Transcript - Capital Markets Outlook - Spring 2016

Welcome to the RBC Global Asset Management Capital Markets Update for Spring 2016. 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 so much for joining us today, Dan.

Well, thanks for having me, Karen.

To start off, markets have had a significant rally in recent weeks. Does this mean the economy is improving?

Well, I don't know if it's improving so much as the rate of deterioration has slowed. There is a series of charts I perhaps could walk you through, but the first one I want to put up shows a good view of what's happening in the various regions in the world, and the decline in the bounce that we've seen since January. I think it's very important.

The first of these are the Purchasing Managers Indices, and you can see pretty much all of them in the fall of 2015 started to head down, but in January and February we had a bit of a surprise bounce upwards in the United States, so a glimmer of hope here: as the world economy is kind of flat-lining at a very, very low level, the world's most important economy, and that's the United States, actually seems to be doing a little bit better.

Now, I want to be clear: "a little bit better" is in the context of a sub-2% growth, but no recession. There was a deep recession fear earlier this year which appears to have passed. There are still some pretty important headwinds. We don't know how China sorts out. We still think it's a soft landing. Eric Lascelles has got a very, very good handle to this point, but that is a challenge.

Europe and the refugee crisis: weak growth, low inflation, dealing with these refugees. We have, of course, terrorism problems. When all these things are taken together we still see big challenges, but we think the recession, the threat of recession was overstated in the first place; slow growth is more likely what's to come of this.

Can you talk to economic data out of the U.S.? Has it been what you expected?

Well, I think you really have your finger on something there, and this next chart shows exactly what you're talking about. The data came in much below expectations and got progressively worse in the week-to-week or day-to-day releases out of the Fed, the Bank of England or anybody. The chart that you're looking at right now shows the balance of surprise. You take every data plot – what was the expectation and was it above or below that expectation? – you can see very clearly, as you get towards the end of 2015, they were universally missing the mark and getting progressively worse.

And then around the time that the oil price bottomed, we saw suddenly that the rate of deterioration stopped. In fact, what we haven't really seen is net improvement, but we've seen more of a balance between positive and negative surprises, and you can see that index is about to cross zero. Now, that was coincident with the improvement in markets that we've seen.

You had a few things happen all at once: finally the plunge in the oil prices stopped. I suppose oil players started to notice the real change in fundamentals that was setting up, and hadn't really already passed, and at the same time we saw that the flow of data started to reach a better balance and some confidence was restored and markets bounced.

There's been some talk of disinflation or possible deflation. Should we be concerned about that?

Well, deflation should always be a big concern. If you think of the programs that Central Banks have clung to more and more since 2009, quantitative easing, and then very aggressive types of quantitative easing – even buying corporate debt, for example, and targeting directly risk premia in Europe – what these things are trying to do is move tomorrow's consumption, basically, into today by either lowering rates or making it cheaper to do that today, because to the extent that we defer consumption the economy doesn't improve right now. That's not what you want. Savings, of course, is a virtue, but not so much when you're trying to get some growth into the economy.

To the extent that deflation can be avoided, the efficacy of monetary programs and the beginning of a sustainable recovery in the global economy moves forward.

About three months ago, Janet Yellen, Chair of the Fed, said, "Here are a half a dozen ways of looking at inflation. You ought to monitor them." I think what she was really saying to the Street was, "We're watching them; so should you." These are the kinds of things that will influence monetary policy. Now, those six charts are in front of you right now, and what you'll notice is only one of them shows inflation falling very low and then recovering sharply. That's headlined inflation and included in there, of course, are commodity prices and especially energy. Oil is in there. A big plunge in oil dominates the CPI basket, and then the recovery shows up, too.

But if you look at the other measures of inflation – there are many of them: sticky consumer prices ex-energy, et cetera – most them are actually converging on 2%. I think that's really important. First, it says that inflation never was really almost zero in the United States. That was heavily dominated by a single important commodity. But if we take that as our message on inflation, and we start to plan for further declines, that becomes very dangerous. Then deflation can get hold.

Her move to popularise other inflation measures, have the Street report on even when inflation is actually is a little firmer than you think, the Fed's 2% target, except for energy prices, is largely being achieved is the appropriate thing for a Central Bank to do. I think this is really good news. Too much inflation isn't a good thing, but a bit of an inflation illusion is a good thing. As I say, it promotes the efficacy of monetary policy, and that's what we really need right now.

I'm actually quite surprised and a bit emboldened by the fact that the United States economy can actually sustain a 2% inflation rate. Maybe the health and the vigour of the US economy is even a little bit better than we think. This isn't true elsewhere; it's true of the United States. But, again, this is the most important piece of the puzzle right now. I would say this is good news.

Given that backdrop, what do you think the Fed will do?

Well, the Fed has a bunch of challenges here. It needs to weigh that inflation is really closer to 2% than 0% and that's its target. They don't want to go too much above 2%. It has got very strong employment conditions in the United States, and by many measures, if you use only employment count as your decision tool for when we should raise rates, they've long since have been raising rates. Those two key indicators – inflation and employment – all point to at least the beginning of rate hikes or even maybe a bit more aggressive than she's done so far.

