the global investment outlook

NEW YEAR 2018

THE GLOBAL INVESTMENT OUTLOOK RBC GAM Investment Strategy Committee

The RBC GAM Investment Strategy Committee consists of senior investment professionals drawn from all areas of RBC GAM. The Committee regularly receives economic and capital markets related input from internal and external sources. Important guidance is provided by the Committee’s regional equity advisors (North America, Europe, Asia, Emerging Markets) and from the Global Fixed Income & Currencies sub-committee. From this, the Committee 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 GAM 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.

THE RBC GAM INVESTMENT STRATEGY COMMITTEE

CONTENTS

EXECUTIVE SUMMARY 2The Global Investment Outlook Eric Savoie, MBA, CFA – Senior Analyst, Investment Strategy, RBC Global Asset Management Inc.

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

ECONOMIC & CAPITAL MARKETS FORECASTS 4RBC GAM Investment Strategy Committee

RECOMMENDED ASSET MIX 5RBC GAM Investment Strategy Committee

CAPITAL MARKETS PERFORMANCE 10Milos Vukovic, MBA, CFA – V.P. & Head of Investment Policy, RBC Global Asset Management Inc.

GLOBAL INVESTMENT OUTLOOK 13Secular stagnation ebbsEric Lascelles – Chief Economist, RBC Global Asset Management Inc.

Eric Savoie, MBA, CFA – Senior Analyst, Investment Strategy, RBC Global Asset Management Inc.

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

GLOBAL FIXED INCOME MARKETS

The bond-market outlook 46Soo Boo Cheah, MBA, CFA – Senior Portfolio Manager, RBC Global Asset Management (UK) Limited

Taylor Self, MBA – Analyst, RBC Global Asset Management (UK) Limited

Direction of rates 49Soo Boo Cheah, MBA, CFA – Senior Portfolio Manager, RBC Global Asset Management (UK) Limited

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

CURRENCY MARKETS 52Dagmara Fijalkowski, MBA, CFA – Head, Global Fixed Income and Currencies, RBC Global Asset Management Inc.

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

REGIONAL EQUITY MARKET OUTLOOK

United States 60Brad Willock, CFA – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc.

Canada 62Irene Matsyalko, CFA – Portfolio Manager, RBC Global Asset Management Inc.

Sarah Neilson, CFA – Portfolio Manager, RBC Global Asset Management Inc.

Europe 64James Jamieson – Portfolio Manager, RBC Global Asset Management (UK) Limited

Asia 66Derek Au – Research Analyst, RBC Investment Management (Asia) Limited

Emerging Markets 68Richard Farrell, CFA – Portfolio Manager, Emerging Market Equities RBC Global Asset Management (UK) Limited

FEATURED ARTICLE Should indexes have a conscience? 70 The tragedy of Venezuela prompts a rethink of how emerging-market bond indexes are constructed

Jane Lesslie, MSc, CFA – V.P. & Senior Portfolio Manager, Fixed Income and Currencies – Emerging Markets RBC Global Asset Management Inc.

Earl D’Almeida, MBA, CFA – Analyst, RBC Global Asset Management Inc.

RBC GAM INVESTMENT STRATEGY COMMITTEE 84

THE GLOBAL INVESTMENT OUTLOOK New Year 2018 I 1

Global economic growth

is running at its fastest

clip in seven years thanks

to a number of positive

factors. The expansion is

increasingly broad-based

and signs of weakness

in the economy are not

yet in evidence. Robust

confidence measures

and risk appetite are also

fueling macroeconomic

strength.

Eric Savoie, MBA, CFASenior Analyst, Investment Strategy RBC Global Asset Management Inc.

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

2 I THE GLOBAL INVESTMENT OUTLOOK New Year 2018

Global expansion gains momentumWe are increasingly of the view that the secular stagnation that held back economic growth for much of the past decade may be finally fading as the bad memories of the financial crisis recede, a new generation of business leaders rises to power, animal spirits revive and business investment picks up. Also buoying the economy is the fact that financial conditions remain friendly thanks to still-low government bond yields, narrow credit spreads, rising equities and oil prices in a sweet spot that supports global growth without punishing oil exporters. Looking forward, we anticipate further strong, above-consensus GDP growth and rising, above-consensus inflation. Our global GDP forecast is for 3.8% growth in 2018 – an upward revision from the prior estimate. Growth in 2018 should just surpass 2017, itself the fastest pace in several years.

Challenges remain, but upside potential exists tooThere are a number of risks that could challenge our above-consensus view. The business cycle is aging, protectionism is on the ascent and international relations have become precarious in several pockets of the world. After dodging several populist threats, European politics now face another onslaught of challenges in the form of elections, independence movements and nationalist governments. Chinese risks have shrunk given stabilizing growth and improving debt metrics, but the country’s economy is still likely to decelerate over time and the highly indebted corporate sector is vulnerable

EXECUTIVE SUMMARY

to rising interest rates. Canada’s housing market is also susceptible to higher borrowing costs, as are a variety of exotic investment instruments that rely on leverage to boost returns in a low-yield world. Fortunately, the current environment also features a number of positive developments. These are related to fading concerns surrounding secular stagnation, structural factors inhibiting an unwelcome surge in inflation and the potential for governments to deploy fiscal stimulus, particularly in the U.S.

Post-U.S. election optimism persistsThe election of President Trump a year ago appeared to have had a significantly positive effect on global confidence. The rationality of this optimism is debatable – Trump’s proposed policies have at best mixed implications, few have been implemented so far, and fewer still would appear to benefit any country but the U.S. Nevertheless, we cannot ignore that consumers and businesses both began to feel much more confident about their economic prospects immediately after the election, and this positive sentiment can boost economic growth.

U.S. dollar bull market maturingWe’re nearing the end of the U.S. dollar upswing, but it’s a process that will take time, possibly years. Patience is now required as the environment is one where foreign-exchange fluctuations are no longer driven predominantly by the direction of the U.S. dollar, but rather by the relative merits of each currency. Differences


Executive Summary | Eric Savoie, MBA, CFA | Daniel E. Chornous, CFA

the U.S. could provide an additional boost to profits, though at least some portion of the anticipated changes has already been priced in. Given current valuations, stocks would be vulnerable if earnings underwhelm and/or Congress fails to enact the proposed tax changes.

Asset mix: maintaining overweight stocks, underweight bondsIn our base case scenario of improving economic growth and firming inflation, prospective returns for sovereign bonds are especially unattractive. The capital loss from rising yields is likely to offset any income earned from coupon payments, resulting in low or even negative returns for sovereign bonds, perhaps over many years. In comparison, stocks continue to offer superior total-return potential. We recognize, however, that the deep discounts available at earlier stages of the bull market have been erased and that further gains for equities will depend on earnings growth. We are watching ever more diligently for signs of a top in equity markets, but we are not seeing an abundance of signals that would indicate the end of the cycle. We had been reducing risk exposure in our asset mix over the past several quarters, but have opted to pause this quarter given the absence of technical deterioration, the ongoing strength in profits and the increased possibility of meaningful U.S. corporate-tax cuts coming to fruition. As a result, we have maintained a moderate overweight in stocks and underweight in fixed income. For a balanced, global investor, we currently recommend an asset mix of 58% equities (strategic neutral position: 55%) and 39% fixed income (strategic neutral position: 43%), with the balance in cash.

will likely be gradual and occur over a period spanning many years. Our fixed-income models suggest that real (after-inflation) interest rates are currently too low. Some of the factors that have been depressing real interest rates include unorthodox monetary policy and a heightened demand for safe-haven assets. But in an environment where economic growth is gaining momentum and secular stagnation may be starting to lessen its grip, we would expect real interest rates to ultimately rise back towards their long-term average as investors (savers) at some point demand a true after-inflation payment to defer consumption. Our models assume this reversion occurs over the next five years, though we would place emphasis on the direction rather than the exact timing.

Global equities narrow discount to fair value, become more dependent on earnings growth to sustain the bull marketGlobal stock markets continue to be supported by the synchronized global expansion and better-than-expected corporate profit growth around the world, but the recent rally has pushed equities closer to fair value. The S&P 500, in particular, hovers just below the midpoint of its fair-value band and, while our model doesn’t suggest stocks are as expensive as some other popular metrics, we recognize it may be prudent to lower total-return expectations and consider the potential for higher volatility in the months ahead. Without support from rising valuations, further gains in stocks will likely be paced by corporate profit growth. Earnings have indeed been coming through and analysts are optimistic that the positive trend can persist. Corporate tax cuts in

in growth and balance-of-payments dynamics are likely to be the key factors going forward and, with that in mind, we expect the euro and the yen to fare better than the pound and Canadian dollar.

Firming inflation may be limited by structural forcesSeveral factors suggest higher inflation over the next year. Commodity prices have rebounded, developed-world economies are approaching their full potential and we detect rising wages amid an increasingly tight labour market. Counteracting these positives are some structural pressures that may limit how quickly inflation can rise. The constraints include adverse demographics, the effects of globalization and some technology-induced deflation. To be clear, inflation can still accelerate and likely will, but not by quite as much as traditional models might indicate.

Central banks continue to dial back accommodative policies in response to firming economic backdropAs growth has picked up, economic slack diminishes and inflation begins edging higher, central banks are responding with a slow pivot away from extreme monetary stimulus. The U.S. Federal Reserve (Fed), the Bank of Canada (BOC) and the Bank of England (BOE) have all begun travelling down this tightening path, with the Fed leading the way. Others, such as the European Central Bank (ECB), are still some distance away but are beginning to at least reduce their rate of stimulus delivery.

Global bond yields remain too low according to our modelsWe expect bond yields to continue moving higher, but that the pace

TARGETS (RBC GAM INVESTMENT STRATEGY COMMITTEE)

NOVEMBER 2017FORECAST

NOVEMBER 2018CHANGE FROM

FALL 20171-YEAR TOTAL RETURN

ESTIMATE* (%)

CURRENCY MARKETS AGAINST USD

CAD (USD–CAD) 1.29 1.37 N/C (6.0)

EUR (EUR–USD) 1.19 1.12 0.05 (7.8)

JPY (USD–JPY) 112.54 110.00 N/C 0.5

GBP (GBP–USD) 1.35 1.15 N/C (15.9)

FIXED INCOME MARKETS

U.S. Fed Funds Rate** 1.25 1.88 0.25 N/A

U.S. 10-Year Bond 2.41 2.75 N/C (0.5)

Canada Overnight Rate 1.00 1.50 0.25 N/A

Canada 10-Year Bond 1.89 2.25 0.15 (1.3)

Eurozone Deposit Facility Rate -0.40 -0.40 N/C N/A

Germany 10-Year Bund 0.37 0.90 0.15 (4.7)

U.K. Base Rate 0.50 0.75 0.25 N/A

U.K. 10-Year Gilt 1.33 1.75 0.25 (2.5)

Japan Overnight Call Rate -0.06 -0.10 N/C N/A

Japan 10-Year Bond 0.04 0.10 N/C (0.6)

EQUITY MARKETS

S&P 500 2648 2800 175 7.6

S&P/TSX Composite 16067 16350 250 4.6

MSCI Europe 130 139 5 10.0

FTSE 100 7327 7700 (150) 9.2

Nikkei 22725 25000 3500 11.7

MSCI Emerging Markets 1121 1215 40 10.9

*Total returns are expressed in local currencies with the exception of MSCI Emerging Markets whose return is expressed in USD. **The FOMC raised the target range for the federal funds rate to 1.25% - 1.50%, a 25-basis-point increase from the prior range, on December 13, 2017. Source: RBC GAM

ECONOMIC & CAPITAL MARKETS FORECASTS

ECONOMIC FORECAST (RBC GAM INVESTMENT STRATEGY COMMITTEE)

UNITED STATES CANADA EUROPE

UNITED KINGDOM JAPAN CHINA

EMERGING MARKETS*

New Year 2018

Change from Fall

2017New Year

2018

Change from Fall

2017New Year

2018

Change from Fall

2017New Year

2018

Change from Fall

2017New Year

2018

Change from Fall

2017New Year

2018

Change from Fall

2017New Year

2018

Change from Fall

2017

REAL GDP

2016A 1.60% 1.43% 1.68% 1.85% 0.99% 6.73% 4.99%

2017E 2.25% N/C 3.00% 0.25 2.25% 0.25 1.50% N/C 1.75% N/C 6.75% N/C 5.50% N/C

2018E 2.75% 0.25 1.50% N/C 2.00% 0.25 1.50% N/C 1.50% 0.50 6.00% N/C 5.50% N/C

CPI

2016A 1.28% 1.41% 0.25% 0.65% 0.77% 2.12% 3.66%

2017E 2.00% N/C 1.50% N/C 1.50% N/C 2.75% N/C 0.50% N/C 1.50% (0.25) 2.50% N/C

2018E 2.00% N/C 2.00% (0.25) 1.50% N/C 2.75% N/C 1.25% N/C 2.25% (0.25) 3.00% (0.25)

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


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

Every individual has differing return expectations and tolerances for volatility, so there is no “one size fits all” strategic asset mix. Based on a 40-year study of historical returns1 and the volatility2 of returns (the range around the average return within which shorter-term results tend to fall), we have developed five broad profiles and assigned a benchmark strategic asset mix for each. These profiles range from very conservative through balanced to aggressive growth. It goes without saying that as investors accept increasing levels of volatility, and therefore greater risk that the actual experience will depart from the longer-term norm, the potential for returns rises. The five profiles presented below may assist investors in selecting a strategic asset mix best aligned to their investment goals.

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

RECOMMENDED ASSET MIX

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

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

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

The value-added of tactical strategies is, of course, dependent on the degree to which the expected scenario unfolds.

Regular reviews of portfolio weights are essential to the ultimate success of an investment plan as they ensure current exposures are aligned with levels of long-term returns and risk tolerances best suited to individual investors.

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


1 Average return: The average total return produced by the asset class over the period 1977 – 2017, based on monthly results.

2 Volatility: The standard deviation of returns. Standard deviation is a statistical measure that indicates the range around the average return within which 2/3 of results will fall into, assuming a normal distribution around the long-term average.

*Citigroup World Global Bond Index **MSCI World Index Source: RBC GAM Investment Strategy Committee

GLOBAL ASSET MIX

BENCHMARK POLICY

PAST RANGE

NEW YEAR 2017

SPRING 2017

SUMMER 2017

FALL 2017

NEW YEAR 2018

CASH 2.0% 1.0% – 16% 1.0% 2.0% 3.0% 3.0% 3.0%

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

STOCKS 55.0% 36.0% – 65.0% 61.0% 60.0% 59.0% 58.0% 58.0%

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

REGIONAL ALLOCATION

GLOBAL BONDSCWGBI*

NOV. 2017PAST

RANGENEW YEAR

2017SPRING

2017SUMMER

2017FALL 2017

NEW YEAR 2018

North America 39.6% 18% – 44% 38.1% 44.2% 44.3% 34.1% 37.1%

Europe 40.6% 32% – 56% 33.5% 36.4% 34.1% 40.4% 38.1%

Asia 19.7% 17% – 35% 28.4% 19.5% 21.6% 25.5% 24.7%

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

GLOBAL EQUITIESMSCI**

NOV. 2017PAST

RANGENEW YEAR

2017SPRING

2017SUMMER

2017FALL 2017

NEW YEAR 2018

North America 60.8% 51% – 61% 60.3% 60.8% 59.9% 59.9% 60.0%

Europe 20.5% 20% – 35% 20.3% 20.3% 21.3% 20.6% 20.6%

Asia 11.4% 9% – 18% 11.9% 11.4% 11.4% 12.0% 11.9%

Emerging Markets 7.3% 0% – 8.5% 7.5% 7.5% 7.5% 7.5% 7.5%

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

GLOBAL EQUITY SECTOR ALLOCATION

MSCI** NOV. 2017

RBC GAM ISC FALL 2017

RBC GAM ISC NEW YEAR 2018

CHANGE FROM FALL 2017

WEIGHT VS. BENCHMARK

Energy 6.27% 4.95% 4.37% (0.59) 69.7%

Materials 5.19% 5.98% 6.09% 0.11 117.3%

Industrials 11.49% 12.42% 13.29% 0.87 115.7%

Consumer Discretionary 12.06% 11.27% 14.06% 2.78 116.6%

Consumer Staples 8.87% 9.49% 8.87% (0.62) 100.0%

Health Care 11.95% 12.95% 12.85% (0.10) 107.5%

Financials 18.02% 18.13% 18.02% (0.10) 100.0%

Information Technology 17.18% 18.15% 19.18% 1.03 111.6%

Telecom. Services 2.71% 2.00% 0.71% (1.29) 26.3%

Utilities 3.15% 3.25% 1.25% (2.00) 39.7%

Real Estate 3.12% 1.41% 1.32% (0.10) 42.2%


Recommended Asset Mix


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

ASSET CLASSBENCH-MARK RANGE

LAST QUARTER

CURRENT RECOMMENDATION

Cash & Cash Equivalents 2% 0-15% 2.9% 2.9%

Fixed Income 78% 55-95% 74.1% 74.1%

Total Cash & Fixed Income 80% 65-95% 77.0% 77.0%

Canadian Equities 10% 5-20% 10.6% 10.6%

U.S. Equities 5% 0-10% 5.9% 6.0%

International Equities 5% 0-10% 6.5% 6.4%

Emerging Markets 0% 0% 0.0% 0.0%

Total Equities 20% 5-35% 23.0% 23.0%

RETURN VOLATILITY

40-Year Average 8.7% 5.5%

Last 12 Months 4.8% 3.7%

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

reviewing the strategic asset mix for all of our multi-asset solutions. With

an emphasis on consistency of returns, risk management and capital

preservation, we have developed a strategic asset allocation framework for

five client risk profiles that correspond to broad investor objectives and risk

preferences. These five profiles range from Very Conservative through

Balanced to Aggressive Growth.

“

”



LAST QUARTER



Fixed Income 43% 20-60% 39.0% 39.0%



U.S. Equities 20% 10-30% 20.8% 20.9%


Emerging Markets 4% 0-10% 4.3% 4.3%

Total Equities 55% 40-70% 58.0% 58.0%

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

RETURN VOLATILITY




LAST QUARTER



Fixed Income 63% 40-80% 59.0% 59.0%



U.S. Equities 10% 0-15% 10.9% 11.0%


Emerging Markets 0% 0% 0.0% 0.0%

Total Equities 35% 20-50% 38.1% 38.1%

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

RETURN VOLATILITY






LAST QUARTER



Fixed Income 28% 5-40% 23.9% 23.9%



U.S. Equities 25% 15-35% 25.8% 25.9%


Emerging Markets 6% 0-12% 6.4% 6.4%

Total Equities 70% 55-85% 73.1% 73.1%

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

RETURN VOLATILITY




LAST QUARTER



Fixed Income 0% 0-10% 0.0% 0.0%


Canadian Equities 32.5% 20-45% 31.8% 31.8%

U.S. Equities 35.0% 20-50% 34.8% 34.9%

International Equities 21.5% 10-35% 22.2% 22.1%

Emerging Markets 9.0% 0-15% 9.2% 9.2%

Total Equities 98% 80-100% 98.0% 98.0%

AGGRESSIVE GROWTH

RETURN VOLATILITY



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



The U.S. dollar appreciated against two of the four major currencies during the three-month period ended November 30, 2017, falling only against the British pound. The greenback rose 3.3% versus the Canadian dollar and 2.4% versus the yen, while finishing essentially unchanged against the euro and declining 4.4% against sterling. For the latest 12-month period, the U.S. dollar declined against all four major currencies, falling 11.0% versus the euro, 7.5% versus the pound, 4.0% against the Canadian dollar and 1.6% against the yen.

Major fixed-income markets were mixed during the three-month period, with the U.S. and Japan down slightly versus gains in Europe amid

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


CAPITAL MARKETS PERFORMANCE

continued subdued inflation and modest economic growth. The FTSE TMX Canada Universe Bond Index, Canada’s fixed-income benchmark, dropped 2.2% in U.S. dollar terms.

Global equities surged during the three-month period, as strengthening economic growth around the world pushed earnings higher. The S&P 500 Index rose 7.7% and the MSCI Japan gained 9.9%. The MSCI Germany climbed 8.5%, while the MSCI U.K. returned 4.1%. Over the 12-month period, the S&P 500 gained 22.9% and the MSCI Japan rose 24.3%. In Europe, the MSCI Germany returned 36.6%, the MSCI France gained 36.1% and the MSCI U.K. returned 21.3%, all in U.S. dollar terms. The S&P/TSX Composite Index gained 3.0% in U.S. dollar terms during the three months. For the 12-month period, the S&P/TSX benchmark index gained 14.1%.

Over the past year, growth stocks in the U.S. significantly outperformed value stocks – the Russell 3000 Growth Index gained 30.3%, while the Russell 3000 Value Index returned only 14.7%.

All of the 11 global equity sectors recorded gains during the quarter ended November 30, 2017. The best-performing sector was Energy with a return of 11.0%, followed by Information Technology, which rose 9.5%, and Financials with a 7.8% gain. The worst-performing sector over the three-month period was Telecommunication Services, which returned 1.5%.

Capital Markets Performance | Milos Vukovic, MBA, CFA

CANADA Periods ending November 30, 2017

USD CAD

Equity Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

S&P/TSX Composite 2.96 12.19 14.11 1.85 3.25 6.37 9.60 6.01

S&P/TSX 60 3.99 12.98 14.88 2.30 3.94 7.44 10.33 6.48

S&P/TSX Small Cap 0.82 4.24 8.32 2.05 (0.08) 4.16 4.04 6.22

U.S.Periods ending November 30, 2017

USD CAD


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

S&P 500 TR 7.65 20.49 22.87 10.91 15.74 11.22 18.01 15.45

S&P 400 TR 10.17 15.99 18.53 11.37 15.46 13.83 13.84 15.93

S&P 600 TR 12.56 13.83 17.66 13.25 16.87 16.29 13.01 17.88

Russell 3000 Value TR 7.14 11.76 14.70 8.53 14.16 10.69 10.17 12.97

Russell 3000 Growth TR 8.56 28.65 30.25 12.95 17.03 12.16 25.10 17.58

NASDAQ Composite Index TR 6.93 27.69 29.12 12.78 17.96 10.47 24.01 17.40

EXCHANGE RATES Periods ending November 30, 2017

Current USD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

USD–CAD 1.2902 3.32 (3.91) (3.96) 4.09 5.37

USD–EUR 0.8402 0.02 (11.56) (10.96) 1.49 1.79

USD–GBP 0.7394 (4.38) (8.87) (7.48) 4.96 3.45

USD–JPY 112.5450 2.37 (3.70) (1.63) (1.75) 6.42

Source: Bloomberg/MSCI

CANADA Periods ending November 30, 2017

USD CAD

Fixed Income Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

FTSE TMX Canada Univ. Bond Index TR (2.16) 7.13 6.65 (1.15) (2.19) 1.09 2.43 2.90

U.S. Periods ending November 30, 2017

USD CAD


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

Citigroup U.S. Government TR (0.54) 3.11 3.24 2.12 1.98 2.75 (0.84) 6.29

Barclays Capital Agg. Bond Index TR (0.55) 3.07 3.21 2.11 1.98 2.75 (0.87) 6.29

GLOBALPeriods ending November 30, 2017

USD CAD


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

Citigroup WGBI TR (0.11) 7.09 6.74 1.61 0.81 3.20 2.51 5.77

Citigroup European Government TR 1.33 13.56 13.78 0.58 2.13 4.69 9.28 4.70

Citigroup Japanese Government TR (2.41) 3.95 1.01 3.89 (3.85) 0.83 (2.98) 8.14

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 Periods ending November 30, 2017

USD CAD


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

MSCI World TR * 6.43 20.77 23.66 8.19 11.75 9.37 18.48 12.68

MSCI EAFE TR * 5.14 23.06 27.27 5.97 8.24 8.03 21.94 10.37

MSCI Europe TR * 4.01 23.64 30.12 4.61 7.64 6.88 24.67 8.96

MSCI Pacific TR * 7.25 22.56 23.12 8.88 9.51 10.21 17.97 13.40

MSCI UK TR * 4.06 16.51 21.33 1.54 4.63 6.93 16.25 5.76

MSCI France TR * 6.10 29.04 36.14 8.69 9.77 9.02 30.44 13.20

MSCI Germany TR * 8.45 27.66 36.56 7.15 9.53 11.44 30.85 11.60

MSCI Japan TR * 9.85 23.13 24.32 10.83 12.16 12.88 19.12 15.43

MSCI Emerging Markets TR * 3.30 32.53 32.82 6.15 4.61 6.15 27.26 10.55

Source: Bloomberg/MSCI

GLOBAL EQUITY SECTORS Periods ending November 30, 2017

USD CAD

Sector: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

3 months (%)

1 year (%)

3 years (%)

Energy TR * 10.99 0.29 3.93 (1.02) 0.62 14.05 (0.42) 3.09

Materials TR * 6.01 24.27 26.15 8.07 5.74 8.94 20.87 12.55

Industrials TR * 7.50 23.21 24.30 10.42 13.29 10.46 19.10 15.01

Consumer Discretionary TR * 7.73 21.05 22.65 9.45 14.33 10.70 17.52 14.00

Consumer Staples TR * 2.76 14.81 18.23 6.68 9.78 5.60 13.28 11.11

Health Care TR * 2.29 19.88 21.76 5.09 13.98 5.11 16.66 9.46

Financials TR * 7.81 20.36 25.12 8.84 12.40 10.78 19.88 13.36

Information Technology TR * 9.54 38.31 40.25 16.71 19.39 12.55 34.38 21.56

Telecommunication Services TR * 1.46 4.55 10.77 2.28 7.76 4.26 6.14 6.53

Utilities TR * 2.05 19.39 24.63 5.70 9.22 4.87 19.41 10.09

Real Estate TR * 2.41 13.75 16.24 NA NA 5.23 11.37 NA

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


Capital Markets Performance | Milos Vukovic, MBA, CFA

Secular stagnation ebbs

Global economic growth is travelling at the highest altitude in seven years thanks to a confluence of positive supports (Exhibit 1). The expansion is highly synchronized, encompassing the bulk of developed and many emerging-market nations. Measures of confidence and risk appetite are also robust, benefiting from this macroeconomic strength and simultaneously helping to sustain it (Exhibit 2).

