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The Global Investment Outlook 

RBC Investment Strategy Committee 

SUMMER 2012 

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The RBC Investment Strategy Committee 

The RBC Investment Strategy Committee consists of senior investment professionals drawn from 

individual client focused business units within RBC. The Committee regularly receives economic 

and capital markets related input from internal and external sources. Important guidance is 

provided by the Committee’s regional advisors (North America, Europe, Far East), from the Global 

Fixed Income & Currencies Subcommittee and from the global equity sector heads (financials and 

healthcare, consumer discretionary and consumer staples, industrials and utilities, energy and 

materials, telecommunications and technology). From this it builds a detailed global investment 

forecast looking one year forward. 

The Committee’s view includes an assessment of global fiscal and monetary conditions, 

projected economic growth and inflation, as well as the expected course of interest rates, major 

currencies, corporate profits and stock prices. 

From this global forecast, the RBC Investment Strategy Committee develops specific guidelines 

that can be used to manage portfolios. 

These include: 

• the recommended mix of cash, fixed income instruments, and equities 

• the recommended global exposure of fixed income and equity portfolios 

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• 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.

Contents 

Executive Summary 2 

The Global Investment Outlook 

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

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

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

Economic & Capital Markets Forecasts 4 


Recommended Asset Mix 5 


Capital Markets Performance 8 

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

Global Investment Outlook 11 

Summer washout 

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

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

John Richards – Investment Strategy Research Analyst, RBC Global Asset Management Inc. 

Global Fixed Income Markets 34 

Soo Boo Cheah, CFA – Senior Portfolio Manager, RBC Asset Management UK Limited 

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

Currency Markets 43 

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

RBC Global Asset Management Inc. 

Regional Equity Market Outlook 

United States 54 

Raymond Mawhinney – Senior V.P. & Senior Portfolio Manager, RBC Global Asset Management Inc. 

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

Canada 56 

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

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Europe 58 

Dominic Wallington – Chief Investment Officer & Chief Executive Officer, 

RBC Asset Management UK Limited 

Asia 60 

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

Emerging Markets 62 

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

RBC Investment Strategy Committee 64 

The global investment outlook RBC INVESTMENT Strategy coMMITTEE Summer 2012 I 1

Executive Summary 

Sarah Riopelle, CFA 

V.P. & Senior Portfolio Manager 


While it is true that economic data is weakening, global risks are growing, and market confidence is faltering, these 

grim comments need to be put into context. Conditions aren’t all bad. Recession remains unlikely outside of Europe 

and long-standing American economic dysfunctions are beginning to heal. Enormous risks abound and should not 

be idly discounted, but we do not ultimately expect most of them to transpire. Should these risks eventually be 

swept aside, past experience demonstrates that markets can perform decently even if underlying economic growth 

is merely sluggish. 

Economic data falters, but 

all is not lost 

The extent of the economic 

downshifting varies by country, but 

spans the bulk of economic indicators 

and nations. Even as the economic 

outlook has deteriorated, we have held 

mostly firm with our own forecasts. This 

is not due to neglect or obstinacy, but 

rather because our forecasts already 

capture the weakening state of affairs. 

We continue to have a more sluggish 

outlook than the consensus, and so are 

able to hold fast to our prior convictions 

even as others scramble to downgrade 

their views. Our 2013 economic outlook 

is higher on an absolute basis, yet is 

even further below consensus given 

our belief that fiscal drags will apply 

themselves with greater conviction next 

year in the U.S., Europe’s recession 

does not look to be easily solved, 

and slow growth remains the mantra 

in a post-crisis world of deleveraging 

banks, businesses, households and 

governments. 

Although most nations are suffering 

through a period of decelerating 

economic activity, we must make an 

important distinction between Europe 

and the rest of the world. Europe is 

suffering far more than other regions 

and has now indisputably tumbled into 

Eric Lascelles 

Chief Economist 


recession. The trio of fiscal austerity, 

rock-bottom confidence and weakening 

credit have seen to that. We believe the 

odds of a Greek exit from the Eurozone 

have risen notably, but remain well 

under 50%. Nonetheless, exit is no 

longer absurd to contemplate. No 

one wants this, and so quite a lot of 

firepower will be used to avoid this fate. 

We reiterate that while this scenario is 

difficult to imagine, it also constitutes 

a central reason why a Greek exit 

remains unlikely: nobody wants the 

consequences. 

The U.S. economy has slowed in 

recent months but, at the same time, 

several dysfunctional elements of the 

economy have become rather less 

dysfunctional. Confidence is back 

in a big way, even if it has not fully 

translated into risk appetite. The U.S. 

labour market is beginning to turn, 

the U.S. credit market is showing 

improvement as banks extend loans 

to consumers and businesses, and the 

U.S. housing market has very likely 

bottomed. For all of the good work 

the U.S. economy has managed, there 

are two late-blooming and somewhat 

intertwined fiscal risks that could cast 

a dark shadow over the end of 2012. 

The first is the U.S. debt ceiling, which 

will likely present itself again sometime 

in November. The second is the arrival 

Daniel E. Chornous, CFA 

Chief Investment Officer 


of an unprecedented “fiscal cliff” at the 

end of 2012 which could result in the 

U.S. economy shedding about three 

percentage points of economic growth. 

This yawning gap marks the difference 

between solid growth and the cusp of 

a recession. Our view is that politicians 

will come to their senses and ensure 

that some portion of this fiscal drag is 

delayed, but a substantial impact will 

still be felt in 2013. 

Continue to favour U.S. dollar 

based on valuation and safehaven 

qualities 

The recent performance of the U.S. 

dollar has been better than many 

expected with the greenback inching 

higher from the all-time lows of a year 

ago. The slow appreciation fits with the 

gradually improving domestic economy. 

We continue to favour the U.S. dollar for 

its attractive long-term valuations and, 

in the short-term, for its safe-haven 

qualities. The euro base case is one 

of slow depreciation, although the tail 

risk of a Greek exit, even if it is orderly, 

would bring about a faster decline. The 

Canadian dollar remains the global 

growth proxy, negatively correlated 

to the performance of U.S. equities. 

Importantly, when the “loonie” exceeds 

parity with the U.S. dollar, adding 

the greenback to Canadian dollar 

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2 I The global investment outlook RBC INVESTMENT Strategy coMMITTEE Summer 2012

Executive summary • Sarah Riopelle, CFA • Eric Lascelles • Daniel E. Chornous, CFA 

portfolios provides some valuable 

tail risk insurance. In these uncertain 

markets, with low risk limits imposed 

on many trading institutions, headlines 

frequently cause short covering rallies 

in currencies that had been losing 

ground against the U.S. dollar. Such 

volatility presents opportunities for 

more tactical traders to add to or 

re-establish long U.S. dollar positions. 

Longer-term investors should take 

advantage of it as well. 

Inflation under control and 

short-rates remain low 

Inflation has been remarkably well 

behaved in recent years. In fairness, 

it has occasionally flitted higher 

than normal on the back of sporadic 

commodity spikes, but these have 

always unwound, as is now happening. 

We expect inflation to remain 

controlled, and perhaps even subdued. 

Central banks remain resolute in their 

support of global economic growth. 

With few exceptions, they are either in 

the process of delivering more stimulus 

or holding interest rates extremely 

low. This is unlikely to change in the 

near term, as economies slow and 

fiscal policy becomes less amenable to 

growth. The U.S. Federal Reserve Board 

may yet deliver more stimulus should 

global conditions deteriorate, though 

this depends greatly on the progression 

of the economy and inflation, and 

is not presently a component of our 

base case. The Bank of Canada is an 

outlier among advanced nations given 

its hawkish tilt, but this is not entirely 

inappropriate given the state of the 

Canadian economy. The question is 

whether the global economy will permit 

such action this year, or force a rain 

date in 2013. 

Upside risks to bond yields 

remain 

Bond yields remain strikingly low and 

the recent trend has been toward 

even lower yields as European fears 

mount. Unorthodox monetary policy, 

aimed at stimulating the economy 

through targeting low policy rates 

and providing liquidity to the market 

through bond purchases, is clearly 

an important factor. This is referred 

to as “financial repression” and 

reflects central bankers’ desire to hold 

yields at massively stimulative levels. 

Simply put, central banks continue to 

dominate the bond market. Ultimately, 

in an environment where this level 

of stimulus is no longer needed or 

appropriate, the path for interest rates 

will reverse to the upside. 

Equities fall from cycle highs, 

but valuations are supportive 

The past three months have been 

difficult for equity markets. Many of 

the indexes that reached cycle highs 

by the end of the first quarter of 2012 

have since erased a large portion of 

those gains. The S&P 500 Index is a 

good proxy for both the dynamics of 

the near-term trading range for global 

equity markets and for longer-term 

return potential. Current levels of 

economic growth, corporate profits 

and confidence indicate a range 

of 1200 to 1400 for the S&P 500, 

although valid scenarios certainly 

exist suggesting outcomes both above 

and below these levels. Drops below 

1200 would likely come if investors 

see a significant threat to earnings, 

or worse, if that was combined with a 

shock to confidence. A break through 

the upper boundary of 1400 would 

require the market P/E to rise closer 

to equilibrium than it has been since 

the financial crisis or, alternatively, a 

view that earnings will exceed current 

forecasts by a meaningful amount. In 

the meantime, we have been taking 

advantage of volatility within this range, 

with tactical management of cash and 

stock exposure, and will continue to 

do so until some of the bigger issues 

threatening the recovery begin to 

resolve themselves. 

Remain overweight stocks, 

underweight bonds 

Threats to the global economy have 

hit sentiment hard, driving down 

equity-market valuations while causing 

investors to bid up government bonds. 

Given the risks, it is unlikely that 

yields will normalize in the near term, 

but barring another severe recession, 

we believe they will eventually move 

higher resulting in capital losses 

for fixed-income investors. In this 

uncertain environment, record-high 

corporate profits have been going 

largely unrewarded, providing an 

attractive investment opportunity 

should risk aversion subside. While 

stock markets are highly unlikely to 

jump to fair value in the short term, at 

current depressed levels potential longterm 

returns are compelling. Since the 

last edition of the Global Investment 

Outlook, we have made a number of 

changes to our tactical asset mix. We 

continue to overweight equities and 

underweight bonds, and these trades 

have simply moderated the degree of 

these exposures. For a balanced global 

investor, we recommend an asset mix 

of 59.5% equities (versus a neutral 

level of 55%), 35% bonds (versus a 

neutral level of 40%) with a balance of 

5.5% cash. 

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Economic & Capital Markets Forecasts 

Real GDP 

Currency Markets against usd 

Targets (RBC Investment Strategy Committee) 

June 2012 

Forecast 

May 2013 

Change from 

Spring 2012 

1-Year Total Return 

Estimate (%) 

USD–CAD 1.04 1.04 N/C 0.7 

EUR–USD 1.24 1.20 N/C (2.5) 

USD–JPY 78.06 83.00 N/C (6.4) 

GBP–USD 1.54 1.62 0.02 6.3 

Fixed Income Markets 

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

U.S. 10-Year Bond 1.45 2.75 0.25 (9.8) 

Canada Overnight Rate 1.00 1.50 0.50 N/A 

Canada 10-Year Bond 1.63 3.00 0.25 (10.1) 

Eurozone Policy Rate 1.00 0.50 N/C N/A 

Germany 10-Year Bund 1.17 2.00 (0.50) (6.3) 

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

U.K. 10-Year Gilt 1.53 2.25 (0.25) (4.8) 

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

Japan 10-Year Bond 0.82 1.10 (0.15) (1.9) 

Equity Markets 

S&P 500 1278 1450 N/C 15.6 

S&P/TSX Composite 11361 12750 (500) 15.1 

MSCI Europe 1143 1375 (60) 25.3 

FTSE 100 5260 6100 (200) 20.0 

Nikkei 8440 9650 (50) 16.6 

MSCI Emerging Markets 894 1125 (75) 28.9 

Source: RBC GAM 

Summer 

2012 

Economic forecast (RBC Investment Strategy Committee) 

United 

States Canada Europe 

Change 

from 

Spring 

2012 

Summer 

2012 

Change 

from 

Spring 

2012 

Summer 

2012 

Change 

from 

Spring 

2012 

United 

Kingdom Japan CHINA 

Summer 

2012 

Change 

from 

Spring 

2012 

Summer 

2012 

Change 

from 

Spring 

2012 

Summer 

2012 

Change 

from 

Spring 

2012 

Emerging 

markets 1 

Summer 

2012 

2011A 1.72% 2.50% 1.50% 0.70% (0.70%) 9.20% 6.71% 

2012E 2.00% N/C 2.00% N/C (0.75%) (0.25) 0.25% (0.25) 1.75% N/C 8.25% N/C 6.00% N/C 

2013E 2.00% N/C 2.00% (0.25) 0.50% N/C 1.50% N/C 1.50% N/C 8.00% N/C 6.00% N/C 

CPI 

2011A 3.14% 2.90% 2.71% 4.48% (0.28%) 5.53% 6.21% 

2012E 2.25% 0.50 2.25% 0.25 2.25% 0.75 2.75% N/C 0.50% 0.50 3.50% N/C 4.75% (0.25) 

2013E 1.75% N/C 2.00% N/C 1.50% N/C 2.00% N/C 0.50% 0.50 3.50% N/C 4.25% N/C 

A = Actual E = Estimate 

1 GDP Weighted Average of China, India, Brazil, Russia, South Korea and Mexico 

Change 

from 

Spring 

2012 

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Recommended Asset Mix 

Asset mix – the allocation within 

portfolios to stocks, bonds and cash 

– should include both strategic and 

tactical elements. Strategic asset mix 

addresses the blend of the major asset 

classes offering the risk/return tradeoff 

best suited to an investor’s profile. It 

can be considered to be the benchmark 

investment plan that anchors a portfolio 

through many business and investment 

cycles, independent of a near-term view 

of the prospects for the economy and 

related expectations for capital markets. 

Tactical asset allocation refers to fine 

tuning around the strategic setting in an 

effort to add value by taking advantage 

of shorter term fluctuations in markets. 

Every individual has differing return 

expectations and tolerances for 

volatility, so there is no “one size fits 

all” strategic asset mix. Based on a 

35-year study of historical returns 

and the volatility of returns (the range 

around the average return within which 

shorter-term results tend to fall), we 

have developed five broad profiles 

and assigned a benchmark strategic 

asset mix for each. These profiles 

range from very conservative through 

balanced to aggressive growth. It goes 

without saying that as investors accept 

increasing levels of volatility, and 

therefore greater risk that the actual 

experience will depart from the longerterm 

norm, the potential for returns 

rises. The five profiles presented below 

may assist investors in selecting a 

strategic asset mix best aligned to their 

investment goals. 

Each quarter, the RBC Investment 

Strategy Committee publishes a 

recommended asset mix based on 

our current view of the economy and 

return expectations for the major asset 

classes. These weights are further 

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, 

40% fixed income, 5% cash. 

A tactical range of +/- 15% around the 

benchmark position allows us to raise or 

lower exposure to specific asset classes 

Global Asset Mix 

Benchmark 

Policy 

Past 

Range 

Spring 

2012 

March 28, April 16, 

2012 2012 

May 10, 

2012 

Summer 

2012 

Cash 5.0% 1.5% – 16% 7.5% 6.5% 6.5% 6.5% 5.5% 

Bonds 40.0% 25% – 54% 35.0% 37.0% 36.0% 35.0% 35.0% 

Stocks 55.0% 36% – 65% 57.5% 56.5% 57.5% 58.5% 59.5% 

Regional Allocation 

Global Bonds 

CWGBI* 

May 2012 

Past 

Range 

Summer 

2011 

FALL 

2011 

New year 

2012 

Spring 

2012 

Summer 

2012 

North America 32.5% 18% – 37% 34.8% 35.0% 33.7% 36.9% 29.5% 

Europe 35.3% 32% – 56% 35.8% 34.5% 31.7% 32.6% 35.3% 

Asia 32.2% 20% – 35% 29.5% 30.5% 34.6% 30.5% 35.3% 

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

MSCI** Past 

Global Equities 

May 2012 Range 

FALL 

2011 

New year 

2012 

Spring 

2012 

April 16, 

2012 

Summer 

2012 

North America 58.5% 51% – 60% 56.0% 58.3% 58.8% 57.0% 59.5% 

Europe 23.5% 23% – 35% 24.3% 23.3% 23.3% 24.1% 22.8% 

Asia 12.6% 10% – 18% 13.3% 12.5% 12.0% 12.9% 11.5% 

Emerging Markets 5.5% 0% – 6.5% 6.5% 6.0% 6.0% 6.0% 6.3% 

Global Equity sector allocation 

MSCI** 

May 2012 

RBC ISC 

Spring 2012 

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. If, for example, the 

recommended current equity exposure 

for the Balanced profile is set at 62.5% 

RBC ISC Change FROM 

summer 2012 spring 2012 

Continued on next page... 

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WEIGHT vs. 

BENCHMARK 

Energy 10.97% 11.46% 10.00% (1.46) 91.15% 

Materials 7.09% 7.68% 7.00% (0.68) 98.76% 

Industrials 11.00% 13.30% 11.00% (2.30) 100.00% 

Consumer Discretionary 10.98% 11.54% 12.25% 0.71 111.58% 

Consumer Staples 10.80% 10.31% 11.80% 1.48 109.26% 

Health Care 10.23% 10.08% 10.25% 0.17 100.17% 

Financials 18.51% 17.69% 18.50% 0.81 99.93% 

Information Technology 12.80% 14.26% 14.50% 0.24 113.25% 

Telecom. Services 3.98% 2.00% 3.20% 1.20 80.37% 

Utilities 3.64% 1.67% 1.50% (0.17) 41.26% 

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



...Continued from previous page 

(i.e.: 7.5% above its benchmark of 55% 

and part way toward its upper limit of 

70% for equities), that would imply 

a tactical shift of + 5.02% to 25.02% 

for the Very Conservative profile (i.e.: 

a proportionate adjustment above the 

benchmark equity setting of 20% within 

the allowed range of +/- 15%). 

The value-added of tactical strategies 

are, of course, dependent on the 

Very conservative 

Asset Class 

Range 

Last Current 

quarter recommendation 

Cash & Cash Equivalents 5% 0-15% 7.5% 5.5% 

Fixed Income 75% 55-95% 71.4% 71.7% 

Total Cash & Fixed Income 80% 65-95% 78.9% 77.2% 

Canadian Equities 10% 5-20% 10.6% 10.4% 

U.S. Equities 5% 0-10% 7.0% 7.7% 

International Equities 5% 0-10% 3.5% 4.7% 

Emerging markets 0% 0% 0.0% 0.0% 

Total Equities 20% 5-35% 21.1% 22.8% 

Conservative 

Asset Class 

Benchmark 

Benchmark 

Range 

Return 

Last Current 



Fixed Income 60% 40-80% 55.5% 55.5% 



U.S. Equities 10% 0-15% 12.9% 13.7% 


emerging markets 0% 0% 0.0% 0.0% 


degree to which the expected scenario 

unfolds. 

Regular review of portfolio weights is an 

essential part of the ultimate success 

of an investment plan as it ensures 

that current exposures are aligned with 

the level of long-term returns and risk 

tolerances best suited to individual 

investors. 

1. Average Return: The average total return produced by the asset class over the period 1977 – 2012, 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. 

Volatility 

35-year average 9.4% 6.2% 

Last 12 months 5.2% 1.9% 

Anchoring portfolios with a suitable 

strategic asset mix, and placing 

boundaries defining the allowed range 

for tactical positioning, imposes a 

discipline that can limit the damage 

caused by swings in emotion that 

inevitably accompany both bull and 

bear markets. 

Very Conservative investors will seek income with 

maximum capital preservation and the potential 

for modest capital growth, and be comfortable 

with small fluctuations in the value of their 

investments. This portfolio will invest primarily 

in fixed-income securities, and a small amount 

of equities, to generate income while providing 

some protection against inflation. Investors 

who fit this profile generally plan to hold their 

investment for the short to medium term 

(minimum one to five years). 

SAMPLE 

Return 

Volatility 


Last 12 months 2.5% 3.0% 

Conservative investors will pursue modest 

income and capital growth with reasonable 

capital preservation, and be comfortable with 

moderate fluctuations in the value of their 

investments. The portfolio will invest primarily 

in 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). 



Balanced 

Asset Class 

RANGE 

Last Current 



Fixed Income 40% 20-60% 35.0% 35.0% 



U.S. Equities 20% 10-30% 23.2% 24.0% 


Emerging markets 3% 0-10% 3.5% 3.5% 


Growth 

Asset Class 

Range 

Last Current 



Fixed Income 25% 5-40% 19.7% 19.6% 



U.S. Equities 25% 15-35% 28.5% 29.3% 


Emerging markets 4% 0-10% 5.0% 5.1% 


Aggressive Growth 

Asset Class 

Benchmark 

Benchmark 

Benchmark 

Range 

Return 

Volatility 


Last 12 months -0.2% 5.5% 

Return 

Volatility 


Last 12 months -2.8% 7.3% 

Last Current 



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



U.S. Equities 30% 15-45% 33.1% 34.4% 

International Equities 22.5% 10-35% 19.4% 19.9% 

EMERGING MARKETS 7.5% 0-15% 7.0% 7.3% 


The Balanced portfolio is appropriate for 

investors seeking balance between long-term 

capital growth and capital preservation, with a 

secondary focus on modest income, and who are 

comfortable with moderate fluctuations in the 

value of their investments. More than half the 

portfolio will usually be invested in a diversified 

mix of Canadian, U.S. and global equities. This 

profile is suitable for investors who plan to hold 

their investment for the medium to long term 

(minimum five to seven years). 

Investors who fit the Growth profile will seek 

long-term growth over capital preservation 

and regular income, and be comfortable with 

considerable fluctuations in the value of their 

investments. This portfolio primarily holds a 

diversified mix of Canadian, U.S. and global 

equities and is suitable for investors who plan to 

invest for the long term (minimum seven to ten 

years). 

SAMPLE 

Return 

Volatility 


Last 12 months -7.8% 10.5% 

Aggressive Growth investors seek maximum longterm 

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). 


Capital Markets Performance 

Milos Vukovic, MBA, CFA 

Vice President, Investment Policy 


Between March 1, 2012, and May 31, 

2012, the U.S. dollar rose against the 

euro, the pound and the Canadian 

dollar, while falling against the yen. 

Both the greenback and the yen 

benefited from their safe-haven status 

amid uncertainty in the Eurozone. Over 

the 12-month period ended May 31, 

2012, the U.S. dollar rose versus the 

euro, the pound and the Canadian 

dollar, but declined against the yen. 

The 12-month return for the U.S. dollar 

was 16.4% against the euro, while the 

greenback fell 4.0% versus the yen. 

The ongoing crisis in Europe caused 

fixed-income markets to move in 

opposite directions during the quarter. 