On the other hand, in a way the Fed is the world's central banker, too. It has to worry about if it raises rates too fast, does it slow growth outside of the United States, especially for dollar-indexed nations? And does it cause the U.S. dollar to spike so much higher that it ultimately slows growth domestically? So those put her in sort of a quandary as to what's the right balance for that.

Now, she's given us more information just over the last 24 hours, and that information actually is very close to what our view was in the first place, which is the Fed can be very patient in this circumstance. It can err on the side of slow, very deliberate, highly transparent hikes in monetary policy or in interest rates, and we'd look for one, maybe two 25 basis point hikes before year end. So, not too much different from what the Fed expectation has been.

Okay. Do you want to talk about your views on the fixed income markets?

Sure. Here, too, I have some charts to show you. Most of you will be familiar with the equilibrium bands, and what the band shows is that as much as we're shocked when we look at the headline rate of 1.8% or 2% for US 10-year T-bonds – that's sort of the base rate of interest for the bond market in the world – it says they're kind of where they should be. Relative to a need for a normal inflation premium and past demands and what we'd need in the future for a real rate of interest, kind of 2% is about the right level.

The band that you can see also heads up, so as the economy progressively normalises, you could expect both of those components to make up the normal rate to normal: in other words, yields will gradually rise, or will rise, over some period of time as long as the economy continues to avoid recession.

The real question here, I think, Karen, is that band rises quite sharply. Do we really think that it's going to follow that? And I don't. The reason is the chart beside it. If you look at the levels of interest rates outside of the United States, Spain, Italy, have interest rates, 10-year bond yields, lower than the United States, yet these were countries we were worried about making it through only two years ago and maybe three years ago in the Eurozone crisis.

I think that's a big downward pressure on the speed at which US yields can adjust higher to reflect the rate of the pace of growth of the US economy. I think that yields will move higher, but I think that move will be stretched over a long, long period of time.

What does it mean for equity markets?

Well, it's been a pretty tough start and a surprising rebound for equity markets in 2016. A good place to start then is valuations. The composite you see in front of you is built on, I think, two dozen or so fair value channels that we run for the major and developing markets. The lack of progress in markets and the decline in January has actually moved stocks to being about as attractive on a pure valuation basis as they've been, oh, in three or four years. Nowhere near where they were in 2009: they were about 45% below fair value. Cheapest we'd seen in decades. But they're still almost 20% below fair value, which, on a valuation basis? Quite attractive.

I think the problem is, and why the market's been sort of locked in this long trading range for years, it needs some earnings growth to move it forward. Now, this chart you have in front of you, these descending lines are the month-by-month progression for the consensus for S&P earnings for 2015, '16 and '17. You can see that in each case, they kind of follow this profile starting out with a lot of dreaming and then plunging. But lately they've been flat-lining.

Now that plunge in profits has clearly impacted stock prices. Because even at a normal level of valuations, which is, well, actually, we're at a slightly sub-normal of valuations, you still need some profit growth to generate interest in equities. Almost all of those declines are due to a very weak oil price, and a rising U.S. dollar impacting foreign trade amongst the big companies that dominate these indices.

The oil price is no longer falling, and more importantly the oil group is now such a small part of the index, it just doesn't have that much of a follow-through impact going forward. Oil devastated the S&P earnings expectation for '15, '16, '17. It's done the most damage it can do, and maybe now it actually starts to contribute a bit.

The dollar is even more surprising. As much as the dollar remains strong, the bulk of its advance actually completed over a year ago now. So, again, the real pressure from the dollar, even though it's at a high level, and it's crawling a bit higher, has already been absorbed by the earnings pool.

As long as you can sustain 2% growth in the United States economy, maybe earnings have got a chance to actually rise a bit here. Now, you've combined then slightly below-normal valuations with at least normal rates of growth in corporate profits, and equity prices could rise from here. But I think that the first piece you've got, the second piece we're still looking for and that's profit growth. We can see how it shapes up, but we want to see that.

Okay. Can you talk to how this is all reflected in our asset mix right now?

Well, we've maintained an overweight in equities, and that's been a long term, tactical bias, and an underweight in bonds. Well, the chart we have in front of you now is one that I think I've shown pretty much in every presentation over the last number of years, and it's a good place to fall back on. Rather than focusing on what happened in the first three weeks of the year and then the bounce back, what's the long term outlook? Because that's what's really going to impact once returns over their saving period, rather than trying to guess highs and lows in the markets.

Once again, the decline in equity prices has positioned the trailing ten-year returns for equities minus the ten-year returns for bonds at a very, very weak level. You can see this is a kind of a mean reverting series that after a long period of higher returns from bonds and stocks, you go through a period of higher returns from stocks and bonds. And on this, we're at a very attractive level for stocks versus bonds.

Now, we trimmed our asset mix slightly, oh, about three or four weeks ago, with a view that there were more challenges to the equity bull market in the near term than there had been – and I talked about some of those earlier. But we still have an overweight in equities, a fairly substantial overweight in equities that served us well over the last few years, we have an example of this on our balanced profile. We have a 55% neutral setting, we had it as high as 62%, and we pared it a bit to 60. Recognising the better return potential from stocks than other listed assets but also recognising some of the headwinds that we're faced with, we still like equities.

Great. Thank you for joining us today, Dan. That was very informative, and we look forward to seeing you again for the Summer 2016 Capital Markets Outlook.

If you have any further questions, please speak with your Global Asset Management representative.