Transcript - Capital Markets Outlook - New Year 2011

Hi, my name is Dan Chornous and I'm Chief Investment Officer of RBC Global Asset Management. As we approach the end of 2010 we just completed our forecast for early-mid 2011 with respect to the economy and capital markets. I'd like to share those with you over the next few minutes.

The slide in front of you shows our main points. Economic data releases since the summer of 2010 have been encouraging in the United States, in Canada, even in Europe-where a banking system crisis has revealed itself-in Asia and in the emerging world. Moving the economy ahead are clearly massive amounts of monetary and fiscal relief now including a second massive round of bond purchases by the US Federal Reserve board, referred to as Quantitative Easing II.

The corporate sector is healthy and it's been a mainstay of the recovery so far, and certainly the passage of time has made a difference. It's allowed for balance sheet repair in the financial system, balance sheet repair at the consumer level and an all-important recovery in consumer confidence. But we don't want to make a mistake, headwinds remain fierce, enough to limit growth to probably half the speed that we've grown used to in post-war recoveries.

Housing remains a problem. The signs of recovery that were evident last spring are now in question with the removal of government support payments. We think that there's an equilibrium that's been developed in that market, but we're watching it closely. Credit channels are functioning but not normally. Credit creation is all important to healthy growth in an economy and it's getting there but not quite there.

And now we have the sovereign debt crisis in Europe which has threatened confidence in the financial system again. We believe this crisis is contained and containable but we don't think it's done and we're monitoring it very closely. We look as a result for a 2.5 to 3% growth in North America, slightly lower growth in Europe and in Japan, call it 1.5 to 2%, but that half-speed recovery has gained traction and a threat of double dip is increasingly remote.

In this environment I think it's reasonable to accept short rates to remain at rock-bottom levels really until next summer and perhaps further out. We look for low bond yields to be sustained, but having said that we appear to be testing the upside of the expected range that we would look for over the next several months and we're adjusting our asset mix accordingly. We remain underweight in the bond market but are modifying the degree of that underweight.

We look for good but not unprecedented gains in stocks. Valuations are very attractive, even in an environment of slow growth, as a result of lean balance sheets, great operating leverage and solid profit growth. So normal to slightly above normal gains in stocks are consistent with the environment we see unfolding.

I want to share with you four or five slides or panels that were key to forming or shaping this outlook that we've put in front of you. The first one looks at the headwinds coming from Europe and we see two distinct... two distinct images here. On the left-hand side, we see lines sweeping upwards; on the right hand side of the chart, lines that are barely moving. The left-hand charts are the cost of insuring peripheral banking system debt in Europe. So these are the cost of insuring banks that exist in Portugal, Ireland and Spain.

Now, the cost of insurance has risen four to six fold over the last three to four months as the degree of problems in those banking systems has revealed itself and governments have had to move in and guarantee that debt, which has caused the sovereign debt problem. So of course this threatens to morph into a more broadly based issue for the global banking system and one wonders if it doesn't have the power of what ultimately manifested itself in the fall of 2008. We don't think so, and the chart on the right supports our view, but we're monitoring it.

The chart on the right is the cost of funding the banking system outside of the PIIGS, so this is core Europe and the rest of the world, largely US and Canadian banking. It's barely budged. The gold line is the cost of funding the European banking system. So there has been some impact of what's happened in the peripheral nations, but when we take these two charts together the market is betting that this is a contained and manageable issue. We don't think we've seen the end of it, it still holds the ability to rule markets and likely to play out over the first quarter or first half of 2011, but as we see it now, contained to the peripheral or PIIGS economies of Europe.

Really key to the situation in North America, and the most watched economic indicators rate now, are employment. Now why is that? Well there's the political issue of a 9 to 10% unemployment rate being unacceptable. There's an economic issue of-in a fast-paced economy like North America has-the longer you leave people out of a job, the less likely they are to be integrated at satisfying and high-paying jobs. This is the economic reality that until you create jobs at a faster pace you'll be locked into a slower rate of growth of consumption and therefore a half-speed recovery.

