious of the fact that the Eurozone’s woes pose systemic risks to the global banking system.

Volatility will characterize fi xed-income markets over the next 12 months, with yields likely continuing lower in the short term if the macroeconomic backdrop does not improve. We believe, however, that much bad news is already priced into the current market and that bond yields will realign with fundamentals, rising eventually to the upper band of ranges established over the past two years. Nevertheless, we recognize the unquantifi able risks of government policy, which will have a big impact on the macroeconomic outlook and bond yields over the next 12 months.

As our forecasts call for rates to rise from current depressed levels, a marginally underweight duration stance will mitigate capital losses from rising yields. Should our forecasts play out, bond portfolios would post negative returns across all regions, as coupon income would fail to counteract the drop in bond prices.

U.S. – There is no change to our forecast on Fed policy from the previous quarter. Our 0.25% fed-funds forecast is in line with market expectations for low front-end rates (Exhibit 2). As long as the policy rate remains well anchored, yields further out the curve are expected to stay low. U.S. economic data has been resilient, and has surpassed expectations over the past month. However, it has failed to push bond yields higher (Exhibit 3), as Treasuries have been largely tied to turmoil in the Eurozone. Assuming progress in Europe, negative sentiment would subside over the forecast horizon and send yields higher. Market positioning also suggests that investors have crowded into bonds, making them vulnerable to a reversal (Exhibit 4) and further supporting our cautiously


bearish bond outlook. For this quarter, we are raising yield forecasts on 2-year and 5-year bonds, but lowering the forecast on 10-year securities (3%, down 0.25% from the previous quarter) and 30-year securities to refl ect the latest round of Fed intervention.

Germany – The country is Europe’s economic superpower, and its vast wealth logically makes it the best candidate for safe-haven status during times of turmoil in Europe. Markets still assign relatively low risks to German debt, despite the country being the largest contributor to past (and any future) bailouts. Keep in mind that any impairment of weaker nations’ assets will have a direct negative impact on German banks and the balance sheets of German savers, who for years have effectively been accumulating foreign assets via trade surpluses. This will strain German’s fi scal situation. Moreover, investors doubt the ability of policy measures announced so far to deliver relief, so even a little bit of good news would push yields higher quickly. Bold economic reforms in the Eurozone, combined with the successful implementation of programs such as the European Financial Stability Facility (EFSF) or sovereign-bond insurance could further reverse safe-haven fl ows into German Bunds.

For all these reasons, we are expecting German Bund yields to retrace higher and test the 3% level within the next 12 months. In terms of policy rates, the ECB recently withdrew its rhetoric about infl ationary concerns and cut its policy rate by 0.25% to 1.00%. We are expecting further cuts to bring the rate down to 0.50%, below the level reached in the wake of the global fi nancial crisis a few years ago.


Japan – About nine months after the 1995 Kobe earthquake, Japanese GDP started to pick up strongly and ushered in a sustained recovery, assisted by a ramp-up in reconstruction spending. Using that experience as a blueprint, we expect stronger 2012 economic growth derived from capital spending, residential construction, private consumption and government spending. Recent labour statistics indicate rising job creation and falling unemployment, developments that could reduce two decades of defl ationary expectations (Exhibit 5).

For Japan, that is the equivalent of raising infl ationary expectations and could stimulate consumption and investment. The strong spending and investment outlook is expected to slow growth in bank deposits. A shrinking pool of assets available for investment at a time when demand for loans is rising suggests that the Japanese government would need to compete for reconstruction funding, likely pushing up yields on Japanese government bonds (JGBs). We are expecting yields on 10-year JGBs to rise to 1.5% within the forecast horizon. This result is

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Citi US Economic Data SurpriseUST 10-Year Yield (LHS)

+ve Surprise

-ve Surprise

Source: Bloomberg, Citigroup

EXHIBIT 3. Positive Economic Data Failed to Push UST 10-Year Yield Higher

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Source: Bloomberg, Trend and Cycle

EXHIBIT 4. Bond Bullish Sentiment Reached Extreme, Risk of a Reversal



derived from an upbeat growth outlook, offset by a continued preference for JGBs by an aging population and money managers trying to align expected returns with future payouts.

As for policy rates, we expect nothing to change. We look for the Bank of Japan to continue with non-traditional monetary-policy measures and attempts to moderate appreciation of the yen.

Canada – Government of Canada bonds continued to benefi t from global uncertainties, and Bank of Canada Governor Carney recently stated that “Europe is the biggest threat facing Canada.” Europe’s woes, combined with the fact that the Fed is likely to remain on hold until at least mid-2013, mean that Canadian short rates are likely to stay unchanged over the next year. There is speculation of possible rate cuts in Canada, but we believe such an event would come only if the situation in Europe deteriorates markedly or U.S. economic growth slows dramatically. Longer-term rates should rise over the next year, matching the rise in U.S. rates, although Canadian bonds may outperform due to Canada’s stronger fi scal fundamentals and well anchored infl ation expectations. We forecast that policymakers will keep the benchmark rate on hold for the next 12 months at 1.0%. We have lowered our forecast for yields on the 10-year Government of Canada bond to 3.0% from 3.5% last quarter.

U.K. – The U.K. economy is experimenting with painful adjustments following years of fi scal largess, increasing the burden on an economy enfeebled by the fi nancial recession

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Job to Applicant RatioUnemployment rate (RHS - inverted)

Source: Bloomberg

EXHIBIT 5. Improving Japanese Labour Market Points to Near-Term Infl ationary

Pressures

of 2008. Strong infl ationary pressures that had been sticky for the past year are expected to fall away in the quarters to come, as temporary factors such as VAT hikes, rising food prices and higher energy bills roll over. Infl ationary pressures are expected to undershoot the 2% target in late 2012 and 2013 given the current policy mix, according to the latest Monetary Policy Committee (MPC) forecast. The MPC also raised concerns over the Eurozone crisis and its negative effects on the U.K. economy. Essentially, the Bank of England is signaling more quantitative easing to support the fi nancial system and moderate the impact of government austerity on the broader economy. Under these circumstances, the Bank of England would have no choice but to maintain the policy rate at current levels and keep its options open for more rounds of quantitative easing. Given this backdrop, gilts are expected to continue to outperform as long as additional quantitative easing does not lead to uncomfortably high infl ation.

We expect higher yields across global bond markets and negative total

returns for the 12-month holding period. Listed below are the key risks to this base case.

Eurozone break-up – The Eurozone is vulnerable to a break-up that could be triggered by extreme events in any member state. The political and legal hurdles have proven that solutions to the current crisis are extremely diffi cult to reach, leading to something close to a state of fi nancial panic. The recent sell-off in short- and mid-maturity non-German AAA-rated sovereign debt within the Eurozone could be interpreted as signifying the increased risk of a break-up rather than rising default risks alone. The EU summit in late October indicated that eventual changes to the EU treaty are unavoidable, and the outcome is virtually impossible to handicap.

Banking crisis – Europe’s banks have been the primary vehicles for funding government defi cits, and government debt therefore represents a large portion of banks’ assets. This interdependence threatens the solvency of both banks and governments should a write-down on



sovereign debt take place. Given weak economic growth in the Eurozone, European banks now pose a systemic risk as most governments are having diffi culty gaining access to funding and are subject to greater investor scrutiny.

Protectionism – With the upcoming U.S. election cycle nearing at a time of rising unemployment, the chances have increased that populist policies favouring protectionism will be implemented. Many voters and politicians are blaming job losses and imbalances on globalization, while completely ignoring the benefi ts of globalization. A deteriorating social environment may exacerbate the class warfare and street violence that we have seen in Greece and Italy. Political tension is likely to push investors into less risky assets.

Defl ation – One possible outcome of low economic growth and private-sector deleveraging is asset-price defl ation. A defl ationary scenario would be supportive of fi xed-income assets, whose fi xed payments retain their value better when infl ation is low.

Regional preferences

We remain generally bearish on bonds, but are lowering our yield forecasts across most regions to refl ect the highly uncertain environment over the next 12 months and lower expectations for economic growth. Given this backdrop, we look to overweight both U.S. Treasuries and JGBs by 2.5%, with a corresponding underweight of 5% in German Bunds. This is a change to the previous quarter, when we were overweight Treasuries by 5%, 3% underweight Bunds and 2% underweight JGBs.