We are increasingly of the view that secular stagnation – the plague of fear and diminished expectations that enfeebled the post-crisis period – is starting to lessen its grip. This helps to explain better growth today and offers the hope of sustainably faster growth in the future, though not a complete return to the pre-crisis trajectory given other headwinds still in place. Against this backdrop, our own growth forecasts have edged a little higher and are overall above consensus.

At the same time, it is fair to concede that there are considerable risks to this rosy narrative. Among them,

GLOBAL INVESTMENT OUTLOOK

the U.S. business cycle looks to be at a fairly late stage, if hardly at the very end of the cycle (Exhibit 3). We are now on watch for evidence of excessive risk-taking – a classic sign of an economic cycle on its last legs. Tightening central banks introduce a narrative twist not experienced in over a decade.

U.S. protectionism is another key risk, as are several geopolitical considerations. China’s recent policy

pivot offers a few things to like, but also a few to fret over.

For now, markets remain preternaturally calm. There is some logic to this, but it is not fully justified (Exhibit 4). Market technical signals are similarly stretched, with valuations across most asset classes erring on the optimistic side.

Synthesizing these disparate observations into a coherent


Exhibit 1: Global manufacturing expansion continues

4748495051525354555657

2012 2013 2014 2015 2016 2017

Man

ufac

turin

g P

MI

J.P.Morgan Global PMI Developed markets PMI Emerging markets PMINote: PMI refers to Purchasing Managers Index for manufacturing sector, a measure for economic activity. Source: Haver Analytics, RBC GAM

Contraction

Expansion

Eric Lascelles Chief Economist RBC Global Asset Management Inc.

Eric Savoie, MBA, CFASenior Analyst, Investment Strategy RBC Global Asset Management Inc. Daniel E. Chornous, CFAChief Investment Officer RBC Global Asset Management Inc.

Exhibit 2: Investors in risk-seeking mode

-4

-3

-2

-1

0

1

2

1991 1998 2005 2012

Ris

k ap

petit

e in

dex

(ave

rage

= 0

)

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

Seeking

Loving

Neutral

Reluctant

Averse

2017


Exhibit 3: U.S. business-cycle probability

Start of cycle Early cycle Mid cycle Late cycle End of cycle Recession

Like

lihoo

d

Note: Calculated via scorecard technique by RBC GAM. Source: RBC GAM

Most likely here

Conceivably here

A smaller risk

Exhibit 5: Global macro forecast summary

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

whole, we are content to maintain a modest equity-overweight position given the superior relative valuation of equities over bonds, strong economic momentum, our hypothesis that secular stagnation is fading and the potential for U.S. tax cuts to provide a further push higher. That said, let us acknowledge that our tendency has been to gradually reduce this overweight over the past year – largely for business-cycle reasons – and that this trend could yet re-emerge in coming quarters.

Macro strength persistsGlobal economic growth continues to be quite good by post-crisis standards. The synchronized acceleration that began in the middle of 2016 has mostly transformed into steady, robust growth. But there are tentative signals that it may have sped up again in the latter half of 2017. Looking forward, we anticipate further robust, above-consensus GDP growth and rising, above-consensus inflation.

This quickening of growth was not the work of policymakers. The global fiscal impulse remains roughly flat and several prominent central banks have begun the gradual removal of monetary stimulus. Instead, we see several other factors at play (Exhibit 5).

Financial conditions remain friendly thanks to still-low government yields, narrow credit spreads, rising equities and oil prices in a sweet spot that supports global growth without punishing oil exporters. The

Vs. market Key points

GrowthModestly

above consensus

• Strong momentum • Friendly financial conditions • Political/fiscal optimism • Classic late-cycle behavior • Secular stagnation fading?

InflationModestly

above consensus

• Oil to rise slightly • Economies tighten • Wages to rise – Phillips curve • Central banks more stimulative than policy rules

suggest

Source: RBC GAM

Exhibit 4: Market volatility should be low but not this low

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.8

2004-07average

2010 2011 2012 2013 2014 2015 2016 2017

Z sc

ore

(num

ber o

f sta

ndar

d de

viat

ions

)

External spillovers Funding and liquidity conditionsCorporate performance Macroeconomic fundamentalsVIX Index Model-fitted VIX index

Note: IMF volatility model estimated using an ordinary least square regression with explanatory variables including U.S. GDP growth, Citi U.S. Economic Surprise Index, net income to assets and payouts to assets for S&P 500 companies, TED spread, cross-currency basis swap rates, yield spreads and supply of U.S. Treasuries. Source: IMF GFSR October 2017, RBC GAM


Exhibit 6: Global credit impulse treads lower

-40

-30

-20

-10

0

10

20

2001 2003 2005 2007 2009 2011 2013 2015 2017

Glo

bal c

redi

t im

puls

e fo

rpr

ivat

e no

n-fin

anci

al c

orpo

ratio

ns

(ppt

)

Note: Credit impulse measured as year-over-year change in year-over-year change in credit outstanding as percentage of GDP. Source: IIF, RBC GAM

Credit impulse addsto GDP growth

Credit impulse detracts from GDP growth


fairly late point of the business cycle is also frequently associated with solid economic growth.

The U.S. election of a year ago appeared to have had a powerfully positive effect on global confidence. The rationality of this trigger is debatable – President Trump’s proposed policies have at best mixed implications, few have been implemented so far, and fewer still would appear to benefit any country but the U.S. Nevertheless, it is undeniable that consumers and businesses both began to feel much more confident about their economic prospects immediately after the election, and such sentiment can boost economic growth.

We also continue to think, with growing conviction, that the plague of secular stagnation that held back economic growth for much of the past decade may finally be starting to fade as the bad memories of the financial crisis ebb, a new generation of business leaders takes the helm, animal spirits revive and business investment picks up. A key signal of this – productivity growth – is now on the upswing. This boost, if genuine, would enable faster growth on a sustained basis.

Not everything is perfect, of course. The aforementioned financial conditions, while still helpful, are no longer actively improving. Similarly, the global credit impulse appears to be in negative territory, meaning that global credit is growing less quickly than before. This exerts a theoretical drag on growth, though

Exhibit 7: Keep structural headwinds to economic growth in mind

Human factors Economic structure Post-crisis

• Demographics:

– Slower population growth

– Rising retired %

• Decelerating gains:

– Education

– Health

– Urbanization

• Rising complacency:

– Low labor mobility

– More segregated

– Less risk-taking

• Falling societal trust

• Fading globalization

• Declining creative destruction

– Lower firm turnover

– Higher firm concentration

• Regulatory burden

• Goods services

• Maturing EM economies

• Populism/protectionism

• Secular stagnation

– Diminished expectations

– Less business investment

– Skill decay

• Debt excesses

– Servicing

– DeleveragingTechnology

• Running out of big new innovations?

Source: RBC GAM

little repercussions are visible in the economy to date (Exhibit 6). Finally, let’s not forget that there are many reasons why future growth is unlikely to match the sustained heroics of earlier decades (Exhibit 7).

Economic forecast refreshOur global GDP forecast is for a 3.8% increase in 2018 – an upward revision from the prior estimate and moderately above the consensus. If achieved, growth in 2018 should

just outmuscle 2017, itself the fastest clip in several years. This outlook means that macroeconomic factors should be supportive of further stock-market gains and yield increases.

We are comfortable with an above-consensus stance on economic growth for a variety of reasons, most discussed in the prior section. But a further technical consideration is that there has been a profound shift


Exhibit 9: RBC GAM GDP forecast for developed markets

3.00%

2.25% 2.25%

1.75%1.50%1.50%

2.75%

2.00%

1.50% 1.50%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Canada U.S. Eurozone Japan U.K.

Ann

ual G

DP

gro

wth

(%)

2017 2018Source: RBC GAM

in the way that consensus growth forecasts are evolving. For the great bulk of the post-crisis period, the consensus for each year began too optimistically and then tumbled lower until eventually matching the reality of the situation. Betting below the consensus was reliably the winning strategy. That has now changed. Forecasters have been beaten down after years of excessive optimism at the same moment that growth has perked up, leaving above-consensus growth forecasts as the new winning strategy (Exhibit 8).

The pillars of this global forecast are a slightly greater contribution from both developed and emerging economies. Developed countries should collectively grow by 2.2% in 2018, their best in nine years, while emerging economies should grow by 5.4%, their best in four years.

Naturally, not every country is set to trump market expectations. The U.S., Eurozone and Japan are the developed nations most capable of besting consensus. Canada may lag the consensus for competitiveness and housing-related reasons, while we are not far from a dreary Brexit-infused consensus for the U.K. (Exhibit 9).

Inflation to sneak higherAbove-consensus inflation also seems a reasonable expectation for 2018 (Exhibit 10). Granted, optimism has hardly been a winning bet for inflation during the post-crisis period. However, we detect several things beginning to change in favour


Exhibit 10: RBC GAM CPI forecast for developed markets

2.75%

2.00%

1.50% 1.50%

0.50%

2.75%

2.00% 2.00%

1.50%1.25%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

U.K. U.S. Canada Eurozone Japan

CP

I (Y

oY %

cha

nge)


Exhibit 8: Consensus forecast starts to trend higher

2012:3.4% 2013:

3.2%

2014:3.3% 2015:

3.1%2016: 3.0%

2017: 3.7%

2018: 3.7%

2.9

3.1

3.3

3.5

3.7

3.9

4.1

4.3

4.5

2012 2013 2014 2015 2016 2017

Con

sens

us fo

reca

st o

f wor

ld re

al

GD

P (%

)

Date when forecast was madeSource: Consensus Economics, IMF, RBC GAM

Outlook revised steadily lower for many years...

...has finally started to turn!


Exhibit 11: Phillips Curve remains and wages could accelerate

y = -0.5156x + 8.7242R² = 0.6002

y = -0.2458x + 6.1751R² = 0.8556

0

1

2

3

4

5

6

6 8 10 12 14 16 18Atla

nta

Fed

med

ian

wag

e gr

owth

of

prim

e-ag

e w

orke

rs (%

)

Broad unemployment rate (%, 3MMA with 12-month lag)Before 2010 2010 and after

Source: BLS, Federal Reserve Bank of Atlanta, Haver Analytics, RBC GAM

of higher inflation. First, as with the growth outlook, market expectations are no longer being revised steadily downward from month to month. Furthermore, there are several positives specific to the inflation outlook over the next year:

• The commodity shock has ended and for that matter oil prices have recently spurted higher, with implications for near-term inflation.

• Developed-world economies are finally approaching their full potential. This unavoidably maps onto greater inflation pressures.

• Despite claims that wages are not responding to faster economic growth, we detect rising wages and still believe that a declining unemployment rate must eventually lead to faster wage growth (Exhibit 11).

Pitted against these positives are a somewhat subdued level of inflation expectations and some structural constraints that arguably make it harder for inflation to rise as nimbly as one would otherwise have expected. The constraints include adverse demographics, the effects of globalization and some technology-induced deflation (Exhibit 12). To be clear, inflation can still rise and likely will, but not by quite as much as traditional models might indicate. We are left content with an above-consensus inflation outlook.


Debt erosion

Large monetary base

Monetary policy

risk/reward

Commodity prices

Economic slack

Clear inflation target

GlobalizationDemographics

Inflation

Inflation expectations

• Comparative advantage

• Global Phillips curve

• Technology prices

• Automation

• Industry disruption

Tech deflation

2

1

Exhibit 12: Inflation barometer: shifting up toward normal inflation

Source: RBC GAM

A new project for central banksAs growth has picked up, economies tighten, and inflation begins edging higher, central banks are responding with a slow pivot away from extreme monetary stimulus. This is momentous for three reasons: reversals of this sort are a roughly once-a-decade occurrence, this particular version is in uncharted waters given the need to simultaneously shrink distended

central-bank balance sheets, and the occasion likely also marks the end of a 34-year bull market in bonds.

The U.S. Federal Reserve (Fed), the Bank of Canada (BOC) and the Bank of England (BOE) have all begun down this tightening path. The Fed leads the charge. Others, such as the European Central Bank (ECB), are still some distance away but are beginning to at least reduce their rate of stimulus delivery.


0

100

200

300

400

500

2000 2003 2006 2009 2012 2015 2018 2021

Cen

tral b

ank

tota

l ass

ets

(Dec

-200

6 =

100)

Canada projection U.S. CanadaNote: Projection for Bank of Canada assets based on growth rates from 2000 to 2007 and July 2010 to June 2017. Source: Haver Analytics, RBC GAM

Projection

Exhibit 13: Broadest measure of U.S. unemployment falls nicely

6

8

10

12

14

16

18

1994 1998 2002 2006 2010 2014

U.S

. bro

ad u

nem

ploy

men

t rat

e (%

)

Note: Broad unemployment rate defined as U-6 unemployment rate. Historical average since 1994. Source: BLS, Haver Analytics, RBC GAM

Historical average

Matches previous cycle trough

2017

Exhibit 14: Global monetary-policy tightening has started

2

3

4

5

6

7

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Glo

bal p

olic

y ra

te (%

)

Note: Policy rates of the U.S., Canada, U.K., Eurozone, Switzerland, Sweden, Norway, Japan, Australia, China, India, South Korea, Russia, Brazil and Mexico aggregated and weighted by PPP-based GDP share. Source: Haver Analytics, RBC GAM

Exhibit 15: Fed balance sheet to return to normal growth rate


We view these monetary recalibrations as appropriate. Even if economic growth had not accelerated over the past year, the gradual progress of the prior seven years whittled away enough economic slack to demand a shift in stance. As an illustration, the broadest measure of the U.S. unemployment rate now matches the prior cycle’s low (Exhibit 13).

That said, even as monetary stimulus starts to fade and interest rates rise, there remains an enormous amount of stimulus. The average global policy rate is still very low, and has increased only slightly so far (Exhibit 14).

The central banks that partook in the extreme practice of quantitative easing – printing money and buying bonds with the proceeds – are now beginning to reverse themselves. Since October, the Fed has allowed its portfolio of bonds to begin shrinking. Within several years – assuming no recession interrupts – the Fed’s balance sheet and thus the U.S. monetary base should shrink down to a more normal size, though significantly larger than before the crisis. The extra size is because the economy is larger than before and also because a capital-constrained banking sector requires a relatively larger monetary base just to ensure a normal amount of money is circulating in the economy (Exhibit 15). This balance-sheet reduction should impose an upward pressure on bond yields, though the effect should be surprisingly modest.


Risks to the base case viewThere are a number of risks to the base case forecast (Exhibit 16). Among the negative scenarios, three are especially prominent. The business cycle is aging, protectionism is on the ascent and international relations have become precarious in several pockets of the world. The latter two risks have worsened slightly over the past quarter. All three are discussed in more detail later.

Several of the lesser risks have improved somewhat, though still remain relevant:

• European politics had a good year for most of 2017, dodging several populist threats, but now face another onslaught of challenges in the form of elections, independence movements and nationalist governments coalescing in Eastern Europe.

• Chinese risks have shrunk given stabilizing growth and improving debt metrics, but the country is still likely to decelerate over time and sports an enormous amount of corporate debt by emerging-market standards.

• Policy tightening by a handful of major central banks brings with it the risk of a brisker increase in interest rates, though it is reassuring that the market response so far has been measured.

• By extension, rising interest rates could at some point spell trouble for the world’s debt hot spots. These include Canada’s housing


market, China’s aforementioned corporate debt sector, emerging-market corporate debt more generally, and a myriad of exotic investment instruments that rely upon leverage to boost returns in a low-yield world.

Fortunately, the current environment also reveals a number of upside risks:

• The decade-long scourge of slow post-crisis growth – “secular stagnation” – could

fade even more quickly than we are budgeting for, enabling sustainably faster growth.

• To the extent that it is now harder for inflation to rise due to structural constraints, this might extend the length of the economic expansion.

• Governments could opt to deploy fiscal stimulus, in contrast to the current IMF projection (Exhibit 17). There is a good chance of this in the U.S., it is plausible

Aging business cycle International relationsProtectionism

China growth/Credit

Higher interest rates Debt hot spots

Fiscal stimulus Structural Japan reforms

Secular stagnation ends

Structurally low inflation

Do

wn

sid

e r

isk

Ups

ide

risk

European populism

Exhibit 16: Macro risks: slight improvement in landscape

Source: RBC GAM

Exhibit 17: Global fiscal impulse fairly neutral ahead

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2005 2007 2009 2011 2013 2015 2017 2019 2021

Cha

nge

in w

orld

stru

ctur

al fi

scal

ba

lanc

e (p

pt) Fiscal boost

Fiscal drag

Note: Forecast from latest IMF World Economic Outlook. PPP-based country GDP as share of world total used as weights. Source: IMF, Haver Analytics, RBC GAM


Exhibit 18: U.S. business-cycle scorecardU.S. economy most likely in “late cycle,” but some debate

in Japan, and Germany may yet pursue a similar tack. In the context of declining monetary stimulus, this would help to sustain global growth.

• Japan’s structural reforms may be starting to gain traction, potentially unleashing a period of superior growth for the world’s third-largest economy.

The latest on the business cycleThe U.S. economic cycle is now more than eight years old. While expansions don’t die of old age, risk factors do tend to accumulate over time (Exhibit 18).

Among the many factors relevant to assessing the phase of the business cycle, the plurality argue for a “late-cycle” interpretation, meaning that one would normally expect the next recession to arrive within the next few years. Supporting factors include the fact that there is essentially no economic slack remaining in the U.S. economy, consumer and business confidence are high, market volatility is low, monetary policy is tightening, the yield curve has flattened considerably, credit spreads are narrow and profit margins are starting to ebb.

In anticipation of the approaching completion of this business cycle, we have gradually reduced our risk-taking over the past year by reducing the extent of our equity-overweight position and also lowering the level of risk taken within the bond portfolio.


Start of cycle

Early cycle

Mid cycle

Late cycle

End of cycle Recession

Cycle age

Economic trend

Economic slack

Sentiment

Business investment

Consumer durables

Housing

Loan growth

Leverage

Inventory ratio

Employment

Prices

Expected market volatility

Monetary policy

Bonds

Credit

Stock direction

Equity profitability

Votes for each stage of business cycle 1 2.5 11.5 13 4.5 0

Note: Darker shade indicates the most likely stage of business cycle (full weight); lighter shade indicates alternative interpretation (0.5 weight). Source: RBC GAM

Another way of thinking about the gradually rising risk of a downturn is in the context of economist Hyman Minsky’s financial-instability hypothesis (Exhibit 19). To summarize, a period of low volatility such as the one currently underway encourages a quest for additional yield; this, in turn demands additional risk-taking. The extra risk-taking eventually translates into a bubble, and the bursting of the bubble then spikes volatility higher and sends the process careening back in the opposite direction. In a nutshell, stability begets volatility.

We are on high alert for evidence of rising risk-taking and any side-effects that could bring the business cycle to a jarring halt. There is starting to be some evidence of this.

The short and long of geopoliticsInternational relations seem unusually fraught with risk (Exhibit 20).

In the short run, two geopolitical issues dominate. The first is North Korea. The situation has undeniably deteriorated over the past year.


North Korean leadership has always been inclined toward uttering threats and symbolic shows of force, but the new U.S. leadership is now retaliating in kind rather than turning the other cheek. This new U.S. tactic reduces the margin for error, especially at a time when North Korea appears to have made significant progress in its nuclear and missile technologies.

Still, we believe the basic calculation remains fundamentally the same for both sides, and that war is thus unlikely (Exhibit 21). North Korea will not realistically abandon its nuclear-weapons program given the untimely fate of Libyan and Iraqi leaders after similar concessions. At the same time, North Korea will not attack the West given that any retaliation would devastate the country. The U.S. options are similarly limited. A pre-emptive attack is tempting, but would yield unacceptable casualties for American allies. Recent rhetoric from President Trump seems to acknowledge this. Instead, the U.S. is likely to remain locked in an antagonistic relationship with North Korea, but without the kind of disaster that would be pivotal for the global economy or markets.

Another short-term risk revolves around Saudi Arabia. The country recently went through a leadership transition, elevating a young and progressive new crown prince – Mohammed bin Salman – to effective control. This has been positive from an economic standpoint, with the rights of


High volatility

Low volatility

Quest for safety

Quest for yield

Lower risk-taking

Delevering

Bubble bursts

Higher risk-taking

Bubble formsFinancial

instability hypothesis

Exhibit 19: Minsky hypothesis: stability begets volatility

Exhibit 21: North Korean game theory

Source: RBC GAM

Likely at this stage:

• High confidence

• Rising economy-wide leverage

• Inflows into riskier assets (EM, credit); $500B in target-volatility funds, selling VIX

• Very low risk premiums

• Pockets of rising consumer defaults

9/11

Iraq invasion

Madrid bombing

London bombing

Iran nuclear tensions

Arab Spring: Syrian and Libyan wars

Syrian civil war escalation

Russian annexationof Crimea

ISISescalation

Parisattacks

Barcelona attacks,North Korea ICBM

threat

0

100

200

300

400

500

600

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Geo

polit

ical

Ris

k B

ench

mar

k In

dex

(200

0-20

09 =

100

)

Source: Caldara, Dario and Matteo Iacoviello, “Measuring Geopolitical Risk," working paper, Board of Governors of the Federal Reserve Board, August 2017, RBC GAM

Exhibit 20: Geopolitical tensions heightened recently

Stance Pacifism Antagonism Attack

North Korea

• U.S. or South Korea might invade

• North Korean leadership would be removed

• Bad endings for Libya and Iraq

• Sustain domestic popularity via us-vs-them rhetoric

• U.S. or South Korea unlikely to invade

• North Korean leadership unlikely to be removed

• Attacking others would induce devastating retaliation

• North Korea would lose• North Korean leadership

would be ousted

United States

• North Korea might be emboldened to invade South Korea

• North Korea sells nukes?• Lose face

• Prevent North Korea from invading South Korea

• Save face

• Would win, eliminating North Korean threat

• Gain border with China• But U.S. and allies would

suffer unacceptable losses

This is the Nash equilibrium. The logic is only strengthened by North Korea’s acquisition of nuclear capabilitiesSource: RBC GAM


women expanding, the power of the religious police declining, an anti-corruption drive and a series of economic reforms aimed at eventually diversifying the economy away from oil.

However, Saudi Arabia’s political shift has been much more complicated from a political and foreign-policy perspective. The new leadership recently charged dozens of Saudi elites with corruption. If this were to backfire, it could undermine bin Salman’s control over the country. On the foreign-policy front, Saudi Arabia has long had an acrimonious relationship with Iran as both vie for influence over the Middle East, with an underpinning of religious differences.

This spat has not merely spilled over into an intensification of the longstanding proxy war in Yemen, but more recently into an embargo on Qatar and now political chaos in Lebanon. Iran, for its part, is taking advantage of the recent void created by ISIS losses in Syria and Iraq to bolster its influence over the vacated territory. Against a backdrop of massive oil production in the region, there is the chance of an accidental oil-supply shock, with the effect of sharply higher oil prices, spiking inflation and weaker global growth.

Finally, and perhaps most important, is a longer-term geopolitical risk. The power dynamic among global superpowers is palpably shifting (Exhibit 22):


• Trade tensions• North Korea • China navy in Pacific• New multipolar world• “Thucydides” Trap?

• Friendlier relations• Natural gas deal

• Initially friendly relations• Russia interferes in U.S.

election• Russia bellicose in Eastern

Europe

China looks outward Russia seeks empire

U.S. retreats from world

Exhibit 22: Geopolitical power shift after several quiet decades

Source: RBC GAM

• The U.S. appears fatigued with its international responsibilities and so is tilting toward isolationism. In this environment, other powers are happy to step into the void this creates.

• Russia appears intent upon rebuilding an empire of sorts for itself, annexing territory along its borders, re-involving itself in the Middle East and currying favour with North Korea.

• China, which had long punched well below its weight geopolitically, has set a clear goal of engaging more actively with the world beyond mere commercial concerns. This is an entirely reasonable expectation for a country with China’s population, economy and military might, and one cannot deny that its curious blend of one-party rule plus capitalism could prove an attractive model for less successful nations.

All the same, China’s ascent is something of a headache for the world as the country’s emergence marks a profound shift from a period of undisputed U.S. dominance toward a multi-polar landscape in which multiple countries vie for influence. Not only does Chinese and Russian strength make the outlook less certain, but multi-polar worlds tend to be associated with less economic growth. Framed differently, the “Thucydides Trap” becomes relevant: as global dominance has shifted from one country to the next over the great sweep of history, war has frequently resulted between the ascending and descending nation. Friction is likely over the coming generation between the U.S. and China.

Protectionist tendenciesIt is not entirely fair to describe the current growth-impeding trend toward protectionism as emanating


Exhibit 23: Non-tariff trade barriers growing everywhere

0

200

400

600

800

1000

Germany U.K. France Mexico Japan SouthKorea

India Canada China EU U.S.

Non

-tarif

f mea

sure

s as

of

Jun

e 30

2000 Technical 2007 Technical 2017 Technical 2000 Targeted 2007 Targeted 2017 Targeted

Note: Targeted barriers include anti-dumping, countervailing, safeguards and special safeguards, tariff-rate quotas, export subsidies, quantitative restrictions and state trading enterprises. Source: World Trade Organization, RBC GAM

2000

solely from the U.S. since non-tariff barriers are rising in many countries (Exhibit 23) and the populist attitudes that often underlie protectionism have strengthened in many places, including the U.K. and Eastern Europe. However, the U.S. is the clear leader, outpacing the rest with its growing number of trade impediments (such as on softwood lumber from Canada).

NAFTA, the longstanding free-trade agreement between the U.S., Canada and Mexico, is still being renegotiated and the goal is to finalize a new deal by the end of the first quarter of 2018. The early going has not been promising. Some minor progress has occurred but negotiators appear to be talking past one another on key points.

