Portfolio Strategy Quarterly

Transcription

1 Portfolio Strategy Quarterly A publication for the private clients of RBC Dominion Securities Winter 2011 Professional Wealth Management Since 1901

2 Table of Contents Executive Summary 3 Market Performance 5 Global Scenario Analysis 8 The Global Economy 10 Equity Markets 12 Canada/U.S. Sector Scorecard 13 Fixed Income Markets 15 Currencies 16 Economic and Capital Markets Forecast 17 Asset Mix 18 Canadian Focus List Update 20 Canadian Focus List 24 US Focus List Update 26 US Focus List 30 Research Resources The global economy > The outlook for the global economy in 2011 can be described as mixed but on balance positive. Evidence that a sustainable recovery is developing in the United States coupled with robust growth in developing nations is expected to offset risks elsewhere. Expectations for U.S. growth reflect encouraging economic data, stimulative monetary policy, and recently enacted tax cuts. While policy makers in developing nations will continue to balance additional growth against the risks of higher inflation, there are few signs of over heating in most economies. Europe will remain a key risk in 2011 as policymakers try to follow through on austerity measures without choking off regional growth. Equity markets > Following a period of heightened uncertainty largely associated with double dip concerns, equity markets have been propelled higher by better-than-expected economic growth, attractive valuations and corporate earnings momentum. With data pointing to an ongoing economic recovery in the U.S. and China, solid trends in corporate earnings, attractive valuations and positive multi-year technical indicators, we remain overweight equities. Fixed-income markets > Following the November 3 announcement by the Federal Reserve that it intends to purchase $600 billion in U.S. Treasuries, 10-year government yields in the U.S. and Canada moved significantly higher, a classic sell the fact response as investors took profits. Rising interest rates in the months ahead may create opportunities for income-oriented investors. Corporate credit spreads have displayed renewed volatility, and while corporate debt will benefit portfolios in a rising rate environment as tightening of credit spreads will act as a shock absorber to higher yields, significant capital gains are now less likely. In preferreds, share price movements have moderated. Higher interest rates across the yield curve and an influx of high-quality rate-reset issuance has taken prices down from their 2010 highs set last month. Asset allocation > In our view stock markets enter 2011 with the wind at their back. The growth rate of the world s largest economy looks set to notch up to the 3% level driven by moderate employment growth, quantitative easing, and recent temporary tax cuts. Although the rally in stock prices since the summer has left most markets somewhat overbought in the near term, this improved economic and earnings backdrop suggests the full year should allow equities to deliver worthwhile, perhaps even generous, all-in returns. PORTFOLIO STRATEGY RBC DOMINION SECURITIES

3 Market Performance Global equity markets benefited from a strong rally in the second half of the year, aided by the second round of quantitative easing in the U.S. and stabilizing global economic indicators. North American indices are firmly in positive territory year-to-date, while Asian bourses have continued to lag their peers on a relative basis. The resourceweighted S&P/TSX Composite is up 10.3% on the year, with strength attributed to increased fund flows into the benchmark s substantial precious metals space. Additionally, small-cap leadership has been impressive in 2010, with the TSX Small Cap Index outperforming the TSX 60 by a margin of 16 percentage points. Major U.S. indices rebounded off year-lows, led by the technologyheavy Nasdaq index. In the commodities complex, natural gas remained the greatest laggard, tumbling over 35% year-to-date. The proliferation of unconventional natural gas development has led to persistently high storage levels, which continue to depress the outlook for natural gas. Precious metals have been a source of consistent outperformance all year, as investors seek alternative investments amid ongoing concerns over the Eurozone s fiscal woes and growing inflationary pressure in emerging economies. The Japanese yen has been the top-performing major currency year-to-date. The U.S. tradeweighted dollar has recovered to remain in positive territory for the year after facing selling pressure in recent months. Relative to the U.S. dollar, the Euro and British pound have depreciated by 11.2% and 3.8%, respectively, year-to-date. Index YTD* S&P % DJIA 5.5% Nasdaq 10.1% S&P/TSX Composite 10.3% S&P/TSX % Nikkei % FTSE % Shanghai Composite -13.9% Commodity WTI Crude oil -0.4% Natural gas -38.2% Heating oil 1.6% Gold 26.4% Silver 66.4% Platinum 13.1% Copper 13.0% Zinc -16.8% Currency, relative to U.S. dollar U.S. dollar index (trade-weighted) 4.3% Canadian dollar 2.5% Euro -9.3% Japanese yen 11.1% British pound -3.8% Australian dollar 6.8% Swiss franc 3.0% South Korean won 0.5% Source: Bloomberg * Returns based in local currency, simple price appreciation as of November 30, Index returns YTD* 20% S&P 500 S&P/TSX Composite NASDAQ Shanghai Composite Nikkei 225 FTSE % 0% -10% -20% -30% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Commodity returns YTD* 70% Gold Silver Copper Crude Oil Natural Gas Platinum 55% 40% 25% 10% -5% -20% -35% -50% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Currency returns YTD* 20% U.S. Dollar Index Canadian Dollar Euro Japanese Yen British Pound Australian Dollar 10% 0% -10% -20% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 3