Government bond prices in the U.S. 

and Japan rose, while in Europe they 

declined significantly. The Citigroup 

Japan Total Return Index climbed 4.9% 

in U.S. dollar terms due largely to 

the yen’s appreciation. The Barclays 

Capital Aggregate Bond Index, a 

broad measure of U.S. fixed-income 

performance, climbed 1.5%, and the 

DEX Universe Bond Index lost 2.3% 

in U.S. dollar terms. Meanwhile, the 

Citigroup Europe Total Return Index 

fell 6.2%, as the euro fell and large 

declines in Spanish, Italian and 

other peripheral-country bond prices 

overwhelmed a flight-to-safety rise in 

German bunds. The situation in Europe 

contributed to a 0.6% decline for the 

Citigroup World Government Bond 

Index (WGBI). During the 12-month 

period, Europe was the only region to 

post a decline in bond returns, with a 

5.6% fall. Japanese government bonds 

performed best among fixed-income 

indexes with a 7.7% increase, followed 

by a 7.1% rise for the U.S. and a 2.8% 

return for the DEX. 

All developed-market equity markets 

posted losses during the three-month 

period, in many cases in the double 

digits. Eurozone stock markets 

performed the worst, with the MSCI 

France Index falling 17.2% and the 

MSCI Germany Index declining 15.7%. 

The MSCI U.K. Index lost 11.4%. Over 

the past year, European equity markets 

have sustained significant losses, in 

part due to the weak euro. The MSCI 

France fell 32.3%, followed by a 26.1% 

drop for the MSCI Germany and a 

13.5% decline for the MSCI U.K. The 

S&P 500 Index outperformed other 

major stock markets, falling 3.5% 

during the quarter and 0.4% over the 

latest 12-month period. The S&P/TSX 

Composite declined 12.5% during the 

three-month period, beating the S&P/ 

TSX Small Cap Index’s loss of 19.5%. 

The S&P/TSX 60 Index declined 12.2%. 

The S&P 400 Index, a measure of the 

U.S. mid-cap market, lost 4.9% over 

the latest three months and 6.1% 

for the 12-month period, while the 

S&P 600 Index, a gauge of small-cap 

performance, dropped 4.8% over 

the three months and 4.4% over the 

12-month period. Value and growth 

stocks had similar returns in the 

quarter, with the Russell 3000 Growth 

Index losing 3.7% and the Russell 

3000 Value Index dropping 4.1%. Over 

the last 12 months, the growth index 

outperformed significantly, rising 0.6% 

versus a 4.2% decline for the value 

index. The MSCI Emerging Markets 

Index fell 15.2% during the latest threemonth 

period and dropped 20.3% in 

the 12-month period. 

All 10 global equity sectors declined 

over the quarter, but the range of 

performance was wide. The best 

performing sector was Consumer 

Staples, which lost 1.1%, followed 

by Health Care with a loss of 1.9%, 

and Telecommunication Services, 

down 3.3%. The worst-performing 

sectors were Materials, which lost 

17.2%; Energy, which fell 16.4%; and 

Financials, which declined 11.8%. 

Over the 12-month period, the bestperforming 

sectors were Information 

Technology and Consumer Staples, 

and the worst-performing sector was 

Materials. The spread between the 

best and worst sectors was about 

27 percentage points. 

SAMPLE 


Capital markets performance • Milos Vukovic, MBA, CFA 

Equity Markets: Total Return 

3 months 

(%) 

YTD 

(%) 

CANADA 

Periods ending mAY 31, 2012 

USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

S&P/TSX Composite (12.50) (4.29) (19.67) 8.48 (0.46) (8.22) (14.19) 6.42 

S&P/TSX 60 (12.23) (4.17) (19.86) 6.00 (0.72) (7.93) (14.40) 3.99 

S&P/TSX Small Cap (19.46) (7.51) (27.54) 15.37 (2.82) (15.51) (22.60) 13.18 


Current 

USD 

3 months 

(%) 

3 months 

(%) 

YTD 

(%) 

EXCHANGE RATES 


U.S. 


USD 

1 year 

(%) 

YTD 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

S&P 500 (3.53) 5.16 (0.41) 14.92 (0.92) 0.65 6.17 12.83 

1 year 

(%) 

3 years 

(%) 

CAD 

1 year 

(%) 

CAD 

1 year 

(%) 

5 years 

(%) 

USD–CAD 1.0329 4.33 1.39 6.61 (1.82) (0.70) 

USD–EUR 0.8090 7.77 4.82 16.41 4.58 1.71 

USD–GBP 0.6490 3.33 0.89 6.79 1.63 5.15 

USD–JPY 78.3450 (3.50) 1.81 (3.95) (6.33) (8.44) 

Note: all changes above are expressed in US dollar terms 

Fixed Income Markets: Total Return 

3 months 

(%) 

YTD 

(%) 

CANADA 


USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

DEX Universe Bond Index (2.31) 0.62 2.77 9.47 7.66 1.91 9.56 7.48 


3 months 

(%) 

YTD 

(%) 

U.S. 


USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

Citigroup U.S. Government 2.12 1.82 8.90 5.90 6.92 7.39 16.42 3.93 

Barclays Capital Agg. Bond Index 1.46 2.33 7.12 7.12 6.72 5.86 14.19 5.18 


3 months 

(%) 

YTD 

(%) 

GLOBAL 

Periods ending May 31, 2012 

USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

Citigroup WGBI (0.57) 0.94 2.28 5.37 6.57 3.73 9.04 3.45 

Citigroup Europe Government (6.24) (0.94) (5.57) 1.07 3.49 (0.67) 1.71 (0.57) 

Citigroup Japan Government 4.88 (0.36) 7.70 9.67 12.09 9.42 14.82 7.67 

3 years 

(%) 

3 years 

(%) 

S&P 400 (4.94) 5.90 (6.09) 18.87 1.72 (0.83) 0.11 16.71 

S&P 600 (4.77) 3.64 (4.40) 18.71 0.67 (0.65) 1.91 16.56 

Russell 3000 Value (4.10) 3.51 (4.24) 13.81 (3.50) 0.05 2.08 11.75 

Russell 3000 Growth (3.74) 6.88 0.56 16.92 1.92 0.42 7.20 14.80 

NASDAQ Composite Index (4.70) 8.53 (0.28) 16.80 1.66 (0.58) 6.31 14.68 

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

Source: Bloomberg/MSCI 

The global investment outlook RBC INVESTMENT Strategy coMMITTEE Summer 2012 I 9 

CAD 

1 year 

(%) 

CAD 

1 year 

(%) 

CAD 

1 year 

(%) 

3 years 

(%) 

3 years 

(%) 

3 years 

(%) 

SAMPLE

Capital markets performance • Milos Vukovic, MBA, CFA 


3 months 

(%) 

YTD 

(%) 

GLOBAL 


USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

MSCI World* (8.51) 0.78 (11.02) 8.99 (4.07) (3.79) (4.87) 6.96 

MSCI EAFE* (13.62) (3.79) (20.48) 3.40 (7.34) (9.16) (14.99) 1.48 

MSCI Europe* (14.77) (5.13) (24.10) 2.94 (8.38) (10.37) (18.86) 1.02 

MSCI Pacific* (11.57) (1.32) (12.98) 4.48 (5.07) (7.00) (6.97) 2.54 

MSCI UK* (11.40) (3.50) (13.49) 8.57 (5.60) (6.83) (7.51) 6.56 

MSCI France* (17.19) (6.42) (32.29) (2.64) (11.07) (12.91) (27.61) (4.45) 

MSCI Germany* (15.69) 1.04 (26.10) 2.96 (7.56) (11.34) (20.99) 1.04 

MSCI Japan* (10.66) (1.90) (10.47) 0.74 (7.49) (6.04) (4.28) (1.13) 

MSCI Emerging Markets* (15.20) 0.08 (20.31) 7.91 0.07 (10.82) (14.81) 5.90 

Sector: Total Return 

3 months 

(%) 

YTD 

(%) 

GLOBAL EQUITY SECTORS 


USD 

1 year 

(%) 

3 years 

(%) 

5 years 

(%) 

3 months 

(%) 

Energy (16.40) (9.45) (18.38) 4.47 (1.95) (12.08) (12.74) 2.53 

Materials (17.20) (5.51) (26.06) 5.45 (3.80) (12.92) (20.95) 3.49 

Industrials (9.76) 0.73 (13.83) 11.85 (3.80) (5.10) (7.88) 9.77 

Consumer Discretionary (5.51) 7.81 (3.45) 16.77 (1.31) (0.63) 3.23 14.60 

Consumer Staples (1.09) 2.49 0.99 15.21 4.79 4.01 7.97 13.07 

Health Care (1.89) 2.39 (2.46) 12.26 0.85 3.18 4.28 10.17 

Financials (11.82) 1.73 (20.41) 1.48 (14.75) (7.27) (14.91) (0.40) 

Information Technology (6.55) 7.11 1.00 14.19 1.02 (1.72) 7.98 12.06 

Telecommunication Services (3.27) (2.62) (9.92) 9.22 (2.55) 1.73 (3.69) 7.19 

Utilities (4.83) (3.97) (9.41) 1.76 (5.75) 0.08 (3.15) (0.13) 

CAD 

1 year 

(%) 

CAD 

1 year 

(%) 

3 years 

(%) 

3 years 

(%) 

SAMPLE 

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

Source: Bloomberg/MSCI 


Global Investment Outlook 




Summer washout 

The global economy is locked in a 

curious seasonal rhythm, surging each 

winter and early spring before petering 

out in the summer and fall. Alas, right 

on schedule, it is again showing signs 

of distress as the mercury rises. A 

promising winter is once more melting 

into a summer washout. Economic data 

is weakening, global risks are growing, 

and market confidence is faltering. 

These grim comments need to be put 

into context. Conditions aren’t all bad. 

Recession remains unlikely outside 

of Europe. Long-standing American 

economic dysfunctions are beginning 

to heal. While enormous risks abound 

and should not be idly discounted, 

we do not ultimately expect most 

of them to transpire. Should these 

risks eventually be swept aside, past 

experience demonstrates that markets 

can perform decently even if underlying 

economic growth is merely sluggish. 

Downward data trend 

Global economic data has ceased to 

cook up the saccharine confections 

that so enamoured markets in early 

2012. Instead, economic releases 

have soured, disappointing markets 

(Exhibit 1). This transformation has 

been underway for several months, 

and there is little evidence it is about 

to reverse. In the past, these patterns 

have normally taken the better part 

of six months to completely unfurl, 

suggesting at least several months of 

further deterioration. 




EXHIBIT 1. 

Index, 1 Std Dev=100 

Manufacturing PMI 

80 

60 

40 

20 

0 

-20 

-40 

-60 

-80 

Global Economic Surprises Turn Negative 

G10 

EM 

Negative Surprises 

John Richards 

Investment Strategy Research Analyst 


Positive Surprises 

Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 

Source: Citigroup Alpha Surprise Index, RBC GAM 

EXHIBIT 2. 

65 

60 

55 

50 

45 

40 

35 

30 

Downshifting Data 

Contraction 

U.S. 

Euro Area 

China 

Expansion 

SAMPLE 

2006 2007 2008 2009 2010 2011 2012 

Note: PMI refers to Puchasing Managers Indices, proxies for economic activity. 

Source: Haver Analytics. RBC GAM 

The extent of the economic 

downshifting varies by country but 

spans the bulk of economic indicators 

and nations (Exhibit 2). This decline 

is the product of several malign 

influences. First, warm weather 

artificially boosted winter activity in 

North America (Exhibit 3), rendering 

economic growth in the spring and 

summer comparatively underwhelming. 

Second, seasonal factors may 

have been modestly distorted by 

the financial crisis, consequently 

overstating the extent of winter good 

cheer. Third, commodity prices, and 

oil in particular, surged again over 


Global Investment Outlook • Eric Lascelles • Daniel E. Chornous, CFA • John Richards 

the winter and spring, denting global 

growth. Fortunately, commodity prices 

are now easing. Fourth, European woes 

have re-intensified as angry voters 

bring rather less austerity-friendly 

politicians to the fore, just as forward 

progress becomes all the more urgent. 

European growth has been snuffed out. 

Fifth, the Chinese economy continues 

to decelerate due to the country’s 

moderating real estate market. Sixth, 

the global economy is simply incapable 

of outsized economic growth during 

the post-financial-crisis period. Prior 

brief spurts have repeatedly proven 

unsustainable. 

Steady aim 

Even as the economic outlook has 

deteriorated, we have held mostly firm 

with our own forecasts (Exhibit 4). This 

is not due to neglect or obstinacy, but 

rather because our forecasts already 

capture the deteriorating state of 

affairs. We continue to have a more 

sluggish outlook than the consensus, 

and so are able to hold fast to our prior 

convictions even as others scramble to 

downgrade their views. 

Outside of Europe, we still do not 

expect recession. Most metrics show a 

U.S. recession to be a low-probability 

outcome, and even as the economy 

slows, there is nothing pointing to 

outright decline. To the extent that the 

threat of a U.S. recession exists, it is 

based on massive event risks. 

The U.S., Canada and Japan are all on 

track for growth near 2% in 2012. This 

is slightly disappointing for the U.S. 

and Canada, and rather positive for an 

aging Japan. 

The U.K. should eke out a sliver of 

growth in 2012 but is technically in 

EXHIBIT 3. 

U.S. Heating Degree Days, 

Deviation from Normal (4m moving avg) 

Y/Y GDP Change (%) 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

-0.5 

-1.0 

80 

40 

0 

-40 

-80 

-120 

-160 

EXHIBIT 4. 

Unprecedented Warm Winter in U.S. 

Cooler than usual 

Warmer than usual 

Warmest 

winter in over 

a decade 

1998 2000 2002 2004 2006 2008 2010 2012 

Source: Haver Analytics, RBC GAM 

RBC GAM Forecast for Developed Market GDP 

2.00% 2.00% 2.00% 2.00% 

2012 

2013 

1.75% 

1.50% 

0.25% 

1.50% 

-0.75% 

0.50% 

U.S. Canada Japan U.K. Eurozone 


SAMPLE 

recession. The Eurozone is stuck in a 

deepening recessionary rut. Among the 

few tweaks to our forecasts are quarterpercentage-point 

snips to both the U.K. 

and Eurozone economic outlooks for 

2012, taking already below-consensus 

views even lower. 

Our 2013 economic outlook is less 

grim on an absolute basis, yet is 

even further below consensus. It 

is hard to fathom why so many 

forecasters provide such a sunny 

weather forecast given long-enduring 

overcast conditions. Fiscal drags will 

apply themselves with even greater 

conviction next year in the U.S., 

Europe’s recession does not look to be 

easily solved, and slow growth remains 

the mantra in a post-crisis world of 

deleveraging banks, businesses, 

households and governments. 

Growing drags, mounting risks 

A rogue’s gallery of drags and risks 

continues to loom, and the danger 

has increased in recent months. As we 

discuss in this report, Eurozone risks 

have again soared due to growing fears 

of a Greek exit, Spain’s mounting woes 



and the corrosive effect of deepening 

recession. China is also manifestly 

slowing, with an uncertain trajectory. 

The U.S. grapples once again with its 

debt ceiling this fall and confronts a 

sheer fiscal cliff at year-end. Together, 

this imperilled trio – the Eurozone, 

China and America – make up fully half 

of the global economy. 

For all the fear-mongering and even our 

own below-consensus forecasts, let us 

be clear that these are risks and not 

realities. In each case, we anticipate 

rather more benign outcomes than the 

worst-case scenarios discussed here. 

The winning investing strategy over 

the past several years – despite the 

many risks throughout – has been to 

maintain a steady keel. 

Unsung heroes 

Policymakers continue to be the 

unsung heroes in this era of discontent, 

delivering additional stimulus whenever 

the situation has demanded it. Real 

interest rates remain outright negative 

(Exhibit 5). They are a key reason why 

worst-case scenarios have generally 

not transpired. Lately, great gobs of 

monetary stimulus have been ladled 

onto emerging nations, adding to the 

stimulative elixir already brewing in 

developed nations. There remains 

a good chance that more monetary 

stimulus may yet be conjured in the 

developed world, too. 

In contrast, fiscal policy has its back 

up against the wall in many parts of 

the world, and is unable to materially 

improve growth without risking an even 

larger debt problem. This represents a 

constraint that did not exist in 2008 

or 2009. 

EXHIBIT 5. 

Global Real Policy Rate (%) 

5 

4 

3 

2 

1 

0 

-1 

-2 

2000 2002 2004 2006 2008 2010 2012 

Regions included: U.S., Canada, U.K., Eurozone, Switzerland, Sweden, Norway, 

Japan, Australia, China, India, South Korea, Russia, Brazil, Mexico. PPP weights by 

GDP share. Source: Haver Analytics, RBC GAM 

EXHIBIT 6. Fiscal Drag in 2012 

Eurozone 

Germany 

France 

Greece 

Italy 

Spain 

Portugal 

Global Real Monetary Policy Rate 

0.4 

0.9 

0.9 

2.2 

2.5 

3.1 

3.3 

0 1 2 3 4 

Change in Budget Balance as a % of GDP 

Note: A positive number is a reduction in budget balance in 2012 compared to 2011. 

Source: International Monetary Fund, Haver Analytics, RBC GAM 

SAMPLE 

European recession as 

easy as 1-2-3 

Europe has now indisputably tumbled 

into recession. The trio of fiscal 

austerity, rock-bottom confidence and 

weakening credit have seen to that. 

While fiscal austerity is biting hard 

in several peripheral European 

nations, the Eurozone-wide drag is not 

particularly overwhelming due to far 

smaller drags among large members 

like Germany and France. We expect 

that fiscal austerity will subtract no 

more than a percentage point from 

overall Eurozone GDP growth in 2012 

and 2013 (Exhibit 6). 

Consumer and investor confidence is 

low in Europe, translating into a dearth 

of risk-taking and a concomitant safehaven 

bid for bonds (Exhibit 7). 

Hardly the most obvious, but possibly 

the most pernicious, drag on European 

growth is the scourge of poor credit 

conditions. Banks and financial 

markets are increasingly unwilling to 

extend credit within Europe (Exhibit 8). 



This is understandable given Europe’s 

poor economic prospects and the need 

for deleveraging by banks. But this 

deleveraging is very potent: every dollar 

of recapitalization represents roughly 

10 dollars not lent. In this manner, 

small adjustments to bank balance 

sheets reverberate in a magnified 

fashion across the economy. Bank 

lending is now in retreat (Exhibit 9). 

We have long appreciated these 

dynamics, but nonetheless feel 

compelled to nudge our Eurozone GDP 

forecast lower to -0.75% from -0.5% for 

2012. The 2013 outlook is unchanged, 

with the economy expected to expand 

0.5%. The euro’s recent weakness and 

the potential for more European 

Central Bank (ECB) rate cuts temper the 

bad news. 

Greek exit risk 

Despite several bailouts and a major 

debt writedown, Greece’s underlying 

problems have never truly gone away. 

Now, owing to an inconclusive election, 

they are re-emerging from hibernation. 

We believe the odds of a Greek exit 

from the Eurozone have risen notably, 

but remain well under 50%. Exit is no 

one’s desired outcome: 81% of Greeks 

wish to remain a part of the Eurozone 

(Exhibit 10), and European leaders have 

said that they unanimously wish Greece 

to stay. Nonetheless, exit is no longer 

absurd to contemplate. 

The May 6 Greek election failed to 

arrive at a workable coalition of 

parties, and so a second election has 

been commissioned for June 17. Polls 

continue to fluctuate. Recent trends 

suggest Greece should emerge with a 

moderate ruling coalition not dissimilar 

to prior governments. The less likely, 

EXHIBIT 7. 

Global Risk Appetite Index 

Credit Availability 

(Standard Deviations from Norm) 

9 

6 

3 

0 

-3 

-6 

Risk Appetite Is Poor 

Good 

Poor 

-9 

2006 2007 2008 2009 2010 2011 2012 

Source: Credit Suisse 

EXHIBIT 8. 

2 

1 

0 

-1 

Eurozone Banks Reluctant to Lend 

Easy Credit 

Tight Credit 

Business Loans 

Consumer Credit and Others 

Mortgages 

-2 

2003 2006 2008 2010 2012 

Note: 12-month moving average of the simple average of the normalized Bank 

Lending Survey and the underlying normalized index level. 

Source: European Central Bank, Haver Analytics, RBC GAM 

SAMPLE 

EXHIBIT 9. 

Bank Loans (Y/Y % Change) 

20 

15 

10 

5 

0 

Eurozone Bank Lending in Retreat 

Households 

Non-Financial Corporations 

-5 

1998 2000 2002 2004 2006 2008 2010 2012 

Source: European Central Bank, Haver Analytics, RBC GAM 



but more problematic, alternative is a 

much more extreme Greek government 

that will seek to pry loose major planks 

of the Greek bailout, and in so doing 

risk the viability of Greece within the 

Eurozone. In fairness, some form of 

renegotiation with Europe will be 

necessary regardless of the election’s 

victor: Greece still has too much debt, 

possibly insolvent banks and a freefalling 

economy. It is also missing 

austerity targets left and right. 

Meanwhile, in the lead-up to the 

election, Greece is effectively 

rudderless. A slow-motion run on 

its banks is occurring, and if this 

continues to accelerate, there are no 

leaders to arrest it. This is just one 

of several scenarios that could push 

Greece out of the Eurozone. A failed 

bluff or a simple policy misstep would 

also suffice. 

The most cogent argument in favour of 

continuing Greek membership is that 

an exit would set an awful precedent 

and quite possibly begin an irreversible 

unravelling of the Eurozone. No one 

wants this, and so quite a lot of 

firepower will be used to avoid this fate. 

Greece’s exit would certainly be 

economically devastating. Estimates 

vary widely, but the Greek economy 

would likely shrink by 15% or more, 

and it would suffer a massive run 

on its banks, widespread business 

bankruptcies, a bout of very high 

inflation, and an assortment of other 

ills. Meanwhile, the rest of Europe 

would be presented with a bill for 

about €300 billion in loans gone bad, 

and conceivably incur total costs in 

the range of €1 trillion. All told, the 

economic hit might be akin to the post- 

EXHIBIT 10. 

% 

EXHIBIT 11. 

% 

100 

80 

60 

40 

20 

90 

80 

70 

60 

50 

0 

Greece Wants Euro 

81% 

Greeks wish to 

remain in Euro 

Source: GPO SA, May 30, 2012 

Spanish Debt-to-GDP Ratio Not So Bad 

France 


Lehman experience. Eurozone-wide 

GDP could easily shrink by 2% to 4%. 

It is difficult to say whether global 

financial markets would freeze with 

quite the ferocity of 2008 given the 

lessons learned since then, but they 

would certainly not function normally, 

and this would be the primary means 

by which a Greek exit could ricochet 

well beyond European shores. 

We reiterate that while this scenario 

is horrifying to contemplate, it also 

constitutes a central reason why a 

Germany 

2011 

52% 

Greeks wish to remain in Euro even if 

bailout not renegotiated 

Spain 

SAMPLE 

Greek exit remains unlikely: nobody 

wants the consequences. 

Spanish woes 

Spain remains a curious case. It has 

far less government debt than the 

European norm, and even than France 

or Germany (Exhibit 11). By this 

definition it is eminently solvent and in 

an enviable position. 

However, everything else about Spain 

is much more dour. It has a large 

fiscal deficit that is proving resistant 



to conventional remedies. Regional 

governments have only reluctantly 

undertaken austerity, and some are 

now being punished by the market. 

The Spanish unemployment rate is a 

whopping 24% and rising (Exhibit 12), 

and home prices continue to plummet 

at double-digit rates. The resultant nonperforming 

loans are eating through 

bank-capital ratios like a swarm of 

locusts through a farmer’s field. 