We identify four possible outcomes (Exhibit 24). While it would be lovely for the sides to reach a technocratic solution that refreshed the deal for a more modern age, we assign a mere 25% probability to this happy outcome. Just as likely is that NAFTA negotiators fail and the pact remains as is. Together, then, we assign a roughly 50% chance to a fairly “benign” outcome, meaning that North American growth avoids a new headwind.

However, this leaves a 50% chance of a more negative outcome. One is that Canada and Mexico largely accede to U.S. demands, significantly hobbling NAFTA though not quite technically killing it. Finally is the possibility that NAFTA is killed, with a worryingly high 40% chance.


Exhibit 24: NAFTA renegotiation scenarios

Scenarios Odds Assumptions Economic effect

Termination 40%

• NAFTA scrapped• Canada and U.S. revert to

prior trade deal, but also likely scrapped

• WTO default tariffs apply

• Problematic, resulting in higher costs, supply-chain headaches, worker permit• Cdn GDP -0.8%

• U.S. GDP -0.4%

Substantial changes 10%

• U.S. largely gets its way: NAFTA defanged

• Trade dispute tribunals scrapped• U.S. can impose safeguard

exclusions• U.S. protects procurement• U.S. carves out minimum auto

share• Pact renewal necessary every

5 years

• Modest to moderate negative economic effects, depending on how substantially NAFTA is undermined in practice

Modest changes 25%

• Some modernization with benign or even beneficial changes

• Better incorporation of intellectual property and modern industries

• Throw a bone: accede to lesser U.S. asks

• Limited economic effect, ranging from slight negative to slight positive depending on precise changes

No change 25%

• Canada and Mexico run out the clock

• Trump policy has often fizzled

• Short-term uncertainty; no long-term effect

Source: RBC GAM


President Trump has repeatedly uttered this threat, though how much represents bluff remains unclear. Simultaneously, Canada and Mexico have also come to recognize that they might be better off outside NAFTA (where modest WTO tariffs and impartial rules would apply), rather than inside a bad deal.

Given the number of plausible scenarios, it is impossible to speak with precision about the economic implications of NAFTA negotiations. What we can do is estimate that a bad outcome would theoretically cast a shadow subtracting about 0.8% from the Canadian economy, and around 0.4% from the U.S. economy.

U.S. economy stays strongAs with the global economy, U.S. GDP has continued to gallop and the country’s leading indicators remain unusually strong. Confidence is high, and business investment intentions signal further health ahead. Hurricane-related depressants in the third quarter were smaller than feared, suggesting a modest rebound in the fourth quarter.

In assessing the many and varied economic effects of a Trump presidency, we continue to believe that the U.S. economy can grow faster than otherwise in the short run to the tune of an extra 0.4% to 0.5% of growth per year above normal, though slower over the medium run as constraints on trade and immigration begin to accrue (Exhibit 25).


Exhibit 25: Effect of Trump policies on U.S. GDP

+0.9

-0.5

+0.5+0.4

-0.2

-0.5 -0.4-0.3

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2017 2018 2019 2020 2021 2022

Per

cent

age

poin

ts

Cumulative effect on GDP level Effect on annual GDP growthSource: RBC GAM assumptions and calculations

Positive economiceffect in short term

Negative economiceffect in long term

through Congress. The Senate and the House of Representatives have pitched slightly different visions of the bill, and further adjustments will almost certainly have to be made to accommodate a few holdout Republicans who remain on the fence. Time is of the essence as the U.S. midterm elections are now less than a year away and betting markets indicate that Democrats could take possession of the House,

The short-term effects are supported by the spike in confidence since the election, growth-friendly deregulation (Exhibit 26) and the prospect of tax reform. As a result, we upgrade our 2018 U.S. GDP forecast to 2.75%, with the view that inflation will remain in the vicinity of 2.0%.

At the time of writing, U.S. tax reform remains highly contentious, though a bill is moving steadily

Exhibit 26: Considerable U.S. deregulation already underway

Approaches to deregulation Speed Difficulty

Theoretical effectiveness

Legislative (change laws) Slow Hard High

Executive orders (change interpretation of laws) Medium Medium Medium

Change enforcement climate (lighten enforcement of laws) Instant Easy Medium

No longer adding new rules Instant Easy High

Financial sector

Energy / environment

Labour laws

Health care

Making progressWell underway

Source: RBC GAM


impeding further serious policy action for another two years.

We assign an 90% chance to the passage of U.S. tax reform in the near term (Exhibit 27). Why? Republicans almost universally like tax cuts and are desperate for a political win. A key sticking issue – whether the tax reform will be allowed to increase the public debt or not has already been hashed out: it will, by US$1.5 trillion.

Highlights of the proposed reform include a substantially lower corporate-tax rate, accelerated depreciation on capital investments, and several lower personal tax brackets. We estimate the U.S. economy would expand by an additional 0.6 percentage point in the event that the proposals succeed, and that after-tax corporate earnings could rise by 5% to 9%. This boost is not yet fully priced into markets, suggesting some upside yet to come.

On the other hand, we continue to point to a roughly 25% chance of a U.S. recession over the next year, motivated in large part by the late stage of the business cycle and the high degree of policy uncertainty that exists in the U.S. regarding the tax, trade and foreign-policy outlooks. There is also no denying that the U.S. has lost a fair amount of competitiveness in recent years due mainly to currency strength (Exhibit 28). The latest IMF assessment matches our recession-risk estimate.


Exhibit 27: U.S. tax reform very likely

Proposed size(over decade)

• $1.5T of additional fiscal stimulus (=net debt)

Tax cuts

• Corporate rate from 35% to 21%; territorial, repatriation

• Full, immediate depreciation on capital investment

• Fewer and lower personal tax brackets; higher deduction

Partially paid for via• Limit corporate deductions; foreign excise tax

• Reduce credit for state & local taxes paid, mortgage interest

Challenges • Razor thin Republican majority in Senate

Outcomes• 90% chance of 2018 U.S. tax cut

• Tax reform temporary – lasts only 10 years

GDP effect• Tax cuts = 0.6% GDP boost, spread over a few years

= 5% to 9% boost to corporate profits

Source: RBC GAM

Exhibit 28: Countries with strong currencies lose competitiveness

-40-30-20-10

0102030

Rus

sia

Irela

ndM

exic

oAu

stra

liaC

anad

aB

razi

lN

orw

ayIn

done

sia

Sout

h A

frica

Sw

eden

Chi

leTu

rkey

Bel

gium

Net

herla

nds

Hun

gary

Cze

ch R

ep.

Indi

aG

reec

eFr

ance

Pol

and

Spai

nP

ortu

gal

Italy

Japa

nD

enm

ark

U.K

.Fi

nlan

dA

ustri

aG

erm

any

New

Zea

land

Sw

itzer

land

Sout

h K

orea

Chi

naU

.S.

Rel

ativ

e un

it la

bour

cos

t, to

tal

econ

omy

(cum

ulat

ive

3-ye

ar %

ch

ange

, 201

6)

Developed markets Emerging markets

More competitive

Less competitive

Source: OECD, Haver Analytics, RBC GAM

The Fed raised the fed funds rate earlier this month, and we expect another two rate hikes by November 2018. This represents the continuation of a process that started in late 2015 and has gained steam over the past year (Exhibit 29). This anticipated clip represents a slightly above-consensus forecast on our part, meshing well with the

earlier observation that the time for below-consensus wagers on growth, inflation and policy rates has arguably come and gone. In this scenario, the U.S. dollar likely has a bit more room left to run due to the country’s attractive real yields, more hawkish central banks, prospect of tax reform (including the repatriation of assets into U.S. dollars) and


Exhibit 29: U.S. fed funds rateEquilibrium range

-202468

1012141618202224

1980 1985 1990 1995 2000 2005 2010 2015 2020

%

Last plot: 1.16% Current range: -0.40% - 1.77% (Mid: 0.69%)Source: Federal Reserve, RBC GAM

descent into protectionism (a classic currency-positive force).

U.K. challenges aheadThe British economy has exceeded expectations since the surprise Brexit vote in June 2016. The weak pound has been instrumental in buffering the initial negatives associated with this British decision to part from the European Union (EU) (Exhibit 30). The actual severing won’t begin until 2019 at the earliest, but the interim uncertainty, prospective loss of finance jobs and reduced business investment have all cast a chill.

It would appear that the negatives are starting to outmuscle the positives. Various macroeconomic signals in the U.K. have begun to weaken even as other countries have managed a coordinated economic acceleration (Exhibit 31). The U.K. continues to run a large current-account deficit, and the personal savings rate has fallen sharply, suggesting unsustainable spending.

We anticipate further depreciation of the pound, which should alleviate a portion of the economic damage. But that still leaves us with an underwhelming on-consensus forecast of just 1.5% GDP growth in 2018. Normally, that kind of growth wouldn’t cause the BOE to budge from its stimulative setting, but prior economic progress, paired with pound-induced inflation, have altered the equation. We forecast steamy 2.75% inflation for 2018 (Exhibit 32). In turn, the BOE has


Exhibit 30: Pound has remained weak since Brexit vote

85

90

95

100

105

110

115

120

125

130

135

2003 2005 2007 2009 2011 2013 2015 2017

Nom

inal

bro

ad e

ffect

ive

exch

ange

ra

te, p

ound

ste

rling

(200

0=10

0)

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

Exhibit 31: U.K. activity starting to rise less enthusiastically

30

35

40

45

50

55

60

65

-5-4-3-2-101234

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

U.K

. Man

ufac

turin

g PM

I

U.K

. bus

ines

s in

tent

ions

(sco

re le

vel)

PMI (RHS) Emp., manufacturing (LHS) Emp., services (LHS)Inv., manufacturing (LHS) Inv., services (LHS)

Note: U.K. business intentions in hiring and investment of manufacturing and services sectors. Scores range from -5 (rapid contraction) to +5 (rapid growth). Source: BoE, IHS Markit, Haver Analytics, RBC GAM



tightened its policy rate once recently and may deliver another increase in the coming year.

With the added complexity of a minority government after last summer’s election, Brexit negotiations are proving vexing. A tentative agreement over British financial obligations to the EU still leaves very difficult negotiations over the Irish border and then even more fundamental questions about trade access. Although we ultimately assume a fairly “soft” Brexit deal is reached (Exhibit 33), there is the considerable risk of negotiations and thus uncertainty extending beyond the original early-2019 deadline.

A snap election could well add to the swirling uncertainty, with Prime Minister May’s party support at historic lows. While this might yield an even softer Brexit, the far-left orientation of the main opposition represents a further threat to the British economy were it to gain power.

Eurozone on the ascentThe Eurozone has continued to impress, clocking in at a 2%-plus growth with a persistence that would have been hard to fathom several years ago. The majority of the region’s leading economic signals are absolutely on fire, at least by European standards (Exhibit 34). The breadth of the growth is also good. The great majority of countries have strengthened, though it is fair to concede that Catalonia’s recent pursuit of independence

Exhibit 33: Ongoing U.K. political intrigue

U.K. election chaos

Positive economic implications

Exhibit 32: U.K. inflation ratchets up since Brexit vote

-0.50.00.51.01.52.02.53.03.54.04.55.05.5

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

U.K

. CP

I (Yo

Y %

cha

nge)

Source: ONS, Haver Analytics, RBC GAM

Prior bouts of high inflation

Exhibit 34: Eurozone sentiment high; manufacturing growth strong

7580859095100105110115120

30

35

40

45

50

55

60

2001 2003 2005 2007 2009 2011 2013 2015 2017

Inde

x le

vel

Eur

o ar

ea M

anuf

actu

ring

PMI

(inde

x le

vel)

Euro area Manufacturing PMI (LHS) Euro area Economic Sentiment (RHS)Germany ifo Business Climate (RHS)

Source: European Commission, ifo Institute, Haver Analytics, RBC GAM

• Mere minority for Conservatives• Fragile alliance with DUP• Risk of snap election/PM resignation

• Minority governments tend to be more fiscally stimulative• Brexit likely to be softer, though more uncertain

No Brexit

Soft Brexit Hard

BrexitVery hard

Brexit

Source: RBC GAM


is likely to undermine Spanish growth temporarily, and that some of the Italian leading indicators are wobbling. All in all, we have upgraded the Eurozone 2018 outlook to 2.0% GDP growth. Inflation should be in the vicinity of 1.5%.

The Eurozone arguably has more room left to run than the U.S. before the currency union bumps up against capacity constraints (Exhibit 35). By virtue of the Eurozone’s double-dip recession, its recovery began much later than in the U.S. This was bad news at the time, but today represents something of an opportunity. Whereas the U.S. will struggle to continue outpacing its normal growth speed limit for much longer, the Eurozone can sustain a few more years of relatively fast growth without running into trouble. The ECB is thus in no hurry. The central bank can gradually scale back its bond-buying plan, but is unlikely to pivot toward outright tightening until 2019. We expect | a fairly quiet euro-U.S. dollar exchange rate.

We grant that the Eurozone is grappling with more than its fair share of banking-sector woes and political challenges. But both areas have improved somewhat. Eurozone banks are steadily increasing their capital buffers and they now benefit from the ECB’s oversight. Also, several of the most troubled have now been bailed out.

The European political environment is imperfect, though other places


Exhibit 36: Probability of a euro breakup is low by recent standards

0

10

20

30

40

50

60

70

80

Jun-12 Jul-13 Aug-14 Sep-15 Oct-16 Nov-17

sent

ix E

uro

Bre

akup

Inde

x, e

uro

area

(%)

Note: Index measures the percentage of investors that expect at lease one country to leave the euro area within the next 12 months. Source: sentix GmbH, Haver Analytics, RBC GAM

Exhibit 35: Eurozone still has excess capacity; U.S. output gap already close to zero

-6-5-4-3-2-101234

2007 2009 2011 2013 2015 2017

Out

put g

ap (%

of p

oten

tial G

DP

)

U.S. EurozoneSource: IMF, Haver Analytics, RBC GAM

Europe has more upside

such as the U.S. are hardly pillars of strength in this regard. The past year has mostly been a story of trouble avoided, as populist bids to gain control of several major Eurozone nations have failed. The Dutch, French and German elections all kept power in centrist hands. There have also been some tentative steps to better integrate the continent’s military forces. It is not surprising, then, that surveys show that the perceived risk of a Eurozone breakup

is the lowest it has been in years (Exhibit 36).

Looking forward, the Italian election set to occur by next spring could yield a precarious outcome, in part because of populist forces and in part because a stable coalition might prove impossible to form. It is also worth acknowledging the nationalist sentiment that has accumulated in the old footprint of the Austrian Empire. Voters in Poland, the Czech Republic, Slovakia, Hungary and


Exhibit 37: East/West divide replaces core/periphery

Poland

Czechia

HungaryAustria

Slovakia

Austria have given considerable influence to nationalist parties, though they don’t seem inclined to exit the EU (Exhibit 37).

Japanese reforms continueLike other developed nations, Japan has managed to impress of late, with the economy appearing to finally lock into regular, solid (at least by Japanese standards) economic growth (Exhibit 38).

Markets were bolstered by the larger-than-expected election victory of Prime Minister Abe in the fall. Abe’s support had been lukewarm at best when he called the snap election, but he then managed not merely to win but to sustain his supermajority in the lower house of Parliament. In turn, this political clout provides considerable leeway for the continuation of Abe’s growth-friendly economic policies, including the likely reappointment of Haruhiko Kuroda as governor of the BOJ.

We have wavered in our assessment of Abe’s economic bona fides over the years as some of his promises – a snappy return to 2% inflation, most prominently – went unfulfilled. But a more thoughtful analysis, aided by a few more years of data, argues that Abe has been a positive force for Japan. The economy has now managed its longest period of uninterrupted growth in 16 years, inflation has edged higher and wages are making cautious progress. The labour market has made huge strides and is now the tightest in a quarter-century.


Exhibit 38: Japan on longest growth streak since 2001

-20

-16

-12

-8

-4

0

4

8

12

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Rea

l GD

P

(QoQ

% c

hang

e an

nual

ized

)

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

Abenomics

Exhibit 39: Japanese women now in labour force

55

57

59

61

63

65

67

69

71

73

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017

Labo

ur fo

rce

parti

cipa

tion

rate

, fe

mal

e (%

)

Japan U.S.Source: Haver Analytics, RBC GAM

Japan's labour market structure was

gradually improving...

...Abenomics has accelerated

the pace

Nationalism rises in the East

• Divide between core and peripheral Europe shrinking

• But political gap between west and east is growing

• Right-leaning parties with nationalist tendencies now lead Hungary, Poland, Czech Republic, Slovakia and Austria

• All likely to remain in EU, but angry at open borders and wary of EU as “USSR-lite”

• Unlikely to support “more Europe”

Austrian Empire reviving?

Collective economic heft is bigger than Italy

Source: RBC GAM


Exhibit 40: Japanese corporate reforms: room for improvementFurthermore, Japan is starting to implement structural reforms, which theoretically increase the speed at which the economy can grow. Amazingly, Japan’s female labour-force participation rate recently surpassed the U.S., though there are still serious constraints on women advancing up the corporate ladder (Exhibit 39). Similarly, Japan has laid the groundwork for a more efficient and profitable corporate sector (Exhibit 40). We accordingly remain overweight Asian equities.

Going forward, we anticipate attractive Japanese growth of 1.5% in 2018, an upgrade from our prior forecast. Inflation should transition higher to 1.25% for the coming year. Until inflation seriously challenges the 2.00% target, however, it is unlikely that the BOJ will let its foot off the monetary accelerator. From a currency perspective, the yen is quite cheap. Thus, in contrast to the depreciating trend anticipated for several other currencies, we expect the yen to hold its own versus the greenback.

China sets a new courseThe Chinese economy remains a central consideration for investors, generating as it does nearly a third of global growth. Fortunately, the country has been cruising along at a remarkably steady clip over the past 18 months, exceeding expectations. We anticipate a moderate slowdown to a below-consensus 6.0% of growth in 2018 for a mix of reasons including a naturally maturing economy, U.S. protectionism,


Low Japan base = room for improvement:

Median % of independent corp. directors: 26% (vs 50-89% in other countries)

Median % of women on corp. boards: 0% (vs 22-43% in other countries)

Just 8/500 Topix firms have majority independent board with 2+ women

17% of Topix firms have annual meeting on single day; 39% in same week

Evidence of tentative improvement:

Stewardship code for investment firms passed in 2014• Asset managers have doubled their votes against company directors from 2014 to 2016• GPIF demanding good stewardship when allocating passive funds

Corporate governance code passed in 2015• Requires disclosure and justification of cross-holdings• Banks have cut “strategic” cross-holdings; other firms persist

Source: Bloomberg Professional Services, RBC GAM

Exhibit 41: China’s new policy goals

Goals Main points Implications

Growth quality over quantity

• No explicit growth target, suggesting slower growth to come

• Focus instead on quality of growth: • Less reliance on credit • Address inequality • Environment

• Ultimately, a positive pivot

• Begins to reduce Chinese debt risks

• Nevertheless, expect a bit less steady-state growth from China

Central role for state

• Sharp reversal from prior plan

• Market forces lose, gov’t control wins

• Ruling party wary of losing control

• Xi consolidates power

• Easier to implement policy agenda

• Hard to boost productivity and profits without market influence

• Autocracy bad for long-run growth

Outward focus

• China has long punched below weight in foreign policy, now finally engaging

• Rising global leadership (i.e. Davos)

• One Belt One Road plan builds influence, foreign supply & demand

• Implications mainly over long run

• Marshall Plan for Asia and Africa

• Thucydides Trap = friction with U.S.

• From hegemonic to multipolar world = slightly slower global growth

Source: RBC GAM

deteriorating competitiveness (refer back to Exhibit 28) and a shifting policy emphasis.

The latest Chinese National Congress, held every five years, clarified three main themes

regarding China’s intended path forward (Exhibit 41). One relates to the country’s aspiration for greater international clout, as discussed earlier in the geopolitical risk section.


Another is a pivot toward prioritizing the quality of economic growth over the quantity. This development is a welcome one, as China’s past obsession with maximizing GDP growth led it down an undesirable path, resulting in an excessive reliance on credit as a driver of growth and overcapacity in certain industries. The shift portends less economic growth, but it is a worthwhile trade in the name of sustainability.

The final theme is an elevated role for the state in the direction of the economy. We view this in a mostly negative light. Previously, the expectation was that China would allow market forces to nudge lumbering state-owned enterprises toward greater efficiency. The country now appears to be defending the centrality of the Communist Party in guiding the economy. It is hard to fathom this being as efficient a process as if market forces were involved.

The centralization of power is actually operating at two levels. Not only is the party seeking to regain its economic influence, but President Xi himself is consolidating power within the party. It is increasingly likely that he will opt to stay on past the normal end of his presidency in five years. A more autocratic structure might make it easier to implement policy in the short run, but tends to be a negative over the long run as policy errors gradually stack up.


Exhibit 42: China’s debt growth has accelerated since 2010

6080

100120140160180200220240260280

1990 1995 2000 2005 2010 2015

Non

finan

cial

sec

tor d

ebt-t

o-G

DP

ratio

(%)

Advanced economies EM economies ex China ChinaNote: Nonfinancial sector debt of G20 countries includes government, household and nonfinancial corporation debt. Source: IMF GFSR October 2017, RBC GAM

2016

China’s biggest risk has long been its heavy debt load (Exhibit 42). Fortunately, our concerns are lessening thanks to several welcome developments:

• The overall rate of credit growth has converged downward toward the rate of economic growth (Exhibit 43).

• Heavy industries are reducing their excess capacity and in so doing cutting their non-performing loans (Exhibit 44).

• The stock of China’s long fretted-over Wealth Management Products recently recorded their first quarterly decline in years.

• Local governments continue to be reined in, reducing their longstanding debt risks.

Emerging-market expansion intactThe emerging-market story is also a positive one, though the acceleration in growth has been less pronounced than in the developed

Exhibit 43: China’s credit and GDP growth finally converging

0

5

10

15

20

25

30

35

40

2007 2009 2011 2013 2015 2017

YoY

% c

hang

e

Total social financing Nominal GDPSource: China National Bureau of Statistics, PBoC, Haver Analytics, RBC GAM

Credit boomduring last slowdown

Gap narrowing nicely


Exhibit 45: Slightly faster growth in emerging markets

0

2

4

6

8

10

2000 2003 2006 2009 2012 2015 2018EM

-6 a

nnua

l rea

l GD

P g

row

th (%

)

Note: EM-6 includes Brazil, China, India, Mexico, Russia and South Korea.Source: Haver Analytics, RBC GAM

RBC GAM forecast

world (Exhibit 45). Nevertheless, the positive readings from emerging-market leading indicators confirm that a prior multi-year swoon has definitively ended.

Broad-based tailwinds for emerging markets include the strong expansion of global demand and “risk-on” market sentiment that tends to translate into inflows for emerging-market assets.

On the other hand, a few broad-based headwinds include our forecast for a moderately stronger U.S. dollar, the prospect of central-bank tightening and the possibility that a deleveraging China might compromise demand for emerging-markets products and services from other Asian countries.

Of course, individual emerging market nations vary significantly from one another (Exhibit 46). We continue to believe that China could underperform growth expectations for reasons discussed earlier. On the other hand, Brazil and Russia both look capable of exceeding expectations due to their substantially improved competitiveness and sensitivity to rebounding commodity prices (Exhibit 47).

A promising structural trend is that a number of emerging markets with a history of chronically high inflation have made progress toward solving this problem (Exhibit 48). Russia, Brazil and India are prominent beneficiaries and their economic


70

90

110

130

150

170

190

210

230

2007 2009 2011 2013 2015 2017

Chi

na's

out

put (

mill

ion

tons

)

Steel CementNote: Steel output includes steel, steel products and corrugated steel bars.Source: CNBS, Haver Analytics, RBC GAM

Exhibit 44: Chinese heavy industries no longer expanding rapidly

Exhibit 46: Varied EM economic drivers

Outlook for: China India Korea Brazil Mexico Russia

Structural reforms + + + 0 + + 0Competitiveness – – 0 – + ++ ++

U.S. protectionism – – 0 – 0 – – –Credit – – – 0 – 0 0

Commodities – – – + + 0 + +Geopolitics 0 0 – – – 0 0

Overall – – O – + O +Note: + means positive, – means negative, O means neutral. Source: RBC GAM

Common tailwinds: Strong global demand growth, “Risk on”Common headwinds: Rising USD, CB tightening, China to delever?

Source: RBC GAM


8.3

8.5

8.7

8.9

9.1

9.3

9.5

9.7

Apr-15 Sep-15 Feb-16 Jul-16 Jan-17 Jun-17 Nov-17

U.S

. cru

de p

rodu

ctio

n (m

illio

n bb

l/day

)

Source: EIA, Haver Analytics, RBC GAM

Exhibit 47: RBC GAM GDP forecast for emerging markets

6.75%6.00%

3.25%2.50% 2.25%

1.00%

6.00%

7.25%

2.75%

2.00%2.75% 2.75%

0

1

2

3

4

5

6

7

8

China India South Korea Mexico Russia Brazil

Ann

ual G

DP

gro

wth

(%)


Exhibit 48: EM inflation structurally falling – a big positive

0

1

2

3

4

5

6

7

8

9

Russia Brazil India Indonesia Mexico China Poland

Late

st c

ore

CP

I cha

nge

vs.

aver

age

core

CPI

cha

nge

over

pa

st fi

ve y

ears

(%)

Note: Latest core CPI YoY % change versus average core CPI YoY % change over past five years. Source: Haver Analytics, RBC GAM

Inflation falling in traditionally high

inflation countries

Inflation rising in traditionally low

inflation countries

Exhibit 49: U.S. shale producers boost production

speed limits could increase accordingly.

Canadian moderation aheadThe Canadian economy is on track to record its most impressive performance in seven years for 2017, growing by roughly 3.0%. This white-hot performance was sustained by strong global demand, rising commodity prices, generous government spending and monetary-policy support.

The oil shock of 2014-2016 concluded more quickly than prior downturns due to the remarkable nimbleness with which U.S. shale-oil producers cut their production (Exhibit 49). In turn, the Canadian economy was able to rebound sooner than in prior commodity cycles. However, while oil prices may advance a little further in the short run, rising U.S. crude production hints that the equilibrium price for oil is likely no higher than US$45 to US$50 per barrel – a downgrade from current levels and a constraint on additional Canadian economic growth.