U. S.

3-month 2-year 5-year 10-year 30-year Horizon return (local)

Base 0.25% 1.00% 1.90% 3.00% 3.90% -3.4%

Change to prev quarter 0.00% 0.25% 0.15% -0.25% -0.35%

High 0.25% 1.80% 2.85% 4.00% 4.75% -8.1%

Low 0.00% 0.25% 0.50% 1.50% 2.75% 3.0%

Expected Total Return US$ Hedged : - 3.1%

Duration bias: Short

GERMANY


Base 0.50% 1.50% 2.50% 3.00% 3.40% -3.1%

Change to prev quarter -1.00% 0.50% 0.50% -0.50% -0.50%

High 1.50% 3.00% 3.50% 4.00% 4.25% -9.6%

Low 0.50% 0.65% 0.90% 1.50% 2.25% 6.5%



JAPAN


Base 0.10% 0.40% 0.70% 1.50% 2.50% -2.7%

Change to prev quarter 0.00% 0.05% 0.05% 0.00% 0.00%

High 0.20% 0.60% 1.00% 2.00% 2.90% -6.2%

Low 0.00% 0.10% 0.25% 0.80% 2.00% 1.3%



CANADA


Base 1.00% 1.75% 2.25% 3.00% 3.60% -3.8%

Change to prev quarter -0.50% -0.50% -0.50% -0.50% -0.40%

High 2.00% 2.75% 3.10% 3.75% 4.10% -7.9%

Low 0.75% 0.75% 1.00% 1.75% 2.50% 3.5%



U.K.


Base 0.50% 1.00% 1.60% 2.75% 3.60% -1.9%

Change to prev quarter 0.00% -0.50% -0.65% -0.50% -0.40%

High 1.00% 2.50% 3.50% 4.50% 4.20% -11.5%

Low 0.25% 0.35% 0.60% 1.75% 3.00% 4.9%


Duration bias: Neutral

INTEREST RATE FORECAST – 12-MONTH HORIZON

Source: RBC GAM



Overweight U.S. – The extreme steepness of the U.S. yield curve means attractive carry-and-roll returns, mitigating the negative impact of rising bond yields. Although we forecast that yields will rise from their current low levels, we are being less aggressive in this stance relative to Bunds given our view that the Fed is likely to stay on hold longer and more willing to monetize debt.

Overweight JGBs – We expect the upbeat growth outlook in Japan and rising infl ation expectations to push yields higher before yield-hungry savers return to lock in higher rates for their retirement savings.

Underweight Bunds – Germany’s position at the heart of Europe means that any solution to the Eurozone crisis – be it ECB debt monetization and/or the establishment of Eurobonds – leave it in the weakest position of the major developed bond markets.

HORIZON TOTAL RETURN BREAKEVEN ANALYSIS: 10-YR BUNDS (EUR TERM) Changes In Yield From Current Level (bps)

(30) (20) (10) Unch 10 20 30 40 50 75 100

3-MTHS 3.6% 2.7% 1.8% 0.9% 0.1% (0.8%) (1.7%) (2.5%) (3.3%) (5.4%) (7.4%)

6-MTHS 4.5% 3.6% 2.7% 1.8% 1.0% 0.1% (0.7%) (1.5%) (2.3%) (4.4%) (6.3%)

9-MTHS 5.3% 4.4% 3.6% 2.7% 1.9% 1.1% 0.2% (0.6%) (1.4%) (3.3%) (5.3%)

12-MTHS 6.1% 5.3% 4.4% 3.6% 2.8% 2.0% 1.2% 0.4% (0.4%) (2.3%) (4.2%)

HORIZON TOTAL RETURN BREAKEVEN ANALYSIS: 10-YR JGB (JPY TERM)Changes In Yield From Current Level (bps)

(30) (20) (10) Unch 10 20 30 40 50 75 100

3-MTHS 3.3% 2.4% 1.4% 0.5% (0.4%) (1.3%) (2.2%) (3.1%) (4.0%) (6.2%) (8.3%)

6-MTHS 3.7% 2.8% 1.9% 1.0% 0.1% (0.8%) (1.7%) (2.6%) (3.4%) (5.6%) (7.6%)

9-MTHS 4.1% 3.2% 2.3% 1.4% 0.6% (0.3%) (1.2%) (2.0%) (2.9%) (4.9%) (7.0%)

12-MTHS 4.5% 3.6% 2.8% 1.9% 1.1% 0.2% (0.6%) (1.5%) (2.3%) (4.3%) (6.3%)

HORIZON TOTAL RETURN BREAKEVEN ANALYSIS: 10-YR UST (USD TERM) Changes In Yield From Current Level (bps)

(30) (20) (10) Unch 10 20 30 40 50 75 100

3-MTHS 3.6% 2.7% 1.8% 0.9% 0.0% (0.9%) (1.7%) (2.6%) (3.4%) (5.5%) (7.5%)

6-MTHS 4.4% 3.5% 2.6% 1.8% 0.9% 0.1% (0.8%) (1.6%) (2.4%) (4.5%) (6.4%)

9-MTHS 5.2% 4.3% 3.5% 2.6% 1.8% 1.0% 0.1% (0.7%) (1.5%) (3.5%) (5.4%)

12-MTHS 6.0% 5.1% 4.3% 3.5% 2.6% 1.8% 1.0% 0.2% (0.6%) (2.5%) (4.4%)

Source: RBC GAM


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CURRENCY MARKETS

U.S. dollar volatility erupted in the latest quarter. The greenback rallied over 6% in September, only to give back most of the gains in October (-4.5%), before rallying again by 6%1 in November. Such volatility is typical of late-stage dollar bear markets (exhibits 1 and 2), and considering that this bear market will be 10 years old in January, is to be expected.

We cannot know whether the U.S. dollar lows last summer marked the bottom of the cycle and the beginning of a new greenback bull market, or whether the 8% bounce since is merely a safe-haven rally. From a technical standpoint, we would need to see another 4% to 10% rally, depending on which dollar index we use, to have a clearer picture. From a fundamental view, it is diffi cult to conclude that we are at the beginning of a new dollar bull market when so many negatives cloud the outlook. These include continued weakness in U.S. house prices and the failure of the Congressional “super committee” to agree on $1.2 trillion of spending cuts. We can assert, however, that the European crisis, like the fi nancial-system collapse of 2008, has made it obvious that the greenback remains a safe-haven currency. At a time when central banks are intervening to hold down the value of other traditional safe havens such as the Swiss franc and the yen, risk-averse foreign-exchange investors are running out of options.

1 Trade-weighted basis against major trading partners

65

85

105

125

145

1971 1979 1987 1995 2003 2011

USDDowntrend

8 yrs-26%

USDUptrend

6 yrs+67%

USDDowntrend

10 yrs-47%

USDUptrend

7 yrs+43%

USDDowntrend

9 yrs?-40%

Source: Bloomberg, Deutsche Bank

EXHIBIT 1. Long-Term U.S. Dollar Cycles

Trade-Weighted USD Index (Nominal, Major Currencies)

50

60

70

80

90

100

1 51 101 151 201 251 301 351 401 451 501Weeks into bear market

2002-Present1985-19951971-1981

Source: RBC GAM, Bloomberg

EXHIBIT 2. Comparison of USD Bear Markets

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

The U.S. dollar

One positive for the U.S. dollar is the fact that the explosive growth in international foreign-exchange reserves over the past decade continues to ease (Exhibit 3). This is good news for the greenback because it refl ects a shrinking U.S. current-account defi cit and implies that the drive to diversify foreign reserves into euros, pounds

and Australian dollars, among others, is diminishing. As long as international reserves grow at a slower pace, downward pressure on the U.S. dollar lessens, and new lows are less likely.

The improvement in the U.S. current-account defi cit may be a harbinger of longer-term trends. As America’s reliance on imported oil declines over time, thanks to increased energy


CURRENCY MARKETS • Dagmara Fijalkowski, MBA, CFA

effi ciency, abundant domestic natural-gas reserves and higher oil production at home, it is feasible that the defi cit will continue to shrink. However, this is a long-term scenario and petroleum products still account for about 60% of the U.S. trade defi cit. For now, we want to highlight the improvement in the current-account defi cit, especially excluding oil and China (Exhibit 4), and the slower growth of foreign-exchange reserves held by emerging markets – both of which are supportive of the dollar.

One factor standing in the way of sustainable strength in the U.S. dollar is a lack of support from interest rates, and more generally, the perception that expansionary U.S. monetary policy will last indefi nitely. Although the Fed’s balance sheet has stopped growing (Exhibit 5), the prominence of Fed doves means that every weak data point prompts discussion about renewed quantitative easing. For now, a streak of better-than-expected data has silenced proponents of QE3.

Another indicator receding in importance is purchasing power parity. Our analysis shows that it pays to bet on the dollar (or any currency) when it trades at least 20% below purchasing power parity. However, the dollar breached the 20% undervaluation line in the summer before rising, and is now about 14% undervalued.

As for positioning, for the fi rst time in years surveys indicate that most U.S. dollar short positions have been closed. That is not necessarily a contrarian indicator – remember that positioning was long the euro for many years of the dollar bear market. A contrarian bet against the euro would not have paid off.

