Portfolio Strategy Quarterly

Transcription

1 Portfolio Strategy Quarterly A publication for the private clients of RBC Dominion Securities Fall 2010 Professional Wealth Management Since 1901

2 Table of Contents Executive Summary 3 Market Performance 4 Market Update 9 The Global Economy 12 Equity Markets 14 Canada/U.S. Sector Scorecard 15 Fixed Income Markets 18 Currencies 19 Economic and Capital Markets Forecast 20 Asset Mix 21 Canadian Focus List Update 23 Canadian Focus List 27 US Focus List Update 29 US Focus List 33 Research Resources The global economy > Recent mixed economic data are symptomatic of a transition to the half-speed recovery we have been forecasting for the remainder of 2010 and The data suggest there is enough fuel for positive but uninspiring growth over the year ahead. Employment gains remain very modest and are unlikely to put a dent in the unemployment rate for some time, but decent income growth is allowing consumer spending to expand at ~2% per annum. Consumers outside of North America appear to be in better shape, and China seems to be managing policy in a way that will sustain an acceptable rate of growth. With growth in the emerging markets likely to come in a range of 5-6% versus ~2% in the developed world, the global outlook remains reasonably positive. Equity markets > Equity markets remain attractively valued from a longer-term view, but given the magnitude of the challenges faced by developed world economies, valuations do not provide a catalyst or assurance of a material move to the upside. While we think equities will beat the low returns from bonds and cash, we are not ready to issue a blanket call to overweight stocks from a big picture view. However, we believe that stocks can take a run to the high point of their recent range in the weeks and months ahead because: (1) economic data is likely to be more buoyant than the market believes; (2) investors are almost universally pessimistic and have already reflected that in their portfolios; and (3) our technical research team s study of four-year cycles suggests that we are in an environment where near-term volatility will likely give way to an upside trend somewhere towards the end of the year. Fixed-income markets > The summer rally in U.S. and Canadian 10-year government bonds has pushed yields below 3%, levels we view as unsustainable given our economic outlook. Fundamental and technical indicators suggest rates may be poised for a reversal, but the timing and extent of any move higher in yields will continue to be driven by economic data and levels of investor risk aversion. Asset allocation > We continue to believe that equities will outperform in the year ahead, both on an absolute basis and relative to the low hurdles set by bonds and cash. We do not yet believe we are in an environment where the odds favour a blanket approach to taking on more risk than set out in an investor s long-term strategic asset allocation. For those with extra cash on hand, we see potential in the months ahead to add to equities at attractive levels. PORTFOLIO STRATEGY RBC DOMINION SECURITIES

3 Market Performance The performance of global equity markets was marked by meaningful divergence year-to-date. The resource-weighted S&P/TSX Composite remains a bright spot, aided by a relatively more constructive economic outlook in Canada and the benchmark s substantial exposure to precious metals. Additionally, small-cap leadership has been evident in 2010, with the TSX Small Cap Index outperforming the TSX 60 by a margin of 580 basis points. In stark contrast, major U.S. indices endured a volatile August in the wake of a series of underwhelming economic data points: existing home sales, consumer confidence and initial jobless claims. The Asian bourses were notable underperformers on a relative basis. In the commodities complex, natural gas was the greatest laggard, tumbling over 20% in August alone, as the abundance of supply and persistently high storage levels continue to depress its near-term outlook. Precious metals have been a source of consistent outperformance all year, as investors seek alternative investments amid heightened concerns over moderating global growth forecasts and debates over a deflationary scenario in the U.S. economy. The Japanese yen has exhibited strength in recent months, up over 2% in August, while the U.S. trade-weighted dollar has also recovered some ground, reversing its downtrend during the summer months. Relative to the U.S. dollar, the euro and British pound have depreciated by 11.5% and 5.1%, respectively, year-to-date. Index YTD* S&P % DJIA -4.0% Nasdaq -6.8% S&P/TSX Composite 1.4% S&P/TSX % Nikkei % FTSE % Shanghai Composite -19.5% Commodity WTI Crude oil -13.7% Natural gas -35.3% Heating oil -10.3% Gold 13.7% Silver 14.7% Platinum 4.0% Copper 1.1% Zinc -19.6% Currency, relative to U.S. dollar U.S. dollar index (trade-weighted) 6.9% Canadian dollar 1.2% Euro -11.5% Japanese yen 9.5% British pound -5.1% Australian dollar -0.8% Swiss franc -1.9% South Korean won 3.0% Source: Bloomberg * Returns based on simple price appreciation as of August 31, 2010; charts indexed to 100 as at January 1, Index returns YTD* 115% 105% 95% 85% 75% S&P 500 S&P/TSX Composite NASDAQ Shanghai Composite Nikkei 225 FTSE % Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Commodity returns YTD* 120% 108% 96% 84% 72% Gold Silver Platinum Copper Crude Oil Natural Gas 60% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Currency returns YTD* 115% 107% 99% 91% 83% U.S. Dollar Index Canadian Dollar Euro Japanese Yen British Pound Australian Dollar 75% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 3

