lobal insight – 2013 o · global insight – 2013 outlook 6 2013 outlook looking across the...

DECEMBER 2012

Global InsIGht – 2013 outlookDelivering insight, research, and analysis of global financial markets, using the extensive international resources of RBC Wealth Management. Global Insight is a publication by the Global Portfolio Advisory Committee.

GLOBAL INSIGHT – 2013 OUTLOOK 2

In ThIs Issue

Introduction 3

Regional Forecasts for 2013 5

2013 Outlook: Looking Across the Valley 6

Europe Inc. is Not Eurozone GDP 13

Emerging Markets: Time to Buy? 19

Shale Oil Revolution in North America 25

Fixed Income: Play Defense 32

Gold: A Shining Juggernaut 37

� Prospects for the U.S. economy should shape the outlook for financial markets in 2013. The path for global equities could be determined by whether Washington delivers much-needed fiscal certainty.

� China’s gradual re-acceleration should gather momentum, which is good news for other emerging economies and commodity-sensitive markets like Canada.

� Europe’s painful adjustment period, complicated by politics, could extend through most of the year.

� In fixed income, risk premiums have declined precipitously, leaving defensive positioning as our preferred strategy for the new year.

Global InsIGhT – 2013 ouTlook


here We Go aGaInCourageously Revisiting Last Year's Predictions

We boldly proclaimed at the onset of 2012 that the Mayans would be wrong, and the world triumphantly woke up on December 22nd (note we are writing this intro prior to the 22nd, so there is some supposition here), turned to its Mayan friends, and emphatically stated, “We will not go quietly into the night! We’re going to live on! We’re going to survive!” (Yes, we are quoting from the movie Independence Day.) Anyway, after taking our victory lap for our prescient “Mayan call,” we thought we would also highlight a few other things we discussed nearly a year ago:

� Despite a tepid growth forecast for the U.S., a European economy that had already fallen into recession, and an extended period of “adjustment” in China, we believed a “neutral” stance on global equities was warranted as valuations worldwide helped to offset some of the macro risks. In hindsight, we wish we had been more bullish as 2012 turned out to be a strong-ish year for most, but not all, global markets. However, we take some comfort from the fact we did not “tuck tail” despite a somewhat daunting wall of worry.

� Our treatise on U.S. housing argued that a turn might have been afoot and, while it remains early days, a turn seems to be afoot. Prices, especially in non-distressed units, have been steadily rising, while ultra-low mortgage rates and favorable demographics point to a continuation of what has become an encouraging recovery.

MaTT barasch – ToronTo, canada [email protected], RBC Dominion Securities Inc.


� We also asked whether or not stronger economic growth might have been coming sooner than most thought. Alas, it did not come in 2012; however, we continue to believe that if the U.S. fixes some of its fiscal woes and with the aforementioned recovery in housing, a shift to a higher growth gear may not be that far off (see our 2013 outlook on page 6 for more).

For 2013, we are combining bling and bitumen in a pair of commodity-related articles. The last time gold had a down year, Bill Clinton was still in the White House and George Lucas had only ruined one of the three new Star Wars movies (note he will have three more opportunities beginning in 2015). Fast forward a dozen years, and we ask whether gold's amazing run can possibly go on from here. On the oil side, so-called tight oil plays are emerging as a huge potential source of supply in North America with the once unthinkable—the U.S. achieving energy independence—suddenly, errr, thinkable. We explore what this means for crude and whether it’s time to trade in that hybrid for a monster truck (just kidding).

Could the three-decade bull market in fixed income be at an end? We are not quite prepared to go out on a limb that has claimed too many victims over the past several years; but, we do think there are some risk issues investors need to consider in the fixed income square.

We tackle the issue of Europe and point out, despite a challenging economic backdrop, “Europe Inc.” offers some intriguing opportunities. Risks remain, and the periphery faces many intractable problems, but some progress has been made, and many strong businesses with global footprints may offer long-term opportunity for investors.

We also look at emerging markets (EM), which have been a tough sandbox to play in for a while now. Although EM growth has far outpaced that of the developed economies over the past few years, it has slowed nonetheless. This, coinciding with reduced investor appetite for risk, has left EM stocks fairly cheap by historical standards.

The world is an especially challenging place these days with a recession in Europe, the fiscal cliff in the U.S., China at a crossroads, and the aftereffects of the global crisis still coursing through the veins of the financial system. But markets have been known to scale walls of worry and often refuse to be cowed by what everyone already knows. We suspect 2013 may set up in just such a way and encourage you to read on for more.

here We Go aGaIn

... markets have been known to scale

walls of worry and often refuse to

be cowed by what everyone already

knows. We suspect 2013 may set up

in just such a way ...


ReGIonal FoRecasts FoR 2013

GDP: +2.0%Inflation: +2.0% Growth outlook steady. Employment gains keeping consumers confident.

GDP: +2.0%Inflation: +1.8%Better tone to housing, consumer confidence. At risk if Congress can't deliver on fiscal certainty.

GDP: +3.5%Inflation: +5.5%Government intervention a blow to foreign investment. Growth flagging.

GDP: +1.3%Inflation: +1.8%Employment surprisingly resilient. Coming deeper fiscal cuts a challenge.

GDP: +0.5%Inflation: +1.5%Uncertainty abounds. Politics complicating an already risky environment.

GDP: +6.0%Inflation: +8.0% Exports weak despite falling rupee. Domestic demand positive.

GDP: +8.3%Inflation: +3.5%Easing plus infrastructure/investment spending will offset challenging export outlook.

GDP: +1.5%Inflation: +0.5%China argument hurting trade. Election may improve domestic confidence.

GDP: +3.0%Inflation: +4.0%Trade flows need China export resurgence.

GDP: +3.0%Inflation: +2.5%Commodities responding to better China demand. Housing weak.

GDP: +3.5%Inflation: +3.0%Trade dependent. Awaits Asian regional revival.

Source - RBC Global Asset Management, RBC Capital Markets, RBC Wealth Management, RBC Dominion Securities


2013 ouTlookLooking Across the Valley

Prospects for the U.S. economy in 2013 have replaced Europe’s debt crisis as the principal focus for investors. The Chinese slowdown looks to be transitioning to a moderate re-acceleration for the coming year. Europe’s recession may deepen before a weak recovery gets underway late in the year.

As the year begins, investors will have to look across a policy and growth valley, centering mostly on the U.S. budget/debt ceiling negotiations that could extend through the first half.

If Washington does manage to deliver much-needed fiscal and taxation certainty, then we believe the improvements that began to take root in the economy in 2012 should become more firmly established in 2013.

This would put the U.S. economy on sounder footing and boost economic activity domestically. It would also have positive implications for growth in Canada, China, the U.K., and Europe, while pointing toward stronger earnings and share prices.

A great deal hinges on policy. The fiscal cliff negotiations could conclude in a way that produces more, not less, uncertainty. That might lead to a deeper, longer valley or even a U.S. recession. Separately, there is a likelihood European debt and banking issues will flare up again over the course of the year.

Following, we outline RBC’s base-case 2013 forecast and briefly discuss alternative scenarios.

kelly boGdanov & JaneT enGels – unITed sTaTes [email protected], [email protected]; RBC Capital Markets, LLC

JIM allWorTh – canada [email protected]; RBC Dominion Securities Inc.


RBC’s Base-Case Forecast

The investment focus pivots toward the U.S.; economic activity accelerates in the second half of the year; and stocks deliver worthwhile returns and outperform bonds.

The near-TerM valley

Uncertainty persists surrounding the U.S. fiscal cliff and debt ceiling debates, specifically the potential magnitude of tax hikes and government spending cuts and their impact on the U.S. economy. In our view, the outcome poses the greatest risks to global growth.

A partial resolution should materialize by which the economy will be spared some of the automatic tax increases and spending cuts, but not all. A compromise deal could constrain nominal U.S. GDP by roughly 1.0% at best or 2.5% at worst, in our assessment. The first quarter may bear the brunt of fiscal cliff fallout and could be messy under multiple scenarios.

But even if an agreement takes a toll on nominal GDP, RBC Global Asset Management’s Chief Economist Eric Lascelles forecasts the U.S. economy can still grow in 2013. For example, a 1.25% nominal fiscal drag might still permit real (after inflation) growth of 2.25% for the full year. We anticipate the economy will get off to a slow start, but accelerate in the second half.

Three seeds of TransforMaTIon

If Washington manages to move past its near-term fiscal challenges or, better yet, takes bold steps to forge a “grand bargain” with a tax code overhaul and credible long-term deficit reduction, then at least three transformative developments that emerged in 2012 should make even more positive contributions in 2013.

Housing Becomes a Welcome Tailwind

Homebuilder sentiment is signaling housing construction’s contribution to GDP growth should rise meaningfully in 2013. It tends to lead housing construction (and related employment) by roughly 12 months. The sentiment index has been rising steeply, albeit from a depressed level, since late 2011. If activity follows sentiment in the way it usually does, residential investment as a share of GDP could increase meaningfully (see chart).

Housing supply conditions have improved. Inventories of existing and new homes for sale had declined steadily to 5.4 months of supply by October from 7.6 months the prior year, the lowest level since February 2006. This is markedly below the 12.1 months peak in mid-2010 and the 6.6 months average since 2000. In some metropolitan areas, housing supply is tight.

Less supply has helped boost selling prices. Home prices in 20 large metro markets have risen by an average of 9.1% since the bottom, as measured by S&P Case/Shiller. Some coastal and Southwestern markets have surged by double-digits.

2013 ouTlook

Residential Investment Should Rise in 2013

Source - RBC Dominion Securities, Bloomberg

2

3

4

5

6

7

8

2002 2004 2006 2008 2010 20128

17

26

35

44

53

62

71

80

89Residential Investment as a% of Nominal GDP (left axis)

Homebuilder Sentiment Index(advanced 12 months, right axis)

It tends to follow the increase in homebuilder sentiment.


“Shadow inventory”—foreclosures not yet listed for sale and homes with delinquent mortgages—remains on banks’ balance sheets, but there’s little risk this inventory will flood into the market all at once. Now that home prices have improved and foreclosure and delinquency rates have pulled back, banks are under less pressure to move their shadow inventory immediately. They can feed it into the market at a measured pace as long as home prices continue to drift higher.

For the first time in years, the demand side of the equation has perked up. The rate of new household formation has risen to its fastest pace since March 2007, according to the Census Bureau. There were 1.1 million new households in 2012, well ahead of the 700,000 annual average from 2008 to 2011. There are more households forming than there are new home completions, the first time this has occurred on a consistent basis since the early 1980s (see chart). Household formations may rise further, possibly to 1.3 million or more annually, if job growth and the economy improve.

Energy Revolution Picks Up Speed

New technologies have already unleashed immense natural gas resources and are now beginning to extract heretofore unrecoverable oil resources bound up in shale and tight rock formations. The accessible U.S. shale oil resource base is large and could grow significantly if technological advances are successful in improving recovery factors (see article on page 25).

Shale oil development means energy could become an even more important driver of economic and employment growth. Since 2002, the energy sector has created one million jobs, or 37% of the total, according to the Labor Department. Most pay well above-average salaries. Shale oil development should also spill over into increased rail, trucking, manufacturing, and construction activity.

