Transcript - Capital Markets Outlook - Summer 2015

Welcome to the RBC Global Asset Management Capital Markets Update for Summer 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. Thank you for joining us, Dan. 

Well, thanks for having me, Martha.

Dan, lots of concern these days about global growth. Are you worried about the slow start to the year, and what do you see as the implications going forward?

Well, it was a slow start to the year, but I think we have to provide some context around that. It was most apparent in the United States where we had a very, very cold winter, and hard to remember that as we approach hopefully a warm summer, but it really did take some of the wind out of the sails of the US economy, particularly in the Northeast where it was toughest. We had a dock strike that took away from GDP numbers, and of course we had the rising US dollar which hurts the trade account, as well. Taken together, at least two out of those three things are probably non-repeatable. For sure, we're not going to get a cold winter in this summer, so some of the growth will normalize: you flip out; you flip in.

Still, as I'll come back to in a moment, it's going to be a fairly sluggish 2015: more like 2.5%. We shaved our numbers a bit to reflect that. Of course, that has a knock-on effect on the Canadian economy which has really front-end-loaded the impact of lower oil prices because the benefit we get from lower oil prices will be distributed later in the year.

China was slower than expected. We still consider that to be more of an adjustment down to a 7% growth rate. There are downside risks there. We're monitoring them. But that takes away from global growth because it's been a very, very important engine for GDP growth contribution, and we're losing some of that. But still, 7% growth is 7% growth.

What's really interesting to us, though, is that Europe has been sort of a perpetual loser since the financial crisis and then its own Eurozone crisis for the last five or six years. Finally, the preconditions for sustainable growth in Europe seem to have moved into place. By this I mean Greece might be a sideshow. Eric Lascelles and I were at the IMF in Washington for a meeting last week, and one of the chief economists there said, "You guys worry too much about Greece. Do you realize that the Greek economy is roughly the size of Düsseldorf? Do you worry a lot about Düsseldorf?" And, of course, our concerns and the industry's concerns aren't so much about the loss of growth or the specific contribution of output from Greece, it's that if Greece left the Union and the whole Union structure then gets put in question. But we think that'll be managed to a good place, and we're watching that very carefully.

But what's really going unreported, though, is if you look at lending conditions in Europe, the banks have had trouble because of balance sheet pressures and regulation and the need to stabilize those balance sheets; they've had trouble opening up lending facilities since the Eurozone crisis. Those balance sheets are now in pretty good shape, so the ability to initiate loans – and that's fundamental to growth in the economy – is now there. We're also seeing improving business and consumer confidence. So, the desire to borrow money now pairs with the ability to lend money, and maybe we see some better growth come out of Europe than we've grown used to for the last five years.

So, yes, a weak start to the year. I think explainable by mostly one-off factors, and some interesting developments in Europe that make the last half of 2015 look a little bit better, and 2016, we've left our original forecasts unchanged. It's sort of 3% in the United States, and roughly those levels elsewhere in the world.

Interestingly, though, this cycle continues to be one where peak levels of growth don't approach peak levels of prior cycles. It's a sluggish, modest growth environment.  Inflation remains low, but it is slight inflation, not deflation. That's probably bottoming. But growth, nonetheless.

And so in light of all of this, what's your view on the fixed income markets?

With the short end, there's a model we can put in front of you. This is our basic equilibrium model for the short term interest rate. A lot of concern that, well, now that the US is going to ramp its growth a bit, time for the Fed to start raising rates. It isn't always a bad thing for the economy and markets, but it's especially not true. If you go back over the last 40 or 50 years of monetary policy, about half the time you have a problem when the Fed starts raising rates. In all of those cases, though, the Fed needed to raise rates quite rapidly because inflation was already blossoming. That's hardly likely to happen here.

Really, as the chart shows, the channel that heads higher from here shows, first of all, that rates should be roughly where they are, so they're not really too low in the context of where the economy and inflation is: they're appropriate. So, why raise them? Well, you want to raise them, well, for two reasons, really. First, if you leave them too low for too long you will ultimately seed the next inflation. But I think even more importantly this time, because the bias is against inflation, is you want to raise them to a level that you've got a tool to fight the next crisis and recession – when that ever occurs, and so it's a good time, now that the economy will be on a sustained, upward, gradual path, to begin that process.

But when really the only compelling reason to move them higher is so you've got this future tool, you can be patient, you can be transparent, you can telegraph your actions, you can suspend your program if needed. So, I think this will be a very gradual, well-understood and not at all destabilizing upward course for short term interest rates. It probably begins later in 2015, early in 2016, and I think it will be very much of a non-event.

It will have implications, though, further out the curve. This next chart shows us the 10-year T-bond, but even here we're moderating our view. You can see that that band shows that the bond yield is currently pretty close to the middle of the band, up from the bottom, so this correction we've gone through in the bond market over the past six weeks has been quite intense, has taken away some of the forward danger, then, up for the correction.