4 Estimated value of investment in Canadian dollars assuming $100 initial investment. Figures do not include management fee or commission. 20% North American indices in Canadian dollar S&P 500 Nasdaq S&P/TSX Composite 15% MSCI indices in Canadian dollar MSCI World MSCI EAFE MSCI BRIC North American indices YTD* 15% 10% Mexican IPC Brazil Bovespa 10% MSCI World Small Cap MSCI Pacific X Japan S&P 500 $ % 5% Nasdaq $ % 0% S&P/TSX Composite $ % -5% Mexican IPC $ Brazil Bovespa $97.63 MSCI indices MSCI World $99.25 MSCI EAFE $94.35 MSCI BRIC $99.69 MSCI World Small Cap $ MSCI Pacific X Japan $ % -15% -20% -25% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10-10% -15% -20% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 European indices FTSE 100 $95.75 European indices in Canadian dollar Asian indices in Canadian dollar CAC 40 $81.08 DAX $ % FTSE 100 CAC 40 DAX IBEX 35 Euro Stoxx 50 30% Nikkei 225 Shanghai Composite Hang Seng S&P/ASX 200 S&P CNX Nifty IBEX 35 $ % 20% Euro Stoxx 50 $ % 10% Asian indices -20% 0% Nikkei 225 $ % -10% Shanghai Composite $85.62 Hang Seng $ % -20% S&P/ASX 200 $97.83 S&P CNX Nifty $ % Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10-30% Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Source: Bloomberg * Returns based in Canadian dollar and simple price appreciation as of November 30, PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 4

5 Global Scenario Analysis In our view stock markets enter 2011 with the wind at their back. The growth rate of the world s largest economy looks set to notch up to the 3% level driven by moderate employment growth, quantitative easing, and recent temporary tax cuts. That s good news for all other economies including Canada s. It also makes it highly likely corporate revenues and earnings will both add to the good gains delivered in the past year. Shares in North America are very reasonably-valued based on current earnings and quite attractive in relation to forward projections. Although the rally in stock prices since the summer has left most markets somewhat overbought in the near term, this improved economic and earnings backdrop suggests the full year should allow equities to deliver worthwhile, perhaps even generous, all-in returns. While this outlook for equities is quite constructive, it is important to acknowledge that the global economy faces an unusually high level of uncertainty. Most developed countries are struggling to generate sustainable growth following a fragile recovery and face significant challenges including high unemployment, excess capacity, and the effects of consumer deleveraging. Adding to these challenges, many European governments have opted for extreme fiscal austerity to quell the sovereign debt crisis. The exceptional measures taken by the Federal Reserve through its quantitative easing program may have alleviated fears of deflation, but bring longer-term risks that are difficult to quantify. Meanwhile, China s growing contribution to the global economy also poses a risk, particularly when one considers the centralized nature of the Chinese economy, the potential problems associated with large foreign fund flows, and lately the emergence of inflationary pressures and the use of unconventional methods to contain these pressures to avoid asset bubbles and maintain a steady growth trajectory. This backdrop suggests a wide range of possible outcomes, which are worth exploring in some detail. The following analysis looks at four global scenarios and the implications of each for different asset classes. Scenario 1 Base Case 45% probability China maintains growth leadership and manages to contain inflation while experiencing only a moderate slowdown. The US muddles through and generates positive but uninspiring growth. Our base case scenario is for a relatively mild global recovery by historical standards, as de-leveraging and spare capacity in developed economies limit the pace of growth. Under this scenario, China orchestrates a soft landing of its economy without hitting any major speed bumps, while the US economy muddles-through and manages to generate growth averaging a below-potential 2-2.5% per annum for several years. Monetary policy would likely remain highly accommodative in developed economies and start to gradually normalize early in Emerging markets would continue to outperform, but by a smaller margin. Returns delivered by Canadian and US equity performance would converge. Bond yields would likely move back up to somewhat above fair value. Monetary Policy Bond Yields Currencies Commodities EPS Growth P/E Stocks Gradually normalized starting early in bps $US long bottoming process, $CAD par +/- 10 cents. Plateau short of peak levels but high enough to justify new project investment % 15X forward All-in returns of 9-12% PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 5