U.S. domestic oil production has risen by almost 1.6 million barrels per day over the past four years, to 2.5 million, even as consumption has fallen by two million barrels. That has already had a salutary effect on the country’s balance of trade with more to come. Some portion not spent on imported oil will find its way into the purchase of other imports from Europe, Canada, China, Japan, and other trading partners, which promises to exert a greater “multiplier effect” on global growth than the oil trade.

U.S. Manufacturing Enjoying a Renaissance

Conventional wisdom has it the American manufacturing sector lost its edge decades ago and has been in decline ever since. Against that widely held perception is the fact that the U.S. remains the largest manufacturing economy in the world producing 18.2% of manufactured products globally, ahead of China’s 17.6%. Moreover, it does that with just 12 million manufacturing workers (9% of the workforce) versus more than 100 million in China. The sector is an important source of U.S. innovation, funding about two-thirds of the country’s private sector research and development.

2013 ouTlook

Household Formations Have Risen Above Household Completions

Source - RBC Capital Markets US Market Economics, Haver

0

500

1,000

1,500

2,000

2,500

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

Household FormationHousing Completions

Hou

ses

(tho

usan

d)


2013 ouTlook

U.S. manufacturing shipments have bounced back notably since the Great Recession, recently approaching an all-time peak (see top chart).

Technological and productivity gains as well as a lower dollar and rising wages overseas have brought some production back to the U.S. from Asia and elsewhere. This trend should extend for at least several years as the cost and logistical gap widens. North America's cheap natural gas─less than one-third of the import costs in Europe and Japan─is proving to be a durable competitive advantage for the manufacturing sector.

confIdence, capITal spendInG, and Jobs

In addition to these encouraging trends, any rebound in U.S. business confidence would be welcome. CEO confidence fell during the third quarter to its lowest level since the height of the financial crisis, according to The Conference Board.

Capital spending, a considerable contributor to growth in 2011, has been slowing all of 2012, posting an outright decline in the third quarter, something that usually occurs only during recessions. But with the election over and the tax code likely becoming more certain in 2013, CEOs and small business owners should quickly adjust to the new rulebook once they have a copy. As one corporate executive aptly observed, “The greatest stimulus is certainty.”

A jump in CEO sentiment usually also coincides with stronger S&P 500 operating earnings. In turn,

faster profit growth accompanied by a renewed commitment to capital investment has usually been a good read-through to stronger growth in employment, hours worked, and wages.

Consumer confidence has risen steadily since the fall of 2011, reaching its highest level since before the financial crisis. If it remains elevated as business confidence and capital spending improve, the U.S. economy could finally shift into a higher growth gear even as government stimulus fades.

Good neWs for The u.s. Is Good neWs for europe

Just as the U.S. housing collapse and the financial crisis it precipitated led much of the world into the Great Recession, any step-up in the pace of growth in the world’s largest economy is going to confer important spillover benefits to most other economies. Accounting for about one-quarter of world GDP, the U.S. imports goods and services valued at almost $2.8 trillion annually. Faster U.S. GDP growth is likely to translate into faster growth in imports even after allowing for declining imports of foreign energy.

This could be important for most of the European Union where aggregate demand is being suppressed by government and forced private sector austerity. The U.K., like much of the eurozone, is facing even deeper fiscal cuts in 2013. Better export flow into the U.S. than currently forecast would provide some welcome private sector offset. RBC Capital Markets forecasts

If CEO Confidence Improves, Operating Earnings Should Follow

Source - RBC Capital Markets, Standard & Poor's, The Conference Board Inc.

15

25

35

45

55

65

75

85

95

1980 1984 1988 1992 1996 2000 2004 2008 2012-50

-30

-10

10

30

50

70

90

110

130CEO Business Confidence Survey:Business Executive Confidence(advanced 2 quarters, left axis)

S&P 500 Operating Earnings (y/y% chg, right axis)

Manufacturing Thriving

Source - U.S. Department of Commerce: Census Bureau

$200

$250

$300

$350

$400

$450

$500

$550

1992 1995 1998 2001 2004 2007 2010 2013

(US

$ B

illio

ns)

U.S. Manufacturing Shipments


2013 ouTlook

eurozone GDP growth will move (barely) back into the positive column in Q2. If the U.S. economy re-accelerates in the second half along with its appetite for European imports, as anticipated in our base-case forecast, one good quarter might extend into a positive trend for the eurozone.

chIna’s sloWdoWn Is endInG

Stronger U.S. growth could also be an extra plus for China, where exports into Europe (formerly its biggest customer) declined by 6% in 2012.

Although exports are a large part of China’s economy, there are many important drivers of domestic growth policymakers can influence. We expect China to experience some re-acceleration in 2013 and to deliver GDP growth higher than in 2012. Together with the expected better pace of U.S. expansion, this represents an important potential sea change in the global growth outlook, particularly for emerging economies including much of Asia.

Economic activity began to bounce in September and has improved since then. China’s new leaders will formally take the reins of power in March. They are likely to remain committed to policies that would support economic growth and maintain social stability. Li Keqiang, the incoming premier, has already signaled the leadership team will continue an aggressive urban growth strategy.

We expect China’s central bank to continue its policy of deliberate, targeted easing designed not to reignite housing price pressures. While it has been

slow to lower bank reserve requirements and its one-year lending rate, the People’s Bank of China’s monetary injections into the banking sector have been frequent, sizeable, and getting bigger recently. Money supply (M2) growth rose above 14% in September and October on a year-over-year basis, its fastest two-month pace since mid-2011. (See page 19 for more about China and other emerging markets.)

IT Works for canada

Canada would directly benefit from improvements in China and the United States. About three-quarters of Canada’s merchandise exports are destined for the U.S., but more than one-third of those are energy and other commodities, which more and more are priced by the growth in marginal demand in China, the largest consumer of most industrial commodities. Canada’s GDP growth is rarely more than a fraction of a percent different from that of the U.S. and is almost always headed in the same direction (see bottom chart). However, in recent years, the degree to which it outperforms or underperforms the U.S. has been increasingly explained by the influence of Chinese growth on commodity prices and shipments. Re-acceleration in China and a shift to a higher growth gear in the U.S. would be unambiguously positive for the Canadian economy and arrive at a time when two other growth drivers may be flagging: 1) residential construction in response to new, tougher mortgage qualification rules; and 2) capital spending on oil sands development as U.S. domestic oil production ramps up (see article on page 25).

China's Money Supply Trends and GDP Growth are Often Correlated

Source - RBC Wealth Management, Bloomberg

6

8

10

12

14

16

18

1999 2001 2003 2005 2007 2009 20110.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8Chinese GDP Growth - y/y (left axis)Chinese M1/M2 Growth (right axis)

Because the ratio of M1 to M2 has turned up, GDP growth could rise.

Real GDP Growth: U.S. and Canada Joined at the Hip

Source - RBC Dominion Securities, U.S. Bureau of Labor Statistics

-4%

0%

4%

8%

1981 1985 1989 1993 1997 2001 2005 2009 2013

U.S.

CanadaEstimates

2012 & 2013


2013 ouTlook

IMplIcaTIons for equITy MarkeTs

We believe macro conditions would be supportive of higher equity prices across developed and emerging markets if policy uncertainty abates and a credible fiscal cliff compromise materializes.

With stronger activity in the U.S. and China, global GDP could grow by 3.5% in real terms in 2013 compared to just under 3% in 2012. Typically, such growth is consistent with equity returns of 5%-10%.

Major global central banks are likely to maintain their very accommodative monetary policies. The European Central Bank (ECB) and Bank of Japan could become more aggressive with asset purchases. In the past, equity returns have been correlated with the expansion of central banks’ balance sheets.

Corporate earnings headwinds could develop during the first half of 2013. The current full-year $107 consensus forecast for the S&P 500 Index seems ambitious but not unachievable if our macro thesis unfolds. European earnings growth will be challenged if the eurozone recession persists. We doubt the 11% consensus growth forecast for the region will be met.

Nevertheless, we’re encouraged because the pace of earnings downgrades has slowed for most markets (Europe being the exception). Usually, earnings momentum follows economic momentum, so earnings revisions could potentially improve in the second half of 2013.

Revenue growth expectations may prove to be too cautious. 2013 consensus sales forecasts of 3.5% in the U.S. and 2.6% in Europe are well below the International Monetary Fund’s 4.9% global nominal GDP forecast (includes inflation). Normally, U.S. corporations tend to grow sales above the rate of global nominal GDP growth. For the past 10 years, revenue growth has exceeded it by better than 2% on average.

Profit margins may have peaked; however, we don’t anticipate any rapid retrenchment. Usually margins tend to hold up until almost one year after wage growth has risen meaningfully. This cycle, developed market wage growth has barely budged. Other conditions that tend to precede steep margin declines (supply shocks, overinvestment, closing of the output gap) are not on the horizon.

Overall, equity valuations are undemanding for most markets. Based on the $107 consensus earnings forecast, the S&P 500 trades at a 13.3 price-to-earnings ratio, which is near the long-term average. P/E ratios are well below average in some European and Asian markets. More importantly, equities are much cheaper than bonds on a variety of measures.

Finally, long-term investors’ equity positioning is unusually low. Pension funds, insurers, and even many individual investors are carrying below-normal equity weightings. There is room to expand equity holdings.

Sales Expecations for 2013 Could be Too Low

Source - National research correspondent, IMF, Thomson Reuters I/B/E/S, Eurostat

Normally sales growth exceeds global nominal GDP growth.

2.6%

3.5%

1.6%

3.5%

4.9%

MSCIEurozone

Sales

U.S. S&P500 Sales

EurozoneNominal

GDPGrowth

U.S.Nominal

GDPGrowth

GlobalNominal

GDPGrowth


2013 ouTlook

alTernaTIve scenarIos

RBC’s preceding base-case forecast hinges on Washington cobbling together a credible deal on at least part of the fiscal cliff provisions in a timely manner. It’s unclear at this stage whether or not that will occur. It’s also dependent on avoiding the resumption of major stress in Europe. Our assumptions could be challenged by unexpected positive or negative developments, and the following alternative scenarios could unfold:

Alternative Scenario A

U.S. economic growth climbs above trend and a new secular bull market cycle begins.

� If the president and Congress forge a market-friendly fiscal cliff compromise, and especially if they lay the groundwork for a tax code overhaul and entitlement reform, there’s a possibility the U.S. economy could gain more traction than we anticipate.

� GDP growth could exceed the lackluster 2.0%-2.5% pace that has characterized much of the recovery period.

� If this occurs, the U.S. stock market could finally break out of the 13-year secular consolidation range, trade to new highs, and ostensibly begin a new long-term secular advance.

Alternative Scenario B

Fiscal austerity hurts U.S. growth or a recession materializes, which impacts other regions, and stock prices decline.

� If Washington botches the fiscal cliff negotiations or the debate lasts far longer than the market has patience for, the U.S. economy could end up working through a deeper economic valley during 2013 or a recession could occur.

� Earnings could drop 20% or more if a recession develops. A commensurate decline in stock prices could also take place.

