INFLECTION POINT. Why Now Is The Time To Invest In Emerging Markets. RBC GAM Fundamental Series

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1 INFLECTION POINT Why Now Is The Time To Invest In Emerging Markets RBC GAM Fundamental Series

2 RBC GAM Fundamental Series Inflection Point: Why Now Is the Time to Invest in Emerging Markets 1 Executive Summary With valuations at current levels, we believe that the time to invest in emerging market equities is now. We expect emerging market equities to continue to exhibit relative performance advantages when compared to developed market equities, despite poor absolute and relative performance in 2013 and In this paper, we will discuss the specific circumstances that caused emerging markets to struggle in 2013 and Furthermore, we will highlight three key factors that we believe will drive future emerging markets growth and performance. Productivity growth. Emerging markets already exhibit substantially higher productivity growth than developed markets. In terms of long-term potential, China is operating at a level of gross domestic capital (GDP) per capita that is equivalent to that of the United States before 1947, whereas India s GDP per capita level is near that of the United States in the early 1900s. This leaves plenty of potential for emerging markets to catch up to their developed market peers. Valuations. The silver lining to emerging markets poor showing in 2013 and 2014 is that valuations of price-to-book and price-to-earnings look very attractive relative to developed markets, positioning the asset class well for near-term outperformance. Bond yields. Spreads between the JP Morgan EMBI Global Diversified Index and the 10-Year U.S. Treasury Index are significantly lower now than they were at their nearly 410 basis point high in December As of June 2015, emerging market spreads hovered around 330 basis points and the 10-year Treasury rate was near 2.5%, making extreme negative moves less likely and therefore reducing downside risk. It is unlikely that emerging markets will continue to outperform developed markets by the same margin as they have over the last 25 years, but we don t expect 2013 or 2014 to repeat themselves either. With valuations at current levels, we believe that the time to invest in emerging market equities is now.

3 RBC GAM Fundamental Series Inflection Point: Why Now Is the Time to Invest in Emerging Markets 2 Introduction The lackluster performance of emerging market equities over the last two calendar years has made retail and institutional investors alike wary of entering the emerging market space, maintaining their allocation, or increasing their allocation. The MSCI Emerging Markets Index struggled in 2013, returning a disappointing -2.6% compared to its developed market counterpart, the MSCI World Index, which returned 26.7%. The near 30% differential made 2013 the second worst year of relative performance versus developed markets since Although 2014 performance was not nearly as poor on an absolute or relative basis as 2013, emerging markets (-1.8%) continued to trail developed markets (+5.5%) on a relative basis, this time by 7.3%. Not surprisingly, emerging market equities saw massive outflows yet again. Following outflows of over $15 billion in 2013, emerging markets saw $23 billion flee the asset class in 2014 in response to their poor absolute and relative performance results. So what drove emerging markets to struggle so much more than their developed market peers over the last two years? There were a variety of macroeconomic factors that weighed on investor sentiment, however the drivers that led to the underperformance in 2013 and 2014 differed. 2013: The Fed s taper tantrum and other macroeconomic factors Emerging markets were first stung in May 2013 as the U.S. Federal Reserve (the Fed) announced a plan to taper its quantitative easing program. Emerging market currencies were hit hard by this announcement due to liquidity concerns, in addition to the fear that tapering could lead to higher interest rates in the United States and thus higher borrowing costs for emerging market companies. Emerging market countries with current account deficits and in turn poor macroeconomic fundamentals such as Turkey, Indonesia, Brazil, South Africa and India (often referred to as the Fragile Five ) were especially impacted by the news. By September 2013, emerging market countries breathed a collective sigh of relief and managed to regain some of their losses when the Fed surprised markets by not dialing back its bond purchasing program. In the fourth quarter of 2013, however, the Fed moved earlier than expected to announce the beginning of its tapering program. Emerging market companies took the news in stride and posted positive returns for the quarter, but it was not enough to recover the losses incurred earlier in the year. Fed tapering was not the only macroeconomic issue that affected emerging markets during the year, however. Slowing growth in China hurt commodity-exporting countries; the overheating Chinese property sector caused concerns about a potential real estate bubble and a plethora of emerging market countries faced uncertain political futures (Thailand, India, South Africa, Indonesia and Brazil, among others, faced future elections that could potentially change the economic path of each country). 2014: Oil prices plunge, extensive geopolitical unrest and other macroeconomic factors Emerging market countries with heavy oil price dependency (and in many cases an overreliance on that single commodity) were hit hard in the second half of 2014 as oil prices fell nearly 50%. Russia, Columbia, Malaysia and Mexico, all dependant on oil exports, suffered in Russia alone was down over 48% on the year. Oil importing countries such as China, Turkey and India (who all benefit from lower oil prices) offset some of the poor performance caused by oil exporting countries. Geopolitical issues were a key driver of the underperformance of emerging markets in Pro-democracy protests in Hong Kong against China, unrest in Thailand due to a military coup and disappointing Brazilian elections (among other economic difficulties in Brazil) all played an important role in emerging markets underperformance. The standout negative geopolitical event was the annexation of Crimea by Russia. The hostilities between Russia and Ukraine led to wide-spread contagion, as U.S. and European Union sanctions of Russia took their toll not only on Russia, but on other countries, as Russia issued reciprocal sanctions on the rest of the world. In addition, the initiation of tapering by the Fed in 2014 led to widespread liquidity fears, especially towards the latter half of the year. The strength of the U.S. dollar in 2014 negatively impacted emerging markets performance, as did the fact that many emerging markets increased their interest rates to stop their currency depreciation (relative to the dollar). All of this, topped with fears of future rising U.S. interest rates, only added to the relative underperformance of emerging markets versus developed markets in In the wake of the struggles during 2013 and 2014, many investors have begun to question the benefits of investing in emerging markets in this climate. With the last two years behind us, however, we see a powerful combination of productivity growth, attractive valuation levels and potential declining emerging market bond spreads that will allow emerging markets to maintain their performance advantage relative to developed markets for years to come. Relative growth translates into relative performance Historically, the typically higher growth rates in emerging markets have driven long-term relative outperformance versus developed markets. Indeed, the growth premium of emerging markets has declined since 2009 following decades of expansion but it still materially exceeds that of developed markets. The emerging/developed markets growth differential may indeed be narrowing, but we do not expect this trend to continue indefinitely. We believe emerging market growth rates will continue to exceed those of developed markets for decades to come as a result of a few key emerging market growth drivers that will in turn drive emerging markets performance.

