High stock market valuations and a rising interest rate environment have many investors rethinking where they should allocate money in the short- to medium-term. Lower valuations and strong growth prospects in emerging markets such as China and India show some appeal, and there are also growing signs that Canada's economy is starting to recover.
According to RBC's Chief Economist Craig Wright, there is an increased risk of a market correction. "I think we've overshot with the enthusiasm," Wright said of market activity in recent months. "But we see decent growth on a longer-term basis."
RBC GDP growth forecasts
- RBC is forecasting global gross domestic product (GDP) growth of 3.5 percent in 2017 and 3.6 percent in 2018, driven by growth in developing economies such as China, Brazil and India
- Emerging market growth is expected to be 4.5 percent this year and 4.8 percent in 2018, versus forecasts of 2 percent for advanced economies over the next two years
- Average growth for all advanced economies is expected to be slightly lower compared to Canada's 2.7 percent in 2017 and 2.1 percent in 2018
- The US is forecast to grow 2.3 percent both in 2017 and 2018
As investors strive to maintain forward-looking returns, capital allocation has received increased focus
The forecasts provide a backdrop for asset managers looking to best position their portfolios. According to Jim Cole, Institutional Portfolio Manager at Phillips, Hager & North Investment Management, a division of RBC, achieving target investment returns has become increasingly challenging. Low interest rates stemming from easy monetary policy, combined with strong recent returns from many financial assets globally, translate to lower future expected returns. As investors strive to maintain forward-looking returns, capital allocation has received increased focus.
The following are key takeaways from RBC Investor & Treasury Services' recent panel discussion featuring Cole and Wright as keynote speakers.
The US market influence on global growth
Global growth of 3.5 percent is now "good growth," Wright said, even though it remains below levels before the 2008-2009 global financial crisis. He added that one of the greatest sources of uncertainty in global markets today is what policies the Donald Trump administration in the US will implement in the months ahead, including the size and timing of promised tax cuts.
While a delay or even diffusion of tax changes will likely impact growth, Wright said consumer spending, strong employment and a recovery in business investment would continue to propel the US economy forward. "It's all about the consumer," said Wright, adding that their activities account for about 70 percent of the US economy. "If the US consumer is doing well, the US economy is doing well."
Emerging markets to drive global GDP
Key insights
- Emerging markets such as China, India, and Indonesia are propelling global GDP growth, with a forecast of a 3.8 percent rise in 2018, versus 2 percent for developed countries
- The greatest source of uncertainty for the global outlook is what policies the Trump administration will implement in the months ahead. There is a lack of clarity about the size and timing of tax cuts promised in the 2016 election campaign.
- Despite political uncertainty, strong employment and consumer spending will support economic growth in the US, the world's largest economy
- Emerging markets have underperformed developed markets in recent years, but a rising middle class, regulatory reforms and diversified economies are driving growth in those regions. This presents opportunities for investors looking for investments with lower valuations.
While emerging markets have underperformed developed markets in recent years, Cole said valuations are starting to look more attractive. "We are starting to see a bit of a turn in the tide," said Cole of the overall performance of emerging markets. "The dynamics from a valuation perspective are a lot more attractive."
Future growth in emerging markets will rely on market and political reforms, and the good news is that many emerging market governments are focused on necessary reforms as a means to continue transforming local economies. Examples include China, which has aggressive plans to privatize many of its businesses and is investing heavily in infrastructure and technology, including clean energy projects to help tackle a major pollution problem. India has unveiled widespread reforms to unlock bottlenecks for investment, while Indonesia's new government is focused on energy and infrastructure.
Still, China, the world's second-largest economy, has been a lingering concern as its economy has slowed from years of double-digit growth to around 6.5 percent today.
While there are risks in the Chinese economy, both Wright and Cole said the government has monetary policy levers it can pull to ensure its economy continues to expand at a steady pace.
Future growth in emerging markets will rely on market and political reforms
Cole cited emerging market equity exposure as one potential way for investors to maintain future expected returns while, at the same time, bringing increased diversity to their portfolios. GDP growth and earnings are showing signs of stabilization. "Although rising interest rates in developed markets have historically presented challenges for emerging market countries, from our perspective, the balance sheets of many emerging market countries are much more resilient today than they have been in the past." Cole said. Cole cautiously noted that, "There are risks that one needs to be mindful of, however, which vary from country to country."
Cole said, for valid reasons, many Canadian institutional investors historically have not maintained a policy allocation to emerging markets. In particular, emerging markets have been seen as significantly influenced by natural resources, and therefore highly correlated to the Canadian economy and market. Today, however, emerging markets now offer greater diversity into other sectors such as financial services, technology, health care and consumer discretionary. Going forward, a dedicated allocation to emerging markets may be an opportunity worth considering.
Canada lags, but opportunities remain
While growth in Canada is lagging emerging markets and global GDP overall, there are still opportunities for investors as the economy starts to slowly pick up speed. Wright said the Canadian economy has "cleared the hurdle" thrown up from the 2016 drop in oil prices after posting three consecutive quarters of strong growth.
While oil isn't expected to return to USD 100 per barrel in the near future, Wright believes prices could hit about USD 60 next year, which will help give the overall economy a boost. "Longer term, I think we have to get used to a lower oil price environment," Wright said.
A worry for Canada's economy is the growing amount of consumer debt. The ratio of debt to disposable income is about 167 percent, or CAD 1.67 for every dollar of disposable income. "Canada has a debt challenge," Wright said. However, he isn't overly concerned as long as the economy remains stable. "There are indicators to suggest we can comfortably manage what we have," Wright said of existing consumer debt levels. "We just don't want to go higher."
Wright forecasts the Canadian economy will continue "at cruising speed"
Canada could also be impacted by the Trump administration's upcoming renegotiation of the North American Free Trade Agreement (NAFTA). Wright says trade is relatively balanced between the two countries. He does not expect a major rewrite of NAFTA. Canada has also reduced its reliance on the US for trade, exporting about 75 percent of its goods south of the border, versus 85 percent years ago, he said.
Overall, Wright forecasts the Canadian economy will continue "at cruising speed." Low interest rates have helped to stabilize the economy in recent years and the Bank of Canada's recent interest rate rise, the first in seven years, should help guide a steady recovery and offer more opportunities for investors. "Growth is broadening out," Wright said. "Consumers are still carrying most of the economy and other investment shouldn't be too far behind to help support growth overall."
Source
- RBC Investor & Treasury Services' Canadian Market Intelligence Forum (June 27, 2017)