Capital Markets Outlook

Welcome to the RBC Global Asset Management Capital Markets Update for Summer 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. Dan, thank you so much for joining us today. Let's jump in. Real shock last week on the UK choosing to exit the European Union. Of course, that day was an incredibly difficult one. We've now had two days to think about it. What are your thoughts?

Well, let me go back to last Thursday night for a moment, Karen, just to set up how big a shock it actually was. I was in the United Kingdom last week, and I went to bed in London about 11 o'clock and checked the betting lines just before because the betting markets actually were giving us better indications – or we thought they would give us better indications – than the official polls. That was the case: of course, the reference point there was the prior election in the UK.

I guess the betting line had gone from 80% stay to 90% stay. I was actually ruminating that, boy, we spend an awful lot of time worrying about things that never happen. Went for a comfortable night's sleep. Woke up about five o'clock in the morning, and first thing checked my iPad and, of course, the first thing you see is "UK Votes To Leave..." and I just assume in that fog of waking up in the morning, this can't be right! The news is wrong. And then started to sort through that, boy, this is gonna be very, very ugly. Because when you have a shock of that size, you have to believe that there are large positions on the wrong side of that.

We also went into that with a fear of illiquid markets, so you don't know what that day is really going to look like. Markets are illiquid because there's been tremendous regulatory change and reform since the financial crisis, which has really made it difficult to find big positions and move them quickly.

So, Friday, I think, was a big test for markets in general, and we came through it quite well. There were certainly some big changes. Some of the UK banks, for example, some of the world's biggest banks, trade down 30% at the open. There was one housing company in the UK down almost 70%. This is dislocation in the extreme. But we didn't see counterparties fail. I checked our trading desk frequently during the day – and was actually sitting on one through the day in London – and trade was happening, and we've seen stabilisation since.

This is actually not that uncommon, but it's the first big gut check for markets since the financial crisis. We looked at it a long time ago: how does the market respond to crisis? We have different types of crises that we look at – unexpected invasions, terrorist attacks – and we looked at economic events reaching back to the Second World War. For example, Nixon's imposition of inflation controls was not expected. There's something from out of the blue. Lehman Brothers was clearly an economic event that was not expected. Bear Stearns, another one. There were 13 of them we looked at. And you always expect a disaster the next morning when they actually get the markets open.

In fact, what happens, markets do a trade-down. 3% to 4% would be the median decline. But usually by the third day, the worst of the decline is absorbed, and it spends the next week or so getting all the way back to where it started.

What message can we take from Brexit, then?

Well, it is a short term question. Well, I guess that's now an intermediate term question because at the point of our taping they've haven't triggered Article 50 of the EU Constitution. That looks to be kicked down the road towards maybe October, so there's going to be this much longer period than anybody thought possible where we'll be building scenarios. One of those scenarios, of course, is maybe that Brexit doesn't happen. Eric Lascelles has used a number as high as 25%. You know, that's a good number. It's a significant number. But there's no way of setting hard probabilities around any of these scenarios. The UK right now is largely without a political leadership and a lot of questions which markets are going to be buffeted by. The slower growth, perhaps lower inflation outside of the United Kingdom – we can come back and talk about the economic implications – but clearly a period where there's going to be lots of uncertainty and unanswered questions.

Longer term, I think it poses or summarises something we all have to grapple with as investors. Do you know that 48% of people voted for the status quo? Within that 48% is some group, whether that's large or small, that's always going to vote for the status quo. They might be mad as anything at the EU, but they just don't like change. So there seems to be an underlying tone of disappointment or resentment with institutions right now. We can see it in that vote. Maybe we shouldn't be reading this much into it, but we have to wonder about it. The U.S. presidential politics, the elections in Rome or last weekend's elections in Spain, people seem to be dissatisfied. And you have to wonder if the real problem, they're calling it "too much immigration", or too much micromanagement by Brussels or whatever the local Roman problems were. Maybe really it has a lot to do with the post-financial crisis environment of low growth and low inflation. There's less to go around, and so it causes distribution questions which show up as anger in a variety of places, but maybe that is the message from all of this stuff that's happening.

What impact will that have on future monetary policy, future fiscal policy and the distribution of profits in the economy? I think that's the very big unanswered question.

Well, our scenario, or a core scenario, going into this was I would describe as flattish to gradually upward, led by the United States, with inflation low but perhaps reaching a more acceptable level in the United States as we move further into the investment horizon.

Nothing we see here flatters that. You know? There's nothing that's going to be a plus to that – except perhaps a little higher inflation in the United Kingdom as they suffer through the currency decline, and maybe a little higher than expected inflation in the United States, because employment has been quite firm, despite the most recent releases. So I think you've got to take a little bit off growth, and I think that the risks are asymmetrically pointed to the downside.

Now, it still doesn't mean that the core scenario, though, shifts to one that's unfriendly to at least equity market investors. Right? One thing it does is the chance of rate hikes is clearly off the table. I think that the night before that Thursday night, there was something like a 39% chance of a rate hike before yearend in the United States. That's now down to 10%, and there are even people looking now for rate cuts in the United States. So, that's a bit of a change that buoys the different.

