Transcript - Global Economic Outlook - Spring 2016

Karen McNally

Welcome the RBC Global Asset Management Economic Update for Spring 2016. I'm happy to have Eric Lascelles, Chief Economist at RBC Global Asset Management, provide context around recent market events. Eric, thank you so much for joining us today.

Eric Lascelles

It's my pleasure.

Karen McNally

Let's jump in. We had a wild end to 2015. Can you talk about how the market and economies are looking so far in 2016?

Eric Lascelles

Alas, no less wild is probably the simplest way to put this. We saw some big swings, as you say, at the end of last year. We've seen some even bigger swings by some measures at the start of 2016. The big drop right off the start of the year, a pretty nice recovery since, but I suspect that volatility isn't quite done. So it's been very bumpy.

I think in terms of why markets at least initially felt sour, part of it was they thought that policy-makers and central bankers maybe weren't giving as much assistance as they desired; part of it was that oil prices had fallen, and the market has decided – I think wrongly, but nevertheless decided – that low oil means lower stock markets, for instance; and, undeniably and probably more up my alley, we can say economic growth has slowed to some extent.

In fact, this first exhibit shows you some leading indicators for the world, for the developed world and for the emerging markets, and you can see all of them have signalled a general deceleration over time, and they're actually continuing to generate that signal. So, undeniably, we're still in a world of slowing growth, and we're also in a world with some pretty substantial downside risks, and that's something I think we'll get into a little bit later. So not an optimal macro backdrop, you might say.

I do want to emphasise, though, that we are still seeing economic growth. It's just less than before and less, I think, than was expected. Risks are quite large, but let's distinguish between risks and reality: many never come to fruition, or they linger for quite some time. And in the end, as a firm, we are still recommending an overweight equity position. Less than before, because we do have a little bit less confidence in a positive growth and market outcome, but we still think, all else equal, that is the most likely scenario.

It's a bit of a mixed bag, struggling for a macro perspective, but not to the point of abandoning the stock market, by any means.

Karen McNally

Okay. Central Banks responded to this market weakness with negative interest rates. Has that stimulus worked?

Eric Lascelles

Well, that's a great question. Here we are now, really many years into this era of monetary easing. Let me start by saying this era seems not to be done yet. In just the last few months, we've seen the Bank of Japan go into negative interest rates. We saw the European Central Bank do it late last year, and we've seen, in fact, the European Central Bank since deliver even more types of stimulus since then.

The starting answer is: negative interest rates don't seem to be quite as effective as some of the other tools that central bankers have used. We think we understand why it hurts banks: banks are not able to necessarily respond as much as they'd like to by lending more, and for a number of other reasons it doesn't seem to give quite the same kick to risk appetite that quantitative easing once did and that more traditional rate cuts once did.

Nevertheless, it has clearly succeeded in pulling borrowing costs down. In fact, this next exhibit shows you the yield curve for some of the major countries out there, and what you can take away from this is a lot of countries now can borrow – for multiple years in some cases – at a negative interest rate. Japan is, in fact, the most incredible example. Japan can borrow for ten years at a negative interest rate. There has been success in pulling down borrowing costs, so some good you might say has come from that. Some stimulus has come, but it hasn't necessarily done as much for other aspects of the economy.

We can extend that and say Central Banks are learning that negative interest rates maybe are not highly successful by themselves, and so the European Central Bank recently introduced a cocktail of stimulus measures. Some of that was cutting rates further into negative territory, some was expanding quantitative easing operations, some was giving liquidity to banks, and that combination was actually quite well-received. So I would say Central Banks still have some ammunition here. There are still things that they can do, and they have been acting quite recently. I think that's a big reason why markets have been reviving.

Now, in terms of a last thought or two on this subject, the Fed, the US Central Bank, is clearly an outlier in this regard. The Fed raised rates in December. Now, it's made quite clear that is itself scaling back its plan, so it's shifting in the same direction as everyone else, just not quite to the point of delivering stimulus; it's more about removing a bit less stimulus than previously planned. But it's also been shifting in that direction.

