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THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE 1

THE GLOBAL INVESTMENT OUTLOOK

RBC Investment Strategy Committee

FALL 2008

THE RBC INVESTMENT STRATEGY COMMITTEE

The RBC Investment Strategy Committee consists of senior investment professionals drawn

from individual client focused business units within RBC Financial Group. The Committee

regularly receives economic and capital markets related input from internal and external

sources. Important guidance is provided by the Committee’s regional advisors (North

America, Europe, Far East), from the Global Fixed Income & Currencies Subcommittee and

from the global equity sector heads (fi nancials and healthcare, consumer discretionary

and consumer staples, industrials and utilities, energy and materials, telecommunications

and technology). From this it builds a detailed global investment forecast looking one year

forward.

The Committee’s view includes an assessment of global fi scal and monetary conditions,

projected economic growth and infl ation, as well as the expected course of interest rates,

major currencies, corporate profi ts and stock prices.

From this global forecast, the RBC Investment Strategy Committee develops specifi c

guidelines that can be used to manage portfolios.

These include:

the recommended mix of cash, fi xed income instruments, and equities

the recommended global exposure of fi xed income and equity portfolios

the optimal term structure for fi xed income investments

the suggested sector and geographic make-up within equity portfolios

the preferred exposure to major currencies

Results of the Committee’s deliberations are published quarterly in The Global Investment

Outlook.

an

THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE

EXECUTIVE SUMMARY 2 The Global Investment Outlook

Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Asset Management Inc.

ECONOMIC & CAPITAL MARKETS FORECASTS 4 RBC Investment Strategy Committee

RECOMMENDED ASSET MIX 5 RBC Investment Strategy Committee

CAPITAL MARKETS PERFORMANCE 8 Milos Vukovic, MBA, CFA – V.P. Investment Policy, RBC Asset Management Inc.

INVESTMENT OUTLOOK 10 Not So Happy Anniversary, But Checking Out Could Be Costly

Daniel E. Chornous, CFA – Chief Investment Offi cer, RBC Asset Management Inc. and

Phillips, Hager & North Investment Management Ltd

Jason Storsley, CFA – Senior V.P., Institutional Portfolio Management & Director, Global Equity Research, RBC Asset Management Inc.

GLOBAL ECONOMIC OUTLOOK 33 Patricia Croft, Chief Economist – Phillips, Hager & North Investment Management Ltd.

FIXED INCOME MARKETS 38 Robin Gullason, CFA – V.P., Fixed Income Portfolio Advisory Group, RBC Dominion Securities Inc.

CURRENCY MARKETS 44 Dagmara Fijalkowski, MBA, CFA – V.P. & Senior Portfolio Manager, RBC Asset Management Inc.

REGIONAL OUTLOOK United States 52 Raymond Mawhinney – Senior V.P., U.S. & Global Equities, RBC Asset Management Inc.

Brad Willock, CFA – V.P. & Senior Portfolio Manager, RBC Asset Management Inc.

Canada 54 Stuart Kedwell, CFA – Senior V.P. & Senior Portfolio Manager, RBC Asset Management Inc.

Europe 56 Vittorio Fegitz –Senior Portfolio Manager, RBC Asset Management UK Limited

Asia 58 Yoji Takeda – Director & V.P., Asian Equities, RBC Investment Management (Asia) Limited

RBC INVESTMENT STRATEGY COMMITTEE 60

DISCLAIMER 63

CONTENTS


2 THE GLOBAL INVESTMENT OUTLOOK RBC INVESTMENT STRATEGY COMMITTEE

EXECUTIVE SUMMARYDANIEL E. CHORNOUS, CFA

Chief Investment Offi cer – RBC Asset Management Inc. and Phillips, Hager & North Investment Management Ltd.

ECONOMY EXPANDS BUT GROWTH DEFINITELY SLOWING

Economic growth so far this year has shown surprising resilience, defying even the loftiest expectations. There’s no question that the credit crisis remains a serious challenge to the economy. While a negative real fed funds rate is accommodative, borrowing costs, credit availability, asset prices, risk preferences and the capital needs of fi nancial intermediaries are all imposing varying degrees of restraint. At the same time, an end to the crisis would pose substantial risks for fi xed-income investors – especially those who have ejected corporate credit from their portfolios to weather the current storm. In the U.S., strength in the fi rst half of the year as well as further improvement in the terms of trade leave us comfortable with our 2008 growth forecast of 1.75%. We have cut our 2009 forecast to 1.5%, as weakness at the tail end of 2008 and early 2009 stalls the economy. We expect Canadian growth to slow to 1% this year before gaining traction to 1.5% in 2009. We expect Eurozone growth to slow to 1.25% this year and 1% next year as the economy is plagued by declining

business and consumer confi dence, a rising currency and a stubborn central bank choosing to strong-arm infl ation rather than stimulate growth. Accelerating weakness in the U.K. housing market and consumer spending have led us to pare our U.K. GDP forecast to 1.25% for this year and next. Japan’s domestic demand remains anemic at best, while moderating growth in China and weakness in the U.S. and Europe will put further strain on Japanese exports. GDP in Japan should grow 1% in 2008 and 1.25% in 2009.

ENCOURAGING SIGNS ON THE INFLATION FRONTOn balance, even as reported infl ation posts new highs, there are encouraging signs that one of several key threats to the economy is beginning to subside. The retreat in oil prices has begun to steady the dollar, perhaps signaling a broader lift in investor confi dence that will be needed to put the economy back on track in 2009. With commodity prices likely past their peak, headline infl ation rates are set to fall sharply by year-end. Nonetheless, as long as interest rates remain low, infl ation remains a threat.

Core rates have been well behaved, but remain slightly above the 2% level considered to be the upper limit of the Fed’s “comfort zone.”

