Transcript - Capital Markets Outlook - Spring 2015

Welcome to the RBC Global Asset Management Capital Markets Update for Spring 2015. I'm happy to have Dan Chornous, Chief Investment Officer at RBC Global Asset Management, with us today to provide context around recent market events. Dan, thanks for joining us.  

Always great to be here, Dave.

Dan, there appears to be a great deal of uncertainty surrounding the global economy and capital markets. How is the US economy faring in this environment?

Well, the US economy has clearly been the leader over the last couple of years, but to the extent that the economy needs to broaden out, it's probably going to happen now. We look at the series of charts in front of you, this is a good leading indicator of not just the US but the global economy: it's the Purchasing Managers Indicator, almost the most reliable of those future indicators that we look at. What you can see is a gradual upsweeping sort of aspect to all of those lines, a bit of a correction in the United States, but the US still at the highest level. This tells us a lot about where we've come from and where we're going. The US has led. It's giving up a bit of steam, but not settling into anything other than the sort of the subtle but sustainable growth rate that we've grown used to. But there is important upward movement in other areas of the world that was lacking before.

Looking at this next chart, I think the root of this – the leadership from the United States – is not a surprise, and the handoff to the rest of the world shouldn't be either, because really it's the same thing. The chart on the left shows employment against interest rates, so that dotted line – you can see rising lately on the chart and then flat – is the inverse, or we flipped over the short term interest rate in the United States: the Fed drops interest rates, that line rises.  

Almost coincident with that, you can see the aspect, where that line below at the green line rises and falls, falls very closely to the dashed line. What we're seeing here is that employment follows interest rates. You drop interest rates to effectively zero, then you get employment moving in the right direction with a very, very strong jobs market now in place in the United States. It's critical.

This chart on the right relates jobs to spending: 70% of the United States economy and about 60% of most advanced economies is actually consumer spending at the stores, and as interest rates fell and employment rose, as employment rose, confidence returned; as confidence returned, consumption blossomed. You have the strongest jobs market in the United States that you've had since the mid-1990s; that says a lot about where consumption goes in the future.

So, the growth we've grown used to, which is, as I said, subtle but sustained, is going to continue, but the elements of a long cycle remain in place for the United States. But this next chart shows that the things that happened in the United States that put in place the sustainable business cycle appear to be finally falling into place in Europe. So, we have famously difficult negotiations with Greece, the Eurozone crisis, the creakiness of their banking system, all these things are a problem for Europe.

But that chart on the left is a good leading indicator of what's ahead. It shows lending conditions in the European banking system, which of course is the root of growth. If you can't lend, it's very difficult to put in place conditions for future growth. The weakness of the banking system in Europe was a critical problem. But you can see that the lines here, which measure lending officers' desires to lend or not have now passed through that horizontal axis. So, we've moved from a very long period, really reaching back all the way back into the last decade, where we've seen progressive tightening of lending conditions where it's getting harder and harder to get a loan in Europe because of the weakness of banking balance sheets, to the point where finally we're seeing an ease in lending conditions. So, half of the equation is beginning to be solved: there's money available to invest in the future.

Now, the problem is, even if the money's available, does anyone want to borrow it to invest in their plans? The chart on the right is Confidence in the Eurozone in Germany, the largest economy. You can see that confidence, in both the case of consumers and businesses, has actually rebounded and is as high as it's been in the last ten or fifteen years. So you have the two conditions that ultimately moved the United States onto a sustainable growth track and the ability to provide funds for future growth and the confidence that made people borrow to invest in their future are now falling into place finally for Europe.

Let's not get too excited: still, much lower growth than any of us grew used to, but sustainable growth, even if it's at a low level.

You pull that all together, and what would you say our expectation is for the Federal Reserve and what they're going to do with interest rates in the near future?

Well, I think a very strong consensus is one that's almost impossible to go against, much as you might want to, is that the next step for monetary policy in the United States is for a rise in interest rates. This chart helps us with, well, what does that mean? Does that mean that they're going to destabilize the economy and capital markets and start to punish it with a tight level, a high level, of interest rates? Hardly likely. The band gives us a sense of where interest rates should be. A good guess is interest rates should be at the middle of this band – that's sort of their central tendency. It's quite interesting that, at effectively zero percent, they're actually at the middle of the band. That's a result of a decline in inflation premiums, but more importantly real rates are after-inflation rates of interest. Very gradually those real rates are going to normalize, and you can see the band start to head up. Gives us not a bad target. It's like, okay, even when they start to raise rates, are they way behind? They gotta catch up quickly?

I don't think so. You know, usually, if you're behind, inflation's your problem. Well, inflation's not a problem. If anything, inflation's a little low, and we think that will resolve itself over the year ahead. But the urgency to raise rates just isn't there, so why do it? Well, you don't want to leave rates lower than they should be because you can encourage inefficient investment, maybe sow the seeds of a future inflation. There's no reason for that.

The real reason why I think they should raise rates is to get them to a level that they have a tool to fight the next crisis – and zero percent isn't that tool. So... what? The pressure on the Fed? Pretty modest. They can be very transparent. They can communicate very clearly with the Street. And I think what they will be communicating is very gradual and paced rises in short term interest rates stretched out over a very long period of time, hardly the kinds of things that'll distort the economy or destabilize capital markets.