I think really, though, the problem is, over the next several years, maybe many years, that band continues to rise. That happens because we need to normalize the real or after-inflation rate of interest. The after-inflation payment for saving versus spending is simply too low. It's historically low. As the pain of the financial crisis and pressures of sustained growth move forward, that band should continue to rise.

Having said that, as we all adjust down our very long term expectations for growth and inflation and, really, the process of adaptive expectations plays through – that is, the longer that real rates have been low, the more likely we are to accept low real rates in the future – the path to higher nominal bond yields probably flattens a bit. So, the combination of maybe a bit more tame forecast and the increase in bond yields that we've seen over the last six or eight weeks, what does that work out to? Well, maybe 2.5% for US bond yield a year from now. We're not all that far away from it.

So, you know, total returns over the next year, low single digits. Not all that attractive. There's always a chance that the correction progresses further, that you actually get a negative total return. I still think you're going to get very low and disappointing total returns out of government bonds over a very long period of time. But the adjustment that will lead to those low returns has partially happened, and the rest is going to be distributed over a long time.

What does this mean for equity markets, then?

Well, this next chart, this bar chart, is our aggregate of global equity market valuations. The horizontal line indicates the point at which the average valuation around the world's equity markets is neutral: things are at fair value. So, you can see that at the beginning of this great bull market, or the end of the financial crisis, we're about 45% below world fair value. We're now about 10% below.

What does that mean? Stocks were stunningly cheap. Not a whole lot had to go right in 2009 for people to make some money in equities. They're kind of cheap now. But in historic context, lots of times they've been this cheap. So valuations are still, on balance, a mild positive. They were extraordinarily positive five years ago.

If you go to this next chart, we give a little more granular detail. The world's biggest market, the S&P 500, and here's its fair value channel. These are built up into that prior chart that I showed you. You can see that the US stock market moved from below the band in 2009 into the band, 2010 through 2014/5. Sometime early in 2015 we actually crossed above the middle. As you cross above the middle, you're moving from just beneath to fair value to just above fair value, and has the important impact on returns and volatility: as you move above the middle of the band, total returns tend to shift down and volatilities tend to shift up. It’s interesting, in the last few weeks, the stock market has made no net progress and, as a result, has fallen right back to the middle of its band. Reasonable to expect kind of normal returns to slightly below, but normal volatilities, as well.

Now, some markets in the world, of course, are much more attractive than this. Emerging markets, for example, are closer to the bottom of their channel, Europe and the UK, as well, and here we see economic conditions picking up. That has good things to say about future earnings, and so we reflected that in our asset mix. But as we look at valuations around the world, neutral to positive for equity markets, with the United States the most advanced and roughly at fair value, and the rest of them generally below.

Now, you mentioned asset mix. How are we reflecting all of this in our asset mix?

Well, this next chart gives us a very, very long term perspective on asset mix. We looked at 150 years of stock market history a few weeks ago, and the chart shows five periods where you've gone for ten years and more with no net progress in stocks. So the 1930s; the 2000s were a great example of that; the end of the '60s through the '70s – these tended to be periods of great economic disruption where risk assets made no net progress. Interesting, you fell into this last great or latest great super-cycle bear market, the peak of the tech bubble, and following that, the unwind of that, and subsequently the financial crisis: no net progress in US stocks for 13 years, and really a lost decade for equity investors.

About the middle of 2013 or early fall in 2013, you'll notice that the S&P 500 finally poked above that channel. There is accumulating evidence that that lost decade or decade and a half is now behind. Now why is that important? Because our analysis shows that during so-called super-cycle bull markets – that's when you're not in those long consolidation phases – that your rally phases are almost twice as long as during the consolidation phases, that the drawn-downs or the corrections are less than a year, and tend to be more like 18% versus almost two years and 35% or 38%. That has important implications, I think, for how one manages their assets.

Of course, we're always concerned about protecting against downside. But on balance, your rallies are going to be strong and your corrections should be used to reload to prepare for the next long up-cycle during a super-cycle bull, and there's accumulating evidence that that's actually what we've been in now since 2009.

This last chart that I want to show drills even further into asset mix. Here, we've looked at trailing ten-year total returns for bonds less stocks going back to the '30s. You can see it works in really long sweeps: once you get sort of a cycle in favour of bonds, it tends to play out over a decade from the top to the bottom and the opposite for stocks versus bonds.

We began this cycle, because of that lost decade, at the lowest print reaching all the way back to 1932 for stocks versus bonds, and at that point it reversed and the cycle moves in favour of stocks. It also shows that it's fairly early in that oscillation. Of course, our valuation models would support stocks over bonds, and so, too, would the view that we are in a gradual business cycle upswing, but a business cycle upswing nonetheless, and approaching a period of tighter monetary conditions. For a long time our asset mixes reflected this, with the overweight in stocks, which we've maintained, and a slight underweight in government bonds, which we've also maintained.

Thank you very much, Dan. This was very informative, and we look forward to your fall 2015 Capital Markets Update.

Thank you, Martha.

And if you have any further questions on the current investing environment, please speak to an RBC advisor today. Thank you.