We can already see that the Canadian economy is starting to decelerate, both in terms of GDP and our own leading indicator (Exhibit 50). The BOC has raised rates twice and fiscal spending will no longer actively add to growth in 2018. As a result, the country is likely to settle back into a more subdued rate of growth, with a below-consensus 1.5% gain in 2018. Inflation should alight around 2.0%.



Canadian competitiveness threats versus U.S.

Moral suasion • President Trump threatens companies that consider major expansions outside U.S.

Labour

• Tougher labour laws in Canada (ON, AB, BC) • Higher minimum wage • Easier unionization • FT/PT equivalency

Environment • Canada in Paris agreement, U.S. out • New carbon taxes ramp up over next five years • Gov’t wants more extensive resource consultation process

Regulations • U.S. deregulating, Canada regulating

Taxes • U.S. taxes could fall, Canadian taxes have mostly risen

Tariffs • U.S. threatening tariffs on Canada (competitiveness hit)

Source: RBC GAM

Supporting this cautious Canadian outlook, the country’s competitive landscape is arguably deteriorating vis-a-vis the U.S., and there are, of course, ever-present housing risks.

Canadian competitive headwinds appear to be forming (Exhibit 51). From the perspective of businesses choosing where to expand their operations, Canada now suffers several disadvantages versus the U.S. including moral suasion from the White House, a sharp increase in Canadian minimum wages, tightening environmental rules, rising regulations and a general increase in tax rates for highly mobile workers. The U.S., by contrast, is loosening environmental rules and regulations, and cutting taxes. Canada will be at a further disadvantage if the U.S. continues to step up its imposition of tariffs on Canadian goods.

Canada’s housing market also eventually needs to give back some of its gains. The growth of household borrowing that has taken place in recent years is well beyond that experienced in any other country save China (Exhibit 52), and housing has expanded to occupy an unusually large share of GDP (Exhibit 53). It is unlikely in our view that housing’s share of the economy can continue to grow, suggesting less support for the economy going forward.

Housing booms are usually extinguished by one of two things: higher borrowing costs or higher unemployment rates (Exhibit 54).


Exhibit 50: Canadian growth to dip

-5

-4

-3

-2

-1

0

1

2

2001 2003 2005 2007 2009 2011 2013 2015 2017

Can

adia

n E

cono

mic

Com

posi

te(s

tand

ard

devi

atio

ns fr

om

hist

oric

al n

orm

)

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

Exhibit 51: Canadian medium-term competitiveness challenges

Canada is getting a taste of the first, but not yet enough to seriously impede residential real estate. Unemployment, however, remains low and probably will remain so until the next North American recession comes around. Whenever the next North American recession occurs, it

stands to reason that it could thus be worse for Canada than the U.S.

In the present context, two further factors could impede the Canadian housing market. The first is that governments are now focused on cooling Canada’s housing market via a series of targeted rule changes,


with more likely if housing does not obey. Lastly, parabolic rises in any asset cannot go on forever, implying a tamer future for Toronto and Vancouver home prices in particular.

None of this is to say that Canada has serious trouble immediately ahead of it, especially given minor victories such as a new free-trade deal with Europe, an interprovincial trade deal and rising immigration. But the overall backdrop is distinctly less friendly than it has been. In this environment, we anticipate no more than two BOC rate hikes over the next year. The Canadian dollar should decline to partially offset the brewing competitive challenges.

Flattening yield curve could elicit volatilityThe solid and improving economic backdrop, combined with low interest rates, has created a comfortable environment for investors. Credit spreads are historically narrow, liquidity is high and volatility has been unusually low. History, unfortunately, suggests that these favourable conditions are unlikely to persist.

One sign bumpier times may lie ahead is the fact that the yield curve has reached its flattest point since before the financial crisis. The slope of the curve, measured as the spread between the yields on U.S. 2-year and 10-year government bonds, has been declining gradually since 2008. Such flattening is the normal experience during economic expansions, but we would become concerned if the yield curve actually


Exhibit 52: Household debt soared with rapid home-price gains

-20

-10

0

10

20

30

40

Chi

na

Can

ada

Sout

h Ko

rea

Aust

ralia

Braz

il

Turk

ey

Rus

sia

Indo

nesi

a

Mex

ico

Indi

a

Sout

h Af

rica

Ger

man

y

Fran

ce

Italy

Japa

n

U.K

.

U.S

.

Cha

nge

in h

ouse

hold

deb

t-to-

GD

P ra

tio fr

om 2

006

to 2

016

(ppt

)

Countries with home price growth > 25% Countries with home price growth < 25%Note: Nominal home price growth from 2006 to 2016. Source: IMF GFSR October 2017, RBC GAM

Exhibit 53: Canadian housing share of GDP is high, signalling risk

161718192021222324

1990 1993 1996 1999 2002 2005 2008 2011 2014

Hou

sing

sha

re o

f C

anad

ian

GD

P (%

)

Nominal Nominal, historical average Real Real, historical averageNote: Housing share of GDP calculated as residential construction, renovations, transfer costs, housing rent (both actual and imputed for home owners), maintenance and repair of dwellings, utilities, a housing wealth effect, plus half of furniture, textiles and appliances & equipment for house and garden. Historical average from 1990 to 2006. Source: Haver Analytics, RBC GAM

2017

BC's housing share of GDP is nearly 30%

Higher interest

rates

Economic recession

Tighter regulations

Parabolic home price

increase• Hurts

affordability

• Higher mortgage default rate

• Canada’s next recession to be extra deep?

• Increases unemployment

• Higher mortgage default rate

• Constrains access to or desirability of home buying

• Actions spanning national and regional gov’ts

• Prices out buyers

• What goes up must come down

• A bit less acute than in 2016-H1 2017

MEDIUM MEDIUM HIGH HIGH

Threat

Why

Near -term risk

Exhibit 54: Threats to Canada’s housing boom

Source: RBC GAM


Exhibit 55: U.S. Treasury yield curveSpread between yield on 2-year and 10-year maturities

-3

-2

-1

0

1

2

3

4

1980 1985 1990 1995 2000 2005 2010 2015 2020

%

Recession Average Max RangeSource: Bloomberg, RBC GAM

Maximumhistorical spread: 2.81%

Average spread: 0.97%

Last plot: 0.63%

Exhibit 56: U.S. yield curve vs. VIX volatility

0

10

20

30

40

50

60

70-2%

-1%

0%

1%

2%

3%1990 1994 1998 2002 2006 2010 2014 2018 2022

Inde

x le

vel

Recession periods U.S. 10yr-2yr spread (LHS, Inv, Adv 30 months) VIX (RHS)Source: Bloomberg, RBC GAM

VIX last plot: 11.3

inverts (i.e. slope falls below zero) because recessions often follow soon thereafter (Exhibit 55). Even though the curve is still 63 basis points away from inversion, the flattening we have seen thus far could introduce volatility into capital markets. Exhibit 56 plots the CBOE S&P 500 Volatility Index (VIX) alongside the reverse of the yield curve, advanced 30 months. The fact that the yield curve has flattened by over 100 basis points since 2015 suggests that a pick-up in volatility may lie ahead.

Expecting gradual rise in bond yieldsGlobal bond yields could rise gradually over many years supported by the strengthening economy and the fact that central banks continue moving away from the extremely stimulative monetary policies that have been in place since the financial crisis. Yields have already begun moving higher, but have been mostly range-bound in 2017 following a sell-off in the second half of 2016. Our models continue to suggest that valuation risk exists in the fixed-income market, with yields below our estimate of equilibrium in all major regions (Page 44).

Although the U.S. 10-year yield is only slightly below our estimate of equilibrium, the modelled level rises over time and represents a potential headwind to fixed-income returns for many years to come. Exhibit 57 breaks down our U.S. 10-year Treasury model into

its two components: an inflation premium and a real (after-inflation) rate of interest. Together, these elements project a rise in yields of approximately 70 basis points over the year ahead. The inflation premium poses little threat at its current level of 1.9% – our model indicates that is the appropriate setting for the year ahead given our forecast for reported inflation through the next two years. The bigger threat to bond prices comes from the real interest rate, which

according to the model could rise 60 basis points over the year ahead. A number of structural factors have been depressing real interest rates including unorthodox monetary policy, heightened demand for safe-haven assets and an aging population. But in an environment where economic growth is gaining momentum and secular stagnation may be starting to lessen its grip, we would expect real interest rates to ultimately move back towards their long-term average as investors


(savers) will at some point demand a true after-inflation payment to defer consumption. Our models assume this reversion occurs over the next five years, but the actual time frame is not as important as the direction. Our forecast is for the U.S. 10-year yield to be at 2.75% a year from now.

Equities: a year in reviewGlobal stock markets have delivered sizeable returns through the past year, supported by the increasingly broad-based economic expansion and better-than-expected corporate profit growth around the world. As of November 30, 2017, the MSCI Emerging Markets Index was up 30% and the S&P 500 Index had risen 18% so far this year. Japanese stocks, measured by the Nikkei Index, were up 19% in local-currency terms, benefiting from President Abe’s re-election. The victory solidified his power and allowed him to extend his agenda of fiscal stimulus and pro-growth structural reforms. European and Canadian markets had more modest gains because their stock indexes have minimal exposure to the strong returns delivered by the Information Technology sector.

Although stocks remain below our estimate of fair value in most regions (page 45), the recent rally has narrowed that gap on an aggregate measure and reduced further upside potential (Exhibit 58). The S&P 500, in particular, hovers just below the midpoint of its fair-value band (Exhibit 59), and it is worth taking a closer look at what this valuation


-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1960 1970 1980 1990 2000 2010 2020

%

Real T-Bond Yield Real 10-Year Time Weighted YieldSource: RBC GAM, RBC CM

+1 SD

-1 SD Average: 2.1%

Last Plot: 0.5%

12-Month Forecast: 1.14%-4

-2

0

2

4

6

8

10

12

14

16

1960 1970 1980 1990 2000 2010 2020

%

36-month Centred CPI Inflation Actual Monthly CPI InflationSource: RBC GAM, RBC CM

Last Plot: 1.9%12-Month Forecast: 2.0%

36-month Centred

Exhibit 57: U.S. 10-year bond yield Fair-value estimate composition

0

2

4

6

8

10

12

14

16

1980 1985 1990 1995 2000 2005 2010 2015 2020

%

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

Nov. '18 Range: 2.26% - 4.04% (Mid: 3.15%)

United StatesCPI Inflation

United StatesReal 10-year T-bond yield

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

+

Exhibit 58: Global stock-market compositeEquity-market indexes relative to equilibrium

-60

-40

-20

0

20

40

60

80

100

1980 1985 1990 1995 2000 2005 2010 2015 2020

% a

bove

/bel

ow fa

ir va

lue

Source: RBC GAM

Last Plot: -12.9%


implies given the importance of U.S. equities on the world stage.

The U.S. market, proxied by the S&P 500 Index, has spent most of the current bull market in a high-return valuation zone and, according to our model, is on the cusp of transitioning into a less favourable environment. Exhibit 60 illustrates this clearly by plotting a standardized version of our equilibrium model for the S&P 500 in which we’ve ‘stretched’ the fair-value bands horizontally. The dotted line running through the centre of the chart is fair value – our modelled estimate of the appropriate level for stocks given today’s interest rates, inflation and corporate profitability – and the solid lines represent one standard deviation above and below fair value. We’ve segmented the chart into four zones, or buckets. The current bull market began with stocks situated in Bucket 1 (more than one standard deviation below fair value) but quickly graduated to Bucket 2 (between fair value and one standard deviation below), where it has spent the majority of the bull market except for a brief period in Bucket 3 (between fair value and one standard deviation above) in 2013. We ran return statistics based on which bucket the S&P 500 was situated in and noticed that stocks have historically done very well in Bucket 2 (Exhibit 61). In this zone, stocks have delivered average one-year returns of 12.1% and risen in 83.9% of periods – with the lowest volatility of returns in any of the four zones. Notice, though, what


Exhibit 60: Standardized S&P 500 fair-value bands

1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 2020Source: Haver Analytics, RBC GAM

S&P 500 most overvalued

S&P 500 most undervalued

+1 SD

-1 SD

FV

4

3

2

1

Exhibit 61: S&P 500 IndexReturn prospects by valuation zone

Valuation

Data set

(Bucket)

1-year average return

Batting average^

1-year average return in

win*Max loss

1-year return

Std. dev.

4 (0.7%) 48.6% 14.8% (27.5%) 17.0%

3 3.5% 62.3% 13.0% (41.4%) 15.6%

2 12.1% 83.9% 16.0% (44.8%) 13.5%

1 14.7% 80.2% 19.9% (12.8%) 16.3%

*Win = Periods where returns are above 0%. ^Batting average = Incidence of winning in any given period. Source: RBC GAM

(S&P 500 most overvalued) 1 SD Above

Equilibrium

1 SD Below(S&P 500 most undervalued)

Exhibit 59: S&P 500 equilibriumNormalized earnings & valuations

40

80

160

320

640

1280

2560

5120

1960 1970 1980 1990 2000 2010 2020

Source: RBC GAM

Nov. '17 Range: 2015 - 3363 (Mid: 2689)Nov. '18 Range: 2148 - 3585 (Mid: 2867)Current (30-November-17): 2648


earnings estimates as corporate profits continually exceeded analysts’ expectations, and that’s been especially true through the past eight months (Exhibit 65). Normally, analysts start the year too optimistic and are forced to lower their earnings estimates as the year progresses (Exhibit 66). But estimates have moved up repeatedly this year, a pattern that is also reflected in the higher-than-usual number of companies that have

earnings growth, with the balance delivered by expanding price-to-earnings ratios. Exhibit 64 plots the contribution to returns from valuations and earnings over time. Notice that expanding valuations were a significant and constant source of fuel for stocks between 2011 and 2016, but that earnings have been the key driver in 2017.

One of the major investment themes of 2017 has been the constant upward revisions to

Exhibit 62: S&P 500 IndexNormalized valuation metrics, as at November 2017

0.72

1.70 1.55 1.31 1.27 1.09

-0.06-0.41

-0.68

-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.5

Average Marketcap ÷ U.S.

GDP

Tobin's Q Shiller P/E(CAPE)

12-Mtrailing

P/E

12-Mforward

P/E

RBC GAMfair value

Equity risk

premium

Z-sc

ore

Market is expensive

Market is cheap

Notes: Historical data from Jan 1956 for 12-M Trailing P/E, 12-M Forward P/E, Equity risk premium, Shiller P/E and Fed model. Historical data from Mar 1956 for market cap ÷ U.S. GDP. Historical data from Jan 1960 for RBC GAM fair value. Source: Haver Analytics, RBC CM, RBC GAM

Market is slightly expensive

Market is slightly cheap

Fed model

Exhibit 63: S&P 500 IndexSimple average of valuation metrics

-2.0-1.5-1.0-0.50.00.51.01.52.02.53.0

1956 1963 1970 1977 1984 1991 1998 2005 2012 2019

Z-sc

ore

Market is expensive

Market is cheap

Notes: Historical data from Jan 1956 for 12-M Trailing P/E, 12-M Forward P/E, Equity risk premium, Shiller P/E, Tobin's Q and Fed model. Historical data from Mar 1956 for market cap ÷ U.S. GDP. Historical data from Jan 1960 for RBC GAM fair value. The r-square figures used for the weighted composite are based on the relationship of each valuation indicator with S&P 500 10-year returns. Source: Haver Analytics, RBC CM, RBC GAM

Market is slightly cheap

Market is slightly expensive

happens to these statistics when stocks transition into Bucket 3. Returns drop to an average of 3.5% over one-year periods, the batting average falls to 62.3% and volatility rises. While stocks haven’t crossed into this less attractive zone, they are awfully close and it might therefore be prudent to lower total-return expectations and consider the potential for higher volatility in the months ahead.

A number of other popular valuation measures suggest that stocks have been expensive for some time. Exhibit 62 plots eight valuation metrics in terms of standard deviations from their historical averages. Five of the measures suggest stocks are expensive. While we have long argued that the environment of historically low interest rates and inflation justify higher price-to-earnings multiples, our own multifactor model no longer suggests stocks are particularly cheap. Exhibit 63 plots a simple average composite of the eight indicators over time and shows that valuations have clearly pushed closer to expensive territory as a result of the rally in equities and rise in interest rates since 2016.

Earnings power throughValuations are only one part of the equation affecting stock returns. A significant portion of the market’s gains this year has been delivered through rising earnings. More than two-thirds of the S&P 500’s 18.3% price return from the start of the year to November 30, 2017, came from



Exhibit 65: S&P 500 IndexConsensus earnings estimates

110

120

130

140

150

160

170

2011 2012 2013 2014 2015 2016 2017 2018

Con

sens

us e

arni

ngs

estim

ates

($

US

)

2014 2015 2016 2017 2018 2019Source: Thomson Reuters, Bloomberg

Exhibit 66: U.S. analyst overoptimism in S&P 500 EPS estimatesMonthly pattern, averages for 1985-2016

$115

$120

$125

$130

$135

Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecAverage Forecast Error Rebased to Feb. 2017 Forecast2017 bottom-up consensus earnings estimate

Source: Chopra, ThomsonReuters, RBC GAM

been exceeding analysts’ estimates (Exhibit 67). Such widespread earnings beats are unusual in the later stages of a cycle, suggesting analysts have been too pessimistic about corporations’ abilities to increase profits. S&P 500 earnings climbed at a double-digit rate in the first two quarters of 2017 and at a high single-digit rate in the third quarter, and current analyst expectations suggest this trend could continue or even accelerate in the quarters ahead.

Potentially adding to the positive earnings momentum is the chance of large-scale U.S. corporate-tax cuts. The House of Representatives and the Senate have both passed tax bills, and Congressional leaders have vowed to have the bills to President Trump for his signature before the end of the year. Markets have already responded positively, although some legislative details still need to be sorted out. Optimism about impending tax cuts can be observed in a comparison of the performance of stocks that stand to benefit most if the tax bill is enacted (i.e. companies with high effective tax rates) versus those that won’t (i.e. companies with already-low tax rates). Wolfe Research has identified 112 stocks that would fall in either of the two camps (56 in each), and the relative performance of these unweighted baskets is plotted in Exhibit 68. The rising line in the chart since September reflects the increasing likelihood of tax cuts coming to fruition as high-tax companies outperformed. Wolfe


-60%

-40%

-20%

0%

20%

40%

60%

'87

'89

'91

'93

'95

'97

'99

'01

'03

'05

'07

'09

'11

'13

'15

'17

(YTD

)

Multiple Expansion Earnings Growth S&P500 Price ReturnSource: RBC GAM, RBC CM

Exhibit 64: S&P 500 return decompositionReturn contribution of earnings growth and multiple expansion



0%10%20%30%40%50%60%70%80%90%

100%

2003 2005 2007 2009 2011 2013 2015 2017 2019

Abo

ve c

onse

nsus

repo

rts

% Greater Than Expectations Long-Term Average: 62%Source: Thomson Reuters

Last Plot: 73%

Exhibit 67: Companies reporting results above consensus forecastsResearch’s analysis also suggests that every 5-percentage-point cut to the corporate tax rate would boost S&P 500 earnings by 3% (Exhibit 69). Thus a 15-percentage-point reduction to 20% from the current 35% corporate tax rate could result in a 9% boost to aggregate S&P 500 earnings, or roughly US$10 per share. While the tax cuts would clearly be a significant tailwind to the stock market, the fact that the high-tax stock basket has outperformed so strongly indicates that at least a portion of the anticipated change has already been priced in.

Gauging the potential for stocksTo get a sense for where stocks could trade in the year ahead if tax cuts are passed, we ran scenarios combining earnings estimates at different price-to-earnings levels. Exhibit 70 outlines these scenarios for 2018 with and without the impact of tax cuts. With the US$10 boost to S&P 500 earnings expected from tax cuts, the S&P 500 could reach 2948 by the end of next year and deliver a total return of roughly 13% from November 30, 2017. This scenario assumes the market trades at our modelled equilibrium P/E of 18.9 and the S&P 500 generates earnings of US$156 per share (analysts’ top-down consensus estimate of US$146 plus US$10 from tax cuts). In the event that the tax bill fails, the S&P 500 would rise to only 2759, generating a lesser but still positive total return of about 6%. While a

Exhibit 68: U.S. corporate tax reform long/short basketRelative performance

-202468

1012

Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18

Rel

ativ

e pe

rform

ance

(%

)

Notes: U.S. corporate tax reform long/short basket is a long-short portfolio based on Wolfe Research's outlook for corporate tax reform. The chart represents the equal-weighted net performance of being long 56 stocks poised to benefit most and 56 stocks likely to face the largest headwinds in Wolfe Research's base case scenario for corporate tax reform. In the S&P 500, they identified the top/bottom ~10% of each industry group that would be most impacted under their base case of a 25% corporate rate and transfer pricing/income shifting being materially curtailed. They did not include real Estate or a border adjustment tax. Source: Wolfe Research, Bloomberg, RBC GAM

Exhibit 69: S&P 500 EPS impact at varying U.S. corporate tax rates

9%

6%

4%3%

20% 25% 28% 30%

Estim

ated

cha

nge

to S

&P 5

00 E

PS

U.S. corporate tax rateSource: Wolfe Research



Exhibit 71: Value to growth relative performanceS&P 500 Value Index / S&P 500 Growth Index

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

2014 2015 2016 2017 2018

Cum

ulat

ive

rela

tive

perfo

rman

ce

Source: Bloomberg, RBC GAM

Nov 9, 2016: Trump wins U.S. election

Pre-election trough: Jan 25, 2016 Trough:

Nov 27, 2017

wide range of outcomes is possible, these scenarios illustrate that even from a starting point of relatively full valuations, returns can still be decent as long as earnings come through.

Styles: value stabilizes versus growthValue stocks have stabilized relative to growth stocks and may suggest increasing investor confidence in the ability of Congress to implement pro-growth policies. Coincident with the Senate making progress on its version of a tax bill, value stocks rose 1.7% relative to growth stocks in the last few days of November (Exhibit 71). While this move represents only a fraction of the 12% relative loss for value versus growth stocks since the start of the year, the recent stabilization in value as a theme could signal renewed confidence that the economy is about to accelerate. Value stocks generally outperform growth equities when the economy is picking up momentum because investors generally prefer cheaper stocks in an environment where earnings gains are more broad-based.

Asset mix: maintaining overweight stocks/underweight bondsNearly a decade after the financial crisis, the economy is gaining momentum through a synchronized global expansion and the forces of secular stagnation may be beginning to fade. Inflation is firming, but not yet problematic, and monetary policy is appropriately moving away

from crisis levels. Aside from rising interest rates, other risks to our outlook include the ever-present risk of protectionism, European politics and international relations, particularly with respect to North Korea. We are cognizant that the business cycle is aging, but in our view the balance of risks and opportunities tilts in favour of growth in the economy, and we are not yet seeing signs of any imminent downturn.

In this improving growth environment, it is difficult to get excited about prospective returns in sovereign fixed-income assets. Yields remain extremely low throughout the world and a starting point of low yields often leads to low total returns over the medium to longer term. In the past, the yield to maturity on a 10-year T-bond has provided a reliable forecast for forward 10-year total returns on that bond (Exhibit 72). If this relationship holds, investors could

Consensus Consensus + $10.00 from corporate tax cuts

2018 Top down

2018 Bottom up

2018 Top down

2018 Bottom up

P/E $146 $147 $156 $157

+1 Standard Deviation 23.2 $3389 $3412 $3621 $3645

+0.5 Standard Deviation 21.1 $3074 $3095 $3285 $3306

Equilibrium 18.9 $2759 $2778 $2948 $2967

-0.5 Standard Deviation 16.7 $2444 $2462 $2612 $2629

-1 Standard Deviation 14.6 $2130 $2145 $2276 $2290

Source: RBC GAM

Exhibit 70: Earnings estimates and alternative scenarios for valuations and outcomes for the S&P 500 Index



Exhibit 72: U.S. 10-year Treasury note and returns

02468

1012141618

1910 1930 1950 1970 1990 2010 2030

%

10y UST Yields, Advanced 10Yrs Subsequent Realized 10yr Compound Annual Nominal Returns

Source: Deutsche Bank, Haver Analytics, RBC Capital Markets

Correlation: 0.96

5

10

15

20

25

30

35

40

45

50

2009 2011 2013 2015 2017 2019

Bas

is p

oint

s (b

ps)

Source: RBC CM, RBC GAM

Last plot: 13 bps

Exhibit 73: U.S. 10-year TreasuryRequired move in yields for break-even return against 30-day T-Bill

expect to earn 2.4% annualized over the next decade. As central banks continue to tighten and/or dial back the stimulative monetary policies that have been in place for most of the post-financial-crisis era, yields are likely to drift upward, acting as a headwind to fixed-income returns. At the current low level of yields, a 13-basis-point increase in the U.S. 10-year yield wipes out any incremental returns to cash over the next 12 months (Exhibit 73). While we expect only a gradual rise in yields over the next year, our sovereign-bond return forecasts are near zero or even slightly negative in all major regions one year from now.

Compared to fixed income, stocks continue to offer superior total-return prospects. We recognize, however, that the deep discounts available at earlier stages of the bull market have since been erased. Valuations are now more demanding and further gains for equities will depend on earnings growth. The outlook for corporate profits is indeed positive, but should earnings fail to meet analysts’ expectations and/or the U.S. tax bill fails to go through, equities would be vulnerable given current valuations.

We are watching ever more diligently for signs of a top in stock markets, but at this point we are not seeing an abundance of signals that would indicate the end of the cycle. Over the past several quarters, we had

been reducing risk exposure in our asset mix but have opted to pause this quarter given the absence of technical deterioration, the ongoing strength in profits and the increased possibility of meaningful U.S. corporate-tax cuts coming to fruition. As a result, we have maintained a moderate overweight in stocks and underweight in fixed income in our

asset mix relative to our strategic neutral levels. For a balanced, global investor, we currently recommend an asset mix of 58% equities (strategic neutral position: 55%) and 39% fixed income (strategic neutral position: 43%), with the balance in cash.

