Global Insights Feb 2012


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Global Insights Feb 2012

  1. 1. FEBRUARY 2012RBC Wealth Management Global Insight New central bank policies have calmed equity and fixed income markets. In this issue Does this mean all is quiet on the European front? (page 3) 2 Financial Markets Commentary 4 Politics in 2012: The Stakes are High In 2012, politics could have an even greater impact on markets than last 8 Global Equities year. The stakes are high. (page 5) 16 Global Fixed Income 18 Commodities 19 Currencies Stocks are relatively cheap in most markets, reflecting the challenges facing the global economy. Risks need to be acknowledged in portfolios. 20 Key Forecasts (page 9) 23 Market Valuation & Equilibrium Within the fixed income sector, investment-grade corporates continue to offer attractive opportunities. (page 16) Priced as of January 31, 2012, unless otherwise stated. Global Insight is a monthly publication by the Global Portfolio Advisory Committee 1 GLOBAL INSIGHT - JULY 2011
  2. 2. Global OverviewRBC’s Investment Stance Global Asset Class ViewThe lingering Eurozone risks, combined with their potential spillover effects in the U.S. and China, are primary reasons we maintain Asset Class Viewour “Neutral” stance on global equities. To be clear, “Neutral” means including equities at a benchmark weighting in portfolios—that is, a weighting up to but not more than the long-term target allocation. After all, Eurozone officials could surprise markets again Equities =and announce new policies that would reduce the region’s vulnerabilities. A sufficiently constructive announcement could trigger Fixed Income –another worthwhile rally in equities. Cash +Equally plausible, any of several tripwires (Greece, Portugal, politics, bank lending, etc.) could worsen the European and globaloutlook, and induce more painful volatility episodes. “Invested but vigilant” sums up our stance. Equity view: Overweight Equity view: Neutral Nikkei: 8,802 (+4.1%) Equity view: Neutral Equity view: Underweight Equity view: Neutral FTSE 100: 5,681 (+2.0%) 10-yr JGB: 0.97% (-2 bps) S&P/TSX: 12,452 (+4.2%) Stoxx Eur. 600: 254.41 (+4.0%) Shanghai Comp: 2,292 (+4.2%) Fixed Income view: Underweight Economy: production back in Fixed Income view: Underweight Fixed Income view: Underweight 10-yr Govt: 3.41% (-3.6 bps) 10-yr Gilts: 1.97% (+1 bps) gear, needs a reacceleration 10-yr Cdn: 1.89% (+5 bps) 10-yr Bund: 1.79% (+4 bps) Economy: within the 7%-9% Equity view: Neutral Economy: weak and under pres- Economy: domestic strength Economy: in recession, austerity policy growth target and likely in China S&P 500: 1,312 (+4.4%) sure from the Eurozone sapped by weaker trade headwind blowing hard to stay there Fixed Income view: Underweight 10-yr Tsy: 1.80% (+8 bps) Economy: stuck in a 2% rut Hang Seng: 20,390 (+10.6%) 10-yr Govt: 1.32% (-19 bps) Economy: inflation stubborn, global trade flow dominates Bovespa: 63,072 (+11.1%)10- 9-yr Govt: 11.50% (+17 bps) S&P/ASX 200: 4.262 (+5.08%) Economy: 3%+ growth positive 10-yr Govt: 3.72% (+5 bps) but below potential Economy: headed for 3%+ growth, capex leading the wayEquity index returns and fixed income change in basis points (bps) are for January 20122 GLOBAL INSIGHT | FEBRUARY 2012
  3. 3. Financial Markets Commentary> The ECB has taken great strides to protect the Financial markets breathed a sigh of relief after the concerns aside and focus primarily on market European Central Bank forcefully intervened to fundamentals. global financial system from bank defaults, prevent cascading bank failures. But now is not the time to become complacent. All and another round of stimulus is in the offing. The new policy represents more than a massive is not quiet on the European front:> Even so, the Eurozone must negotiate many liquidity injection or back-door quantitative ƒ Banks have a limited ability to support difficult hurdles in the coming months. easing. It indicates central bankers are unwilling sovereign debt markets. There have been Renewed global market volatility can’t be to stand idly by when weak institutions threaten media reports Eurozone banks could use ruled out. Now is not the time for investment to exacerbate a financial crisis à la the Lehman February LTRO proceeds to purchase sizeable Brothers collapse in 2008. The ECB signaled it complacency. amounts of Italian and Spanish debt (and stands behind the banking system and, in turn, the earn attractive returns in the process), thus global financial system. further stabilizing the sovereign debt market No wonder most debt markets stabilized and and banking system. RBC Capital Markets’ equity markets traded higher after the ECB European bank analysts caution this is an unveiled its Long-Term Refinancing Operations unrealistic expectation and “at the bottom of (LTRO) plan in early December. Continental banks’ to-do list,” based on recent management European markets led the rally; the S&P 500 contacts. Sizeable purchases would makeEquity Market Scorecard recorded its best January performance since 1997. banks even more vulnerable to any renewed sovereign debt stress or disorderly defaults. Our LTRO Round II Index (local currency) Level 1 mo 6 mo 12 mo analysts believe banks’ first priority will be to Markets are now focused on the next LTRO S&P 500 1,312.41 4.4% 1.6% 2.0% use LTRO cash to pre-fund their corporate bond liquidity injection in late February. Eurozone banks S&P/TSX Comp 12,452.15 4.2% -3.8% -8.1% redemptions. will once again have the opportunity to borrow FTSE 100 5,681.61 2.0% -2.3% -3.1% ƒ Sovereign yields could trend back up once the funds at 1% over three years instead of the ECB’s Hang Seng 20,390.49 10.6% -9.1% -13.0% typical one-year program. This provides more time LTRO impact fades. Italy, Spain, and others Dow (DJIA) 12,632.91 3.4% 4.0% 6.2% to clean up balance sheets, recapitalize, and raise are scheduled to sell significant debt during funds in the private debt market. the next few months. Positive sentiment about NASDAQ 2,813.84 8.0% 2.1% 4.2% Market expectations are high, with some analysts the LTRO program