050

100150200250300350400450

00 01 02 03 04 05 06 07 08 09 10

Oil DeficitNon Oil DeficitNon Oil, Non China Deficit

Source: TD Securities

EXHIBIT 4. U.S. Trade Defi cits

Normalized to 100 in December 2000

-5%

0%

5%

10%

15%

20%

25%

30%

35%

2005 2006 2007 2008 2009 2010 2011-5%

-3%

-1%

1%

3%

5%

7%

9%

12-Month Change (LHS)3-Month Change (RHS)

Source: Bloomberg

EXHIBIT 3. Growth of International Reserve Assets

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2004 2005 2006 2007 2008 2009 2010 2011Source: Federal Reserve

EXHIBIT 5. Fed Balance Sheet

Total Assets (U.S. Dollars, in Trillions)


Correlation with stocks

The U.S. dollar continues to move in the opposite direction of U.S. stocks most of the time, and this negative correlation is now at its most extreme level in 40 years (Exhibit 6). We should be cautious, however, about extrapolating this correlation into the future. After all, when measured over the 40-year period, there has been almost no correlation between stocks and the U.S. dollar, a sign that the relationship historically reverts to the mean. The time may be coming when good news for the U.S. stock market will also be good news for the U.S. dollar.

The correlation is even more stunning when we look at individual currencies and their correlations with equities (Exhibit 7). With the exception of the yen, all major currencies have been moving in step with the S&P 500 more than 60% of the time. Is this unusual? Very. Exhibit 8 shows the difference in returns of the weakest and strongest G10 currency versus the U.S. dollar since 1983. 11 months into 2011, the gap between the best and the worst currency is the narrowest in 18 years. As of November 30, the strongest currency so far in 2011, the yen, was up 4.6% versus the U.S. dollar, while the weakest, the Canadian dollar, was down 2% – a performance gap of less than 7%. In the past 30 years, the average performance difference between the strongest and the weakest currency has been 23%, ranging from 10% in 2004 to 46% in 2008, according to Deutsche Bank.2

2 Alan Ruskin, "What a 30-year range record says about 2012 volatility," Deutsche Bank FX Daily Nov. 4, 2011


-1.0

-0.6

-0.2

0.2

0.6

1.0

USD JPY CHF GBP SEK NZD EUR NOK CAD AUDSource: Deutche Bank, RBC GAM

EXHIBIT 7. 20-Day Correlation With S&P 500

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.81.0

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010Source: RBC GAM, Bloomberg

EXHIBIT 6. U.S. Dollar and U.S. Equities (S&P 500)

Rolling 60-Day Correlation

0%

10%

20%

30%

40%

50%

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: Deutsche Bank, Bloomberg

EXHIBIT 8. Difference in Annual Returns

Strongest Minus Weakest G10 Currency



This atypical performance of late is not due to lack of volatility – we have seen plenty of that – but rather to the limited sustainability of currency moves. We agree with Deutsche Bank’s Alan Ruskin, who attributes it to the recent activist behaviour of central banks. The Swiss National Bank, the Bank of Japan and many emerging-market central banks and reserve managers have all been intervening mainly to redirect capital from their countries, although some emerging-market reserve managers are acting to soften the depreciation of reserve or systematically important currencies. All this intervention has produced a bit of a global “currency impasse.”

Ruskin points out that the low interest rates prevalent in developed economies are another factor contributing to narrow currency-trading bands. Differentials in short-term rates are considered the “bread and butter’’ of currency forecasting, and with rates set at or near 0% in all markets, there is little to distinguish developed-market currencies from an income standpoint. Even setting aside the weak economies of Japan, the U.S., the U.K. and the Eurozone, valuations in the rest of the G-10 are already on the rich side, so there’s little room for those currencies to appreciate.

To illustrate how important equity performance has become in determining the direction of currencies, see Exhibit 9. It shows currency correlations with manufacturing activity (PMI), economic growth (oil, copper), risk appetite/aversion (gold, equities), and interest rate differentials. While currencies had different dominant drivers over long time periods, over shorter periods the stock market

EXHIBIT 9. Correlation of Currencies With Driving Factors

was the strongest indicator of any currency’s direction.

We can only speculate about what might reverse the connection between stocks and the greenback. Analysts at GaveKal, a Hong Kong-based investment research company, believe that the correlation is about to turn, based on:

• The possibility that the improvement in the U.S. current-account defi cit, excluding China and oil producers, might lead to fewer dollars in circulation outside the U.S.

• A gradual improvement in the U.S. economy at a time when investors have doubts about the safety of their money in Europe. In the present climate, these two factors

would be enough to lead to the repatriation of foreign assets by U.S. money managers.

The euro

As recently as last year, the difference between yields on the two-year Bund and the comparable Treasury was a fairly good guide to the short-term direction of the euro (Exhibit 10). This year, the relationship has broken down. In the fi rst half of the year, the euro traded below what would be expected and, in the second half, above. These days, contagion is a driver of the euro, which now tends to rise and fall with Italian bond yields. As for economic growth, the ability of Europe’s economy to expand has been severely constrained by austerity measures and stricter regulatory requirements on

60 DAY CORRELATIONS

USD EUR GBP JPY CAD

PMI INDICES N/A N/A N/A N/A N/A

OIL (0.65) 0.43 0.36 0.00 (0.56)

COPPER (0.62) 0.49 0.43 (0.09) (0.62)

GOLD (0.40) 0.24 0.24 (0.17) (0.44)

S&P500 (0.83) 0.85 0.71 (0.21) (0.88)

MONETARY POLICY N/A (0.47) 0.13 (0.12) (0.09)

CARRY N/A (0.10) 0.10 0.13 0.20

60 MONTH CORRELATIONS

USD EUR GBP JPY CAD

PMI INDICES (0.14) 0.12 0.34 0.29 (0.27)

OIL (0.52) 0.48 0.67 0.32 (0.60)

COPPER (0.52) 0.47 0.55 0.18 (0.62)

GOLD (0.45) 0.40 0.32 (0.24) (0.49)

S&P500 (0.60) 0.57 0.50 0.18 (0.75)

MONETARY POLICY N/A (0.54) 0.04 (0.10) (0.18)

CARRY N/A (0.27) 0.07 (0.12) (0.36)

Source: RBC GAM



bank capital. The growth differential between Europe and the U.S. will likely widen, as indicated by the difference between U.S. PMIs and those in Europe, which points to a weaker euro (Exhibit 11).

In the short term, the one potential saviour of the Eurozone – the entity that has the power to reverse the contagion – is the ECB. So far, the ECB has been reluctant to explicitly commit its balance sheet to saving the peripheral members of the Eurozone, even though the ECB and combined national central banks have much more leeway to add to their balance sheets relative to the Fed and the Bank of Japan (Exhibit 12). The growth in the ECB’s balance sheet, so far, is the result of offering unlimited short-term liquidity to European banks, and more recently, covered bond purchases. Were the ECB to pursue this path further, the euro could weaken far more.

While the “mutualisation of debt”, through steps such as debt-buying by the ECB and an eventual fi scal union, seems the obvious endgame to people outside Europe, the debate continues. Europeans are also getting frustrated by the lack of appreciation for what they have accomplished so far. The task of engineering a closer fi scal union has been likened to the fall of the Berlin Wall in 1989. While it brought German national unifi cation, it was followed by a painful decade for those living in Germany. The current need for a cross-national fi scal unifi cation and the cost of such a plan are even more diffi cult to sell to German citizens, so it’s no wonder these decisions are not coming easily. On the other hand, citizens in Italy, Spain, Greece

-15

-10

-5

0

5

10

2003 2004 2005 2006 2007 2008 2009 2010 2011 20121.0

1.1

1.2

1.3

1.4

1.5

1.6EZ Manufacturing PMI Minus U.S. Non Manufacturing PMI (LHS)EUR-USD (RHS)

Source: Nomura, Bloomberg

EXHIBIT 11. PMI Surveys

Differential Leads EUR-USD at the Turns

50

100

150

200

250

300

350

2008 2009 2010 2011

FedBoJEurosystem Central Banks

Source: Federal Reserve, Bank of Japan, European Central Bank

EXHIBIT 12. G3 Central Bank Balance Sheets

Indexed at 100 in December 2007

-0.5%-0.3%-0.1%0.1%0.3%0.5%0.7%0.9%1.1%1.3%1.5%

May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-111.151.201.251.301.351.401.451.501.551.602-Year Yield Differential (LHS, Europe Minus U.S.)

EUR-USD (RHS)

Source: Bloomberg

EXHIBIT 10. EUR-USD Versus 2-Year Interest Rate Spread



and other peripheral counties are not eager to submit to the Eurozone-wide budgetary scrutiny that would go with closer fi scal ties. A weaker euro would be one way to soften the blow by helping boost economic growth, and it is a solution that Germany would probably not oppose given its large export sector.