“Our models continue to

suggest that valuation risk exists

in the fixed-income market,

with yields below our estimate

of equilibrium in all major

regions.”



Eurozone 10-Year Bond YieldEquilibrium range

0

2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010 2015 2020

%

Last Plot: 0.85% Current Range: 1.46% - 2.60% (Mid: 2.03%)

Source: RBC GAM, RBC CM

U.S. 10-Year T-Bond YieldEquilibrium range

0

2

4

6

8

10

12

14

16

1980 1985 1990 1995 2000 2005 2010 2015 2020

%



Canada 10-Year Bond YieldEquilibrium range

0

2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010 2015 2020

%



Japan 10-Year Bond YieldEquilibrium range

-2

0

2

4

6

8

10

12

14

1980 1985 1990 1995 2000 2005 2010 2015 2020

%



U.K. 10-Year Gilt Equilibrium range

0

2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010 2015 2020

%





GLOBAL EQUITY MARKETS


S&P/TSX Composite EquilibriumNormalized earnings and valuations

400

800

1600

3200

6400

12800

25600

1960 1970 1980 1990 2000 2010 2020

Source: RBC GAM

Nov. '17 Range: 13799 - 20905 (Mid: 17352)

Nov. '18 Range: 14010 - 21225 (Mid: 17617)Current (30-November-17): 16067

S&P 500 EquilibriumNormalized earnings and valuations

40

80

160

320

640

1280

2560

5120

1960 1970 1980 1990 2000 2010 2020

Source: RBC GAM

Nov. '17 Range: 2015 - 3363 (Mid: 2689)

Nov. '18 Range: 2148 - 3585 (Mid: 2867)

Current (30-November-17): 2648

Eurozone Datastream Index Normalized earnings and valuations

50

100

200

400

800

1600

3200

1980 1985 1990 1995 2000 2005 2010 2015 2020

Source: Datastream, Consensus Economics, RBC GAM


Japan Datastream IndexNormalized earnings and valuations

65

130

260

520

1040

1980 1985 1990 1995 2000 2005 2010 2015 2020



Emerging Market Datastream IndexNormalized earnings and valuations

20

40

80

160

320

640

1995 2000 2005 2010 2015 2020

Source: Datastream, RBC GAM


U.K. Datastream IndexNormalized earnings and valuations

210

420

840

1680

3360

6720

13440

26880

1980 1985 1990 1995 2000 2005 2010 2015 2020




The bond-market outlook


A global economic upswing is eliminating what slack remains in developed and emerging economies, while major central banks have either begun or are expected to begin tightening monetary policy for the first time in several years. In addition to rate hikes, central banks are slowing asset purchases in another likely harbinger of higher yields. By the second half of 2018 – and for the first time in a decade – net purchases by global central banks will not be adding liquidity to the global financial system.

The reaction of central banks to accelerating global economic growth is the most important factor currently affecting fixed-income markets, and investors are sanguine in their belief that central banks can tighten monetary policy without much jeopardizing economic growth. Both the bond market and central banks foresee a gradual path toward policy normalization, and investors’ faith in the ability of central banks to deliver at least a few more years of economic growth and relatively low inflation has never been greater.

The U.S. Federal Reserve (Fed) was the first central bank to begin gradually withdrawing stimulus – so

Soo Boo Cheah, MBA, CFASenior Portfolio Manager RBC Global Asset Management (UK) Limited

Taylor Self, MBAAnalyst RBC Global Asset Management (UK) Limited

Exhibit 1: Underlying inflation pressures are higher

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2012 2013 2014 2015 2016 2017

Perc

enta

ge c

hang

e ye

ar-o

n-ye

ar

Underlying inflation gauge Core PCE inflationSource: Federal Reserve Bank of New York, Bureau of Economic Analysis, Bloomberg

far by raising interest rates over the past two years. The Fed’s ability to raise rates amid a backdrop of steady economic growth has encouraged the U.S. central bank to also begin reducing the size of its balance sheet. The Fed started this process in October, with little market impact, and its actions in this area speak to its success so far in guiding market expectations.

In the Eurozone, Mario Draghi, president of the European Central Bank (ECB), has also won the hearts of investors, as expectations for ECB rate actions almost exactly match those laid out by the ECB. The ECB’s plans and the evolution of economic data look strikingly similar to the Fed and the U.S. economy in the first quarter of 2014, at which point the first hike for the Fed was about 18 months away. For the time being, bond yields across Europe still depend significantly on the ECB’s bond-purchase program, which Draghi has said will last until September 2018.

Investors expect Bank of Japan (BOJ) Governor Haruhiko Kuroda to continue his efforts to fix the yield on the 10-year Japanese government bond (JGB) at 0%, as inflation has not reached the central bank’s target of 2%. We note that it is getting easier for the BOJ to achieve this goal because, as the central bank’s share of the JGB market approaches 50%, smaller amounts of bond purchases are required to maintain bond-yield levels under the BOJ’s “yield-curve control” program. We foresee a slight risk that the BOJ could adjust its policy framework, especially surrounding yield-curve control.

One global condition that has enabled central banks to keep rates low is persistently benign inflation, and it is therefore faster inflation that would most likely undermine the current mood in the market. Another possible culprit is a withdrawal of central-bank liquidity that is faster than the economy can tolerate.


belief that central-bank support in the form of asset purchases and a gradual tightening of financial conditions would buoy asset prices.

The recent flattening of the yield curve has attracted a lot of attention (Exhibit 3). Investors are worried about a possible inversion of the curve down the road, which would mean that short-term yields rise above long-term yields. This rare occurrence has historically been a harbinger of recession. The spread

Global Fixed Income Markets | Soo Boo Cheah, MBA, CFA | Taylor Self, MBA

The challenge, therefore, will be for central banks to contain deflationary pressures while withdrawing stimulus, and hope meanwhile that a tight U.S. labour market leads to higher wages. A new inflation measure released by the Fed’s New York branch suggests that underlying inflation pressures are higher than more widely followed indicators suggest (Exhibit 1). Moreover, with unemployment so low, history suggests that faster wage growth should follow.

With central banks hiking and removing liquidity over the next year, we expect investors to be more discriminating in assessing risks than they were over the past year, when asset prices benefited significantly from quantitative easing that exceeded the supply of government bonds (Exhibit 2). Now that central banks are less involved, private investors will have more influence on prices than they have had since central banks became such important buyers, and the yield curve should be more responsive to market preferences.

The slowdown in central-bank asset purchases and a possible comeback of inflation will not only affect yields on higher-quality bonds. A sell-off in the government-bond market will almost certainly reverberate in markets for more risky assets such as equities and higher-yielding fixed-income investments. Investors have spent recent years chasing all forms of risky investments to boost portfolio returns, confident in their

Exhibit 2: Central-bank quantitative easing and global government-bond supply

-2,500

-1,500

-500

500

1,500

2,500

2011 2012 2013 2014 2015 2016 2017 2018

Rol

ling

12 m

onth

s su

m (U

S$

Bil)

Global QE demand Bond supply Net

Projection

Source: BoE, BoC, ECB, Fed, BOJ, U.S. Treasury, Ministry of Finance (Japan), SNB

-100

-50

0

50

100

150

200

250

300

1987 1991 1995 1999 2003 2007 2011 2015

U.S

. Tre

asur

y C

urve

2-1

0s

Fed tightening

Forecast

Source: RBCGAM, Bloomberg, November 2017

Exhibit 3: The yield curve flattens while the Fed tightens policy

between 2-year and 10-year bonds has narrowed to 60 basis points and our forecast is for further flattening to 35 basis points in the next 12 months (Exhibit 4). The concern for investors is that the U.S. 10-year bond yield is now lower than it was in December 2015, around the time that the Fed was beginning to raise rates. Since then, the Fed has raised rates four times, pushing up short-term yields. So, why haven’t long-term rates risen as well?


There are several forces at work. The first is market expectations that inflation will stay low even with the near-record-low unemployment rate. The Phillips-curve assumption that inflation rises as the unemployment rate falls appears to have broken down, and the thinking these days is that today’s economy is subject to structural influences such as technology and demographics that will limit inflation for the foreseeable future.

The other factor affecting the yield curve is the Fed itself, whose long-term forecast for the policy rate has dropped to 2.75% recently from 3.50% in December 2015. We believe that these Fed projections are a powerful influence on long-term bond yields. It is worth noting, however, that this long-run policy rate is less a trading signal, and more of a long-term valuation guidepost. In conclusion, we think that bond yields will go higher, but most likely not too much higher. We will elaborate in the Direction of Rates article that follows.

-50

0

50

100

150

200

250

0 1 2 3 4 5 6

US

Tre

asur

y C

urve

2-1

0s (b

ps)

Fed Funds Rate %

Forecast for Current Cycle

2004 Tightening Cycle12 months ForecastYield Curve = 35bpsFed Funds = 1.875%

Source: RBCGAM, Bloomberg, November 2017

Exhibit 4: Yield curve is expected to flatten to 35 basis points

Soo Boo Cheah, MBA, CFASenior Portfolio Manager RBC Global Asset Management (UK) Limited

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

Direction of rates


We expect bond yields to rise over the next 12 months, with short-term yields rising faster than those on longer-term bonds. The global economy continues to expand at a healthy pace, the odds of recession are remote and the direction of monetary policy is gradually changing. Concerted policy tightening by major central banks is expected to gather pace over the next year and is likely to push bond yields higher. Moreover, a decrease in asset purchases by central banks should start to exert upward pressure on yields.

U.S. – The U.S. Federal Reserve (Fed) raised the fed funds rate earlier this month, and we expect another two rate hikes by November 2018. Meanwhile, the Fed should proceed with plans to scale back reinvestments in its portfolio of Treasuries and mortgage-backed securities. We believe the risk of significantly higher longer-maturity bond yields should be contained as long as inflation stays within the Fed’s desired range and its long-range policy-rate forecast stays between 2.75% and 3.00%. However, there is a short-term risk of higher volatility across asset prices


induced by higher bond yields. Investors may have to abandon risky strategies pursued to boost portfolio returns in recent years now that the cost of financing has risen and global liquidity is less plentiful. While yields have been rising as a result of Fed tightening, they could reverse to the benefit of Treasury prices when investors seek safety during periods of heightened volatility.

Our core scenario envisages the Fed continuing to tighten policy via rate hikes and a shrinking balance sheet. Assuming that economic growth remains stable and inflation rises gradually, Treasury yields should rise. We expect the 10-year yield to rise to 2.75% over the next 12 months, and factoring our expectations of higher asset-price volatility, we see the range for the next 12 months to be between 1.90% and 3.25%. The fed funds rate will rise to 1.88% from about 1.13% currently, in our view.

Germany – The European Central Bank (ECB) bond-purchase program has been keeping pressure on government-bond yields across Europe at levels that are too low given the positive outlook for economic growth and inflation. As long as financial conditions remain supportive and inflation rises gradually, we believe the ECB will remain on the path to policy normalization. We think, therefore, that investors will be forced to price in higher ECB policy rates in the first

half of 2018, pushing the German bund yield higher and away from today’s extremely rich level. As the ECB buys fewer bunds, the cost of borrowing bunds should decline and demand ebb for the limited supply of bunds, allowing breathing room for yields to rise.

Using a fair-value model based on historical trends of economic growth and short-term bond yields, the 10-year bund yield could be trading close to 0.90% in 12 months absent ECB intervention (Exhibit 1), 0.15% higher than our previous forecast. Our projection for the policy rate remains at negative 0.40%.

Japan – The Japanese central bank is likely to keep holding down the yield on the 10-year Japanese government bond (JGB) so long as inflation remains below 2%. However, we see a possibility, when yields on U.S. Treasuries and German bunds start to rise, that the Bank of Japan (BOJ) shifts its policy focus to target yields on shorter-maturity JGBs instead of 10-year bonds. We believe that Japanese economic growth is strong enough and the labour market tight enough to justify higher government-bond yields. The BOJ may allow short-term rates to climb over the next 12 months, implying a higher ceiling for 10-year JGB yields. This scenario depends on both the Fed and the ECB making progress with their plans to scale back bond purchases.

We expect the BOJ to keep its official target on the 10-year JGB at


but wage gains and productivity have been weak. Even prior to the referendum to leave the EU in June 2016, U.K. household finances had been deteriorating.

Household savings have been declining, while unsecured borrowings to maintain consumption have tracked higher. None of these trends speaks well for the long-term health of the economy. Chancellor Philip Hammond, in his recent budget speech, said the potential for a slowdown in U.K. growth has increased and showed a willingness to expand fiscal policy to cushion Brexit headwinds, implying higher government borrowing. In

months. The BOC’s cautious stance on rates, offset by another U.S. rate increase this month, should continue to support the relative near-term performance of Canadian bonds. We expect Canadian yields to move higher in 2018 in conjunction with our view of rising yields in the U.S. We forecast an increase in the BOC policy rate of 50 basis points to 1.50% over the 12-month horizon. Our forecast for the 10-year government bond rises to 2.25%, a 15-basis-point increase.

U.K. – For more than a year, the narrative has been about economic uncertainty linked to Brexit. Employment continued to improve,

0.00%, but to allow it to stray higher than the assumed ceiling of 0.10% observed since the launch of yield-curve control policy. We maintain our deposit-rate forecast at negative 0.10% over the next 12 months.

Canada – After surprising the market with a rate hike in September, the Bank of Canada (BOC) has since adopted a more cautious tone. The BOC recently said that the outlook “remains subject to substantial uncertainties about geopolitical developments and about fiscal and trade policies” and that policymakers “continue to be preoccupied with the downside risks to inflation.” While the BOC was delivering a dovish message, the federal government delivered lower-than-expected budget deficits and third-quarter growth underwhelmed expectations, as growth slowed from the torrid pace of the first half of the year. These factors make Canada’s bond market quite attractive to international investors.

Provincial bonds have enjoyed particular attention outside Canada. The country’s AAA credit rating and relatively high liquidity are fostering demand from international investors, who face a reduced global supply of government and quasi-government bonds due to the EU’s quantitative-easing program. Moreover, strong global demand for longer-dated bonds aligns with the longer duration of provincial issues.

Our preference for Canadian government bonds over U.S. fixed income worked well in recent

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

0.350.92

-2

0

2

4

6

8

10

12

Model

Actual

Exhibit 1: Bund yield should revert to fair value absent ECB intervention

-0.58

-2

-1

0

1

2

3

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

Fair Value

Source: RBC GAM, Gavekal, Macrobond

Fair Value Model: 10-year German Bund Yield

Model minus Actual


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

our opinion, higher government borrowing does not automatically lead to higher gilt yields given that slower economic growth will typically lead to lower yields. Under these circumstances, the Bank of England would most likely ease monetary policy, or at the very least stay on hold, while other major central banks are tightening.

We expect the U.K. to be negotiating the terms and timeline of Brexit for a good part of our forecast horizon. Even with the talks’ increasing frailty, we have penciled in a 25-basis-point BOE rate hike premised on the extension of the global economic expansion. We are raising the 10-year gilt yield forecast to 1.75%, a 25-basis-point increase.

Regional preferencesWe are reducing our underweight exposure to the U.S. by half to 2.5 percentage points from 5 percentage points and initiating a 2.5-percentage-point underweight position in German bunds. We maintain our 5-point overweight in JGBs. We expect bond returns in most regions to underperform cash. JGBs are the exception, after factoring in returns from currency hedging.

U.S.

3-month 2-year 5-year 10-year 30-year Horizon

return (local)

Base 1.88% 2.40% 2.60% 2.75% 3.10% (1.67%)

Change to prev. quarter 0.25% 0.40% 0.10% 0.00% (0.15%)

High 2.38% 3.00% 3.15% 3.25% 3.60% (4.37%)

Low 1.38% 1.50% 1.70% 1.90% 2.40% 2.78%

Expected Total Return US$ hedged: (1.50%)

GERMANY


return (local)

Base (0.40%) 0.00% 0.35% 0.90% 1.50% (3.14%)

Change to prev. quarter 0.00% 0.10% 0.10% 0.15% 0.20%

High (0.20%) 0.40% 0.75% 1.25% 1.75% (5.86%)

Low (0.40%) (0.50%) (0.25%) 0.25% 0.90% 2.96%


JAPAN


return (local)

Base (0.10%) (0.05%) 0.00% 0.10% 0.90% (0.08%)

Change to prev. quarter 0.00% 0.00% 0.02% 0.00% (0.10%)

High 0.00% 0.10% 0.10% 0.25% 1.10% (2.70%)

Low (0.10%) (0.10%) (0.10%) (0.10%) 0.60% 3.94%

Expected Total Return US$ hedged: 1.90%

CANADA


return (local)

Base 1.50% 1.90% 2.05% 2.25% 2.60% (1.17%)


High 2.00% 2.30% 2.60% 2.75% 3.00% (4.72%)

Low 0.75% 1.00% 1.10% 1.30% 1.70% 7.31%


U.K.


return (local)

Base 0.75% 1.00% 1.30% 1.75% 2.15% (3.17%)


High 1.00% 1.25% 1.65% 2.00% 2.25% (4.87%)

Low 0.25% 0.25% 0.30% 0.75% 1.50% 6.92%


INTEREST RATE FORECAST: 12-MONTH HORIZON Total Return calculation: Nov. 24, 2017 – Nov. 23, 2018

Source: RBC GAM

CURRENCY MARKETS

U.S. dollar cycle becomes extendedWe have long held that cyclical movements in the trade-weighted U.S. dollar offer a useful tool for gauging the currency-investing landscape. Our analysis usually begins with these longer-term cycles before considering the shorter-term factors of individual currencies.

A glance at Exhibit 1 suggests that the current U.S. dollar upswing may have run its course now that the rally has matched what is typical in both length and magnitude. However, there are good arguments why this cycle could run longer than average and why the inevitable reversal will not be as sudden as peaks in 1985 and 2001, when policymakers reacted to excessive U.S. dollar gains that had disrupted global markets. We believe that similar intervention is less likely in 2018 because the U.S. dollar is not as expensive as it was at the time of the previous tops (Exhibit 2). In addition, closer examination of the prior peaks shows that, even in those sharp reversal episodes, it took time for turning points to occur as the greenback made highs versus currencies at different times (Exhibit

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

Daniel Mitchell, CFAPortfolio ManagerRBC Global Asset Management Inc.

3). We conclude that this process can take several years to unfold, especially in the absence of policy intervention.

What could lead the U.S. dollar to strengthen in 2018? Three points come to mind. First, the U.S. Federal Reserve (Fed) continues to hike rates while other central banks are still pushing bond yields lower via quantitative easing. Second, the passage of tax reform could

result in meaningful demand for the greenback as U.S. corporate earnings are repatriated. Finally, protectionism could give the U.S. dollar a boost by prompting trade partners to weaken their currencies to maintain competitiveness. So, while 2017 has largely been a year of U.S. dollar weakness, we expect this combination of factors to drive a rebound next year toward the highs previously seen in 2016.


Exhibit 1: Long-term cycles in U.S. trade-weighted dollar

60

70

80

90

100

110

120

130

140

150

1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015U.S. Trade-weighted dollar

8 yrs-26%

6 yrs+67%

10 yrs-47%

7 yrs+43%

9 yrs-40%

6.5 yrs+42%

42%

Source: U.S. Federal Reserve, Bloomberg

Exhibit 2: Purchasing power parity (U.S. trade-weighted dollar)

60708090

100110120130140150

73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

USTW$: 88.68 [Nov. 24, 2017] PPP: 80.88 [Nov. 2017] 20% Band : [64.70, 97.05]

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


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

Greater dispersion of currency returnsThe maturing stage of the U.S. dollar cycle leads us to examine some of the fundamental factors that drive returns of individual currencies, and in doing so we find that these elements support improved outlooks for the euro and yen but signal deteriorating trends in the U.K. and Canada. Our forecasts reflect this divergence and assume that, while the U.S. dollar may have already peaked against the yen and euro, it has room to strengthen against the other two major developed-market currencies discussed here.

It is the nature of foreign-exchange markets that different factors can be driving currencies at any given time. These are easy to spot after the fact. The trick to successfully trading currencies, however, lies in anticipating the rotation of driving factors. In today’s environment of improving global growth, it seems logical that economic trends drive currency performance. This has certainly been the case over the past year, when currency movements have corresponded to the degree of economic improvement (Exhibit 4). Recent trends of economic data in Canada and the U.K. suggest that these countries may experience weaker growth than others going forward – a dynamic we expect to persist as both struggle to negotiate with key trading partners.

Looking forward, we ask ourselves which factors will dominate in 2018. We think current-account balances

Exhibit 3: U.S. dollar peaks against major currencies

CAD

CHF

JPY

SEKEUR

AUD

GBP NZD

60

70

80

90

100

110

120

130

140

150

1980 1980 1981 1982 1983 1984 1985 1985 1986 1987 1988 1989 1990

U.S

. tra

de w

eigh

ted

dolla

r(1

973

= 10

0)


4 yrs

Exhibit 4: FX returns versus economic data

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

-300 -200 -100 0 100 200 300 400 500

1-ye

ar F

X sp

ot re

turn

s

Citigroup data change measure vs U.S.Source: Citibank, Bloomberg

CADCHF

JPY

SEKEUR

AUD

GBP

NZD

70

75

80

85

90

95

100

105

110

115

120

1990 1991 1992 1993 1995 1996 1997 1998 2000 2001 2002 2003 2005

U.S

. tra

de w

eigh

ted

dolla

r (1

973

= 10

0)


3.5 yrs

1985 peak

2001 peak


Exhibit 5: Current-account balances (% GDP)

-8-6-4-202468

10

U.K

.

Turk

ey

Col

ombi

a

N.Z

.

Can

ada

S.A

frica

U.S

.

Aust

ralia

Mex

ico

Indo

n.

Indi

a

Pol

and

Bra

zil

Phi

lip.

Chi

na

Rus

sia

Mal

aysi

a

Eur

ozon

e

Japa

n

Nor

way

Swed

en

Kore

a

Hun

gary

Sw

itz.

% o

f GD

P

C/A Balance, % of GDP 2 years agoSource: Bloomberg

will begin to draw more attention as the macroeconomic landscape shifts to one marked by central-bank liquidity withdrawal which may upset investor complacency. It is now quite clear that central banks are transitioning away from providing liquidity: the Fed will continue to shrink its balance sheet over the course of the year while the European Central Bank (ECB) and Bank of Japan (BOJ) purchase fewer assets.

Meanwhile, central banks in Canada, China, Sweden and the U.K. are also tightening policy. The combined effect of these actions on financial markets has so far been limited, but as more tightening occurs we would expect greater market volatility and a tougher environment for countries needing to fund large current-account deficits. Some, including emerging-market countries, have made improvements in recent years. Canada and the U.K., however, stand out for their lack of progress (Exhibit 5).

EuroWe have raised our 12-month euro forecast this quarter to 1.12 per U.S. dollar from 1.07, reflecting a still-bearish outlook from the current level of 1.19 but recognizing improvements in the longer-term drivers of the currency. These include reduced political risk, with less-dramatic-than-feared outcomes in Spain’s Catalonia region, as well as French and German elections; and a brisk pace of economic growth,


which has broadened to include southern Europe. Two other factors also deserve elaboration.

The first is a diminishing tendency for Europeans to invest abroad. Portfolio outflows from the Eurozone peaked at 550 billion euros in 2016 but have fallen to levels that may no longer weigh on the euro. Looking forward, the improved balance of capital flows should persist given that the ECB will be placing less downward pressure on bond yields. The second euro-positive development is the resumption of growth in global foreign-exchange reserves. These are mostly U.S. dollar assets accumulated by countries trying to prevent strength in their own currencies, and such stockpiles would expand if the Trump administration continued its protectionist tendencies. As a way of ensuring a more balanced pool of assets, reserve managers tend to sell U.S. dollars for other major currencies, the largest share of

which goes to the euro. Given that foreign-exchange reserves total more than US$11 trillion (Exhibit 6) – these flows could offer significant support for the single currency.

The reason we aren’t definitively optimistic about the euro is because we think its current exchange rate more than reflects these improvements. A comparison of the exchange rate with interest-rate differentials, a reliable guide historically to the euro’s value, indicates that the currency should be trading closer to parity than to its current level of 1.19 (Exhibit 7). Moreover, the ECB understands the risk that an elevated currency can pose to growth and inflation. This is why ECB President Mario Draghi cited his concerns about foreign-exchange movements in a September press conference and why the ECB has indicated to investors that it will be keeping negative interest rates for some time. Recent euro strength seems


inconsistent with money-market expectations that interest rates will remain negative until the fall of 2020. Short-term factors, like the currency’s negative cost of carry and overbought positioning, also suggest that further gains are limited.

Japanese yenSimilar to the Eurozone, Japan is enjoying stronger economic growth and positive net capital inflows, and these flows indicate improving demand for the yen. The so-called basic balance, which combines the current account, foreign direct investment and portfolio flows, is in positive territory for the first time since 2014 (Exhibit 8). The improving basic balance of payments magnifies another important long-term support for the yen – its persistent undervaluation. The yen has been one of the few extremely undervalued currencies based on all long-term metrics that we follow. These metrics, which suggest the Japanese currency is 20%-25% undervalued, are consistent with the BOJ’s own estimates.

Reviewing the yen’s typical drivers, we see that the currency has historically moved in unison with bond yields and Japanese equities. These relationships are now breaking down. Perhaps this hints at a lack of faith in ”Abenomics,” the set of policies put forth by Prime Minister Shinzo Abe to revive the Japanese economy, and lower expectations that the BOJ’s policies will continue to exert downward pressure on the yen. In any case,


Exhibit 7: U.S., Euro 2-year spread vs. EURUSD

1.00

1.10

1.20

1.30

1.40

1.50

1.60

-300

-200

-100

0

100

200

300

2008 2010 2012 2015 2017

EUR

USD

bps

EURUS 2Yr spread (LHS) EURUSD Spot Rate (RHS)Source: Bloomberg

0

2

4

6

8

10

12

14

2003 2005 2007 2009 2011 2013 2015 2017

Inte

rnat

iona

l res

erve

s ( $

trill

ions

)

Source: Bloomberg

Global FX reserves are

growing again

Exhibit 6: Global foreign-exchange reserves

Exhibit 8: Japan’s basic balance of payments

-50-40-30-20-10

010203040

Jan-04 Dec-05 Nov-07 Oct-09 Sep-11 Aug-13 Jul-15 Jun-17

Trill

ions

(Yen

)

Net portfolio flows Current accountNet foreign direct investment Basic balance of payments

Source: Bank of Japan, Macrobond


celebrations will be short-lived. The new trade relationship between the EU and the U.K. will form the second phase of the negotiations, and these are set to be far more complex than the earlier round of talks.