6 Scenario 2 Change in Leadership 25% probability Chinese economy hits speed bump. U.S. generates reasonable growth and offers relative stability. This is perhaps the most overlooked scenario, but one that warrants attention. The strong performance of the Chinese economy over the past several years has pushed consensus firmly into the camp expecting continued strong growth with minimal turbulence going forward. These expectations appear to be reflected in the price of commodities and other assets for which demand is highly dependent on Chinese growth. As inflationary pressures intensify, measures to slow portions of the Chinese economy in order to contain price increases and prevent a bubble in the property market could lead to a significant reduction in lending and construction activity that may not be offset by the rest of the economy. Under this scenario, expectations for China would be adjusted to reflect a bumpier and more uneven growth trajectory. The global economy would be affected, but US markets would offer relative stability and the US dollar would likely appreciate. Emerging markets and commodities would be particularly vulnerable under such a scenario. Canadian equities would underperform and the Canadian dollar would correct. Monetary Policy Bond Yields Currencies Commodities EPS Growth P/E Stocks Remains accommodative +50 bps $US stronger, $CAD weakens to mid-80s Fall sharply then stabilize at low end of new elevated range +5-8%, flat to down in Canada 14-15X US market grinds higher, Canadian lower Scenario 3 Bull Case 15% probability U.S. growth surprises to the upside. China manages to maintain a strong and steady pace of growth while containing inflationary pressures. Under this scenario, most equity markets would perform very well, with emerging markets, Canada and commodities outperforming given their greater leverage to global growth. The gap between the growth rates of emerging and developed economies would narrow somewhat. Sovereign risk in Europe would likely abate given improving growth prospects. Central banks around the world would initiate gradual policy tightening. Fixed income markets would underperform significantly. Monetary Policy Bond Yields Currencies Commodities EPS Growth P/E Stocks Gradually normalized starting in the first half of to 200 bps $US stronger against most, $CAD moves above par. Enjoy renewed strength. Move back to highs, some go higher % in the US, somewhat stronger in Canada X forward U.S. and Canadian indices regain, perhaps surpass old highs. Scenario 4 Bear Case 15% probability Return-to-recession scenario. This scenario would involve a second recession. Escalating tensions in Europe could lead to sovereign default with counterparty concerns resulting in a renewed financial crisis. Credit conditions would tighten globally. As concerns over deflation increase, central banks would introduce exceptional easing measures once again. The Fed would likely launch a third aggressive quantitative easing program. Under that scenario, bonds would outperform, US equities would post losses but provide some margin of safety given cheaper valuation, while Canada, emerging markets and commodities would underperform significantly. Monetary Policy Bond Yields Currencies Commodities EPS Growth P/E Stocks QE3-100 to 150bps $US stronger on flight-to- safety, $Cdn below 80. Slump to lows that curb new investment. -10 to 20% 12X Bear market, S&P falls into 800s PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 6

7 Conclusions Careful consideration of the scenarios highlighted above reinforces the following ideas: 1 Continued outperformance of the Canadian market relies heavily on steady growth in China, which is part of our base case but by no means guaranteed. The Canadian market is well positioned to benefit from the continued strong growth in China described in Scenario 1 (base case) and Scenario 3 (bull case). But as expectations rise and commodity prices continue to rally, the margin of safety afforded to investors is rapidly declining. In other words, as the market s level of comfort around the prospects for continued steady growth in China increases, so does the downside risk associated with the less optimistic scenarios (2 and 4). Elevated commodity prices will also be required to sustain the Canadian dollar close to parity. 2 U.S. equities may not offer as much torque to a recovery under our base case, but offer a greater margin of safety when other scenarios are considered. U.S. stocks appear to offer a more compelling risk/ reward proposition at current levels given lower valuations. The U.S. market also provides exposure to some of the sectors that are not well represented in Canada. We believe careful consideration of the scenarios highlighted above reinforces the case for maintaining some exposure to the U.S. market, particularly in light of the heavy reliance of the Canadian market and dollar to continued strong growth in China. 3 Most scenarios suggest limited upside for fixed income markets, while faster than expected interest rate normalization could bring considerable pain for long-duration assets. This scenario analysis highlights the limited upside potential and sizable downside risk for longer duration fixed income instruments, particularly if economic conditions normalize more quickly than expected. Bond yields are expected to increase under all but the bear scenario, which presents a challenging backdrop. 4 The structure of the Canadian market creates a difficult benchmark for most investors. Most Canadian investors maintain a majority of their equity holdings in Canada to avoid currency risk but allow themselves only limited exposure to commodity sectors due to their higher volatility. Such a strategy results in an equity portfolio that often relies heavily on interest sensitive sectors, a reflection of two factors: the need for (comfort of) regular dividend income and the scarcity of investable names in other non-commodity related sectors (consumer, industrial, healthcare and technology). Portfolios positioned this way i.e., heavy in financials and other interest sensitives and light on commodities - is likely to underperform the benchmark under most of the scenarios where China s growth leadership continues. And the same portfolio would also prove to be somewhat vulnerable to the effects of a normalization in interest rate conditions i.e., higher interest rates. While there are no easy solutions, maintaining or initiating exposure to the U.S. market to access a greater variety of names in the sectors that are not well represented in Canada while acknowledging that the S&P/TSX represents a volatile and somewhat riskier benchmark given its 50% weighting in resources seems like an appropriate first step. The second would be addressing the balance between interest sensitive holdings and commodity exposure in the Canadian component. Interest sensitive stocks are more comfortable and commodity stocks are generally more volatile. A comfortable portfolio is likely to underperform the S&P/TSX index if 2011 unfolds in the probability-weighted manner discussed above. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 7

8 The Global Economy The outlook for the global economy in 2011 can be described as mixed but on balance positive. Evidence that a sustainable recovery is developing in the United States coupled with robust growth in developing nations is expected to offset risks elsewhere. Expectations for U.S. growth reflect encouraging economic data, stimulative monetary policy, and recently enacted tax cuts. While policy makers in developing nations will continue to balance additional growth against the risks of higher inflation, there are few signs of over heating in most economies. Europe will remain a key risk in 2011 as policymakers try to follow through on austerity measures without choking off regional growth. The outlook for Canada s economy in 2011 is relatively bright. Steady demand for commodities, buoyant consumer confidence, and low inflation provide a solid foundation that RBC Economics believes will result in 3.2% GDP growth in However, Canada is not immune from external economic forces. Economic growth expectations are vulnerable to any slow down that were to develop in emerging economies, a fresh credit crisis spawned by Eurozone issues, or a renewed slowdown in the United States. Three major themes will be prominent through early 2011: the effectiveness of quantitative easing and its implications for long-term growth in the United States.; the inflationary burden that emerging economies may endure due to the artificially low interest rates produced by quantitative easing in developed countries; and, the ability of the Eurozone to navigate the current debt crisis. 8% 6% 4% 2% 0% -2% U.S. real final demand growth and the yield curve Real Final Demand Growth U.S.10-year bond yield minus T-bill yield advanced two years -4% Extremely easy monetary conditions are giving a green light to U.S. economic growth out at least to Good news for Canada and the rest of the global economy. 30% 20% 10% 0% -10% -20% Source: U.S. Department of Commerce U.S. capital spending on equipment & software yoy (%) Source: U.S. Department of Commerce -30% Capital spending will continue to contribute to growth. 10% 8% 6% 4% 2% 0% -2% Consumer spending is growing in line with household incomes. millions Sources: U.S. Labor Department; Statscan U.S. real consumer spending vs. real disposable income Canada (Left scale) Employment Source: U.S. Department of Commerce United States (Right scale) Income growth Spending growth -4% millions Both should be helped in 2011 by improvements in the employment picture. Canada has already gained back all the jobs lost in the recession PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 8