Alternative Scenario C

Europe descends back into crisis, negatively affecting global growth and multinational earnings.

� Europe’s policymakers could stumble at some point during the year if challenges for Greece, Spain, or Italy bubble back up to the surface.

� The ECB’s policies have yet to be implemented and tested. Any unraveling of political agreements or sovereign debt stress could pressure the fragile banking system. The risk of a banking crisis, while considerably diminished, is not fully off the table.

� The re-emergence of severe eurozone stress could cause stock prices to decline across markets.

U.S. GDP is Still Well Below Potential, But Should Begin to Catch Up Soon

Source - RBC Wealth Management, Congressional Budget Office (CBO), National Bureau of Economic Research

Potential GDP is the CBO's estimate of the output the economy would produce with a high rate of use of its capital and labor resources.

10

12

14

16

18

20

2000 2005 2010 2015 20200.00.10.20.30.40.50.60.70.80.91.0

Recession

GDP

Potential GDP

Actual Projected


europe Inc. Is noT eurozone Gdp While Macro Economic Conditions Contract, World-class European Companies Flourish

Following developments in Europe in 2012 was much like doing a dot-to-dot puzzle─going from crisis to crisis, from summit to summit, one easily lost track of the big picture.

The fact is Europe probably has achieved more than it has been credited for. Yet, much remains to be done if the euro project is to survive.

For investors, the reality of investing in the region is quite different from its politics. Europe Inc. is not eurozone GDP. Opportunities abound.

frédérIque carrIer – london, unITed kInGdoM [email protected], Royal Bank of Canada Investment Management (UK) Ltd.


Much has been achIeved …

Improvements in the current account deficits of the periphery countries (Spain, Italy, Ireland, Portugal, and Greece) are one sign the medicine is starting to work. True, the improvement comes from very low levels and is enhanced by a drastically reduced demand for imports, but the trend is notable nonetheless. In fact, exports in a number of periphery countries are growing. Spanish and Portuguese exports are up more than 20% over the past three years. Exports have expanded by 15% for Ireland, a particularly encouraging improvement because exports, at 100% of GDP, are an important driver for the economy. Overall, the euro area current account has moved to a surplus of 0.8% of GDP in 2012, the largest surplus for a decade, with the IMF projecting 1.3% for 2013.

Budget deficits have also improved, particularly the primary budget balances (the deficit or surplus before any interest payments). This is vital as a growing primary deficit feeds into more debt. Thanks to drastic austerity measures, primary deficits have narrowed, and Italy has even achieved a primary surplus. Even Greece can boast a substantial improvement in its primary budget balance.

Unit labour costs in the periphery have also fallen since 2009, boosting competitiveness. Ireland, Spain, and Portugal, in particular, have registered notable improvement. Italy’s labour reforms haven’t yet fed through but should, in time.

Importantly, over the same period, Germany’s unit labour costs have risen. Real wage increases in Germany, after many years of decline, is a welcome development. This provides not only spending stimulus within the domestic German economy, but it also helps narrow the relative competitiveness gap between core and periphery, sharing the burden of adjustment in the process.

Finally, progress was made on much-needed structural reforms aimed at enabling eurozone countries to deal with the straight jacket of the single currency. Earlier in 2012, Spain’s Prime Minister Mariano Rajoy announced a comprehensive labour market reform package aimed at tackling the country’s high unemployment

europe - 2013 ouTlook

Primary Budget Balances as % of GDP

Source - International Monetary Fund, World Economic Outlook

-30

-25

-20

-15

-10

-5

0

5

10

1999 2002 2005 2008 2011

Italy

Portugal

Greece

Ireland

Spain

Current Account as % of GDP

Source - International Monetary Fund (IMF), World Economic Outlook

-16

-14

-12

-10

-8

-6

-4

-2

0

2

1999 2002 2005 2008 2011

Ireland

Italy

Spain

Portugal

Greece

Current accounts improve throughout the periphery.

Nominal Unit Labour Costs

Source - RBC Capital Markets

90

100

110

120

130

140

150

2000 2002 2004 2006 2008 2010 2012

Italy

Spain

Ireland

Portugal

Germany

Rebased: 2000 = 100

Irish and Spanish unit labour costs fall, German cost rises.

General Government Primary Net Lending/Net Borrowing


and improving competitiveness. Even French Socialist President Hollande recently announced steps to improve France’s competitive position. The tax burden on corporations will be reduced to the tune of €20 billion via a series of tax credits designed to lower the “social cost” payments borne by businesses. These have acted as a tax on jobs in the economic downturn. The loss of revenue will be funded through government spending cuts of €10 billion and an increase in value-added tax and other indirect taxes. The move away from taxation that discourages job creation toward a broader tax base is significant.

... buT More efforTs are needed

Much remains to be done. Most eurozone countries are struggling to turn around economies smaller than they were in 2008, with further declines likely to be posted in the fourth quarter. The prognosis for 2013 isn’t much better. While Germany, Ireland, and Finland might be able to eke out growth of around 1%, periphery economies will likely experience economic contraction again─Greece for the sixth-consecutive year. RBC economists have penciled in a meagre 0.1% gain for 2013 for the region as a whole. Banks' lending standards remain restrictive while private sector credit growth overall continues to edge lower,

a reflection of constraints in credit supply and weakness in loan demand.

Unemployment is high and still rising everywhere but Germany, a painful reminder of the social cost of recent adjustments. While capital flight from the periphery has only recently subsided, the situation remains fragile. These economic conditions, worsened by austerity, make it virtually impossible to close deficits and reduce debt burdens. Paradoxically, it appears more fiscal tightening is needed to stabilise government debt-to-GDP ratios in the periphery; however, the more governments tighten at this point, the faster GDP falls.

Bridging the gap between North and South must be a priority. Should all the required adjustments occur through the South, a populist backlash


Private sector loan growth suffering from lack of demand and supply constraints.

Private Sector Loan Growth (y/y)


-2

0

2

4

6

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10

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14

1992 1996 2000 2004 2008 2012

ECB M3 Reference Rate

Germany labour markets flourish while Spain’s flounder.

Euro Area Unemployment (m/m change, 000s)


-200

-100

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100

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2007 2008 2009 2010 2011 2012

OtherItalyFranceGermanySpainEuro area



A banking union would break the

vicious circle involving weak banks

and weak sovereigns by taking

the responsibility of resolving a

banking crisis away from national

governments.

could occur against adjustment policies. The gap between periphery and core needs to narrow, both in terms of GDP growth and unemployment. The bottom right chart on the previous page shows while Spain has consistently added to the ranks of the unemployed, Germany’s labour market has improved.

A banking union would clearly help. Periphery governments are relying on their national banks, often with shaky capital positions themselves, to buy government bonds. A banking union would break the vicious circle involving weak banks and weak sovereigns by taking the responsibility of resolving a banking crisis away from national governments. A union would ideally involve common supervision and a deposit guarantee scheme. While politicians seemed to agree in principle to the need for common bank supervision in the summer, they now appear to be shying away from taking the necessary steps. This leaves the eurozone, for all its improvements, still vulnerable to shocks.

European Central Bank (ECB) President Mario Draghi’s Outright Monetary Transactions policy, announced in September, brought relief by reducing bond yields in Spain, Portugal, and Italy. It has also likely helped Ireland regain access to capital markets. But ultimately, while a lot rests on the ECB, the eurozone needs politicians to rise to the occasion. More structural reforms are required, particularly regarding the welfare system

and entitlements and also with respect to the rules and functioning of markets for goods, services, and labour.

rIsks are consIderable

Many challenges lay ahead. Despite the recent agreement, Greece remains a major concern. Its government debt-to-GDP ratio is not expected to get down to 127% (close to the 120% level deemed sustainable by the IMF) before 2020, and that is thanks only to overly optimistic assumptions. Greece is insolvent, though the probability of a “Grexit” is likely low. The cost of a Greek withdrawal from the euro would be very high (estimated by many at €200 billion) and would almost certainly entail messy defaults on private- and public-sector loans. With the German general election in the fall of 2013, Chancellor Angela Merkel is likely to try to avoid the major turmoil for the euro area that would accompany a Greek departure.

Spain is also a considerable risk, given its economy is six times larger than Greece’s. The country has been praised for its efforts at reform, yet its plight is now being exacerbated by regional governments admitting they are themselves insolvent and need financial help. This adds to the central government’s financial burden. With moribund domestic demand, deficit-reduction targets will likely be missed. In our view, more austerity is in the offing. The private sector is reluctant to invest. The recession will last longer and perhaps deepen



The STOXX Europe 600 ex UK is

up 15.7% so far in 2012 despite the

political and economic headwinds.

Why? In our view, it is because

investors have been willing to

dissociate Europe Inc. from the

macroeconomic situation.

as the vicious circle continues. Prime Minister Rajoy knows he needs a bailout but is dragging his feet having previously insisted the country does not need one. But his reluctance to ask for help has created great uncertainty. How long can Spain muddle through on its own? What conditionality will be imposed on its loans? Exactly how will the ECB’s Outright Monetary Transactions policy work? A bailout would relieve much of the uncertainty.

In Italy, Prime Minister Mario Monti's recent resignation means most of the reforms his government had been working on are unlikely to be approved in parliament. These targeted an improvement in competition, a simplification of the taxation system, a much-needed slimming down of bureaucracy, a new constitutional requirement for a balanced budget, as well as a growth stimulation package. Elections due in the spring will now likely be brought forward. A comeback by former Prime Minister Silvio Berlusconi is unlikely but cannot be ruled out. Moreover, a recent local election in Sicily was won by a new anti-establishment party with 20% of the vote, the highest percentage of any single party. This is a reminder that should such a force emerge at the parliamentary election, it would complicate matters, not only in forming a new government, but also by undermining the government's capacity to ask for ESM help, should that prove necessary.

Of greatest importance will be the German elections in October 2013. Chancellor Merkel

is well ahead in the polls, her popularity rising after she became tough on Europe, refusing to endorse eurobonds. She will likely maintain an uncompromisingly tough position until the elections. Her position may well change once she is re-elected, particularly if pro-European parties gain ground in the Bundestag.

buT for all The debaTe abouT The crIsIs, europe Inc. Is noT eurozone Gdp

A casual observer would be forgiven for thinking with the eurozone's macroeconomic entanglement and the political challenges ahead, the European stocks should be avoided at all costs. In fact, the STOXX Europe 600 ex UK was up 15.7% year to date through mid-December, one of the best-performing markets in 2012. Why? In our view, it is because investors have been willing to dissociate Europe Inc. from the macroeconomic situation.

Europe offers a wealth of world-class, global companies that generate a mere 50% of aggregate revenues in Europe. Excluding the largely domestic sectors of Utilities and Telecoms, only 40% of sales are European-based. Europe Inc. is more dependent on emerging markets and the U.S. for growth than on its domestic economy. Furthermore, balance sheets are generally robust, with companies─unlike their governments─having taken advantage of the very low interest rates engendered by the financial crisis to further bolster their already strong balance sheets. The ratio of net



debt to EBITDA for the market excluding Financials hovers around 1.0. There are also good corporate governance standards and generally shareholder-friendly managements. The dividend yield of the market is an attractive 4%, the second-highest of all regional markets after the United Kingdom. Furthermore, whilst valuations in price-to-earnings (P/E) terms troughed mid-summer, valuations are not stretched, with the market at a P/E of 11.5x estimated 2013 earnings and 10.3x projected 2014 earnings. On a cyclically-adjusted basis, the European P/E ratio is 38% below its 30-year average. It is also at a 44% discount to the U.S. P/E ratio, the widest gap over the same period.