and abundant liquidity may Russell 2000 792.82 7.0% -0.5% 1.5% forecasting banks will borrow over €1 trillion—far help keep rates at manageable levels near term, STOXX Europe 600 254.41 4.0% -4.1% -9.2% more than the €489 billion ($641 billion) in loans but over time supply could overwhelm the German DAX 6,458.91 9.5% -9.8% -8.7% issued during the first three-year LTRO tranche in market and funding costs could rise again— Nikkei 225 8,802.51 4.1% -10.5% -14.0% December. especially if countries miss their austerity and Straits Times 2,906.69 9.8% -8.9% -8.6% growth targets. Shanghai Comp 2,292.61 4.2% -15.1% -17.8% All Quiet on the European Front? Think Again. ƒ Greece may request additional write-downs Brazil Bovespa 63,072.31 11.1% 7.2% -5.3% It’s tempting to assume the ECB can solve most or could succumb to a disorderly default evenSource: Bloomberg, equity index returns do not include dividends; data is of the region’s woes with this unprecedentedthrough 1/31/12. if the country strikes a deal soon with private program. This rare, positive development feeds creditors to forgive a portion of its debt. Its into the understandable desire to cast Eurozone debt-to-GDP ratio will remain unsustainably 3 GLOBAL INSIGHT | FEBRUARY 2012
  4. 4. Financial Markets Commentary Central Bank Total Assets in U.S. dollars (bln) Another Wildcard Market Scorecard The European economy is another wildcard for Bond Yields 1/31/12 12/31/11 1/31/11 12 mo chg 4000 markets and earnings in 2012, and could weigh on US 2-Yr Tsy 0.215% 0.239% 0.562% -0.35% 3500 North American and Asian growth. As Eurozone US 10-Yr Tsy 1.797% 1.876% 3.370% -1.57% 3000 banks shed assets to improve capital ratios, the Canada 2-Yr 0.955% 0.956% 1.667% -0.71% result may be reduced lending to the region’s Canada 10-Yr 1.889% 1.941% 3.275% -1.39% 2500 businesses and households, thereby increasing the UK 2-Yr 0.357% 0.327% 1.299% -0.94% UK 10-Yr 1.970% 1.977% 3.656% -1.69% 2000 risk of a prolonged or deeper European recession. Germany 2-Yr 0.158% 0.144% 1.372% -1.21% We also anticipate Eurozone banks will continue 1500 Germany 10-Yr 1.787% 1.829% 3.155% -1.37% European Central Bank to reduce loans to emerging markets where they Commodities (USD) Price 1 mo 6 mo 12 mo 1000 Federal Reserve fund a meaningful share of private-sector debt. Gold (spot $/oz) 1,737.60 11.1% 6.7% 30.4% 500 Silv er (spot $/oz) 33.18 19.2% -16.8% 18.2% Even though U.S. economic momentum has 2008 2009 2010 2011 2012 Copper ($/ton) 8,299.50 9.3% -15.4% -15.0% improved recently and China seems headed for a Oil (WTI spot/bbl) 98.48 -0.4% 2.9% 6.8%Source: Bloomberg; data through 1/31/12 soft landing, neither region can completely side- Oil (Brent spot/bbl) 111.62 2.7% -4.7% 12.3%Note: ECB total assets converted into U.S. dollars using spot EUR/USD step these headwinds. Many large multinational Natural Gas ($/mlnBtu) 2.52 -15.4% -40.8% -43.1%exchange rates companies are already beginning to see signs of Agriculture Index 434.46 0.0% -8.5% -19.7% sluggish European demand, and Asian export Currencies Rate 1 mo 6 mo 12 mo high as long as the public sector (ECB, growth is relatively weak. US Dollar Index 79.29 -1.1% 7.3% 2.0% Eurozone central banks) is unwilling to take CAD/USD 1.00 1.9% -4.7% -0.2% RBC’s Investment Stance USD/CAD 1.00 -1.8% 5.0% 0.2% steep losses on its debt. The country is mired EUR/USD 1.31 1.0% -9.1% -4.5% in a deep recession or worse. Its austerity plans The lingering Eurozone risks, combined with their GBP/USD 1.58 1.4% -4.1% -1.6% have missed the mark on multiple occasions. potential spillover effects in the U.S. and China, AUD/USD 1.06 4.0% -3.4% 6.5% There’s no guarantee the next government— are primary reasons we maintain our “Neutral” USD/CHF 0.92 -1.9% 17.1% -2.5% elections are tentatively scheduled for April— stance on global equities. To be clear, “Neutral” USD/JPY 76.27 -0.8% -0.6% -7.0% EUR/JPY 99.78 0.1% -9.7% -11.2% will honor previous austerity agreements. means including equities at a benchmark EUR/GBP 0.83 -0.4% -5.3% -2.9% weighting in portfolios—that is, a weighting up to EUR/CHF 1.20 -1.1% 6.4% -6.9%ƒ Portugal could slide deeper into a debt trap. but not more than the long-term target allocation. USD/SGD 1.26 -3.0% 4.5% -1.7% Its short- and long-term sovereign yields have After all, Eurozone officials could surprise markets USD/CNY 6.31 0.2% -2.0% -4.3% soared despite the new LTRO program. Its USD/BRL 1.75 -6.4% 12.7% 4.8% again and announce new policies that would credit default swaps are signaling a 70% chance reduce the region’s vulnerabilities. A sufficiently Source: Bloomberg, RBC Wealth Management; data through 1/31/12. Bond of default. RBC Global Asset Management’s constructive announcement could trigger another yields in local currencies. U.S. Dollar Index measures USD vs. six major cur- Chief Economist Eric Lascelles anticipates rencies. Currency rates reflect market convention (CAD/USD is the exception). worthwhile rally in equities. Portugal will ultimately need to negotiate a Currency returns quoted in terms of the first currency in each pairing. debt writedown. We doubt global markets fully Equally plausible, any of the tripwires noted above Examples of how to interpret currency data: CAD/USD 1.00 means 1 Canadian reflect this possibility. (Greece, Portugal, politics, bank lending, etc.) dollar will buy 1 U.S. dollar. CAD/USD -0.2% return means the Canadian dollar could worsen the European and global outlook, has fallen 0.2% vs. the U.S. dollar in the past 12 months. USD/JPY 76.27 means 1 U.S. dollar will buy 76.27 yen. USD/JPY -7.0% return means the U.S. and induce more painful volatility episodes. dollar has fallen 7.0% vs. the yen in the past 12 months. “Invested but vigilant” sums up our stance.4 GLOBAL INSIGHT | FEBRUARY 2012
