Annual Financial Forum

William F. White, President, IBK Capital Corp., and Director, The Empire Club of Canada; Nick Barisheff, Founder and President, Bullion Marketing Services Inc.; C. Alexander Squires, CFA, Managing Partner, Brant Securities Limited; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; John Popelas, Director, Money Markets, RBC Capital Markets; Judy Goldring, General Counsel and Senior Vice-President, AGF Management Limited; Dan Machacek, CFA, Managing Director, TD Newcrest; Margaret M. Samuel, CFA, Chief Investment Officer and Portfolio Manager, Quadrexx Asset Management Inc., and Director, The Empire Club of Canada; Paul Moore, Vice-Chair, Ontario Securities Commission; Mark Wellings, Director, GMP Securities L.P.; Reverend Bruce Smith, King-Bay Chaplain, King-Bay Chaplaincy; Christina A. Cavanagh, Executive Director, Toronto CFA Society; Richard W. Nesbitt, CEO, TSX Group; Morley W. Salmon, Chairman, Limited Market Dealers Association of Canada; and David Fleck, Co-Head Equity Products, BMO Capital Markets.

Introduction by John Niles

Honoured guests, Past Presidents, Directors, members and guests of the Empire Club of Canada:

It is my privilege to welcome our guest speakers--Andrew Pyle, Jeffrey Rubin and George Lewis.

To borrow a phrase from a song made famous by the Beatles, "The best things in life are free, but you can keep them for the birds and bees. I want money."

Given everything that is currently happening with the markets, the economy and predictions on the economy, today's Empire Club financial forum couldn't be more timely. Our financial forum has become an annual tradition having noted financial experts share their insights and help us make some sense of what is happening in the markets.

Today, we have three eminent speakers who will share their views with us in succession. Each speaker will have a maximum of 10 minutes.

Our first speaker is Mr. George Lewis, Chairman and CEO, RBC Asset Management Inc., and Executive Vice-President of Wealth Management, RBC Financial Group.

Mr. Lewis is responsible for Canada's largest single mutual fund family, RBC Funds, and one of Canada's largest asset management firms with over $68 billion under management. He joined RBC Asset Management in 2000.

Our second speaker is Mr. Andrew Pyle, Vice-President and Head of Capital Markets Research, Scotiabank Group, who provides support and strategy recommendations to internal trading and sales staff and is a member of the Equity Strategy Committee. In addition to his internal advisory role, Andrew provides analytical and research support to domestic and international clients from the Equity, Fixed Income, and Foreign Exchange markets.

Andrew joined the Scotiabank Group in 2000 from ABN AMRO, where he was Chief Strategist. Prior to that, Andrew co-founded the market analytics firm PATH International and was Chief Canadian Economist for MMS International.

Our third speaker is Mr. Jeffrey G. Rubin, Chief Economist and Chief Strategist, Managing Director, CIBC World Markets.

Mr. Rubin has been the top-ranked economist in Canadian financial markets over the last decade. Since becoming Chief Economist at CIBC World Markets in 1992, Mr. Rubin has obtained a number-one ranking in either the Brendan Woods survey of institutional equity or institutional fixed income investors on no less than 10 separate occasions. In 2003 he also took over responsibility for equity portfolio strategy becoming the firm's Chief Equity Strategist. Mr. Rubin has been a managing director of the firm since 1995.

Ladies and gentlemen, please welcome our first speaker Mr. George Lewis.

George Lewis

Thanks very much John. Thank you Bill and thank you Margaret. Honoured guests, ladies and gentlemen, it's a pleasure for me to be here. Happy New Year! I'm here to provide RBC's view of the global equity markets and in doing so I think you'll note some differences and agreements and assumptions with my co-panelists Jeffrey and Andrew who I'm sure will follow with excellent arguments. I hope you will allow some repetition from my point of view in terms of comments they might make as well.

Now those of you who attended the event two years ago heard from Dan Chornous, our Chief Investment Officer at RBC Asset Management and Chair of the RBC Investment Strategy Committee. Now modesty prevents Dan from speaking with you again today since his outlook for 2005 and 2006 was fairly spot-on, so the task this year is mine.

