Transcript - Global Economic Outlook- Summer 2015

Jackie Porter- Bateman

Hello, and welcome to RBC Global Asset Management's Quarterly Economic Update. I'm joined today in the studio by our chief economist Eric Lascelles. Eric, welcome. We're delighted to have you.

Eric Lascelles

Thanks for having me.

Jackie Porter- Bateman

Let me start by asking you, the past quarter has managed to combine weaker economic growth but with higher bond yields and oil prices. What do you make of that?

Eric Lascelles

Well, it is an unusual mix. I think the reality is there are a few different things going on all at once. First of all, to establish that indeed the global economy is a bit weaker, we can look at this first exhibit of Global Purchasing Manager Indices, as good a leading indicator as there is, and you can see there's been a general downward trend there. If we dig into the details, we can see that the world's two largest economies in particular have slowed. The US had a fairly poor beginning to the year. China has been on a decelerating trend for quite some time. If we were to broaden that assessment out, the Canadian economy has been softer, as well, and actually quite a number of emerging market economies.

 So, on a number of fronts, there has been some weakness. In terms of how concerning that weakness is, a little bit less than it first looks, in particular with regard to the US, because in fact the US economy is not as weak as it first looks in our opinion. We can talk more about that a little bit later.

If we talk about oil and yields, indeed oil prices have risen to some extent. That's largely because a significant part of the supply excesses that sent oil prices down has been eliminated. That's a constructive development I think largely unrelated to what the economy has been up to. On bond yields, yields have gone up as the deflation threat has faded. A lot of that has to do with oil, by the way, recovering to some extent. And, as we push into the future, it's undeniable that higher oil and higher bond yields are a bit of a drag on global growth. I think the better way to think about this is actually, though, that there was this unbelievable tailwind coming from very low oil, very low bond yields, and actually weak exchange rates, as well. There is still a tailwind. These are still blowing a tailwind a little bit less forcefully than before.

In the end, we still think that the developed world can grow faster this year than last year. We think, more generally, the global economy can start to make more clear strides into 2016.

Jackie Porter- Bateman

Great. Nevertheless, we look at the current environment and there are certainly still some risks out there. What do you see are the biggest risks?

Eric Lascelles

Right. Well, the two we have tended to follow most closely are, of course, Greece and the Greek debt saga, and also I suppose higher bond yields and the risks that create around the world. On the Greek side, really, it's a process that evolves almost every day. It is a saga. It's a problem. It isn't that Greece is a particularly large economy. It's actually a fairly small economy. The risks are arguably diminished in general compared to where they would have been a few years ago simply in the sense that other countries are finding their feet and the contagion threat is generally diminished. But the negotiations are still quite complicated. We really can't speak with precision about Greece right now. There are ways in which it could affect the world negatively. It's more likely that Greece actually manages to sidestep that, so Greece we are watching very closely.

With regard to the rest, though, and this threat of higher bond yields, well, to begin with, we've seen higher bond yields. We've seen the beginning of that trend. Now, markets rarely work in a straight line, and so it's not clear whether that trend pushes further in the near term. But, in general, we can likely expect higher yields over the next several quarters and the next several years with the US Federal Reserve thinking about rate tightening potentially being a catalyst, but also as that deflation threat fades and as valuation concerns become more prominent, as well.

You can see, for instance, in this next exhibit that the German 10-year yield was astonishingly low. In fact, it was almost 0% for a brief moment. It's now sold off almost 100 basis points. Still very low, but much less low than it was. The concern is in part what that means for investors, of course, but I think more acutely what it means for certain groups of borrowers. Overall, the world should be fine in a higher rate environment, but it's undeniable there are some pockets of vulnerability, be it emerging market external debt borrowers or a few corporate borrowers particular in Portugal and Spain, or perhaps countries that are – companies or countries – that are exposed to low oil in a negative way and suddenly also high interest rates.

We've spent a lot of time on all of this. Some of them are truly somewhat worrying. Most of them look a bit more manageable than people think. So, again, there are downside risks in the world. There are always are. This is one of the reasons why we're not aggressively overweight risk assets like the stock market. We still think it's a manageable risk. 

Jackie Porter- Bateman

Eric, you mentioned that emerging market growth has slowed yet again. What do you see as the future prospects in emerging market economies?

Eric Lascelles

That's right. Well, the emerging market space is truly fascinating right now and as you allude to, initially, we should acknowledge that emerging market growth has slowed. We've seen quite a number of countries decelerate, be they Russia on the back of commodity challenges, along with much of Latin America; China with its own credit and competitiveness challenges, as well. So quite a fraction of them have slowed.