  5. 5. Politics in 2012: The Stakes are High 2011 was a year of significant political change—scheduled and unscheduled—that contributed to volatility across global markets. In 2012, politics could play an even greater role because more is at stake. Power shifts could … > take place in 5 of the 10 largest global economies, > affect 4 of the 5 permanent members of the U.N. Security Council, > involve nearly half of the world’s population, and > directly impact countries that produce more than 40% of the world’s GDP. Russian Presidential Election - March 15th French Presidential Election China - 18th National - first round (22 Apr), second Congress of the Communist round (6 May) Party - Oct Greek Presidential U.S. Presidential Election Election - Apr (TBD) - Nov 6th Egypt Parliamentary India Presidential Election Election - Jul 1st - July Mexico Presidential Taiwan Presidential Election - Jul 1st Election - JanMajor Political Timeline Throughout 2012, RBC Wealth Management will discuss key election issues with an emphasis on how they could potentially affect financial markets and investment portfolios. Other Political Events In this article, the first in the series, we provide an overview of the French and U.S. elections and China’s power transition.5 GLOBAL INSIGHT | FEBRUARY 2012
  6. 6. Politics in 2012: The Stakes are HighCountry Election Date In an environment fraught with contentious First, France is under market pressure to adopt economic and fiscal policy issues, the 2012 more austere economic and social policies toTaiwan Presidential January 14, 2012 election cycle will soon catch investors’ attention. reduce its national debt—not ideal issues toTaiwan Legislative January 14, 2012 Election outcomes in France, the United States, discuss with voters during an election. The and Greece, and China’s power transition imposition of austerity measures in responseFinland Presidential First Round January 22, 2012 could have a considerable effect on investment to the crisis have proved highly unpopular.Egypt Legislative Stage One January 29, 2012 portfolios around the world. Opposition parties will push strongly for a changeFinland Presidential Second Round February 5, 2012 > Many of the Eurozone’s challenges remain in policies.Syria Legislative (Tentative) February 2012 unresolved, particularly the way the region will Second, if the main opposition candidate, forge a closer fiscal union. The French election François Hollande, were to be elected, it couldRussia Presidential March 4, 2012 in May should help determine whether Europe create uncertainty about the relationship betweenIran Parliamentary March 29, 2012 becomes more or less integrated and if it takes France and Germany—the two countries mostEgypt Presidential March 2012 on a German or French bent. It may also end up active in resolving the Eurozone crisis. influencing whether the Eurozone as we know itFrance Presidential First Round April 22, 2012 Even though German Chancellor Angela Merkel today exists in the years ahead. and Sarkozy—dubbed “Merkozy” in the press—Greece Parliamentary (Tentative/ Snap) April 2012 > In the U.S., voters will choose between two have disagreed on many occasions, the twoSouth Korea Parliamentary April 2012 very different economic recovery plans and managed to hammer out important compromisesPalestine Presidential May 4, 2012 approaches to tackle the federal deficit and in an attempt to stabilize the crisis. Sarkozy’s debt. The election will lay the groundwork for campaign is likely to lean heavily on his abilityPalestine Parliamentary May 4, 2012 the 2013 legislative agenda, which should be to influence key European leaders. Further, heFrance Presidential Second Round May 6, 2012 one of the busiest in years. More importantly, it advocates using Germany as an economic model could establish the course for the world’s largest and suggests some reforms to increase France’sFrance Legislative First Round June 10, 2012 economy during the next decade. productivity.France Legislative Second Round June 17, 2012 > A major transition in Chinese leadership will A change atop France could not only alter theIceland Presidential June 30, 2012 begin this year. Any significant policy shift German-French relationship, it would possiblyMexico Presidential July 1, 2012 would take some time to surface. But one thing require previous Eurozone agreements to be is certain—a new generation of leaders will reviewed and changed—if Hollande’s rhetoric isMexico Legislative July 1, 2012 eventually make its mark on the world’s second- to be believed. He has been critical of Merkel’sKenya Presidential First Round August 14, 2012 largest economy and the global balance of demands for changes to European Union treatiesKenya Parliamentary August 14, 2012 power. to allow disciplinary actions against overspending Eurozone governments and has expressed a desireHong Kong Legislative September 2012 France – April/May to renegotiate agreements from 2011. This wouldUnited States Presidential November 6, 2012 President Nicolas Sarkozy will likely face Socialist likely further delay any lasting solutions as well Party candidate François Hollande in his bid forUnited States Legislative (Congress) November 6 2012 as create market volatility. Hollande also seeks to reelection. raise taxes on affluent French citizens.Romania Parliamentary November 2012 The Most Important Election in Decades The uncertainty created by the French electionSouth Korea Presidential December 2012 For France, the Eurozone, and global markets, this calendar and outcome could test German election is critically important. leadership. Merkel will be faced with a re-election 6 GLOBAL INSIGHT | FEBRUARY 2012