9 YoY % Change Overall CPI CPI Excluding Food China consumer price index Source: China National Bureau of Statistics China s inflation problem is presenting challenges to policy-makers. The effects of quantitative easing (QE) on the prospects for the U.S. economy will continue to be a primary theme in Fed policy is designed to achieve its dual mandate of increased employment and price stability. Certain economic data points support the Fed s contention that stimulus is needed to kick-start employment growth and ward off deflation: the unemployment rate remains stubbornly high (9.8% in November) and private sector hiring remains volatile (+50K in November, but down over 70% from the prior month s increase), while core inflation remains uncomfortably low at 0.8%. However, other key metrics such as the ISM Manufacturing Index and retail sales, suggest that the economy may be able to grow without the aid of QE. The New Year may see a tug-of-war between those worried withdrawing stimulus too soon and those who point to data suggesting the U.S. recovery has become self-sustaining. Quantitative easing in the U.S. will also have consequences for the emerging economies. To the extent that QE weakens the US dollar, countries such as Brazil, China, and India, which need to keep their own currencies in alignment with the dollar, could face potentially higher inflation as they pay more U.S. dollars to import the same quantity of goods. Second, since quantitative easing is aimed at reducing long-term U.S. interest rates, capital could flow out of the United States toward developing countries where rates are more attractive. Such hot capital inflows could be inflationary for those economies as foreign money bids up the price of real estate and financial assets. Policies (like capital controls) designed to keep their currencies competitive could set off another damaging round of trade disputes and protectionism. A third theme for 2011 will be the implications of the Eurozone debt crisis for global growth. While Greece and Ireland both accepted financial aid packages in 2010, attention in 2011 will turn to the ability of (much larger) Spain to roll-over its expiring debt. For now the buoyant growth of the German economy (and some others) is keeping the overall growth rate of the Eurozone respectable. But next year fiscal austerity programmes will kick in for most states, including Germany, which is likely to produce a more anemic GDP performance. Europe represents only some 15% of world GDP so a slow Eurozone by itself won t have an overwhelming impact on the global economic trajectory. However it could mean renewed bouts of sovereign debt concerns and currency convulsions that could damage the outlook for global trade beyond Europe s boundaries. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 9

10 Equity Markets Following a period of heightened uncertainty largely associated with double dip concerns, equity markets have been propelled higher by better-than-expected economic growth, attractive valuations and corporate earnings momentum. S&P 500 equilibrium Source: RBC GAM S&P 500 earnings expectations Source: RBC CM In the U.S., we continue to see confirmation of the economic recovery as evidenced by five consecutive quarters of GDP growth and continued positive readings from leading economic indicators. Government spending and inventory restocking have been the key contributors to growth. While these factors are expected to fade into 2011, growth should be supported by a robust capital spending cycle and stronger consumer spending. Investment by businesses is expected on the back of earnings growth and solid balance sheets. Consumer spending should be supported by improving jobs growth and the recent cut in payroll taxes. Finally, monetary policy remains extremely accommodative. The recently announced $600 billion quantitative easing program should help to keep interest rates low. Valuations are well below long-term equilibrium levels. S&P/TSX Composite earnings expectations Source: RBC CM Robust earnings growth in 2010 followed by solid growth expectations for Price-to-forward earnings and VIX Source: RBC Capital Markets Quantitative Research, Haver Analytics, CBOE China s expansion slowed somewhat through 2010; however, the rate of growth remained strong at 9.6% in the third quarter. The pace of moderation appears well controlled and has been driven by government policy choices, rather than a fundamental deterioration of the economy. The Chinese Purchasing Managers Index, a key leading economic indicator, has turned back up which points to further expansion ahead. Robust earnings growth in 2010 followed by solid growth expectations for Source: RBC Capital Markets Quantitative Research, Haver Analytics, CBOE 10.5 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 S&P 500 Price-to-Forward Earnings (LS) CBOE Market Volatility Index (Inverted) (RS) The market P/E remains inversely correlated to the level of expected volatility PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 10