We can take some solace, though, in a few things. One is we suspect 2015 represents a bottom, at least for the overall set of emerging market countries. They may manage a bit more growth into 2016. The other one, as this next exhibit demonstrates, is that emerging market growth really is just reverting back to a more normal outperformance versus the developed world. That's what those bars depict in front of you. So, we can say that the first decade of this millennium was unusually good by that standard. Much of the deceleration since then is reverting back to the more normal relationship.

Let's be clear then: emerging market countries are still out-growing the developed world despite some of the challenges that they face. In fact, we can say that the outlook is enormously varied depending on the emerging market country. So, for instance, resource importers are very pleased right now; resource exporters much less so. We can acknowledge that those embroiled in credit excesses, like China, are struggling; others not to the same degree. And then lastly, of course, the structural reform environment: some countries are now embracing reforms. This will boost their growth going forward. India is a classic example, by the way, of checking all of these boxes. Other countries are not quite as eagerly in that direction. So, quite mixed prospects.

I would be remiss if I didn't then add from a stock market investor perspective that we have been overweight emerging market equities. The logic behind that isn't so much their growth stories: it's their slowing. It has more to do with quite attractive valuations and the recognition, of course, that we don't have to invest in every country and every stock – we can be selective – and so to the extent some countries are getting this right, actually there are quite a number of opportunities. 

Jackie Porter- Bateman

Let's flip over to the United States for a minute. How would you characterize the shifting US environment today?

Eric Lascelles

Right. Well, to begin with, we shouldn't sidestep the fact that the first quarter numbers in the US were atrocious. The US economy was reported to have outright shrunk in the first quarter. That was not a desirable outcome. It created all sorts of concerns and worries. In terms of why that happened, it's fair to say quite a fraction of that was artificial or temporary. There were difficult winter weather conditions, there was a port strike on the US west coast, some seasonal distortions that are becoming increasingly acknowledged and incredible, I think, in the economic community. So it probably wasn't as weak as it first looked, and it almost certainly won't be as weak as we proceed into future numbers.

But there was some real weakness in there. Keep in mind, as much as a lot of countries out there enjoy weak currencies, the US doesn't. The US dollar has been very strong. That's a legitimate drag. It has diminished the US outlook, and we've faded our own growth forecasts a little bit to respond to that. We think the US economy is fine. But it's entering a more mature phase and perhaps doesn't get to grow quite as quickly as it did over the last year or two. So, a bit of a downshift. Not a serious questioning of the US economy. We still see that the Beige Book looks fine and hiring actually has picked up to some extent again. We still think the Fed can tighten this year, perhaps in September. If not then, a little bit later in 2015.

But it's fair to say it's moving a bit less quickly than before. Again, the huge part in this exhibit shows that it's really that the dollar strength is a legitimate weight on the economy. This is a measure of US manufacturing export sentiment. You can see, indeed, it's been on a downward trend for some time.

Jackie Porter- Bateman

Right. You mentioned Greece. Let's pull back and look at Europe as a whole for just a moment. How does Europe fare in an environment like this, particularly given some of the political risks?

Eric Lascelles

Right. I think this is the tricky discussion in the sense that Europe has among the largest downside risks in the world, Greece being one of them; perhaps some lingering deflation threat being another, though I'm not overly concerned about that; perhaps some Russian linkages being a concern, though again I don't view that as being necessarily central to their near term prospects.

On the other hand, and as this next exhibit shows, their economy is clearly ticking higher once again. You see two leading indicators in front of you, both of them getting generally better. We think there is some persistence to that. The Eurozone still benefits enormously from the low oil, low rates, low exchange rate combination that has been fairly potent over the last little while. The fiscal austerity is broadly done, which is quite helpful. We're seeing some breadth to Eurozone growth. For instance, at the start of this year, for the first time, believe it or not, since 2010, we saw the four largest countries of the Eurozone all growing at the same time, which we hadn't seen in five years, and so that's quite positive.

It's fair to say, maybe stylistically, that the Eurozone economy seems to be following the US with something of a lag. The US managed this multi-year recovery and is now maturing. The Eurozone is perhaps beginning that journey, as well. Again, there are risks to that view, but in general we feel that the market doesn't fully appreciate some of the positive news coming out of Europe.

Jackie Porter- Bateman

Yeah, I would agree with that. How should we be thinking about Japan these days, Eric?

Eric Lascelles

Right. Well, to begin with, Japan tends to be neglected – sometimes by us, as well – so I'm glad to talk to it for a moment. It is still the world's third largest economy, so it is relevant. Of course, it went through a 20-year malaise and so tended not to get the same close examination by investors. It's, of course, doing things differently now, or it's trying to, at least. For the last three or so years, Abenomics has been in play under a new and bold prime minister. It's had some successes. Not all successes, by the way. It is truly a mixed story, still. But, for instance, the first quarter GDP numbers this year were unexpectedly strong.