  7. 7. Politics in 2012: The Stakes are Highbid in 2013, which will require increased focus on up for election, they would win control of this S&P 500 Returns in Presidential Election Yearsdomestic issues in 2012 and provide an incentive 100-member upper chamber—a real possibility. Conditional on Political Party Changesto stabilize the Eurozone crisis prior to her At this stage, opinion polls indicate the House of Election Outcomes 17.2%election campaign. Representatives, the lower chamber, could remain 14.7% 13.2% Annual ReturnsA Runoff is Likely in Republican hands, although their advantageThe French presidential election is based on could shrink.securing a majority of the popular vote. If after -2.7% Pocketbook Issues to Drive the Debatethe first round of voting (April 22, 2012) a single In addition to economic recovery andcandidate has received over 50% of the vote, the employment issues, many voters will consider Democrat to Democrat to Republican to Republican toelection is over and (s)he is declared the winner. candidates’ spending and austerity proposals Democrat Republican Democrat RepublicanIf no one secures a majority, there is a runoff due to the high federal deficit (8.7% of GDP) andbetween the top two candidates that would occur mounting federal debt (99% of GDP). Source: National Research Correspondent; election years 1926 to presentMay 6, 2012. This ensures that one of the top two Eric Lascelles, chief economist for RBC Globalcandidates wins a majority in the second round, candidate who accumulates at least 1,144 of 2,286 Asset Management, estimates austerity measuresand that winner becomes the next president. total delegates will become the nominee. already in place could reduce annual U.S. GDPThere are 15 candidates for the first round, three growth by 1.0%-2.5% in 2013 and beyond, The campaign for president will begin in earnestof which are attracting some 70% of voter support; depending on which policies are actually when one of the Republican candidates has aPresident Nicolas Sarkozy (Union for a Popular implemented or allowed to expire. New austerity plausible, mathematical pathway to winning aMovement; centre-right), François Hollande measures could add additional economic majority of delegates. The race will shift into full(Socialist Party; centre-left), and Marine Le Pen headwinds. gear by early September, when the Democratic(National Front Party; extreme-right nationalist). Party holds its convention and officially re- Tax policy almost always plays a big part in nominates President Obama.A poll published January 23 for the first round American elections; this election should be nosuggests Hollande (31%) leads President Sarkozy different. Both parties favor overhauling the tax The U.S. does not elect its president by popular,(25%), while Le Pen gathers 17% of the votes. Polls code for individuals and corporations, and there national vote. Instead, an “electoral college” processfor the second round, focusing on Hollande (60%) is a predictably wide gap in the way they would allocates “electoral votes” to be cast for candidatesand Sarkozy (40%), suggest the former is leading approach it. Regardless of who wins the presidency, to all 50 states and Washington D.C., proportionalthe race to become the next president. Congress will play a key role in shaping the tax to their populations. The overwhelming majority reform debate in 2013. Budget constraints could of states award all of their electoral votes to theU.S. – November force a revenue-neutral plan. With a lot at stake, candidate who wins the popular vote in that state.President Barack Obama will likely face the race to control the Senate and House becomes The candidate who can amass at least 270 of theRepublican Mitt Romney or Newt Gingrich in crucial. total 538 electoral votes wins the presidentialhis race for a second term. A high-profile, third- election. As a result, races in “swing states” or It’s a Unique, State-by-State Processparty candidate could also surface and alter the “battleground states” where votes for each Republicans are currently selecting theirelectoral arithmetic. candidate could be closely divided (such as Florida, presidential nominee through a series of state- Virginia, Pennsylvania, Michigan, New Mexico, andThe national congressional elections should play wide primary elections and caucuses that award others) will attract more of candidates’ time anda pivotal role in shaping U.S. economic policies. “delegates” to the Party’s national convention in attention compared to states where the electorateThe Senate, currently controlled by Obama’s late August. One candidate could begin to pull tends to be highly skewed toward one party.Democratic Party, is in play. If Republicans ahead in the primary race in February or March,achieve a net gain of four seats among the 33 seats and most states will have voted by early June. The7 GLOBAL INSIGHT | FEBRUARY 2012
  8. 8. Politics in 2012: The Stakes are HighChina – Late 2012 and Beyond widespread dissatisfaction with the availability agreements, plans to step down. Eurozone and and affordability of housing. IMF officials have repeatedly sought out andChinese politics have long been dominated by the received written pledges from all Greek politicalPolitburo Standing Committee (PSC). Although the One might reasonably expect the mainland party leaders that they will adhere to previouslyNational People’s Congress is formally the ultimate Chinese stock market, which is dominated by negotiated bailout and austerity agreements.decision-making body in China, in reality it is the state-owned enterprises with the government as Even so, there remains great uncertainty aboutPSC that holds the power. the majority shareholder, to exhibit less volatility whether the new Greek government will honorDue to the PSC’s informal rules on retirement age— this year. It is also unlikely investors will witness its commitments. As a practical matter, thisleaders over 68 years should retire—2012-2013 any dramatic moves in the value of the Chinese may be impossible considering the country’swill likely see a generational shift in leadership. currency in 2012, in our view. extreme debt load and severe economicThe country’s top two leaders will most likely Most importantly, after a political transition condition. The new government may ultimatelyrelinquish their positions. In total, seven of nine occurs, major policy initiatives are typically determine whether Greece exits the Eurozone.PSC members may step down. introduced. That could make 2013 a particularly Antonis Samaras, head of the conservative NewCurrently, Hu Jintao is president and Wen Jiabao interesting year. Chinese/U.S. policy issues will be Democracy Party, currently leads in the opinionis prime minister. The two politicians widely in focus, with potential leadership changes in both polls but would likely need to form a coalitionexpected to take over are, respectively, Xi Jinping countries. Clearly any Chinese policy changes are government to become prime minister.