Recent economic data releases are now showing some weakness in household spending (Exhibit 10). What’s more, U.K. consumer sentiment seems to be faltering most in the lower quartile of the income distribution (Exhibit 11).

one that is bound to precipitate a more painful adjustment at a time when Brexit negotiations are creating business uncertainty.

Foreign-exchange markets, so far, do not reflect this reality. The British pound has rallied 10% this year and now sits near its post-Brexit highs. This is due, in part, to bearish positions being unwound on speculation of progress in negotiations toward a divorce bill with the EU. However, we think these

Exhibit 9: USDJPY spot exchange rate

108109110111112113114115116117118

Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17

USD

JPY

exch

ange

rate

Source: Bloomberg

the yen has had difficulty weakening beyond 114 per dollar (Exhibit 9), even after Abe’s mandate was strengthened following his landslide victory in October elections and as U.S. Treasury yields trended higher.

The final element that feeds our more optimistic stance on the yen is its safe-haven status. Japan has had a positive net international investment position for many years – which is to say that its government and citizens own more assets abroad than foreigners do in Japan. This investment balance matters more during periods of markets stress, when foreign assets tend to be liquidated and cash is brought home to Japan. It is at these times that the yen tends to perform best, even if the uncertainty is caused by a Japanese event as was the case after the 2011 Fukushima earthquake and tsunami. While we can’t forecast earthquakes, we are wary of the low levels of volatility in global asset markets, as well as exuberant investor behavior. As a result, we like owning yen in our portfolios as insurance against such risks and forecast the yen to strengthen toward 110 per U.S. dollar over the coming 12 months.

British poundWe have referred before to the gloomy outlook for U.K. consumers. Disposable incomes have been squeezed by high inflation, savings rates have collapsed to multi-decade lows and households have been borrowing to maintain consumption. This model is unsustainable, and


Exhibit 10: U.K. retail sales (ex autos & fuel)

-6

-4

-2

0

2

4

6

8

10

1989 1992 1995 1998 2001 2004 2008 2011 2014 2017

% c

hang

e (Y

oY)

Source: U.K. Office for National Statistics, Macrobond


This is the segment that is most sensitive to changes in economic conditions because a large portion of what they earn is spent rather than saved. It is for this reason that we find it odd that the Bank of England (BOE) chose to begin raising interest rates last month. The BOE’s move was especially puzzling because the inflation-targeting central bank should also be aware that the temporary effect on inflation from currency weakness has now passed (Exhibit 12). All this is to say that we expect the BOE to be more cautious going forward. Combining the U.K.’s sluggish growth outlook with its large current-account deficit and slow-to-tighten central bank, our 1.15 forecast suggests a much weaker pound in the year ahead.

Canadian dollarThe loonie has fallen 6.5% since early September, partly reversing summer gains from two rate hikes in response to economic growth exceeding 4%. Our 12-month forecast of 1.37 is premised on a slower pace of economic growth in the year ahead, a widening interest-rate gap with the U.S. and poor competitiveness that will widen Canada’s current-account deficit.

Shorter-term factors such as the movements in the price of crude oil often distract Canadians from what is really important to the direction of currencies over the long term. We observe that the currency’s correlation to crude is far from constant (Exhibit 13) and that the


Exhibit 12: GBP performance and U.K. imported inflation

-10%

-5%

0%

5%

10%

15%

20%

2006 2007 2009 2011 2013 2015 2017

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

YoY

(% c

hang

e)

YoY

(% c

hang

e)

GBP trade weighted index, inverted rhs Consumer goods import prices (excl. cars), lhsSource: Bloomberg, UK Office for National Statistics

rapidly changing economic-policy environment could have more influence than it did in the past. In this section, we focus on Canada’s poor competitiveness and explain how Canada’s currency will need to cheapen to offset some of the economic headwinds that lie ahead.

There is no shortage of developments that are complicating the landscape for Canadian businesses:

• Rising taxes for small-business owners, with more stringent treatment of passive income and income splitting;

• Tighter housing regulations, stricter mortgage rules and stress tests to be implemented in January 2018;

• Stronger unions than south of the border;

• Tougher environmental standards, including carbon levies;

Exhibit 11: U.K. consumer confidence by income quartile

-30-25-20-15-10

-505

1015

1st Quartile 2nd Quartile 3rd Quartile 4th Quartile

Leve

l

End of 2015 Before Brexit CurrentSource: U.K. Office for National Statistics, Macrobond


• Provincial opposition to pipelines, preventing crude oil from moving east and west from land-locked western Canada;

• President Trump’s protectionist tendencies, with moral suasion to “Buy American” and risks to NAFTA;

• Significant increases in minimum wages.

Given that small businesses are responsible for a large share of employment growth, these developments form a hurdle for the economy. A recent survey by the Canadian Federation of Independent Business found that its members expect taxes and wages to be their greatest cost constraints (Exhibit 14), and such concerns appear to be increasing, thanks to recent initiatives by the federal and provincial governments. For example, a carbon tax of $10 per tonne will be introduced in 2018 and rise by $10 per tonne in each of the following four years. Some provinces, keen to collect the additional revenue have already imposed the tax earlier than mandated (Exhibit 15). Minimum wages are set to rise to $15/hour in Alberta next year and to the same level in Ontario over two years. This sizable increase from current wage rates of $11.60 in Ontario and $12.20 in Alberta may be tough for businesses to absorb. Studies of past wage hikes in Ontario have shown a negative impact on employment among 15-24-year-olds as businesses hire fewer but better skilled workers.


Exhibit 13: CADUSD correlation with crude oil

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.81.0

1989 1993 1997 2001 2005 2008 2012 2016

26 w

eek

corr

elat

ion

Source: Bloomberg, RBC GAM

Exhibit 14: Top cost constraints for Canadian businesses

0

10

20

30

40

50

60

70

Taxes,Regulations

Wages Fuel,Energy

Insurance Banking Productinputs

ForeignCurrency

Occupancy Borrowingcosts

Capitalequip.,Tech.

Leve

l of c

once

rn

Oct-16 Oct-17Note: Data from business barometer survey. Source: CFIB, Macrobond

Exhibit 15: Tax revenue generated from carbon levies

0

1

2

3

4

5

6

07-0

8

08-0

9

09-1

0

10-1

1

11-1

2

12-1

3

13-1

4

14-1

5

15-1

6

16-1

7

17-1

8

18-1

9

Rev

enue

(bill

ions

CAD

)

BC AB ON QCSource: Government of B.C., Alberta, Ontario & Quebec, RBC Economics



These measures further dent Canadian competitiveness, and mean the country will likely be plagued by trade and current-account deficits for many years to come (Exhibit 16). As investors, we would prefer that these deficits be funded by stable inflows such as foreign direct investment (FDI) – purchases of physical assets like factories, for example. But FDI is actually going in the wrong direction as foreign investment dries up and Canadian firms continue to seek better opportunities abroad. Canada still enjoys portfolio inflows in the form of foreign purchases of Canadian government and corporate bonds, but these flows can be a fickle source of funding and represent heightened vulnerability for the loonie.

Exhibit 16: Canada balance of payments (as % of GDP)

-8

-6

-4

-2

0

2

4

6

8

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

% o

f GD

P

Current account Net foreign direct investmentNet portfolio flows Basic balance of payments

Source: Statistics Canada, Macrobond

To summarizeWe’re nearing the end of the dollar upswing, but it’s a process that will take time, possibly years. Patience is now required as the environment is one where foreign-exchange fluctuations are no longer driven predominantly by the direction of the

U.S. dollar, but rather by the relative merits of each currency. Differences in growth and balance-of-payments dynamics are likely to be the key factors going forward, and with that in mind, we expect the euro and the yen to fare better than the pound and Canadian dollar.


40

80

160

320

640

1280

2560

5120

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


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

REGIONAL OUTLOOK – U.S.

UNITED STATES RECOMMENDED SECTOR WEIGHTS

RBC GAM INVESTMENT STRATEGY COMMITTEE

Nov. 2017

BENCHMARK S&P 500

Nov. 2017

Energy 4.9% 5.9%

Materials 2.9% 2.9%

Industrials 11.0% 10.0%

Consumer Discretionary 12.7% 12.1%

Consumer Staples 8.1% 8.1%

Health Care 14.1% 14.1%

Financials 16.0% 14.8%

Information Technology 25.0% 23.9%

Telecommunication Services 1.0% 2.0%

Utilities 2.0% 3.1%

Real Estate 2.0% 2.9%

Source: RBC GAM

The U.S. stock market recorded returns that were well above average over the past three months, rising 7.7%, on the back of solid returns from cyclical sectors such as Financials, Information Technology, Energy and Materials. Returns were pressured by weak performance from the bond-proxy sectors, including Real Estate, Utilities, Consumer Staples and Telecommunication Services. The strong overall performance was driven by the continuation of the synchronized global economic expansion, still accommodative global central-bank policy and low market interest rates and inflation, which drove better-than-expected financial performance for most U.S. companies. Improving prospects for tax reform also helped to lift investor sentiment.

The U.S. economic backdrop remained solid, as real GDP growth has been roughly 3% in the last two quarters compared with the 2% trend seen since the global financial crisis. Growth appears to have had decent momentum into the fourth quarter as surveys of economic activity, which correlate well with GDP, have been coming in above trend. Business-activity indicators such as the American Trucking Association’s tonnage index sit at a four-year high, and volumes carried by intermodal cars on the railroad

to support consumer spending, and the housing market in particular. During the quarter, sales of new homes rose over 6% year over year to a level not seen since October 2007, and a survey of homebuilder optimism touched the second-highest reading since 2005 – the midst of the housing bubble. The low unemployment rate and improving

network reached record highs in recent weeks. According to the Federal Reserve Bank of Atlanta, real GDP growth for the current quarter is rising at a 3.4% pace. In addition, the Conference Board’s Consumer Confidence Survey recently hit a 17-year high. The unemployment rate in November was unchanged at 4.1%, the lowest since 2000, helping

S&P 500 EQUILIBRIUM Normalized earnings and valuations


Regional Outlook – U.S. | Brad Willock, CFA

availability of mortgage credit should support further growth in the housing market, but affordability is becoming stretched as home prices have risen much faster than wages.

The S&P 500 is up almost 20% over the past year, driven primarily by solid corporate fundamentals. After three years of essentially flat earnings, the S&P 500 is expected to generate roughly 11% earnings growth in 2017. The drop in the oil price from mid-2014 until early 2016, plus the 20% rally in the trade-weighted U.S. dollar over a similar period, depressed the earnings of the Energy sector and large multinational producers. The negative effects of the U.S. dollar and oil prices started to wane a year ago and earnings growth has rebounded strongly, although in the most recent quarter earnings growth decelerated due to hurricane-related losses. Despite this, profitability remains exceptional as net profit margins were roughly 13% and the incremental margin on a dollar of new sales was 17%, similar to percentages in the prior three quarters. The remarkable profitability is being driven by manufacturers of capital goods and software. These highly profitable companies sport profit margins that

are 15% above the market average and year-over-year revenue gains that are more than double the rest of the market. Looking forward, earnings growth is expected to accelerate to 11% in the fourth quarter, above the long-term trend of 7%, as activity rebounded after the hurricanes and energy prices continued to rise. Our base case assumption is that the economy continues to expand and that short-term interest rates rise slowly over the next year. With respect to the stock market, we must recognize that asset prices have gone up substantially, and that the tailwinds of low corporate borrowing costs, falling energy prices and inflation, and low short-term interest rates are no longer incrementally helping or are likely to turn into headwinds in the year ahead. However, we are comforted by the solid economic backdrop, the good corporate financial performance and the optimism of management teams.

It is too early to turn completely defensive given that prospects for tax reform have become more likely. If the tax bill is signed into law, corporate earnings could be revised higher by 5%-9% in 2018; repatriated foreign earnings could lead to increased merger

activity, dividends or buybacks; and consumer spending will likely improve. While all of this would likely push the stock market higher in the short term, we recognize that expectations for a tax bill to make it through Congress have been rising since early September.

While our base case is for stocks to rise modestly over the next year, there are several scenarios that could lead to declines, including an escalation of tensions with North Korea, a policy mistake by the U.S. Federal Reserve (Fed) or protectionist trade moves by the Trump administration. Stock markets would become more volatile and likely fall under any of these scenarios. However, any pullback would probably be minor and short-lived unless a recession ensued. Our indicators suggest that the odds of a recession remain fairly low, but with valuations at an eight-year high and the Fed intent on normalizing interest rates, the risks have increased. As a result, we have adjusted our portfolios to be somewhat more defensive by raising our stake in the Health Care and Utilities sectors and trimming some of our overweight exposure to the most cyclical parts of the Information Technology sector.


400

1600

6400

25600

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


Canadian stocks rose 6.4% in the most recent quarter, but remain one of the worst-performing developed markets so far in 2017. As of November 30, the S&P/TSX Composite Index had returned 7.8% in 2017, compared with returns of 15.8% for the S&P 500 Index and 16.6% for the MSCI World Index, both in Canadian dollars. The comparison is particularly notable considering that Canada’s first-half GDP was one of the highest among G10 countries. The Canadian index was held back by the Energy sector, appreciation in the Canadian dollar and concern that the economy lacks a growth driver for the slowing housing market. Market sentiment continues to be hurt by looming uncertainty regarding NAFTA, as the U.S. has taken a tougher-than-anticipated stance in negotiations.

Our expectations for economic growth remain healthy, with U.S. GDP forecast to grow 2.25% in 2017 and 2.75% in 2018. Faster-than-expected growth in Canada over the first half of the year has pushed our 2017 GDP forecast to 3.0%, but fading tailwinds from stronger oil prices and competitiveness concerns result in a much weaker 1.5% forecast for 2018. The Bank

Irene Matsyalko, CFA Portfolio Manager RBC Global Asset Management Inc.

Sarah Neilson, CFAPortfolio Manager RBC Global Asset Management Inc.

CANADA RECOMMENDED SECTOR WEIGHTS


Nov. 2017

BENCHMARK S&P/TSX COMPOSITE

Nov. 2017

Energy 18.5% 19.7%

Materials 11.0% 11.1%








Utilities 3.0% 3.8%


Source: RBC GAM

REGIONAL OUTLOOK – CANADA

Analysts’ consensus estimates for S&P/TSX Composite earnings are $935 in 2017 and $1,021 in 2018, representing annual increases of 13% and 9%, respectively. While market valuations for both the S&P/TSX and the S&P 500 are somewhat elevated relative to history, S&P/TSX valuations are lower than they are for the S&P 500. This difference seems

of Canada (BOC), following two interest-rate hikes earlier this year, chose to leave its overnight rate unchanged in October, while noting that economic slack will act as an offset to potential inflation concerns. We are monitoring the impact of higher interest rates given the economy’s reliance on residential real estate and consumer spending.

S&P/TSX COMPOSITE EQUILIBRIUM Normalized earnings and valuations


Regional Outlook – Canada | Irene Matsyalko, CFA | Sarah Neilson, CFA

justified given the dependence of the Canadian market on commodity-price increases and the size of financial earnings in the domestic market’s overall profit pool.

The Financials sector drove a significant amount of the Canadian index’s recent performance, with bank stocks climbing roughly 9% since the end of August. Bank shares are trading slightly above their historical average of 11.7 times the forward P/E multiple, boosted by the BOC’s more hawkish rate outlook. As banks benefit from higher borrowing rates, their net interest margins will stabilize and gradually rise. Regulatory conditions that take effect January 1, 2018, are expected to slow house-price appreciation and new mortgage originations, as all borrowers will be required to qualify at higher mortgage rates. However, most banks have said they believe the impact on earnings will be minimal.

The outlook for life-insurance companies remains positive. Higher interest rates and a leadership change at Canada’s largest insurer, Manulife, have driven solid outperformance since the end of August. We believe there is more room for gains as the insurers trade at reasonable multiples of price to book value and their returns on equity are set to benefit from rising rates. In additional, both Manulife and Sunlife generate about 40% of revenue in the U.S. and are poised to benefit from lower corporate tax rates.

Consumer Discretionary has been the best-performing sector so far this year. The outperformance came from stocks like Dollarama, Restaurant Brands, Cogeco Communications, Martinrea and Linamar. After months of concern about a slowdown in North American vehicle production and NAFTA risks, automotive suppliers have posted double-digit returns and are no longer trading at depressed valuations. The industry is changing rapidly in part due to the emergence of self-driving technologies, and Magna is among those well positioned to adapt.

Grocers continued to weigh on the Consumer Staples sector due to concerns about competitive pressure from online retailers such as Amazon, as well as higher minimum wages, NAFTA and falling prices for generic drugs. Valuations have compressed as a result after several years of robust performance. The grocers continue to generate solid free cash flow and demonstrate the capacity to return capital to shareholders through dividends and share buybacks.

Canadian National and Canadian Pacific have contributed significantly to TSX performance and profit growth in 2017, benefiting from solid rail volumes and pricing. However, they face tougher year-over-year comparisons and already trade at the upper end of the historical valuation range. Other Industrials sector constituents such as heavy-equipment distributors and

construction are set to benefit from economic growth and a recovery in capital spending by commodity producers.

Energy has been the worst-performing TSX sector in 2017, mainly because of volatility in crude-oil prices. Crude has rebounded recently, creating a favourable outlook for sector earnings in 2018. Momentum has been driven by solid demand growth and continued confidence in OPEC’s willingness to cut global inventories by maintaining lower output levels into 2018. The resilience of growth in global demand and production by U.S. shale producers will help determine whether crude prices can rise further.

The Materials sector is up less than 2% so far this year as price increases for copper, zinc and precious metals have failed to translate into significant stock-market gains. Gold equities, which make up roughly half of the sector’s weight, have retreated amid uncertainty in the outlook for gold prices given the potential for rising interest rates, a stronger U.S. dollar and a relatively stable geopolitical backdrop. Base-metals companies comprise about 15% of the sector and rallied recently to reflect rising prices supported by solid demand growth in China. This scenario bodes well for the cyclically skewed Canadian stock market.


EUROPE RECOMMENDED SECTOR WEIGHTS


Nov. 2017

BENCHMARK MSCI EUROPE

Nov. 2017

Energy 6.3% 7.3%

Materials 9.0% 8.1%








Utilities 2.5% 3.7%


Source: RBC GAM

EUROZONE DATASTREAM INDEX EQUILIBRIUMNormalized earnings and valuations

50

100

200

400

800

1600

3200

1980 1985 1990 1995 2000 2005 2010 2015 2020Source: Datastream, Consensus Economics, RBC GAM


make concessions. The average trade deal takes 2.8 years to complete, so the two-year window is invariably optimistic and likely to create volatility as the negotiations ebb and flow.

There is also the issue of EU integration. German Chancellor Angela Merkel supports efforts by French President Emmanuel

REGIONAL OUTLOOK – EUROPE

After a robust first six months of 2017, the European equity market consolidated through the summer as strength in the euro lowered earnings estimates and the escalation of tensions in North Korea reduced demand for risky assets. Both of these issues have subsided in recent months, and the wider picture continues to look positive. But we remain mindful that structural and cyclical uncertainties remain, and that these potential disruptions could come back to the fore at some point.

We have passed through the big event-risk peak in European politics, at least for this year. In 2017, a crescendo of major elections occurred, with the Netherlands, the U.K., France and Germany voting to deliver favourable results for EU continuity and the stock market. However, the middle ground of politics is less secure, and this backdrop poses a risk further down the road. The next big risk on the horizon is the Italian general election set for some time in the first half of 2018. This vote is important given Italy’s position as the third-largest economy in the Eurozone, the rise of Euroscepticism and the complexity of the region’s political ecosystem.

The unprecedented Brexit negotiations are set to begin properly in 2018. From an equity

standpoint, these talks are crucial given that the U.K. represents about one-third of Europe’s stock-market capitalization, but also as a roadmap should comparable situations arise elsewhere. A stronger EU recovery could serve Britain well during the bargaining because representatives of a more prosperous single market would likely have some leeway to

James JamiesonPortfolio Manager RBC Global Asset Management (UK) Limited


Macron to foster a reinvigorated sense of European unity at this vulnerable time. However, she will have increasing difficulty making concessions on financial transfers from richer EU countries to poorer ones (the transfer union) after she forms what is certain to be a more fragmented governing coalition. Getting the go-ahead for a Eurozone-wide budget, a Brussels-based finance minister and collective military will be a hard-sell for voters in Germany, where there is much less discussion than in other countries about the benefits of EU membership.

As in the U.S., low inflation in Europe doesn’t appear to concern the European Central Bank (ECB), which has just announced that it will begin reducing asset purchases beginning early next year. As expected, tightening will begin with QE tapering, followed by rate hikes further down the road. The U.K.’s need to control inflation following sterling’s decline prompted the Bank of England to raise the policy rate in November, the first hike since 2007. It is unclear how the mechanics of these central-bank interventions will work through the system, but we expect the tightening to be gradual enough for stock markets to absorb them without great shocks.

Ultimately, near-term decisions made by central banks in Europe will depend on currency movements, and policymakers are very aware of the impact that their actions can have on foreign-exchange rates. The U.K. looks to have more tightening

headroom given the sizeable devaluation of the pound. It is also worth noting that ECB President Mario Draghi’s eight-year term as chief ends in October 2019. The search for Draghi’s successor will begin in 2018, so the equity market will be discounting the news through next year.

Aside from inflation, key macroeconomic indicators in Europe continue to look sound, although the marginal rate of progress has lessened. It is possible we are gently nearing the “slowdown” phase of the economic cycle but, importantly, key economic metrics appear to provide a solid foundation for a continuation of corporate profit growth. Growth in the money supply remains at a decently positive level. The dynamics of growth may change when tightening comes through, but the trend should remain intact. Europe’s manufacturing purchasing managers’ index rests at cycle highs, while unemployment in the Eurozone continues to move steadily lower and now sits below the average in place over the course of the current cycle.

After a depressed 2016, the value of Western European merger-and-acquisition activity was up more than 90% for the period between January and late October. Much of this is due to vertical integration to drive efficiency. The U.K. is dominating takeover activity, with 50% of the total, as the currency collapse has made U.K. assets more attractive. Cyclical indicators of Eurozone capital expenditures are also picking up. With capacity

Regional Outlook – Europe | James Jamieson

utilization above the cycle average at 83%, such spending is well supported assuming financing conditions remain favourable. The robust pick-up in investment also signals an uptick in European corporate risk appetite, a trend that looks set to continue given that the cost of credit for European businesses has never been lower. Encouragingly, rising capital expenditures have not come at the expense of cash returns to shareholders as evidenced by the fact that dividends are back near pre-crisis levels.

In spite of the recent progress, European equities still appear cheap compared with other stock markets. European equities also offer value on a yield basis relative to other income-producing assets amid the improving profitability of companies in the region and the decline in political risk.

For the first time in many years, consensus earnings estimates for 2017 are holding up, so absolute valuations look well supported. Importantly, EPS momentum is now being driven by revenue growth for the first time since 2011, compounding the positive impact of cost-cutting and the adoption of technology. Furthermore, a likely rebound in buybacks would enhance earnings.

All in all, the outlook is positive. Volatility remains depressed on a long-term basis, although we may still see some oscillations around the risks raised above.


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1980 1985 1990 1995 2000 2005 2010 2015 2020Source: Datastream, Consensus Economics, RBC GAM


REGIONAL OUTLOOK – ASIA

ASIA RECOMMENDED SECTOR WEIGHTS


Nov. 2017

BENCHMARK MSCI PACIFIC

Nov. 2017

Energy 2.5% 3.1%

Materials 6.5% 6.7%








Utilities 2.0% 2.4%


Source: RBC GAM

Derek AuResearch Analyst RBC Investment Management (Asia) Limited

JAPAN DATASTREAM INDEX EQUILIBRIUMNormalized earnings and valuations

Asia-Pacific markets rallied during the period, adding to the strong year-to-date gains that have propelled the region’s indexes to the leadership position in global equity performance. The region largely shook off the U.S. Federal Reserve’s commitment to balance-sheet reduction, as tensions on the Korean peninsula eased. Earnings growth supported cyclical sectors such as Industrials and Financials against a backdrop of inexpensive currencies and a strong technology cycle.

China was again the biggest outperformer, as investor sentiment improved on the back of stabilizing economic indicators and rising corporate-earnings expectations. The MSCI China Index has soared 49% this year, easily outpacing the regional benchmark. In Japan, equity markets advanced 10.9% in U.S. dollar terms on generally supportive macroeconomic data and a rosier corporate earnings outlook. Further, a resounding election victory for Prime Minister Shinzo Abe in October provided a tailwind for the economy, and the Bank of Japan (BOJ) is well positioned to continue with monetary easing. Elsewhere, the strongest-performing markets in the region were Hong Kong and Thailand. The Indian market, where valuations were expensive at the start of the year, fared surprisingly well, even amid

relatively soft earnings. Indonesia was the laggard during the period, as its central bank and government are running out of policy options to fire up the economy after six interest-rate cuts last year.

Across the region, the best-performing sectors were Financials, Information Technology and Consumer Discretionary, while

Utilities and Telecommunication Services underperformed.

JapanJapanese equities soared to their highest levels since December 1996, reflecting the market’s optimism that domestic companies will continue to increase earnings as business sentiment improves, as well as the


by wealth-management products. While we believe these provisions should be stronger, they lead us to expect further reforms to address excessive leverage. The task of China’s central government in the years ahead will be to pursue orderly financial-market deleveraging and prevent systemic risk.