Some of you may know that Dan is both a member of my management team on the one hand and also my boss on the other in my capacity as Co-Manager of the RBC Global Titans Fund. This fund invests in leading companies operating in various industry sectors around the world and as a manager of the fund I'm in the same position as all of you here today--interested in the overall view of the global equity markets from the RBC Investment Strategy Committee and the implications that they have for my portfolio. Now I hope to do justice to the 2007 outlook from Dan and the committee because my bonus may be resting on it.

First a few words about the RBC Investment Strategy Committee. It's comprised of individuals-- professionals from RBC Asset Management's offices from around the world in North America, Europe and Asia, as well as representatives from RBC's other wealth management businesses in Canada and around the globe. Businesses like Dominion Securities, Dain Rauscher and Global Private Banking. At least quarterly the committee meets to review the outlook for economic growth, inflation, interest rates, currency, fixed-income markets as well as equity markets on both a geographic and sector basis. The committee recommends changes to portfolio asset mix for a typical balanced investor with a neutral recommendation being 55 per cent equities and 45 per cent bonds and cash. It also recommends geographic and sector weightings within asset classes and has been able to add value with each type of recommendation.

For the last few years the committee has consistently recommended an overweight position in equities, which has translated into good performance for our funds and our clients. The headline news for 2007 is that this view remains intact. Global equity markets again offer solid opportunities for investors evidenced by the recommended weight of 62 1/2 per cent for equities in a balanced portfolio. Importantly though, we expect better returns from non-Canadian equity markets than from Canadian exchanges. In addition to the benefits of diversification from investing in foreign markets, which are always present, this leads to a sense of urgency on our part to highlight the importance of increasing exposure to equity markets outside Canada particularly those in the U.S. Nor is it too late to act.

Going back in time we have seen that on average after a soft landing, which is our expectation, there is typically an additional 10 quarters of positive stock market returns. So history suggests we could see a continuation of the bull market through 2007, 2008 and into 2009.

Let me explain why we remain optimistic about equities in general and foreign markets in particular. There are three reasons.

We believe the Federal Reserve in the U.S. and most central banks around the world have completed a cycle of increases in short-term interest rates or tightening that has successfully moderated inflation. Low and predictable levels of inflation are key to positive returns in both fixed-income and equity markets over time.

Number two. We believe that this cycle of Fed tightening has led to a modest slow-down in economic growth--the soft landing economists refer to and not recession. This is important for the ability of companies to continue to generate increases in earnings per share and it also has some powerful historical precedent in terms of the performance of equity markets after a period of Fed tightening.

And finally, valuations in our view are extremely compelling particularly in the U.S. but in other foreign markets as well. The S&P 500 U.S. Index trades at roughly 16 1/2 times earnings, significantly lower than its peak in 2000 of over 30 times and lower than warranted by our outlook for low and predictable levels of inflation and interest rates.

While the current bull market may feel like it has lasted a long time, increases in share prices to date have been delivered through growth in earnings. We continue to expect increases in earnings but we also believe that share prices can be propelled higher by increases in the P/E ratio to at least the 20 times range.

I'll spend a few minutes on the first two of our reasons for optimism since the economic data in most observers, although thankfully not all, have conformed to this view since the summer.

Firstly, we do need to be concerned about inflation in every economic cycle because the acknowledged role of central banks is to control it. Therefore they will keep increasing interest rates, which is not good for growth, profits or equity returns until they believe this goal is achieved. This is exactly what has transpired this cycle in our view. Based on the inflation data since June of 2006 we believe the Feds should be confident that no further interest rate increases are required to combat inflation. So have they gone too far in combating inflation and pushing the global economy into recession? We don't believe so as all signs point to modest positive economic growth in all major economies in 2007.

While most observers now agree with our view of moderating inflation and a soft landing, I do want to emphasize how important this is to our recommendation to overweight equities. Based on a review of past cycles of Fed tightening and there have been about 19 I believe since World War II, whether the economy achieves a soft landing on the one hand or a recession on the other is crucial in determining the returns from the stockmarket following the end of a Fed tightening. The average stockmarket return in the 12 months following the end of a Fed tightening is a positive 20 per cent when the economy achieves a soft landing. The average return is negative 10 per cent when the economy slides into recession.