(Xi is pronounced like “see”) and Li Keqiang likely to produce important domestic and global > It seems inevitable Russian leadership will(Keqiang is pronounced like “kur-chiang”). They outcomes. officially shift back to Vladimir Putin in March—will likely assume the top PSC positions in the although in practical terms his power andfourth quarter of 2012 and take over the presidency Contribution to Global GDP Growth (%) influence have been dominant for years. At thisand the premiership in March 2013 at the National 1.6% stage its unclear if there will be major changes 1996-2005People’s Congress. According to the informal rule 1.4% 2006-2011 in economic or foreign policies. Russia’son retirement age, they would be the only two 2011 economy is too small to have much impact on 1.2%continuing PSC members. 2012 global growth, but its energy policy can impact 1.0% Europe. Further, the anti-Kremlin protestMajor Changes Could Occur in 2013Leadership changes to the PSC have occurred a 0.8% movement will be monitored by investors tonumber of times before. What makes it different 0.6% assess stability.this time is the extent of change within the PSC and 0.4% > While India, the world’s largest democracy, willthe position China now holds on the global stage. also elect a president, the position is largely 0.2%From an investment perspective, Chinese 0.0% ceremonial. The country is governed primarily 0.0% by Prime Minister Manmohan Singh, who wasgovernment policy typically has a conservative U.S. EU-15 China Indiatendency during the transition year. It should be reelected to his second five-year term in 2009. As Source: The Conference Board; 2011-2012 data are projections finance minister in the 1990s, he implementedno surprise, then, that stable monetary and fiscalpolicy were set forth as two key themes for 2012 at important reforms to open up the Indianthe annual Central Economic Work Conference that Other Elections economy. He remains a respected leader, butended last December. > Greek parliamentary elections, tentatively as prime minister he has been less effective in scheduled for April, will choose a new prime advancing additional reforms and large-scaleCurbs on China’s private housing market will likely infrastructure projects than investors had minister. Current Prime Minister Lucascontinue in 2012 while the government brings to hoped. Papademos, leader of the caretaker coalitionmarket large volumes of low-cost units to quell government that negotiated recent bailout > Presidential elections will take place in Mexico, Finland, Egypt (TBD), and South Korea.8 GLOBAL INSIGHT | FEBRUARY 2012
  9. 9. Global EquitiesGlobal Asset Class View Attractive Valuations Overshadowed by Lingering Risks Asset Class View A coordinated central bank move to ease banking system liquidity in Europe, together with an unexpected reserve requirement cut for Chinese banks, accompanied by better manufacturing and Equities = holiday spending data out of the U.S. allowed most markets to gain their footing in December and post Fixed Income – worthwhile gains in January. The successful inauguration of the European Central Bank’s LTRO facility giving the region’s banks access Cash + to low-cost funding for at least three years removed the immediate threat of a banking system meltdown and put a welcome bid into the market for French, Italian, and Spanish bonds.Regional Equity View That in turn allowed equity investors to switch their focus back onto market fundamentals (improving) and valuations (cheap). Region Weighting Because most major stock markets are still very attractively valued while bonds offer unacceptably U.S. Neutral = low coupon returns as well as price risk, we would like to be able to recommend an “Overweight“ commitment to equities. However, we find ourselves constrained by the recognition the Eurozone crisis Canada Neutral = could still deteriorate in a way that could jolt North America from slow growth into recession and prolong Continental Europe Underweight – China’s economic slowdown. U.K. Neutral = Were that to happen, earnings would come under Global Equities are Cheap on a Historical Basis Asia (ex Japan) Neutral = pressure, today’s price/earnings ratios would no longer look so attractive, and stocks would 35 Japan Overweight + likely be vulnerable to an additional period of 30 retrenchment. 25 While that is not our forecast, we rate the probability of it occurring at about 30%, high 20 Average: 19.0 enough that it needs to be acknowledged. 15 We recommend a “Neutral” exposure to stocks— 10 that is, portfolios should contain up to but not Last Plot: 12.9 more than their long-term target allocation to 5 1994 1997 2000 2003 2006 2009 2012 equities. We also counsel vigilance since we expect many present uncertainties will be resolved over Source: Datastream; World Index P/E data through 1/31/12 the next six months in a way that forces us off our “Neutral” stance in one direction or the other.Jim Allworth – Vancouver, Canadajim.allworth@rbc.com9 GLOBAL INSIGHT | FEBRUARY 2012
  10. 10. Global Equities: United StatesNeutral (=) Market Developments Portfolio Recommendations ƒ The S&P 500 has rallied 19.4% from its October ƒ Stick with high-quality, dividend-paying stocks;> The S&P 500 is trading at a compelling low due to improved economic data and the can better withstand periods of earnings valuation, as the chart on page 23 llustrates. ECB’s LTRO policy. Employment growth picked erosion. This lays the foundation for attractive returns up, manufacturing activity expanded, and ƒ Among cyclicals, favor Industrials (upgraded to over the long term. some housing indicators began to stabilize “Overweight” from “Neutral”) and Technology.