Nevertheless, even with these diminished expectations, even with our assumption – a pretty soft economic growth in 2016 – I think we should still count on the Fed raising rates once or twice. That still seems to be their plan. It's arguably justified, and so that does put a bit of upward pressure on yields, but I think the dominant trend is still one in which yields and interest rates are going to stay quite low, likely through 2016.

Karen McNally

Okay. You often talk about downside risks. Do you see those downside risks as rising or decreasing? Can you talk to that?

Eric Lascelles

I would say I see them as large – unfortunately. That's been a constant, really since the financial crisis, so let's not say that risks are incompatible with market gains. Markets have gained in a risky environment, but of course, we'd rather the risk profile be a little bit less. I would say the risks are evolving, in a sense. In the early part of 2016, there were some acute temporary concerns about European banks. I would say those concerns are probably overblown. We see some issues. If you want to be worried about banks, Europe might be the place you'd look, but they seem to be solvent, they seem to be liquid, particularly with the European Central Bank's help, and so we don't think that's a huge risk or likely to be a catalyst for negative outcomes elsewhere.

I would say the resource sector risk is probably fading a little bit. It's hard to say whether we've truly seen the lows or not, but commodity prices are not actively pushing lower, and we've gotten a pretty good sense for the first order, and even some of the second and third order consequences of lower commodity prices. Not pretty – clearly Canada is suffering, for instance, but we've got a handle on that. It's no longer in the risk department; it's maybe more in the reality department.

But we do have some risks that are arguably large or maybe growing. I think some of the debt risks out there are quite large still and maybe growing. We can talk a bit later about some emerging market debt risks, specifically. But there is a lot of debt out there, and some of it is looking a bit precarious. We can also say that China is still a big risk. It's not that we're seeing a collapse right now. We're not actually seeing that, but there are clearly some debt excesses and there clearly is less economic growth, as well.

The geopolitical environment is also quite complicated. Some of that relates to various activities in the Middle East and wars around the world. Some of that, though, just relates to politics. You can look around the world, and there's a lot of policy uncertainty that exists out there: relating to various European governments, Spain, for instance, unable seemingly to form a government, and Brazil another example with impeachment ongoing for Roussef; but also for the UK, with Brexit, this debate as to whether the UK stays in the European Union or not, to be resolved in June of this year; and also the US with the US election. I would say some candidates who do not come from the centre, which is normally where you get US presidential candidates from, and that creates some policy uncertainty, too. So the geopolitical risks are high.

And I guess maybe all of that gets summarised into what is the risk of a recession? Let me start by saying there is always a risk. It's never a zero number. The question is, is it a high risk or a low risk? We can say that risk, using the US as an example – it's the big country out there – the US risk has clearly gone up. It's still below 50% – and we're not predicting a recession by any means. But it's probably sitting at 25% or 30%. You can measure that many different ways, but one way is this next exhibit which is just looking at the slope of the yield curve. As the yield curve gets flatter, as the spread comes down, arguably the risk of recession goes up. Traditionally, when you get to a negative level, that's when you get the blinking red light. We're not getting a blinking red light. Some measures are quite benign; others are less so.

Overall, we would say the risk of a US recession over the next year might be sitting around 25% right now. So, clearly higher than normal, clearly higher than it was, but well below 50%.

Karen McNally

Okay. Let's stick with the US. How is the US and maybe other developed markets doing right now?

Eric Lascelles

Right. Well, developed economies have clearly lost a step. When we think of the last three or four years, we could say most of the slowdown was emerging markets slowing. Interestingly, they might be starting to bottom out, though I don't want to make that claim with too, too much precision or confidence, but maybe they're starting to. The developed world seems actually to be slowing right now, whereas they had mostly held steady beforehand. So we have seen some deceleration.

Let me be clear when we look at the US we're still seeing economic growth. You can actually find some quite favourable indicators if you choose to look for them. The US job market, for instance, has tended to be quite good. Various other pictures have also been reasonably favourable.