4 Market Update Various markets have produced conflicting signals over the past few months. On the one hand, most equity markets sank as expectations emerged for a much slower second half for both the economy and earnings. Bond markets for their part went well beyond that, pricing in both a double-dip recession and an imminent onset of deflation. At the other extreme, copper prices, some emerging market equity indices and more recently oil all regained their footing and pushed higher apparently in anticipation of a reacceleration in the economies of China and greater Asia. Is this what half speed feels like? These conflicting messages are indicative of a significant amount of noise emanating from the economic data. Given our long-held expectations of a transition to what can best be described as a half-speed recovery in the year ahead, it is not surprising to witness multiple data series providing conflicting readings. Our analysis of this data arrives at the following conclusions: For the U.S., the more positive tone to recent data releases provides comfort that the probability of a double-dip recession remains low (see chart 1). Buoyed by decent income gains, consumers are growing their expenditures at a 2% clip and evidence suggests employment will continue at a slow, if unsatisfying, grind higher. Strong financial positions and profitability leave corporations in good shape to offset, by way of capital spending, some of the fading effects of fiscal stimulus and inventory replenishment. On balance, there is enough fuel to support positive GDP growth, but the fragile state of the recovery and longer-term structural challenges including large government deficits and the slow process of consumer deleveraging suggests that growth will remain well below its longer-term trend for some time. Outside of the developed world (U.S., Europe, and Japan), prospects appear brighter. Heavy cash inflows and low global interest rates have created highly supportive conditions for domestic demand growth in a number of emerging market economies (see charts 2-4). Of particular importance, recent Chinese data suggest that authorities have so far been successful in orchestrating a soft landing of the economy while reining in some of the excesses in the real estate market. JP Morgan Economics forecasts growth in the emerging market economies of 5.6% in 2011, versus just 1.9% for the developed economies. As long as the U.S. avoids a descent into outright recession, as we expect, the global picture remains constructive, with positive implications for commodity-producing countries such as Canada. The Japan comparison rears its head again Falling bond yields during the month of August once again provoked concerns about the prospects for deflation and comparisons with the lost decade in Japan. A number of similarities exist: excessive leverage and declining asset prices have triggered an impulse amongst businesses and consumers to hoard cash and pay down debt, muting the impact of lower interest rates. However, our U.S. Fixed Income team has noted a number of important differences. U.S. wage growth (an important driver of both inflation and consumer spending) is running at 2-3 times the average of the Japanese experience in the past two decades, overcoming a stagnant employment environment owing to strong gains in productivity. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 4

5 This is partially attributable to a substantial difference in labour force demographics (see chart 5). Most importantly, expectations are a significant determinant of the outlook: a deflationary mindset becomes self-fulfilling once populations begin to modify their behaviour in anticipation of falling prices. Japanese policy makers delayed taking decisive stimulative action long enough to allow such a mindset to sink in and take hold. By contrast, the Fed s actions, though by no means providing a silver bullet, appear to have been both swift and significant enough to keep expectations for positive inflation firmly in place as evidenced by various consumer and business sentiment surveys, as well as pricing in the U.S. TIPS market (see chart 6). Chart 1: NY Fed sees low probability of double-dip Source: NY Fed Chart 2: Global growth contributions Source: IMF All told, there are enough similarities that would lead us to draw a number of observations applicable to investors today: Deleveraging, high unemployment and depressed housing prices imply growth will remain below its potential for an extended period of time, with ongoing potential for periodic deflationary scares. Chart 3: Global domestic demand growth Source: IMF Chart 4: EM equity and bond fund flows Source: EPFR Inflation is likely to remain benign for the foreseeable future despite aggressive reflationary monetary policy. Policy rates and bond yields will likely remain low until evidence of increased demand for credit and bank lending emerges alongside rising house prices and employment. Until this happens, equity markets are likely stuck in a wide trading range. Within this range, there is ample room for bull and bear markets triggered by changes in policy, PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 5