4 3 Inflection Point: Why Now Is the Time to Invest in Emerging Markets RBC GAM Fundamental Series Exhibit 1 Productivity Growth of United States vs. China and India Labor Productivity Growth (GDP Per Person Employed - Compound Annual Growth Rate (CAGR) %) 10 Years ( ) India China U.S. 0% 2% 4% 6% 8% 10% Source: The Conference Board Total Economy Database, January 2015 and JP Morgan Exhibit 2 Potential Long-Term Productivity Growth Emerging Market GDP Per Capita Has Strong Catch-Up Potential 60, % 6.3% China, India, Indonesia, Brazil & South Africa below 1947 level 9.0% Productivity Growth The primary driver of future emerging markets growth will be the productivity growth advantage relative to developed markets. Consider Exhibit 1, which depicts the existing productivity growth advantage of emerging nations, China and India versus the United States. This data becomes even more compelling when considering the fact that output per employee within China and India was just 19% and 11% of U.S. levels, respectively, at the end of This leaves room for superior productivity growth. In Exhibit 2, we can see how much catch-up potential exists by aligning the real GDP per capita level of several emerging nations according to historical U.S. GDP per capita. In this example, China s and India s real GDP per capita do not even appear on the chart, meaning that both countries GDP per capita ($7,150 for China and $1,650 for India) are lower than what U.S. GDP per capita was in In fact, Indonesia, Brazil, and South Africa s real GDP per capita are also all below U.S. levels in Other factors that will drive productivity growth in emerging markets include lower debt levels, urbanization, rising school enrollment and a shift from agriculture jobs to higher productivity work in the manufacturing sector. With a growing middle class, emerging markets will see more discretionary spending which will have a positive compounding effect on emerging market economies. 50,000 40,000 Korea at 1979 level 30,000 20,000 Russia at 1955 level 10, U.S. Real GDP Per Capita Source: U.S. Real GDP Data is from the U.S. Federal Reserve. Real GDP is represented in 2009 dollars. Emerging market country data is from the World Bank, by translating 2013 data into U.S dollars.