Elsewhere in the region, India’s macroeconomic outlook has weakened because of the after-effects of the country’s demonetization program as well as challenges implementing a goods and services tax (GST). While inflation remained healthy amid rising food and housing prices, second-quarter GDP growth slipped to 5.7%, the slowest since 2014. Corporate profits declined in most sectors, likely as a result of GST implementation. These near-term disruptions are not serious enough to change our belief that India has taken the measures necessary to increase the country’s long-run productivity.

Advances in Australian equities were roughly on par with the rest of the region, although gains were skewed towards the Health Care sector. In contrast to the hawkish shift in commentary from major central banks, the Reserve Bank of Australia maintained its neutral policy stance. The labour market continues to show resilience as unemployment ticked lower to 5.5% in September, driven by job creation in health care and construction.

On the economic front, China continued on a firm footing despite GDP growth slowing marginally to 6.8% in the third quarter. That said, the broad trend of moderation in economic growth remains intact for now. Industrial production accelerated somewhat in recent months while the services sectors continue to shoulder much of the growth in the Chinese economy. During the twice-a-decade party congress, the central government abandoned its GDP growth target, as the world’s second-largest economy pledges to focus on the quality of economic growth over the long term. The shift away from ambitious official growth targets would be a departure from past practice.

Regarding China’s banking sector, outstanding assets under management of Chinese bank’s wealth-management products slowed during the quarter, perhaps signalling progress in financial-market deleveraging. Having grown exponentially in the past five years, banks have become increasingly cautious on the market for these off-balance-sheet loans as China’s banking regulator tightened rules. A tighter grip has channeled investment allocations to more diversified instruments such as money-market instruments and bonds, which we view as an encouraging sign for Chinese banks. More encouragingly, Chinese regulators released draft rules in November governing the asset-management industry that propose ending the implicit guarantee offered

Regional Outlook – Asia | Derek Au

supportive political backdrop. A decline in the Japanese yen against the U.S. dollar during the period also supported the rally.

The ruling Liberal Democratic Party gained a decisive victory in snap elections, enabling Abe to remain in office until 2021. While Abe’s primary mandate is reforming the constitution to allow for the strengthening of Japan’s military, the market’s focus will be on the likely re-appointment of BOJ Governor Haruhiko Kuroda for a second term. Kuroda’s continuation in the post would allow for the expansion of the BOJ’s accommodative policies, exerting downward pressure on the yen and Japanese government-bond yields, while providing further support for stocks. Not everyone is convinced that Abe’s victory will be constructive for Japanese equities. The prime minister has indicated that he would like to raise the national sales tax to 10% in October 2019, a move that could push Japan back into recession as the previous increase, to 8%, did in 2014.

Asia Pacific ex-JapanRisk-on sentiment was in full force during the period as Asian equities marched higher into unchartered territory amid easing geopolitical tensions. Chinese markets were driven by a rally in information technology, real estate, insurance and automotive. Stellar performances due in part to cyclicals resulted from a renewed reform push outlined by President Xi Jinping during China’s national congress in late October.


REGIONAL OUTLOOK – EMERGING MARKETS

emerging-market economic outlook will, in our view, continue to be driven by Asia.

In the longer term, we expect higher returns for emerging markets to be supported by a shift in the make-up of the asset class. Emerging markets in Asia now make up 73.5% of the MSCI Emerging Markets Index, up from 52.5% 10 years ago. This shift is positive because Asian companies tend to have higher returns on equity than the emerging-market average. Another shift is being driven by expanding middle classes in emerging-market countries, generating faster growth in sectors with higher-than-average returns. These sectors are centred on domestic consumption and include Information Technology, Consumer Staples, Health Care and, to a lesser extent, Financials.

We are also more confident about China’s economic stability. The latest data from the People’s Bank of China showed that the

After five years of underperformance, emerging-market equities outperformed developed-market stocks in 2016 by 3.7 percentage points and have continued to outperform this year as emerging-market economic growth picked up. The MSCI Emerging Markets Index fell 7.5% in the week following last year’s shock election of President Trump in a very short-term reaction to concern about U.S. policy uncertainty. The turnaround since then in emerging markets, where the 30%-plus return in 2017 has outperformed developed markets, is justified in our view because of improving returns on equity and a stabilizing Chinese economy.

Emerging-market equities remain attractive given a current price-to-book ratio of 1.8 and a current return on equity of 11.4%, up from 10.2% 12 months ago. In contrast, the price-to-book ratio for developed markets is 2.4 and the return on equity 11.3%, meaning that emerging markets trade at a 27% discount to developed markets, but offer slightly higher and rising returns. While emerging markets have been trading at a significant discount to developed markets for a number of years, the notable change is that emerging markets now have positive momentum in terms of earnings growth and returns on equity. Our positive view

on emerging markets over the next 12 months is predicated on the continued improvement in this trend.

We have long argued that the main driver of returns on equity over the short to medium term is changes in profit margins, which along with asset-use efficiency and financial leverage constitute the three main components of a DuPont analysis of returns on equity. In recent years, profit margins have contributed much more to changes in returns on equity, with the recent pick-up in returns due mainly to a rise in net-profit margins to 9.3% from 7.8%. Asset turns and financial leverage have been a net drag during that period.

The rise in profit margins is due mostly to a pick-up in industrial production, particularly via output increases in China, India, South Korea, Taiwan and, to a lesser extent, commodity-exporting economies such as Brazil, Malaysia and Russia. This improvement in the

EMERGING MARKET DATASTREAM INDEX EQUILIBRIUM Normalized earnings and valuations

20

40

80

160

320

640

1995 2000 2005 2010 2015 2020Source: Datastream, RBC GAM


Richard Farrell, CFAPortfolio Manager – Emerging Market Equities RBC Global Asset Management (UK) Limited


rebalancing, come expanding middle classes and their higher pay checks. The latest data show that this rebalancing is actually accelerating, a trend that gives us confidence that the Chinese economy can continue to shift away from excessive investment-led growth and toward consumption-led growth, which we believe is more sustainable in the long term.

Certainly, the Chinese economy faces a number of significant issues, particularly with regard to potential loan losses in the banking sector. However, in contrast to Japan’s zombie-bank crisis or the U.S. sub-prime crisis, Chinese authorities are very aware of the build-up of risks in the financial system and are implementing reforms to address them. In our view, the reforms have stopped these risks from increasing, but initiatives are still required to reduce banking-sector risk over the next few years. Overall, we believe that the odds of a Chinese financial crisis, which was the largest risk of investing in emerging markets in recent years, have declined significantly.

country’s foreign-exchange reserves increased in September for the eighth consecutive month, the longest stretch since 2014. The reserves now sit at US$3 trillion, a 3% increase since January of this year, but below the US$3.9 trillion peak of June 2014. This trend implies that capital outflows are stabilizing after a government crackdown on illegal capital flight, and is a positive for China’s economic stability following the mismanaged renminbi devaluation of August 2015.

One key advantage of the receding capital outflows is that Chinese authorities can continue to slow credit growth by tightening regulation with less risk of creating a renminbi shortfall in the short-term money and interbank markets. China, with banking assets totalling 228 trillion renminbi (US$33 trillion), overtook the Eurozone in 2016 as the world’s largest banking system for the first time due to huge growth in credit. The tightening of financial regulations can be seen in the flattening of growth in off-balance-sheet loans such as social financing and wealth-management products. Estimates of these assets are between 65 trillion and 70 trillion renminbi. Until recently, these

activities were broadly unregulated, but Chinese banking regulators have been requiring banks to gradually bring these assets on balance sheet and to start accounting for them more in line with traditional bank assets. Regulators have also capped interbank liabilities at 1/3 of total liabilities.

Another positive for China’s economic stability are reforms that have reduced production in sectors that were borrowing and producing more than the economy needed. After years of talking about supply cuts in a number of oversupplied sectors, there is evidence of action. Data so far this year point to continued cuts in capacity in industries such as steel, where output has been cut by about 12% since 2014, and coal, where the decline is about 10%. These reductions have bolstered pricing power and profit margins, enabling overleveraged industrial companies to lower their borrowing and reducing stress on their balance sheets.

Growth in real disposable income remains robust for people in both urban and rural areas. That’s in part because, along with the economic

Regional Outlook – Emerging Markets | Richard Farrell , CFA

Jane Lesslie, MSc, CFA V.P. & Senior Portfolio Manager, Fixed Income and Currencies – Emerging Markets, RBC Global Asset Management

Earl D’Almeida, MBA, CFA Analyst, RBC Global Asset Management


Should indexes have a conscience?The tragedy of Venezuela prompts a rethink of how emerging-market bond indexes are constructed

appropriate to invest in tobacco companies? Or in companies that sell guns to drug gangs?... Nowadays, it is emerging markets as an asset class that should make people morally queasy. Should decent people put their money in emerging-market bond funds?”

How to blow a trillion dollars Perhaps it is first worth asking how Venezuela, the wealthiest country in Latin America with a credit rating of Aaa in 1976, became the Caa3 rated pariah of today?2 How did this happen to the country with the world’s largest proven oil reserves?3 How did Venezuela see its oil production decline 31% from 1998 while production elsewhere in the world was sky-rocketing (Exhibit 1)?

2Moody’s Investor Service3BP Statistical Review of World Energy, 2016

Emerging market countries, by their very definition, are those with weaker institutions and governance, which lack checks and balances on power and which suffer from poor transparency. Investor focus on these features ebbs and flows with liquidity and headlines. The vast majority of active investors will screen for a broad variety of economic and valuation factors. But at what point do “social values” indicators make a country un-investable?

Much of this debate for RBC GAM’s emerging market bond team has surrounded Venezuela over recent months. The country has recently announced a restructuring of its debt. In mid-November it began partially defaulting on bond payments. This followed decades of economic mismanagement under former President Hugo Chavez and his handpicked successor, President Nicolas Maduro.

Last May, Professor Ricardo Hausmann, head of the Centre for International Development at Harvard and himself a former Venezuelan planning minister, asked the following question in an article entitled “The Hunger Bonds” on the Project Syndicate website:1

“Investing often creates moral dilemmas over goals: Should we aim to do well or to do good? Is it

1Ricardo Hausmann, The Hunger Bonds, Project Syndicate, May 26, 2017

Exhibit 1: Venezuelan oil production has fallen even as global production has risen

70

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95

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0.5

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1999 2002 2005 2008 2011 2014 2017

Glo

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illio

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rels

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Ven

ezue

la c

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ion

(m

illio

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y)

Venezuela crude production (LHS) Global crude production (RHS)Note: Data as of Jul. 31, 2017. Source: Bloomberg, RBC GAMource: Bloomberg, RBC GAM

PDVSA strike 19,000 employees fired

Chavez inagurated

Chavezdies


the dismantling of the country’s institutions. The judiciary came under presidential control as did the country’s electoral council that oversaw the legitimacy of elections. Press freedom was muzzled. Reporters without Borders ranked Venezuela 137 out of 180 countries in 2015. Mexico and Brazil had managed to successfully introduce poverty alleviating programs without

wheeling spending programs for healthcare, food and education for the poor. Similar programs had been successfully enacted in Mexico and Brazil. Yet the Venezuelan programs came at a price. Within a year of President Chavez’s election, Freedom House5 had downgraded the country from “free” to “partly free” following a referendum that began

5Freedom House is a U.S. based NGO conducting research and advocacy on democracy, political freedom and human rights. It is funded by the U.S. government.

Why, over the last twenty years, when Norway, Saudi Arabia and Russia were building up enormous sovereign wealth funds, did Venezuela run steadily growing budget deficits and sextuple its foreign currency debt, even as oil prices touched US$145? The country, with a population of 31 million, received an estimated $1 trillion in oil revenues over the last 18 years (Exhibit 2).

At the moment, 25% of Venezuelan production goes to domestic sales at wildly subsidized prices. All Venezuelans, whether wealthy or poor, pay less than 1 cent per litre for gasoline. This is a dramatic incentive to smuggle it across borders into Colombia and Brazil. Another 25% goes to China and Russia as debt repayments. Where does the rest of it go?

An oil boom masquerading as a “Bolivarian Socialist Revolution” In politics, timing is everything. Hugo Chavez had the luck to be elected president – with 56% of the vote on a voter turnout of 63%4 – near the post-Asia-crisis nadir in oil prices in December 1998 (Exhibit 3).

An electorate embittered by an indifferent oligarchy voted for his anti-corruption and social inclusion platform. He promised them a “Bolivarian Socialist Revolution.” Venezuelans were understandably enamoured of Chavez’s free-

4Election Guide – Democracy Assistance & Election News

Exhibit 2: Venezuela’s squandered oil wealth

- 100 200 300 400 500 600 700 800 9001,000

0102030405060708090

100

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Cum

ulat

ive

reve

nue

($ b

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enue

($ b

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Yearly revenue (LHS) Cumulative revenue (RHS)Note: Data as of Aug. 31, 2017. Petroleos de Venezuela crude oil basket used for oil price. Crude production is an average of DOE and OPEC data. Source: Bloomberg, RBC GAM

Exhibit 3: Chavez’s regime accompanied a historic boom in oil

10

20

40

80

160

1959 1973 1987 2001 2014

Infla

tion

adju

sted

WTI

pric

e ($

/ ba

rrel

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Note: Data as of Jun. 30, 2017. Price data adjusted using PCE deflator (2009 = 100). Source: Bloomberg, Bondlab, RBC GAM

Jan '99 Chavez

inagurated

Mar '13 Chavez dies

Emerging Markets – Featured Article | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA

An economic travesty has become a social tragedyThe country is a text-book case of economic mismanagement. GDP has plunged more than 40% since 2013. The minimum wage has collapsed more than 88% measured at the black-market foreign exchange rate. People are picking through garbage in search of food. In-patient mortality has risen 10-fold while the death of newborns in hospitals is up 100-fold.7

Multiple exchange-rate regimes permit those with privileged access to buy dollars from the central bank at advantageous prices and then sell them at vast multiples on the black market. Two years ago the black market rate to buy one dollar was 467 bolivares. At the beginning of December it took more than 100,000.8

7Ricardo Hausmann, Venezuela’s Unprecedented Collapse, Project Syndicate August 18,20178www.dolartoday.com


making the institutional sacrifices Venezuela was seeing. Higher spending was accompanied by far lower transparency. Corruption began to skyrocket. Veteran Venezuela analyst Siobhan Morden of Nomura estimates corruption and capital flight have cost the country $300 billion over the past 17 years. Crime increased; most notably the homicide rate which tripled from 1998 to 2015, from 19 per 100,000 people to 57, making Venezuela the third most dangerous country in the world.6

President Chavez began to seize more direct control of national oil company PDVSA, which until then had operated in a reasonably independent and professional manner, in the first years of the new century. Ultimately this led to a strike at PDVSA in 2002 which prompted Chavez to fire 40% of the company’s staff, many of them oil industry experts. Most of them fled the country and their energy expertise went with them. They were replaced by people whose principal qualification was loyalty to the president. The country’s barrels of production per dollar of capex fell from 13 in early 2003 to as low as 1.14 per dollar in 2014 (Exhibit 4).

Yet Venezuelans re-elected President Chavez in 2000, 2006 and 2012. As luck would have it, he would die in 2013 just as the China-driven oil price boom was coming to a close.

6After El Salvador and Honduras, World Bank

Expropriations and political interference have caused domestic production of goods to slump and capital to flee. The country must now import virtually everything it requires, particularly food, prompting intense competition for scarce dollars. Even refined gasoline is imported. Yet as local production of goods has cratered, imports too have collapsed, falling 75% from 2012 to 2016. Analysts estimate they contracted another 15% to the end of August this year. Basic products are imported, the government establishes artificially low regulated prices for them and they are distributed to stores by the military. A military general is Minister for Food. A bakery will pay 2 cents per pound for sugar and then 60 cents for the same pound, separately, as a kickback.9 Estimates are that half of imports are appropriated for the

9Hannah Dreier and Joshua Goodman, Venezuela military trafficking food as country goes hungry, Associated Press, December 28, 2016

Exhibit 4: PDVSA’s CAPEX skyrocketed even as production collapsed

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2003 2005 2007 2009 2011 2013 2015

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Barrels per $ of CAPEX (RHS) CAPEX (LHS)Note: Data as of Jan. 31, 2017. Source: Macrobond, Bloomberg, RBC GAM

Emerging Markets | Jane Lesslie, MSc, CFA | Earl D’Almeida, MBA, CFA


current Vice President, Tarek El Aissami, to the list. On November 2, President Maduro appointed El Aissami as chief debt negotiator for the government.

Perhaps what is most disheartening is that despite all of the burdens that have befallen Venezuelans, ineffective and infighting opposition groups have been unable to arrive at anything resembling a coherent collective strategy.

Venezuela is depending on the “kindness of strangers” Venezuela was able to meet external debt payments last spring only through the “good graces” of Russian state-owned oil company Rosneft. There is little transparency regarding the terms of the transactions with Russia, which amount to some US$6 billion. Similarly, we lack information on the estimated US$19 billion in funding the country has outstanding with Chinese development banks. The country has been shut out of issuance in international capital markets for some time due to its economic deterioration. Instead, the government has relied on selling dollar-denominated debt to locals at an advantageous foreign exchange rate only to have the bonds then leak into international secondary markets at deeply discounted prices.

On August 30, Hausmann published a new article on Project Syndicate. Here he castigated Goldman Sachs Asset Management for reportedly

government or trading new bonds in the secondary market. Treasury’s OFAC10 must issue a license to permit investment banks to participate in a restructuring. It will not issue a license if a restructuring is not approved by Venezuela’s National Assembly.

Confusing as it is the U.S. exports both gasoline and light crude to Venezuela. Venezuela requires light crude to mix with its heavy crude permitting the latter to be transported. In turn, close to 500,000 barrels of Venezuelan oil go to U.S. refiners each day. This puts considerable leverage in U.S. government hands, but using it comes at a cost. The introduction of sanctions has been used as “evidence” by the Venezuelan government that the country is failing, not due to its own ineptitude but as a consequence of a conspiracy by the “Imperialist Americans.” President Maduro’s approval rating rose from 17% to 23% following the U.S. decision.11

Similar “Imperialistic” cries have been raised as the U.S. brought indictments for drug trafficking against the former head of the intelligence service, former anti-drug officials, the former Minister of Defense and the former head of the National Assembly, accusing them of partnering with Colombian and Mexican drug cartels. In February this year, the U.S. added Venezuela’s

10Office of Foreign Assets Control, enforces economic and trade sanctions 11Reuters World News, October 2, 2017

black market, much of which is sold in neighbouring countries.

For years PDVSA has made “social contributions” to the government. In its recent annual report the company noted that from 2015 to 2016 these contributions plunged from US$9.2 billion to US$1 billion as a consequence of buckling oil revenues.

In late July, despite four months of street protests, the Venezuelan government held elections for a new constituent assembly to rewrite the constitution. This was viewed as a broadside against the opposition controlled National Assembly. The election was widely regarded as fraudulent. Twelve nations from the Americas, including Canada, refused to recognize any decision taken by the constituent assembly and further condemned the government for not accepting foreign donations of food and medicine.

The UN recently issued a scathing report charging the government with human-rights abuses and torture by Venezuelan security forces. Opposition leaders have been jailed. Close to 5,000 people have been detained for participating in demonstrations, and 124 demonstrators have been killed this year.

The U.S. Treasury subsequently introduced sanctions, banning U.S. banks from participating in new issues by the Venezuelan


purchasing US$2.8 billion in “hunger bonds” from the Venezuelan national oil company at a deep discount from already low market prices. Hausmann challenged the morality of purchasing such bonds even as the country’s economy collapsed.12

Clearly, Venezuelans have been desperately-ill served by their government. What has happened to investors?

Investors answer the “siren call of the interest carry” From a post oil crash low in January 2015 to early March this year, the Venezuela sub index of the EMBIGD rose more than 150%. Government officials, in order to maintain their grip on power, have chosen to pay bond holders for fear of the steps investors might take to seize the proceeds of oil exports, thus bringing dollar inflows to a halt.

As October came to a close, Venezuelan bonds had fallen 17% from their early spring peak. The total 12-month return on the Venezuela sub-index was -1.4%. However, investors looking more closely would see that while bond prices were down 18.3% over the previous year, interest returns were positive, nearly 21%. Bond holders had been playing the equivalent of Russian roulette with the Venezuelan government. On November 13, with the first defaults, the chamber was finally found to be loaded. For the month of November

12Ricardo Hausmann, Ugo Panizza, Odiousness Ratings for Public Debt, Project Syndicate, August 30, 2017

the Venezuelan subindex fell 29%. The cost to the overall emerging market bond index was 41 basis points. Despite this, the overall index still turned in a modest +0.05% return for the month of November.

In his original May article for Project Syndicate, Hausmann observed that Venezuela represented “only” 5% of the JPMorgan EMBI+ (one widely followed EM bond index) but accounted for 20% of the index’s yield. We employ the JPMorgan Emerging Market Bond Index Global Diversified (EMBIGD) which limits individual country weightings. Venezuela accounted for only 1.42% of our index at the end of October. However, with the country’s bonds carrying yields of more than 30%, this small part of the index contributed nearly 10% of the index’s 5.10% yield. Exhibit 5 illustrates the difference between the yield on the index, with and without Venezuela,

Exhibit 5: Venezuela contributes an ever larger part of index yield as the country approaches collapse

0.00.10.20.30.40.50.60.70.80.91.0

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2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017

Yiel

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nce

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EM (LHS) EM ex Venezuela (LHS) Yield Difference (RHS)Note: Data as of Nov. 2, 2017. Source: Macrobond, JPMorgan, RBC GAM


and how much Venezuela contributed to this yield.

Why we found it hard to jettison VenezuelaWhy don’t we just ignore Venezuela? In part it is driven by that cost of carry, or loss of yield. To try to replace Venezuela’s 30%+ yield contribution to the index at the end of October would have required, for example, increasing the allocation to single B-rated bonds from 21% of the benchmark index to 45% (employing the 6.28% yields prevailing on the single B sector at the end of October).13 We believed it too late in the credit cycle to so dramatically increase the allocation to riskier bonds. Many single B rated bonds are trading near 100 cents on the dollar. Many of these countries also have fundamentals that are deteriorating. Countries in this group, including Angola, Iraq and Pakistan, display social challenges and

13According to Bloomberg Port analytics



Furthermore, countries can make use of restructuring tools that align the interests of investors and citizens. These include warrants that pay out when GDP growth rises above a certain threshold or when oil prices or oil production rise above a particular level. Essentially the country pays more to holders of restructured bonds (who have absorbed principal losses) when it is in a better position to do so.

The historical average recovery value following sovereign defaults was 65 cents on the dollar from 1998 to 2016 according to Moody’s.15 When re-weighted for the size of the issued debt, this falls to 46 cents on the dollar thanks to Argentina, Greece and Russia. Ecuador and Argentina, two serial defaulters, have seen recovery rates as low as 26 and 27 cents respectively. Exhibit 6 illustrates the impact on the Venezuelan sub index and broad index returns using these historic recovery values. Attractive? The catch: will this restructuring occur within the next 12 months or will it take 15 years as it did with Argentina? And during this time – however long – you receive no interest payments and lose the effect of compounding on those interest payments. A second catch: if the current government were to achieve a restructuring without the consent of the National Assembly, then a new government would likely choose to repudiate the restructured debt. And

15Moody’s Investor Service, Sovereign Default and Recovery Rates,1983-2016, June 30, 2017

With the sovereign bonds trading at 21 to 25 cents on the dollar at the end of November, our team would argue that both restructuring and havoc have largely been priced in. The country has been unable to access international capital markets for some time. It has been receiving no foreign direct investment. What the market finds enormously difficult to price is how events will unfold following the default – most critically, with or without more violence and with or without the existing regime.

With a coherent economic policy, international support from multilateral lenders, aid to the many vulnerable in the economy and, yes, a debt restructuring, both citizens and investors could do well. In fact, analysis by our team shows outsize returns by countries as they emerge from restructurings.

Why is this? Well, they exit with lower debt burdens, lower interest costs and maturities extended, thus overall reduced refinancing risk. They have generally adopted better public policies and benefit from IMF oversight. (Venezuela has not undergone an IMF Article IV “audit” since 2004). With this improved outlook and generally high exit yields in line with vulnerable countries, bonds of restructured countries become comparatively attractive.14

14The obvious question would be why don’t more countries restructure? Markets demanding higher risk premiums for countries that default, the risk of having assets seized by creditors, as well as the loss of access to funding both for the sovereign and its banks – all act as deterrents.

indicators that are equal to or worse than those faced by Venezuela. To eliminate the yield differential would have dramatically reduced both the average credit quality and qualitative, or social values, measures for our EM investments overall. In addition to this, we have investment policy limits on how much our average credit quality can be below its benchmark. Lastly, measurements of our active risk relative to the benchmark (tracking error) would increase significantly were we to have simply eliminated Venezuela on its own. Thus while we have been under weight Venezuela for years, except for a brief period following Hugo Chavez’s death when we hoped policies might change, we nonetheless have maintained an allocation. We have emphasized bonds with the lowest price as all bonds tend to trade at similar levels as defaults unfolds. From 2015 on we assumed there would be a restructuring. During an investor trip to Venezuela in 2015 we advised one opposition leader on how they might constructively begin preparing for this.

Putting a price on havocIn his article Hausmann argued:

“Analysts who are bullish on Venezuelan debt have been lobbying the government and opposition leaders with an implied threat. Even considering the restructuring of your bonds, they point out, will allow those managing your assets (sic) to cause havoc in Venezuela.”


what investor would trust the existing government to change its economic spots to stripes?

Hausmann has demanded that JPMorgan eject Venezuela from its various indexes. Unlike many bond indexes, the JPMorgan EMBIGD does not use credit ratings to determine membership but instead employs a Gross National Income (GNI) per-capita ratio measure from the World Bank. To be eligible, countries must have an adjusted GNI below a prescribed level for a minimum of three years. Potential members are also screened for whether pricing is available daily from a third-party vendor. The minimum-issue size for a bond to be included in the index is US$500 million. Even countries that default are not sent into exile. These criteria lead to the amazing result that Mozambique, which defaulted in 2016, delivered returns on its sub-index of well over 15% from January 1 to November 30 in 2017. Very strong inflows to EM bonds, particularly by passive investors who are called upon to simply replicate the benchmark, pushed up the price of the bonds despite Mozambique making no interest payments.