Of great urgency, Spanish banks 

are now short of capital, evidently 

requiring far more than the Spanish 

banking regulator initially estimated. 

The money will be found by hook or 

by crook – either directly from the 

Spanish government via debt issuance, 

from a Eurozone bailout package or 

even from the IMF itself. But in the 

meantime, yet another high stakes 

bluffing game is being played, to the 

detriment of everyone. 

Spanish competitiveness is also poor. 

Structural reforms to make the country 

more competitive are underway, but 

their success can only be measured 

over the span of years, not months. 

Spain should have the necessary 

time to allow these reforms to take 

root given its low debt level, and the 

reforms in turn could bestow a legacy 

of sustainably faster economic growth. 

But the market is losing patience, as 

evidenced by government bond yields 

flirting with 7% (Exhibit 13). It is hard 

not to draw rough parallels with the 

trajectory of Greece’s decline, with the 

notable difference that the Spanish 

economy is five times larger. Urgent 

action is needed, but fortunately 

possible. 

EXHIBIT 12. 

% 

10-Year Bond Yield (%) 

30 

25 

20 

15 

10 

5 

Surging Spanish Unemployment Rate 

2005 2006 2007 2008 2009 2010 2011 2012 

EXHIBIT 13. 

7.5 

7.0 

6.5 

6.0 

5.5 

5.0 


Spanish Fears Again Trump Italian Fears 

Spanish fears trump 

Italian fears 

Spain 

Italy 

Italian fears trump 

Spanish fears 

Unemployment rate 

has tripled in the past 

5 years 

4.5 

Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 

Source: RBC GAM, Haver Analytics 

SAMPLE 

European political pressures 

Uneasy lies the head that wears the 

crown. In Europe’s case, political 

leaders have been ousted at every 

electoral opportunity, including in 

Greece, Italy, Spain, Portugal, Ireland 

and France. This reflects one of 

Europe’s central challenges: public will 

is insufficiently behind the necessary 

reforms to fix Europe. So far, political 

progress has been surprisingly good 

given this shortcoming, but the 

capacity for action is beginning to dull. 

This is why bouts of market distress 

like the current one are actually quite 

useful. They force politicians to do the 

right thing in a hurry, even when they 

don’t want to. 

Europe’s end game remains a tighter 

fiscal union, one that incorporates 

ironclad fiscal limits, a Eurobond for 

common financing, a pan-European 

deposit insurance agency and financial 

regulator, and perhaps even greater 

equalization payments. This is not a 

quick process. Despite the hubbub and 

evident risks, we maintain the same 

benign set of conclusions as before: no 



major European nation should default, 

no major bank should default and the 

Eurozone should manage to avoid a 

leprotic fate. 

China slowing 

The Chinese economy has been on a 

downward glide path for several years. 

This has been understandable and 

even acceptable given the fantastic 

starting point of 10%-plus real GDP 

growth. Recent growth has been in the 

range of 8% to 8.5% per year. However, 

new data hints at the possibility of 

another lurch lower. Chinese credit 

growth is weakening (Exhibit 14), real 

estate excesses are now unwinding 

(Exhibit 15), and several economic 

indicators have fizzled (Exhibit 16). 

The imbalances evident within the 

economy – excess credit, inefficiently 

allocated capital, disproportionate 

reliance on exports – are likely 

manageable for now. Chinese 

policymakers will do their best to 

ensure that growth does not lag 

excessively as leadership changes 

occur toward the end of this year. 

China appears to have the necessary 

resources to achieve this goal, and its 

leaders have recently hinted at further 

stimulus to boost growth. That said, 

the risk of a hard landing at some later 

date remains very real. We forecast 

Chinese GDP growth of 8.25% for 2012 

and 8.0% for 2013, both modestly 

below consensus. 

Other emerging markets 

The remainder of the emerging-market 

space is experiencing something 

broadly similar to China. Latin 

American economies are struggling 

to gain traction now that commodity 

demand and prices have deflated; 

EXHIBIT 14. 

Total Loans (Y/Y % Change) 

35 

30 

25 

20 

15 

10 

5 

0 

Weakening Chinese Credit Growth 

2000 2002 2004 2006 2008 2010 2012 


EXHIBIT 15. 

Diffusion Index of Cities Reporting 

Price Increases Less Decreases 

35 

30 

25 

20 

15 

10 

5 

0 

80 

60 

40 

20 

0 

-20 

-40 

-60 

-80 

-100 

Chinese Home Prices Are Swooning 

Rising 

Falling 

Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 

Source: IMF Global Financial Stability Report, RBC GAM 

SAMPLE 

EXHIBIT 16. 

Y/Y % Change 

Chinese Steel and Cement Output 

Steel 

Cement 

-5 

2000 2002 2004 2006 2008 2010 2012 

Note: Y/Y percentage change of 12-month moving average of steel and cement 

output. Source: Haver Analytics, RBC GAM 



Asian economies are grappling 

with anemic appetites from Europe; 

Eastern European economies are 

decelerating along with their Western 

European counterparts. By all accounts, 

emerging-market countries are still 

growing much more quickly than their 

developed ones, but their growth 

relative to expectations or prior years is 

nonetheless underwhelming. If there is 

a bright spot, it is that falling inflation 

is emboldening policymakers to revive 

growth via interest rate cuts. We 

continue to forecast emerging-market 

economic growth of 6.0% in both 

2012 and 2013 for our basket of EM-6 

nations (China, India, South Korea, 

Brazil, Mexico and Russia). 

Decoupling 

Although most nations are suffering 

through a period of decelerating 

economic activity, we must make 

an important distinction between 

Europe and the rest of the world. 

Europe is suffering far more than other 

regions. Mercifully, the transmission 

mechanisms of economic and market 

pain from one part of the world to the 

rest are not broadcasting at their usual 

strength. 

With regard to trade, European imports 

have fallen, though this is of limited 

relevance for the U.S. and Canada, 

which have little trade exposure to 

Europe. It is more consequential for 

emerging Asia. 

Meanwhile, consumer confidence 

appears to have entirely decoupled 

between Europe and other regions. It 

has fallen in Europe but has rebounded 

elsewhere (Exhibit 17). 

Credit conditions are also quite 

different. Whereas global markets froze 

EXHIBIT 17. 

Normalized Consumer 

Confidence Index 

Bloomberg Index Level (0=Normal) 

3 

2 

1 

0 

-1 

-2 

-3 

-4 

-5 

3 

2 

1 

0 

-1 

-2 

-3 

EXHIBIT 18. 

Diverging Confidence 

U.S. 

Euro Area 

2007 2008 2009 2010 2011 2012 


Financial Conditions Have Decoupled 

U.S. Financial Conditions Index 

European Financial Conditions Index 

Good 

Poor 

-6 

2007 2008 2009 2010 2011 2012 

Source: Bloomberg, RBC GAM 

SAMPLE 

in unison in late 2008, Europe pays 

penitence alone this time (Exhibit 18). 

That could change in a heartbeat if a 

large European bank were to go down, 

but we do not expect this, and so the 

notable credit decoupling may persist. 

U.S. begins to heal 

The U.S. economy has downshifted in 

recent months, and will likely advance 

more slowly than in recent quarters. 

We continue to forecast GDP growth 

of 2.0% in both 2012 and 2013, the 

former constrained by European woes 

and household deleveraging, the latter 

by the coming fiscal cliff and likely 

political dysfunction. In this context, 

the U.S. Federal Reserve Board can be 

expected to avoid tightening policy, 

and could even deliver more stimulus 

should inflation ebb and global risks 

remain elevated. The recent decline in 

gasoline prices is a positive force, but 

the simultaneous appreciation of the 

U.S. dollar removes some of the gloss. 

Still, it is important to celebrate 

successes where they occur, 

especially ones that lay the foundation 



for sustainable growth. Several 

dysfunctional elements of the U.S. 

economy have become rather less 

dysfunctional. Confidence is back 

in a big way, even if it has not fully 

translated into risk appetite. To be sure, 

the past few years have demonstrated 

repeatedly that confidence can be lost 

quite quickly, but the fact remains that 

it is currently very good despite the 

world’s manifold challenges. 

The U.S. labour market is beginning to 

turn. Job creation was unsustainably 

high early in 2012, but has since 

decelerated to a trend of around 

100,000 new jobs per month. This is 

not bad, and is consistent with the 

underlying rate of economic growth 

(Exhibit 19). The unemployment rate 

has managed to inch lower (Exhibit 20), 

alleviating what had been a troubling 

constraint on the economy. While some 

of the decline in the unemployment 

rate relates to an aging population and 

job seekers losing hope, some of the 

improvement is real. 

The U.S. credit market is also beginning 

to improve as banks extend loans to 

consumers and businesses. Credit is 

the lifeblood of the U.S. economy, and 

so this is a crucial box to tick. However, 

this effect should not be overstated. 

Banks remain very stingy with 

residential mortgage credit (Exhibit 21). 

The U.S. housing market has 

very likely bottomed, and should 

eventually recover. Recent data has 

surprised to the upside here (Exhibit 

22). Affordability is now excellent 

thanks to lower prices and rockbottom 

mortgage rates. This does not 

guarantee an immediate resurgence, 

however, as there are still 2 million to 

3 million excess homes in America. 

EXHIBIT 19. 

Private Employment 

Monthly Change ('000) 

400 

200 

0 

-200 

-400 

-600 

EXHIBIT 20. 

% 

18 

14 

10 

6 

U.S. Link Between Growth and Hiring 

-344 

-189 

-102 

-28 

96 

179 

241 

4 

Real GDP Growth (%) 

Note: Data from 1975. Vertical line shows 1 standard deviation range. 


U.S. Unemployment Rate Is High but Falling 

Broad Unemployment Rate 

Official Unemployment Rate 

2 

1994 1997 2000 2003 2006 2009 2012 

Source: Bureau of Labour Statistics, RBC GAM 

SAMPLE 

EXHIBIT 21. 

Mortgage Demand and Supply 

Conditions (Standard Deviations From 

Norm) 

2 

1 

0 

-1 

-2 

-3 

Mortgage Supply and Demand Remain Stingy 

Good 

Poor 

Supply and demand for 

mortgage loans are still at 

extremely depressed levels 

Demand 

Supply 

1991 1995 1999 2003 2007 2011 

Note: 12-month moving average of the simple average of the normalized SLOS 

survey and the underlying normalized indexed level. Source: Federal Reserve 

Senior Loan Survey, RBC GAM 

365 



The aforementioned mortgage market 

remains unfriendly – understandably so 

– given still-high mortgage delinquency 

and foreclosure rates (Exhibit 23). 

And many households remain stuck in 

underwater mortgages. 

Finally, the U.S. has made progress in 

its deleveraging odyssey. The business 

sector has reached the finish line, the 

banking sector is nearly done, and 

households have made important 

progress at cutting their household 

debt-to-income ratios (Exhibit 24). 

However, the process is not over. 

Households likely have some distance 

left to travel, and governments have 

barely started. History tells us that postcrisis 

deleveraging tends to take years. 

Low ceilings and high cliffs 

For all of the good work the U.S. 

economy has managed, there are 

two late-blooming and somewhat 

intertwined fiscal risks that could cast a 

dark shadow over the end of 2012. The 

first is the U.S. debt ceiling, which will 

likely present itself again sometime in 

November. Without an increased debt 

ceiling, the U.S. would lose its capacity 

to finance its deficit and risk falling 

into technical default. Recall that the 

debt ceiling was most recently debated 

and grudgingly lifted last summer, and 

that it was a messy affair. As a result of 

the debacle, the U.S. suffered a debt 

downgrade from AAA to AA+ at the 

hands of Standard & Poor’s. 

The process is unlikely to be much 

simpler a second time around. The 

November elections should prevent 

much progress until the last minute, 

and predicting the actions of a lame 

duck session of Congress – even one 

with the same cast of characters as 

EXHIBIT 22. 

Normalized U.S. Housing Activity 

Normalized U.S. Housing Activity Has Bottomed 

4 

3 

2 

Normalized Housing Activity 

Maximum-Minimum Band 

1 

0 

-1 

Clear bottoming, only 

` 

-2 

tentative rebound 

-3 

1963 1970 1977 1984 1991 1998 2005 2012 

EXHIBIT 23. 

Mortgage Delinquency Rate (%) 

12 

10 

8 

6 

4 

2 

Note: Simple average of normalized single-unit housing starts, single-unit building 

permits, existing home sales, new home sales and NAHB housing market index. 


Housing Distress Remains High and Only Abates Slowly 

Mortgage Delinquency Rate (LHS) 

Home Foreclosure Rate (RHS) 

0 

0 

2000 2002 2004 2006 2008 2010 2012 


SAMPLE 

EXHIBIT 24. 

Household Debt-to-Income (%) 

170 

160 

150 

140 

130 

120 

110 

100 

U.S. Household Debt-to-Income Ratio Is Delevering 

1990 1993 1996 1999 2002 2005 2008 2011 


6 

5 

4 

3 

2 

1 

Home Foreclosure Rate (%) 



today – is difficult from this 

distance. There is at least one basic 

truth: the debt ceiling eventually 

has to be increased – but there is no 

guarantee that such a course will be 

easily achieved. 

In fact, it is fairly likely that the U.S. 

will suffer another debt downgrade 

in the fall, either because of further 

brinkmanship over the debt ceiling, 

or because politicians opt to renege 

on the budget cuts they agreed to as 

part of the 2011 debt-ceiling debate. 

Fortunately, U.S. yields are unlikely to 

suffer even if a downgrade does occur – 

the dollar’s status as the global reserve 

currency is a powerful advantage for the 

U.S. But all of this nonetheless 

will result in quite an odious close to 

the year. 

The second matter is the arrival of an 

unprecedented fiscal cliff at the end of 

2012 (Exhibit 25). This is partially due 

to the prior debt-ceiling debate that 

shunted budget cuts from then until 

now, and partially for unrelated reasons. 

Regardless of their provenance, quite 

a large number of fiscal-stimulus 

programs are due to expire as the 

clock strikes midnight on New Year’s 

Eve. These include the Bush tax cuts, 

payroll-tax cuts and unemploymentinsurance 

extensions. Meanwhile, other 

tax increases or spending cuts are 

scheduled to take effect, such as the 

promised Budget Control Act austerity 

from last summer and a host of smaller 

items. 

Altogether, the U.S. economy could 

shed about three percentage points of 

economic growth if this is allowed to 

happen. This yawning gap marks the 

difference between solid growth and the 

cusp of a recession. 

EXHIBIT 25. 

Bush tax cuts 

Payroll tax cut 

Budget control act 

UI extension 

Other 

Source: RBC GAM, CBO 

EXHIBIT 26. 

GDP, Annualized % Change 

U.S. Debt Ceiling and Fiscal Cliff Looms 

FISCAL CLIFF 

2012 2013 

U.K. in Double-Dip Recession 

Our view is that politicians will come 

to their senses and ensure that some 

portion of this fiscal drag is delayed. 

But a substantial fiscal drag should 

nonetheless apply to 2013, and this 

consideration is a central pillar for 

our below-consensus U.S. growth 

forecast for next year. Of course, as the 

political rhetoric becomes ever more 

strident along party lines, predicting 

legislators’ cross-party interactions 

becomes increasingly difficult. It is 

doubly challenging given the many 

permutations that could emerge from 

the elections this fall. 

If nothing is done, 

expiring fiscal policy 

chops a huge 3% off 

2013 GDP growth…. 

U.K. in the rough 

Politicians 

will hopefully 

soften the 

blow…. 

…or a 2013 

recession 

could loom 

6 

4 

Recession #1 

Recession #2 

2 

0 

-2 

-4 

Near miss 

-6 

-8 

-10 

2007 2008 2009 2010 2011 2012 


SAMPLE 

The U.K. continues to struggle through 

a small recession, its second in four 

years (Exhibit 26). The economy should 

shortly return to sluggish growth, but 

anything more than that is improbable 

given the headwinds blowing from 

continental Europe, combined with a 

dogged determination to rein in fiscal 

excesses before markets force the issue. 

This is a commendable objective and 

is in stark contrast to the laissez-faire 

U.S. approach. We forecast GDP growth 



of just 0.25% in 2012, and a more 

respectable 1.5% in 2013. 

Fortunately, inflation has recently begun 

to settle down after an extended period 

of excessive price increases. This is 

very good news indeed, not just for the 

purchasing power of the average Briton, 

but also because it may free the Bank 

of England to deliver more monetary 

stimulus. The pound should remain 

steadfast versus the U.S. dollar, and 

may appreciate versus the euro. 

Japan recovers nicely 

Japan is recovering nicely after the 

March 2011 earthquake, and we 

maintain unchanged forecasts for 

sprightly GDP growth (by Japanese 

standards) of 1.75% in 2012 and 

1.5% in 2013. The strengthening yen 

and slowing Chinese and European 

economies present a risk to this view, 

but so far Japan has managed to deliver 

despite these distractions. 

Fascinatingly, Japanese inflation 

has recently perked up after years of 

stagnation. This may simply be due to 

the latest commodity spike, which is 

already unwinding. But even the core 

CPI metric is showing some signs of life 

(Exhibit 27), and it could just be that 

the Bank of Japan’s recent commitment 

to a 1% inflation target is starting to 

work. If so, this could resolve one of 

Japan’s long-enduring quandaries. It is 

premature to render final judgment on 

this transformation, however. 

Japan’s longer-term prospects remain 

difficult to call. A potential sales tax 

could yet sap growth. The country’s 

fiscal deficit remains enormous, 

and its government debt load is 

unfathomably heavy. One cannot help 

but wonder if Japan might eventually 

EXHIBIT 27. 

Y/Y % Change 

EXHIBIT 28. 

Monthly Change in Employment ('000) 

3 

2 

1 

0 

-1 

-2 

Japanese Inflation Has Perked Up 

Headline CPI 

Core CPI 

-3 

2000 2002 2004 2006 2008 2010 2012 

Note: Core CPI excludes food and energy. Source: Haver Analytics, RBC GAM 

Canadian Job Creation Revived 

100 

Rebound 

80 

60 

40 

20 

0 

-20 

Soft patch 

-40 

-60 

Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 


SAMPLE 

be punished by markets in much 

the same way that Europe has been. 

Recent sovereign downgrades put a 

sharp edge on the topic. Of course, 

Japan’s saving fiscal grace has always 

been that its government debt is held 

almost exclusively by its citizens. 

The impressive savings rates among 

households and businesses perpetuate 

the government excesses. But as the 

Japanese population ages, its capacity 

for saving is diminishing, and Japan’s 

long-standing trade surplus is in retreat 

– an unwelcome development for a 

traditionally mercantilist nation. The 

times are changing, and Japanese fiscal 

policy may need to as well. 

Canada bounces back 

The Canadian economy went through 

a perplexing five months of sluggish 

economic growth and non-existent job 

creation just as the rest of the world 

was surging in late 2011 and early 

2012. But proxy indicators now suggest 

the economy is growing again, and job 

creation has returned with a vengeance 

(Exhibit 28). 



It still doesn’t pay to expect the 

Canadian economy to grow at a 

materially different rate from the U.S. 

– history simply doesn’t bear this out – 

and so we look for 2.0% GDP growth in 

both 2012 and 2013. The 2013 forecast 

is a hair lower than our prior view 

and is motivated by the expectation 

that Canada’s housing market will 

continue to slow. The Canadian dollar is 

appropriately positioned at a few cents 

below the U.S. 

Indeed, when evaluating risks in 

Canada, there are both domestic and 

external threats. The external risks are 

widely appreciated – Europe’s crisis, 

China’s slowdown, the U.S. fiscal cliff. 

But domestic risks are also material. 

Probably the greatest domestic 

challenge is Canada’s housing market, 

which has defied gravity for years but 

is now losing altitude (Exhibit 29). 

Affordability remains reasonable in the 

context of current low interest rates, 

but a normalization of interest rates 

would render affordability statistics 

some 15% to 20% offside. 

Regulators have finally decided 

that enough is enough, and are 

endeavouring to deflate the housing 

market. Among these actions, the 

Bank of Canada is now talking of rate 

increases – an appropriate stance 

given so little remaining economic 

slack and the state of the housing 

market. But we suspect the central 

bank may struggle to actually pull the 

trigger before 2013 due to worsening 

global outcomes. Nonetheless, interest 

rates will eventually work their way 

higher, and with it Canada’s housing 

market will have to deflate. This may 

translate into a lean year for Canada’s 

economy as construction activity 

EXHIBIT 29. 

Average Home Price (Y/Y % Change) 

Competitiveness Gap (%) 

35 

25 

15 

5 

-5 

-15 

Home Prices Beginning to Fall in Parts of Canada 

National 

Vancouver 

Toronto 

-25 

2007 2008 2009 2010 2011 2012 

Source: CREA, RBC GAM 

EXHIBIT 30. 

Index Level 

30 

20 

10 

0 

-10 

-20 

-30 

-40 

800 

750 

700 

650 

600 

Canada–U.S. Economic Competitiveness 

Canada more 

competitive 

U.S. more 

competitive 

Canada now 30% 

less competitive 

than U.S. 

1981 1986 1991 1996 2001 2006 2011 

Note: Competitiveness Gap calculated as currency-adjusted unit-labour cost ratio 

between Canada and the U.S versus the average relationship from 1981 to 2011. 


SAMPLE 

EXHIBIT 31. 

Commodities Have Tempered 

S&P Goldman Sachs Commodity Index (LHS) 

Barrel of WTI Oil (RHS) 

550 

60 

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 


120 

110 

100 

90 

80 

70 

US$ 



eventually ebbs and household 

spending retreats. 

Another Canadian concern is poor 

competitiveness (Exhibit 30). Canada 

has slipped far behind the U.S. 

over the past decade. However, 

there is not a great deal that can be 

done about it: the situation is the 

by-product of a strong currency and 

being a resource-intensive (and thus 

naturally productivity-challenged) 

nation. Fortunately, the effect of the 

poor competitiveness appears to be 

quite limited as the economy, labour 

market and stock market have all 

outperformed the U.S. to varying 

degrees since 2000. This risk is not as 

large as it first appears. We recently 

published an Economic Compass report 

on this topic entitled “Shrugging Off 

Canada’s Competitiveness Shortfall” 

(May 2012). 

Moderate inflation 

Inflation has been remarkably well 

behaved in recent years. In fairness, 

it has occasionally flitted higher 

than normal on the back of sporadic 

commodity spikes, but these have 

always unwound, as is now happening 

(Exhibit 31). Unsaddled from the 

effects of commodity prices, most coreinflation 

metrics are hovering quite 

close to central-bank targets (Exhibit 

32). Despite much fretting, there has 

not been evidence either of deflation or 

hyperinflation. 

We expect inflation to remain 

controlled, and perhaps even subdued. 

Inflation expectations are normal. 

Wage-price spirals are a long way off 

given elevated unemployment rates 

and businesses battling over market 

share. Granted, China may be exporting 

less deflation than it once was, but 

EXHIBIT 32. 

Y/Y % Change 

EXHIBIT 33. 