Throughout 2012, we have advocated investing in resilient companies─those operating in industries with high barriers to entry, with strong business models that enjoy pricing power, and are healthy cash flow generators. Looking for these attributes led us to sectors such as Staples, Discretionary, and Industrials. Those sectors generally performed well. Domestically-oriented companies with poor balance sheets, such as Telcos and Utilities, fared poorly.

Looking forward, consensus earnings estimates for 2013 call for a high-ish 11% growth for the region. Excluding the notoriously volatile Financials sector, this falls to 8.9%, a more-realistic expectation, in our view. After a lacklustre earnings season, earnings estimates might be reined in further.

Nevertheless, with ongoing austerity pressures, and in a world of subdued growth, we believe the resilience theme will also work in 2013. Given tensions in Europe have abated somewhat, it might also be opportune to layer in selective high-quality cyclicals and restructuring plays.

Source - Bloomberg

-14.2%

-9.9%

1.0%

15.8%

16.5%

17.6%

20.0%

20.3%

21.3%

26.8%

Energy

Industrials

Consumer Staples

Basic Materials

Financials

Healthcare

Information Technology

Consumer Discretionary

Telecommunications

Utilities

Sector Year-to-Date Performance (Europe ex U.K.)

Companies with low to no pricing power and poor balance sheets underperform.


eMerGInG MarkeTsWill 2013 See a Rebound in Emerging Market Equities?

Growth in emerging economies should continue to outpace the trend seen in advanced economies.

But deleveraging and risk aversion on the part of international investors has made equity valuations cheap compared to historical averages.

We argue the recent period of underperformance compared to developed market equities may be coming to an end, and there are reasons to be guardedly positive on equities in all of the BRIC nations.

alan robInson – seaTTle, unITed sTaTes [email protected]; RBC Capital Markets, LLC

Jay roberTs – honG konG, chIna [email protected]; RBC Dominion Securities Inc.


eMerGInG MarkeTs - 2013 ouTlook

We are guardedly optimistic on the prospects for emerging markets in 2013. Emerging market growth continues to outpace that seen in developed markets, and valuations appear ever more attractive. However, our positive view still depends on the resolution of three potential headwinds: two with their roots in developed markets and one from within the emerging world.

It is no surprise the trajectory of the Chinese economy commands so much of our attention. As the largest emerging economy with the strongest growth over the last decade, it influences the direction of commodity prices and the extent of emerging market trade and investment flows. China’s outlook is discussed in greater detail on pages 22-23, but the key takeaway is a steadily improving Chinese economy will have a positive impact on emerging markets in general, whereas if China stumbles, other emerging markets may only limp along, too.

The economies and politics of Europe and the United States also play a part. Europe is probably the larger factor due to its historically significant share of investment in emerging markets. As the eurozone struggles with a weak economy, its banks are reducing their overseas investments in order to rebuild capital. Thus, we expect very little new funding from this source and potentially a continued withdrawal of European funding from emerging markets. Although this may present a headwind to emerging asset prices, it also leads to compelling valuations.

The stability of the U.S. economy is also essential to emerging markets, and a political agreement toward a sustainable U.S. budget will be important to maintain overall market confidence in 2013.

The lonG-TerM case for eMerGInG MarkeTs

2013 marks an important turning point for developing economies. According to IMF estimates, it will be the first year to see the total GDP of emerging nations exceed that of advanced economies. And since we expect economic growth in developing nations to continue to outpace that in advanced economies, this gap is likely to expand.

The drivers of this trend are straightforward. First, it’s easier to grow smaller economies than larger. Second, most advanced nations have funded their recent growth with debt, whereas developing nations are still relatively under-leveraged, allowing more fuel for growth in the future. Third, globalization has played a large part in expanding export and import markets for developing economies.

However, this likely outperformance of emerging economies is not without risks. A large part of the emerging growth story is the transition from export-led economies to those that focus on a growing domestic consumer base. This change can be disruptive as emerging economies are forced to restructure their export industries to higher-value products or lose market share as their currencies appreciate.

Share of World GDP, 1980-2017

Source - IMF World Economic Outlook, October 2012, RBC Wealth Management

Actual data for 1980-2011, IMF estimates for 2012- 2017. Advanced Economies comprise the 35 most-developed nations.

30%

40%

50%

60%

70%

1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Advanced EconomiesOther Economies

Developing economies are projected to account for more than half of world GDP beyond 2012.

... since we expect economic growth in developing nations to continue to outpace that in advanced economies, this gap is likely to expand.



Another concern is the best years of emerging market growth may be behind us. We’re not suggesting developing economies are facing structural decline, but we do acknowledge that following the reforms of the 1990s, the easiest productivity gains have probably already been accomplished, and the demographic advantages of certain emerging economies, including China and Russia, may fade further (see chart, top left).

our vIeW for 2013

We believe four key drivers will determine the direction of emerging markets in 2013. We view two of these as positive factors, one neutral on balance, and the other as a potential negative.

Valuations

The steady growth of emerging economies has not been matched by a commensurate increase in valuation multiples, in our view (see table on following page). This is partly due to risk aversion and deleveraging on the part of developed nation investors. However, given the clear trend toward historically low interest rates for extended periods in these countries, we believe even a modest resumption of growth-seeking investment flows has the potential to increase valuation multiples or at least limit the downside for asset prices.

Relative Performance

Emerging market equities generally are a higher-beta asset than developed market stocks; that is, they typically underperform in bad times and

perform really well when the going is good. After a strong rebound from the lows of the global bear market in 2009, emerging markets have lagged the performance of developed markets since 2011 (see chart, bottom left). We believe the recent period of underperformance compared to developed market stocks (particularly U.S. stocks) appears close to an end if historical cycles are a guide.

The Commodity Cycle

There is some evidence the strong performance of industrial commodities since 2002 may be starting to slow. This historical boom has coincided with the secular growth cycle in emerging markets, and there is a strong correlation between commodity prices and emerging market asset prices. So does a potential flattening in commodity price trends suggest we can expect a similar weakness in emerging markets?

We think the answer is “not necessarily.” We note much of the surge in commodities over the last 10 years has been due to the infrastructure buildout in emerging markets, particularly in China. But the economic transition from investment to consumption-led growth in emerging markets means commodity prices should be a less-relevant indicator of growth in the future.

Deleveraging

The debt cycle that culminated in the global recession of 2008 will take many more years to unwind. Emerging economies were relatively under-leveraged during this cycle, but they are still

Emerging Markets Potential Growth Rates

Source - IMF, RBC Capital Markets. Rates for 2012 and beyond are estimates.

Graph represents implied trend growth in real GDP using a Hodrick-Prescott filter.

2%

3%

4%

5%

6%

7%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

Relative Price Performance of Emerging Market and U.S. Stocks

Source - FactSet Research Systems, RBC Wealth Management

Normalized, with January 2, 2008 = 100

30

40

50

60

70

80

90

100

110

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12

MSCI Emerging Markets Index

S&P 500



feeling the impact as developed-nation investors repatriate funds to repair their own balance sheets. This is particularly true for European sovereigns, banks, and other private investors. European lenders were the largest source of emerging market funding before the recession, and their continued absence will dampen emerging asset prices.

The good news is reliance on foreign funding is diminishing. Emerging economies are increasingly funding their own growth as domestic savings and profits are channeled through a rapidly growing internal banking system, particularly in Asia. Additionally, the absence of some foreign investors offers attractive valuation opportunities in emerging markets.

reGIonal ouTlook

From a regional perspective, we expect Non-Japan Asia to attract most funds flows, followed by Latin America, and then Emerging Europe and Africa. This view partly reflects likely risk appetite and, to a lesser extent, cyclical factors. As the largest regional group within emerging markets, Asia can offer more liquidity for foreign investors and potentially stronger currencies. Latin America should still grow well, but the threat of interventionist policies from some South American governments may impose a risk premium to asset prices. Finally, emerging Europe will likely remain in the shadow of its developed neighbors, and we expect deleveraging from eurozone investors to provide a particular headwind here.

defInInG eMerGInG MarkeTs

There is no consensus over what defines an emerging market, but we consider the MSCI list of 21 (see table on next page) to be the most representative. Some borderline “frontier” economies, including Vietnam, Pakistan, and Ukraine miss the MSCI cut.

A common benchmark of emerging status is the size of a nation’s economy compared to its population. Most of these economies generate a GDP per capita below US$20,000. Taiwan, South Korea, and the Czech Republic are clear exceptions, and their inclusion on the list mainly reflects their less-developed currency and capital markets compared to developed nations.

reassessInG The brIc naTIons

The BRIC designation, coined at the start of the century, raised the profile of emerging market investing just as Brazil, Russia, India, and China shifted into high gear. While the field for most investors in emerging markets has broadened beyond these large economies, the BRIC nations together still account for almost two-thirds of emerging market GDP, and they continue to have an outsized influence on emerging market trade and investment. Following, we discuss the major drivers for these economies in 2013.

China

The Shanghai A-Share Index was one of the worst-performing major equity indices in the world in

Premium2 2013 EPS Current1 5-yr Avg (Discount) Growth (E)

Asia Philippines 16.7x 13.9x 20% 12% Taiwan 14.6x 15.1x -3% 25% India 14.1x 14.7x -4% 15% Malaysia 13.8x 14.0x -1% 8% Indonesia 13.4x 12.5x 7% 13% Thailand 11.0x 10.4x 6% 18% China 9.6x 11.4x -16% 10% South Korea 8.4x 9.8x -14% 17%

Europe, Africa Morocco 12.9x 14.5x -11% 9% South Africa 11.8x 10.5x 12% 16% Poland 11.1x 10.8x 3% -9% Turkey 10.6x 8.7x 22% 11% Czech Republic 9.7x 10.7x -9% -1% Hungary 8.0x 8.5x -6% 20% Egypt 6.3x 9.5x -34% 7% Russia 4.9x 6.5x -25% -1%

Latin America Mexico 16.7x 13.4x 25% 15% Chile 15.4x 15.3x 1% 18% Colombia 13.9x 14.8x -6% 17% Peru 11.6x 11.8x -2% 13% Brazil 9.9x 10.0x -1% 19%

12-mo Trailing P/E

Emerging Market Equity Valuations

Source - CIA World Factbook, RBC Wealth Management, MSCI Valuation estimates: I/B/E/S1 For 12 months ended November 30, 2012.

2 Current premium or discount to five-year historical P/E valuations.

Emerging Europe looks cheap on an absolute and historical basis, but average earnings growth forecasts in the single digits are below the mid-high teens levels expected in Asia and Latin America.