> However, in the near term the market must during the period. Industrial earnings revisions should rebound contend with lingering Eurozone risks, ƒ Because market expectations were set rather due to improved manufacturing activity. economic headwinds, and potentially slower low last fall, it didn’t take much for data to Technology valuations are cheap; company earnings growth. These factors argue for surprise to the upside. The U.S. Economic balance sheets sturdy. “Neutral” or benchmark exposure to U.S. Surprise Index, which measures whether ƒ Financials are somewhat more attractive the flow of economic data is exceeding stocks for the time being. (upgraded to “Neutral” from “Underweight”). or undershooting forecasts, began to rise Bank earnings indicate U.S. financial system is> The consensus S&P 500 earnings forecast for meaningfully in October. By early January it finally beginning to heal. 2012 has pulled back to $106 per share but reached its second-highest level since 2004. ƒ Decrease exposure to Utilities (downgraded to remains above our $101 forecast. This also provided a catalyst for stock prices. “Underweight”). Sector is expensive; trades at ƒ History suggests the Surprise Index will the high-end of its 30-year range. eventually retreat as expectations become Sector View ƒ Limit exposure to Health Care (downgraded to overly optimistic. It doesn’t necessarily follow Consumer Staples + Health Care = “Neutral”). Earnings and revenue trends less that the stock market has to come down, too. attractive vs. 2011. Information Technology + Consumer Discretionary – But the record says it is unlikely the market will run away dramatically to the upside with Industrials + Materials – U.S. Economic Surprise Index and S&P 500 expectations already so full. Energy = Telecommunications – 100 1500 ƒ We also anticipate actual economic activity will moderate soon. GDP growth should pull back 1400 Financials = Utilities – 50 from its 2.8% fourth-quarter pace. We forecast 1300Source: RBC Capital Markets 2.0% growth for all of 2012. 1200 0 1100 ƒ Almost 40% of S&P 500 revenues come from outside the U.S., so a worsening global 1000 -50 economic outlook combined with slow U.S. 900 growth calls for subdued earnings expectations. -100 800Kelly Bogdanov – San Francisco, United States S&P 500 earnings are near a record high as a Economic Surprise Index (left axis) S&P 500 (right axis) share of GDP at a time when more sectors are -150 600Janet Engels – New York, United States experiencing profit margin contraction than 2008 2009 2010 expansion. We forecast S&P earnings will grow Source: Bloomberg; Citigroup Surprise Index data through 1/30/2012 by only 4% this year, down from 13% in 2011.10 GLOBAL INSIGHT | FEBRUARY 2012
  11. 11. Global Equities: CanadaNeutral (=) Market Developments Portfolio Implications> We remain “Neutral” for Canada, on a global ƒ The TSX closed up in January, following a string ƒ We believe gold stocks offer a compelling of 9 out of 10 months of lower closes. opportunity at the present time. Shares of gold asset allocation perspective. While we producers continue to discount a much lower remain concerned about the risks of a global ƒ RBC Capital Markets recently reduced its 2012 gold price than is prevailing in the market, slowdown, we believe current monetary EPS estimate for the S&P/TSX to $885. The while global reserve additions continue to run policy, especially in the U.S. and Europe, sharp reduction in estimates is primarily the at less than half of annual production. should be supportive of the Canadian result of weakness in commodity prices and a stagnant U.S. economy, Canada’s largest ƒ We have increased our recommended market for some months to come, given its trading partner. weighting on Industrials to “Overweight” from significant resource exposure. “Underweight” to reflect a more positive overall ƒ At current levels, the TSX is now trading at ~14x view on the macro backdrop. We also note that 2012 estimates, which is roughly in line with its Sector View long-term average. Canadian industrials have significant exposure to mining and energy where capex levels are Consumer Staples + Health Care = ƒ Shares of bank stocks have recovered expected to remain high. Financials + Materials = significantly over the past few months as fears ƒ We have reduced our recommended weighting Industrials + Energy – over Europe have somewhat abated. While still in Utilities to “Underweight”. While the sector below its 15-year average, the valuation gap Telecommunications + Information Technology – offers attractive dividend yields, we believe has narrowed significantly since Q411 earnings valuations are rich and are at risk should the Consumer Discretionary = Utilities – were reported in early December. macro backdrop further improve.Source: RBC Capital Markets ƒ We note that Canadian banks have limited direct exposure to Southern Europe; however, as with most global banks, concerns over Europe are still likely to weigh on valuations from time to time. ƒ A “soft landing” for China would be longer- term positive for Canadian stocks because of the high commodity weighting in the S&P/TSX Index.Matt Barasch – Toronto , Canadamatt.barasch@rbc.com11 GLOBAL INSIGHT | FEBRUARY 2012
  12. 12. Global Equities: Continental EuropeUnderweight (–) Market Developments ƒ With an onerous sovereign funding programme—Eurozone governments need to> With the euro area entering recession and ƒ The recent ECB’s LTRO of €489bn served raise some €219bn in new bonds in the first as a lifeline to Eurozone banks. Prior to the inflation being tamed, the European Central quarter—risk remains. The biggest near-term intervention, they faced severe liquidity stress Bank (ECB), headed by the pragmatic Mario danger is Greece, which is still negotiating an and the prospect of a series of cascading Draghi, should continue to provide support bank failures. With its intervention, the ECB agreement on losses that private bond holders through liquidity provisions and monetary should bear on its government bonds. Even is effectively underwriting bank re-financing policy. Another three-year Long-Term a 50% “haircut” on private debt would leave requirements for at least the next two years. the country with an uncomfortably high and Refinancing Operation (LTRO) is taking place Unlike the Fed balance sheet expansion in unsustainable 120% debt-to-GDP ratio by 2020. at the end of February. 