If we look at the next exhibit, you can see that Japanese credit growth, bank loan growth, is actually moving notably more quickly than we've seen in a while, and so that's often a sign of healing in the economy, as well. The key for Japan, and this is where opinions sometimes differ, is whether Japan is actually starting to deliver the structural reforms that it needs just to permanently elevate itself to a faster growth rate. It seems to be starting to finally push in that direction. There have been false dawns on this front a number of times, but it seems to be pushing that way – we've seen governance reforms, more independent directors on Japanese corporate boards, some labour market reforms that are bringing more women in particular into the labour market, but also reducing the two-tiered nature of the labour market between permanent and temporary workers. It looks like the Trans-Pacific Partnership trade deal will happen now that US Congress has managed to push an important element of that through.

So, we think things are coming together. I suppose that makes me a cautious optimist on Japan, acknowledging, though, that that is a country with serious demographic challenges and a very high debt load.

Jackie Porter- Bateman

Right. Right. It's been a tumultuous year for Canada so far. Going forward, in the context of lower oil prices and really middling US demand, what's the outlook here?

Eric Lascelles

Undeniably, it has been a different year, a difficult year for Canada. That's right. And so, stylistically, we can start by saying, of course, one big negative shock – that's the decline in oil prices – against a number of positive helps. One would be a fairly robust US economy. Another one would be the Canadian dollar that's been quite weak. Another one would be the Bank of Canada's rate cut way back in January. So, there have been some helping hands, but it is undeniable that the oil hit has dominated.

This next exhibit shows you our own composite leading indicator – in fact, a mix of other composite leading indicators. You can see, indeed, there has been a very clear hit to Canada. It's not quite on the scale of the 2009-2010 recession, not quite as bad as the hit that occurred in the early 2000s, but very real nevertheless. We are starting to see a bit of a tick higher. In fact, this raises one of the key questions, which is: is this Canadian hit a reflection of a worse than expected economic shock or just a more front-loaded shock that unwinds? The Bank of Canada thinks more front-loaded – this is why they're not cutting rates further. I suspect they're right, but I do think there is a bit more pain left to come, nevertheless, on the Canadian front. We look for growth, but not particularly good growth over the next year or two.

It's fair to say the housing market has been a silver lining in the sense that it has rejuvenated – but possibly too much – in the sense that when we look at Vancouver and Toronto home prices, for instance, they're suddenly rising at 10% a year. That's actually not ideal, given that there are some affordability issues that hit a little bit further down the line.

So, I'm happy Canada seems to be avoiding a recession in this context. We can't say that with certainty, but that seems to be the trajectory so far. More generally, I think it's still a bit of a slog over the next few years.

Jackie Porter- Bateman

Eric, you've shared some terrific insights with us today. Can I ask you just to summarize what your outlook is for our listeners?

Eric Lascelles

Sure. In general, as an economist, I can say that growth should be troughing this year. We think the developed world in fact actually picks up this year; emerging markets start to move faster over the next year, such that we should manage somewhat more growth. I think that's important. The normalization process occurs, the post-crisis normalization, particularly now shifting from the US and the UK which have largely accomplished that feat more towards the Eurozone and Japan, so there's room for them to manage a little bit more growth.

It is much more mixed in fairness in the emerging market space. So, China, for instance, does have some very serious credit problems. Its government can probably handle those, but there are, again, some very mixed prospects in the emerging market space.

Then, if I can take off my economist hat for a moment and put on my strategist hat, I can say from a market perspective, we still think bond yields are likely too low. They probably will trend higher, though a lot of that work is now done given the move recently. For the stock market, stocks are roughly fairly valued. They're not cheap, but they're roughly fairly valued, so we're still overweight stocks relative to fairly low bond yields, which are less attractive. We're holding a bit more cash than we sometimes do, simply reflecting the uncertainty of this environment and hoping to either deploy it into bonds if yields become significantly more attractive, or into stocks if some of the risks in the world start to fade.

And then just on two other asset classes, in general, the US dollar probably can continue to strengthen, including versus the Canadian dollar. In the commodity space, we think commodity prices have probably over-corrected, which is to say there's probably room for them to move a little bit higher going forward. So, that more or less summarizes my main market thoughts.

Jackie Porter- Bateman

Perfect. Eric, thank you so much for joining us today. I want to thank all of you for tuning in and listening to our Economic Update. If you have questions, please don't hesitate to seek out your RBC advisor, and they'll be happy to answer them for you. Thank you so much.