2012. We expect much better performance from the Index in 2013. The threat of a hard landing for the economy, which was heatedly debated in the first half of the year, has receded after data improved in the summer, although equity investors have been slow to digest the better news. Growth and confidence in the Chinese economy should be higher in 2013 as it modestly re-accelerates from the summer trough. One of the key risks remains a further downturn in the U.S. and Europe, two of China’s major export markets.

Economic data is stabilizing: This includes the manufacturing and services Purchasing Managers' Indices, export and import growth, money supply, power consumption, industrial profits, and certain aspects of the housing market. RBC Capital Markets forecasts Chinese GDP growth of 8.3% in 2013.

Leadership change: The formal change in the Chinese Communist Party leadership took place in November. Xi Jinping and Li Keqiang took the top positions. In the second half of 2013, the new leadership may begin to roll out its policy agenda, which should be a positive for markets.

Low inflation/targeted easing: Inflation pressures have clearly subsided in China over the past six months, and any increase from here should be gradual and benign. This would allow for continued targeted monetary and fiscal policy easing. The People’s Bank of China has preferred short-term liquidity measures over cutting interest rates or further reductions in the required reserve ratio,

which impact bank lending. This preference is likely due to an aversion to re-stimulating the housing market.

Equity valuations: After over a year of analysts cutting earnings estimates, forecasts finally began to level out towards the end of third-quarter 2012, and estimates have begun to improve for some sectors. The Shanghai Composite Index is now trading at historically low valuation levels, near 9.6x on a trailing P/E basis and 1.6x on a price-to-book basis. This inexpensive valuation is heavily weighted toward Chinese financials, which constitute about one-third of the Index. With the ongoing improvement in Chinese economic data, it is reasonable to suggest bank valuations may enjoy some degree of expansion from here.

Brazil

Similar to China, Brazil also struggles with imbalances in its economy. Unlike China, Brazil’s economy has been driven by a free-spending consumer class over the past few years, while the infrastructure investment side of the economy has lagged. The goal of President Dilma Rousseff’s government in 2013 will be to address this imbalance without unduly shrinking the consumer sector.

The Brazilian Central Bank (BCB) has played its part by cutting the SELIC base interest rate to an all-time low of 7.25% in October 2012. Inflation remains within the 2.5%-6.5% target range, and the BCB appears less hawkish than in the past,

GDP GDP PopulationPer Capita1 Growth2 (Millions)

Asia Taiwan $37,700 4.0% 23 South Korea $31,200 3.6% 49 Malaysia $16,200 5.1% 29 Thailand $9,400 0.1% 67 China $8,400 9.2% 1,343 Indonesia $4,700 6.5% 249 Philippines $4,100 3.9% 104 India $3,700 6.8% 1,205

Europe, Africa Czech Republic $27,100 1.7% 10 Poland $20,200 4.3% 38 Hungary $19,600 1.7% 10 Russia $16,700 4.3% 143 Turkey $14,400 8.5% 80 South Africa $11,000 3.1% 49 Egypt $6,500 1.8% 84 Morocco $5,100 4.9% 32

Latin America Chile $17,400 5.9% 17 Mexico $14,700 3.9% 115 Brazil $11,800 2.7% 199 Colombia $10,200 5.9% 45 Peru $10,100 6.9% 30

Emerging Market Economies

Source - CIA World Factbook, RBC Wealth Management, MSCI Valuation estimates: IBES1 2011 figure, in US$, based on Purchasing Power Parity.

2 2011 figure.

Emerging Asia accounts for 65% of total emerging mar-ket GDP due to the outsize contributions from China and India. The Brazilian and Russian economies each account for about 7% of the total.



suMMary

We believe emerging market assets will continue to play an important part in well-diversified portfolios in 2013.

As the global economy slowly regains its footing against a backdrop of continued low interest rates, we believe the relative growth and valuation advantages of emerging markets will provide a tailwind to assets in these economies.

stating low rates are likely for a “prolonged” period. The government has also targeted the high cost of electricity in Brazil by unilaterally cutting the prices power generators are contractually allowed to charge businesses and consumers, although this has also raised the specter of government interference in the eyes of international investors.

This is compounded by fears over continued declines in the Brazilian real. The BCB allowed the real to fall from 1.70 to 2.10 against the U.S. dollar during the first half of the year. After a period of stabilization, the currency is flirting with new lows again, which may deter foreign investors.

Russia

In August 2012, after nearly 20 years of negotiations, Russia was finally admitted as the 156th member of the World Trade Organization (WTO). Typically, WTO membership is viewed as a boon to markets as the economic liberalization required of membership acts as a long-term boost to new member economies. The accession of China to the WTO in 2001, and the country’s growth since, provide a good example.

However, Russia is a lot different than China. Russia already has a large trade surplus ($116 billion for the first six months of 2012) thanks to its oil and gas exports, so the bigger effect of trade reforms is likely to be felt in domestic consumption. But, as we enter 2013, consumer confidence in Russia is low, due partly to high inflation and interest rates (both around 7%). Fiscal austerity is likely to

dampen growth, and much of the resource-driven inflows will likely go to strengthen the under-capitalized banking sector.

Russian asset valuations are relatively cheap, partly due to poor visibility and shaky confidence in the business environment, and the country’s reliance on energy exports makes the economy more sensitive to global economic conditions. However, if the global economy surprises to the upside, Russia should perform well.

India

International sentiment toward India started 2012 at a low ebb. Growth had fallen to a 10-year low, and the rupee fell from 48 to 57 against the dollar between February and June. However, a raft of government reforms announced in September suggest 2013 might see the markets turn the corner. These reforms are centered on easing restrictions on foreign direct investment in the retail, broadcasting, aviation, and power sectors and were widely applauded by credit agencies and international investors.

The announcement of a new National Investment Board tasked with expediting infrastructure projects is another positive. However, some skepticism remains over the implementation of these reforms, particularly in the run-up to federal elections in 2014. In the meantime, government spending ahead of these elections should continue to boost the consumer sector at the cost of further slippage in fiscal targets.

Selected Economic Data for the BRIC Nations, 2011

Source - IMF, Economist Intelligence Unit, CIA World Factbook

* as a % of GDP

Brazil Russia India China

GDP growth 2.7% 4.3% 6.8% 9.2%

Inflation 6.6% 8.4% 8.6% 5.4%

Unemployment 6.0% 6.5% 9.8% 4.0%

Investment* 20.6% 23.2% 34.4% 48.3%

Savings* 18.4% 28.6% 31.6% 51.0%

Current Account Balance* -2.1% 5.5% -2.8% 2.8%

Budget Balance* -2.6% 1.6% -8.7% -1.2%


shale: an end To hIGh oIl prIces?An In-Depth Look at the Shale Oil Revolution in North America

The explosion of shale gas activity over the past seven years has led U.S. gas production to eclipse its 1970s peak and dramatically transform the dynamics of North American supply and demand.

With the same extraction techniques now being applied to oil, the shale oil revolution has begun and has many investors wondering if a similar impact on the oil market may be experienced in the years ahead.

Mark allen – ToronTo, canada [email protected], RBC Dominion Securities Inc.


shale - 2013 ouTlook

WhaT are shale and TIGhT oIl?

Shale and tight oil are conventional oil trapped in unconventional rock formations. The presence of these extremely large resources has been known by geologists for decades. However, accessing them has only become economically viable in recent years.

Shale and tight oil reservoirs have low porosity and permeability, which bind oil in place instead of allowing it to flow as in a traditional oil pool. To get around this problem, energy companies have applied horizontal drilling and hydraulic fracturing to crack open the rock and, thus, create channels that allow oil to flow. While these techniques are often referred to as “new” or “unconventional,” in reality, they have been available for some time. Horizontal drilling started to see commercial application in the 1980s, while fracturing techniques began to see rapid growth in the 1950s.

Horizontal drilling has become pervasive and now represents nearly two-thirds of all drilling in the United States. Horizontal wells are drilled down vertically thousands of feet, then turned horizontally to maximize their reach through the flat expanses of shale reservoirs that were created through a sedimentary process. Hydraulic fracturing involves pumping high pressure fluid (water, sand, chemicals) down the wellbore to create fissures in the rock formation.

The use of these techniques in tandem to access shale reservoirs was first applied in a large-scale

way by Mitchell Energy to produce natural gas from the Barnett shale in Texas. Barnett grew rapidly over the next decade, and its success in the early 2000s led other producers to apply these techniques to a variety of shale gas and shale oil plays across North America. As natural gas prices swooned in recent years, the industry has moved aggressively toward redirecting its efforts toward investment in shale oil.

u.s. oIl producTIon— pasT, presenT, and fuTure

U.S. crude oil production peaked in 1970 and saw roughly two decades of steady declines following the late 1980s. Since then, a marked reversal has taken place, driven by shale oil.

With shale oil plays in an emerging stage of development, it is difficult to predict confidently the growth rate that will be achieved as we look out over the next decade. Wood Mackenzie, a U.K.-based global energy consultancy, expects U.S. tight oil to increase to 4 million barrels per day (mbpd) by 2020 from roughly 1.5 mbpd in 2012. A Harvard Kennedy School study forecasts an additional supply of 4 mbpd over the next eight years, implying 2020 production closer to 5-6 mbpd.

From its low point in 2008, total U.S. crude oil and liquids production has soared to 8.6 mbpd currently from approximately 7 mpbd. As shale oil gains momentum, this figure could soon surpass the production rates of the world’s largest producers, Saudi Arabia and Russia, which each

U.S. Crude Oil Production

Source - U.S. Energy Information Administration (U.S. Field Production of Crude Oil)

0

2,000

4,000

6,000

8,000

10,000

12,000

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010

U.S

. Cru

de O

il P

rodu

ctio

n(th

ousa

nd b

arre

ls p

er d

ay)



key plays

There are some 20 shale oil plays in North America with the most prominent including: Bakken (North Dakota, Montana, and Saskatchewan), Eagleford (Texas), Niobrara (Colorado, Wyoming, and Nebraska), and the Permian basin plays (Texas and New Mexico).

Other emerging shale oil plays include: Granite Wash, Barnett, Woodford, Monterey, Utica, and Uinta.