While the headlines scream panic in the Eurozone, many currency analysts have been scratching their heads over the euro’s resilience. The euro has remained quite strong, even after the recent 8% decline, and is still more than 15% overvalued versus the dollar on a PPP basis. Among the most commonly cited reasons for the euro’s strength are the repatriation of funds by European banks, mainly French ones confronted by the need to raise capital to fund their U.S. assets. In a sense, European investors are pulling capital from the rest of the world, leading to a boom in net portfolio infl ows. These infl ows have so far offset repatriation by foreigners, who until recently had elected to switch their Eurozone holdings to euro-denominated German Bunds from Italian or Greek debt, also denominated in euros. Only in November did investors start taking their money out of the Eurozone altogether. U.S. Treasury data and the rise in Bund yields relative to yields on U.S. Treasuries suggest that the money is going into U.S. government debt. It is a worrisome signal for the euro, since U.S. fund managers control what is probably the largest pool of investor assets, and foreigners in general have more invested in Europe than Europeans invest externally (Exhibit 13).

A weak economy, lack of interest rate support and risk aversion might all

-50

-40

-30

-20

-10

0

10

20

30

2004 2005 2006 2007 2008 2009 2010 2011

Negative values indicate more interest/dividend payments from Eurozone entities to U.S. investors

Source: Haver Analytics

EXHIBIT 13. European Investment Income Balance With U.S.

Euros, in Billions

60708090

100110120130140150

2006 2007 2008 2009 2010 2011 2012

0.900.951.001.051.101.151.201.251.30

Journal of Commerce Industrial Commodity Index (LHS)USD-CAD (RHS, inverted)

Source: Bloomberg

EXHIBIT 14. Commodities and the Canadian Dollar

be dismissed if the euro were cheap, but the overvaluation (PPP value is about $1.14) makes it vulnerable to further negative developments in the periphery, and expansion of what is perceived to be the periphery. Clearly, the current government funding crisis in the periphery will only add to the negative economic momentum. We continue to believe the euro is likely to weaken to around $1.25 within our forecast horizon, with the downward pressure reinforced by the ECB eventually having to explicitly expand its balance sheet.

We acknowledge that our interpretation of the euro reaction to the ECB blowing up its balance sheet is not the only one proposed in the market. Our answer draws on parallels with the U.S. dollar, which lost value following QE announcements. However, if the negative correlation of the euro with risky assets were to be upheld, then QE in the Eurozone could lead to a risk rally, and counter-intuitively support the euro at the expense of the dollar. While there’s room for debate on whether the euro would fall versus the U.S. dollar in the event of an expanded


euro-area balance sheet, we would be more confi dent in our view that the euro would fall versus the Canadian dollar in such a scenario.

The Canadian dollar

The Canadian currency weakened during the summer as the Canadian economy started showing vulnerability to the global growth slowdown. The close correlation between the currency and the Journal of Commerce Industrial Commodity Index has been maintained, with weakness in the index coinciding with a decline in the loonie (Exhibit 14).

It would be premature to expect the Canadian dollar to strengthen from here, as global purchasing managers’ surveys suggest further downside to global growth in 2012.

Moreover, Canada’s terms of trade (the relationship between prices of goods that Canada exports versus prices of goods that it imports) and the composition of commodity exports suggest it is highly unlikely that any Canadian dollar strength would be of the same magnitude as it was in 2007. Canada’s sensitivity to commodities and smaller benefi ts from their high prices than in 2007, suggest that the Canadian dollar is fairly valued at 1.02 in the short term, and any drops of the U.S. dollar below parity should be bought unless the global growth picture improves.

For the past few years, many foreigners looking for safe havens became keen on Canadian assets and have been loading up on Canadian bonds. The pace of the accumulation, however, has slowed recently, with cumulative 12-month purchases falling (Exhibit 15). It is probably not widely


-40-20

020406080

100120

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011-30-20-100102030405060

Foreign Purchases of Canadian Bonds (LHS, 12m sum)Canada Federal Deficit (RHS, negative = surplus, 12m sum)

Source: CIBC, Haver, Bloomberg

EXHIBIT 15. Foreign Accumulation of Canadian Assets Is Slowing

Canadian Dollars, in Billions

appreciated that, despite Canada’s fi scal superiority, the Canadian 10-year government bond had as of late November underperformed U.S. Treasuries by about 0.8% in 2011. We wonder if the drop-off in foreign bond purchases is related to an awareness of this underperformance, or whether it simply refl ects the reduction in reserve diversifi cation discussed earlier.

Not all bodes negatively for the Canadian dollar over the next 12 months. We have been paying particularly close attention to the Bank of Canada’s economic-growth forecasts. One thing that has been keeping us cautious on the Canadian dollar for the past year (in addition to valuations) was the fact that the central bank had been forecasting consecutively lower economic growth out to 2013. However, that trend changed in the most recent BOC economic update. Two items stood out for us:

• First, the BOC is forecasting a short recession in Europe, and

• Second, the revised Canadian GDP growth signifi cantly higher for 2013. This is the fi rst such revision

in a long time, with the bulk of the increased optimism coming from higher fi nal domestic demand.

The bottom line is that the Canadian dollar will be negatively affected by weaker global growth and lower demand for commodities. A lower appetite for Canadian bonds decreases the margin of safety for investors with a bullish view on the currency, and it’s possible the Canadian dollar will retreat to between 1.06 and 1.08 in the fi rst half of 2012.

However, it’s hard to be too negative once such levels are reached. With the passage of time, the re-emergence of global growth should approach, and currencies like the Canadian dollar will react positively well in advance. As a result, we keep in mind that economic growth in 2013 should be higher than 2012, and the Canadian dollar should strengthen back towards current levels by then. Our one-year forecast is 1.04.

Japanese yen

Japanese economic growth slowed in line with other developed markets in the past quarter, and yet the slowdown


currency fl ows can at times become destabilizing.

Despite BOJ efforts to weaken the yen, the currency has stayed strong and the intervention has simply offered exporters and safety seekers better opportunities to acquire more yen. Among those safety seekers are emerging-market central banks, which seem to have developed a fancy for the yen. At the end of the second quarter of 2011, the portion of emerging-market countries’ known reserves in yen had risen to 3.2% from 2.3% a year earlier. With investment managers risk-averse to begin with, their interest in the Japanese currency may overwhelm the desires of those wishing to accumulate U.S. dollars.

(160)(140)(120)(100)

(80)(60)(40)(20)-2040

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

May 2002: The US dollar slides on pessimism about the US economy, prompting Japanese officials to weaken the yen.

JPY Sold

JPY Bought

70

80

90

100

110

120

130

140

150

Stronger Yen Sept 2001: Japanese officials intervene asthe yen jumps after the terrrorist attacks on the US.

June 1998: US joins Japan in helping to boost the yen amid worries about the Japanese banking system.

Jan 2003: Japan sells yen amid concerns that the US was dropping strong dollar policy.

Aug & Oct 2011: Japan battles risk-aversion flows from sovereign debt crisis.

March 2004: Japan completes 15-month, 35 trillion yen campaign

Sept 2010: Japan intervenes after yen hits 15-year low

March 2011: Post earthquake G7 coordinated

EXHIBIT 16. Japanese Currency Intervention


didn’t hurt the yen. Quite the contrary. In nominal terms, the U.S. dollar fell to an all-time low of 75.35 yen on October 31 of this year (Exhibit 16). The world’s preference for yen had much to do with the dwindling number of safe-haven alternatives following the Swiss central bank’s decisive intervention to keep the franc’s appreciation at bay. The intervention unnerved the Bank of Japan, leading it to also intervene. On the day that the dollar reached its new low versus the yen in the morning, the BOJ executed its single largest one-day intervention ever, buying approximately $100 billion. The fact that Japan did not encounter criticism from other G-10 countries for intervening implies that, in spite of the general allegiance to free markets, there is an understanding that

Our view is that the BOJ may slow the yen’s appreciation, and perhaps even stop it. However, there is little the central bank can do to weaken the yen decisively as long as Japanese economic growth is decent, domestic investors are repatriating capital, and the Fed stays on hold. We lower our U.S. dollar forecast to 80.

The pound

The outlook for sterling has become clearer in recent months. The Bank of England’s decision on October 6, 2011 to buy 75 billion pounds of gilts, and subsequent dovish comments, are negative for the pound. It appears that the BOE has successfully waited out the infl ation spike, as infl ation

Source: Wall Street Journal

Quarterly Intervention(USD Billions)



expectations and average earnings have not increased unduly (Exhibit 17).