% 

% 

5 

4 

3 

2 

1 

0 

-1 

2000 2003 2006 2009 2012 

Note: CPI's of all OECD countries. Core CPI excludes food and energy. Shaded area 

is approximate inflation target range of 1.5 to 3.0%. Source: OECD, Haver Analytics, 

RBC GAM 

20 

15 

10 

5 

OECD Inflation Moving to Middle of Target Range 

Eurozone Repo Rate 

Equilibrium Range 

Last Plot: 0.53% 

Current Range: 1.00% - 2.65% (Mid: 1.82%) 

0 

1980 1985 1990 1995 2000 2005 2010 2015 

Source: RBC GAM, RBC CM 

OECD Headline CPI 

OECD Core CPI 

SAMPLE 

EXHIBIT 34. 

U.K. Base Rate 


18 

16 



14 

12 

10 

8 

6 

4 

2 

0 

1980 1985 1990 1995 2000 2005 2010 2015 




there is sufficient economic slack in 

the world that steady-state inflation 

should trend no higher than centralbank 

targets. 

Central banks contemplate 

more help 

Central banks remain resolute in their 

support of global economic growth. 

With few exceptions, they are either in 

the process of delivering more stimulus 

or holding interest rates extremely 

low. This is unlikely to change in the 

near term, as economies slow and 

fiscal policy becomes less amenable to 

growth. A few of the central banks that 

are on hold, such as the ECB and the 

Bank of England, stand a good chance 

of returning to easing (exhibits 33 and 

34). The Bank of Japan should continue 

delivering stimulus in workmanlike 

fashion (Exhibit 35). 

The U.S. Federal Reserve Board (Exhibit 

36) may yet deliver more stimulus 

should global conditions deteriorate, 

though this depends greatly on the 

progression of the economy and 

inflation, and is not presently a 

component of our base case. The 

Bank of Canada (Exhibit 37) is an 

outlier among advanced nations given 

its hawkish tilt, doubly so as fellow 

commodity-intensive nations like 

Australia, Norway and Sweden cut their 

policy rates. But this is not entirely 

inappropriate given the state of the 

Canadian economy. The question is 

whether the global economy will permit 

such action this year, or force a rain 

date in 2013. 

EXHIBIT 35. 

% 

% 

Japan Overnight Call Rate 


14 

12 



10 

8 

6 

4 

2 

0 

-2 

1980 1985 1990 1995 2000 2005 2010 2015 


EXHIBIT 36. 

U.S. Fed Funds 


24 


22 

20 


18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

-2 

1980 1985 1990 1995 2000 2005 2010 2015 

Source: Federal Reserve, RBC GAM, RBC CM 

SAMPLE 

EXHIBIT 37. 

% 

25 

20 

15 

10 

Canada Overnight Rate 




Bond yields remain low 

Bond yields remain strikingly low. 

Whereas the stock market has swung 

between ebullience and depression 

5 

0 

1980 1985 1990 1995 2000 2005 2010 2015 




over the past year, the bond market 

has remained stubborn in its 

commitment to very low rates since 

August 2011. There have been a few 

brief blips to the upside when growth 

looked to be recovering, but none 

proved sustainable. The recent trend 

has been toward even lower yields as 

European fears mount. But overall, 

as the Global Fixed Income Markets 

charts on page 31 show, yields have 

remained in the range of 2% or below 

in the U.S., Canada, Germany and the 

U.K. Japanese yields are even lower. 

Simply put, central banks continue 

to dominate the bond market, both 

at the short end of the curve – their 

traditional bailiwick – and more 

unusually at the long end given their 

unconventional actions in recent 

years. Normally valid drivers such 

as inflation, fiscal affairs, economic 

growth and mean-reversion effects 

have faded into the wallpaper. 

Emerging markets have substantially 

higher yields, of course, but these have 

been coming down too, thanks to slow 

growth, lower inflation and centralbank 

rate cuts. 

Equities fall from cycle highs 

The past three months have been 

difficult for equity markets. Many of 

the indexes that reached cycle highs 

by the end of the first quarter of 2012 

have since erased a large portion of 

those gains. Our fair-value models, 

shown on page 32, demonstrate just 

how undervalued equity indexes 

currently are. At its highest level since 

the financial crisis, the S&P 500 Index 

reached only 88% of fair value based 

on the current level of interest rates, 

inflation and corporate profits. Many 

EXHIBIT 38. 

Earnings Estimates and Alternative Scenarios for Valuations and 

Outcomes for the S&P 500 

2012 

Top Down 

2012 

Bottom Up 

Trailing 

12 months Recessionary* 

$101.9 $104.9 $96.8 $72.6 

Equilibrium P/E 16.5 1680.2 1729.3 1595.6 1196.7 

1 Standard Deviation Below 12.6 1285.8 1323.4 1221.1 915.8 

2 Standard Deviations Below 8.7 891.4 917.5 846.6 634.9 

other major global markets exhibit 

even larger discounts. 

Current levels of economic growth, 

corporate profits and confidence 

indicate a range of 1200 to 1400 for 

the S&P 500, although valid scenarios 

certainly exist suggesting outcomes 

both above and below these levels. 

We have established the upper and 

lower boundaries of this range using 

forecast earnings and our estimate of 

the equilibrium price-earnings ratio 

(P/E). For the S&P 500 (Exhibit 38), the 

top-down earnings estimate for 2013 

of $108, combined with the equilibrium 

P/E, would provide an index level of 

1779. Based on the S&P 500 level as 

of June 1, that points to a potential 

return of almost 40%! It seems highly 

unlikely, however, that the current 

shaky economic environment can 

support an equilibrium P/E. Since the 

financial crisis, the market P/E has 

trended near one standard deviation 

below equilibrium, a P/E level of about 

13 currently. Combined with the same 

top-down earnings estimate, the S&P 

2013 

2013 

Top Down Bottom Up 

$107.9 $118.0 

Equilibrium P/E 16.5 1778.9 1945.4 

1 Standard Deviation Below 12.6 1361.3 1488.7 

2 Standard Deviations Below 8.7 943.8 1032.1 

*Trailing 12-Month Earnings to May 2012 less 25% 

Source: Bloomberg, Thomson Reuters, RBC GAM 

500 would rest at about 1400. On the 

downside, chopping 15% off the upper 

boundary would drop the S&P 500 

to 1200. At this level and with this 

potential return in prospect, many 

investors may chose to move back into 

equities barring deterioration in the 

outlook for earnings or a change in risk 

preference, and in doing so, form a 

floor once again for the recent trading 

range. 

Drops below 1200 would likely come 

if investors see a significant threat 

to earnings, or worse, if that was 

combined with a shock to confidence. 

A break through the upper boundary 

of 1400 would require the market 

P/E to rise closer to equilibrium than 

it has been since the financial crisis 

or, alternatively, a view that earnings 

will exceed current forecasts by a 

meaningful amount. In the meantime, 

we have been taking advantage 

of volatility within this range, with 

tactical management of cash and 

stock exposure, and will continue to 

do so until some of the bigger issues 

SAMPLE 



threatening the recovery begin to 

resolve themselves. 

Valuations depressed 

While valuations are depressing index 

levels in the U.S., Canada and Japan, 

that is not the case for all countries 

(Global Equity Market Valuations 

charts on page 33). For those currently 

in recession, such as the U.K. and the 

Eurozone, the P/E appears much closer 

to equilibrium. Despite the mild nature 

of these recessions, below-trend 

earnings growth is dragging down the 

price level of indexes in these regions. 

Small-cap outperformance 

beginning to turn 

For all the focus on index valuations, 

portfolio returns can also be driven 

by the investment styles dominating 

performance within the market. A 

good example of a style attribute is 

grouping companies based on their 

market capitalization. While there are 

many definitions, we typically define 

U.S. small-cap companies as those 

with market values under $2.5 billion; 

mid-caps between $2.5 billion and 

$11 billion; and large-caps over $11 

billion. Other styles include value and 

growth, which focus on under-priced 

stocks and those with relatively strong 

earnings potential, respectively, as 

well as momentum, which monitors 

the pace of change in share prices or a 

variety of fundamental factors. 

Small-cap companies have been 

dominating the market since the initial 

leg of the rally in March 2009, although 

that trend may now be reversing. 

Exhibit 39 shows the small-cap Russell 

2000 Index against the large-cap S&P 

500 Index. Heightened risk aversion 

during the latest market downturn 

EXHIBIT 39. 

1.30 

1.25 

1.20 

1.15 

1.10 

1.05 

1.00 

EXHIBIT 40. 

15% 

10% 

5% 

0% 

-5% 

-10% 

U.S. – Small Cap/Large Cap Performance 

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

2009 2010 2011 2012 


U.S. Factor Returns 

Cumulative Returns to QUBE Small Cap 

*Returns to small cap vs. S&P 1500 starting 03/2009 

Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 


SAMPLE 

EXHIBIT 41. 

10.0% 

7.5% 

5.0% 

2.5% 

0.0% 


Cumulative Returns to QUBE Value 

*Returns to value vs. S&P 1500 starting 03/2009 





has caused investors to move out 

of relatively risky small-cap stocks. 

Exhibit 40 shows the same trend using 

data from our quantitative model, 

QUBE, and other style factors that we 

monitor are presented in exhibits 41 

to 43. In these, we use the S&P 1500 

as the universe of stocks, with each 

chart tracking the performance of a 

particular style relative to the universe. 

In addition to small-cap stocks, value 

stocks (Exhibit 41) have outperformed 

significantly, although both gave up 

ground during the latest correction. 

Should style leadership change, we 

would look to some of the factors 

that have not been working to move 

to the forefront. Momentum has 

underperformed significantly, although 

in the last month it has shown some 

signs of life (Exhibit 42). Growth 

stocks, in Exhibit 43, have largely 

kept pace with the market since the 

bottom and could also be a candidate 

for leadership going forward. These 

factors will bear monitoring as we 

progress through the cycle, and 

especially as the next up-leg takes 

hold. 

Asset mix tilted 

toward equities 

Bond yields have once again 

plummeted, with the U.S. 10-year 

T-bond moving to all-time lows. 

Unorthodox monetary policy, aimed 

at stimulating the economy through 

targeting low policy rates and 

providing liquidity to the market 

through bond purchases, is clearly an 

important factor. This is referred to 

as ‘financial repression’ and reflects 

central bankers’ desire to hold yields 

at massively stimulative levels in the 

EXHIBIT 42. 

2.5% 

0.0% 

-2.5% 

-5.0% 

-7.5% 

-10.0% 

EXHIBIT 43. 

5.0% 

2.5% 

0.0% 

-2.5% 


Cumulative Returns to QUBE Momentum (Technical) 

*Returns to momentum vs. S&P 1500 starting 03/2009 




Cumulative Returns to QUBE Growth 

*Returns to growth vs. S&P 1500 starting 

-5.0% 



SAMPLE 

EXHIBIT 44. 

10-Year Break-Even Yields 

Current 

10-Year 

Bond 

Yield 

Current 

Money 

Market 

Yield 

Current 

Excess Yield 

to Money 

Market Maturity Duration 

Break- 

Even* 

Break- 

Even 

Yield* 

U.S. 1.45% 0.07% 1.38% 30/06/2022 9.279 15 bps 1.60% 

Canada 1.63% 0.92% 0.71% 30/06/2022 9.188 8 bps 1.71% 

Germany 1.17% -0.03% 1.20% 30/06/2022 9.424 13 bps 1.30% 

U.K. 1.53% 0.38% 1.15% 30/06/2022 9.237 12 bps 1.66% 

Japan 0.82% 0.11% 0.70% 30/06/2022 9.614 7 bps 0.89% 




EXHIBIT 45. 

Asset Class Forward Returns 

Current 

Asset Class 

Return 

U.S. Treasury Bill -0.36% 

hopes of spurring economic activity. In 

addition, considerable threats to the 

recovery and memories of 2008/2009 

continue to worry investors. As risky 

assets such as equities are sold in 

favour of safer investments, Treasury 

bonds receive large inflows, moving 

yields even lower. Ultimately, in 

an environment where this level 

of stimulus is no longer needed or 

appropriate, the path for interest rates 

will reverse to the upside. While it is 

unlikely the environment and yields 

will normalize in the near term, barring 

another severe recession, both should 

eventually move higher. 

As yields rise, even modest capital 

losses on principal amounts may 

overwhelm coupon payments from 

bonds. Exhibit 44 shows the results 

of a break-even analysis for 10-year 

Treasury bonds in several major 

markets. This analysis examines the 

income component of bond returns 

versus capital gains. Bond yields have 

an inverse relationship with bond 

prices, meaning that when yields 

rise, prices fall, leaving investors with 

1-Year 

Forward 

Return 

2-Year* 

Forward 

Return 

3-Year* 

Forward 

Return 

capital losses. Break-even in this case 

is the number of basis points that will 

generate a capital loss large enough 

to completely offset the income 

component of the bond. As we can 

see in Exhibit 44, from the current 

level of yields in the U.S. (current 

10-Year Treasury Bond yield: 1.45%), 

a rise of only 15 basis points over the 

next year would be enough to wipe 

out any income from an investment, 

demonstrating just how expensive 

Treasury bonds have become. 

On the other hand, stock markets are 

depressed worldwide. While many 

came off their lows during the winter 

months, confidence since then has 

been shaken and markets have fallen 

back. To be sure, there are a variety 

of stiff headwinds facing investors. 

Europe continues to struggle with 

growth and austerity, as well as 

continued uncertainty regarding 

Greece and Spain, while patchy 

economic data in North America and 

the so-called fiscal cliff threatens the 

sustainability of the current business 

cycle. Slowing growth in China is 

5-Year* 

Forward 

Return 

10-Year* 

Forward 

Return 

U.S. 10-Year Treasury Bond -17.27% -12.68% -5.26% -3.19% -1.50% -0.19% 

Canada 10-Year Government Bond -17.76% -14.37% -6.74% -4.12% -1.96% -0.28% 

U.S. Investment Grade Bond** -10.49% -3.65% 0.62% 1.59% 2.39% 3.03% 

Canada Investment Grade Bond** -11.87% -6.81% -1.86% -0.22% 1.13% 2.19% 

15-Year* 

Forward 

Return 

20-Year* 

Forward 

Return 

U.S. Stocks (S&P 500) TR 29.35% 40.88% 24.05% 25.01% 18.65% 13.58% 11.78% 10.86% 

Canadian Stocks (TSX) TR 20.01% 21.05% 14.25% 13.58% 12.48% 10.46% 9.94% 9.66% 

*Annualized Returns **Bank of America ML Indexes, assuming long-term reversion to normal spread to T-bond, evenly through to end date 

Source: RBC GAM, Bloomberg 

stoking fears that it too may fall into 

recession. Nevertheless, in the past 

year, we have seen considerable 

advances in the economic recovery 

in North America and, while the 

problems in Europe remain complex, 

policymakers appear to have the 

tools and the wherewithal to guide 

the European Union to recovery, 

however long that may take. China’s 

policymakers also appear willing 

to support the Chinese economy, 

increasing the odds of a soft landing. 

These threats to the global economy 

have hit sentiment hard, driving down 

equity-market valuations while causing 

investors to bid up government bonds. 

In this environment, record- high 

corporate profits have been largely 

unrewarded, providing an attractive 

investment opportunity should 

risk aversion subside. Exhibit 45 

demonstrates the returns to investors 

for various asset classes based on 

a highly artificial, but impactful, 

assumption that they all move to levels 

forecast by our equilibrium models 

over a variety of time frames. For the 

SAMPLE 



U.S., yields moving to equilibrium 

over the year ahead would provide a 

loss of 13% for a 10-year T-bond. In 

the long term, even holding periods 

of five years or more would not be 

enough to provide positive compound 

annual returns to bond investors. 

Alternatively, were the S&P 500 to 

move to equilibrium, it would provide 

double-digit annual returns even if 

it took 10 years to get there! While 

stock markets are highly unlikely to 

jump to fair value in the short term, 

at current depressed levels potential 

long-term returns are compelling. 

Since the last edition of the Global 

Investment Outlook, we have made 

a number of changes to our tactical 

asset mix. We continue to overweight 

equities and underweight bonds in 

our recommended asset mix, and 

these trades have simply moderated 

the degree of these exposures. 

For a balanced global investor, we 

recommend an asset mix of 59.5% 

equities (versus a neutral level of 

55%), 35% bonds (versus a neutral 

level of 40%) with a balance of 5.5% 

cash. 

SAMPLE 



Global Fixed Income markets 

% 

% 

% 

16 

14 

12 

10 

8 

6 

4 

2 

0 

14 

12 

10 

1980 1985 1990 1995 2000 2005 2010 2015 

8 

6 

4 

2 

0 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 




U.S. 10-Year T-Bond Yield 


Japan 10-Year Bond Yield 




1980 1985 1990 1995 2000 2005 2010 2015 


U.K. 10-Year Gilt 




1980 1985 1990 1995 2000 2005 2010 2015 


% 

% 

17 

15 

13 

11 

18 

16 

14 

12 

10 

9 

7 

5 

3 

1 

8 

6 

4 

2 

Eurozone 10-Year Bond Yield 




1980 1985 1990 1995 2000 2005 2010 2015 




1980 1985 1990 1995 2000 2005 2010 2015 


Canada 10-Year Bond Yield 


SAMPLE 

“The bond market has 

remained stubborn in 

its commitment to very low rates 

since August 2011.” 



Global Equity markets 

3311 

2026 

1240 

759 

464 

284 

174 

106 

65 

40 

1000 

717 

514 

368 

264 

189 

136 

97 

70 

50 

14791 

9190 

5710 

3548 

2205 

1370 

S&P 500 Equilibrium 

Normalized Earnings & Valuations 

Jun. '12 Range: 1154 - 1938 (Mid: 1546) 

Jun. '13 Range: 1302 - 2186 (Mid: 1744) 

Current (01-June-12): 1278 

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


1980 1985 1990 1995 2000 2005 2010 2015 

Source: Datastream, Consensus Economics, RBC GAM 

851 

529 

329 

204 

Japan Datastream Index 

Normalized Earnings & Valuation 

Jun. '12 Range: 146 - 347 (Mid: 246) 

Jun. '13 Range: 333 - 793 (Mid: 563) 


22387 

14307 

9143 

5843 

3734 

2387 

1525 

975 

623 

398 

4467 

2899 

1881 

1221 

792 

514 

334 

217 

141 

513 

394 

303 

233 

179 

137 

106 

81 

62 

48 

S&P/TSX Composite Equilibrium 


Jun. '12 Range: 10650 - 15897 (Mid: 13273) 

Jun. '13 Range: 10729 - 16014 (Mid: 13371) 

Current (01-June-12): 11361 

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


Eurozone Datastream Index 


Jun. '12 Range: 1442 - 2659 (Mid: 2051) 

Jun. '13 Range: 1661 - 3062 (Mid: 2362) 


1980 1985 1990 1995 2000 2005 2010 2015 


SAMPLE 

U.K. Datastream Index 


Jun. '12 Range: 3392 - 5948 (Mid: 4670) 

Jun. '13 Range: 5699 - 9993 (Mid: 7846) 


1980 1985 1990 1995 2000 2005 2010 2015 


Emerging Market Datastream Index 


Jun. '12 Range: 205 - 364 (Mid: 285) 

Jun. '13 Range: 219 - 389 (Mid: 304) 


1995 2000 2005 2010 2015 

Source: Datastream, RBC GAM 



Global EQUITY MARKET Valuations 

X 

X 

X 

35 

30 

25 

20 

15 

10 

5 

0 

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


120 

100 

80 

60 

40 

20 

0 

30 

25 

20 

15 

10 

S&P 500 Index 

Normalized (Equilibrium) Price/Earnings Ratio 

Jun. '12 Range: 1 Std. Dev.: 12.6x - 20.4x (Mid: 16.5x) 


Current: 13.2x 

P/E on Trailing 12 Months Earnings 

+/- 1 Standard Deviation from Equilibrium P/E 

+/- 2 Standard Deviations from Equilibrium P/E 

Japan Datastream Index 








1980 1985 1990 1995 2000 2005 2010 2015 


X 

X 

X 

35 

30 

25 

20 

15 

10 

5 

0 

196019651970197519801985199019952000200520102015 


30 

25 

20 

15 

10 

5 

0 

S&P/TSX Composite Equilibrium 








Eurozone Datastream Index 








1980 1985 1990 1995 2000 2005 2010 2015 


SAMPLE 

United Kingdom Datastream Index 




Current: 9.5x 

5 




0 

1980 1985 1990 1995 2000 2005 2010 2015 


21 

19 

17 

15 

13 

11 

9 

7 

5 

Emerging Market Datastream Index 








2000 2005 2010 2015 



Global Fixed Income Markets 

Soo Boo Cheah, CFA 

Senior Portfolio Manager 


Review of previous 

recommendation 

The bond market continued to post 

solid returns during the three-month 

period, as yields across developed 

markets extended declines beyond 

the already low levels of last quarter. 

This time around, yields on 10-year 

German bunds and U.K. gilts posted 

new lows and outperformed all other 

major government bond markets. 

In North America, yields on U.S. 

Treasuries and Canadian government 

bonds fell to near-historic lows. In 

the previous edition of the Global 

Investment Outlook, we advocated 

overweighting countries and regions 

with central banks that are willing and 

able to intervene in financial markets, 

prompting us to pick U.S. Treasuries 

and Japanese government bonds (JGBs) 

over bunds. This recommendation 

detracted value from performance 

because we underestimated the degree 

of financial imbalances in the Eurozone 

and the effectiveness of the European 

Central Bank's (ECB) three-year longterm-refinancing-operation 

(LTRO), 

which flooded the banking system with 

liquidity. This liquidity worked its way 

into perceived better-quality bunds, 

and along the way pushed shortmaturity 

yields to levels below those in 

the lowest-yielding government-bond 

market – Japan (Exhibit 1). 

Market view 

The belief that banking or credit crises 

are almost always followed by years 

of below-average economic growth 

and frequent recessions remains well 

Exhibit 1. 

2.0 

1.6 

1.2 

0.8 

0.4 

Suzanne Gaynor 



Short Maturity German Bund Yields Are Now Lower Than JGBs 

JGB 2-Year Yields 

Bund 2-Year Yields 

0.0 

May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 

Source: Bloomberg 

entrenched among investors. For the 

past three years, this phenomenon 

has been playing out according to 

script. Investors remain comfortable 

with the idea of preserving capital via 

government bonds, contributing to 

the strong performance in this area. 

Furthermore, central-bank intervention, 

the cyclicality of macroeconomic risks 

and unresolved European debt issues 

have all forced bond yields lower still. 

As was the case last quarter, we remain 

of the view that short-term factors 

will keep bond yields low until an 

improving outlook clears the way for 

higher yields. 

We expect the European crisis to 

remain the key driver of risk sentiment 

and bond yields in the near term. 

This crisis is no longer just about the 

negative feedback loop between banks 

and sovereign debt. It has revealed 

the severity of the imbalances among 

member states and the inflexibility of 

the idealism on which the euro-project 

was predicated. The acronym EMU 

Bund yields are lower than JGBs! 

is commonly mistaken as “European 

Monetary Union,” but it really stands 

for “Economic and Monetary Union.” 

The “E” has been the weakest link 

since the launch of the EMU. Before the 

2008 financial crisis, peripheral nations 

had been enjoying all the benefits of 

using the euro, as their economies 

boomed and seemed to converge with 

Germany’s. However, the boom was 

fueled by debt rather than productivity 

gains, leading to large imbalances, 

especially with regard to Germany. 

When the financial crisis struck, asset 

prices collapsed, magnifying collateral 

losses on private-sector balance sheets 

and eventually on the public sector. 