5 RBC GAM Fundamental Series Inflection Point: Why Now Is the Time to Invest in Emerging Markets 4 Valuation We witnessed historically poor relative performance in 2013; only once since 1989 has the performance of the MSCI Emerging Markets Index been so poor relative to that of the MSCI World Index, as illustrated in Exhibit 3. In addition, we saw 2014 relative performance disappoint once again following the historical underperformance of The 2013 sell-off in emerging market equities and the continued decline in 2014 is not without a silver lining though: relative to developed markets, emerging market equity valuations now look very attractive. Comparing the trailing 1-year price/book ratio of the MSCI Emerging Markets Index to the MSCI World Index, we can see that emerging market equities are trading at a 31% discount (Exhibit 4). This is the largest year-end discount since 2002, at which point emerging markets traded at a price/book discount of 30%. It is worth noting that in the 12-month period following 2002, emerging markets proceeded to outperform developed markets by 23%. The MSCI World Index is trading at 2.2 times price/ book and the MSCI Emerging Markets Index is trading at 1.5 times price/book (Exhibit 4). So not only do emerging market price/book ratios look attractive relative to developed market price/book ratios, but on an absolute basis they are trading at nearly a 25% discount to their 10-year average. Emerging market equity valuations in terms of the trailing 1-year price/earnings ratio tell an equally compelling story, trading at a 27% discount on a price/ earnings basis compared to developed market equities. At the end of 2013, this discount was nearly 33%, the largest two consecutive year average discount since 2003 and 2004, when emerging markets traded at a price/earnings discount of 33% and 34%, respectively. Again, in the 12-month period following 2004, emerging market equities proceeded to outperform developed market equities by 25%. Finally, as Exhibit 5 illustrates, at the end of 2002, 2003, 2004 and 2009 emerging market equities had a price/earnings discount relative to developed market equities that was either greater than or equivalent to that which they had at the end of 2013 and Once again, in each of the 12-month periods first mentioned above, following those year-end discounted price/earnings levels, emerging markets meaningfully outperformed developed markets by 23%, 11%, 25% and 7%, respectively. With emerging market valuations beginning the year at such discounted levels, we believe that there is potential for a similar outcome in Exhibit 3 Historical Relative Performance of Emerging vs. Developed Market Equities* MSCI Emerging Markets Index vs. MSCI World Index 60% 48% 40% 20% 0% -20% -40% -60% % % 16% % -13% % -27% -28% % % -18% % % % 14% 11% 12% % % -13% -13% % 2% % 1 Year Relative Performance: MSCI Emerging Markets vs. MSCI World (USD gross of fees) Exhibit 4 Historical Price/Book Values Comparison* MSCI Emerging Markets Index vs. MSCI World Index Historical Price/Book Values 50% 40% 30% 20% 10% 0% -10% -20% MSCI Emerging Markets Index Price/Book MSCI World Index Price/Book Exhibit 5 Historical Price/Earnings Values Comparison* -9% MSCI Emerging Markets Index vs. MSCI World Historical P/E Ratios 40% 33% 34% 16% 7% 23% 28% 9% % 2014 MSCI Emerging Markets Index Price/Book 10-Year Average 18% % % % 2014 MSCI Emerging Markets Index Price/Equity Discount versus MSCI World Index MSCI Emerging Markets Index Price/Equity Premium versus MSCI World Index *Source for charts on this page: MSCI as of

6 5 Inflection Point: Why Now Is the Time to Invest in Emerging Markets RBC GAM Fundamental Series Exhibit 6 Emerging Markets Bond Prices* Bond Yields JP Morgan EMBI Global Diversified - Price % 3.0% 2.5% 2.0% 1.5% Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Exhibit 7 10-Year U.S. Treasury Index (%)* JP Morgan EMBI Global Diversified - Price (USD) Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Rising emerging market bond yields also contributed significantly to the underperformance of emerging market equities compared to developed market equities, alongside a rise in the 10-Year U.S. Treasury Index resulting from the Fed s announcement to taper its quantitative easing program. The Fed made its announcement in May 2013, and as measured by the JP Morgan EMBI Global Diversified Index (Exhibit 6), emerging market bonds sold off significantly on the news, hitting their lows in June The chart also illustrates the steady climb through 2014 and into the first half of 2015 of the price of the JP Morgan EMBI Global Diversified Index since its June 2013 lows. Because of the inverse relationship of bond prices to interest rates, when emerging market bonds sold off, emerging market interest rates rose. The 10-Year U.S. Treasury rate also jumped on the news and began a steady climb higher through 2013 (Exhibit 7). We have however seen a reversal of this trend, as the 10-Year U.S. Treasury has fallen from about 3% at the end of 2013 to the low to mid 2% in the first half of So how do these events affect emerging market companies, and in turn, their stock performance? The sell-off in emerging market bonds (which caused emerging market interest rates to rise) and the rise of the 10-Year U.S. Treasury rate required emerging market companies to pay higher interest rates for debt financing. Debt financing is used for many reasons, including operations and capital expenditures. Higher interest burdens hurt company bottom lines, and therefore stock prices take a hit and stockholders begin to feel the pinch as the market anticipates the negative impact of higher interest costs on the company. Therefore, the fall of the 10-Year U.S. Treasury since its 2013 highs is positive for emerging markets going forward. U.S. 10-Year Treasury (%) *Source for charts on this page: FactSet, RBC GAM-US as of