Chattanooga

Eagle Ford

Devonian (Ohio)

MarcellusUticaHermosa

Niobrara*

Bakken***

Niobrara*

Monterey

Monterey-Temblor

Avalon

Heath**

Tuscaloosa

MowryAntrim

Barnett

Bend

New Albany

Woodford

Barnett-Woodford

Lewis

Hilliard- Baxter-Mancos-Niobrara

Excello-Mulky

Fayetteville

Floyd-Neal

Gammon

Cody

Haynesville-Bossier

Mancos

Pierre-Niobrara

Conasauga

Colorado Group

Utica

Doig Phosphate

Montney

Muskwa-Otter Park

Muskwa-Otter Park, Evie-KluaLower

Besa River

Frederick Brook

Horton Bluff

Pimienta

Eagle Ford,Tithonian

Maltrata

Eagle Ford,La Casita

Pimienta,Tamaulipas

North American shale plays

0 400 800200 600

Miles±Source: U.S. Energy Information Administration based on data from various published studies. Canada and Mexico plays from ARI.Updated: May 9, 2011

(as of May 2011)

* Mixed shale & chalk play ** Mixed shale & limestone play

*** Mixed shale & tight dolostone-si ltstone-sandstone play

Stacked playsCurrent shale plays

Shallowest / youngest

Deepest / oldest

Basins

Prospective shale plays

Intermediate depth / age

North American Shale Gas and Shale Oil Plays

Source - U.S. Energy Information Administration based on data from various published studies. Canada and Mexico plays from ARI. Updated May 9, 2011.



produce about 10 mpbd. Major agencies look for U.S. oil and liquids production of approximately 9-11 mpbd by 2020. Despite this impressive growth potential, U.S. self-sufficiency in oil seems a long way off with current oil consumption around 19 mbpd—which, interestingly, is down by almost 2 mbpd from 2007 levels.

shale oIl resource base

In its Annual Energy Outlook 2012, the U.S. Energy Information Administration estimates U.S. tight oil resources at 33 billion barrels. This estimate likely understates the resource base, given the rapid pace of development since the date of these findings—January 2010. Recoverable resource estimates are inherently uncertain given: (i) limited drilling history, (ii) limited production history, and (iii) a dynamic environment for technology. Estimates of the original oil in place are much, much larger. For example, a study published by the State of North Dakota in 2008 estimated original oil in place for the state’s Bakken formation at 149 billion barrels. As companies apply waterfood and other stimulation techniques to improve recovery percentages, the estimates of recoverable resources could increase dramatically. Some operators that are applying these techniques are hoping to move recovery factors up to double-digit levels from 1%-3% today.

challenGes To developMenT

While shale oil holds the prospect of substantial growth, there are a number of challenges to its development. The associated big ramp up in drilling activity may give the illusion it will be easy to achieve overall production growth well into the future. However, production declines for individual wells of 60%-75% in the first year alone mean significant drilling expenditures will be needed just to keep production flat. Pipeline constraints exist, which will limit growth in the near term and means even further capital investment over the longer term. Finally, environmental concerns have been raised, including: potential impact on groundwater, high water usage in areas of water shortages, noise controls, and carbon emissions.

WIll shale oIl IMpacT prIcInG The Way shale Gas has?

Parallels have been drawn in the media between the potential of shale oil on global oil prices and the impact of shale gas on North American natural gas prices. Two key differences stand out—the size of the market and the potential impact on the industry cost floor.

North American natural gas is largely an isolated market, albeit with some modest flows to the rest of the world via liquefied natural gas shipments. Thus, the influence of shale gas has been concentrated almost entirely on that continent. Shale gas has grown to be so large that it now

Unproved Technically Recoverable Tight Oil Resources (As of January 2010)

Source - U.S. Energy Information Administration Annual Energy Outlook 2012

* Includes Sanish-Three Forks

6.5

5.4

2.1

5.1

Niobrara WillistonBakken*

Eagleford Permian

Billio

n ba

rrel

s

Austin Chalk

Eagleford



represents approximately one-third of North American production. By comparison, U.S. shale oil production should grow to 4-6 mbpd by 2020 from roughly 1.5 mbpd. Within a global market for oil that consumes roughly 89 mbpd, the contribution of U.S. shale oil is relatively small.

Global supply growth is reliant upon high-cost sources of oil. It is estimated that U.S. shale oil plays are economically viable at approximately $50-$75 per barrel. Other major sources of global growth include the Canadian oil sands, which require an estimated $70-$80 per barrel to justify further development; Brazilian deep-water, which is thought to be economic at about $45 per barrel; and U.S. Gulf of Mexico deep-water, which has breakeven costs near $55-$70 per barrel. U.S. shale oil costs are roughly in the middle of the pack and are unlikely to affect the industry cost floor for marginal production growth. This situation is quite different from that of shale gas where supply costs of $2.50-$5.00/mcf have been in sharp contrast to conventional gas development costs of $6.00-$8.00/mcf or higher.

The true test of shale oil’s impact on world oil prices may come from global exploitation of these resources. Other parts of the world such as China, Argentina, and Russia are thought to hold significant promise for shale oil exploitation. While this growth may ultimately come to pass, it is likely this kind of development would take longer to unfold than what is taking place in the United States. Shale oil development in the U.S.

has benefited from well-documented geology, a well-developed exploration industry including the largest rig fleet in the world, well-established property rights, and existing pipeline and refining infrastructure. Other geographies will have a tremendous amount of work ahead to replicate these inherent advantages of the U.S. experience.

conclusIon

The vast oil resources bound up in shale and tight rock formations have finally been unlocked by technology and are now coming to market. While still in the early stages of development, shale oil has already had a marked impact on U.S. production growth. The scope and pace of future development is difficult to assess; however, the accessible resource base is large, and it may grow significantly if technological advances are successful in improving recovery factors. The development of shale oil is a boon to energy-hungry Americans who crave security of supply. However, its impact on global oil pricing is likely to remain muted, at least for now.

appendIx: a brIef hIsTory of The key plays

There are some 20 shale oil plays in North America with the most prominent including: Bakken (North Dakota, Montana, and Saskatchewan), Eagleford (Texas), Niobrara (Colorado, Wyoming, and Nebraska), and the Permian basin plays (Texas and New Mexico). Other emerging shale oil plays include: Granite Wash, Barnett, Woodford, Monterey, Utica, and Uinta.

U.S. Natural Gas Prices $per MBTU


$0

$2

$4

$6

$8

$10

$12

$14

$16

2002 2004 2006 2008 2010 2012

The arrival of shale gas



Bakken

The Bakken play is part of the Williston basin, which covers about 200,000 square miles and extends mainly across North Dakota, Montana, and Saskatchewan. The Bakken formation was discovered in 1953 and named after Henry Bakken, owner of the Montana farm where the first discovery well was drilled. As a relatively shallow shale play, the Bakken provided an excellent candidate for early shale oil development. The U.S. Energy Information Administration estimates the Williston/Bakken formation contains unproved technically recoverable resources of 5.4 billion barrels.

The Bakken has grown rapidly and in size. In North Dakota, production has increased some six-fold since the mid-2000s to over 700,000 barrels per day (kbpd) by mid-2012. With the U.S. on pace for 6.3 mbpd in 2012, the North Dakota Bakken has soared to roughly 10% of nationwide crude oil production. Growth remains rapid, and forecasts for the U.S. Bakken put production at approximately 1 mbpd by mid-decade. In Canada, 2012 shale oil production, which is primarily Bakken, is estimated to be approximately 100-150 kbpd.

Eagleford

The Eagleford shale in the Texas Maverick basin runs along a 50-mile-wide corridor that extends east from the border with Mexico. The region contains stacked plays including the large, oil-bearing Austin Chalk formation. The U.S. Energy Information Administration estimates unproved technically recoverable resources of 5.1 billion barrels in the Eagleford and Austin Chalk.

The Eagleford is not strictly a shale oil play and can be broken down into three distinct zones—oil, liquids-rich natural gas, and dry natural gas—which run in that order from north to south. Activity in the Eagleford began in 2007-08, but subsided because of the global financial crisis and did not get underway in earnest until 2010. Production from the Eagleford has soared to over 800,000 barrels of oil equivalent per day, with the mix approximately 40% gas and 60% oil and liquids.

Niobrara

The Niobrara extends across Colorado, Wyoming, and Nebraska, with the bulk of the activity focused on the DJ basin in Northeastern Colorado. The Niobrara is largely oil at the northern end and almost purely gas at the southern end. Development began in 2009 and gained significant momentum in 2011. While the core of the play has been well established in the Wattenberg field, the geology is highly faulted, making horizontal

Eagleford Production

Source - IHS, RBC Capital Markets

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

2007 2008 2009 2010 2011 2012

Prod

uctio

n (b

oe/d

)

Natural Gas

Crude Oil

Williston Production (North Dakota & Montana)


0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

2007 2008 2009 2010 2011 2012

Pro

duct

ion

(boe

/d)

Natural Gas

Crude Oil



drilling more challenging, and there have been mixed results as producers have moved north in to Wyoming. While current production is modest, the resource base is large. The Niobrara is at an earlier stage of development, with production in 2012 estimated at roughly 60 kbpd. However, the U.S. Energy Information Administration estimates the formation contains unproved technically recoverable resources of 6.5 billion barrels, larger than either the Bakken or the Eagleford.

Permian

The Permian basin spans 86,000 square miles across West Texas and Southeast New Mexico and can be divided into at least six big shale plays, including Avalon Shale, Bone Spring, Leonard Shale, Spraberry Shale, Yeso, and Wolfcamp. Oil industry activity in the Permian dates back to the 1920s, and since then the basin has produced an estimated 30 billion barrels, with production peaking near 2 mpbd in the mid-1970s. After decades of declining production, which bottomed at 850 kbpd in mid-2007, the Permian is seeing a renaissance fuelled by horizontal drilling that has taken production back up to 1.2 mbpd. It has taken longer for horizontal drilling to become widely used in the Permian basin because the economics of vertical drilling have remained attractive enough for producers to simply remain focused on conventional activity. The U.S. Energy Information Administration estimates tight oil in the Permian includes unproved technically recoverable resources of 2.1 billion barrels.

Permian Production (Texas and New Mexico)


0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

2007 2008 2009 2010 2011 2012

Pro

duct

ion

(boe

/d)

Gas - Horizontal Wells (boe/d)Oil - Horizontal Wells (bbl/d)Gas - Vertical or Directional Wells (boe/d)Oil - Vertical or Directional Wells (bbl/d)


fIxed IncoMe InvesTInG In 2013The Best Offense is to Play Defense

Fixed income investors will be facing a very different market at the start of 2013 than was the case in the beginning of 2012.

While safe-haven government bond yields seem poised to finish 2012 at levels below those of a year ago, corporate yields have fallen even further. This significant shrinking of the “risk premium” is by far the most important development facing investors as we go into the new year.

raJan bansI – ToronTo, canada [email protected], RBC Dominion Securities Inc.


fIxed IncoMe - 2013 ouTlook

Fixed income investors in North America and Europe will need to be much more discerning in 2013 when it comes to adding corporate credit exposure. Thanks to a seemingly insatiable investor appetite for yield, the compression of high-grade corporate yield spreads has acted to drag down yields on lesser-quality issues as well. Companies of relatively poor credit quality have been able to raise money on very advantageous terms, increasing leverage in the process, while their ability to repay funds over the course of a full business cycle remains far from guaranteed. Kicking off 2013, the best offense for fixed income investors may very well be a sound defense.

spreads coMpress In The u.s. aMIdsT “zIrp” and “qe”

Investors in the U.S. fixed income markets could easily be lulled into thinking 2013 likely will be another year of dependable returns as government bond yields continue to grind lower. After all, as the top left chart illustrates, U.S. Treasury yields are poised to do in 2012 exactly what they did in 2011 and 2010—finish at levels below those of the year prior.

However, our view is that focusing on low government bond yields are a red herring. Thanks to a rally in corporate bonds that has driven yield spreads over government bonds to very tight levels, the fixed income investing landscape in 2013 will likely be vastly different—and riskier—than was the case in 2012.