Given the evidence of moderating inflation and interest rates as well as positive economic growth since mid-2006 when the Feds ceased tightening as well as the positive performance of all major equity markets in the second half of 2006, we believe the debate can now progress to a more challenging but enjoyable question, "How high is up?" In short the upside we expect is driven by our outlook for rising corporate profits and increases in P/E valuations. We believe corporate profits will maintain their current high level in terms of percentage of GDP and will continue to grow in absolute terms for two main reasons.

Continuing improvements in productivity from outsourcing, offshoring and improvements in supply chain management will support increases in profit margins from already high levels. Secondly, superior economic growth and developing economies continue to offer global companies, many of whom are listed in the U.S., European or Japanese markets, the ability to grow earnings. We believe analysts may be underestimating the impact of these factors new to this cycle. In the past 15 quarters, analysts' estimates have been lower than actual results and by margins much greater than their average degree of conservatism.

So given the scenario I've outlined today, relatively low and stable inflation and interest rates, positive economic growth, and rising corporate profits we might expect the equity markets to be trading at all time highs in terms of price earnings multiples. Yet when we look at the major equity markets around the world almost all of them lie below valuation levels that are consistent with this outlook.

Of course there's one notable exception to that and that is Canada. We are one of the world's most expensive markets after several years of out-performance. And furthermore we are a very concentrated market with almost 50 per cent of our equity market comprised of energy and material stocks. We believe Canadian investors should increase their exposure to foreign markets in 2007 not only to achieve the superior returns we expect over the next few years but to achieve diversification in industry exposure from this very concentrated market.

In the near term we see the best return potential in the U.S. market where large cap stocks have lagged behind until very recently. EPS growth in the range of 10 to 15 per cent per annum combined with a potential multiple expansion of 20 per cent over the next few years indicate the potential for significant returns.

Furthermore the U.S. market offers sector diversification for Canadian investors due to its greater concentration of companies in the industrial, consumer, health-care and technology sectors.

Finally many of these U.S.-based companies have significant and growing global operations and are poised to generate corporate profit growth significantly in excess of the domestic GEP growth in the U.S. We see solid opportunities for returns in other developed markets as well including Europe and Japan, which are beginning to generate their share of global leaders as well. Companies like Toyota, Group DENON, PBVA and Novartis. While we believe opportunities exist for some companies in all industry sectors to deliver good returns to investors, we see new market leadership emerging in the so-called disinflation stocks, financials, consumer, health care and technology.

Yes, the Canadian equity markets have performed well over the last five years. However, they no longer have the potential upside that exists in foreign markets. Our position at RBC is that there are solid potential in these markets for at least the year ahead and probably longer but you will have to get involved and become a little less Canada-centric if you want to realize that potential.

Thank you for your attention today and best wishes for a successful 2007.

Introduction by John Niles

Now ladies and gentlemen, please welcome Mr. Andrew Pyle.

Andrew Pyle

Thank you very much John for that warm welcome. Ladies and gentlemen, it is my distinct pleasure to be here today with you and I hope I can give you an economist new year's present to start 2007 off right. No I don't mean a 100-per-cent accurate forecast but perhaps a discussion of the general outlook for the fixed-income markets both in North America and globally. I will try to keep it intelligible and I'll try to keep it within 10 minutes. I'm not sure which is more achievable but let's try to succeed in at least the latter.

I'm actually pleased we are talking about bonds today as I don't think I would have been as optimistic had I been talking about equities so again we will try to keep this very upbeat.

There is a long-held view that the U.S. only experiences mid-decade slowdowns and not mid-decade recessions. Those episodes are reserved for the early stages of a decade. Well, we are well passed the half-way mark of this decade and so far thankfully no recession. But we still have a few more years to grind through before we can say that that pattern is held intact.

For those who believe the Federal Reserve under the stewardship of a learner chairman has once again succeeded in producing a coveted soft landing the recent weeks have indeed been welcome. Economic indicators have largely surprised on the upside since the start of December and growth forecasts for 2007 and 2008 have started to be lifted. Goldilocks apparently has returned to the building.