Then what about fixed income in general, with that as a backdrop?

Well, we have the same chart for the 10-year bond in the United States and for virtually all the major bond markets in the world, and we have expressed a concern over a long time now that yields – the longer term interest rates – are unsustainably low. You can see that they've fallen for a long, long time, first in the 1980s and 1990s as inflation was pounded out of the system, but more recently in the post-financial crisis, partially by risk aversion – you know, people saying, "You know, I don't mind taking a very low rate of interest because I don't want to be hurt in risk assets" – and that's passing.

But more importantly, what's held not only interest rates down at the long end has been unorthodox monetary policy: quantitative easing in the United States, now programs in Japan and England, similar to Japan and Europe, similar to that. But this program is over in the United States. We're moving towards a more orthodox or ordinary monetary policy, so those artificial forces that have pushed down interest rates are gradually going to recede, and I think that bond yields are going to follow that band: as the band rises, as real rates, or after-inflation interest rates, go back to their normal level that we've seen over the last 50 or 60 years. Now, it could take a long period of time.

But, you know, yields are around 2%, either side of, in Canada and the United States in the critical 10-year level. I think a year from now they're 2.5% in the United States. But I think a year beyond that you're equivalently higher, and for many years, I think we're going to see progressively higher interest rates, more of a grind that's going to happen.

Now, yields are so low it doesn't take much of an increase in interest rates to wipe out your coupon income. You look back at a total return, even in that very measured environment that we have ahead, I think you're going to earn very, very low single digits, maybe even negative total returns, on sovereign bonds over a very long period of time reflecting the ongoing normalization of the economy and the fact that these artificial pressures on yields are now being gradually removed.

We'll get to what we do strategically relating to that, but before we do we should also talk about stocks that have had a really nice run. Are we still fairly positive there, or is our view changing at all?

Well, I think we have to adjust our expectations to reflect, as you said, it's been a pretty good time in the stock market. Hard to believe with where we came from. You think if it's now six years ago we were at 6-6-6 on the Index – only six years and two days ago or something, that's how long this is going on – and it's more than triple. So some of the agents or the elements of what got us there are no longer as attractive, but I still think that risk assets are the way forward.

This chart shows you, kind of quantifies the movement. If we compare the world's stock markets to what we calculate is their fair value, you can see that that bar chart was further below the horizontal axis or global fair value than it had ever been reaching all the way back to the 1960s. We were 45% below equilibrium or fair value in March of 2009, markets kind of priced for the end of the world. We're only about 7% below fair value now, and – where we could say then the word "unprecedented" had got tiresome, everything was unprecedented at the time – this is not an unprecedented level of valuation we're at. We're a little below fair value. Some markets more attractive than others. But it's quite common to be within 10% of fair value, and we're still below fair value. It's a bit of a cushion, adds to future returns, but it's a lot less spectacular than it had been.

Do you still view that we're in the midst of what we'd describe as a secular bull market?

I actually think that there are elements that suggest that we are in a... more than whether we're in a secular bull market, I don't think we're in a secular bear market anymore. I understand that I'm hedging the answer because one never wants to declare that there's clear blue sky out there. We are in capital markets, after all. These markets have come a long way. But the elements of and the indicators of a long cycle are more and more compelling.

And never to say that we can't have significant pullbacks in the midst of a secular bull market, anyway.

Of course. Of course.

Again, you pull all this together – the view on bonds, the view on stocks – what does that do with our asset mix, and any areas in particular that interest us?

Well, for a long time we've been overweight equities and underweight fixed income, particular sovereign bonds, and within fixed income, we've had a nod towards corporate credit, even some high yield credit, portfolios where your coupons are higher, and so where pressure on interest rates will be somewhat absorbed by those higher coupons. We've left that in place, cognizant of the fact that, after many years of six years of a bull market and very strong returns particularly out of US equities, that the chance of correction is always looming.

But, you know, if you are in a super-cycle bull market, if that ten years of correction and consolidation that happened in 1999 until 2009 are truly behind, what you should actually start to look for is strong, long-lasting bull markets and fairly brief and mild bear markets. Because, remember the last decade was the exact opposite of that, just as the period 1966 to 1980 was the opposite to that. So, if we're into some sort of a correction, it's probably in the range of 15% to 20% would be the maximum you would see in a period like this. Now it's such a reload for another up-leg in the bull market, and I think you want to reflect some chance of that in your asset mix, which is hold your asset mix above your neutral exposure with regard to equities.

Now, within those equities, we've been heavily overweight or overweight the United States for quite a while, particularly out of our North American allocations. We're harvesting some of that and moving it towards Europe where we're seeing a decade of underperformance and a decade of relative valuation lost to the United States, beginning to show it might want to reverse. So, I think the opportunities are still reasonable in the United States, but you should expect lower total returns and higher volatility because valuations are higher. But they're improving in Europe and I think they're still quite attractive in emerging markets.

Dan, as always, great to get together. I look forward to seeing you again to tape the 2015 Summer Capital Markets Update. We'll talk to you soon.

Thanks for having me, David.

If you have any further questions on the current investing environment, please speak with an RBC Advisor today.