11 Corporate earnings performance has been even better than that achieved by the global economy. Profits are benefiting from cost cutting measures taken through the recession that are now offering substantial earnings leverage as volumes rise. Revenue gains and margin expansion have driven earnings estimates for the S&P 500 up 39% in 2010, with a further gain of 13% anticipated for U.S. gross demestic product recovery Source: RBC CM Quantitative Research, ISM U.S. home prices Source: RBC Cm Quantitative Research Valuations remain attractive with both the S&P 500 and S&P/TSX now trading at about 13x consensus earnings. These levels remain modest as the market factors in concerns about economic, currency, and geopolitical risks. Intermediate technical indicators are at somewhat overbought levels following the strong rally since the summer. This presents some risk to the downside in the near term. However, taking a step back to a multi-year view, our technical analysis team has correctly called the occurrence of a dip in markets mid-to-late 2010 concurrent with the expected timing on a 4-year cycle. North American equity markets have rallied since, and confirmation has developed across a number of macro barometers, notably Asia stock markets, commodities and more recently bonds. This pattern suggests that we may be in the early innings of the next multi-year uptrend. U.S. GDP has recovered to stand 0.8% below its 2007 peak level. S&P/Case-Shiller index plunged 33.5% from its June 2006 peak to the April 2009 trough, climbed 7.2% over the past seventeen months but is once again faltering. With data pointing to an ongoing economic recovery in the U.S. and China, solid trends in corporate earnings, attractive valuations and positive multi-year technical indicators, we remain overweight equities and would add exposure on pullbacks. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 11

12 Canadian Sector Scorecard U.S. Sector Scorecard Sector Weighting RBC Focus List Sector Weighting RBC Focus List Financials (28.0% recommended vs. S&P/TSX weight of 28.6%) As the positive impact of normalizing credit conditions for banks starts fading, the focus is shifting to revenue growth. Capital positions remain adequate while indicators of future profitability continue to trend in the right direction. Visibility around the lifecos remains limited but the recent reversal in long-term interest rates should support valuations. 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. Telecom Services (4.0% recommended vs. S&P/TSX weight of 4.3%) Incumbents have so far demonstrated their ability to maintain margins in a difficult environment despite the entrance of new wireless competitors. Low leverage to the economic cycle offers performance stability, while valuations and dividend yields are attractive. Consumer Discretionary (5.0% recommended vs. S&P/TSX weight of 4.5%) 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. Consumer Staples (2.0% recommended vs. S&P/TSX weight of 2.6%) 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. Healthcare (1.0% recommended vs. S&P/TSX weight of 0.8%) Valeant, the sector bellwether, has recently transformed to an enticing growth story. Investors should consider looking at the U.S. market for a more broad-based group of names. Industrials (5.0% recommended vs. S&P/TSX weight of 5.5%) Sector remains attractively valued with the potential to disproportionately benefit from an economic recovery. Rail stocks offer particularly attractive potential. Technology (4.0% recommended vs. S&P/TSX weight of 2.7%) Prospective profitability metrics have 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. Bank of Montreal (BMO); National Bank (NA); TD Bank (TD); Brookfield Asset Mgmt (BAM); Royal Bank (RY); Sun Life (SLF); Intact Financial (IFC) None BCE (BCE) Magna International (MG) Metro (MRU.A) Valeant (VRX) CP Rail (CP) Research In Motion (RIM) Financials (15.0% recommended vs. S&P 500 weight of 15.6%) 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. Favour franchises that are positioned to benefit from stronger capital markets activity, which is expected in the first half of Utilities (3.0% recommended vs. S&P 500 weight of 3.1%) Sector offers attractive attributes such as above-average dividend yields and relative earnings resiliency, particularly from regulated businesses. Valuations across the group not as favourable following recent price movements. Telecom Services (3.0% recommended vs. S&P 500 weight of 3.5%) 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. Consumer Discretionary (11.3% recommended vs. S&P 500 weight of 10.7%) Favour companies that are focused on returning capital to shareholders and are well positioned to benefit from ongoing strength in the emerging markets and a stronger U.S. consumer. Consumer Staples (10.0% recommended vs. S&P 500 weight of 11.1%) Sector offers strong international growth opportunities, relative stability, and above average dividend yields. Organic volume growth may prove challenging but valuations appear appropriate. Healthcare (10.0% recommended vs. S&P 500 weight of 11.3%) Sentiment remains poor due to lower U.S. utilization of health care, concerns over European price cuts as austerity initiatives are implemented, and ongoing concerns about the potential impact from legislation passed earlier in the year. Industrials (11.5% recommended vs. S&P 500 weight of 10.6%) Sector offers exposure to global economic recovery. Favour businesses with mid-cycle exposure, exposure to attractive end markets like transportation and aerospace, and companies that have levers that can drive earnings growth. Technology (20.0% recommended vs. S&P 500 weight of 19.0%) Demand trends have been mixed, with pockets of strength in areas like storage and mobile, offset by weakness in some PC, networking and communications areas. Weakness has been most prevalent among companies with public sector and European exposure. Our preference is to focus on areas of growth within the sector, including wireless communication, data storage, and IT infrastructure management. Product momentum remains strong in select areas of hardware and software. T. Rowe Price (TROW); State Street (STT); PNC Financial Services Group (PNC) None American Tower (AMT) YUM Brands (YUM); Limited Brands (LTD) Colgate (CL); Kraft (KFT) Medco Health (MHS); Amgen (AMGN) United Technologies (UTX); Union Pacific (UNP) Texas Instruments (TXN); CA Inc (CA); Microsoft (MSFT); EMC (EMC) Materials (22% recommended vs. S&P/TSX weight of 23.6%) Powerful policy stimulus and the economic recovery should remain key supports for the sector, but a peak in leading indicators suggests more volatility ahead. Energy (27.0% recommended vs. S&P/TSX weight of 25.7%) The sector is likely to find support from ongoing global recovery and associated gains in energy commodities. Earnings estimate revisions continue to lag the commodity price move. Barrick Gold (ABX); Eldorado (ELD); Potash (POT); Teck Resources (TCK.B) EnCana (ECA); Arc Energy (AET.UN), Suncor (SU); Canadian Natural Resources (CNQ); Enbridge (ENB); Trican (TCW) Materials (4.2% recommended vs. S&P 500 weight of 3.6%) The outlook for the sector has improved with continued signs of expansion in emerging markets and signs of recovering activity in parts of the developed world. We continue to favour more cyclical areas of the sector that offer leverage to emerging market demand. Domestically, we believe the chemicals industry will continue to benefit from a recovery in volumes and pricing. Energy (12.0% recommended vs. S&P 500 weight of 11.5%) The outlook for the sector has improved, with improving growth in parts of the developed world and rising consumption in emerging markets. Our focus is 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 and demand in the U.S. remains muted. Freeport McMoran (FCX); Eastman Chemical (EMN) Occidental Petroleum (OXY); Schlumberger (SLB) PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 12