The magnitude by which credit spreads narrowed in 2012 is underappreciated by many. Using credit default swap data as a proxy, the bottom left chart shows how investment-grade credit spreads are set to finish 2012 much lower than where they started the year. This is in contrast to the end of 2011 after credit spreads widened sharply over much of the year, which presented compelling valuations going into 2012. Today’s very low yields and compressed spreads have brought an avalanche of new supply recently, but enormous investor demand for yield has absorbed new issuance and left spreads, in many cases, at levels best described as “skinny.”

However, the investment-grade space cannot do full justice to how low risk premiums have fallen. The U.S. high-yield market has been as hot, if not hotter, than the investment-grade market. The chart below shows many high-yield investors have

U.S. Treasury Curve Flattens (Again) in 2012

Source - Bloomberg

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%

3m 6m 1y 2y 5y 10y 30y

3-Dec-1230-Dec-1131-Dec-1031-Dec-09

Investment Grade Risk Premiums Decline in 2012

Source - Bloomberg

80859095

100105110115120125130

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12

Ba

sis

Po

ints

Performance of High Yield vs. the S&P 500

Source - Bloomberg

-60

-40

-20

0

20

40

60

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11Re

turn

(%)

High-Yield ETF (HYG)

S&P 500

Total Returns: High-Yield Bonds vs. Stocks



actually done better than their equity counterparts thanks to a significant decline in risk premiums that accelerated in 2012, driving even greater interest in the asset class.

These healthy returns in high-yield have produced even more robust fund flows into the sector, exacerbating the decline in risk premiums. Several measures suggest high-yield spreads have shrunk so much that investors should consider a more-defensive portfolio posture. The default rate for high-yield debt has fallen to a stunningly low 2%, close to pre-financial crisis levels and not too far off from multi-decade lows. Meanwhile, the so-called yield-to-worst* has fallen below the psychologically important 7.0% level as investors continually reach for yield into ever more risky parts of the market.

Investors are clearly betting heavily the fiscal cliff will be averted in a way that allows the U.S. to avoid a recession in 2013. If they are wrong in that assumption—and there is probably a 20% chance they will be—then default rates would likely soar, and spreads would widen dramatically, as they have in other recession periods. Against this risk, when call provisions are taken into account, the yields on offers in the high-yield space are lower than at any time in more than three decades.

U.S. credit conditions have also tightened in the municipal bond market. The chart on the left illustrates how the AAA benchmark for municipal bonds has not only traded through the Treasury equivalent, but the premium is richer than it was at the commencement of 2012 and just barely away from the highest levels for the year.

In many ways, the decline in municipal yields and a compression in the spread between tax-exempt securities and Treasury securities are positive developments. Easier access to funding for these issuers represents a potential economic tailwind, and rising investor interest in the space could help drive greater new issuance in 2013. Assessing the underlying credit quality of issuers in this sector is of paramount importance for investors, given the diminished importance of bond insurers since the financial crisis began in 2007. In the post-crisis era, municipal bonds are now much more akin to corporate bonds than to U.S. government securities; credit analysis and security selection will be primary drivers of investment returns. Defaults are expected to remain low in 2013 if growth is positive, but fears of a recession could easily spook markets and drive spreads materially wider.

10-Year AAA Municipal vs. 10-Year U.S. Treasury

Source - Municipal Market Data (MMD)

1.25

1.50

1.75

2.00

2.25

2.50

Jan-12 Apr-12 Jul-12 Oct-12

10-yr Muni

10-Yr Treasury

* Whichever is lower between the yield-to-maturity and the yield-to-first-call price.



canada looks The saMe

Investors in Canada are facing similar challenges to their counterparts in the United States. The compression of spreads has not only been evident in the corporate bond market, but also in the preferred share market. Valuations of some newly issued preferred shares suggest a white-hot market as lower-quality issuers have been able to price deals not too far removed from the levels achieved by competing issues from higher-rated firms.

Adding exposure to provincial bonds has been and still is a compelling risk-reward opportunity. If the environment continues to be supportive for risky assets, corporate credit will likely go on outperforming the broader market but only by a marginal amount. However, if the investing environment shifts and risky assets go out of favour, corporate credit is likely to underperform in a meaningful way, given today’s very tight valuations. The top left chart illustrates how the yield spread between 10-year corporate bonds versus a Province of Ontario bond of the same maturity is close to the narrowest it’s been in the past 20 years.

As we enter 2013, yields on provincial bonds are also compelling versus safe-haven Government of Canada yields. As shown in the bottom left chart, the rise in yields on shorter-dated (one- to five-year) provincial bonds has outpaced the modest increase in Government of Canada bonds, leading to a widening of spread in these maturities. At the same time, yields at the long end fell further for

Canada issues than for provincials. Whether hiding out from compressed spreads in the corporate debt market, the risky yield distortions evident in preferred share pricing, or the sheer inadequacy of the yields on offer in a Government of Canada market brought by foreign “safe haven” flows, on all counts, provincial bonds would seem to offer some defensive appeal.

dITTo for europe and The u.k.

The risk-reward opportunity in the fixed income markets of the U.K. and Europe are in many ways similar to conditions in North America. The resolve of the European Central Bank to backstop the eurozone and progress amongst government leaders to stitch together a bailout plan for embattled nations have served as tailwinds for risk appetite in European markets. The chart below

10-Year A-Rated Corporate Spread Less 10-Year Ontario Spread

Source - Bloomberg

0

50

100

150

200

250

Apr-92 Apr-96 Apr-00 Apr-04 Apr-08 Apr-12

Spr

ead

(bps

)

Not far removed from the tightest levels seen in the last 20 years

Provincial Bonds vs. Government of Canada Bonds

Source - Bloomberg

0.5%

1%

1.5%

2%

2.5%

3%

3.5%

2y 5y 10y 30y

GOVT OF CANADA 03-Dec-12

GOVT OF CANADA 30-Dec-11

PROV OF ONTARIO 03-Dec-12PROV OF ONTARIO 30-Dec-11

CDS Prices for Debt Issued by Various European Governments

Source - Bloomberg

0

200

400

600

800

1000

1200

2009 2010 2011 2012

SpainItalyGermanyIreland



highlights the significant decline in the value of credit default swaps (CDS)—a form of insurance against default by an issuer—linked to debt issued by various European governments.

Meaningful progress has been made in Europe during 2012, but that is not to say a clear path to recovery is on the horizon. Numerous challenges remain on the policy-making front, and even the best-laid plans are vulnerable to execution and implementation risk.

Many investors believe Europe’s corporate debt market is very attractive, given the persistence of wider spreads illustrated in the chart on the left, in stark contrast to the landscape in the United States.

However, the relevant point of comparison is not European spreads versus North American spreads, but, instead, European spreads in the context of the economic and financial risks facing Europe. Investors should be aware Europe’s situation is complicated and in flux, which suggests credit markets may be ahead of themselves, given the current pricing of risk. Select opportunities still exist within the corporate market; however, investors are encouraged to focus on the shorter end of the maturity spectrum, given current valuations.

The U.K. market is facing challenges similar to those of U.S. and Canada. Short-term interest rates are likely to remain anchored, government bond

yields will remain depressed under the influence of quantitative easing, and credit spreads should remain range-bound absent a recession; however, at current tight levels, valuations are vulnerable. While the announced ascension of Mark Carney to the governorship of the Bank of England raised some eyebrows, there has been no indication his arrival will result in a marked departure from the central bank’s supportive approach.

This low-yield, compressed-spread environment will make the management of fixed income portfolios challenging in the United Kingdom. Active credit and duration risk management will need to be employed for clients, based upon their risk tolerance, in the current environment.

conclusIon: In favour of defensIve posITIonInG

Risk premiums declined precipitously in fixed income markets around the globe during 2012, leaving defensive positioning as our preferred approach to kick off the new year. Emphasis on shorter maturities, favorably mispriced sectors, selective credits, and ample liquidity should allow the investor to extract the best possible risk-adjusted returns from what is offered today, while providing the flexibility to reposition the portfolio when better opportunities eventually present themselves.

European Credit Spreads Fall from Widest Levels in Debt-Crisis Era

Source - iBoxx

0

1

2

3

4

5

6

7

8

9

2005 2007 2009 2011 2013

iBoxx Euro Corporates

iBoxx Euro Germany

Average Yield (Semi Annual) - Daily


Gold A Shining Juggernaut of Performance

Following years of steady price appreciation from early in the last decade, a perfect storm of conditions in the past few years has driven the price of gold ever higher.

What has led to this very strong performance—up more than $1,400 per ounce since 2001 with over $800 per ounce gained since 2008—and why have gold equities lagged so badly?

Mark allen – ToronTo, canada [email protected], RBC Dominion Securities Inc.


Gold - 2013 ouTlook

scarcITy value

Global production has remained relatively flat over the last 15 years at about 70-80 million ounces per year. This depletion of global reserves drives a steady need for replacement, and exploration spending has boomed, increasing industry-wide to $8 billion from approximately $1 billion over the last 10 years. However, despite this frenzy of activity, the pace of discovery of viable, economic ore bodies has fallen steadily.

In addition to declining discoveries, lower and lower grades have exacerbated the challenging supply outlook. RBC Capital Markets estimates mined grades for the largest North American producers have declined to 1.3 grams per tonne of ore from 2.0 grams per tonne over the last 15 years.

The relentless decline in discovered grades, the dramatic increases in input costs, and the geographical remoteness of many of the largest discoveries have combined to push the estimated marginal cost of supply up to US$1,400/oz and higher. The RBC Capital Markets gold team has argued that two-thirds of proposed projects require a gold price of $1,500/oz to generate an after-tax return of 20%. Such high hurdles provide important downside benchmarks in support of elevated gold prices.

As the quantity and quality of discoveries have diminished and with much of the higher-grade material long since mined out, new supply looks

increasingly hard to come by and is likely to be expensive to develop going forward.

Why does everybody WanT Gold?

Some investors see gold as a hedge against inflation, others deflation. While these views seem at odds, the common thread is uncertainty. For thousands of years, gold has provided a store of value, and this property has never been more in focus than in uncertain times.

Future gold prices are unknown; however, what we do know is that major countries around the world are saddled with too much debt and anaemic economic growth. The U.S., the U.K., Europe, and Japan have taken the traditional approach to dealing with these simultaneous strains—printing money. In addition to stimulating the economy, this expansionary monetary policy usually tends to produce inflation down the road, debasing a country’s currency and easing the burden of debt repayment in the process. Fears that today’s aggressive monetary policies will produce those effects have sent some investors toward gold as a store of value.

Gold prices have increased 24%, 30%, and 10% in 2009, 2010, and 2011, respectively, and were up 9% in the first 11 months of 2012. Such strong performance has led many investors to view gold as a way to diversify away from traditional asset classes, such as stocks or bonds, which have seen less-impressive performance in recent years.

Global Gold Production and Discoveries

Source - Metal Economics Group

Note: Represents 189 gold deposits discovered since 1990, each with at least 2M oz of gold in total reserves, resources and past production (or at least 1M oz in reserves).