But, when you dig beneath the surface, the latest GDP figures are seemingly trending a little bit softer. We think we understand why economic growth in the developed world is moving a bit less quickly. One of them is actually this next exhibit, which is just financial conditions have tightened. Because credit spreads are wider and credit availability has gotten a bit worse, you've got a headwind that you wouldn't know if you were just looking at a government ten-year yield, but as a headwind nevertheless on economies, and that policy/political uncertainty side is also I think more relevant and a drag on growth. Would you, as a business, invest right now when you're not sure what the policy environment might look like after November in the US or after Brexit in the UK? So I think we're seeing some companies sit on their hands, essentially, because they're unsure about that.

We're not seeing great growth, but we are seeing US growth. When we look at Europe, a bit of a deceleration there, as well, but we're feeling okay, I would say, about that part of the world. Japan has had a rough go. Japan has shrunk recently, and some of the figures we're seeing quite recently remain soft. We think it's getting a bit of a bad rap. Things are not quite as bad off as maybe the headline figures suggest, but everyone really has slowed to some extent. We have downgraded our forecasts. But again, let's distinguish between less growth and no growth: we're still seeing growth for the most part.

Karen McNally

Okay. You didn't touch on China. Let's talk about China. China seems to be becoming a greater importance to the global economies and financial markets. What are your thoughts on China right now?

Eric Lascelles

Right. China is very important. It's gradually become more important over time. But I think the market really began to understand that in the second half of last year. It crystallised in the market's mind. There's no debating the numbers. This next exhibit shows what share of global growth China generates. The answer is more than 30%, so when you're generating about a third of the global economy's growth, you can't deny the importance of China. It's actually about three times more important than the US right now in terms of driving global growth forward. So it is very important.

When we look at China, there have been a number of concerns raised over the last six months relating to the currency, relating to Chinese stocks, Chinese debt and Chinese growth. We still think the currency and the stock market side is a bit of an overblown concern. There's something there, but it's not a huge problem in our mind. In fact, we have seen the currency stabilise, we have seen the worrying capital outflows slow to some extent, and the Chinese stock market has staged a bit of a rebound, too.

So I would say set those ones mostly aside, focus instead on the debt side of things, focus instead on the growth side. There are some legitimate debt worries there. We think there are some credit issues in China, and some of them are coming to a fore, but the government is grappling with them and ultimately capable of dealing with them. It really instead adds up to less economic growth for China.

I sound like a broken record because I've said that every time we've talked over the last five years probably, but it's been true, and I think it is still true the Chinese economy is growing. It's growing at an enviable rate for anyone who's really not in China right now. But it is clearly slowing. We think it slows to 6% this year, into the high 5s next year. That does put us a little bit below consensus in terms of our forecast, but it's not a hard landing/collapse scenario, either.

Karen McNally

Okay. Eric, you made reference to emerging markets earlier. Emerging markets have been on a slowing trajectory for the last number of years. Do you see that continuing?

Eric Lascelles

Right. As I said a moment ago, and as you noted, some signals suggest that emerging market growth is stabilising. I'm hopeful that's true. I think really only time will tell, but I'm crossing my fingers that 2016 is the year when that growth bottoms out. It's been a multi-year deceleration. Let's be clear again that emerging market countries are for the most part still growing, certainly. In fact, on the aggregate they're easily outpacing the developed world. But of course, we have such high standards for them that people don't feel all that great, nevertheless.

I guess I would say one of the worries about emerging markets is that they are now quite indebted. There's a lot of corporate debt there. This next exhibit in fact shows that the corporate debt in the emerging market world is actually now higher, relative to the size of those economies, than the corporate debt in the developed world. I think a lot of this borrowing was done on the presumption of very low rates, and they are still very low, but of course the Fed is thinking of raising rates further. It was done on the presumption of a weak US dollar, and the dollar has gotten stronger, which makes it a bit more complicated, and it was done on the presumption that these countries could keep growing quite quickly, and of course, they're not growing quite as quickly.

I don't know quite how this plays out, but I think it's fair to say that there are some risks around emerging market corporate debt.