13 Fixed Income Market Government bonds Following the November 3 announcement by the Federal Reserve that it intends to purchase $600 billion in U.S. Treasuries, 10-year government yields in the U.S. and Canada moved significantly higher, a classic sell the fact response as investors took profits given both the expectations that the Fed s policy will lead to an eventual rise in inflation and the political backlash to the policy that has dominated headlines ever since. 3.5% 3.0% 2.5% 2.0% 1.5% Source: Bloomberg U.S. 5-Year Canada 5-Year 5-year government bond yields QE2 Announced 3 November 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Source: Bloomberg RBC yield curve forecast Forecast Current The recent agreement on tax cuts and unemployment benefits between the administration and Congressional leaders, if passed, would likely lead to an upward revision to U.S. growth expectations for the year ahead, implying further increases in interest rates, particularly for longer maturities. RBC Capital Markets suggests that this would be consistent with a rise in 10-year U.S. Treasury yields to 4.30% by end of We would note that there are a number of risks that could alter this trajectory or lead to a highly uneven and volatile path. These would include the failure to ratify the agreement, ongoing effects of the Fed s quantitative easing program, and the resurgence of European sovereign debt issues. That said, rising interest rates in the months ahead may create opportunities for incomeoriented investors. 1.0% Dec-09 Mar-10 Jun-10 Sep-10 Dec % Bond portfolio scenario analysis 3M 6M 1 Y 2 Y 3 Y 4 Y 5 Y 7 Y 10 Y 20 Y 30 Y Portfolio 2-year bond 5-year bond 10-year bond 1-5 year ladder 1-10 year ladder 2/10 barbell* Yield at inception 1.67% 2.50% 3.25% 1.92% 2.45% 2.47% Rates fall to late 2008 levels 2.37% 6.43% 9.20% 3.67% 5.94% 5.83% No change 1.95% 3.54% 4.31% 2.43% 3.19% 3.15% RBC forecast 0.78% -0.69% -0.78% 0.18% -0.40% -0.01% Rates rise 1% 1.00% -0.13% -2.75% 0.65% -0.49% -0.89% Rates rise 2% 0.06% -3.64% -9.24% -1.07% -3.96% -4.64% Source: Bloomberg * 2/10 barbell consists of a 50/50 combination of 2-year and 10-year Government of Canada bonds 0 PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 13

14 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Source: Bloomberg 5-year A credit spreads Crisis Peak: 394 bps Long-Term Average: 83 bps 0.0% Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Credit After relative stability in the third quarter, corporate credit spreads have displayed renewed volatility. Normally, investors would expect that a brightening economic outlook would lead to a reduction in corporate credit spreads even as government bond yields rose, thereby providing a measure of protection in a rising interest rate environment. Rather, in this case, spreads have held steady, leading to higher absolute yields for corporate debt. Heavy new issue supply is the primary culprit as companies take advantage of record low financing rates to pre-fund debt that has yet to come due. Interestingly in Europe, non-financial corporate credit default swaps are now trading at significantly lower spreads than the average of European sovereigns. While this is a testament to the pressure facing the European periphery, it is a timely reminder that not all sovereign debt is created equal and that some government bonds can be just as volatile as corporates. Preferred shares After six months of remarkable gains, preferred share price movements have moderated. Higher interest rates across the yield curve and an influx of high-quality rate-reset issuance has taken prices down from their 2010 highs set last month. A sharp rise in 5-year yields combined with new supply led to a rate-reset preferred share sell-off earlier this year, and a similar risk may exist today. The sell-off in rate-reset preferreds has not kept pace with bonds, and recent new issues compare favorably to secondary market valuations, which may lead existing issues to adjust lower to reflect the new environment. Perpetual preferreds have held up well as bond yields have risen, but we think investors who want to maintain exposure to this potentially volatile asset class should move to higher coupon issues, as these typically exhibit less price volatility than perpetuals with smaller dividend rates. Rate Reset BEY Source: 5Y Canada Bloomberg Yield 8.5% 7.5% 6.5% 5.5% 4.5% Source: Bloomberg 3.5% Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Average rate-reset preferred bond equivalent yield 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% We regard investment grade credit spreads as fairly valued and accordingly, the extraordinary gains of the past two years are likely behind us. While corporate debt will benefit portfolios in a rising rate environment as tightening of credit spreads will act as a shock absorber to higher yields, significant capital gains are now less likely. Non-investmentgrade debt remains attractively valued on both a yield and credit spread basis, but with a risk profile more akin to equities, should not be viewed as a direct substitute for investment grade corporates. $27 $25 $23 $21 $19 $17 Average perpetual preferred price Source: Bloomberg $15 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 14