2008/09 that dealt with the cause of the crisis— A much bigger haircut or a disorderly default the financial system—the ECB’s LTRO does not> The weak macroeconomic backdrop could shock investors. address the root of the problem—namely, the continues, though there are signs some euro sovereign debt crisis. It merely gives the banks area countries are stabilising. Portfolio Recommendations breathing space to recapitalize. ƒ We continue to recommend investing in> The Eurozone crisis is not over, and the ƒ An abrupt market rotation occurred in January resilient companies with a solid market region still faces an arduous road ahead. We when the immediate risk of a financial system position, a high proportion of recurring sales, remain “Underweight” the region. collapse was averted. The discrepancy between exposure to growing regions or industries, the highly valued defensives and lowly valued and a healthy balance sheet. Such companies cyclicals was partially restored. Cyclical and should be well equipped to weather challenges value stocks outperformed while defensives in upcoming months. lagged. European Central Bank’s Total Assets (€ billion) ƒ The “flash” Purchasing Managers’ Index readings rose for the third-straight month 2750 in January, indicating stabilisation in euro- Assets have grown almost 40%, to 2600 €2.7 trillion, in the past year as efforts area economic activity. The surveys suggest continue to maintain liquidity during the that although business conditions remain 2450 regions debt crisis. challenging, economic headwinds may no 2300 longer be quite so intense. The pick-up in U.S. growth, the weaker euro, and the ECB 2150 policy stimulus are providing some relief for 2000 the economy. But with fiscal austerity set to 1850 intensify this year, the economy is expected to Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 remain very fragile.Frédérique Carrier – London, United Source: Bloomberg12 GLOBAL INSIGHT | FEBRUARY 2012
  13. 13. Global Equities: United KingdomNeutral (=) Market Developments Portfolio Recommendations> The U.K. economy continues to suffer from ƒ Following the ECB’s LTRO operation and ƒ We have been favouring companies with a with global leading indicators improving, relatively high exposure to North American the pressures of austerity. Tight credit the FTSE 100 gained in January. The FTSE customers and relatively low exposure to conditions, eroded real disposable income, Europe, in particular Energy, Health Care, and 250 outperformed as small- and medium- and unemployment all crimp consumption. cap stocks rallied. Greater risk appetite was Utilities. Growth in exports has been disappointing also evident in the sector performance, with ƒ The recent outperformance of these stocks led and unable to offset the malaise in the Financials and Basic Materials leading while to higher valuations, and further meaningful domestic economy. RBC Capital Markets Utilities, Health Care, Consumer Goods, and outperformance may be harder to come by in expects weak, but not necessarily Energy lagged. the short term. disappointing, growth. ƒ Encouragingly, the manufacturing, services,> With fears concerning the Eurozone and its and construction PMIs have all surprised on the upside, although still consistent with a U.K. Inflation Peaked in 2011 banks receding somewhat in January and global leading indicators improving, the weak economy. UK Retail Price Index YoY % Change U.K. stock market gained during the month. ƒ U.K. CPI inflation declined to 4.2% y/y in 6% Further expansion of the Bank of England’s December. The deceleration in prices reflects 5% quantitative easing programme expected in base effects with transport and utility prices 4% February should help support markets. rising sharply in December 2010. These are now 3% falling out of the annual comparison, and RBC 2%> Recession risks continue to linger for 2012. Capital Markets expects this to take inflation 1% These could weigh on corporate earnings down to below 3% by April. 0% and equity prices. A disorderly outcome ƒ Unemployment increased to 8.4% in -1% to the European sovereign and Financial November, a little higher than expected, though -2% sector crisis remains the key risk, though the pace of the rise in unemployment seems 2006 2007 2008 2009 2010 2011 2012 we continue to expect this risk will not to have moderated. Confidence remains weak, Source: Bloomberg, data through December 2011 crystallise. and real income growth is set to stay in negative territory throughout 1H12. However, slightly easing credit conditions for households, less real wages erosion as inflation becomes less punitive, and no marked deterioration of the unemployment picture should all help to attenuate headwinds later in the year.Frédérique Carrier – London, United Kingdomfrederique.carrier@rbc.com13 GLOBAL INSIGHT | FEBRUARY 2012
  14. 14. Global Equities: Asia (ex Japan)Neutral (=) Market Developments Fitch had already adjusted its rating in December 2011, and S&P may do the same in the next few ƒ For January, the Hang Seng Index rose 10.6%;> Asia ex-Japan equity performance continues the Singapore Straits Times Index 9.8%; the months. to be capped by a slowdown in Chinese Nikkei 4.1%, South Korea’s KOSPI 7.1%, Shanghai Portfolio Recommendations growth, slower global growth affecting A-Share Index 4.2%, and Australia 5.1%. Equity performance was strong in January despite the ƒ General: We prefer a “Neutral” benchmark demand for Asian exports, and negative weighting but recognize regional economic Chinese New Year, which is usually a quiet period investor sentiment from the European for markets. leading indicators may be bottoming. There may sovereign debt crisis. We maintain our be an opportunity to consider an “Overweight” ƒ Central banks in the region are no longer position later in the first half of the year if “Neutral” stance on regional equity markets. tightening. They are either on hold, as in the stabilization in the regional economy is> However, we do note that leading indicators Australia, New Zealand, South Korea, and China, confirmed. or loosening policy, such as in