In the end, when you broaden out beyond China, which is the dominant emerging market entity, we can ask what about the other so-called BRIC nations? Brazil and Russia, still very much struggling related to the resource shock, related to politics, as well, in Brazil. So we think they stay quite soft this year. We're not looking for a big revival there. India, on the other hand, has been the success story out of those four BRIC nations. It's still doing fairly well. We think it can continue to do fairly well.

We still think that the right framework here is to talk about countries that like low commodity prices thriving in this environment, countries that have sustained their competitiveness, countries that are delivering structural reforms and countries that didn't extend too much credit over the last five to ten years. It takes some picking and choosing, but there certainly are some countries that fit that bill.

In the end, I guess I would say – and this is small consolation because it's been a tough sector to be in over the last few years – but from an absolute valuation perspective, emerging market equities do seem to be quite cheap. Now, that's different than saying they go up tomorrow. They may or may not, but they do seem to be cheap right now.

Karen McNally

Okay. Eric, Canada. Is Canada starting to emerge from the effects of the global oil shock?

Eric Lascelles

I think a little bit. We're not getting indicators quite as soft as we did, for instance, in the first half of last year. That was when all the recession debate was going on. There's certainly still a recession risk, but I can say empirically, December GDP was positive, the January number is tracking fairly good, and so we're getting at least a bit of growth.

That said, our leading indicator is still pretty weak. That's what this next exhibit shows. Our Canadian leading indicator looks about like it's sloped since the start of 2016, so we are budgeting for growth, but not a ton of growth. This is still that tug-of-war between low commodity prices being bad and Bank of Canada rate cuts, and reasonably steady US demand, and the currency softness being helping hands. We can start to see the currency softness actually helping in the sense that non-energy exports are picking up at a pretty decent pace. But, of course, now the currency has gone up significantly such that we'll see whether that can keep running nor not.

There are a number of balls in the air right now. I would say expect growth but don't expect a lot. The fact that the labour market really defied gravity in 2015 suggests a bit of risk from that perspective for 2016, and indeed three of the last four months have seen declining employment in Canada. So I think 2016 is going to be slow-go, a little better towards the end of the year as the fiscal stimulus kicks in and, as I'd like to think, as oil prices continue to become a little bit less low. But I wouldn't look for outright fireworks.

Of course, in the end, though it matters and depends entirely on where you live in the country, because there are huge regional disparities, the obvious ones, Alberta suffers, Saskatchewan and Newfoundland for resource-related reasons. If you look at Ontario and B C and to a lesser extent Quebec, you see at worst normal economic growth if not actually better than normal economic growth. So it really does depend where in the country you are.

Karen McNally

Okay. Can you just summarise for us key points?

Eric Lascelles

Absolutely. Happy to. This next exhibit maybe gives a good summary events, or at least of the challenges that we face. Here we are with less growth, substantial, maybe more risks but certainly substantial risks, and we've seen some market displeasure, as well. There is a legitimacy to that. Growth has slowed. Risks are big. So let's be respectful, I think, of that, absolutely. Do keep in mind, though, our default assumption is that growth persists, that risk do prove manageable, and keep in mind that active investors actually tend to thrive in a bumpy environment, so I think there are some redeeming features that exist here.

When I run through things on a market-by-market perspective, I can say bonds, well, bonds have been expensive for many, many years. We think they probably stay expensive. That is to say yields stay quite low, and so that's a condition that persists for now, but isn't necessarily a forever phenomenon. Stock markets are roughly fairly-valued, in fact you can say some of them are still looking a bit cheap, and so there certainly are opportunities that exist there, as well.

There's recently been a lull in this, but we think the US dollar goes back up. We think, by the way, the Canadian dollar goes back down and so could find its way down even maybe below the lows it struck not too long ago, so we think that reasserts itself.

And then, finally, from a commodity perspective, and we've said this for a while, we think commodity prices overshot – they went too low, arguably. They're starting to recover. We'll see whether it's a straight line. It probably isn't a straight line upward from here, but we think in the end over the next year that we can see particularly oil prices work their way at least a little bit higher.

Karen McNally

Thank you, Eric. That was very informative, and we look forward to seeing you again for our Summer 2016 Economic Outlook.
And if you have any further questions on the current investing environment, please speak with your RBC advisor today.