0

20

40

60

80

100

120

140

160

180

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Gol

d D

isco

vere

d (M

oz)

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

Gold P

rice (US

$/oz)

Gold Discovered

World Mine Production

Gold Price

Source - Company reports, RBC Capital Markets estimates

0.500.751.001.251.501.752.002.252.502.753.00

1996 1998 2000 2002 2004 2006 2008 2010 2012E

g/to

nne

$0$100$200$300$400$500$600$700$800$900

Cash Costs (US$/oz) (right axis)Reserve Grade (g/t)Mined Grade (g/t)

Gold Grades (North American Tier 1 Producers)


Gold - 2013 ouTlook

Who Is buyInG?

Demand for gold has increased to 4.6 tonnes in 2011 from 2.8 tonnes in 2002, up 64%. Over this timeframe, industrial demand has remained relatively flat, while worldwide jewellery demand has declined as this luxury good has become more expensive. The primary drivers of demand growth have been from investment sources: central banks, exchange-traded funds (ETFs), and physical demand (e.g., gold bars and coins).

Central banks, with their sizeable foreign currency reserves, have sought to protect themselves against fiat currency debasement with purchases of gold. They emerged as a new source of buying power in 2010 after two decades of being net sellers of gold in the global marketplace. Central banks, as a group, grew to represent an impressive 10% of all demand in 2011 and have slightly exceeded this level so far in 2012.

While ETF demand has been solid, with total holdings remaining on a steady upward climb, the second notable change in demand has been from investment in physical gold, particularly from China and India. Worldwide purchases of gold bars and coins have more than doubled over the last five years and now represent approximately 30% of global purchases, up from 14% in 2007.

In China, where interest rates set by the government make savings accounts unattractive and where access to stock and bond investments is more limited than in the developed world, owning gold in the form of coins, bars, or jewellery is a recognized way to save for the future. This attitude toward physical gold as a form of savings is also prevalent in India. Rising wealth in these countries has led to a sharp increase in demand, such that these two regions now represent 40% of all bar and coin purchases worldwide.

Demand from Central Banks (Aggregate Purchases Net of Sales)

Source - Thomson Reuters GFMS, World Gold Council, RBC Capital Markets estimates for 2012-14

Source - Bloomberg, Company Reports, RBC Capital Markets

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

2005 2006 2007 2008 2009 2010 2011 2012

Gol

d P

rice

(US

$/oz

)

0102030405060708090100110120

Gold O

unces (MM

oz)

ETF Holdings

Net Speculative Position

Gold

84.2

25.2

Demand from Exhange-Traded Funds

-800

-600

-400

-200

0

200

400

600

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

E

tonn

es

Source - World Gold Council, RBC Capital Markets estimates

Notes: Physical demand includes jewellery, bar and coin investment Greater China includes Hong Kong and Taiwan.

0

200

400

600

800

1,000

1,200

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

E

2013

E

2014

E

Phy

sica

l Dem

and

(Ton

nes)

20%

30%

40%

50%

60%

% from

India and Greater C

hina

IndiaGreater China% China + India

WGC Estimates

Demand from Physical Buying in India and China


Gold - 2013 ouTlook

Gold prIce ouTlook

The gold price has been moving steadily higher since 2001. From time to time during that almost 12-year span, the price has consolidated for a few months or quarters, each time forming a new, more-elevated plateau. Arguably, it has been doing just that since peaking above US$1,900/oz in the summer of 2011.

RBC Capital Markets estimates more of the same, expecting gold to trade in a broad $1,600/oz to $1,850/oz range during 2013.

While the gold price has moved in a sideways range since hitting the 2011 peak, it has never in that span suffered the kind of pronounced weakness that would suggest a trend breakdown. Indeed, all the factors propelling demand and constraining supply outlined above would appear to be very much in place and still operative.

In our view, reversing this long-term uptrend in the bullion price will require that one of the elements in the bullish story come undone or, more precisely, that expectations at the margin deteriorate. Any of the following would be of concern:

� Any indication—even a small change in language—from the Fed that the era of money printing (aka QE) was drawing to a close;

� A well-supported conviction that financial markets were “normalising”—i.e., rates were about to move back above the rate of inflation;

� A perceived loss of appetite for accumulating additional gold reserves on the part of the central banks of the developing economies or a renewed desire to sell reserves by the developed ones;

� Any regulatory action by China or India that would constrain the purchase of physical gold by the public; or

� Any major new gold find that could have the potential to alter the forward mine supply picture materially.

At the moment, no such developments are anywhere on the horizon. In their absence, it is likely the long-term uptrend has further to run.

underperforMance of The sTocks relaTIve To bullIon

The performance of gold equities has significantly lagged the price of gold bullion in recent years. Cost inflation has been a major factor.

High gold prices together with high prices for energy and base metals have led to record levels of exploration and the construction of major resource development projects. A limited supply of skilled labour, the long-term trend of lower gold grades, and more remote locations are all factors that have driven costs higher. RBC Capital Markets estimates that costs, including growth capital expenditures, for the Tier 1 gold producers have risen to $1,600/oz in 2012 from about $600/oz in 2007. This trend

Source - Bloomberg

Note: XAU is the Philadelphia Gold & Silver Index

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

Aug

-85

Aug

-87

Aug

-89

Aug

-91

Aug

-93

Aug

-95

Aug

-97

Aug

-99

Aug

-01

Aug

-03

Aug

-05

Aug

-07

Aug

-09

Aug

-11

0

100

200

300

400

500

600

700

800Gold Price in USD, rebased to 100XAU Index Value, rebased to 100Ratio XAU Index/Gold Price

Rat

io X

AU

Inde

x/G

old

Pric

e

Gold P

rice & X

AU

Index, rebased to 100

Performance of Gold Equities versus Bullion


Gold - 2013 ouTlook

in costs has lowered expectations for company free cash flows in the coming years and, hence, valuations.

It is also true the gold sub-indices are dominated by a handful of very large-capitalization gold miners that have had even more difficulty growing what are already very large resource bases, which are being depleted by commensurately large production. They have tended to make dilutive acquisitions as part of their effort to grow reserves. In their search for projects large enough “to move the needle,” they have been involved in some of the largest, most remote, and lowest-grade development projects that have been most prone to delay and execution risk. Their performance has suffered accordingly and further held back index performance.

Investors have fared better with mid-cap gold miners, growing reserves by developing smaller projects.

conclusIon

Declining discoveries and a slow erosion of higher-quality reserves have increased the scarcity value of gold. This tight picture for supply, coupled with rising investment demand, have led to a strong uptrend in the price of bullion.

By comparison, gold equities have languished as rising costs have taken their toll on the outlook for free cash flows.

Capital cost escalation in the industry remains an ongoing risk for the valuations of gold equities, while the conditions for well-supported bullion prices continue to prevail.

� The performance of gold equities

has signifcantly lagged the price

of gold bullion.

� Cost inflation has impacted

the outlook for cash flows and

constrained valuations.

� Reaching for growth through

acquisitions has also played a

role in holding back the equities.


research resources and IMporTanT InforMaTIonResearch ResourcesThis document is produced by the Global Portfolio Advisory Committee within RBC Wealth Management’s Portfolio Advisory Group. The RBC WM Portfolio Advisory Group provides support related to asset allocation and portfolio construction for the firm’s Investment Advisors / Financial Advisors who are engaged in assembling portfolios incorporating individual marketable securities. The Committee leverages the broad market outlook as developed by the RBC Investment Strategy Committee, providing additional tactical and thematic support utilizing research from the RBC Investment Strategy Committee, RBC Capital Markets, and third party resources.

Global Portfolio Advisory Committee members: Janet Engels – Co-chair; Head of U.S. Equities, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Jim Allworth – Co-chair; Portfolio Strategist, RBC Dominion Securities Inc.

Maarten Jansen – Head of RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc. Mark Allen – Portfolio Advisor, RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc.

Rajan Bansi – Head of Fixed Income Strategies, RBC WM Portfolio Advisory Group, RBC Dominion Securities Inc. Matt Barasch – Head of Canadian Equities, RBC WM Portfolio Advisory Group, RBC Dominion Securities Inc.

Craig Bishop – Manager, Fixed Income Strategies, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Kelly Bogdanov – Portfolio Analyst, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC

Frédérique Carrier – Director, European Equities, Royal Bank of Canada Investment Management (UK) Ltd. George King – Head of Portfolio Strategy, Royal Bank of Canada Investment Management (UK) Ltd.

Tracy Maeter – Head of Investments, British Isles, Royal Bank of Canada Investment Management (UK) Ltd. René Morgenthaler – Head of Investment, RBC (Suisse) SA, RBC International Wealth Management

Jay Roberts – Head of Asian Equities, RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc. Alan Robinson – Portfolio Advisor, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC

The RBC Investment Strategy Committee (RISC), consists of senior investment professionals drawn from individual, client-focused business units within RBC, including the Portfolio Advisory Group. The RBC Investment Strategy Committee builds a broad global investment outlook and develops specific guidelines that can be used to manage portfolios. RISC is chaired by Daniel Chornous, CFA, Chief Investment Officer of RBC Global Asset Management Inc.

DisclaimerThe information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Additional information is available upon request.

To U.S. Residents: This publication has been approved by RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC, which is a U.S. registered broker-dealer and which accepts responsibility for this report and its dissemination in the United States. RBC Capital Markets, LLC, is an indirect wholly-owned subsidiary of the Royal Bank of Canada and, as such, is a related issuer of Royal Bank of Canada. Any U.S. recipient of this report that is not a registered broker-dealer or a bank acting in a broker or dealer capacity and that wishes further information regarding, or to effect any transaction in, any of the securities discussed in this report, should contact and place orders with RBC Capital Markets, LLC. International investing involves risks not typically associated with U.S. investing, including currency fluctuation, foreign taxation, political instability and different accounting standards.To Canadian Residents: This publication has been approved by RBC Dominion Securities Inc. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. ®Registered trademark of Royal Bank of Canada. Used under license. RBC Wealth Management is a registered trademark of Royal Bank of Canada. Used under license.To European Residents: Clients of United Kingdom subsidiaries may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £50,000. The Channel Islands subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only. To Hong Kong Residents: This publication is distributed in Hong Kong by RBC Investment Services (Asia) Limited and RBC Investment Management (Asia) Limited, licensed corporations under the Securities and Futures Ordinance or, by Royal Bank of Canada, Hong Kong Branch, a registered institution under the Securities and Futures Ordinance. This material has been prepared for general circulation and does not take into account the objectives, financial situation, or needs of any recipient. Hong Kong persons wishing to obtain further information on any of the securities mentioned in this publication should contact RBC Investment Services (Asia) Limited, RBC Investment Management (Asia) Limited or Royal Bank of Canada, Hong Kong Branch at 17/Floor, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong (telephone number is 2848-1388).To Singapore Residents: This publication is distributed in Singapore by RBC (Singapore Branch) and RBC (Asia) Limited, registered entities granted offshore bank status by the Monetary Authority of Singapore. This material has been prepared for general circulation and does not take into account the objectives, financial situation, or needs of any recipient. You are advised to seek independent advice from a financial adviser before purchasing any product. If you do not obtain independent advice, you should consider whether the product is suitable for you. Past performance is not indicative of future performance.

Copyright © RBC Capital Markets, LLC 2012 - Member NYSE/FINRA/SIPCCopyright © RBC Dominion Securities Inc. 2012 - Member - Canadian Investor Protection Fund

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