6 Chart 5: Divergence in population trends between U.S. / Japan Chart 6: U.S. inflation expectations Source: Haver, RBC CM Source: University of Michigan, RBC CM investor positioning and traditional business cycle influences. Unusually, when viewed against historical experience, rising bond yields in this instance would be seen as positive for equity markets. Quality growth assets those that offer a combination of predictable earnings growth, yield and quality will remain in high demand. Forecast updates Softer economic data has led our economists to make a number of forecast revisions: RBC Economics lowered its U.S. growth outlook by 0.4% for 2010 and 2011 to 2.7% and 3.0% respectively. Canadian growth forecasts have been trimmed by 0.3% to 3.3% in 2010, and 3.2% in Our outlook for 10-year government bond yields has been revised down to 2.75% for year-end 2010 and 3.25% by mid-2011, down 35 and 50 basis points respectively. Expectations of Fed rate hikes have been pushed out to the third quarter of 2011 at the earliest. The Bank of Canada is likely to take a break until March of 2011 as it watches events unfold outside its borders. RBC CM forecasts S&P earnings at $74 for 2010 and $85 for 2011 implying earnings growth of 20% and 15% respectively, but below street consensus of $84 and $96 respectively. The RBC Investment Strategy Committee maintains one-year targets of 1,250 for the S&P 500 and 12,750 for the S&P TSX. Asset allocation remains unchanged We continue to believe that equities will outperform in the year ahead, both on an absolute basis, and relative to the low hurdles set by bonds and cash. We do not yet believe we are in an environment where the odds favor a blanket approach to taking on more risk than set out in an investor s long-term strategic asset allocation. For those with extra cash on hand, we see potential in the months ahead to add to equities at attractive levels. Equity markets Equity markets remain attractively valued from a longer-term view as illustrated by the RBC Investment Strategy Committee s valuation models (see charts 7, 8). However, in the current environment, these valuations imply reluctance by investors to pay the historical going rate for earnings given the complexity of the challenges faced by developed world economies. Current readings of key leading indicators continue to suggest only modest prospects for the year ahead. A near-term challenge for equity markets is that moderating growth in earnings has yet to filter into analyst estimates, reflecting the tendency to overestimate earnings at the top of an economic cycle and underestimate them at the bottom. For those with idle cash, we see potential opportunities to add equity exposure over the months ahead: We expect economic data will ultimately provide evidence of enough strength to thwart serious risk of a double dip and support continued growth of corporate earnings. Paradoxically, a more negative economic outcome in the near term would increase the odds of further quantitative easing by the Fed. Such a move, while not a long-term remedy in and of PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 6

7 Aug '10 Range: (Mid: 1353) Aug '11 Range: (Mid: 1666) Current (31-Aug-10): 1049 Chart 7: S&P 500 equilibrium Source: RBC Asset Management 65 Normalized Earnings & Valuations Chart 8: S&P/TSX Composite equilibrium Aug '10 Range: (Mid: 13761) Aug '11 Range: (Mid: 13470) Current (31-Aug-10): Source: RBC Asset Management Normalized Earnings & Valuations itself, would likely be very supportive of markets were it to occur. Investors have by and large committed themselves to a negative outlook, suggesting the risk of surprise is likely biased towards the upside. Funds flows have heavily favored bond funds over the past year, with some of the money coming from equities. Investor sentiment data as recently as August were at depths not seen since the March 2009 lows, despite the equity markets being largely flat for the year. For tactical insights, we often turn to our Trend & Cycle technical research team, which currently views the market as transitioning between the end of one four-year cycle and the beginning of a new one in the months ahead. These cycles often conclude with some weakness followed by a more sustainable cyclical upswing. We remain alert to the potential buying opportunity that the commencement of such a cycle would represent. Fixed income markets U.S. and Canadian 10-year government bond yields, at less than 3%, recently touched what we view as unsustainable lows given our economic outlook, although we have also lowered our interest rate forecasts. Were they to move back above 3%, bonds would be appropriately priced when viewed against the backdrop of today s inflation and monetary policy, however at those levels they would provide very little protection should economic growth revert to its long-term trend in the years ahead. Of course, were the economy to perform worse than we expect, buying bonds issued by trustworthy governments (a.k.a. Canada) would deliver worthwhile returns. The 3-4 year maturity area strikes us as offering the most attractive tradeoff between price volatility and yield. However, we would also avoid the temptation to own only short-term bonds. A core ladder of 1-10 year bonds with an overweight 3-4 year position makes sense to us. Corporate bond spreads have become more attractive by historical standards and provide some degree of protection from rising rates. That said, the greatest value can be found in the high-yield sector, which is most effectively accessed through bond funds or ETFs. Investment strategies Year to date, equity markets have continued to trade in a range bracketed by the April highs and July lows, with the direction largely set by economic data surprises. At this juncture, upswings tend to favor the cyclically sensitive sectors of the markets (materials, industrials, consumer discretionary and financials), while downswings heavily favor those investments most likely to retain value in a deflationary environment (government bonds, health care, utilities, consumer staples). The lack of short-term visibility provides a challenging backdrop for investors hoping to anticipate the timing of rapid market shifts. With that in mind, we offer below some proven longerterm strategies that seem particularly well-suited for the current market environment: The quality growth theme. In a market where investors are no longer rewarded just for showing up, there exist many companies that manage to create wealth for their shareholders. They are ones that can reliably deliver earnings growth through market share gains, industry leadership, standard-setting technologies and products and oligopolistic market structures. RBC CM notes that we are currently in that part of the market cycle where these companies are favored by investors seeking a balance between growth and predictability (see chart 9). Our Canadian Focus List is currently positioned to provide a balance between these themes. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 7