Bond vigilantes punished the bond 

markets of these nations and forced 

them to seek external help. The onesize-fits-all 

EMU essentially limited 

individual member states to fiscal 

tools for combating the financial crisis, 

and these have not proved helpful at 

a time when both the economy and 

domestic bond markets are in turmoil. 

SAMPLE 


Global Fixed income markets • Soo Boo Cheah, CFA • Suzanne Gaynor 

The short-term fixes rely heavily on 

the ECB and member assistance that 

comes with high political hurdles. 

The long-term solution is to gain 

economic competitiveness via internal 

devaluation within the union, and this 

painful adjustment involves much 

needed structural reforms that provoke 

social unrest. If EMU was founded 

purely for economic reasons, surely it 

would not have been conceived, but 

EMU was mostly driven by a desire 

on the part of Europeans to avoid 

the military conflicts of the past. This 

very fundamental founding principle 

is currently under serious threat. 

Eurozone leaders need to move to the 

next level with drastic and difficult 

measures to strengthen the existence 

of the EMU. Anything other than this 

will prove that bond investors are right 

to feel apprehensive. 

Europe’s crisis so far has not been 

accompanied by massive capital flight 

from the Eurozone. Exhibit 2 shows 

foreigners have been liquidating 

European assets, but the scale is not 

matched by the larger liquidation 

by European investors of foreign 

assets that are being repatriated and 

sheltered in bunds. However, there 

is serious capital flight taking place 

within the Eurozone as evident in large 

imbalances in TARGET2, the system 

that settles cross-border flows among 

national central banks in the Eurozone. 

Prior to the crisis, trade-deficit outflows 

were usually counterbalanced by the 

capital inflows of surplus countries. 

With the onset of the current crisis, 

the weaker nations have incurred 

large liabilities (capital flight) and 

left the German national bank with 

large surplus claims (€650 billion as 

of April 2012, equivalent to 25% of 

Exhibit 2. 

12-Month Sum, Billions 

1,000 

800 

600 

400 

200 

0 

-200 

No Capital Flight Out of the Eurozone 

Eurozone Balance of Payments Portfolio Flows 

European Purchases of Foreign Assets 

Foreign Purchases of European Assets 

-400 

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

300 

200 

100 

0 

-100 

-200 

-300 

-400 

-500 

Europeans have been 

bringing money home! 

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


Germany’s annual GDP). Eurozone 

residents still believe in the cohesion 

of the Eurozone as a whole, which 

is illustrated by continued positive 

net inflows. However, doubts remain 

about the ability of the weaker nations 

to weather the current crisis. From a 

bond-market standpoint, large capital 

inflows into the German banking 

system will be recycled into bunds. 

The rising demand for bunds from the 

Eurozone banking system and private 

investors is taking place while the 

supply of bunds dwindles. The fear of 

contagion if Greece exits the Eurozone 

is causing extended turmoil in financial 

markets and sending bund yields lower 

by the day. Markets are scrutinizing 

the Greek political campaign leading 

up to the June 17 election to assess 

the possibility of damage from 

contagion in the global financial 

system. Investors are also monitoring 

the political will of the member states 

to hold the Eurozone together in the 

face of antagonistic domestic political 

agendas. 

SAMPLE 

In addition to risk aversion, centralbank 

intervention has been fueling 

the rally in government bonds. All 

major central banks have intervened 

in the past three months, either by 

expanding their balance sheets or 

offering generous liquidity. However, 

quantitative easing by the Bank of 

England has now ended, and the U.S. 

Federal Reserve Board’s “Operation 



Twist” ends this month. The LTRO 

program was a huge success initially, 

but the effect is wearing off quickly. The 

only new intervention has come from 

the Bank of Japan, which essentially 

put a floor on prices of short-maturity 

JGBs and potentially upward price 

pressure on longer-maturity JGBs. At 

the moment, all central banks are 

in stand-by mode, and will act to 

maintain extraordinarily low yields in 

case the crisis worsens. If European 

policymakers and politicians can avert 

a disaster, bond yields will likely rise. 

Another factor holding down bond 

yields has been disappointing U.S. 

economic data. However, the statistics 

must be viewed in the context of the 

past two years. In recent times, the 

pattern has been for economic news 

at the beginning of the year to be 

generally upbeat, before gradually 

turning south into the summer 

months and then improving again in 

the autumn. Assuming the pattern 

in Exhibit 3 persists for the rest of 

this year, economic data should 

start turning up in late summer. The 

possibility of stonger growth is not 

supportive of the idea that bond yields 

will stay at current low levels. 

Government bonds are the preferred 

investment in today’s highly uncertain 

investment environment. Over the 

past three years, developed markets 

have gone through a cycle that we 

have dubbed a “policy addiction 

loop.” This occurs when policymakers 

intervene in government fixed-income 

markets following significant declines 

in stocks and other risky assets. This 

has generally pushed up stocks only 

temporarily, prompting policymakers 

to resume intervening. Each time 

Exhibit 3. 

Economic Data Surprise Index 

(Analogue) 

150 

100 

50 

0 

-50 

Upside Surprise for the U.S. Economic Data 

2012 

-100 

-ve Surprise 

-150 

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 

Source: Citigroup, Bloomberg 

they step in, the doses get bigger. In 

Europe, we are at the juncture where 

band-aid solutions will no longer 

suffice, and markets are pricing in a 

high probability of the worst possible 

outcome: the uncontrolled exit of 

Greece and subsequent spread of 

financial contagion around the world. 

Absent this extreme scenario, bond 

yields would likely move higher. 

Deleveraging is also on the minds of 

investors. The European crisis to some 

degree foreshadows the progress 

of balance-sheet repair by the U.S. 

private sector following the financial 

crisis. Using a Citigroup road map 

that measures change in privatedebt 

relative to GDP before and after 

systemic banking crises, the U.S. went 

through a similar experience. Since the 

beginning of the 2008 crisis, privatesector 

debt as a percentage of GDP has 

been falling at a rate that is similar to 

that experienced by other countries. 

To date, the U.S. private sector has 

completed three out of the first four 

most painful years. There may be 

further deleveraging, but it will likely be 

to a lesser degree than before. 

+ve Surprise 

2011 

2010 

Where exactly do we find ourselves in 

the deleveraging cycle? H.W. Brock, 

the president of Strategic Economic 

Decisions (SED), argues that the longterm 

relationship between wealth and 

output provides the key to figuring 

out when deleveraging will begin 

winding down. Exhibit 4 shows U.S. 

household net worth (wealth) as a 

multiple of nominal GDP (output). 

Between 2005 and 2008, the multiple 

rose to unsustainable levels and was 

followed by crisis and deleveraging. 

The last data point shows the multiple 

is approaching the long-run average 

and signals that less aggressive U.S. 

deleveraging is required. 

SAMPLE 

A more intuitive way of considering 

sustainable wealth is through the 

multiple of net worth to household 

disposable income (Exhibit 5). In a 

trend that resembles the Brock model, 

U.S. household wealth relative to 

disposable income has fallen from 

levels during the 2005-2008 period, 

and currently rests at the long-term 

average multiple. Judging from both 

the wealth-to-output and net worthto-disposable 

income measures, 



U.S. private-sector balance sheets 

are on a much firmer footing than is 

generally believed and suggests further 

aggressive deleveraging is no longer 

warranted. This argues for a more 

conservative stance toward bonds. 

Bond yields at their current low levels 

are pricing in a raft of bad news. We 

acknowledge that the threat from the 

European crisis could wreak havoc 

on financial markets, leading to even 

higher fund flows into safe-haven 

government bonds. Concern about the 

Eurozone is less about the departure of 

Greece and more about the secondary 

effects on other peripheral economies 

and bond markets. The most likely 

immediate impact would be a surge 

in sovereign-risk premiums for other 

member states. This would be met 

with temporary capital controls across 

the EMU to curb bank runs, choking 

off credit and likely destroying wealth 

around the globe. In the U.S., politics 

are highly polarized, suggesting that 

much needed private investment to 

boost the economy is off the table until 

at least after the November election. 

The looming “fiscal cliff” – a mix 

of higher personal taxes and lower 

spending – could pare as much as 4% 

from U.S. economic growth and further 

depress U.S. Treasury yields. We do 

not place much weight on this worstcase 

scenario. The other risk pertains 

to an economic-growth slowdown in 

emerging markets, where relatively 

fast growth has been offsetting nearrecessionary 

conditions in much of the 

developed world. The plethora of nearterm 

risks could send bond yields to 

new lows. 

While the aforementioned risks could 

push yields to new lows over the short 

Exhibit 4. 

Multiple 

Exhibit 5. 

Multiple 

5.0 

4.5 

4.0 

3.5 

3.0 

2.5 

2.0 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

4.0 

3.5 

U.S. Net Worth to Nominal GDP 

Average = 3.6x 

Source: SED, Bloomberg, RBC GAM 

U.S. Net Worth to Personal Disposable Income 

Average = 4.9x 

3.0 

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 


SAMPLE 

term, we believe a reflation trade 

could emerge in the longer run. We 

expect more pro-growth governmental 

policies to appear in the pipeline. This 

scenario would contravene the extreme 

pessimism embedded in bond prices 

and warrant a reallocation out of safehaven 

assets. Bond yields are most 

at risk under this scenario, especially 

given their extremely rich valuations 

and crowded positioning. Also, the 

rationale for holding bonds to preserve 

capital is getting less appealing as 

rates fall. A small jump in interest rates 

would more than erase any returns 

from income as capital erodes. This is 

the thinking behind our bias for higher 

rates, but we are conscious that this 

is a bet on policymakers coming up 

with solutions that can bridge today’s 

polarized politics. 

Direction of rates 

We remain mildly bearish on bonds 

over the next 12 months. Our yield 

forecasts for Canada and the U.S. 

are a touch higher than they were 

in the previous quarter, reflecting 



our view that both economies are 

in better shape than suggested by 

their bond markets. For Germany, 

the U.K. and Japan, yield forecasts 

have been slightly lowered to reflect 

shifts in the political and economic 

landscape. In the near term, the threat 

of even lower yields is real should 

the European debacle worsen. The 

initial reaction would be for investors 

to flee to government bond markets 

outside Europe until aggressive 

policy steps bring yields into line with 

fundamentals. This could be a long 

work-out period and non-European 

government-bond markets are the most 

likely beneficiaries. 

Given the headwinds facing global 

governments, we expect major central 

banks to keep monetary policy 

accommodative. The ECB is likely 

to cut its short-term rate further to 

0.50% from the current 1.00%, and 

to implement further non-traditional 

monetary stimulus. At home, however, 

we expect the Bank of Canada to 

tighten its policy rate within the next 12 

months because the bank is concerned 

about excessive consumer debt, 

especially in home mortgages. 

We recognize that bond yields are far 

too low and that we are potentially 

in the last phase of the 30-year bull 

market for bonds. However, near-term 

uncertainties would suggest that we 

should not totally give up on bond 

allocations just yet since there is still 

the potential for a final surge in prices. 

We are also cognizant that 

policymakers will likely implement 

further measures to hold down yields. 

Taking all factors into consideration, 

we expect the market to wade through 

the current impasse and eventually 

Exhibit 6. 

Predicted minus Actual (%) 

6.0 

5.5 

5.0 

4.5 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

U.S. 10-Year Treasury Yield Is Extremely Rich 

Intercept + UST 2-Year + Business Cycle Index 

Actual 10-Year Yield = 1.78 

Model-Predicted Forecast = 2.75 

Bonds Expensive 

-0.5 

Bonds Cheap 

-1.0 

2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 

Source: Deutsche Bank, RBC GAM 

refocus on fundamentals. This makes 

us mildly bearish on bonds but not 

“super bears.” 

U.S. – There is no change to our fed 

funds forecast from the previous 

quarter. Our 0.25% prediction is in 

line with market expectations for low 

front-end rates. As long as the policy 

rate remains well anchored, yields 

further out the curve are expected 

to remain low. The binary nature of 

the European crisis has shortened 

investment horizons for most investors 

and held down Treasury yields. Since 

our forecast is for 12 months out, we 

are hopeful that the current tensions 

will have subsided by then. We expect 

economic data to surprise to the upside 

later this year as household balance 

sheets strengthen. In this scenario 

of gradual economic improvement, 

we expect the Fed to stay sidelined 

and yields to move toward fair value. 

Our fair-value model, which takes 

into account short-term yields and 

the business cycle, suggests that the 

10-year Treasury yield should be at 

2.75% (Exhibit 6). 

SAMPLE 

Another powerful tool for forecasting 

the direction of U.S. 10-year Treasury 

yields is an examination of bond 

returns relative to growth in the money 

supply (Exhibit 7). This model shows 

that bond returns have been keeping 

pace with money-supply growth. For the 

relationship between bond returns and 



money supply to normalize, bond total 

returns will need to fall by 7.2%. Using 

both models as guides, our 12-month 

yield forecast for the 10-year Treasury 

rises a notch to 2.75% from 2.50%. 

Germany – In the current environment, 

Germany’s bund market is the only 

liquid and relatively safe place to 

park capital in the Eurozone, and 

absent a comprehensive solution, any 

new liquidity measures will continue 

to bolster these securities. Further 

supporting bund yields is the limited 

supply given the country’s strong 

economic growth and shrinking budget 

deficit. We are lowering our forecast 

for 10-year German yields to 2.25% 

from 2.50% to reflect our belief that a 

solution to the crisis will require a long 

work-out period. 

Japan – This remains a country that 

is far too rich to go broke, and JGBs 

tend to outperform in a global bear 

market for bonds. Japanese households 

are still among the richest in the 

world. Even taking into account the 

large stock of government debt, the 

country’s net wealth is extremely high 

relative to most countries. Household 

assets remain highly liquid, with cash 

deposits continuing to accumulate and 

supporting the ever rising government 

debt. We continue to expect postearthquake 

reconstruction programs to 

support economic growth in the coming 

months, but JGB yields will likely take 

their cue from global markets over the 

near term. 

Some of the negatives for yields 

include the inflationary impact of a 

probable hike in consumption taxes 

and the Bank of Japan’s (BOJ) embrace 

of an inflation target in a country that 

has suffered two decades of deflation. 

Exhibit 7. 

Bond Return / Money Supply Growth 

Bond Returns Have Been Keeping Pace With Money Supply Growth 

3.0 

2.8 

2.6 

Bond Return > Money Supply Growth 

2.4 

2.2 Average 1996-2012 = 2.13 

2.0 

1.8 

1.6 

1.4 

Bond Return < Money Supply Growth 

1.2 

1.0 

1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 


We expect yields on JGBs to head 

higher when international market 

turmoil starts to subside. In spite of 

that call, we are lowering our 10-year 

JGB yield forecast to 1.10% from 1.25% 

last quarter to reflect the stickiness 

of fund flows into JGBs and what we 

believe will be the BOJ’s willingness to 

expand the basket of securities that it 

will purchase. As for policy rates, we 

expect the BOJ to continue with the 

JGB purchase program and attempts to 

moderate appreciation in the yen. Our 

policy-rate forecast stays at 0%. 

Canada – In the summer of 2011, the 

Bank of Canada appeared on its way to 

tightening monetary policy, but decided 

to hold off after the European crisis 

worsened. In April of this year, the 

central bank returned to its tightening 

bias, but the market is again doubtful, 

believing the bank is unlikely to act 

before the end of 2012. Canadian midterm 

and long-term bonds are heavily 

influenced by U.S. Treasuries, and we 

expect yields in both countries to rise 

once the risk aversion/flight to quality 

trade concludes. While Canada tends to 

lag under those circumstances, it could 

outperform in the longer term due to 

well anchored inflation expectations 

and stronger fiscal fundamentals. We 

have raised our 10-year benchmark 

forecast to 3.00% from 2.75%, and 

expect the administered policy rate to 

be 1.50% in 12 months, up from the 

current 1.00%. 

U.K. – The latest Bank of England 

inflation report showed inflation in line 

with the target over the medium term, 

but with a high uncertainty surrounding 

its trajectory. However, inflationary 

concerns are the least of the Bank 

of England’s worries at the moment. 

In the report, the bank lowered its 

growth forecast to reflect disappointing 

recent data and admitted that it 

was less optimistic about demand 

and productivity growth. However 

one analyzes the U.K. economy, the 

fiscal outlook faces headwinds. The 

government plans to extend austerity 

measures even in the face of GDP 

contraction in the Eurozone, and this 

resoluteness can hardly improve the 

outlook for the U.K. economy. The 

litmus test will be whether the U.K. can 

maintain any growth momentum that 

it gains from this summer’s Olympic 

Games in London. It appears that the 

SAMPLE 



central bank will have no choice but 

to maintain the policy rate at current 

levels and keep its options open 

for more quantitative easing. This 

means that gilts will likely remain well 

supported. We are lowering our yield 

forecast for the 10-year gilt to 2.25%, 

down from 2.50% last quarter, partly 

on expectations of more quantitative 

easing and partly because of capital 

inflows from the Eurozone. 

For all regions, we generally 

expect higher yields by the end 

of the forecasting horizon while 

acknowledging the possibility that 

bond yields will reach new lows in the 

near term. Listed below are the key 

risks to this base case. 

Dissolution of the EMU – Such an 

outcome would send shock waves 

around the world. Government bond 

yields in the U.S., Canada, U.K. and 

Japan would probably reach new lows. 

Overregulation – After the nearcollapse 

of the global financial system 

in 2008, policymakers are formulating 

regulations to prevent a recurrence. We 

expect an announcement on new Basel 

III capital and liquidity requirements in 

the coming months. While the longerterm 

goal is to make banks safer, the 

immediate effect will likely be to push 

up demand for safe-haven assets and 

dampen much needed credit growth. 

U.S. politics and the fiscal cliff – 

Hopefully, the weakness in Europe 

serves as an example for U.S. 

politicians to be sensible when it 

comes to addressing their own budget 

situation. A failure to act decisively 

will push the country into another 

recession. We expect the spotlight 

12-MONTH Horizon total return breakeven analysis: 10-YEAR UST (USD term) 

Changes in Yield From Current Level (bps) as of May 21, 2012 

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

2-Yr @ 0.29% 0.44% 0.34% 0.24% 0.14% 0.04% -0.06% -0.16% -0.45% -0.65% 

10-Yr @ 1.75% 5.6% 4.8% 3.9% 3.1% 2.2% 1.4% 0.6% -0.2% -1.0% -3.4% -4.9% 

12-MONTH Horizon total return breakeven analysis: 10-YEAR JGB (JPY term) 


12-MONTH Horizon total return breakeven analysis: 10-YEAR Bunds (EUR term) 


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

2-Yr @0.04% 0.04% -0.02% -0.12% -0.22% -0.31% -0.41% -0.66% -0.91% 

10-Yr @1.43% 5.5% 4.6% 3.8% 2.9% 2.1% 1.2% 0.4% -0.4% -1.2% -3.3% -5.2% 


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

2-Yr @0.09% 0.09% -0.01% -0.11% -0.21% -0.31% -0.41% -0.65% -0.90% 

10-Yr @ 0.85% 4.5% 3.6% 2.7% 1.9% 1.0% 0.1% -0.7% -1.6% -2.4% -4.5% -6.5% 

Exhibit 8. 

Scenario: 

Naïve 

Expected 12-Month Return Distribution for U.S. 10-Year Treasuries 

Scenario: 

No middle ground 

Scenario: 

Gradually higher 

Prob. Yield % Return Prob. Yield % Return Prob. Yield % Return 

SAMPLE 

25% 1.55 4.8% 50% 1.55 4.8% 33% 2.05 0.6% 

50% 1.75 3.1% 50% 2.75 -4.9% 33% 2.25 -1.0% 

25% 2.75 -4.9% 33% 2.75 -4.9% 

Exp. 12-Month TR 1.5% Exp. 12-Month TR -0.1% Exp. 12-Month TR -1.8% 




to shine more on this topic as the 

presidential election nears. 

Deflation – One possible outcome of 

low economic growth and private-sector 

deleveraging is asset-price deflation. 

A deflationary scenario would support 

fixed-income assets, whose interest 

payments retain their value especially 

well when inflation ceases. 

Subordination – The more governments 

intervene in the bond market, the more 

likely it is that private bondholders will 

find their claims subordinated. Bond 

holders will eventually require higher 

risk premiums if they sense a rising 

probability of default. However, the 

added risk premiums will most likely 

be countered by additional aggressive 

bond-buying by policymakers and other 

‘repressive’ measures (e.g. mandatory 

bond allocations in governmentsponsored 

pension plans). 

Regional Preferences 

We remain fundamentally bearish on 

bonds over the long term, although 

we expect bond yields to increase 

gradually rather than surge quickly. 

Plotting simple scenarios on U.S. 

Treasuries, the range of expected 

returns does not warrant a strongly 

bearish stance (Exhibit 8). For 

this quarter, we recommend a 3% 

overweight allocation to JGBs, with an 

equal underweight in U.S. Treasuries. 

This is a change from the previous 

quarter, when we were overweight 

both Treasuries and JGBs by 2.5%, and 

underweight bunds by 5%. 

Underweight U.S. – A reversal of this 

bet on the best safe-haven asset is 

expected once euro-bashing starts to 

Interest rate forecast: 12-Month Horizon 

Total Return Calculation: May 22, 2012 – May 23, 2013 

U.s. 

3-Month 2-Year 5-Year 10-Year 30-Year 

Horizon Return 

(local) 

Base 0.25% 0.75% 1.50% 2.75% 3.85% -2.7% 

Change to prev. quarter 0.00% 0.15% 0.05% 0.25% 0.35% 

High 0.25% 1.25% 2.40% 3.50% 4.50% -5.8% 

Low 0.00% 0.00% 0.50% 1.50% 2.75% 2.8% 

Expected Total Return US$ Hedged: -2.44% 

Germany 



(local) 

Base 0.50% 0.75% 1.25% 2.00% 2.35% -1.5% 

Change to prev. quarter 0.00% -0.25% -0.25% -0.50% -0.50% 

High 1.00% 1.50% 2.50% 3.25% 3.40% -9.4% 

Low 0.25% 0.10% 0.50% 1.25% 2.00% 2.6% 


Japan 



(local) 

Base 0.10% 0.25% 0.50% 1.10% 2.20% -1.8% 


High 0.10% 0.50% 0.80% 1.75% 2.75% -6.1% 

Low 0.00% 0.00% 0.25% 0.75% 1.80% 1.5% 


Canada 



(local) 

Base 1.50% 2.25% 2.60% 3.00% 3.50% -5.0% 

Change to prev. quarter 0.50% 0.50% 0.35% 0.25% 0.25% 

High 2.00% 2.90% 3.20% 3.50% 3.90% -7.8% 

Low 1.00% 1.20% 1.50% 1.75% 2.40% 2.6% 


SAMPLE 

U.K. 



(local) 

Base 0.50% 0.75% 1.25% 2.25% 3.25% 1.0% 


High 0.50% 1.40% 2.25% 3.25% 3.60% -4.3% 

Low 0.25% 0.35% 0.50% 1.50% 2.75% 7.3% 

Expected Total Return US$ Hedged: 0.33% 




recede. Investors should shift their 

focus back to the strong fundamental 

stories. The Fed is also expected to 

step aside under these circumstances, 

and intervention premiums in 

Treasuries will gradually dissipate. 