The rally in Treasury yields from mid-summer of last year through to November of last year can be mainly attributed to two things--the quasi calming down of inflation helped in part by the drop in energy prices and the enshrined belief that the Fed would deliver on monetary easing at some point in 2007. Now that energy prices appear to be stabilizing and could perhaps even venture higher, the argument in favour of lower yields in 2007 essentially comes down to one assumption and that is the Fed cuts rates. Yet if we took this week's December 12th FOMC minutes at face value there is a suggestion that the Fed could leave the funds target at 5 1/4 per cent all the way through 2007 on the belief that they would still be able to achieve decent growth in the U.S. economy. The longer the Fed delays in serving up these cuts, the more restless the U.S. bond market becomes.

The problem is that much of the apparent improvement in recent economic conditions, modest albeit, has resulted from declines in mortgage rates and gasoline prices during the second half of last year. As soon as rates began to pick up and as soon as pump prices stopped falling, activity in the U.S. during December began to break down. Mortgage applications during the middle two weeks of December sank and retail sales anecdotes from the holiday season have been far from stellar.

Housing in particular is going to be a major problem at the start of 2007 since the lack of sustained improvement in housing demand will leave a massive inventory overhang from last year in place. This will force builders to cut back on output or face the consequences of further corrosion in home prices.

At the end of the day a negative wealth effect shock could cause the consumer to cut spending on a quarterly basis for the first time since 1991. Ironically, if this scenario pans out not only will the original forecast of Fed easing come into fruition but investors may discover that the final outcome will be a longer period of monetary easing with the magnitude of rate cuts in excess of those forecasts.

Goldilocks' presence was also felt in the corporate market. Despite concerns of a possible near-term hard landing spreads remained snug during 2006 and surprisingly tightened in the auto sector of all things. All the wild volatility in corporate stock and debt prices fell to extremely low levels and as volatility declined the cost of taking out insurance on corporate exposure also fell as evidenced by the sliding credit default swaps spreads. But still this weakening in premiums was not enough to detract providers of insurance from writing that insurance as the hunger for yield continues.

At the beginning of the new year we are faced with a risk-reward imbalance. The prospect for significant growth in real returns on corporate paper is limited while the risk of an economic or event-driven widening in spreads has increased. That applies equally to sovereign debt. Emerging market spreads have tightened in by close to 650 basis points or 60 per cent since the last sizeable back-up in 2002. In comparison during the lead-up to 2000 spreads narrowed 970 basis points or 66 per cent. Emerging market equity indices have also skyrocketed and Mexico's rally of well over 300 per cent in the past four years is not far off the NASDAQ's four-year return ending in 2000.

Fundamentals in today's emerging markets are definitely better than the vacuous state at the height of a tech bubble in terms of earnings but do they validate current levels? Either a negative credit or sovereign development would likely produce a flight to quality from assets that are not priced adequately for the extra risk they involve. As far as the market is concerned both of these risks have minimal probabilities and that is a common characteristic of the Goldilocks' view.

A higher probability can and should be assigned to another wave of U.S. dollar selling. For all the resiliency in global growth during 2006 and a further erosion in the greenback's value there has been no improvement in the U.S. current account deficit nor in the massive global savings imbalance. And as positive as some of the more recent U.S. indicators seem they may not be good enough to generate a continued growth in the demand for U.S. dollars as that imbalance remains in place.

The 2008 federal election may seem like a long way down the road but as it approaches we are likely to see more not less protectionism from Washington aimed at the likes of China. Any sabre rattling on trade usually conjures up thoughts of repercussions such as threatened acceleration in Asian reserve diversification away from U.S. paper, but the focus now should not be on China nor Japan as being the catalyst for a major sell-off in U.S. dollars. The greater threat for destabilization in the dollar and debt market stems from non-official holders of U.S. paper, the central banks of some of the rich or some of the petrol-rich nations namely Russia and parts of the Middle East. The reason is that there is simply not the same vested interest in the viability of the U.S. consumer among the latter group of countries as there are in most of Asia and therefore a greater potential for an exodus of funds.