8 16 15 Chart 9: Recommended style bias over the business cycle Stability * Present. Fundamental Momentum Traditional Value We are here Quality Growth Chart 10: Mega-caps attractively valued X Source: RBC CM Source: RBC CM Dividend stocks. A complementary strategy to the quality growth theme puts an emphasis on companies that can deliver sustainable and growing dividends. This offers a suitable strategy for all environments, but particularly for conservative to moderate investors seeking a combination of reduced volatility and growth in the current environment. Our Equity Income Focus List looks to include companies that meet these criteria. An important consideration for investors following such an approach is to realize that it is too easy for a dividend portfolio to inadvertently become overweight the traditional dividend-paying sectors of the market such as financials, utilities, telecoms and energy while building in little or no exposure to some important sectors like technology and basic materials (including mining) that typically pay no dividends. Investors should be aware that being underweight these latter sectors, which can account for some 25% of the total S&P/TSX Composite Index, will cause material differences between their portfolio returns and the broader index on a quarter-to-quarter basis. U.S. companies selling to emerging market consumers. While the deflationary impulse is greatest in the U.S., there are many largecapitalization U.S. companies that derive a disproportionate share of their revenue from consumers in the emerging markets and other countries experiencing greater domestic economic growth and consumer activity. In addition, RBC CM notes that within the S&P 500, the mega-cap companies (those in the top 20% by market capitalization) are amongst the most attractively valued, both relative to historic norms, and relative to their peer group (see chart 10). Our U.S. Focus List offers a number of ideas that aim to exploit these themes. While conflicting economic data is creating a great deal of noise for investors, in filtering this noise, we believe that in the year ahead, we will find ourselves in a restrained, yet positive economic environment where the risk of a double-dip recession remains low, and in which investors can find long-term investment opportunities Q1 Q2 Q3 Q4 Q5 Median Fwd P/E (S&P 500 Q1 = Largest Mkt Cap) Long-term Average * Ranked by Quintile PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 8

9 The Global Economy The outlook remains split between developed and emerging economies, the former hobbled by ongoing deleveraging, high unemployment and prospects for only muted growth. By contrast, the outlook for emerging economies appears much brighter based on growing domestic demand and lower leverage amongst consumers and governments. JP Morgan Economics forecasts growth in the developing nations of 5.6% for 2011 versus 1.9% for the developed nations. Every country is fighting for an increased share of the global export pie. One consequence is that while the U.S., Japan, and to a lesser extent the eurozone are pursuing aggressive monetary policies to combat risk of deflation, other countries are adopting similarly stimulative policies in order to prevent their currencies from appreciating. A case in point is the recent intervention by the Japanese to halt the rise in the Yen in order to protect the profitability of their export sector. Another is Canada, which is likely to hold off on further rate hikes for a few quarters given the potential damaging impact of a strong Canadian dollar on exports to the U.S. Increasingly, this calculus is affecting monetary policies in the emerging nations, creating ample liquidity in many economies, which are already operating at or above their long-term growth rate. Thus, while deflation remains the risk in the Western economies, rising inflation may become a risk everywhere else. Chart 1: ISM services and manufacturing employment Source: Haver, RBC CM While service-sector employment continues to straddle the breakeven point, its manufaturing counterpart remains at cycle highs. Chart 3: Real weekly earnings Source: Haver, RBC CM While job growth has been modest to say the least, those that are employed are witnessing robust real earnings growth Chart 2: U.S. fiscal and inventory support -2 Q Q Q Q Q Q Q Q Contribution to U.S. GDP: Percentage points, quarterly annualized rate Source: RBC Economics, Macroeconomic Advisers Stimulus Impact Change in Inventories Impact on GDP Growth As fiscal and inventory support begins to fade, the corporate and consumer sectors are expected to fill the gap. Chart 4: Real exports of goods and services Source: Haver, RBC CM Source: Haver, RBC CM Exports are now back to levels that existed prior to the onset of the recession. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 9

10 Chart 5: U.S. gross domestic investment as % of GDP Source: RBC CM, BEA The U.S. Key barometers continue to foreshadow moderating growth and the recovery has been slow to extend from manufacturing to the services sectors of the economy (chart 1). The positive effects of fiscal stimulus and inventory replenishment are abating and will likely turn negative in 2011, leaving the corporate sector and consumers to fill the gap (chart 2). The latter seems to be happening but more slowly than previously expected, making it likely that growth in the quarters immediately ahead will be somewhat softer than forecast Source: RBC Capital Markets, BEA Jan-47 Jan-52 Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Gross Private Domestic Investment as a % of GDP Depreciation as a % of GDP Investment spending is now only at an historically low ebb as a share of GDP, but it is running below replacement rate. Chart 6: Canadian real exports of goods & services Source: Haver, RBC CM That said, fuel for positive growth exists; employment continues to grind slowly higher, while real weekly earnings (a combination of pay rates and hours worked) are running at a 2.6% annual rate (chart 3), all of which supports our expectations that consumers will continue to grow their expenditures at above 2%. Exports (chart 4) have also regained their footing; our economists note that nearly 25% of the S&P 500 companies derive more than half of their revenues from non-u.s. sources. Finally, the corporate sector remains highly profitable and flush with cash, but has maintained a below-average rate of investment in its capital stock (chart 5). Housing remains weak, but its importance to the U.S. economy has shrunk to the point that further weakness would have little impact on GDP growth. According to the latest RBC Consumer Outlook, fully 75% of homeowners anticipate either no change or further declines in house prices. That will continue to keep a lid on consumer optimism but not enough to obviate the growth in wages and salaries noted above. U.S. monetary authorities have noted that core inflation, recently running at an annual rate of 0.9%, remains below levels consistent with the Fed s mandate, suggesting additional quantitative easing is in the works, possibly before year end. Fate of Canadian exports linked to U.S. domestic demand. Canada Q2 GDP decelerated markedly to a 2.0% annual rate from 5.8% in Q1. A closer look reveals a slightly more positive picture as much of the decline came from a rise in imports that is related to a 40% surge in imports of machinery and equipment for industry, somewhat obscuring the fact that domestic consumption forged ahead at a 3.6% clip. Looking forward, there is evidence of moderation in economic activity; home sales and prices appear to have peaked, consumer activity softened in the summer, and a diminished outlook for the U.S. economy raises the prospects for weaker exports. Headline inflation took a small jump upwards in the wake of the introduction of the HST in B.C. and Ontario, however core inflation, at 1.6%, remains below the Bank s 2% target and capacity utilization remains well below average. Against this backdrop, markets are divided on the prospects of further rate hikes by the Bank of Canada on October 19. While Canadian monetary policy is still regarded as being at emergency settings, we believe the Bank will pause for the remainder of the year and through the first quarter of 2011 to reassess the impact of its rate hikes to date and monitor developments abroad. Europe Second-quarter real GDP grew at a 4.0% annualized rate, however the headline figures do not tell the whole story. Germany was the area s growth leader posting a 9.0% annualized increase. More impressive is that while exports have been a driver of German growth earlier in the year, domestic demand has also risen smartly, PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 10