Overweight JGBs – The best 

performing market in a bond bear 

market (Exhibit 9). 

Neutral Bunds – The liquidity 

warehouse and perceived safe-haven 

asset of the Eurozone. The near-term 

range of possible outcomes for bunds 

is very diverse, and a neutral allocation 

is, therefore, prudent this quarter. 

Exhibit 9. 

10-Year Yield Spread: 

U.S. minus JGB 

200 

150 

100 

50 

0 

-50 

-100 

-150 

U.S. Treasuries Tend To Underperform in a Rising Rate Environment 

Rising 

Spread 

Rising Yield 

-200 

-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 

3-Month Change in U.S. 10-Year Treasury Yield 


SAMPLE 


Currency Markets 

Dagmara Fijalkowski, MBA, CFA 

Head, Global Fixed Income & Currencies (Toronto & London) 


The recent performance of the U.S. 

dollar has been better than many 

expected, with the greenback inching 

higher from the all-time lows of a year 

ago. The slow appreciation fits with the 

gradually improving domestic economy. 

For all its progress, the greenback is 

still about 10% of its nadir and far 

from levels that would be a problem 

for U.S. economic growth. Valuations 

will not stand in the way of further 

strengthening for a long time, as even 

with another 10% gain, the U.S. dollar 

would remain cheap (Exhibit 1). 

We believe there are three reasons 

why U.S. dollar bearish bets, 10 years 

after the dollar bear market began 

and nearly 40% below the highs, 

are poor risk-reward trades. First, an 

improving current-account deficit, 

due to lower reliance on imports to 

meet the energy shortfall, is expected 

to continue (Exhibit 2). At the same 

time, the growth of foreign-exchange 

reserves has been slowing since 2009, 

which, combined with the Eurozone 

crisis, means less need to diversify 

reserves by selling the U.S. dollar. The 

second reason is valuations, as the 

dollar is about 16% undervalued and 

just a few percentage points above 

its line in the sand (Exhibit 3). Third 

is demographics, which, thanks to 

immigration, compares favourably not 

only to developed countries, but also 

to some emerging-market countries like 

China and South Korea 1 (Exhibit 4). 

1 These LT fundamentals have been discussed in 

more depth in the Global Investment Outlook, 

Spring 2012. 

EXHIBIT 1. 

Billions of Cubic Feet 

145 

135 

125 

115 

105 

95 

85 

75 

65 

-2,500 

USD Down 

8 yrs 

-26% 

Long-Term U.S. Dollar Cycles 

Trade-Weighted USD Index (Nominal, Major Currencies) 

USD Up 

6 yrs 

+67% 

USD Down 

10 yrs 

-47% 

USD Up 

7 yrs 

+43% 

USD Down 

10 yrs? 

-40% 

1971 1975 1980 1984 1989 1993 1998 2003 2007 2012 

EXHIBIT 2. 

5,000 

2,500 

Source: Bloomberg, Deutsche Bank 

0 

U.S. Energy Shortfall 

U.S. Natural Gas Shortfall 

-5,000 

1982 1991 2001 2011 

Source: U.S. Energy 

In the meantime, while we are waiting 

for dollar-bottoming to signal the 

turn of the trend, holding the dollar 

offers other advantages. It remains 

the safe-haven currency, as its longterm 

correlation with risky assets is 

near 40-year lows (Exhibit 5). This 

characteristic comes in very handy for 

our portfolios. Exhibit 6 compares highyield 

index prices with the relationship 

Millions of Barrels 

6,000 

4,000 

2,000 

0 

-2,000 

-4,000 

U.S. Crude Oil Shortfall 

SAMPLE 

-6,000 

1982 1992 2002 2012 

Source: U.S. Energy 

between the U.S. and Canadian dollars. 

Their negative correlation, which tends 

to be high under normal circumstances, 

increases significantly under stressful 

periods like last fall (circled). This is 

what we refer to when we say that we 

include some U.S. dollar holdings in 

our portfolios as an insurance policy. 

Please note that when stress subsided 

and high-yield prices recovered, the 


Currency markets • Dagmara Fijalkowski, MBA, CFA 

U.S. dollar didn’t give back much of its 

strength. 

Why is the dollar a safe haven? Broadly 

speaking, because U.S. portfolio 

managers invest more money abroad 

than foreign investors invest in the 

U.S. Exhibit 7 shows a comparison of 

net international investment positions 

excluding reserve assets and liabilities, 

which are considered sticky assets. 

The U.S. is one of the three countries 

with net exports of investment capital. 

However, the other two, Japan and 

Switzerland, have been actively trying 

to limit the strength of their currencies. 

This means that in times of stress, 

U.S. investors bring their money home, 

strengthening the greenback in the 

process. 

The euro 

Despite the euro’s resilience early 

in the year, our base case for the 

currency remains bearish. For the time 

being, the stress manifests itself in 

intra-EMU flows, which lead to the 

outperformance of bunds versus bonds 

of peripheral countries. We have, 

therefore, seen relatively little impact 

on the value of the single currency. By 

March of this year, yields on 10-year 

bunds fell to unprecedented levels 

below 1.5%, and yields on 2-year 

German notes fell below comparable 

securities issued by Japan. We believe 

this resilience is temporary. With 

Eurozone problems heating up after 

the failed Greek elections, the ECB 

will likely find itself easing monetary 

policy, while the probability of the Fed 

engaging in QE3 has declined along 

with improvement in the U.S. economy. 

Two-year interest rate differentials 

reflect these expectations and suggest 

the euro will fall further (Exhibit 8). 

EXHIBIT 3. PPP Valuations – April 2012 

% Over/Undervalue) 

40 

30 

20 

10 

0 

-10 

-20 

50% 

40% 

30% 

20% 

10% 

0% 

-10% 

-20% 

-30% 

-40% 

-50% 

33.3 

31.3 

26.4 

20.3 

EXHIBIT 4. Labour Force Growth (Age 15-64) 

14.7 13.9 12.9 12.9 

2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 

Source: UN Population Division, Deutsche Bank 

-0.4 

-15.6 

AUD NZD CHF CAD NOK EUR GBP JPY SEK USD 

Source: Deutsche Bank 

U.S. 

Canada 

U.K. 

China 

Europe 

Korea 

Japan 

SAMPLE 

EXHIBIT 5. Correlation of the U.S. Dollar and U.S. Equities (S&P 500) 

1.0 

Long Term Correlation: -0.11 

0.8 

0.6 

0.4 

0.2 

0.0 

-0.2 

-0.4 

-0.6 

-0.8 

-1.0 

Last observation: -0.69 

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 


50% 

40% 

30% 

20% 

10% 

0% 

-10% 

-20% 

-30% 

-40% 

-50% 



Unlike in previous years, downward 

pressure on the euro will not be 

offset by further demand from central 

banks, which have traditionally sold 

U.S. dollars to diversify their foreignexchange 

reserves into euros. With the 

odds of a Greek exit from the Eurozone 

increasing, contagion risks have been 

growing and weighing on the euro. 

As Steven Englander of Citibank put 

it: “The way to avoid this contagion 

and downward pressure on the euro 

would be to provide an absolute, nonconditional 

guarantee that no other 

country would drop out. This would 

be a spectacular transformation – an 

ECB that is unwilling to act like the Fed 

morphs into the Swiss National Bank.” 

The reference is to the possibility 

that the ECB would mimic the Swiss 

National Bank's extraordinary vow to 

pursue quantitative easing, i.e. much 

more aggressive than the quantitative 

easing embraced by the Fed. Such a 

vow by the ECB would constitute an 

equally extraordinary about-face. The 

lack of such decisive action by the ECB 

implies further declines for the euro, as 

European politicians and technocrats 

have so far failed to deliver preventive 

action. Investors, including those 

managing foreign-exchange reserves, 

understandably have doubts. Exhibit 9 

shows that valuation-adjusted reserve 

allocations by global central banks 

to the euro peaked in 2009 and have 

been declining since. 

Can we imagine a scenario when the 

euro performs better? Yes, but at the 

moment we assign a lower probability 

to this scenario. Commitments 

by the ECB to conduct unlimited 

bond purchases or a promise of allencompassing 

financial support from 

Germany would have to be ironclad. 

EXHIBIT 6. 

110 

105 

100 

95 

90 

85 

EXHIBIT 7. 

140% 

90% 

40% 

-10% 

-60% 

-110% 

Australia 

2011 Weak High Yield Market Offset by Strong Greenback 

Merrill Lynch High Yield Weighted Average Price 

USD-CAD 

Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 


Net International Investment Position (% of GDP) 

Foreign Assets Held Excluding Reserve Assets & Liabilities 

Norway 

Swe 

Source: Credit Suisse 

Canada 

Euro 

area 

SAMPLE 

EXHIBIT 8. 

1.2% 

0.7% 

0.2% 

-0.3% 

-0.8% 

1.15 

Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 


UK 

EURUSD vs. 2-Year Interest Rate Spread 

2-Year Yield Differential (LHS, EU-US) 

EUR-USD (RHS) 

US 

Japan 

Switz 

1.50 

1.45 

1.40 

1.35 

1.30 

1.25 

1.20 



The latter would mean an accelerated 

path to a Eurobond market, in which 

peripheral countries could benefit from 

the financial guarantees of stronger 

countries, Germany being the key 

among them. Only when fiscal union 

becomes a real prospect does it make 

sense to talk about a Eurozone-wide 

government-debt-to-GDP ratio and 

current account. 

Aside from these two long-term 

sources of support (unconditional 

buying commitment by the ECB and/or 

German acquiescence to a fast-tracked 

Eurobond market), other band-aid 

solutions can be considered. Among 

them: additional extraordinary liquidity 

measures similar to the ECB’s Long- 

Term Refinancing Operation (LTRO); 

EMU-wide deposit insurance; and the 

creation of a ‘bad bank’ in Spain to 

hold non-performing real estate loans. 

Paradoxically, the other source of shortterm 

support for the euro may be that 

investors are already so pessimistic 

about the currency. Although 

consensus forecasts call for only minor 

depreciation, every positioning survey 

we monitor shows a persistent euronegative 

bias (Exhibit 10). With many 

investors having lower risk budgets, 

tolerance for losses is very limited, 

and any relief and/or headline-driven 

rallies force them to cover their short 

positions, fueling temporary support. 

But with the euro now less attractive as 

a reserve currency, long-term investors 

will use these rallies as opportunities 

to reduce their holdings. 

In the longer term, investors’ bearish 

stance is justified by most valuation 

frameworks, including purchasing 

power parity, which suggests the euro 

is on the expensive side of the ledger. 

EXHIBIT 9. 

% 

85 

75 

65 

55 

45 

35 

25 

15 

5 

-5 

Central Bank Reserve Allocations 

USD EUR GBP JPY CHF Others 

EUR peaked in 2009 at 33.9% 

2006 2007 2008 2009 2010 2011 

Source: IMF COFER, Barclays Research 

EXHIBIT 10. 

Positioning 

However, a 14% PPP overvaluation 

does not give the high level of 

confidence offered by overvaluations in 

excess of 20%. 

Based on technical analysis, the 

bearish channel suggests further 

downside with the initial objective in 

the 1.20 region, but a more severe drop 

is possible over the next 12-18 months. 

Euro rallies should be contained in the 

low 1.30s for now, which would provide 

a good opportunity to sell. 

IMM TFX State Street Deutsche 

USD Very Long Long Very Long Very Long 

CAD Very Long Neutral Neutral Very Long 

EUR Very Short Short Short Very Short 

JPY Very Short Short Very Short Long 

GBP Very Long Very Short Very Long Neutral 

AUD Very Short Long Short Very Short 

CHF Very Short Short Short Very Short 

NOK N/A Long Very Short Neutral 

SEK N/A Very Long Very Long Long 

MXN Short N/A Very Short Short 


SAMPLE 

Putting together this list of positives 

and negatives from long- and shortterm 

perspectives, we believe that 

short-term rallies should not obscure 

the long-term negatives. Given current 

valuations, the negatives should push 

the single currency down over our 

forecast horizon. A weaker currency 

remains an important component of 

a resolution to the European crisis, 

assuming that Germany can tolerate 

slightly higher inflation. We are calling 

for the euro to fall to 1.20 in 12 

months. While our forecast is much 



lower than the consensus, we don’t 

consider it overly aggressive. 

The Canadian dollar 

As for the Canadian dollar, our 

discussion must start with PPP 

valuations, since our currency is again 

flirting with the line in the sand (Exhibit 

11). Historically, the upside potential 

of buying the loonie at these levels 

is not attractive, and the currency’s 

forays beyond this 20% threshold have 

typically lasted months rather than 

years. Much of the good story on the 

Canadian dollar is already priced in. 

Keeping that in mind, we note that 

shorter-term valuations are more in 

line with current price levels, although 

there is a significant divergence of 

views in the market. Our own shortterm 

model, which is based on different 

monetary policies, commodity prices 

and differences in growth proxies, 

justifies exchange rates within 2% of 

parity (Exhibit 12). From a short-term 

valuation perspective, the Canadian 

dollar remains first and foremost a 

proxy for growth and, unless we expect 

growth to accelerate in 2012, the 

upside is limited. The same goes for 

the downside. 

It appears that in the absence of 

growth surprises or other unexpected 

macroeconomic developments, the 

Canadian dollar will remain comfortably 

around parity. Even after the Bank of 

Canada’s shift to a more hawkish tone 

in April significantly raised expectations 

of interest rate hikes, the loonie barely 

budged. The positive effect of monetary 

policy was overwhelmed by general 

risk aversion surrounding the Greek 

elections in May. Our view is that the 

change in the BOC’s stance would 

EXHIBIT 11. 

1.70 

1.60 

1.50 

1.40 

1.30 

1.20 

1.10 

1.00 

0.90 

1973 1976 1979 1982 1986 1989 1992 1995 1999 2002 2005 2008 2012 

EXHIBIT 12. 

1.06 

1.02 

0.98 

0.94 

0.90 

USDCAD Short-Term Valuation Model 

S&P 500, WTI Oil and 2-Year Interest Rate Differential 

Actual 

Model Estimate 

Actual Value: 1.03 

Estimated Value: 1.01 

Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 


EXHIBIT 13. 

8% 

6% 

4% 

2% 

0% 

-2% 

-4% 

-6% 

USDCAD vs. Purchasing Power Parity 

PPP Average USDCAD 20% Bands 


SAMPLE 

Canada External Balances 

Current Account Balance (% of GDP) 

Foreign Direct Investment Balance (% of GDP) 

Portfolio Flows (% of GDP) 

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

Source: Haver Analytics 



have been much more meaningful had 

the loonie traded at cheaper valuation 

levels. 

Since many foreigners have added 

Canadian dollars and Canadian assets 

to their portfolios over the past few 

years, scrutiny of Canada’s fiscal 

position is now intense. Last year, 

Canada’s current account dipped into 

deficit for the first time in 20 years. 

While short-term portfolio inflows, 

mostly bond purchases, have more 

than offset the deficit, the inflows 

peaked eight quarters ago and the 

stability of the funding depends on 

whether Canadian bonds remain 

attractive to foreign buyers (Exhibit 13). 

This vulnerability is also highlighted 

by Canada’s terms of trade, which 

represent the value of a country’s 

exports relative to its imports. While 

the Canadian dollar’s recent strength is 

comparable to 2007, Canada’s terms 

of trade are 10% lower (Exhibit 14). 

They reflect not only the heavy weight 

of weak natural gas prices in exports, 

but also the unusually low price that 

Western Canada receives for oil exports 

relative to the price paid by eastern 

Canada, which relies on imported oil 

(Exhibit 15). Since energy exports have 

been rising as a percentage of overall 

exports over the past decade (to 25% 

from 10%), global trends in commodity 

prices have become more relevant for 

the Canadian dollar. 

From a technical standpoint, the U.S. 

dollar finds its first support at 98 

cents, the level we have been calling 

an “opportunity” to buy U.S. dollars for 

the past six months. The next support, 

at 96 cents, would be a rare “gift” and 

a great chance to exchange expensive 

EXHIBIT 14. 

0.85 

0.95 

1.05 

1.15 

1.25 

1.35 

1.45 

1.55 

1.65 

U.S. Dollars 

USDCAD vs. Terms of Trade 

USDCAD (LHS, inverted) 

CAD Terms of Trade (RHS) 

1995 1997 1999 2001 2003 2005 2007 2009 2011 

EXHIBIT 15. 

130 

120 

110 

100 

90 

80 

70 

60 

50 

40 


Crude Oil Spot Prices 

Brent (Europe) 

West Texas (U.S. Midwest) 

Western Canada Select 

Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 


SAMPLE 

loonies for cheap greenbacks. The 

longer the time horizon, the more 

attractive the U.S. dollar becomes 

below parity and the more comfortable 

investors should be holding it. 

To summarize, a Canadian currency 

above parity is priced for perfection 

and vulnerable to downward revisions 

in global growth. The most important 

short-term support comes from the 

Bank of Canada’s hawkish stance visà-vis 

the Fed. However, the long-term 

positives are mostly known, and with 

the Canadian dollar 20% higher than 

115 

110 

105 

100 

95 

90 

85 

80 

75 

its PPP valuation, they are already 

reflected in the price. 

The British pound 

The Eurozone crisis means that the 

pound’s limitations are being largely 

overlooked, and sterling now walks 

as a one-eyed man in the land of 

the blind. Looked at in isolation, the 

positives for the currency are not that 

positive, but given valuations and the 

mess across the Channel, the pound 

stands up to closer scrutiny. For one 

thing, Britain’s current-account deficit 



has improved somewhat, and by the 

end of 2011 stood at just under 2% 

compared with a U.S. deficit of more 

than 3%. Interest in the pound from 

reserve managers has been increasing 

steadily, especially after the Swiss 

National Bank’s assertive action 

last fall to keep the Swiss franc from 

strengthening. April 2012 was the first 

month since February 2010 that the 

governor of the Bank of England did not 

have to justify in writing why consumer 

prices were overshooting the bank’s 

forecast. With inflation falling since 

September 2011, the improvement in 

real yields makes the currency more 

attractive on a yield basis than the U.S. 

dollar or the euro (Exhibit 16). Finally, 

while the locals might disagree, British 

politics appear sane compared to the 

risk of Congressional inaction in the 

face of the fiscal cliff in the U.S. and 

European governments’ inability to face 

up to the deepening crisis. 

These positives, combined with 

attractive PPP valuations versus the 

euro and the Canadian dollar, make 

us fairly comfortable with exposure 

to the pound, and we are leaving 

our forecast versus the U.S. dollar 

mostly unchanged. What prevents us 

from being outrightly bullish versus 

the U.S. dollar is our concern about 

the precariousness of Britain’s fiscal 

position and a lack of economic 

growth. As well, the combination of 

tight fiscal and easy monetary policies 

is not generally supportive of the 

currency. While we expect the euro to 

depreciate versus the U.S. dollar, the 

pound would do well by remaining little 

changed. 

EXHIBIT 16. 

0% 

-1% 

-2% 

-3% 

Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 


EXHIBIT 17. 

1.2% 

1.0% 

0.8% 

0.6% 

0.4% 

0.2% 

0.0% 

10-Year Real Yields 

U.S. 

Germany 

U.K. 

USDJPY vs. 2-Year Rate Spread 

2-Year Yield Differential (U.S. minus Japan, LHS) 

USDJPY (RHS) 

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 


SAMPLE 

The Japanese yen 

The yen remains one of the strongest 

currencies because Japanese investors 

are almost single-handedly keeping 

it afloat. Their decisions are first 

and foremost driven by yields and a 

desire to find a safe destination for 

their savings. With the yield on U.S. 

2-year notes dropping back to 25 basis 

points from about 40 basis points, the 

yen found support and has bounced 

back since mid-March (Exhibit 17). 

Exhibit 18 shows the extra yield that 

Japanese investors can pick up on 

94 

89 

84 

79 

74 

hedged 10-year U.S. Treasury bonds 

versus Japanese government bonds 

of the same term. While off the highs 

due to U.S. yield-curve flattening, yen 

investors can pick up over 100 basis 

points without taking currency risk 

through exposure to a country (the 

U.S.) with a lower debt/GDP ratio and 

better credit rating. Income from foreign 

investments helps bring the current 

account into surplus. In addition, 

while nominal foreign-exchange rates 

are near historic extremes, the real 

effective exchange rate is closer to 



the 20-year low than the 20-year high 

(Exhibit 19). 

The conclusion: for now Japanese 

investors have no incentive to take 

foreign-currency risk, and that’s 

supportive for the yen. The yen is 

strong despite the fact that foreign 

investors are not even active in the JGB 

market. Under the right circumstances, 

the yen could become more attractive 

as a destination for reserve managers 

and benefit from such inflows. 

We don’t mean to suggest that 

the long-standing negatives have 

dissipated. They haven’t. Prominent 

arguments against the yen include: 

• The substantial threat of 

intervention by the Bank of Japan 

and/or Japanese Ministry of Finance 

in the foreign-exchange market. 

• BOJ stepping up monetary easing 

with further asset purchases. 

• The Japanese trade deficit, which 

prevailed for most of 2011, is 

expected to continue due to higher 

energy imports after Japan recently 

closed its last nuclear-power 

station. 

• The worst public debt/GDP ratio of 

any major economy. 

• The worst demographic profile of 

any major economy over the next 

40 years. 

• The near certainty that the BOJ 

will be the last major central bank 

to hike interest rates, suggesting 

limited appreciation potential 

versus the U.S. dollar. 

Taking these points together, we 

don’t expect much upside for the yen. 

However, the downside seems limited 

for now too, at least until investors get 

EXHIBIT 18. 

3% 

2% 

1% 

0% 

-1% 

-2% 

-3% 

2002 2004 2006 2008 2010 2012 


EXHIBIT 19. 

160 

140 

120 

100 

80 

60 

1990 1993 1996 1999 2002 2005 2008 2011 

Source: Bank of Japan, Bloomberg 

a signal that U.S. monetary policy will 

tighten. Our one year forecast calls for 

the yen to depreciate slightly versus the 

U.S. dollar to 82. 

Positioning 

Hedged U.S. Treasuries 10-Year Yield vs. USDJPY 

Hedged U.S. 10-Year Treasuries minus 10-Year JGB Yield (LHS) 

USDJPY (RHS) 

Bank of Japan Real Effective Exchange Rate 

SAMPLE 

The final step that we take before 

forming our currency views is a review 

of positioning and available sentiment 

surveys. Since the foreign-exchange 

market is not centralized, and most 

transactions happen over the counter, 

the efficacy of this process depends 

on the number of sources and their 

level of insight into the market. These 

140 

130 

120 

110 

100 

90 

80 

70 

reports are often conflicting, so it is 

when they are in sync that they convey 

a compelling message. For the past 

few months, the surveys show that 

investors are betting on a drop in the 

euro. From a contrarian standpoint, this 

positioning data indicates that the euro 

might be poised to rise. However, the 

reliability of this indicator depends on 

whether these short positions are in the 

money, and since a large proportion 

are, we suspect that positioning is a 

less reliable indicator now. 



Global markets continue to be very 

volatile. That volatility has only 

increased since the failed Greek 

elections in May, when commentators 

coined the term “Grexit’’ to express the 

rising possibility that Greece will exit 

the Eurozone. Those who watch the 

markets daily – and currency traders 

especially – are keeping one eye on 

the headlines at all times. It is at times 

like this that experience becomes 

very important in evaluating risks that 

currencies bring to our portfolios. 