The effects of the U.S. bond market from such a situation are more ambiguous than in a global credit shock and could turn out to be negative if the resulting dollar slide is viewed as inflationary by the Fed and therefore providing grounds for more hawkish stands on policy.

A U.S. dollar sell-off however would drive Canadian bond yields lower. Canada's economy has already underperformed the U.S. during most of the past year and we could see growth slip below 2 per cent in 2007 unless the last quarter and first quarter of this year show a meaningful pick-up. The Bank of Canada has left its options open and should not hesitate to cut rates if the growth trajectory deteriorates. Likewise, the bank should not be fooled by recent upward divisions to growth expectations or the recent weakness in the Canadian dollar. Commodity prices may still turn out to be the saviour of growth for Canada but it would come at the expense of U.S. growth and an even stronger Canadian dollar.

Bottom line, we have experienced what happens when U.S. growth falters and the Canadian dollar is weak and we have tasted what happens when the U.S. economy is strong and the Canadian dollar is rising. We have not yet tested in recent economic history what happens to Canada's economy under conditions where the U.S. economy is weak and our currency is strong. This could happen in 2007 and if it does there will be increased pressure on the Bank of Canada to respond with lower rates.

In summary, most signs do point to a capable landscape for Canadian and U.S. fixed-income markets in 2007 with global bond markets expected to follow suit with a lag. The downward trend in short-term U.S. and Canadian bond yields will continue during 2007 supported by policy easing from both central banks and this trend will be amplified by any of the following--an external geopolitical or credit event, a sudden and sharp retrenchment in U.S. consumer spending caused by the negative wealth effect from the housing correction, or an easing in non-North American central bank policy aimed at offsetting additional devaluation in the U.S. dollar.

Thank you very much and Happy New Year.

Introduction by John Niles

And now I wish to invite Mr. Jeffrey Rubin.

Jeffrey Rubin

Curiously I've been asked to speak about the outlook for the oil and gas income trust sector.

Let me dispense with the formal requirements of my speech. I think the outlook is pretty clear. Within four years they won't exist. And I'm as confident in that forecast as of course I am in all of my forecasts. But let me make some observations about factors that will drive the near-term performance of oil and gas royalty trusts, factors that have bearing on the performance of other assets beyond the trust market and of course I am referring to interest rates, the price of natural gas and the price of oil.

My first observation is that while we know that such instruments will not exist into 2011 there are still 48 months of distribution. And distributions have not stopped. In fact the yield in the income trust market has gone from about 8 per cent to just around 10 per cent. And last time I checked what a long Canada yield was it was barely above 4 per cent. I don't see too many instruments out there that offer a 600-basis-point pick-up over a long Canada yield particularly in a market that has never really had a high-yield bond market and that perhaps is not surprisingly why income trusts have outperformed the broad equity market for the last four years up until of course the minister's announcement.

Well the supply of income trusts is obviously going to be constrained in the next four years, but the demand for yield is not. And I would argue that the demand for yield is in fact going to grow because despite the wise benevolent guidance of our central bank, the fact of the matter is that interest rates are going to be going down in 2007 and not up. And those yields are going to become even more sought in the marketplace.

The context for interest rate cuts is going to be a very weak central Canadian economy, that probably will not be growing at all, an uncompetitive exchange rate even at today's exchange rate let alone where it was a couple of months ago.

Of course the performance of oil and gas royalty trusts don't just depend on the level of interest rates. They also depend very much on the price of oil and the price of natural gas, which as some of you may know, are subjects close to my heart.

First let me point out that the outlook for oil and the outlook for natural gas are two very different outlooks. I know that it is fashionable in some quarters in financial markets to believe in BTU price equivalents. By that I mean that natural gas and oil should trade at the same price energy adjusted. At least one hedge fund went broke last year following that theorem and I'm sure that many investors incurred a lot of red ink. Because the fact of the matter is that only about 20 per cent of natural gas and oil can be switched in the U.S. marketplace.