11 reflecting strong employment gains and buoyant domestic sentiment. On the other side of the coin, many countries on the periphery continued to contract, with Greece recording a 5.8% annualized decline in the quarter and Portugal s economy shrinking at a 3.6% pace. More recent data suggest this two-tiered dynamic will continue to play out and that growth for the eurozone as a whole is likely to converge towards U.S. levels with a bit of a lag. Given the uneven pace of growth within the region, the ECB is likely to keep its policy rate steady until late 2011 when the effect of scheduled fiscal tightening across the eurozone is better understood. Japan Q2 growth moderated to a 1.5% pace from 5% in Q1 with exports and business investment remaining the primary growth engines. Going forward, JP Morgan Economics forecasts no imminent recession for Japan but a succession of weak quarterly results. Yen appreciation, weak equity markets and an uncertain global environment are all contributing to these revised expectations. JP Morgan anticipates that Japanese authorities will instigate further monetary stimulus in the months ahead. China Having linked their currency to the U.S. dollar, the Chinese have effectively imported stimulative U.S. monetary policy, which has been supportive of growth, but has also triggered speculative activity, particularly in the housing market. In response, authorities have focused on targeted actions specific to the property markets while avoiding large-scale rate hikes or currency appreciation. To date, these measures appear to be having the desired effect, with growth moderating but likely to hit 8.8% in 2011, just above the level required to maintain steady employment. Inflation, having risen above the central bank s 3% threshold due to rising food prices, makes it likely that monetary policy will feature gradually rising interest rates and currency appreciation in the year ahead. The key risk to the outlook remains the performance of the export markets. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 11

12 Equity Markets Lingering economic uncertainty continues to put pressure on equity valuations, with price/ earnings ratios remaining well below historical averages. The S&P 500 and S&P/TSX are now trading at 11.7x and 13.3x consensus 2011 earnings respectively, levels which appear to be discounting a significant moderation in economic growth. The RBC Investment Strategy Committee s longer-term valuation framework continues to suggest that a return to normalized valuations would yield significant upside from current levels. Earnings expectations remain elevated in the face of deteriorating macro data and are likely to represent a high hurdle that may prove difficult to reach. Margin expansion has been a key driver of the strong surge in earnings over the past year but the pace of expansion from that source will slow considerably over the next six months. The primary thrust for revenues is also starting to wane as global leading economic indicators continue to moderate. RBC CM s earnings model currently points to annual growth rates of 21% for 2010 and 15% for 2011 for the S&P 500, which are high by historical standards but substantially below those forecast by the bottom-up analyst community. For S&P/TSX earnings, the model suggests growth rates of 17% and 11.5% for 2010 and 2011 respectively Aug '10 Range: (Mid: 1353) Aug '11 Range: (Mid: 1666) Current (31-Aug-10): 1049 S&P 500 equilibrium 65 Normalized Earnings & Valuations Valuations are well below long-term equilibrium levels. S&P/TSX Composite earnings expectations Source: RBC GAM Source: RBC CM S&P 500 earnings expectations RBC CM s earnings forecast implies annual growth rates above historical standards but well below those offered by the bottom-up analyst community. Price-to-forward earnings and VIX Source: RBC CM Source: RBC Capital Markets Quantitative Research, Haver Analytics, CBOE In periods of elevated uncertainty, companies perceived as offering quality and predictability tend to come into favor. These are typically ones that can reliably deliver earnings growth through market share gains, industry RBC CM s earnings forecast implies annual growth rates above historical standards but well below those offered by the bottom-up analyst community. The market P/E remains inversely correlated to the level of expected volatility. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 12