Another factor that is negative for the pound is related to expectations of a global slowdown. According to Deutsche Bank, the pound is one of the most pro-cyclical currencies around based on the OECD G7 leading indicator (Exhibit 18). On the positive side are valuations. Given the U.K.’s strong trade connections with Europe, it would be hard for sterling to disassociate itself from euro weakness. So, while we believe that the pound will outperform the euro, we don’t expect the pound to appreciate much versus the U.S. dollar.

This brings us to our fi nal rumination of 2011. We freely acknowledge that currency forecasting is a hazardous business, but as the year winds down, there is one thing we can forecast with a certain degree of confi dence: the “currency impasse” of the past year may very well extend into 2012. Our forecasts call for the euro to fall versus the U.S. dollar, but for other currencies to be little changed. Keep in mind that this is our forecast for one year out, and we fully expect signifi cant volatility within that period.

To summarize:

• The dollar more than ever trades in line with risk appetite and equities.

• All currencies trade with high correlations to the dollar, and the market doesn’t distinguish much between them.

• The spreading crisis in Europe will eventually weigh down the euro.

• Global growth is the best guide to the direction of the Canadian dollar,

0%

1%

2%

3%

4%

5%

6%

2005 2006 2007 2008 2009 2010 2011Source: U.K. Office for National Statistics

EXHIBIT 17. U.K. Average Earnings (ex-Bonuses)

Year-Over-Year Change

-9%-8%-7%-6%-5%-4%-3%-2%-1%0%

CHF EUR JPY CAD NZD AUD NOK SEK GBPSource: Deutsche Bank

EXHIBIT 18. Currency Returns When Leading Economic Indicators Are Contracting

Annualized Since 1999

which should trade weaker before rising to end little changed in one year’s time.

• The BOJ is just another bank protesting the safe-haven status of its currency and, like the others, is unlikely to be successful until U.S. monetary policy shifts.

• Sterling should be resilient versus the U.S. dollar, but pulled lower by the euro.

• Positioning turning in favour of the U.S. dollar need not be contrarian.

• The “currency impasse” is likely to continue for a while before it is eventually resolved with a higher U.S. dollar.

• Our bias is to buy the U.S. dollar during sell-offs, especially once it is pushed to the extremes of undervaluation against some currencies, and to take advantage of negative correlation with risk assets, while watching for signs of mean reversion.



SUPPORTIVE• The euro, thanks to its liquidity, remains the default choice

for investors seeking an alternative to the U.S. dollar during periods of negative dollar sentiment.

• Reserve managers need to diversify their U.S. dollar holdings, which is positive for the euro at the margin.

• Intensifying pressure on politicians to do what it takes to keep the Eurozone from falling apart.

• The euro is bolstered by a lack of progress in the U.S. to reduce its budget defi cit, a fact highlighted by S&P’s downgrade of long-term U.S. debt and the Super Committee’s failure to reach agreement.

• The recent safe-haven rally in the U.S. dollar has skewed positioning to an overly bullish dollar stance.

NEGATIVE• Nearing signifi cant levels of overvaluation based on purchasing

power parity (PPP).

• Sentiment affected by unresolved European crisis. Contagion has spread, causing fi nancing costs to skyrocket in peripheral Europe. France and Germany are no longer immune.

• Long-term labour-force profi le much worse than in the U.S., refl ecting a shrinking taxpayer base.

• Communication discount necessary as European offi cials frequently contradict each other, eroding confi dence in the euro.

• ECB now easing monetary policy faster than the Fed – with further rate cuts expected and possibility of explicit quantitative easing.

• Eurozone interbank funding markets still broken as U.S money market funds continue to shun European banks.

• Banks still in poor shape, with at least 700 billion euros of issuance scheduled for 2012.

• Reduced selling pressure on U.S. dollar, as the U.S. shrinks its trade defi cit and reduces reliance on foreign sources of oil.

• Falling PMI indices show that growth in Europe is slowing. Continued austerity measures will only aggravate the situation.

• Possibility of second U.S. Homeland Investment Act as part of broader U.S. tax reform would encourage U.S. corporations to repatriate foreign earnings.

EURO

THE CURRENCY OUTLOOK: KEY FACTORS

12-MONTH FORECAST: Rallies not sustainable, target 1.25

SUPPORTIVE• Buying interest from reserve managers.

• IMF and OECD forecasts refl ect an improving fi scal outlook as the U.K. had a signifi cant head-start implementing its austerity program.

• BOE has successfully waited out the period of higher prices and expectations of faster future infl ation don’t seem to be taking root.

NEGATIVE• Housing surveys show continued weakness.

• Highly vulnerable to renewed stress in the global fi nancial system.

• Higher taxes risk driving business and wealth away.

• BOE growth forecasts being revised lower, signalling that October’s increase in quantitative easing may be followed by further asset purchases.

POUND STERLING

12-MONTH FORECAST: Very volati le trading expected with the 12-month forecast litt le changed at 1.60



SUPPORTIVE• Best fi scal profi le in G-8.

• Housing market and fi nancial institutions in better shape than their U.S. counterparts.

• Strong demand for oil expected to continue, particularly from higher-growth emerging economies.

• China adding commodity currencies to its sovereign-wealth fund, demonstrated by the opening of the fund’s fi rst foreign offi ce in Toronto.

• Seaway pipeline reversal contributes to closing the gap between Brent and WTI oil prices.

NEGATIVE• BOC reluctant to tighten due to concerns about consumer

debt, a widening current-account defi cit, low productivity and uncertainty abroad.

• Sensitive to slowdown in global growth. Indicators measuring U.S. data show that further positive surprises will be diffi cult to achieve.

• Nearing extreme overvaluation based on purchasing power parity suggests limited sustainable upside from current levels.

• Currency strength exceeds what would be justifi ed by improvement in terms of trade.

• Worst current-account defi cit in two decades is being fi nanced by foreign portfolio bond purchases, thereby making the Canadian dollar vulnerable to capital fl ight.

• Canada losing competitiveness relative to U.S. and Mexico from strong Canadian dollar.

CANADIAN DOLLAR

12-MONTH FORECAST: Strength below parity or weakness beyond 1.08 not sustainable, our forecast for 12 months is 1.04

SUPPORTIVE• The yen benefi ts during fl are-ups of risk aversion.

• Historic interest rate disadvantage eroded as rates in other developed markets are also very low.

• Low infl ation relative to other developed markets increases the purchasing power of the yen.

• Growing links with Asia helping to insulate Japan from economic woes of the developed world.

• The relatively large size of the market for Japanese government bonds means Japan could be the next major destination for reserve diversifi cation.

• Steep U.S. yield curve encourages Japanese investors to hedge purchases of U.S. Treasuries, limiting need to sell yen.

NEGATIVE• Worst gross public debt/GDP ratio of any major economy

(238% is the IMF’s estimate for 2012).

• Substantial threat of further intervention – weaker yen on the political wish list.

• Worst demographic profi le of any major economy over the next 40 years.

• The yen is the most overvalued currency based on Behavioural Equilibrium models.

• Bank of Japan will be left behind once the global rate-hiking cycle begins.

• Japanese insurers and postal banks underexposed to foreign assets (1% shift by Japan Post would result in $34 billion of yen selling).

YEN

12-MONTH FORECAST: Yen strength not sustainable, target: 80


UNITED STATES RECOMMENDED SECTOR WEIGHTS

RBC INVESTMENT STRATEGY COMMITTEE

NOVEMBER 2011

BENCHMARKS&P 500

NOVEMBER 2011

ENERGY 13.0% 12.4%

MATERIALS 3.4% 3.4%

INDUSTRIALS 10.6% 10.6%

CONSUMER DISCRETIONARY 11.7% 10.9%

CONSUMER STAPLES 11.3% 11.3%

HEALTH CARE 11.0% 11.6%

FINANCIALS 13.2% 13.7%

INFORMATION TECHNOLOGY 20.3% 19.4%

TELECOMMUNICATION SERVICES 2.5% 3.0%

UTILITIES 3.0% 3.7%

REGIONAL OUTLOOK – U.S.

4065

106174284464759

124020263311

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Source: RBC GAM


S&P 500 EQUILIBRIUM Normalized Earnings and Valuations

Source: RBC GAM

The past three months were among the most volatile on record for U.S. equities. The average daily price change for the S&P 500 was about 1.5% based on rolling 100-day periods – a level of volatility rarely seen since 1928. The intensifi cation of the Eurozone credit crisis, political dithering in the U.S. and Europe, and slowing global growth have prompted many investors to reduce risk assets in favour of U.S. Treasuries and cash. The volatility has been accompanied by high correlations among stocks. On any given day, roughly 85% of stocks have moved in the same direction – an unprecedented level of correlation. Investors are herding at a time when anxiety and uncertainty are historically high. The outlook for markets has deteriorated, and urgent policy responses are needed.