So the blue lines on these charts are non-farm payrolls, this is the count that we tend to look at in markets for job creation. The gold line on the left-hand chart is an indicator of manufacturing health, the ISM diffusion indicator. So we find that six months after the ISM moves up that employment or jobs start getting created. So, on this lag basis you see these two lines fit together quite well.

Now the ISM has been expanding and after a stutter in the summer of 2010 has sort of reinvigorated its move higher. It's now leading employment higher but not at the pace that we would expect to see this late into recovery. So like everything else we've seen since 2008, it takes longer to fix things and when they're fixed they just don't come along at the pace that we've grown used to in the post-war period.

Again, why is this important? Well the chart on the right compares employment conditions, which is the blue line... I'm sorry, the gold line, to consumption. Now consumption is positive and moving ahead but it's moving ahead at about a 2% annualized pace. We look for 3 to 4% to be consistent with the long run normal growth of the economy. After all, 70 to 75% of GDP in North America comes from consumption. If you can't create jobs or you can't create jobs at a normal pace, you're stuck with a high unemployment level, you can grow your economy but at a much lower pace than we've grown used to. That really is the root of the half-speed recovery.

Within these bands is the normal range within which we'd expect to capture bond yields. So bonds would be expensive or yields too low at the bottom of the channels and would be attractive or yields too high and unsustainable at the top of the channels. It worked quite well over many, many years of observing movements and interest rates.

So we felt that there was a real risk in the bond market earlier this year as yield sunk in the United States towards the low 2% level, below 2.5%, but in the last six weeks we've seen a real spike upwards. We're now above... near or above the midpoint of these channels in the United States and in other developed economies.

Now, sustaining the channels where they are means we need to hold the economy at a substandard growth pace and over time we're going to gradually normalize and these bands will shift upwards, as we see in the chart in front of you. Nevertheless, at current levels of yields, which are closer to 335 to 340 as I speak today, we've modified our big underweight position in fixed income. We remain modestly underweight, looking for very low single digit returns, and the risk of no return is always evident in that environment, but the risks have really modified in the last six weeks with the rise in bond yields and in an environment of still sluggish growth and very low inflation.

As we move to the stock market on the next page, you can see our channels here for the equilibrium values for the US stock market on the left and the Canadian stock market on the right. These charts capture the normal valuations that investors assigned to stocks over the last 65 or 70 years, as a function of the level of interest rates and corporate profit growth in the economy.

In Canada you see we're moving closer to the midpoint of our channel, which is our minimum expectation during a period of economic growth. In the United States though, we're still towards the bottom end of that channel, about halfway between the bottom boundary and the midpoint.

So we've recovered from the deeply discounted area of the post-Lehman Brothers fall 2008 crisis, but stocks remain very, very attractive on this basis. And when we look at inside corporations that were really priced in the stock market, captured in this chart, we see very strong balance sheets, very high free cash flow, the ability to raise dividends and to withstand a slowly growing economy and in fact produce very strong profits during that weak period.

Stocks remain very attractive to us and attractive relative to bonds. And perhaps the best picture that can capture that relative relationship between stocks and bonds is this last panel that I want to show you now. This chart looks at trailing 10-year returns on stocks versus trailing 10-year returns on bonds. You can see that over the last 75 or 80 years it's oscillated wildly around that mean level, so around that thick line at the centre that runs horizontally through the chart. But, you know, it goes up and it goes down. It seems to be kind of self correcting; stocks get cheap, stocks get expensive relative to bonds.

The ratio of stock price movement over the last 10 years to bond price movement over the last 10 years has only recently been at its lowest level in modern history, lower even than during the Great Depression in 1932. But over the last 12 months, firm gains in the stock market and a gradual weakening of returns in the bond market appear to have reversed this indicator.

To us, as long as the economy moves ahead, as we expect that it will, stocks present a much better return picture going forward than do bonds. Valuations are much more attractive relative to their own history and earnings and dividends should benefit from even the weak growth that we see.

As a result, we've maintained our overweight position in our recommended asset mix in stocks: modified our underweight position but only because yields have moved significantly higher over the last six weeks and are unlikely to move much higher in the near term. For 2011, we continue to favour stocks over bonds. Thanks very much, hope you enjoy your holiday and good luck with your investing plans in 2011.

Thank you.