13 leadership, standard-setting technologies or products and oligopolistic market structures. A complementary strategy to this quality growth theme puts an emphasis on companies that can deliver sustainable and growing dividends. This offers a suitable strategy for all environments, but particularly for conservative to moderate investors seeking a combination of reduced volatility and growth in the current environment. RBC consensus estimate revisions index and Global PMI Source: RBC CM Quantitative Research, ISM Bond yields and P/E multiples Source: RBC Cm Quantitative Research Recent non-cyclical sector leadership (staples, telecoms, utilities) will probably be caught wrong-footed if government bond yields start to back up. However, the more lasting message from the leading macro data encourages us to maintain a bias toward equity sectors with relatively low leverage to the economic outcome. Downward revisions to consensus sell-side earnings estimates appear likely given the deterioration in global leading economic data. The commonly expected inverse relationship between bond yields and P/E multiples breaks down as Treasury yields move substantially below 5%. S&P 500 forecast and subsequent market return Source: RBC CM Quantitative Research There is an inverse relationship between the strength of yearahead forecasts and subsequent stock market performance based on the last 30 years of data. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 13

14 Canadian Sector Scorecard U.S. Sector Scorecard Sector Weighting RBC Focus List Sector Weighting RBC Focus List Financials (29.0% recommended vs. S&P/TSX weight of 29.1%) Banks remain well positioned to handle the lagged impact of challenging 2009 economic conditions on loan losses, while indicators of future profitability continue to trend in the right direction. Visibility around the lifecos remains limited but valuations now suggest more limited downside risk from current levels. Bank of Montreal (BMO); National Bank (NA); TD Bank (TD); Brookfield Asset Mgmt (BAM); Royal Bank (RY); Sun Life (SLF) Financials (16.0% recommended vs. S&P 500 weight of 16.1%) Sentiment is weak in the aftermath of a regulatory reform bill that became law in July. Capital adequacy is less of a concern, and credit conditions continue to improve. However, revenue outlook remains challenged by thin net interest margins, weak loan demand, and volatile capital markets businesses. Favor franchises that can deliver strong normalized earnings potential. Bank of America (BAC); CME Group (CME); PNC Financial Services Group (PNC) Utilities (2.0% recommended vs. S&P/TSX weight of 1.7%) Valuations are elevated but look less challenging during a prolonged period of low bond yields. While the focus list does not have a position in the sector, Enbridge, which is categorized as Energy but has utility-like characteristics, mimics the exposure. None Utilities (3.0% recommended vs. S&P 500 weight of 3.7%) Sector offers attractive attributes such as above-average dividend yields and relative earnings resiliency, particularly from regulated businesses. Power demand, particularly from industrial customers, has shown some signs of recovery. Edison International (EIX) Telecom Services (4.0% recommended vs. S&P/TSX weight of 4.7%) Incumbents have so far demonstrated their ability to maintain margins in a difficult environment despite the entrance of new wireless competitors. Earnings outlook might be bottoming according to recent estimate revisions trends. Low leverage to the economic cycle offers performance stability, while valuations and dividend yields are attractive. BCE (BCE) Telecom Services (3.0% recommended vs. S&P 500 weight of 3.1%) Wireless landscape remains very competitive while wireline businesses face secular challenges. Select opportunities do exist within the tower infrastructure companies as secular themes, such as mobile data usage, continue to play out. American Tower (AMT) Consumer Discretionary (6% recommended vs. S&P/TSX weight of 4.7%) Favour media companies over more consumer-focused businesses. Since the Canadian market offers limited opportunities in the sector, we recommend investors consider U.S. alternatives. Thomson Reuters (TRI) Consumer Discretionary (10.5% recommended vs. S&P 500 weight of 10.2%) Favor media companies over more consumer-focused businesses that appear to reflect high expectations of a rebound to consumer spending. Media should benefit from improvements to ad spending as companies become more comfortable with the outlook. Viacom (VIA.B); McDonald s (MCD) Consumer Staples (3.0% recommended vs. S&P/TSX weight of 2.7%) Most names in the sector offer stable growth prospects and strong balance sheets, while valuations remain above their historical norm. The sector is often used as a source of funds during market recoveries. Metro (MRU.A) Consumer Staples (12.5% recommended vs. S&P 500 weight of 11.5%) Sector offers strong international growth opportunities, relative stability, and above average dividend yields. Organic volume growth may prove challenging but valuations appear appropriate. Colgate (CL); Kraft (KFT) Healthcare (1.0% recommended vs. S&P/TSX weight of 0.6%) Lack of visibility is a recurring theme for the sector. Investors should look to the U.S. market for more broad-based group of names. None Healthcare (11.0% recommended vs. S&P 500 weight of 11.8%) Overhang of healthcare reform is subsiding but investor sentiment remains poor due to lower U.S. utilization of healthcare and concerns over European price cuts. Valuations remain attractive. Medco Health (MHS); Amgen (AMGN) Industrials (5.0% recommended vs. S&P/TSX weight of 5.8%) Sector remains attractively valued with the potential to disproportionately benefit from an economic recovery. Rail stocks offer particularly attractive upside potential. CP Rail (CP) Industrials (11.5% recommended vs. S&P 500 weight of 10.6%) Sector offers exposure to global economic recovery. Favor businesses with mid-cycle exposure, end markets where activity levels remain strong, and companies that have levers that can drive earnings growth. United Technologies (UTX); Union Pacific (UNP) Technology (4.0% recommended vs. S&P/TSX weight of 2.4%) Prospective profitability metrics have recently rebounded and the sector stands to benefit from a strengthening global tech spending cycle. The U.S. market offers a greater number of opportunities in the sector. Research In Motion (RIM) Technology (19.0% recommended vs. S&P 500 weight of 18.5%) Demand trends have improved among data centers and enterprise customers, driving strength in storage and networking. Semiconductors and PC-related hardware may be vulnerable to softness in second half of the year. Product momentum remains strong in select areas of hardware and software. Hewlett Packard (HPQ); Cisco Systems (CSCO); Microsoft (MSFT); EMC (EMC) Materials (21% recommended vs. S&P/TSX weight of 22.7%) Powerful policy stimulus and the economic recovery should remain key supports for the sector, but a peak in leading indicators suggests more volatility ahead. Barrick Gold (ABX); Goldcorp (G); Potash (POT); Teck Resources (TCK.B) Materials (3.5% recommended vs. S&P 500 weight of 3.5%) The outlook for the sector is mixed with continued signs of expansion in emerging markets offset by concerns about slower growth in the developed world. Nevertheless, continue to favor more cyclical areas of the sector that offer leverage to emerging market demand, including copper and iron ore. Freeport McMoRan (FCX) Energy (25% recommended vs. S&P/TSX weight of 25.6%) A profitability upturn on the back of oil price strength maintains our interest. Earnings estimate revisions are lagging the commodity price move. EnCana (ECA); Arc Energy (AET.UN), Suncor (SU); Canadian Natural Resources (CNQ); Enbridge (ENB) Energy (10.0% recommended vs. S&P 500 weight of 11.0%) The outlook for the sector is mixed, with the risk of slower growth in the developed world offset by rising consumption in emerging markets. Focus on strong operators with a track record of delivering returns and being disciplined with their use of capital. Prospects for natural gas remain mixed with inventories that remain elevated while demand in the U.S. remains muted. Occidental Petroleum (OXY); Schlumberger (SLB) PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 14