15 Currencies Canadian Dollar Source: RBC Capital Markets U.S. Dollar The U.S. dollar exhibited a period of weakness through the summer months and into the early fall. This was driven by a soft patch in economic data and anticipation of a second wave of quantitative easing ( QE2 ). During this period, institutional short positions on the dollar reached elevated levels, and since the announcement of QE2 on November 3rd, the U.S. dollar has rebounded sharply from oversold levels. Over the next 6-12 months, we anticipate some additional U.S. dollar strength as the economy moves closer to trend growth and the eurozone faces further challenges related to its sovereign debt crisis. Canadian Dollar Strong commodity price performance and Bank of Canada rate hikes boosted the Canadian dollar from a depressed US$0.77 in early 2009 to par recently. The Bank of Canada has decided to postpone any further rate hikes as economic growth has slowed (1.0% GDP growth in Q3, versus 2.3% in Q2 and 5.6% in Q1) and due to elevated global uncertainty. Our outlook for the Canadian economy is for better growth in 2011 and 2012 which is likely to lead the Bank of Canada to resume its rate hike program next year. This should keep the Canadian dollar near parity through the coming twelve months. Euro Source: RBC Capital Markets 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 the first half of 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 growth and budget forecasts are faring for most of the most intensely affected economies. 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 - 15

16 Economic & Capital Market Forecast RBC Capital Markets forecasts for growth, inflation, interest rates and currencies 10Q4 11Q1 11Q2 11Q3 Growth outlook, % change, year-over-year in real GDP Canada United States United Kingdom Eurozone Inflation outlook, % change, year-over-year Canada United States United Kingdom Eurozone Monetary policy rate Canada United States 0 to to to to 0.25 United Kingdom Eurozone year government bonds Canada United States United Kingdom Eurozone Foreign exchange forecast 30-Nov USD per CAD USD per EUR USD per GBP JPY per USD CAD per EUR PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 16

17 Asset Mix Achieving portfolio risk objectives through asset allocation By determining in advance what a portfolio s long-term target mix will be and setting suitable constraints for each asset class, one can tailor important characteristics like capital stability, income and growth to an investor s individual requirements. To the right we have applied this quarter s asset mix recommendations to portfolios constrained in different ways as an illustration. Secure Asset allocation Range Target mix Current recommendation Cash 0-35% 20% 20% Fixed income % 80% 80% Equities 0% 0% 0% Income Asset allocation Range Target mix Current recommendation Cash 0-35% 5% 5% Fixed Income 65-95% 80% 80% Equities 5-25% 15% 15% Conservative Asset allocation Range Target mix Current recommendation Cash 0-25% 5% 5% Fixed income 45-75% 60% 55% Equities 15-55% 35% 40% Balanced Asset allocation Range Target mix Current recommendation Cash 0-20% 5% 5% Fixed income 25-55% 40% 35% Equities 35-75% 55% 60% Growth Asset allocation Range Target mix Current recommendation Cash 0-20% 5% 5% Fixed income 5-35% 20% 15% Equities 55-95% 75% 80% Aggressive Growth Asset allocation Range Target mix Current recommendation Cash 0-20% 5% 5% Fixed income 0% 0% 0% Equities % 95% 95% PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 17