A high correlation can also be seen between the euro and the S&P 500, which tells us that the European sovereign-debt crisis is the market’s main focus. Unfortunately, what started out as a problem in Greece, Ireland and Portugal has gathered momentum and now infects the entire Eurozone. Investors are boycotting most Eurozone bond markets, forcing the cost of fi nancing to unsustainably high levels. Eventually the European Central Bank will have to act aggressively to bring yields down and reduce the risk of a Lehman-like credit event that would lead to a fi nancial-system meltdown. Europe is on the edge of the abyss and the situation could come to a head over the next month or so.

signifi cant U.S. policy error, a European recession does not necessarily have to drag the U.S. into a slowdown. In fact, the U.S. economy appears to be improving somewhat as unemployment claims moderate, corporate profi ts remain robust, inventories stay low and consumer spending continues to grow.

While fi nancial-system contagion from Europe represents the biggest single risk to the U.S. economic outlook, it is important to note that direct exposure to the Eurozone is relatively small. U.S. exports to the Eurozone amount to just 3% of GDP. So, barring a large negative shock such as a fi nancial meltdown in Europe, a hard landing in China or a

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

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


Indeed, the U.S. is a relative bright spot in the developed world.

With respect to the U.S market, the only thing we can say with any certainty is that stocks appear cheap and government bonds appear expensive. The S&P 500 trades at roughly 11 times trailing earnings extrapolated over a year for an earnings yield of almost 9%, compared with a 10-year Treasury bond yield of under 2%. This spread between earnings yields and bond yields is rare and suggests that while stock prices

REGIONAL OUTLOOK – U.S. • Ray Mawhinney • Brad Willock, CFA

could move lower over the next few months, equity returns over the next one to two years are likely to be above average.

Global markets are at a critical juncture. The global economy is slowing, as governments and households in the developed world repair their balance sheets. The situation is complicated and very unpredictable. In our opinion, the prudent course of action is to position defensively given the potential downside risks. However, we still

advocate some select cyclical exposure to domestic sectors given the recent improvement in U.S. economic data. We are also on the watch for two potential positive catalysts, including a reduction in interest rates by the People’s Bank of China and a move by the ECB to conduct substantial quantitative easing (likely as part of a plan to foster fi scal integration in the Eurozone).


REGIONAL OUTLOOK – CANADA

CANADA RECOMMENDED SECTOR WEIGHTS


NOVEMBER 2011

BENCHMARKS&P/TSX COMPOSITE

NOVEMBER 2011

ENERGY 27.0% 26.7%

MATERIALS 22.6% 23.0%








UTILITIES 1.5% 2.0%

398623975

15252387373458439143

1430722387

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


S&P/TSX COMPOSITE EQUILIBRIUMNormalized Earnings and Valuations

Source: RBC GAM

Macroeconomic concerns continued to dominate global capital markets this quarter and the S&P/TSX Composite Index struggled, fi nishing down. Uncertainty prompted investors to consider the possibility that near-term earnings would be reduced by caution among investors and consumers, notwithstanding satisfactory third-quarter earnings and reasonable equity valuations based on slow-growth earnings projections. Within the S&P/TSX, gold, energy and industrial companies outperformed, while fi nancial and materials companies weighed on performance.

The Canadian dollar’s upward momentum deteriorated and, interestingly, failed to react in its customary fashion to rising crude prices. In fact, the currency softened during the quarter, falling to $1.02 from $0.94 before fi nishing the quarter at $0.98. With economic growth forecast to moderate, we continue to believe that the strength of the Canadian dollar versus the U.S. dollar has largely run its course and expect range-bound trading. While job creation in Canada in 2011 has been admirable, the loss of momentum in recent months indicates an uneven recovery with a number of fi ts and starts. Housing has remained relatively strong, but concern that home prices are too high remains a signifi cant area of focus. Our forecast for 2012 Canadian economic growth is in the 2% range, down from our prior view.

Fears of a possible recession may hold back equity-market gains from current levels. Nevertheless, equities should

deliver reasonable returns for those with an intermediate-term time horizon and a focus on the earnings capacity that exists even in a slow-growth environment. Dividend yields, free cash fl ows and corporate balance sheets remain attractive.

Given the Canadian equity market’s dependence on global growth, steps

by central banks to end restrictive monetary policy in emerging economies are noteworthy. Tightening measures designed to check infl ation in China, Brazil and other emerging-market countries have weighed on stock markets and ignited debate about their ability to lead global growth. But with food prices easing, infl ationary pressures in these markets have

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


ebbed, providing the framework for monetary easing. The prospects for an easing cycle in developing economies would be a positive for global equities.

While the Financials sector struggled in the past quarter, valuations are attractive. The compression of price-to-earnings multiples that has taken place among banks is due, in part, to low interest rates and their impact on net interest margins, as well as concerns over future asset growth and the stability of the global fi nancial system. Nevertheless, returns on equity have proven resilient and returns remain attractive relative to those available from 10-year bonds. Current dividend yields coupled with modest payout growth should combine to provide satisfactory total returns. Domestic employment and the housing market will be key areas of focus in the near term.

Life-insurance companies had a tough quarter as the full force of sustained low interest rates weighed on investors’ minds. We believe that life insurers have enough capital and earnings

REGIONAL OUTLOOK – CANADA • Stuart KEDWELL, CFA

capacity to weather this storm, as the current era of low interest rates and lackluster equity returns will eventually pass.

At current commodity prices, free-cash-fl ow generation in the Materials sector will be signifi cant. Valuations have corrected recently and now refl ect prices that are below those implied by futures contracts. In a seasonally soft period for fertilizer stocks, waning momentum in near-term pricing, coupled with increased debate about capacity additions slated for the middle of this decade, have resulted in below-average multiples. We think the use of the strong free cash that will be generated in the next couple of years will be a key deciding factor in the restoration of multiples. Gold stocks had a better quarter relative to the decline in bullion. Nevertheless, a number of gold stocks have yet to reap the rewards of higher gold prices in their fi nancial results.

Last month’s delay in approval of the Keystone XL oil pipeline had a negative impact on shares of TransCanada,

although discussion of a new route that would avoid an environmentally sensitive region of Nebraska has since improved the outlook for the project. Another notable development in the Energy sector has been the narrowing of the price spread between West Texas Intermediate crude oil and Brent. The spread narrowed to US$8.60 from US$24 on a plan by Enbridge and a partner to ease oversupply at the Cushing, Oklahoma oil-trading hub. The narrowing of the spread is important to a number of Canadian producers.

Pershing Square, the hedge fund of New York investor Bill Ackman, announced during the quarter that it had acquired a signifi cant stake in Canadian Pacifi c Railway and would seek meetings with management to discuss major changes at the company. CP’s operating ratios have been consistently below industry averages. The size of the prize in terms of additional earnings is signifi cant and so the issue will remain in the market’s focus.


assets away from Europe. This has led to a polarization between the valuation of European companies that are considered to be safe havens and those that are expected to be at more immediate risk from events in Europe. It is entirely possible, therefore, that many of the factors associated with this pre-recession stage of the economic

REGIONAL OUTLOOK – EUROPE

It was during the summer that Europe’s crisis began to genuinely extend beyond peripheral countries such as Greece and take hold in Italy and Spain. This development was coincident with, and probably exacerbated by, weakening economic data in the U.S. and the tightening of economic policy in a number of emerging-market countries. Without the safety net of decent global growth, Europe is more vulnerable to the heavy sovereign-debt loads that many of its countries are carrying. The crisis escalated during August, and investors rushed to avoid risk en masse during September, leading to big declines in global stock markets as the implications of a possible break-up of the Eurozone began to sink in.

Slow progress is being made toward aligning European fi scal policies, and European markets exhibit low valuations. Meanwhile, investors are demonstrating extreme risk avoidance – a contrarian indicator – amid increasing signs that the U.S. will not fall back into recession.

This is not to suggest that the situation has become any less worrying or complex. The ramifi cations of a policy error or policy vacuum are severe and many asset markets in Europe remain somewhat dysfunctional. The lack of liquidity in the banking sector has now bled through to the general economy, and our composite leading indicator suggests that Continental Europe is in recession. During recessions, risk aversion continues to be key, and investors gravitate toward value

EUROPE RECOMMENDED SECTOR WEIGHTS


NOVEMBER 2011

BENCHMARKMSCI EUROPE

NOVEMBER 2011

ENERGY 13.4% 11.9%









UTILITIES 3.3% 5.1%

141217334514792

1221188128994467



EUROZONE DATASTREAM INDEX EQUILIBRIUMNormalized Earnings and Valuations

Source: RBC GAM

Dominic WallingtonChief Investment Offi cer & Chief Executive Offi cer RBC Asset Management UK Limited

equities as high-multiple stocks become subject to greater valuation contraction.