15 Interest rates Today s ultra-low interest rates are pricing in a very pessimistic outlook for the economy and offer scant protection from any upside surprise in the economic data. This leaves government bond investors susceptible to mark-to-market losses if rates were to move higher in response to even a modest improvement in sentiment. Accordingly, a shorter-than-average maturity profile may be appropriate. The five-year bond has outperformed with investors drawn to what had been attractive valuations and strong return potential if yields were to remain unchanged, as the continuation of a steep yield curve would augment interest income with capital gains. However, we think the outperformance of the five-year is now largely behind us. Given the likelihood that rates will move at least somewhat higher in the coming months from today s extreme lows and the fact that yields are generally inadequate right across the maturity spectrum, we have identified the 3-4 year range as offering the greatest protection from rising rates while limiting interest rate risk. Fixed Income Market year TSY and 10-year GOC 10-Yr TSY 10-Yr GOC Source: Bloomberg 2.0 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Yield (%) Market expectations: Bank of Canada / fed funds rate Market Expectations September 8 Fed Funds Market Expectations April 20 Fed Funds Market Expectations September 8 BoC Market Expectations April 20 BoC Market not pricing in a full Fed Funds hike until March Source: Bloomberg 0.0 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Bond portfolio scenario analysis Portfolio 2-year bond 5-year bond 10-year bond 1-5 year ladder 1-10 year ladder 2/10 barbell* Yield at inception 1.49% 2.25% 2.96% 1.78% 2.24% 2.24% Rates fall to late 2008 levels 2.04% 5.36% 6.98% 3.29% 4.89% 4.57% No change 1.66% 3.15% 4.15% 2.25% 2.99% 2.93% RBC forecast 0.54% -1.21% -2.99% -0.11% -1.26% -1.26% Rates rise 1% 0.72% -0.69% -3.03% 0.26% -0.89% -1.19% Rates rise 2% -0.20% -4.35% -9.62% -1.66% -4.53% -5.01% Source: Bloomberg * 2/10 barbell consists of a 50/50 combination of 2-year and 10-year Government of Canada bonds Government bond yields are near the lows of their well-defined trading range of the past year, and our scenario analysis indicates that longer-term portfolios will post negative returns should RBC s interest rate forecasts play out. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 15