Valuations are an important compass 

to keep in the back of one’s mind, 

and if they are of little help, hedging 

currency risk is a good option. On 

the other hand, for portfolios where 

currencies can diversify risk, they 

become an important tool. This is 

where the safe-haven qualities of the 

U.S. dollar come in handy. 

Summary 

We continue to favour the U.S. dollar, 

mostly due to its attractive valuation 

and safe-haven qualities. The euro 

base case is one of slow depreciation, 

although the tail risk of a Greek exit, 

even if it is orderly, would bring 

about a faster decline. There will 

be headline-driven periods of relief 

leading to short-covering. They will 

present opportunities for more tactical 

traders to add to or re-establish short 

positions. Longer-term investors should 

take advantage of them as well. 

The Canadian dollar remains the global 

growth proxy and is mostly correlated 

to the performance of U.S. equities. 

When the loonie exceeds parity with 

the U.S. dollar, adding the greenback 

to risky portfolios denominated 

in Canadian dollars is particularly 

attractive. Think of U.S. dollar positions 

as building blocks of your portfolio 

serving as insurance, and not as 

speculative currency positions. 

While the pound isn’t particularly 

attractive based on fundamentals, its 

downside is probably limited, a quality 

appreciated by the central-bank reserve 

managers who have been adding it to 

their holdings. 

Finally, the Japanese yen benefits 

from the home bias of Japanese 

investors and few safe, higher-yielding 

alternatives that would entice them 

to take currency risk. Unfortunately, 

the long-term negatives and everpresent 

risk of political interference 

makes taking long yen positions less 

attractive, so our bias is to sell yen 

strength. 

In these volatile markets, our mantra 

is to use volatility to our advantage, by 

constantly evaluating various scenarios 

and knowing at what levels the U.S. 

dollar and other currencies become 

attractive additions to portfolios. 

SAMPLE 



The Currency Outlook: Key Factors 

EURO 

1.62SAMPLE 

Supportive 

Negative 

Short term 

Short term 

• Reduced stress in European banking system thanks to 

• Increased uncertainty after elections in France and 

LTRO. 

Greece. 

• Italy and Spain prefunded over half of their 2012 

• Foreign-exchange reserve managers have lower appetite 

financing needs. 

for European assets and no interest in peripheral-country 

debt. 

• Sentiment extremely negative, making large short 

positions vulnerable. 

• ECB may be forced to cut rates or increase its balance 

sheet even more. 

• Eurozone banks repatriating foreign assets to shore up 

capital. 

Long term 

• The ECB, in wait-and-see mode, has been reluctant to 

• LTRO took care of liquidity, not solvency. 

pursue further quantitative easing. 

• Austerity measures to suppress growth. 

Long term 

• Global rebalancing decreasing current-account 

surpluses. 

• Bunds are a safe-haven alternative. 

• Lack of population growth. 

• Eurozone fiscal picture better than in the U.S. 

• The ECB’s inability to tighten for a long time. 

• Current account roughly in balance for Eurozone. 

• On PPP terms, the euro remains expensive versus the 

U.S. dollar. 

• Technical indicators show well established downtrend 

since late 2008. 

12-Month Forecast: 1.20 

POUND STERLING 

Supportive 

Negative 

Short Term 

Short term 

• Pre-Olympics appreciation. 

• High vulnerability to renewed stress in global financial 

• Safe-haven buying interest from reserve managers after 

system. 

currency intervention by the Japanese and the Swiss. 

• Expectations of post-Olympics weakness. 

• Increase in real yields, with inflation falling since 

September 2011. 

Long term 

• Housing market weakness (outside London). 

Long Term 

• Persistently high inflation continues to reduce 

• Relatively sane politics (versus the U.S. and EMU). 

purchasing power of GBP versus other G10 countries. 

• IMF and OECD debt-to-GDP forecasts improving fiscal 

• Fiscal malaise (debt/GDP, fiscal deficit) similar to the 

outlook thanks to a meaningful head-start. 

U.S. 

• Improving current-account deficit. 

• Mix of tight fiscal policy and easy monetary policy. 



82SAMPLE 

CANADIAN DOLLAR 

Supportive 

Negative 

Short term 

Short term 

• BOC is concerned more about household leverage than • Positioning very long. 

currency strength, and is expected to hike before other 

• Drag from a weaker-than-expected U.S. economy. 

central banks. 

• Oil prices vulnerable due to growth slowdown, massive 

• Speculative inflows as commodity currencies are 

inventory levels, ebbing of Iran risk. 

benefiting from central-bank reserve diversification. 

Long term 

Long term 

• Extreme overvaluation on PPP basis. 

• Commodity-rich. 

• Near-record current-account deficit makes currency 

• Demographics positive thanks to immigration. 

vulnerable to slowing purchases of Canadian bonds by 

• Reserve-diversification inflows. 

foreigners. 

• Fiscal situation much better than peers. 

• Manufacturing losing out to cheaper production abroad. 

• Healthy banking sector. 

• Canadian-dollar strength is outpacing improvement in 

terms of trade. 

• Excessive household leverage. 

• Potential for U.S. to find other sources of energy. 

12-Month Forecast: 1.04 

YEN 

Supportive 

Negative 

Short term 

Short term 

• Safe haven during times of risk aversion. 

• Substantial threat of BOJ/MOF intervention. 

• Income surplus offsets trade deficit. 

• BOJ stepping up easier monetary policy by increasing 

• Surprisingly good economic data since January. 

asset purchases. 

• Positioning is broadly short. 

• Trade deficit for most of 2011 expected to continue due 

to higher energy imports. 

Long term 

Long term 

• Bond market depth makes Japan an attractive 

destination for reserve diversification. 

• Worst public debt/GDP of any major economy. 

• Lower inflation continues to increase purchasing power • Worst demographic profile of any major economy over 

of yen versus other G10 countries. 

the next 40 years. 

• Right neighbourhood: growing economic links to Asia. 

• BOJ will be the last central bank to hike rates. 

• Ultra-low global short-term rates make foreign assets 

attractive even on a currency-hedged basis. 

12-Month Forecast: 


Regional Outlook – U.S. 

Ray Mawhinney 

Senior V.P. & Senior Portfolio Manager 


U.S. markets were under significant 

pressure during May after moving 

sideways through the first two months 

of the quarter. For the three-month 

period as a whole, the S&P 500 

fell about 5%, though it is still up 

significantly from the early-October 

lows. Investor sentiment has turned 

decidedly negative after the surprising 

results of the Greek election, a 

continuing slowdown in economic 

activity in China and other emerging 

economies, and widespread economic 

weakness in the Eurozone. While U.S 

economic data has been relatively 

decent over the period, the probability 

of Greece giving up the euro has 

increased dramatically and, as a result, 

global stock markets have moved down 

to reflect the rising odds of defaults 

and a breakdown of the Eurozone. 

At the moment, the main fear driving 

markets is that, with global growth 

slowing, a credit event in Europe 

could push the world into a recession 

much like the one experienced after 

the bankruptcy of Lehman Brothers 

in 2008. Given these fears, sectors 

most tied to global growth, such as 

Materials, Industrials and Energy, have 

underperformed significantly relative 

to domestically linked sectors with 

relatively stable cash flows, such as 

Utilities, Telecommunication Services, 

Consumer Staples and Health Care. In 

the Financials sector, shares of global 

U.S. banks have faltered lately, but for 

the sector as a whole, capital levels 

are good, loan growth is picking up 

and dividends have been reinstated or 

raised. In the Information Technology 

sector, the build-out of the mobile 

United States Recommended Sector Weights 

RBC Investment 

Strategy Committee 

May 2012 

Benchmark 

S&P 500 

May 2012 

Energy 10.0% 10.9% 

Materials 3.3% 3.4% 

Industrials 10.5% 10.5% 

Consumer Discretionary 12.5% 11.3% 

Consumer Staples 12.5% 11.4% 

Health Care 12.0% 11.8% 

Financials 14.0% 14.2% 

Information Technology 21.2% 19.7% 

Telecommunication Services 2.0% 3.1% 

Utilities 2.0% 3.7% 


3311 

2026 

1240 

759 

464 

284 

174 

106 

65 

Brad Willock, CFA 



Jun. '12 Range: 1154 - 1938 (Mid: 1546) 

Jun. '13 Range: 1302 - 2186 (Mid: 1744) 


40 

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


Internet, strong demand for consumer 

devices such as smartphones, tablets 

and ultrabooks, and the expansion 

of data centres are combining to 

drive solid top-line growth, and profit 

margins are at all-time highs. 

The macroeconomic environment 

remains challenging. China, the main 

engine of global growth over the past 

S&P 500 Equilibrium 

Normalized Earnings and Valuations 

SAMPLE 

decade, is slowing significantly in 

part due to the weakness of its largest 

export customer, Europe, and also 

because it spent all of last year raising 

interest rates to fight inflation. Now, 

with growth and inflation slowing, 

China and other leading emerging 

economies such as Brazil and India 

have started cutting interest rates, 


Regional outlook – U.S. • Ray Mawhinney • Brad Willock, CFA 

which should help stimulate their 

economies during the second half of 

this year. 

In the near term, the prospect of a 

Greek exit from the Eurozone will 

likely keep markets from making too 

much progress. In the medium term, 

U.S. markets will be influenced by the 

presidential elections scheduled for 

November and the expiration of tax 

cuts and other stimulus measures on 

January 1, 2013. This so-called fiscal 

cliff could hurt gross domestic product 

to the tune of 3% to 4% if all items 

are allowed to expire. We anticipate 

significant anxiety surrounding this 

issue, but believe that the fiscal drag 

will ultimately amount to 1% to 2% of 

GDP. We are positioned defensively, 

but intend to take advantage of any 

market weakness over the next few 

quarters to increase our exposure to 

economically sensitive companies 

that exhibit solid profitability and 

good prospects for long-term dividend 

growth. 

The tone of recent U.S. economic data 

has been much better, as employment, 

housing and consumer spending are 

all showing signs of improvement. In 

terms of the job market, unemployment 

claims remain in a downtrend and 

surveys indicate that companies are 

planning to boost hiring. In the housing 

market, the improvement is even more 

broad-based and impressive, as the 

number of homes for sale has returned 

to pre-crisis levels and the median 

asking price is rising thanks to record 

affordability. Rents are increasing 

at a 10% clip in many regions and, 

combined with record-low mortgage 

rates and the drop in home prices, 

investors and first-time homeowners 

have stepped back into the market. 

Given that the employment and 

housing markets are healing, the U.S. 

consumer is again starting to contribute 

to economic growth. Consumer 

confidence is at cycle highs, credit is 

expanding and household formation is 

finally on the upswing after 6 ½ years 

of a flat or declining trend. While the 

improvement in household formation is 

not great, the trend appears to be selfsustaining 

enough to have encouraged 

1 million people to get out of their 

parents’ basement and into their own 

place. It’s about time! 

Despite the gyrations in the 

macroeconomy, corporate 

fundamentals remain in good shape. 

Stocks are attractive in valuation terms. 

They trade at a roughly 5% trailing freecash-flow 

yield and 12 times this year’s 

estimated earnings. Interestingly, more 

than 50% of the stocks in the S&P 500 

index sport dividend yields greater 

than the yield on the 10-year Treasury 

bond. The only other time that this 

happened was in March 2009 - near 

the market low. While this seems worth 

exploiting, the real attraction of the 

stock market lies in the fact that the 

payout ratio is at an all-time low, while 

cash levels and profitability are at alltime 

highs. The potential for companies 

to raise dividends meaningfully over 

time is extraordinary. 

While the focus of the media and 

most investors is on near-term 

political events in Europe, there 

are many exciting long-term 

developments occurring in the U.S. 

The energy industry is undergoing a 

supply revolution, as it harnesses 

new technologies that will lay the 

groundwork for growing surpluses 

in crude oil, natural-gas liquids 

and natural gas. This has profound 

implications for employment, 

economic growth, the trade deficit, 

the U.S. dollar and energy security. 

In particular, U.S. manufacturing 

is enjoying a renaissance due to 

this new energy-cost advantage, 

relatively high productivity growth and 

subdued labour-cost growth. In China, 

manufacturing wages have been rising 

at a 20%-plus rate over the past several 

years. Add in China’s strengthening 

currency and higher shipping costs, 

and it is no longer a clear-cut decision 

to move manufacturing across the 

Pacific Ocean. In fact, dozens of 

companies have announced plans to 

bring capacity back to the U.S. A road 

to a more energy-secure U.S. will take 

years to play out and policymakers 

could always derail the momentum, but 

the potential is huge and needs to be 

part of investors’ analytical framework. 

SAMPLE 


Regional Outlook – Canada 

Stuart Kedwell, CFA 

Senior V.P. & Senior Portfolio Manager 


The S&P/TSX Composite Index 

extended its underperformance 

versus the S&P 500 Index, with an 

8% decline during the most recent 

quarter, roughly double the pullback in 

the S&P 500. S&P/TSX earnings have 

leveled off almost 10% below the prior 

peak, while S&P 500 earnings have 

surpassed levels witnessed earlier in 

the decade. All major sector groups 

in the S&P/TSX Composite declined 

during the quarter, led by gold and 

energy, as the underlying commodities 

rolled over. We expect 2% growth 

from the Canadian economy in 2013, 

similar to the level expected in the 

U.S. Given a weakening Canadian 

dollar, a relatively modest earnings 

recovery, worries about the Canadian 

housing market and the reemergence 

of concerns that Canada could be 

negatively affected by slowing Chinese 

growth, the likelihood that Canada’s 

equity market will keep outperforming 

the S&P 500 continues to decrease. 

The Canadian dollar fell 4% during the 

quarter and briefly traded through our 

target. With a forecast for moderating 

economic growth, we continue to 

believe that the strength of the 

Canadian dollar versus the U.S. dollar 

has largely run its course, especially 

over the intermediate term. 

Investor sentiment is now back in 

the mid 30% bullish range, the same 

level as last fall when markets began 

to rally, and well below the 55% 

reading in February. The debate about 

the headwinds facing earnings and 

equity markets has resurfaced, leaving 

valuations at attractive levels over the 

Canada Recommended Sector Weights 


strategy committee 

may 2012 

Benchmark 

S&P/TSX composite 

may 2012 

Energy 26.0% 26.1% 











22387 

14307 

9143 

5843 

3734 

2387 

1525 

975 

623 

S&P/TSX COMPOSITE Equilibrium 


Jun. '12 Range: 10650 - 15897 (Mid: 13273) 

Jun. '13 Range: 10729 - 16014 (Mid: 13371) 

Current (01-June-12): 11361 

SAMPLE 

398 

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


medium term for investors who are 

basing decisions on our estimate of 

normalized earnings capacity. Dividend 

yields, free cash flows and corporate 

balance sheets are in good shape 

and reasonable returns are forecast, 

particularly relative to fixed income. In 

Canada, we highlight the difference in 

the valuation between the largest 60 

companies and the broader market. For 

years, the valuations of these segments 

of the market have marched in 

lockstep. Recently, however, valuations 

of the larger companies have lagged, 

opening up an interesting opportunity. 

Price-to-earnings multiples of the 

banks are back at the low end of the 

trailing 10-year range. Despite decent 

second-quarter earnings, consumer 


Regional outlook – CANADA • Stuart Kedwell, CFA 

asset growth and the housing market, 

coupled with lower net-interest 

margins, remain key areas of investor 

focus. 

We continue to believe that a housing 

slowdown is manageable for the banks, 

although the loud debate will act as a 

brake on near-term valuations. As each 

bank prepares to meet Basel III capital 

thresholds in the next 12 months, the 

focus will eventually return to their 

considerable capital generation – even 

in a slow-growth environment. Returns 

on equity have proven resilient and 

the spread of these returns relative to 

those available from a 10-year bond 

remains attractive. Current dividend 

yields coupled with modest dividend 

growth should combine to provide 

satisfactory total returns. 

Insurers’ earnings have been weighed 

down by the growing consensus that 

interest rates will remain low for a long 

time. While the impact of low rates on 

earnings power could persist for several 

years, we believe insurance companies 

have enough capital and earnings 

capacity to weather this storm. From 

a portfolio standpoint, insurance 

companies provide some protection, 

since any rise in interest rates would 

negatively affect utility companies 

and real estate firms, and because we 

believe it’s doubtful that the insurers 

will need to raise additional equity. 

Valuation multiples in the Materials 

sector are unlikely to expand because 

of slowing growth in China. Yet at 

current commodity prices, the sector’s 

free cash flow is significant. We think 

the use of this cash in the next few 

years will be a key factor in the sector’s 

performance. As an example, we note 

that Potash Corp.’s healthy level of 

capital spending will start to tail off, 

leaving the company with strong freecash-flow 

generation even in a weaker 

commodity environment. 

Gold stocks lagged bullion again during 

the quarter as a number of companies 

continue to struggle due to high capital 

costs and operational issues. While 

the spread between traditional goldcompany 

valuations and bullion is at 

historically wide levels, some share 

prices are starting to look attractive on 

a free-cash-flow basis. 

Stocks of companies in the Energy 

sector continue to trade below levels 

one would expect given expectations 

for commodity prices. There are a 

number of reasons for this trend. 

Regional price differences have been 

elevated this year, and rising operating 

and capital costs continue to be a 

concern. As in the Materials sector, 

investors are highly focused on capital 

discipline. Stock valuations suggest 

that many energy companies will find it 

more attractive to buy back shares than 

embark on new projects. 

On the natural gas front, new drilling is 

finally beginning to slow in response 

to a very warm winter and weakness 

in prices for natural gas liquids. With 

an abundance of natural gas in North 

America and extremely low prices for 

gas relative to the amount of energy 

produced versus oil, the market is 

waiting for a concrete and sustainable 

demand response to help prices. 

A positive near-term surprise has 

been the increasing use of natural 

gas instead of coal for electricity 

generation, which has helped ease 

concerns about a lack of storage 

this summer. We expect gas to trade 

between $3.50 (the cash cost of 

production) and $4.50 (the marginal 

cost with a return on capital). 

Research In Motion has been a volatile 

stock as investors debate the value 

of an uncertain stand-alone business 

against a large patent portfolio and $4 

per share of cash representing about 

40% of its market value. 

Canada’s Industrials sector offers 

a number of opportunities where 

current share prices appear to offer 

good returns in a slow but steady 

growth economy. Should earnings 

at companies like Canadian Pacific 

and Finning progress in a reasonable 

manner in the years ahead, and the 

multiple paid on those earnings fall 

within historical bands, the share-price 

appreciation potential for both would 

be attractive. 

SAMPLE 


Regional Outlook – Europe 

Dominic Wallington 

Chief Investment Officer & Chief Executive Officer 


European stock markets have 

had a good run from the lows in 

September 2011, due to a stronger 

global economic backdrop and more 

comprehensive liquidity provisions 

for periphery sovereigns and banks. 

This run in markets appears to have 

matured, and recent news flow on the 

strength of the European economy 

indicates pockets of weakness. 

Somewhat predictably, the political and 

market environment has deteriorated 

as well. The election in France has 

created political uncertainty, and 

the strict adherence of Spain to an 

ambitious austerity plan has led to 

substantial economic contraction and 

fears of a deflationary spiral. Investor 

concern for the Eurozone has grown 

because there is still a widely held 

belief that the risk of contagion from 

the countries undergoing austerity 

to those in better health remains a 

problem that has not been fixed. 

What is clear is that market pain is 

pushing European policy change, and 

more is likely over the summer. There 

remains a political commitment to 

the Eurozone. This is very important – 

even if it is currently articulated as a 

somewhat dogmatic approach to fiscal 

consolidation. The periphery countries 

do not have the policy tools (such as 

their own currency) to offset the effects 

of austerity, and the resultant impact 

on living standards is putting the 

entire strategy at political risk. A more 

nuanced approach to dealing with the 

sovereign-debt problem needs to be 

found, and we hope that this will be 

realized during the course of the year. 

To paraphrase Churchill’s observation 

Europe Recommended Sector Weights 



May 2012 

Benchmark 

MSCI Europe 

May 2012 

Energy 10.8% 11.8% 











4467 

2899 

1881 

1221 

792 

514 

334 

217 

141 

EUROZONE DATASTREAM INDEX Equilibrium 


Jun. '12 Range: 1442 - 2659 (Mid: 2051) 

Jun. '13 Range: 1661 - 3062 (Mid: 2362) 


SAMPLE 

1980 1985 1990 1995 2000 2005 2010 2015 


on the U.S.: (we hope that) Europe will 

do the right thing, even if it comes after 

it has exhausted all other possibilities. 

Against these uncertainties, valuations 

remain at generation-low levels, and 

corporate balance sheets are in better 

shape than at any time during the 

past 20 years. Many companies in 

Europe have limited exposure to the 

problem areas, and the soft power 

of the region remains in engineering 

excellence, pharmaceutical innovation 

and a plethora of leading global 

brands. These brands extend from 

beer to Scotch whisky and French 

wine, through to clothes, watches and 

food. Many of these companies are 

experiencing tremendous growth not 

only in China, but in other Southeast 


Regional outlook – Europe • Dominic Wallington 

Asian countries such as Thailand and 

South Korea, all the way round the 

world to Latin America. In other words, 

there are many props to the growth that 

they are exhibiting through customer 

diversification and geographic 

expansion. This remains an important 

investment theme, and our portfolio 

has exposure to a large number of 

these types of companies. From BMW, 

the car manufacturer, to Diageo, the 

owner of Johnnie Walker, to Swatch, 

the attractively valued owner of the 

Omega watch brand, and Henkel, home 

to Persil and Loctite, we are capturing 

the benefits of the industrialization 

and urbanization trends that are taking 

place in many parts of the world. Even 

if the domestic problems in Europe 

continue to worsen, the area represents 

a viable destination for investors 

wanting exposure to themes playing 

out in other parts of the world. 

In the Consumer Discretionary sector, 

our preference is for niche consumer 

services-related companies with strong 

market-leading positions, particularly 

in gaming. Such stocks should perform 

well in a low-growth environment. In 

the auto sector, we have a focus on 

premium market German manufacturers 

with global exposure. In Consumer 

Staples we bought Diageo during the 

quarter. We expect robust growth 

in spirits consumption in emerging 

markets, and this company provides 

us with exposure to increased global 

luxury spending without the heady 

multiples seen in luxury consumer 

durables. 

The Energy sector still trades at a 

substantial discount to the overall 

market and offers an attractive 

dividend yield. Sector valuations 

discount oil prices that are significantly 

below current levels. Within the sector, 

our preference is for oil services, 

which should continue to benefit 

from a significant increase in capital 

expenditures by the oil majors and 

exploration and production companies. 

The banks remain a market-based 

barometer of the Eurozone crisis. We 

believe that the era of super-normal 

profits for the sector is over, and that 

returns will be much closer to the cost 

of capital both because of legislation 

and because of the need for many 

banks to deleverage their balance 

sheets. The insurers have similar 

dynamics to the banks, but have, in 

general, been less volatile. 

In a low-growth world, the Health Care 

sector’s strong balance sheets, robust 

cash flows, low earnings volatility and 

increasing focus on capital returns are 

an attractive combination. Little future 

R&D success is factored in. 