18 Canadian Focus List Update Canadian Focus List: Bank of Montreal (BMO) National Bank (NA) TD Bank (TD) Brookfield Asset Mgmt (BAM.A) Royal Bank (RY) Sun Life Financial (SLF) - 2.5% Intact Financial (IFC) - 2.5% BCE (BCE) Magna International (MG) Valeant Pharmaceuticals (VRX) CP Rail (CP) Research In Motion (RIM) EnCana (ECA) - 2.5% ARC Energy (AET.UN) Suncor Energy (SU) Canadian Natural Resources (CNQ) Enbridge (ENB) Trican Well Services (TCW) - 2.5% Teck Resources (TCK.B) Barrick Gold (ABX) Potash (POT) Eldorado Gold (G) Deletions: Metro (MRU.A) Thomson Reuters (TRI) Goldcorp (G) Added to the Focus List The Canadian Focus List is positioned for a continued recovery in the global economy. While macro and geopolitical pressures remain, recession risks have abated. History suggests that in a lowgrowth, non-recessionary environment, in which monetary policy is excessively loose, equity returns will tend to be above average. National Bank (NA), Royal Bank (RY), TD Bank (TD), and Bank of Montreal (BMO) remain on the Focus List, each at a 5% recommended weighting. Shares of lifecos, under pressure in the summer quarter due to a sharp decline in longer-term interest rates, rallied during in the fall, as bond yields moved up off depressed lows. While Sun Life s core business remains sound, reported results will remain sensitive to the level and direction of bond yields. With quantitative easing potentially keeping a lid on those rates for some time, the company could face an earnings headwind in the coming quarters. That said, were the Fed to change its policy course, long-term interest rates would move immediately higher as would the shares of lifecos. The recommended position in Sun Life has been reduced from 5% down to 2.5%. At the same time a 2.5% position in Intact Financial (IFC) has been initiated. The earnings of property/ casualty insurance companies are less sensitive to financial market volatility. Intact is the leading Canadian company in the sector. It has delivered strong results and is expected to go on doing so. IFC s balance sheet strength raises the prospect of further dividend increases, share buy-backs, as well as timely acquisitions. While the outlook is subdued and somewhat uncertain for more developed economies (the U.S., Japan, Western Europe), emerging economies in Asia and elsewhere are expected to go on growing at above average rates. The portfolio contains positions in Suncor (SU), Canadian Natural Resources (CNQ), ARC Energy (AET.UN), Teck Resources (TCK.B) and Potash (POT), all of which offer direct exposure to the growing demand for commodities particularly in emerging Asia. Natural gas is one of the few commodities not benefitting because almost none of the gas produced in North America is shipped abroad and because the advent of shale gas has greatly increased the available supply. Despite its status as a core long-term holding with industry-leading assets and a highly regarded management team, Encana (ECA) is almost a pure natural gas play and therefore could be challenged at least through the first half of the coming year. Accordingly the recommended weighting in Encana shares has been lowered to 2.5%. While the development of shale gas has proven for now to be a depressant for gas prices, it has provided a powerful boost for the well-servicing business. Shale gas wells require extensive fracing initially and because they typically experience a rapid decline rate in production, need to be re-stimulated periodically to optimize their economic value. A 2.5% position in Trican Well Services (TCW) was added to provide the Focus List with exposure to this longterm trend. While not offering direct commodity exposure, CP Rail (CP), which generates approximately 44% of its revenues from shipments of bulk commodities, with a large portion destined for overseas ports, provides the portfolio with added exposure to the emerging Asia theme. PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 18

19 RBC CM Canadian Focus List Model vs. S&P/TSX Equity Index $6,100,000 $5,100,000 $4,100,000 $3,100,000 $2,100,000 $1,100,000 $100,000 Focus List Model S&P/TSX Total Return Total Pre-tax Returns $4,130, $945,275 The Canadian Focus List is comprised of approximately 20 stocks that are expected to do well in the economic environment over the next two years. The Focus List is equally allocated across all names and rebalanced every strategy quarter. The RBC Capital Markets Investment Strategy Committee and Equity Selection Sub-Committee spearhead the sector allocation and individual stock selection processes. Every quarter, individual stocks may be removed for a number of reasons, including deterioration in the stock s aggregate multi-disciplined score, existence of more compelling alternatives, or change in sector allocation. There may be circumstances that result in a stock s removal during the quarter, with proceeds stored in cash or distributed to alternative stocks. Since inception in December 1984, the model portfolio based on the Canadian Focus List has delivered a compound annual return of 15.8% versus 9.2% for the S&P/TSX Composite, which represents the eligible universe of stocks for the Canadian Focus List. This return excludes dividends and any transaction costs and/or fees. For important disclosure regarding the Canadian Focus List performance, please refer to the last page in this document. In the consumer space, both Thomson (TRI) and Metro (MRU.A) have been removed from the Focus List. Shares of Thomson have lagged the broader market over the past couple of quarters, largely reflecting concerns over potential job losses in the Financial Services industry. For 2011 Magna (MG) appears to offer a more compelling risk/reward than TRI. Magna shares trade at a significant discount to those of its peers, while the Company has a stronger balance sheet than many and does not have the same long-term pension issues. Further, while North American auto sales remain at depressed levels, Magna is only 40% exposed to the North American market, with a rapidly growing percentage from high growth, emerging Asia. Metro has been a strong performer since it was added to the Focus List one -year ago. However, with margins already at all-time highs and a growing threat posed by the expected aggressive expansion of Wal-Mart into Metro s key Quebec market, the risk/reward is no longer as favourable. Valeant Pharmaceuticals (VRX), the result of a merger between Biovail and Valeant, has been added to the Focus List. The merged company offers a strong growth profile at a very attractive valuation. VRX has a strong balance sheet, generates substantial cash flow, and has a diversified portfolio of drugs most of which are not likely to attract intense competition from the majors. In technology, shares of Research in Motion (RIM) rebounded nicely last quarter but remain undervalued. RIM s strong balance sheet and significant near-term catalysts warrant its continued inclusion on the Focus List. While the outlook for gold remains positive, the senior large cap names have lagged both the metal itself and the rest of the sub-index. Investors apparently have been concerned that growing the very large resource bases of the majors will be difficult and expensive. This quarter Goldcorp (G) has been replaced by Tier-II producer Eldorado (ELD), which has a long history of successful development and disciplined growth. Shares of ELD came under significant pressure during the prior quarter largely because of a failed takeover bid for Andean Resources (losing out, ironically, to Goldcorp) and creating a compelling buying opportunity. Lastly, rounding out the list and providing some ballast to some of the more economically sensitive components of the portfolio, are the positions in Brookfield Asset Management (BAM.A, 10% projected dividend growth), BCE (BCE, 5.5% yield), and Enbridge (ENB, 9% dividend growth). PORTFOLIO STRATEGY RBC DOMINION SECURITIES - 19