Oil and natural gas are two very different animals. Of course natural gas is a continental price, oil is a world price, but there's an even more fundamental difference and that is that U.S. natural gas demand is falling and will continue to fall, which cannot yet be said about U.S. oil demand. The simple fact of the matter is that while North America faces depleting natural gas supply in Canada, the rate of depletion right now is not keeping pace with the rate of demand destruction in the U.S. marketplace. Forty per cent of natural gas consumption in the United States is in the form of industrial usage and it has fallen 20 per cent over the last six years because of the steady exodus of gas-using industries such as the petrol chemical industry from North America where they pay six, seven dollars for gas at the feedstock, to places like the United Arab Emirates or Saudi Arabia where you pay one dollar feedstock prices.

Thirty per cent of natural gas is of course used for home heating and despite what the folks in Calgary may say the fact of the matter is that of the last 164 years eight of the warmest winters have occurred in the last decade. In fact there is now clear and overwhelming evidence of climate change and what we are going to see is natural gas continuing to be a major casualty of that and we can see that right today. We can see that in the space of one year. Natural gas has gone from around $13 in the aftermath of Katrina and Rita and a 50-per-cent premium to oil to $6 and a 50-per-cent discount to oil.

Now of course it can be said that oil too is a casualty of global warming. Certainly if you look at the U.S. northeast which accounts for about 80 per cent of U.S. home heating oil demand it is down about 40 per cent so far this year. Similar factors can be said in Europe. But given proportionately greater North American natural gas heating use, certainly the climate changes within the energy sector are going to be seen on gas a lot sooner than they are going to be seen on oil.

Let me point out within the energy sector what is going to be the biggest beneficiary of these climate changes and with every warm winter the appeal of uranium grows. For those of you who might have heard me at the TSFA forecast dinner back in September, I made a bull forecast that uranium prices would get to $70 a pound in 2007. Seemingly bold at the time. Uranium was around $50. We are already at $72 a pound in the year since the rate started. We are probably going to see $100 a pound prices by the end of the year as it becomes more and more apparent that carbon abatement policies of the kind that have just been engineered in California are going to spread to other jurisdictions in North America.

Now let me just conclude by talking a little bit about the supply side and why I still think that warming climate notwithstanding Canada is a very unique place on the supply side of oil.

Depending on your opinion of the current hospitality of Iraq to foreign investment, Canada represents about 60 per cent of the investible oil reserves in the world because in most places in the world there is a very strong social and political consensus that hydrocarbon assets should be owned and developed by the state. And I'm not just talking about radical regimes like Libya. I'm talking about places like Norway. I'm talking about places like Mexico. In fact Canada is very unique in the sense that its sector is open to foreign investment and given its bitumen resources, that basically accounts for about 60 per cent of investible oil reserves and that's including other supposedly open areas of investment such as strife-torn Nigeria. Surely the rule of law if not the rule of contract requires a huge premium on Canadian energy assets.

Lastly it is true that there is considerable skepticism about whether the oil patch can go from one million barrels a day of unconventional crude from bitumen to three to four million barrels a day in the next 10 to 15 years. If we know anything about the experience of the Athabasca Oil Sands, history has taught us that it usually takes twice as long and costs twice as much to get the oil out of the ground.

But what investors have to realize is that is not a uniquely Canadian story. That is a worldwide story insofar as unconventional hydrocarbons are concerned. Sakhalin II, the world's largest energy project, $10 billion overrun. That has ultimately led to the effect of nationalization of that project by Gazprom. If we look at the deep-water wells, 30 to 35 thousand feet, the technological marvels of what the U.S. oil industry always talks about in the Gulf of Mexico, it is commonplace to have three to four hundred per cent cost overruns. To the extent that Canada will not be able to bring that supply out within that timeframe or at today's cost only means that at the end of the day the price of oil is going to have to be higher because at the end of the day we are the marginal supplier. And I think that when you look around the world you'll find that there are very few places where you can grow production like you can grow in the Canadian Oil Sands and even fewer where you can invest.

Thanks very much.

The appreciation of the meeting was expressed by William F. White, President, IBK Capital Corp., and Director, The Empire Club of Canada.