Indonesia and, in the region may be in the process of more recently, Thailand. Many central bank ƒ Countries: We prefer Japan—lowest valuation in bottoming, and equity performance at the statements have referenced the weak global Asia on book value (see next page); Indonesia— strong domestic consumption theme; Australia— start of 2012 has been more encouraging. growth environment as an impediment to domestic growth. high dividend yield. Asian equity performance was particularly ƒ President Ma Yingjiu was elected to a second four- ƒ Sectors: We prefer defensive, non-cyclical sectors weak in the second half of 2011. but would selectively add to cyclical stocks in year term as Taiwan’s president, with nearly 52%> While the Chinese economy faces numerous of the vote. Taiwan has enjoyed closer ties with portfolios as the economic data stabilizes. challenges, the base case still calls for a China under the rule of Ma’s Kuomintang Party. ƒ Style: We prefer large-cap names, with supportive soft landing. We forecast 2012 Chinese GDP ƒ Chinese GDP data continues to indicate the dividends. growth of 8.4% and moderate appreciation economy is going through a soft landing. Fourth- quarter GDP was up 8.9%, slightly more than Leading Economic Indicators for Select Asian Economies in the Chinese currency. expected. The economy grew 9.1% in 2011. China’s (January - December 2011)> Central banks are either staying on hold or CPI continued to moderate to 4.1% in December. 60 selectively easing, while inflation is also We expect inflation to moderate further and the Chinese economy to grow 8.4% in 2012. 55 moderating. Equity valuations are low. ƒ South Korea’s fourth-quarter GDP grew at the 50 Equity performance over a 12-month time slowest level in two years, rising 0.4% over the horizon has historically been favourable at third quarter and 3.4% over a year ago. This was 45 these valuation levels once central banks slightly below expectations and was the third- 40 have started easing. consecutive quarter of slower growth. Given that JAN MAR MAY JUL SEP NOV exports account for approximately half of South Korea’s GDP, the slowdown is reflective of the Taiwan HSBC Manufacturing PMI broader global slowdown over that period. Nomura/JMMA Seasonal PMIJay Roberts – Hong Kong, China South Korea HSBC ƒ Indonesia, the world’s fourth most populous China Manufacturing PMI country, had its sovereign credit rating raisedYang Yufei – Hong Kong, China Singapore Purchasing Manager Index by Moody’s for the first time in 10 years to investment grade, Baa3, with a stable outlook. Source: Bloomberg14 GLOBAL INSIGHT | FEBRUARY 2012
  15. 15. Global Equities: JapanOverweight (+) Market Developments auto demand, improved U.S. market share and demand, and strong sales growth in China ƒ As we head into Japanese earnings season the> The “Overweight” call on Japanese stocks after a weak 2011. Toyota, the largest Japanese Nikkei 225 index has risen 4.6% since the start is largely a function of valuations—with of 2012. manufacturer, also raised its 2012 sales Japan trading at the lowest price/book value forecasts, although this was on the back of a multiple in Asia—as well as an expected ƒ Japan’s core CPI fell for the third consecutive particularly weak 2011. year in 2011, down 0.3%. Core prices declined economic rebound in 2012 following the by 0.1% in December. One of the reasons Portfolio Recommendations devastating effects of the tsunami in March deflation remains in Japan has been the ƒ Japanese cyclical sectors, such as real estate and 2011. continued strength of the yen in 2011. RBC transportation equipment, that underperformed> Japanese stocks are trading at significant Capital Markets forecasts the yen to appreciate in 2011 have been the outperformers thus far to USD/JPY 70.0 by the middle of the 2012 in 2012. However, this may just be a short- discounts to historical valuations. The before falling back to 75.0 by the end of the term market reaction to the imminent threat Nikkei 225 Index is trading at a forward year. of a European credit crunch dissipating over price/earnings ratio of 11.7x, compared Christmas. We continue to favour large- ƒ Japan posted a trade deficit in 2011, its first such to the 5-year average forward valuation of cap, dividend-paying names as we wait for deficit since 1980. However, this is likely not the 16.4x. The trailing price/book ratio is 0.9x, start of a new trend of deficits for the world’s confirmation the regional economic data in compared to the 5-year average valuation of Asia is stabilizing. We would selectively add to third-largest economy because a number of 1.3x. Negativity prevails: Japanese stocks cyclical stocks in portfolios as the data improves. unusual factors hurt exports in 2011 and helped are priced for a 5% earnings decline in to contribute to the deficit. These include: the ƒ We also favor companies likely to benefit from 2012. March tsunami and subsequent nuclear disaster civil infrastructure projects and reconstruction that impacted the domestic supply chain; severe work resulting from the March 2011 earthquake flooding in Thailand that impacted the regional and tsunami. supply chain; and the European sovereign debt crisis that dampened demand from that region. However, the strong yen—also a headwind—will Japanese Headline and Core CPI (Jan 2009-Dec 2011) likely persist in 2012. 0.5 ƒ The Bank of Japan (BoJ) lowered its growth 0.0 forecasts for fiscal-year 2012, which begins in -0.5 April, to 2% from 2.2%. For the 2011 fiscal year, -1.0 the BoJ forecasts a contraction of 0.4%, slightly higher than the previous forecast of 0.3%. The -1.5 BoJ cites the European sovereign debt crisis as -2.0 Headline (JNCPIYOY Index)Jay Roberts – Hong Kong, China the biggest risk to domestic Japanese growth. -2.5 Core (JNCPIXFF Index) -3.0Yang Yufei – Hong Kong, China ƒ Mr. Takanobu Ito, the President of Honda, Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Japan’s third-largest car manufacturer, forecast earnings for the company will be the best in Source: Bloomberg at least five years on a rebound in domestic15 GLOBAL INSIGHT | FEBRUARY 2012