JPMorgan quietly introduced an alternative benchmark, the EMBIGD – ex Venezuela index, in August. But the random elimination of one country from an index does not answer the underlying question of whether there are minimum qualitative standards countries should meet. Venezuela is not the only “offender.” Is the problem with

companies and six “stewardship” principles for U.S. investors.

The challenge is that sovereign governments are not corporations. Equity investors have the right to vote on corporate management’s decisions or the composition of a company board. Sovereign investors do not. Corporate bond investors can take management to court or seize assets should a company default. If a sovereign government defaults, the ability of investors to confiscate assets in order to be repaid is very constrained. Most notably, foreign investors cannot seize central bank foreign exchange reserves. Investors are buying a sovereign government’s track record and promises.

RBC GAM’s emerging-market bond team considers five broad themes when analyzing the 70+ countries that we follow. Together, these themes comprise our Global Fundamental Model (GFM). Among these themes is a 20% weighting in qualitative factors, as opposed to economic or other quantitative measures. While the team had

Exhibit 6: Impact of a Venezuela restructuring

Note: Data as of Nov. 30, 2017. Return refers to the price impact only, assumes a neutral weighting of 1% and no accrued interest. Recovery values from Moody’s. Source: RBC GAM

Impact of a Venezuela restructuring on the index under different recovery values, assuming an average price for index bonds of 23.5 cents

26 cents (Ecuador)

46 cents ($ wtd. avg.)

65 cents (issuer avg.)

Weighted average

Venezuela Sub-Index Return

+10.6% +95.9% +176.6% +94.2%

Impact on Index 4 bps 96 bps 177bps 92 bps


particular countries or does it lie, as we believe, with the index itself?

Can national governments be judged on their “corporate governance”?Even as the popularity of emerging-market investments has grown, so too has the interest of investors in the social impact of the investments they make. Consequently, debates about social values in emerging markets are destined to increase. In August 2015, RBC GAM became a signatory to the UN’s Principles for Responsible Investment. The UN PRI is recognized as the leading global network for investors committed to integrating environmental, social and corporate governance (ESG) considerations into investment practices and ownership policies. RBC GAM is also a founding member of the Canadian Coalition for Good Governance and has recently become a founding member of the U.S. Investor Stewardship Group, providing a set of six corporate-governance principles for U.S.



political risk consultants, the Eurasia Group, which has developed a political-risk rating based on six-month and two-year views. We have adapted this analysis to develop a proprietary scoring model.

• Transparency International’s Corruptions Perceptions Index is published annually. The CPI employs 13 surveys from 12 institutions.

• The MSCI Environmental Score assesses the extent to which a country’s long-term competitiveness is affected by its “ability to protect, harness and supplement its natural resources, and to manage environmental vulnerabilities.” Data comes from the Energy Information Agency, the Central Intelligence Agency and the UN, as well as proprietary work done by MSCI.

small firms, are those that encourage investment, and therefore economic growth.

• The United Nations Human Development Index (HDI) was based on the work of Nobel Laureate Amartya Sen, a development economist. We look to this measure to ask: Is the country improving the quality of life for its citizens? The HDI index measures such things as life expectancy at birth, expected years of schooling for children, average schooling of adults and income per capita. In 2015, the UN took a new step, adjusting this last indicator for income inequality within countries. Note that under both UN scores, Venezuela ranks above median (Exhibit 7).

• We employ The Eurasia Group’s political trajectory from our

long considered public policy and governance risk in its analysis, we refined this approach further in 2015. We believe the best opportunities lie in countries that are on an improving path. We are not looking for “the best,” as risk premiums will be low, but we ARE looking for “the getting better.” So we review both current measures and their trends.

The current components of our team’s qualitative basket are as follows:

• The World Bank’s Ease of Doing Business Survey is published annually. The focus of the survey is a country’s regulatory system, government efficiency and quality of business governance. Countries that create a legal and regulatory framework fostering private enterprise, especially

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

Note: 188 countries, to be above median, must have a rank of 1-94. Looks at three dimensions of human development – long and healthy life, knowledge and decent standard of living. Source: UN HDI

Country HDI rank

End 2015Inequality adjusted

HDI RankIndex score

2015

Avg. ann. % inc. in score

1990 to 2015Chg- HDI rank

2010-2015

Norway 1 1 0.949 0.45% 0

Singapore 5 5 0.925 1.02% 0

Canada 10 12 0.920 0.32% 1

USA 10 20 0.920 0.27% -3

UK 16 17 0.909 0.64% -4

Russia 49 48 0.804 0.37% 5

Venezuela 71 82 0.767 0.76% -4

Mexico 77 89 0.762 0.65% -5

Brazil 79 98 0.754 0.85% 7

China 90 NA 0.738 1.57% 11

India 131 127 0.624 1.52% 4

Rwanda 159 158 0.498 2.89% 4


Bank Ease of Doing Business Survey. It qualitatively leaves regional peer (and oil blessed) Nigeria in its dust. What if a country is engaged in a civil war? Does one invest in Colombia, which has long been in the index but only in the last twelve months emerged from a decades-long conflict with FARC guerrillas? Does a country have to be a democracy? If so, what do you do with China, the world’s second-largest economy? What do you do with countries where democracy is deteriorating, such as Poland and Hungary?

In Exhibit 8 we provide Venezuela’s overall GFM rank as well as the qualitative rank alone. What qualitative score or rank should make a country “un-investable”?

An Odious Index? In August this year, Hausmann argued that countries should carry not only credit ratings, but “odiousness ratings” as well. He


The challenges in scoring social values But a closer look at these indicators betrays their weaknesses and thus the difficulty in trying to “score” or “rank” countries on a social-values scale. One problem is the frequency with which data are published – usually only once a year. Then there is the lag between the time the data is collected and when it is released. For example, in 2017, we are working with reports based on data from the end of 2015 for the UNHDI. While Venezuela has been steadily deteriorating for some time, the UN survey pre-dates the precipitous decline of the past 18 months.

Another issue is subjectivity. Transparency International’s index measures the “perception” of corruption and is based on opinion surveys rather than hard data. Furthermore, not all countries are covered and in some cases the data histories are quite short. We also need to assess how reliable the data is and whether the supplier of the data has a political bias/agenda. Do we ignore U.S. think-tank Freedom House, which measures levels of democracy, freedom and human rights, because it is funded by a national government?

How does one measure a country such as Rwanda? It has a leader with authoritarian leanings but ranks, according to the UNHDI report, among the countries most rapidly improving its citizens’ well-being. It is in the top quartile of countries worldwide, out of 190, in the World

drew on the writings of Alexander Sack, a Russian legal theorist who developed the concept of “odious debt” in 1927 following the First World War.

Sack argued:

“If a despotic power incurs a debt not for the needs or in the interest of the State, but to strengthen its despotic regime, to repress its population that fights against it, this debt is odious for the population of the State…The debt is not an obligation for the nation; it is a regime’s debt, a personal debt of the power that has incurred it.”

However, as some academics have asked, at what point is a regime determined to be “despotic?”16 Venezuelans elected Chavez in 1998, affirmed his policies in a

16Applied Legal History: Demystifying the Doctrine of Odious Debts, Sarah Ludington (Campbell University, Mitu Gulati (Duke University) and Alfred Brophy (University of North Carolina at Chapel Hill ).

Exhibit 8: Venezuela’s qualitative rankings relative to 69 peers EM Country Universe

Note: Data as of Oct. 17, 2017. *Joint with two other countries. **Joint with eight other countries. Source: RBC GAM

Overall Global Fundamental Rank 65 / 70

Qualitative Ranking Only 65 / 70

Comprised of:

World Bank Ease of Doing Business rank 70 / 70*

Transparency International Corruptions Perception Index 67 / 69

UN Inequality – Adjusted Human Development Index 29 / 62

MSCI Environmental Risk rank 26 / 70

Eurasia Group Political Trajectory Rank 55 / 55**



Source: RBC GAM

Credit Quality

After onset of QEMar. 2009 -

Nov. 30, 2017

Pre crisis peakJun. 2007 -

Nov. 30, 2017

Crisis (peak to trough)

Jun. 2007 - Mar. 2009

A 69.9 84 8.3

BBB 95.6 99.39 1.9

BB 150.9 139.4 -4.6

B 216.3 122.2 -29.7

CCC-C 114.5 -71.9 -86.9

Venezuela 102.5 41.29 -30.2

EMBIGD 119.8 111.2 -3.9

before the financial crisis at the end of June 2007, when risk premiums were at historic lows?

Total returns for B rated bonds and below are materially reduced. Venezuela’s is reduced by 60% and CCC and below falls into negative territory. The index by comparison sees its total return reduced from 119.8% to 111.2%. In the second

Exhibit 10 illustrates in the first column the returns on various credit quality tiers for the period from the low of March 2009 when quantitative easing began in earnest to the end of November this year. Poorer quality bonds have generally outperformed the broad index.

Now what if we look through the financial cycle from immediately

1999 referendum and repeatedly re-elected him until his death in 2013. And yet Freedom House had been downgrading the country since 1999 (Exhibit 9).

Lee Buchheit, one of the best attorneys and legal scholars on the subject of sovereign debt restructurings, poses another question17:

“Someone must assume the task of painting a scarlet letter “O” on a great many regimes around the world. Who will make this assessment of odiousness and on what criteria?”

Who indeed would undertake this Solomon-like decision? Rating Agencies? The UN Security Council? The UN Human Rights Council? Past members of the UNHRC have included Saudi Arabia and Libya under Muammar Gaddafi!

Do investors care about social values? Perhaps the most fundamental question Hausman posed in “The Hunger Bonds” was: Do investors really care about social values? At first glance, the answer seems to be “no” for many investors.

Exhibit 9 shows the risk premium was falling during the second period the country was declared “partly free” by Freedom House. Similarly, rating agencies ignored this democratic decline.

17Lee Buchheit, Mitu Gulati, Robert Thompson, The Dilemma of Odious Debt, Duke University Law Journal, March 2007.

Exhibit 9: Venezuela in crisis – Markets and rating agencies slow to react to democratic decline

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1993 1997 2001 2005 2009 2013 2017

Ris

k pr

emiu

m (b

ps)

Risk premium (LHS) S&P credit rating (RHS)

FreePartly free

Partly free

BB

B+

B

B-

CCC+

CCC

CCC-

SD

Note: Data as of Sep. 1, 2017. Source: Bloomberg, RBC GAM

Notfree

Exhibit 10: Cumulative returns (%)


column the BB sector with a return of 139.4% is the standout throughout this period.

Now let’s look at the magnitude of the decline from the June 2007 peak prior to the financial crisis to its depths in March 2009 in the third column. The index is down 3.9% through the period, while Venezuela is down 30.2%. Single B’s broadly are down 29.7%, while CCC’s and below are down 86.9%. When times are tough, quality counts.

Clearly these returns are not about qualitative indicators alone. However, looking at our Global Fundamental Model scores and our Qualitative scores in Exhibit 11 it is intriguing to observe that the difference between the AA&A rated bucket and the bottom credit bucket is more pronounced for the Qualitative score alone than for the broader GFM score alone.

Four strong winds: EM bond investors are being herded by liquiditySo investors don’t care? In fact we would argue that dedicated active EM investors like ourselves who would otherwise decline to own fixed-income securities issued by countries such as Venezuela are being thwarted by four key factors:

1. Waves of quantitative easing by multiple central banks since late 2008 have left government-bond yields negative in many countries and investors grasping for yield. As of November 30 US$9.2 trillion


Note: Data as of Oct. 17, 2017. Source: RBC GAM

in bonds around the world, or nearly 23% of all outstanding bonds, were trading at negative yields (Exhibit 12). According to JPMorgan, total investment flows into emerging-market investments to the end of November have amounted to more than US$170 billion – multiples of last year for the same period.

2. Issuers that would have been penalized by markets for poor economic and social policies

have been shielded by waves of Chinese state-owned bank lending as the country sought to secure commodity supplies and increase its geopolitical reach. Russia has acted similarly. Official sector lenders such as the IMF normally impose “conditionality” or require policy changes to improve the economy’s recovery chances in exchange for loans. No such demands are in evidence with these bilateral

Exhibit 11: Comparison of RBC GAM Global Fundamental Model (GFM) score to qualitative score only

Overall (GFM) score

Qualitative score only

AA & A 6.10 7.10

BBB 5.04 5.60

BB 4.67 4.95

B 3.90 4.03

≤ CCC 3.80 4.13

Exhibit 12: A growing number of bonds have negative yields

0

10

20

30

40

50

60

2014 2015 2016 2017 2018

US

D (t

rillio

ns)

Bonds trading at positve interest rates Bonds trading at negative interest ratesNote: Data as of Nov. 30, 2017. Source: Bloomberg, Deutsche Bank, RBC GAM



Some social values indicators under stress, even as débutante issuers multiplySocial value indicators are under threat in many emerging markets. Freedom House’s report18 of a trend away from democracy over the last 10 years is particularly striking (Exhibit 14).

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

Russia seized the Crimea region of southern Ukraine. Markets now seem to “assume” that all countries seeking IMF support will receive it.

These successive waves of liquidity, real or expected, have propped up riskier bets in emerging markets, postponing the day of reckoning for poor policy choices.

loans. Chinese loans now dwarf those from official sector lenders (Exhibit 13). Both Russia and China have recently rescheduled their loans to Venezuela.

3. Passive indexes, which account for a significant share of inflows to EM bonds, do not employ any screening, much less screen for social shortcomings. If Venezuela makes up 5% of the EMBI+ index, passive ETF investors will invest that same percentage automatically. The effect is particularly pronounced on smaller country issuers. In a recent report, Citigroup noted that passive investment in emerging-market assets has grown from just over 12% two years ago to nearly 19% today.

4. Lastly, markets have come to believe that the IMF will lend under virtually any circumstances. Traditionally, the IMF was seen as a task master demanding stringent conditions in exchange for loans. However, the fund lost credibility with markets in recent years after it continued to lend to Greece and Ukraine amid unsustainable conditions, a breach of its own guidelines. The IMF may have done so in Greece out of fear for Europe’s financial system and potential contagion risk. For Ukraine the decision was complicated by geopolitics after

Exhibit 13: Chinese state-owned banks fund growth in developing countries with fewer restrictions

0 200 400 600

African Development Bank

European Bank forReconstruction and Development

European Investment Bank

Inter AmericanDevelopment Bank

Asian Development Bank

World Bank

China Development Bank &Export Import Bank of China

Global assets ($ bn)Note: Data as of May, 2016. Source: Boston University – Global Economic Governance Initiative, RBC GAM

Exhibit 14: Net declines in “freedom” scores have outnumbered gains

30354045505560657075

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Num

ber o

f cou

ntrie

s

Improved DeclinedNote: Data as of Dec. 31, 2016. Source: Freedom House, RBC GAM


A look at the Emerging Market Bond Index suggests overall sovereign credit quality has been falling (Exhibit 15). However, there are two forces at work. It’s true that credit quality has been declining with some countries, such as Brazil and Turkey losing their investment-grade status. However, at the same time it is worth considering the growth in the sheer number of issuers in recent years, most of which have been poorer-quality governments. At the end of 2007 the number of countries in the EMBIGD index was 38. Today it is 67. Similarly, the number of sovereign governments covered by Moody’s grew from 71 in 1996 to 132 by the end of 2016.19

Strong commodity markets and abundant liquidity warranted increased investor attention to many new issuers. Many African countries and some Latin American countries were newly rated having undergone Highly Indebted Poor Country (HIPC) debt relief from the official sector. Here lenders such as the IMF and World Bank forgave debt in exchange for improved economic policies, notably an increase in spending on poverty-reduction measures. This was enacted as part of the United Nations’ Millennium Development Goals.

A recent long-term default study from Moody’s determined that the median rating of countries one year prior to default was B2, five notches below the lowest investment-grade

19Moody’s Investor Service, Sovereign Default and Recovery Rates, 1983-2016, June 30, 2017

rating. Single B countries now represent 31% of rated sovereigns, the single largest credit tier in the sovereign spectrum as Exhibit 16 illustrates.

This is not to criticize emerging-markets generally. It is worth comparing the quality of the most widely followed emerging-market equity index (MSCI EM Equity) versus

that for emerging-market bonds (JPMorgan EMBIGD). In the case of the equity index, close to 62% of the index carries a credit rating of A or above, with more than 80% rated investment grade (Venezuela is not part of the EM equity index). By contrast, only 48% of the EM bond index is rated investment grade (Exhibit 17).


Exhibit 15: Quality breakdown of EMBI global diversified

0%10%20%30%40%50%60%70%80%90%

100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Wei

ght i

n in

dex

AA A BBB BB B CCC and belowNote: Data as of Nov. 30, 2017. Source: JPMorgan, RBC GAM

Exhibit 16: Distribution of foreign ratings from 1995 to 2016 (%)

Source: Moody’s investor services, RBC GAM

Rating 1995 2005 2016

Aaa 18% 20% 9%

Aa 24% 7% 12%

A 18% 22% 13%

Baa 18% 14% 16%

Ba 16% 16% 12%

B 5% 16% 31%

Caa-C 0% 5% 7%

Investment Grade 78% 63% 50%

Speculative Grade 22% 37% 50%



Exhibit 17: Country level credit rating comparison of EM bonds (EMBIG div. Index) and EM equities (MSCI EM Index)

0

12.3

35.9

22.825.5

3.4

28.2

34.9

18.3 18.1

0.5 0.00

5

10

15

20

25

30

35

40

AA A BBB BB B < B & notrated

inde

x w

eigh

t (%

)

EM bonds EM equitiesNote: Data as of Nov. 30, 2017. The same methodology used to construct EMBIG Div credit buckets was used for the MSCI index. Source: JP Morgan, MSCI, S&P, Moodys, Fitc

A “doing well by doing good” benchmark?So what have we determined? Well, we know that default rates are sharply higher for countries rated B2 and below relative to their higher-rated brethren and that single-B-rated countries have proliferated. We have seen that the sweet spot through a cycle has been in the BB area; and drawdowns are less pronounced in bad times for those rated BB and above. We also know that there is an association between higher qualitative or social ratings and higher credit quality.

Hausmann has recommended that JPMorgan introduce a “Decent Emerging Markets Index,” or “DEM Index adhering to minimal standards of respect for (EM country) citizens.” In principle, we agree with him. The existing index is indiscriminate. It does not serve investors in the long term and it is certainly not serving the interests of EM country citizens. In the meantime, international investors have little leverage over

these countries’ decisions and are driven by widely referenced benchmarks against which they and their peers are measured. Passive investors simply amplify the effect.

However, given the challenges we have noted in applying indicators that measure social values, the path to such an index is by no means clear. Perhaps, as qualitative indicators mature and there is sufficient data to infer sound conclusions, this will come about.

Once it could credibly be created, a DEM index would guide investors toward countries making decisions with the well-being of their citizens in mind. It would also incentivize countries with lower levels of social capital to improve outcomes for their citizens in order to be included in such an index and thereby gain access to additional international funding.

Or as Hausmann puts it: “You could do well, without feeling bad.”



Daniel E. Chornous, CFA

Chief Investment Officer RBC Global Asset Management

Chair, RBC GAM Investment Strategy Committee

Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc., which has total assets under management of approximately $403 billion. Mr. Chornous is responsible for the overall direction of investment policy and fund management. In addition, he chairs the RBC Investment Strategy Committee, the group responsible for global asset-mix recommendations and global-fixed income and equity portfolio construction for use in RBC Wealth Management’s key client groups including retail mutual funds, International Wealth Management, RBC Dominion Securities Inc. and RBC Phillips, Hager & North Investment Counsel Inc. He also serves on the Board of Directors of the Canadian Coalition for Good Governance and is Chair of its Public Policy Committee. Prior to joining RBC Asset Management in November 2002, Mr. Chornous was Managing Director, Capital Markets Research and Chief Investment Strategist at RBC Capital Markets. In that role, he was responsible for developing the firm’s outlook for global and domestic economies and capital markets as well as managing the firm’s global economics, technical and quantitative research teams.

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

As Head of Global Fixed Income and Currencies at RBC Global Asset Management, Dagmara leads investment teams in Toronto, London and Minneapolis in charge of almost $100 billion in fixed income assets. In her duties as a portfolio manager, Dagmara heads management of several bond funds, manages foreign-exchange hedging and active currency overlay programs across a number of funds. Dagmara chairs the Fixed Income Strategy Committee. She is also a member of the Investment Policy Committee, which determines asset mix for balanced and multi-strategy products, and the RBC Investment Strategy Committee. In 2016, she was appointed to the RBC GAM Executive Committee. Dagmara, who began her investment career in 1994, holds an MBA from the Richard Ivey School of Business in Canada and a Master’s degree in economics from the University of Lodz in Poland. Dagmara has been a CFA charterholder since 1997.

Members


Stu co-leads the North American Equity team and is a member of the RBC GAM Investment Strategy Committee, which is responsible for establishing the firm-wide global asset mix for mutual funds and for institutional and high net worth private clients. Stu began his career in 1996 with RBC Dominion Securities in the firm’s Generalist program, a two-year internship in which participants rotate through different areas of the firm. In 1998, he joined the RBC Investments Portfolio Advisory Group, which provides investment ideas and recommendations to RBC DS Investment Advisors. He was also a member of the RBC DS strategy & focus list committees. Stu has been with the firm since 2002 and is a CFA charterholder.

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

Dagmara Fijalkowski, MBA, CFA

Head, Global Fixed Income & Currencies RBC Global Asset Management

Eric Lascelles

Chief Economist RBC Global Asset Management

Stephen Burke, PhD, CFA

Vice President and Portfolio Manager RBC Global Asset Management

Stuart Kedwell, CFA

Senior Vice President and Senior Portfolio Manager RBC Global Asset Management


RBC Global Asset Management

William E. (Bill) Tilford

Head, Quantitative Investments RBC Global Asset Management

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

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

Sarah Riopelle, CFA

Vice President and Senior Portfolio Manager RBC Global Asset Management

Milos Vukovic, CFA

Vice President, Investment Policy RBC Global Asset Management

Brad Willock joined RBC Global Asset Management in July 2002 and is a Senior Portfolio Manager and CFA charterholder. In his current role, Brad has responsibility for RBC Global Asset Management’s core and income-oriented U.S. equity strategies. He joined RBC in May 1996 after receiving a bachelor’s of commerce degree with distinction from the University of Calgary. Prior to that, Brad obtained a bachelor’s of science degree at the University of British Columbia and represented Canada at the 1992 Barcelona Summer Olympics in volleyball.

Martin Paleczny, CFA


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

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

Hanif Mamdani

Head of Alternative Investments RBC Global Asset Management

Brad Willock, CFA


Milos, who joined RBC in 2003, oversees investment-management activities including new-fund launches, performance analytics and trade-cost analysis. He is also responsible for developing and monitoring investment mandates and implementing tactical asset allocation for the RBC GAM investment solutions. Milos earlier worked for a Big 4 accounting firm and two top-tier securities firms. He earned an MBA at the Schulich School of Business and has held the CFA designation since 2004. He is a board member of both the Canadian Buy-Side Investment Management Association and the Canadian Advocacy Council for Canadian CFA Institute Societies, and recently joined IIROC’s Market Structure Advisory Committee.


RBC Global Asset Management

> Philippe Langham Head & Senior Portfolio Manager,

Emerging Market Equities RBC Global Asset Management (UK) Limited

> Brad Willock, CFA V.P. & Senior Portfolio Manager,

North American Equities RBC Global Asset Management Inc.

> Mayur Nallamala Head & Senior V.P., Asian Equities

RBC Investment Management (Asia) Limited

> Martin Paleczny, CFA V.P. & Senior Portfolio Manager,

Asset Allocation & Derivatives RBC Global Asset Management Inc.

> Dominic Wallington Head, European Equities &

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

> Dagmara Fijalkowski, MBA, CFA Head, Global Fixed Income & Currencies

RBC Global Asset Management Inc.

> Soo Boo Cheah, MBA, CFA Senior Portfolio Manager,

Global Fixed Income & Currencies RBC Global Asset Management (UK) Limited

> Suzanne Gaynor V.P. & Senior Portfolio Manager, Global

Fixed Income & Currencies RBC Global Asset Management Inc.

GLOBAL EQUITY ADVISORY COMMITTEE

> Eric Lascelles Chief Economist

RBC Global Asset Management Inc.

GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE

This report has been provided by RBC Global Asset Management (RBC GAM) for informational purposes only and may not be reproduced, distributed or published without the written consent of RBC Global Asset Management Inc. (RBC GAM Inc.). In Canada, this report is provided by RBC GAM Inc. (including Phillips, Hager & North Investment Management). In the United States, this report is provided by RBC Global Asset Management (U.S.) Inc., a federally registered investment adviser. In Europe, this report is provided by RBC Global Asset Management (UK) Limited, which is authorised and regulated by the UK Financial Conduct Authority. In Asia, this document is provided by RBC Investment Management (Asia) Limited, which is registered with the Securities and Futures Commission (SFC) in Hong Kong.

RBC GAM is the asset management division of Royal Bank of Canada (RBC) which includes RBC GAM Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, the asset management division of RBC Investment Management (Asia) Limited, and BlueBay Asset Management LLP, which are separate, but affiliated subsidiaries of RBC.

This report has not been reviewed by, and is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the above-listed entities in their respective jurisdictions. Additional information about RBC GAM may be found at www.rbcgam.com.

This report is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. The investment process as described in this report may change over time. The characteristics set forth in this report are intended as a general illustration of some of the criteria considered in selecting securities for client portfolios. Not all investments in a client portfolio will meet such criteria. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. 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 RBC GAM’s judgment as of December 15, 2017, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates and market conditions are subject to change.

Return estimates are for illustrative purposes only and are not a prediction of returns. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. It is not possible to invest directly in an unmanaged index.

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.

DISCLOSURE

®/TM Trademark(s) of Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2017.

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the global investment outlook

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