7 RBC GAM Fundamental Series Inflection Point: Why Now Is the Time to Invest in Emerging Markets 6 The Time To Invest In Emerging Markets Is Now The spread of emerging market yields relative to the 10- Year U.S. Treasury Index (as measured by the JP Morgan EMBI Global Diversified Index) widened significantly to their worst level in December 2014, approaching 409 basis points (Exhibit 8). This spread level was even more severe than the 360 basis points we saw in June 2013 following the taper tantrum. Exhibit 8 also shows a reversal of this trend, with spreads generally decreasing since December We expect spreads to potentially trend slightly lower as they are currently at what we believe are elevated levels. The 10-year U.S. Treasury rate is hovering around 2.4% in June 2015, 20% higher than the 2.0% levels we saw in December 2014 when spreads widened to their worst level of 409 bps. That, combined with current elevated spread levels of about 330 bps in June 2015, implies there is not much room to widen on negative news and extreme negative moves are much less likely, reducing overall downside risk. Exhibit 8 Emerging Markets Spreads vs. 10-Year U.S. Treasuries JP Morgan EMBI Global Diversified Spread (bps) Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Source: FactSet, RBC GAM-US as of JP Morgan EMBI Global Diversified Spread (bps) Conclusion With the specific circumstances that caused recent underperformance largely behind us, we believe that a powerful combination of productivity growth, attractive valuation levels and steadying emerging market bond spreads will continue to drive emerging market growth rates for years to come. Indeed, emerging market equities appear to have reached an inflection point following a meaningful correction, we believe that discerning investors who are willing to seize the opportunity are poised to benefit from both the absolute and relative return advantages of this asset class. Authored by: Ashley B. Hyotte, Institutional Portfolio Manager, Emerging Markets Equities Research and data provided by: RBC GAM-US Portfolio Risk & Analytics Team RBC Emerging Markets Equity Team RBC GAM-US

8 This document is provided by RBC Global Asset Management (RBC GAM) for informational purposes only and is intended for institutional or professional investors only. It may not be reproduced, distributed or published without RBC GAM s prior written consent. This document does not constitute an offer or a solicitation to buy or to sell any security, product or service in any jurisdiction, nor is it intended to provide any advice of any kind. This document is not available for distribution to people in jurisdictions where such distribution would be prohibited. RBC GAM is the asset management division of Royal Bank of Canada (RBC) which includes the following affiliates around the world, all indirect wholly owned subsidiaries of RBC: RBC Global Asset Management Inc. (including Phillips, Hager & North Investment Management), RBC Global Asset Management (U.S.) Inc., RBC Alternative Asset Management Inc., RBC Global Asset Management (UK) Limited, RBC Investment Management (Asia) Limited, BlueBay Asset Management LLP, and BlueBay Asset Management USA LLC. In Canada, this document is provided by RBC Global Asset Management Inc. which is regulated by each provincial and territorial securities commission with which it is registered. In the United States, this document is provided by RBC Global Asset Management (U.S.) Inc., a federally registered investment adviser. In the United Kingdom, Europe and the Middle East, this document is provided by RBC Global Asset Management (UK) Limited, which is authorised and regulated by the UK Financial Conduct Authority (FCA). In Hong Kong, this document is provided by RBC Investment Management (Asia) Limited, which is registered with the Securities and Futures Commission (SFC) in Hong Kong. Past performance is not indicative of future results. All views, opinions and estimates expressed herein are as at the date(s) indicated, are subject to change without notice, and are provided in good faith but without legal responsibility. To the full extent permitted by law, neither RBC GAM nor any affiliate nor any other person accepts liability for direct or consequential loss arising from any use of the information contained herein. Information obtained from third parties is believed to be reliable, but no representation or warranty, expressed or implied, is made by RBC GAM as to its accuracy, completeness or correctness. RBC GAM assumes no responsibility for any errors or omissions. Some of the statements contained in this document may be considered forward-looking statements which provide current expectations or forecasts of future results or events. Forward-looking statements are not guarantees of future performance or events and involve risks and uncertainties. Do not place undue reliance on these statements because actual results or events may differ materially from those described in such forward-looking statements as a result of various factors. Before making any investment decisions, we encourage you to consider all relevant factors carefully. MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developed countries. The index is computed using the net return, which withholds applicable taxes for non-resident investors. MSCI World Index is an unmanaged index considered representative of stocks of developed countries. The index is computed using the next return, which withholds applicable taxes for non-resident investors. / TM Trademark(s) of Royal Bank of Canada. Used under license. RBC Global Asset Management Inc., Publication date: July 2015 RBC Global Asset Management Minneapolis Boston Chicago us.rbcgam.com