16 Corporate spreads The yield spread between corporate bonds and governments has increased along with renewed economic concerns. Investors have opted for the safety of government debt, pushing government yields lower while corporate yields have lagged. Despite what we see as uninspiring total returns potential, a moderate allocation to corporate debt is warranted as the extra income and potential for credit spread tightening typically provide a shock absorber to rising government bond yields. High-yield debt remains one of the few areas where yields are attractive on both an absolute and relative basis as corporate defaults have slowed to a trickle. So long as nominal economic growth remains positive and refinancing conditions attractive, default rates are likely to stay low allowing more issuers to refinance without difficulty. While this market is a complex one for individual investors to access directly, ETFs offer broad diversification and the liquidity of a listed security, while bond funds offer similar diversification and professional management of credit risk. 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% Yield pickup by extending term for one year Sweet Spot Source: Bloomberg 1Y 2Y 2Y 3Y 3Y 4Y 4Y 5Y 5Y 6Y 6Y 7Y 7Y 8Y 8Y 9Y 9Y 10Y Each bar represents the additional yield gained by investing for one additional year i.e. buying a three-year instead of a twoyear results in 23 bps of extra yield. 12.0% 10.0% 8.0% U.S. BB credit spreads 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Canadian A credit spreads Source: Bloomberg 0.0% Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 High-quality credit spreads are well off their crisis highs, and after reaching expensive levels earlier in 2010 now sit at reasonable valuations in the context of a slowly growing economy Canadian A five-year yields 6.0% % % 3 Source: Bloomberg 0.0% Sep-02 Jul-03 May-04 Mar-05 Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10 Source: Bloomberg 2.5 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 The high-yield bond market is one of the few areas where we see good value in the corporate bond market. High-yield spreads are well off their highs but also much higher than their average level, affording investors good protection from defaults, which have been falling sharply. Canadian five-year corporate bond yields recently touched generational lows as ultra low government bond yields are only partially offset by higher-than-average credit spreads. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 16

17 Preferred shares Preferred shares have been one of the main beneficiaries of investors thirst for tax-efficient income. Rate-reset preferred share prices have hit new highs (and yields new lows) reaching levels that make it difficult to consider this category for new money. The demand for highyielding securities has also caused average perpetual preferred share prices to rally to their best levels of Although these securities appear to be appropriately valued when the extremely low level of government bond yields is taken into account, just like those bonds they would be susceptible to capital loss were rates to back up, perhaps more so given their lack of a maturity feature. (%) Source: Bloomberg Average rate-reset preferred bond equivalent yield Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Rate-reset preferred share valuations are now at the all-time high of their relatively short history. Many high quality issues now have yields-to-call under 3%, making further gains difficult to come by Average perpetual preferred price Source: Bloomberg 15 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Perpetual preferred share prices are at their highs of the year as investors broaden their horizon in the hunt for tax-efficient yield. Average perpetual preferred bond equivalent yield Average perpetual preferred bond equivalent yield spread (%) 9 (bps) Source: Bloomberg 200 Source: Bloomberg Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Perpetual preferred yields are at their 2010 lows, but are still higher than levels that prevailed pre-crisis due to higher-thanaverage credit spreads. Perpetual preferred share credit spreads are still at elevated levels, leaving the sector well-valued on a relative basis. A spike in government bond yields may lead to a round of profit taking, however. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 17

18 Currencies Data dichotomy starting to close? Source: RBC CM, Bloomberg Economic surprise indicators are beginning to converge as data in the rest of world play catch-up with the underwhelming U.S. data points in recent months. Prematurely pricing out rate hikes in 2011 Source: RBC CM, Statistics Canada, Haver U.S. Dollar The greenback lost ground to its peers in recent months as U.S. economic data generally surprised to the downside, in contrast to more positive dataflow for its peers. This development implicitly assumes a decoupling between prospects for U.S. growth and prospects for growth everywhere else, something that is unlikely, in our view. If pessimism on the U.S. economy proves overdone, then recent U.S. dollar weakness should reverse course in the months ahead. On the other hand, if downside surprises in the U.S. gather momentum, it is highly likely that the rest of the world will follow. Though we view the first scenario as the most likely, we would note that either outcome should see the U.S. dollar gain ground in the months ahead. Canadian Dollar Until recently, the Bank of Canada had been leading the move towards higher short-term interest rates, a situation that would eventually have led to a repeat of its brush with parity against the U.S. dollar. However, we believe the Bank of Canada is growing concerned about the impact of a strong Canadian dollar on Canadian exports into a softening U.S. economy. This should leave it predisposed to bide its time and remain on hold until a clearer picture emerges we have penciled the next rate hike in March Such a pause might allow the loonie to revisit the bottom end of its recent trading range in the low US$0.90s before ultimately resuming its upwards climb as conditions stabilize over the next 6-12 months. Euro We expect challenges related to sovereign debt issued by peripheral eurozone nations will ultimately produce further euro weakness. The bulk of this move is likely to occur in early 2011 when a large portion of this debt comes due for refinancing and thrusts the issue back into the spotlight. In addition, by then investors will have a clearer picture of how well Spanish and Portuguese growth and budget forecasts are faring (our currency research team believes they are overly optimistic) and we will begin to see the effects of fiscal tightening by Germany, France and Italy, which are planning budget cuts totaling just over 1% of total eurozone GDP. Soft U.S. data and moderating indicators in Canada have dampened market expectations for Bank of Canada rate hikes in the next 12 months. Japanese Yen RBC s expectation is that the Yen will remain strong until such time as the U.S., eurozone and other nations begin the process of monetary tightening. Yen strength has caused the Japanese government to step into the currency markets, which may help dampen further appreciation, but is not likely to result in a meaningful reversal of its trajectory. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 18