I think another thing that leans into whatever negative tone comes out of Brexit is that, to the extent there was appetite for fiscal stimulus, it's probably a little greater today. So there are some offsets to this.

I'd like to make another point in that, too, is that it also causes you to go back and reflect. It may be helpful if I showed this series of three charts here. There are three charts that look at where the world and the US economy in particular were on the eve of Brexit. There was a challenge. The first one, top left on your screen, shows the PMIs for the world – the United States, the Eurozone and Asia. Just look at them in aggregate. None of them are pointed higher. They're all sort of flattish to losing a little bit of a momentum. Now, they're not at recession levels, but it shows that the tone to growth in 2016 and into 2017 was going to be kind of sluggish.

Now, the second one, the top right, is called the Duncan Leading Indicator. It's a composite indicator that tends to forecast recession 12 months in advance. It peaked last quarter. Now, I should say that it doesn't mean we will be in recession nine months from now. It doesn't always work. About a third of the time it predicts recession that doesn't happen, and sometimes it predicts recessions that happen five years in the future, so there's not particularly useful indicator, because maybe other things caused that. But there are two indicators that say that there were some questions around the overall level of growth and direction of growth going forward.

The third one, that bottom chart, it looks at high yield credit spreads and the default rate within the high yield market. In fact, the credit market is a little more advanced than one would've otherwise thought. After the system settled down after the financial crisis, defaults on the high yield credits actually sunk to only 2%. Now, they've been rising gradually towards 5% anyway, so we need to monitor these things as we move past this period of shock and through this period of instabilities: do the PMIs deteriorate further? Does the Duncan Leading Indicator and others like it continue to deteriorate? Do we see an uptick in credit loss and negative credit experience? These things would begin to evolve towards a more difficult outcome for the economy, so these are the things we'll be monitoring. 

Well, I went through the rates, it's almost inconceivable that there will be rate hikes in the immediate near term, and even in the intermediate term, one wonders when those rate hikes will be put in place in the United States. They need to, of course, check what kind of pressure comes from and not just Europe but the overall sluggish tone that we were experiencing anyway.

As you move further out the curve, I think the dominant influence here is we went into last week with 30% of world sovereign bonds with negative yields, just briefly even some corporate bonds in Europe with negative yields – that's spreading. Right? It's 30+, and that puts a big cap on our own yields and those of the United States.

There's a chart that we can put up and it shows, I don't know, a dozen or so world sovereign bond yields, and you can see that many of these yields, dominated by Europe, are now below zero. Not a long way below zero, but negative anyway. Then you see on the far left of your chart, there's the United States with one of the world's highest levels of yields. Now, that's a big cap. Only last week, after the shock, did Spain and Portugal see their yields pass up through the United States. It's hard to see how the United States yields could rise particularly higher, even in a strong U.S. economy, if that's what happens, when the anchor of negative rates exists elsewhere.

There's a big force holding yields lower, longer than was expected, contributed to by this uncertainty around Brexit – but it was in place anyway. So, low yields for the foreseeable future in the worlds bond markets. If that was your view before, this contributes to that view.

Okay. What about the stock markets?

Well, there are also two charts on valuations and earnings that are interesting. I suppose that the stock market is even in a better valuation position today than it was a week ago. Our composite of a couple of dozen large equity markets relative to the fair value shows you're about 20% below what we consider to be fair value. We haven't reached global fair value since the financial crisis. We nearly reached it late in 2015 – and you would expect that to be the anchor for equity prices. So valuations I would put as a minor positive for stocks.

The problem stocks have had since last summer when they basically have been treading water in a large trading range is that we've run out of corporate profit growth. Now, there have been two driving forces for corporate profit pressure: energy prices, which had fallen dramatically and were a large portion of the earnings pool in the United States and Canada; and also the strength in the U.S. dollar. 40% of S&P earnings are earned offshore, so when the U.S. dollar rises you have less competitiveness in U.S. multinational companies, and it shows up in the domestic earnings pool.

The chart to the right shows you the month-by-month progression of the S&P earnings forecast for 2014, '15, '16 & '17. It's been pretty much one-directional. Every month the earnings forecasts sink and sink and sink as we sustain a longer period of low oil prices and a strong dollar.

Now, two of those things were set to roll out, right? The oil price has come plunging from 100 to the 20s, but it's now bounced back. Perhaps more importantly, the sink in the price of oil companies' shares has taken them down to be a very small part of the Index, so it's kind of not that relevant right now what happens to oil prices with respect to the corporate profit pool. Also, the U.S. dollar, until the vote last week, had basically done nothing for the better part of a year, so it had risen quite strongly and traded in trading range, so the year-on-year pressure was basically reversing to the positive from the negative to the earnings pool.

Well, I think that I started with what usually happens during a shock, and the best thing to do is to first of all worry about all of your various forecasts – how did those scenarios change relative to that shock? – and remember that the most intense part of the selloff is in the first couple of days: not to respond too quickly based on a single event or a single piece of news. That seems to be sorting out now.

While we've moved down our expected rate of growth in the economy, it's quite modest. There will be winners and losers from this, but overall slightly slower growth, slightly lower inflation. That doesn't seem to be a reason to change an intermediate or a longer term view on either bonds or stocks. We've left our overweight in equities in place and our underweight in fixed income.