While valuations tend to fall during the recession phase of the economic cycle, this time we have already seen a considerable reduction in valuations as a consequence of general investor nervousness and efforts to reallocate


cycle have been brought forward due to the scale and persistence of the Eurozone crisis.

Again, our argument is not that the seriousness of the crisis has been underestimated, but that investors are not attuned to the idea that European stock markets have been relatively effi cient at discounting the risks ahead. Politicians in Europe appear, fi nally, to have realized that addressing the

problems with gradualistic policy measures will not work, and we expect a gentle acceleration of policy moves as we shift into 2012.

Given this backdrop, we have been marginally reducing our investments in truly defensive areas of the market since mid-September and have invested the proceeds in companies that exhibit value characteristics, sound balance sheets and, for the most

REGIONAL OUTLOOK – EUROPE • Dominic Wallington

part, decent return profi les, but which also offer a degree of exposure to an upturn in economic growth. The outlook for Europe remains very uncertain, but with the daily rhetoric all but promising a lost decade for the region, we feel that the market has absorbed the short-term risks and may well be close to bottoming.


REGIONAL OUTLOOK – ASIA

a soft landing. Given the Chinese government’s deep pockets, the European approach of bumbling along is unlikely.

While most Asian markets recovered, the Japanese market barely got above the post-earthquake lows experienced in March. With a historically low price-to-book level of 0.9 and a stable

Asian equity markets have been buffeted in recent months by a trading environment that has mostly tracked the ebb and fl ow of the European debt crisis. Lacklustre investor and consumer confi dence, tighter credit conditions and a global economic slowdown are the three main issues leading to market fl uctuations. But markets are also being swayed by the effect that policy decisions are having on economies. While we are keeping an eye on the risk that a policy mistake in Europe or the U.S. would have an outsized effect on the global economy, a more realistic view for Asia is that equity markets have largely priced in a signifi cant global slowdown, if not a recession.

Asia’s economic fundamentals remain relatively solid. The region’s overall rate of GDP growth stands around 7%, though the pace is moderating slightly. We believe that valuations, at a P/E of 11 times and 1.5 times price to book-value, have largely priced in an earnings drop caused by the global economic slowdown. Furthermore, investor expectations that China will ease monetary policy are gradually rising, which is generally positive for markets.

In China, the economy will continue to face the headwind of slowing exports. The good news is that infl ation may have peaked. October CPI of 5.5% year over year marked the third consecutive month of cooling infl ation. However, the probability of major policy easing seems small in view of the high levels of local government debt,

the prevalance of informal lending channels and persistently high property prices.

Chinese equity markets sold off heavily in late September on reports of risky off-balance-sheet loans, affecting other Asian markets. However, the government is taking steps to try to ensure that the economy experiences

ASIA RECOMMENDED SECTOR WEIGHTS


NOVEMBER 2011

BENCHMARKMSCI PACIFIC

NOVEMBER 2011

ENERGY 3.5% 2.8%









UTILITIES 2.8% 3.8%

507097

136189264368514717

1000



JAPAN DATASTREAM INDEX EQUILIBRIUMNormalized Earnings and Valuations

Source: RBC GAM

Yoji TakedaDirector & V.P. RBC Investment Management (Asia) Limited


currency, Japan probably is a defensive market. The upside may be limited owing to weakening exports and the strong currency. A sharp recovery from the earthquake appears to have run its course, and investors are now waiting to fi nd out whether export demand will recover over the next few quarters.

In early November, the Reserve Bank of Australia embarked on its fi rst interest rate cut of the current cycle. Australia is, to some extent, insulated from

REGIONAL OUTLOOK – ASIA • Yoji Takeda

economic weakness in the U.S. and Europe thanks to its high exposure to Asia, particularly China. Any monetary easing in China should therefore spur Australian exports. While the economy is slowing as housing and consumption remain weak, further rate cuts are possible, and fi scal support is available for AAA-rated Australia. Relatively low valuations and high dividend yields also make this market somewhat attractive.

Among major Asian export products, autos, smartphones and tablets are the bright spots. However, demand remains weak for PCs and fl at-panel TVs. The technology cycle is likely to bottom in the next couple of quarters, presenting an investment opportunity.


REGIONAL OUTLOOK – EMERGING MARKETS

negative implications for property assets used as collateral for these informal loans. Left unchecked, the increase in overall leverage and underground lending has the potential to become a bigger issue. The challenge for Chinese authorities is as much about bringing broader credit growth back in line with nominal GDP growth as it is about keeping a lid on infl ation. Recent data suggests that China is undergoing deceleration in a broad measure of capital-raising known as “social fi nancing”, as well as in total lending, and there are increasing signs of a slowdown in the economy. While a move to full easing is unlikely in the absence of a sharp drop in property prices, policymakers are already fi ne-tuning measures to support selective parts of the economy.

In terms of positioning, our long-standing top-down bias toward “quality” and sectors that benefi t from domestic growth makes even more sense in the current environment given

Europe’s sovereign-debt crisis and its impact on fragile global economic growth have continued to detract from the performance of emerging-market equities, and correlations with other stock markets remain high. In addition, emerging-market stocks have been negatively impacted by cyclical factors that are more specifi c to their fast-growing economies, such as infl ationary pressures and tighter monetary policies, especially during the fi rst half of 2011. A more recent concern has been rising fi nancial leverage in China.

While emerging economies will not be immune to weaker global growth driven by deleveraging, their economic growth is likely to continue at a rate that is signifi cantly higher than their developed counterparts. For example, emerging economies grew by 4% in 2009, a year in which developed economies contracted by the same percentage. Emerging economies are expected to account for over 80% of global growth this year and, in our view, will remain the main driver for years to come. In most cases, emerging markets are less dependent on external funding to support domestic investments, while domestic consumption, supported by a rapidly expanding middle class, has become the main engine of growth.

The debate over emerging-market infl ation and restrictive monetary policies has recently turned 180 degrees. We’ve seen a signifi cant downturn in food infl ation and with it, a moderation in the overall infl ation rate. We are transitioning from the rate-

hiking phase of the cycle, which lasted for over a year, to a new easing phase. Although the peak in emerging-market infl ation is a positive, we prefer to keep a relatively cautious stance, at least in the short term. We are cognizant that the scope for actual declines in infl ation is diffi cult to forecast because food prices can be very volatile and real interest rates are still negative in nine of 19 emerging-market countries.

Investor sentiment in China has been affected by concerns over the country’s rising fi nancial leverage, which has been driven by a surge in lending the past two years. The increase in credit has occurred largely via underground entities, which have channeled funds to the property market and employee-rich small and medium-sized businesses. This has added to concerns that liquidity will dry up as the economy decelerates, and that rising underground lending rates will bankrupt some small businesses and non-bank lenders. This would have

486281

106137179233303394513

1995 2000 2005 2010 2015Source: Datastream, RBC GAM


EMERGING MARKET DATASTREAM INDEX EQUILIBRIUMNormalized Earnings and Valuations

Philippe LanghamSenior Portfolio Manager RBC Asset Management UK Limited


the uncertainty surrounding cyclical areas and commodities. Equity markets are likely to follow credit markets in distinguishing between good and bad credit. In this environment, companies with strong balance sheets, strong free cash fl ows and high returns on capital are likely to outperform. Furthermore, as global growth slows, the stock premium commanded by companies able to deliver consistent and high growth is likely to expand.

Emerging markets as a whole have more than fi ve times the population of developed markets, but total private consumption per capita for the BRIC markets remains less than 40% that of the U.S. We believe that the powerful combination of high saving rates and the huge potential for loan growth among middle-income earners makes emerging-market consumers an investment theme that will remain compelling. The rise in purchasing power is driving, and will continue to

REGIONAL OUTLOOK – EMERGING MARKETS • Philippe Langham

drive, corporate revenues and earnings growth for domestically oriented companies for the next decade. We therefore maintain a strong preference for industries that will benefi t from growth in domestic consumption and this is refl ected in our sector allocation. The largest overweight position we have is the Consumer Discretionary sector, which stands as the prime benefi ciary of the shift in emerging markets to domestic demand from exports. We are also overweight the Consumer Staples sector, and are particularly focused on countries where the portion of the population that can easily afford essentials is still relatively low. In addition, the sector offers defensive growth and its profi ts will benefi t from lower infl ation and commodities prices.

Emerging-market valuations became more attractive in the last quarter, although they have yet to reach the extreme lows seen in late 2008.

With profi t forecasts still subject to downward revisions, the best guide to valuations in this environment is trailing price-to-book ratios. Emerging markets are trading at a price-to-book multiple of 1.5, a 25% discount to their long-term average of 2.0, but above the 1.0-1.25 trough reached on six occasions over the past 35 years.