Our preference within the Industrials 

sector has been for secure growth, and 

for companies offering returns that are 

high and stable. Within Industrials, 

the principal area exhibiting positive 

earnings and operational momentum is 

aerospace and defence. 

Within Information Technology, we 

view software makers as later-cycle and 

beneficiaries of increasing corporate 

spending over the coming years. 

After underperforming during the first 

decade of the 2000s, expectations 

remain relatively low and managements 

are demonstrating a higher degree of 

capital discipline. Balance sheets in 

this sector are particularly robust. 

In the Telecommunication Services 

sector, our focus is on cable operators. 

We see excellent cash generation 

from these companies, and prospects 

for high and increasing shareholder 

returns. 

The Materials sector is exposed to the 

global economic cycle, and mining 

companies have performed poorly 

because investors are beginning to 

realize that China may have finished its 

big infrastructure push. We have added 

to holdings of chemicals companies 

because many of the themes that have 

plagued this industry over the last 20 

years have begun to disappear. The 

supply of many products is still quite 

tight relative to demand, and pricing is 

therefore more robust than in previous 

cycles. 

SAMPLE 


Regional Outlook – Asia 

Yoji Takeda 

Director & V.P. 

RBC Investment Management (Asia) Limited 

Following a market recovery in the 

first quarter of 2012, Asian investors 

are contending with mixed prospects 

for global growth. Valuations have 

recovered from the deeply discounted 

levels of last autumn, albeit based on 

relatively conservative estimates. Until 

there is more clarity in the outlook for 

Eurozone stability and Chinese growth, 

we would remain slightly defensive in 

terms of our portfolio posture. 

Three key factors have been weighing 

on Asian equity markets during the 

last few quarters: the sluggish U.S. 

economy, Chinese economic policy 

and Europe’s sovereign-debt problems. 

Further out, U.S. presidential elections 

in November may provide a positive 

catalyst, but economic growth will 

remain anemic and the issue of the 

“fiscal cliff” remains. In Europe, 

Germany and other continental 

exporters are exposed to the possibility 

of lower foreign demand while the 

peripheral countries try to stabilize 

their debt situations. Gradual policy 

easing in China and other Asian 

countries is probably the only nearterm 

potential positive. Following the 

relative calm of the past few months, 

market volatility may increase, and 

this heralds a slightly negative global 

backdrop for the next few quarters. 

In China, the slower-than-expected 

pace of policy easing continues to 

disappoint investors. So far this 

year, economic statistics have been 

weakening, with the latest data from 

April being the worst this year. Growth 

in industrial production slowed to 

9.3% year over year from 11.9% in 

March. The direction of the slowdown 

was consistent with the government’s 

new official target of 7.5% and its plan 

to reduce inflationary expectations. 

Last year’s tight monetary policy 

successfully reduced the inflation 

rate, and the government is, therefore, 

easing gradually. As a result, new bank 

loans increased by $1 trillion in April, 

or 15% year over year, and in mid-May, 

Asia Recommended Sector Weights 



May 2012 

Benchmark 

MSCI Pacific 

May 2012 

Energy 2.0% 2.8% 











Japan Datastream Index Equilibrium 


1000 

717 

514 

368 

264 

189 

136 

Jun. '12 Range: 146 - 347 (Mid: 246) 

97 

Jun. '13 Range: 333 - 793 (Mid: 563) 

70 


50 

1980 1985 1990 1995 2000 2005 2010 2015 

SAMPLE 


the government cut the bank reserverequirement 

ratio to spur lending. 

The government is also starting to 

follow a slightly expansionary fiscal 

policy. Continued easing in monetary 

and fiscal policy will likely depend on 

macroeconomic data, as China moves 

toward a leadership change later this 

year. The risk of a hard landing or crisis 

stemming from local-government debt 


Regional outlook – Asia • Yoji Takeda 

seems low, as the government’s deep 

pockets mean it is likely equipped 

to deal with either situation. Stock 

valuations are still below the historical 

average, and some moderate upside 

is expected as policy support builds 

confidence for sustained growth in 

the economy. 

Japanese markets caught up with 

their U.S. and Asian peers during the 

first quarter of this year, thanks to 

the Bank of Japan’s surprising step to 

ease monetary policy and the positive 

effect on exports of a weakening yen. 

However, the market continues to 

display a tendency to move with the 

yen and gave back a large portion of 

its recent gains when the currency 

strengthened. Corporate earnings in 

fiscal 2011 fell by about one-third due 

to the March 2011 earthquake and 

subsequent rise in the yen, as well 

as floods in Thailand and weakening 

global demand. Earnings in fiscal 2012 

should snap back, with gains expected 

in both the current fiscal year and the 

next one. During the tough environment 

in place since the financial crisis, 

Japanese corporations have made 

significant progress in reducing costs to 

counter much lower yen-denominated 

revenues, supply-chain problems 

and higher raw-material costs. The 

lower cost base will boost profits as 

revenues normalize this year, resulting 

in stronger cash flows on top of already 

high cash balances. This will likely 

result in dividend hikes and increased 

share buybacks. With the support 

of a strong recovery in earnings, we 

anticipate modest gains in the second 

half of 2012, although the market will 

continue to be affected by currency 

shifts and global risk appetites. 

In addition, political turmoil could 

overshadow higher profits in the near 

term, as the government of Yoshihiko 

Noda may have to contest late-summer 

elections for the lower house of 

Parliament. 

With the global economy slowing, 

stock markets in both South Korea 

and Taiwan have failed to regain 

levels reached before the market 

downdraft that started in August 2011. 

That said, valuations are not deeply 

discounted. Moderate upside can 

be expected in the near term as long 

as export demand from China picks 

up and/or earnings from companies 

with a domestic focus improve with 

policy easing. The economies of both 

countries continue to benefit from 

robust overseas demand for high-end 

electronics such as smartphones and 

tablets. South Korea also enjoys strong 

auto-related exports, particularly to the 

U.S. On the flipside, domestic sectors 

and exporters of flat-panel displays 

and computers remain weak in both 

countries. Raw-material exports such 

as chemicals and steel products are 

also weaker. Inflationary pressures 

are easing and there is room for some 

monetary stimulus, as government-set 

interest rates in both countries have 

not been cut since they started rising 

in 2010. There are some policy risks, 

however. In South Korea, elections set 

for December suggest that economic 

policy will favour social welfare over 

the interests of the “chaebol” industrial 

groups that dominate the economy. In 

Taiwan, the government is preparing 

to introduce a capital-gains tax on 

equity investments starting next year, 

so any meaningful market gains will 

have to wait until better global demand 

produces a recovery in exports. 

The Australian market has performed 

in line with its peers so far this year, 

but with less volatility. The market is 

supported by high dividend yields, 

which are somewhat offset by recent 

weakness in the Australian dollar. The 

economy continues to diverge, with 

a strong mining sector contrasted 

with weak domestic sectors. But with 

Chinese demand growth moderating, 

even mining investments are likely to 

be hurt. Weak domestic growth and 

relatively benign inflation prompted 

the Reserve Bank of Australia to cut 

its benchmark interest rate in early 

May by a more-than-expected 0.5%, 

pushing the currency below parity 

with the U.S. dollar. Monetary easing 

is likely to continue to ensure the 

economy remains healthy. Although 

we do not expect much downside, 

equity valuations are closer to more 

normal ranges, and profit growth will be 

needed to justify higher P/E multiples. 

SAMPLE 


Regional Outlook – Emerging Markets 

Philippe Langham 



Risk aversion returned to markets this 

quarter with a renewed focus on the 

sovereign-debt crisis in Europe and 

its impact on fragile global economic 

growth. This has led to a sharp selloff 

in emerging-market stocks, as 

well as in other risk assets. In this 

environment, the high correlation 

among global stock markets has 

been evident. 

The current public-debt stresses in 

the developed world are a reminder 

of why it makes sense in the long run 

to maintain significant exposure to 

the much healthier economic growth 

found in emerging markets. Growth in 

the developed world will continue to 

be constrained by high government 

debt and private-sector deleveraging. 

While emerging economies will not 

be immune to weaker global growth 

driven by the deleveraging, their rates 

of growth are likely to continue to be 

significantly higher than those of their 

developed-world counterparts because 

they do not face the same debt 

overhang. 

Inflation in developing markets has 

begun to fall, as food prices have come 

down and global growth has slowed. 

Given the improving inflation data, 

most emerging-market central banks 

have begun monetary-easing cycles. 

This is a clear positive for emergingmarket 

assets, which suffered for 

much of last year on concerns over 

inflation and the associated restrictive 

monetary policies. Looking ahead, 

there is a strong case to be made that 

food prices will continue to decline 

over the next year given a high level of 

Emerging Market Datastream Index Equilibrium 


513 

394 

303 

Jun. '12 Range: 205 - 364 (Mid: 285) 

Jun. '13 Range: 219 - 389 (Mid: 304) 


233 

179 

137 

106 

81 

62 

48 

1995 2000 2005 2010 2015 

Source: Datastream, RBC GAM 

long speculative positions and strong 

global growth in arable acreage. The 

one market where there has been 

some investor disappointment with 

monetary easing is China. This reflects 

the leadership’s view that the massive 

post-Lehman surge in credit was a 

mistake. It also reflects their view that 

growth in China can be maintained 

without the need for aggressive 

stimulus. Since the EU accounts for 

a large portion of China’s exports, 

an even larger slowdown in demand 

would likely prompt Chinese officials to 

become more aggressive in stimulating 

the economy. 

The valuation case for emerging 

markets has become more attractive 

in the past 12 months. Based on 

consensus 2012 earnings, the forward 

P/E ratio is under 10 and well below its 

long-run average. On a price-to-bookvalue 

basis, emerging-market equities 

also trade at a significant discount 

to history and at a level that has 

historically portended strong 12-month 

performance. In addition, widening 

spreads between emerging-market 

earnings yields and bond yields since 

2010 are incongruent with current 

market conditions, so we expect these 

yields to converge over time via an 

uptick in equity prices. The valuation 

discount to developed markets has 

also widened following a degree of 

underperformance over the past year, 

and now stands at 15%. 

In terms of positioning, our long-term 

top-down bias for domestic sectors 

and quality, and away from cyclical 

areas and commodities, makes even 

more sense in the current environment. 

Equity markets are likely to follow 

credit markets in distinguishing 

between good and bad credit. In this 

environment, companies with strong 

balance sheets, robust free-cash-flow 

generation and high returns on capital 

are likely to outperform. Furthermore, 

as global growth slows, companies 

that are able to deliver good growth 

will enable their stocks to command 

SAMPLE 


Regional outlook – emerging markets • Philippe Langham 

premiums. We expect global growth to 

remain sluggish for several years and 

identify three long-term themes that 

are key drivers behind our top-down 

positioning. 

Our biggest long-term theme continues 

to be the growth of domestic 

consumption in emerging markets. This 

is confirmed by a number of factors, 

including double-digit wage growth 

across many emerging markets over 

the past decade. Despite this rise in 

personal incomes, current emergingmarket 

wages remain considerably 

below those in developed markets. 

Interestingly, when we examine income 

by age in countries such as China and 

Brazil, it appears that younger workers 

tend to earn much more than older 

workers, which reinforces our faith in 

domestic consumption as a long-term 

theme. In addition to wage growth, the 

powerful combination of a high savings 

rate, relatively low levels of bank credit 

and a fast-growing middle class make 

the emerging-market consumer an 

investment theme that we believe will 

remain compelling for years to come. 

Natural gas is a medium-term theme 

that we believe will play out across a 

number of emerging-market countries 

that export energy. The pros of this 

energy source are its abundance, and 

the fact that it is cheaper and cleaner 

than many alternatives. The underpenetration 

in countries such as China, 

where only 4% of energy usage is 

supplied by natural gas, compares with 

as much as 50% in many developed 

markets and illustrates the growth 

potential. Pricing in many emergingmarket 

countries is regulated at a much 

higher level than in North America, 

and with demand growth estimated at 

10% to 15%, prices in many emerging 

markets are likely to increase. 

The third theme is dividends. The 

current dividend yield in both emerging 

and developed markets is just above 

3%, and over the last five years 

dividends have comprised almost twothirds 

of emerging-market equities’ 

total returns. Given the low level of 

bond yields today, and the hunger 

of many investors for income, we 

believe that this theme will grow to 

be as important for emerging-market 

investors as it already is for those in 

the developed world. Over the past 

10 years, higher-yielding stocks in 

developing markets have significantly 

outperformed lower-yielding stocks 

and the MSCI Emerging Markets Index. 

The portfolio holds a number of higheryielding 

issues, partly as a result of 

the type of company that we focus 

on – businesses with solid balance 

sheets, capital discipline and strong 

cash flows. 

Looking ahead, correlations between all 

equity markets are likely to stay high in 

the short term, and emerging markets 

face further downside risks as long 

as the European crisis does not come 

to a definitive resolution. However, 

we believe it is only a matter of time 

before markets refocus on the healthy 

fundamentals in developing markets, 

where governments, companies and 

consumers are not constrained by 

excess leverage. The post-Lehman 

low proved to be a fantastic time to 

buy emerging market equities, and 

a resolution of the Eurozone crisis is 

likely to provide a similar opportunity. 

SAMPLE 



Members 




Chair, RBC Investment Strategy committee 

Dan Chornous is Chief Investment Officer of RBC Global Asset Management Inc. that have total assets under management $250 billion. Mr. Chornous is responsible for 

the overall direction of investment policy and fund management. In addition, he chairs the RBC Investment Strategy Committee, the group responsible for global assetmix 

recommendations and global fixed income and equity portfolio construction for use in RBC Wealth Management’s key client groups including retail mutual funds, 

International Wealth Management, RBC Dominion Securities Inc. and RBC Phillips, Hager & North Investment Counsel Inc. He also serves on the Board of Directors of 

the Canadian Coalition for Good Governance and is Chair of its Public Policy Committee. Prior to joining RBC Asset Management in November 2002, Mr. Chornous was 

Managing Director, Capital Markets Research and Chief Investment Strategist at RBC Capital Markets. In that role, he was responsible for developing the firm’s outlook 

for global and domestic economies and capital markets as well as managing the firm’s global economics, technical and quantitative research teams. 

Jim Allworth 

Portfolio strategist 

RBC wealth management 

Jim has been in the investment business for 39 years as both a research 

analyst and portfolio strategist. He is currently a director of RBC 

Investments and also Vice-Chair of the RBC Capital Markets Investment 

Strategy Committee. Through his 33 years at RBC Dominion Securities (and 

predecessors), Jim has played a key role in developing investment policy for 

the firm and translating that worked into solutions for individual clients. He 

presents extensively on the topic. 


Head, Global Fixed Income & Currencies 

(Toronto and London) 


As Head of Global Fixed Income & Currencies at RBC Asset Management, 

Dagmara oversees 15 investment professionals in Toronto and London, 

with more than $40 billion in assets under management. In her duties as 

a portfolio manager, Dagmara looks after foreign-exchange hedging and 

active currency-management programs for fixed-income and equity funds, 

and co-manages several of the firm's bond portfolios. Dagmara chairs the 

RBC Fixed Income & Currencies Committee. She is also a member of the 

RBC Investment Policy Committee, which determines the asset mix for RBC 

balanced products, and the RBC Investment Strategy Committee, which 

establishes global strategy for the firm. 

Janet L. Engels 

Senior V.P. & Director 

Private Client Research Group 

RBC Wealth Management 

Janet has more than 27 years of experience in the securities industry. She 

joined Tucker Anthony, later RBC Dain Rauscher, in 1982. Over the course of 

her career, she has held the positions of Director of Equity Research for Sutro 

& Co. and Director of Equity Strategies for Tucker Anthony. In 2002 she was 

named Director of the Private Client Group at RBC Dain Rauscher, now RBC 

Wealth Management, where she is also a member of the Director’s Circle. 

SAMPLE 

Stuart Kedwell, CFA 

Senior V.P. & 



Stu Kedwell began his career with RBC Dominion Securities in the firm’s 

Generalist program and completed rotations in the Fixed Income, Equity 

Research, Corporate Finance and Private Client divisions. Following this 

program, he joined the RBC Investments Portfolio Advisory Group and was 

a member of the RBC DS Strategy and Stock Selection committees. He later 

joined RBC Global Asset Management as a senior portfolio manager and 

now manages the RBC Canadian Dividend Fund, RBC North American Value 

Fund and a number of other mandates. He is co-head of RBC Global Asset 

Management’s Canadian Equity Team. 




RBC Global ASSET Management Inc. 

Eric is the Chief Economist for RBC Global Asset Management Inc. (RBC GAM) 

and is responsible for maintaining the firm’s global economic forecast and 

generating macroeconomic research. He is also a member of the Investment 

Strategy Committee, the group responsible for the firm’s global asset mix 

recommendations. Eric is a frequent media commentator and makes regular 

presentations both within and outside of RBC GAM. Prior to joining RBC GAM 

in early 2011, Eric spent six years at a large Canadian securities firm, the last 

four as the Chief Economics and Rates Strategist. His previous experience 

includes positions as economist at a large Canadian bank and research 

economist for a federal government agency. 

Martin paleczny, CFA 



Martin Paleczny, with 16 years of experience in the investing field, began 

his career at Royal Bank Investment Management, where he developed an 

expertise in derivatives management and created a policy and process for the 

products. He also specializes in technical analysis and uses this background 

to implement derivatives and hedging strategies for equity, fixed income, 

currency and commodity-related funds. Since becoming a portfolio manager, 

Martin has focused on global allocation strategies for the full range of assets, 

with an emphasis on using futures, forwards and options. He serves as advisor 

to the RBC Investment Strategy Committee for technical analysis. 

Jason Storsley, CFA 

President & CEO 

RBC Direct Investing InC. 

Jason joined RBC Direct Investing on Feb. 1, 2009, and is responsible for 

developing strategy, growing assets under administration, and expanding 

revenue and market share. He was previously head of RBC AM's institutional 

investment-management business and Director of Global Equity Research. 

Jason's career at RBC Financial Group dates from 1998, when he joined RBC 

DS. In 2001, he moved to the Fixed Income Portfolio Advisory Group, where 

he was in charge of structuring portfolios for high-net-worth clients and 

formulating trade recommendations. Jason was elevated to Vice President in 

2003, when he assumed leadership of the portfolio advisory group, and the 

retail bond sales and trading desks. 

Members 

Andrew Mitchell, CFA 

V.P. & Institutional Portfolio Manager 

RBC Global ASSET Management Inc. 

Andrew began his career at RBC Dominion Securities and has nearly 

two decades of experience in the investment industry. He is currently an 

institutional portfolio manager and a member of the firm's Phillips, Hager 

& North Canadian Equity team. He is also a portfolio manager at RBC Global 

Asset Management. Prior to joining PH&N, Andrew was a top-ranked sellside 

equity analyst and Managing Director at Scotia Capital. Andrew holds 

an MSc from the London School of Economics. He was appointed to the RBC 

Investment Strategy Committee in 2009. 

GEORGE RILEY, FSCI 

HEAD, DISCRETIONARY INVESTMENT MANAGEMENT 

RBC WEALTH MANAGEMENT UK & TRUST 

George has over 30 years experience in the Financial sector. He was 

appointed Head, Discretionary Investment Management, British Isles in 2010 

and Managing Director of RBC Investment Solutions (CI) Limited in 2011. In 

2006 he was appointed Head of the Global Investment Solutions group for 

RBC Wealth Management, International after moving from RBC (Suisse) where 

he had been the Chief Investment Officer since 2002. He is a Fellow of the 

Chartered Institute for Securities & Investment. Prior to joining RBC, George 

worked with Lloyds Bank International, in their trust business in the British 

Isles and Monaco. He joined RBC in 1988. 

SAMPLE 


c investment strategy committee 

Global equity heads 

Ray Mawhinney 

Yoji Takeda 

Dominic Wallington 

Phil Langham 

Paul Johnson 

Senior V.P. & Senior Portfolio Manager, U.S. & Global Equities 


Director & V.P., Asian Equities 

RBC Investment Management (Asia) Limited 

Chief Investment Officer & Chief Executive Officer 


Senior Portfolio Manager, Emerging Markets 


Global Equity advisory committee 

Chris Beer, CFA 

Stuart Morrow, CFA 

Martin Paleczny, CFA 

Cameron Scrivens 

Robert Silgardo, CFA 

Janice Wong, CA, CFA 

V.P. & Senior Portfolio Manager, Global Equities 


V.P. & Senior Portfolio Manager, Canadian & Global Equities 


Manager & Senior Analyst, Global Equity Research (Financials & Consumer Discretionary) 


V.P. & Senior Portfolio Manager, Asset Allocation & Derivatives 


V.P. & Senior Portfolio Manager, U.S. Equities (Health Care & Technology) 


Senior Analyst, Global Equities (Telecommunications & Technology) 


Senior Analyst, Global Equities (Industrials & Utilities) 


Global Fixed Income & Currencies advisory committee 

Soo Boo Cheah, MBA, CFA 


Suzanne Gaynor 

George Riley, FSCI 

Senior Portfolio Manager, Global Fixed Income & Currencies 


SAMPLE 

Head, Global Fixed Income & Currencies (Toronto and London) 


V.P. & Senior Portfolio Manager, Global Fixed Income & Currencies 


Head, Discretionary Investment Management 

RBC Wealth Management UK & Trust. 


This report has been provided by RBC Global Asset Management Inc. (RBC GAM) for informational purposes only and may not be reproduced, 

distributed or published without the written consent of RBC GAM. It is not intended to provide legal, accounting, tax, investment, financial 

or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-todate, 

accurate and reliable information, and believes the information to be so when printed. Due to the possibility of human and mechanical 

error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC GAM is 

not responsible for any errors or omissions contained herein. RBC GAM reserves the right at any time and without notice to change, amend or 

cease publication of the information. 

Any investment and economic outlook information contained in this report has been compiled by RBC GAM from various sources. Information 

obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its 

affiliates or any other person as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any 

errors or omissions. 

All opinions and estimates contained in this report constitute our judgment as of the indicated date of the information, are subject to change 

without notice and are provided in good faith but without legal responsibility. To the full extent permitted by law, neither RBC GAM nor any 

of its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the outlook 

information contained herein. Interest rates and market conditions are subject to change. 

A Note on Forward-looking Statements 

This report may contain forward-looking statements about future performance, strategies or prospects, and possible future action. The 

words “may,” “could,” “should,” “would,” “suspect,” “outlook,” “believe,” “plan,” “anticipate,” “estimate,” “expect,” “intend,” “forecast,” 

“objective” and similar expressions are intended to identify forward-looking statements. Forward-looking statements are not guarantees of 

future performance. Forward-looking statements involve inherent risks and uncertainties about general economic factors, so it is possible 

that predictions, forecasts, projections and other forward-looking statements will not be achieved. We caution you not to place undue 

reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed 

or implied in any forward-looking statement made. These factors include, but are not limited to, general economic, political and market 

factors in Canada, the United States and internationally, interest and foreign exchange rates, global equity and capital markets, business 

competition, technological changes, changes in laws and regulations, judicial or regulatory judgments, legal proceedings and catastrophic 

events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we 

encourage you to consider these and other factors carefully. All opinions contained in forward-looking statements are subject to change 

without notice and are provided in good faith but without legal responsibility. 

SAMPLE 

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Trademark(s) of Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2012.

SAMPLE 

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