Looking ahead, correlations among equity markets are likely to stay high in the short term, and emerging markets face further risks as long as the European crisis does not come to a defi ning climax. However, we believe that it is only a matter of time before investors refocus on healthy emerging-markets fundamentals, as governments, companies and consumers reduce leverage. The post-Lehman low proved to be a fantastic time to buy emerging markets, and a resolution to the Eurozone crisis is likely to provide a similar opportunity.


DANIEL E. CHORNOUS, CFACHIEF INVESTMENT OFFICERRBC GLOBAL ASSET MANAGEMENT INC.

CHAIR, RBC INVESTMENT STRATEGY COMMITTEE

Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc. that have total assets under management $250 billion. Mr. Chornous is responsible for the overall direction of investment policy and fund management. In addition, he chairs the RBC Investment Strategy Committee, the group responsible for global asset-mix recommendations and global fixed income and equity portfolio construction for use in RBC Wealth Management’s key client groups including retail mutual funds, International Wealth Management, RBC Dominion Securities Inc. and RBC Phillips, Hager & North Investment Counsel Inc. He also serves on the Board of Directors of the Canadian Coalition for Good Governance and is Chair of its Public Policy Committee. Prior to joining RBC Asset Management in November 2002, Mr. Chornous was Managing Director, Capital Markets Research and Chief Investment Strategist at RBC Capital Markets. In that role, he was responsible for developing the firm’s outlook for global and domestic economies and capital markets as well as managing the firm’s global economics, technical and quantitative research teams.

Jim has been in the investment business for 39 years as both a research analyst and portfolio strategist. He is currently a director of RBC Investments and also Vice-Chair of the RBC Capital Markets Investment Strategy Committee. Through his 33 years at RBC Dominion Securities (and predecessors), Jim has played a key role in developing investment policy for the firm and translating that worked into solutions for individual clients. He presents extensively on the topic.

Janet has more than 27 years of experience in the securities industry. She joined Tucker Anthony, later RBC Dain Rauscher, in 1982. Over the course of her career, she has held the positions of Director of Equity Research for Sutro & Co. and Director of Equity Strategies for Tucker Anthony. In 2002 she was named Director of the Private Client Group at RBC Dain Rauscher, now RBC Wealth Management, where she is also a member of the Director’s Circle.

MEMBERS


As Head of Global Fixed Income & Currencies at RBC 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 Investment Policy Committee, which determines the asset mix for RBC balanced products, and the RBC Investment Strategy Committee, which establishes global strategy for the firm.

Stu Kedwell 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.

JANET L. ENGELSSENIOR V.P. & DIRECTOR PRIVATE CLIENT RESEARCH GROUP RBC WEALTH MANAGEMENT

STUART KEDWELL, CFASENIOR V.P. & SENIOR PORTFOLIO MANAGER RBC GLOBAL ASSET MANAGEMENT INC.

JIM ALLWORTHPORTFOLIO STRATEGIST RBC WEALTH MANAGEMENT

DAGMARA FIJALKOWSKI, MBA, CFAHEAD, GLOBAL FIXED INCOME & CURRENCIES (TORONTO AND LONDON)RBC GLOBAL ASSET MANAGEMENT INC.


GEORGE RILEY, FSCI HEAD, DISCRETIONARY INVESTMENT MANAGEMENT RBC WEALTH MANAGEMENT UK & TRUST

Martin Paleczny, with 16 years of experience in the investing field, 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 to the RBC Investment Strategy Committee for technical analysis.

MEMBERS

ERIC LASCELLESCHIEF ECONOMIST RBC GLOBAL ASSET MANAGEMENT INC.

George has over 30 years experience in the Financial sector. He was appointed Head, Discretionary Investment Management, British Isles in 2010 and Managing Director of RBC Investment Solutions (CI) Limited in 2011. In 2006 he was appointed Head of the Global Investment Solutions group for RBC Wealth Management, International after moving from RBC (Suisse) where he had been the Chief Investment Officer since 2002. He is a Fellow of the Chartered Institute for Securities & Investment. Prior to joining RBC, George worked with Lloyds Bank International, in their trust business in the British Isles and Monaco. He joined RBC in 1988.

MARTIN PALECZNY, CFAV.P. & SENIOR PORTFOLIO MANAGER RBC GLOBAL ASSET MANAGEMENT INC.

JASON STORSLEY, CFAPRESIDENT & CEORBC DIRECT INVESTING INC.

Jason joined RBC Direct Investing on Feb. 1, 2009, and is responsible for developing strategy, growing assets under administration, and expanding revenue and market share. He was previously head of RBC AM's institutional investment-management business and Director of Global Equity Research. Jason's career at RBC Financial Group dates from 1998, when he joined RBC DS. In 2001, he moved to the Fixed Income Portfolio Advisory Group, where he was in charge of structuring portfolios for high-net-worth clients and formulating trade recommendations. Jason was elevated to Vice President in 2003, when he assumed leadership of the portfolio advisory group, and the retail bond sales and trading desks.

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 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 of 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.

Andrew began his career at RBC Dominion Securities and has nearly two decades of experience in the investment industry. He is currently an institutional portfolio manager and a member of the firm's Phillips, Hager & North Canadian Equity team. He is also a portfolio manager at RBC Global Asset Management. Prior to joining PH&N, Andrew was a top-ranked sell-side equity analyst and Managing Director at Scotia Capital. Andrew holds an MSc from the London School of Economics. He was appointed to the RBC Investment Strategy Committee in 2009.

ANDREW MITCHELL, CFAV.P. & INSTITUTIONAL PORTFOLIO MANAGERRBC GLOBAL ASSET MANAGEMENT INC.

GORDON TELFERDIRECTOR OF EQUITIES, U.S. RBC GLOBAL ASSET MANAGEMENT (U.S.) INC.

Gordon joined the firm in 2003 from Alliance Capital Management, where he was a senior portfolio manager and member of the investment policy group. Before that, he was a senior vice president and global strategist at Scudder Kemper Investments, where he served on the firm’s investment management committee. Gordon began his career in 1986 at Murray Johnstone International. As a member of the RBC Investment Strategy Committee (RISC), Gordon helps to formulate macro investment strategy and ensure investment best practices. Gordon has spoken at numerous regional and national conferences on portfolio management and been a guest on CNBC. A native of Glasgow, Scotland, he earned a Stock Exchange Diploma from Heriot-Watt University, Edinburgh, Scotland.



GLOBAL EQUITY HEADS

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

Yoji Takeda Director & V.P., Asian EquitiesRBC Investment Management (Asia) Limited

Dominic Wallington Chief Investment Offi cer & Chief Executive Offi cerRBC Asset Management UK Limited

Phil Langham Senior Portfolio Manager, Emerging MarketsRBC Asset Management UK Limited

Paul Johnson V.P. & Senior Portfolio Manager, Global EquitiesRBC Global Asset Management Inc.

GLOBAL EQUITY ADVISORY COMMITTEE

Chris Beer, CFA V.P. & Senior Portfolio Manager, Canadian & Global EquitiesRBC Global Asset Management Inc.

Cameron Hurst Associate Portfolio Manager, U.S. Equities RBC Global Asset Management Inc.

Henry Kwok Senior Analyst, Global Equities (Health Care & Consumer Staples)RBC Global Asset Management Inc.

Stuart Morrow, CFA Manager & Senior Analyst, Global Equity Research (Financials & Consumer Discretionary)RBC Global Asset Management Inc.

Martin Paleczny, CFA V.P. & Senior Portfolio Manager, Asset Allocation & DerivativesRBC Global Asset Management Inc.

Cameron Scrivens V.P. & Senior Portfolio Manager, U.S. Equities (Health Care & Technology)RBC Global Asset Management Inc.

Robert Silgardo, CFA Senior Analyst, Global Equities (Telecommunications & Technology)RBC Global Asset Management Inc.

Janice Wong, CA, CFA Senior Analyst, Global Equities (Industrials & Utilities)RBC Global Asset Management Inc.

GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE

Soo Boo Cheah, MBA, CFA Senior Portfolio Manager, Global Fixed Income & CurrenciesRBC Global Asset Management Inc.

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

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

George Riley, FSCI Head, Discretionary Investment Management RBC Wealth Management UK & Trust.

This report has been provided by RBC Global Asset Management Inc. (RBC GAM) for informational purposes only and may not be reproduced, distributed or published without the written consent of RBC GAM. It 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.

®/TM Trademark(s) of Royal Bank of Canada. RBC Global Asset Management is a registered trademark of Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2011.

®/TM Trademark(s) of Royal Bank of Canada. RBC Global Asset Management is a registered trademark of

Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2011.

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