DOLLAR RALLIES HARD

Our contention in the Spring 2008 issue of Global Investment Outlook that the dollar had entered an extended bottoming cycle found strong validation in the past quarter, with the greenback’s gains since the middle of July almost unprecedented in the past 35 years. The dollar’s trade-weighted index rose more than 7% in one month, a move of such magnitude that it put the rate of change at the 99.8 percentile of dollar moves. Even so, the velocity of the dollar’s recent recovery makes us suspect that the market is getting carried away in the short term. When we analyzed the way the two previous dollar bear markets ended, we observed that in both cases it took 10 years before a sustainable rally developed. Assuming a similar pattern this time around, most of the dollar’s decline would be behind us, although we should expect a period when the market wanders in a fairly broad range of 10% rather than a rapid ascent.

On August 9, 2007, BNP Paribas announced that due to “the complete evaporation

of liquidity” in certain sectors of the securitization market, it was no longer able to

value three of its money-market funds. The date marks the unoffi cial start of what has

become a deeper and more prolonged credit crunch than most forecasters imagined,

including ourselves. One year later, market conditions remain deeply depressed. What

began as a valuation problem in the sub-prime housing and securitization market

has touched virtually every lending and borrowing pocket of the fi nancial system.

Credit conditions remain historically tight and spreads are once again fl irting with the

extremes set at the time of the Bear Stearns collapse last March.


EXECUTIVE SUMMARY • DANIEL E. CHORNOUS, CFA

CENTRAL BANKS HAVE RATE-CUT FIREPOWER AT THEIR DISPOSAL

The Federal Reserve has been swift and deliberate, reaching deep into its arsenal to inject liquidity into the market and minimize the credit crunch spillover into the broader economy. With commodity prices likely past their peak, and with headline infl ation rates set to fall sharply by year end, policymakers have rightly turned their attention to the weakening growth outlook. In the U.S., where the Federal Reserve has already cut rates by 325 basis points to 2%, the lagged effect of the rate-cut impact should fully materialize in the second half of next year and shore up growth, prompting higher policy rates late in 2009. Canada is likely to stand pat with a small bias to cut rates as weak U.S. demand coupled with a stronger Canadian dollar increase the drag on GDP from deteriorating trade conditions. Japan too is expected to remain sidelined, as GDP growth continues to be tenuous and erratic. Our models indicate that the U.K. and ECB still have plenty of fi repower at their disposal, and monetary policy will be infl uenced by declining infl ation and slower

growth. We expect three rate cuts in both regions in the year ahead.

BONDS OVERVALUED; YIELDS SHOULD RISE AS CREDIT CRUNCH ABATES

Fueled by a fl air-up in concern over the health of the fi nancial system, massive risk aversion and downward revisions to global growth, bond yields have plunged in near straight-line fashion over the past quarter. Valuations remain at extreme levels, lying below their equilibrium bands in all major regions. In the U.S., the drop in yields is the second largest on record of any easing cycle since the early 1950s and implies a much deeper and prolonged slowdown than is likely to emerge. As the credit crunch begins to abate, risk premiums normalize and the economy responds to lower rates, bond yields should move to levels consistent with moderate growth, leaving them vulnerable to signifi cant upside pressure. Our forecast for 10-year U.S. bond yields is 4.5% by this time next year. We look for U.K. yields to reach a similar 4.5%, while yields in Canada and the Eurozone should sit 25 basis points below their U.S. counterparts at 4.25%. We expect Japanese yields

to reach the upper band of their nine-year trading range of 1.75%.

STOCKS SHOW SOLID VALUE AND POTENTIALThe crisis environment of the past year shows few signs of clearing, so the way ahead for stocks is unusually murky. Nevertheless, valuations based on normalized profi ts and p/e ratios refl ect a level of pessimism that hasn’t been seen since the great bull market began in the early 1980’s. As we view the recent spike in infl ation to be transitory and primarily the result of sharp increases in energy prices which have now reversed, winning conditions are very much apparent with stocks far below fair value. Risks are evident, but so is the potential for superior returns. At a minimum, as confi dence is ultimately restored, stocks should return to fair value, a climb that would produce double-digit returns.

ASSET MIX TILTED TOWARDS STOCKS

For a balanced global investor, we recommend an asset mix of 60% equities (allowed range 40% to 70%), 32.5% bonds (allowed range 30%- 60%), with the balance of 7.5% in cash.


Source: RBC AM

ECONOMIC & CAPITAL MARKETS FORECASTS

ECONOMIC FORECAST (RBC INVESTMENT STRATEGY COMMITTEE)

UNITED STATES CANADA EUROPE UNITED KINGDOM JAPAN

FALL 2008

CHANGE FROM SUMMER

2008FALL2008

CHANGE FROMSUMMER

2008FALL 2008

CHANGE FROMSUMMER

2008 FALL 2008

CHANGE FROMSUMMER

2008FALL 2008

CHANGE FROMSUMMER

2008

REAL GDP

2007A 2.20% 2.60% 2.80% 3.00% 1.80%

2008E 1.75% N/C 1.00% (0.75) 1.25% (0.50) 1.25% (0.50) 1.00% (0.50)

2009E 1.50% (1.00) 1.50% (1.00) 1.00% (1.00) 1.25% (0.50) 1.25% (0.75)

CPI

2007A 2.90% 2.10% 1.80% 1.70% 0.00%

2008E 4.00% 0.50 2.50% 0.75 3.75% 0.75 3.50% 0.75 1.50% 0.75

2009E 2.75% 0.25 2.25% 0.25 2.75% 0.50 2.50% 0.25 1.00% 0.25

A = ACTUAL E = ESTIMATE

* GDP weighted average of Germany, France and Italy.

TARGETS (RBC INVESTMENT STRATEGY COMMITTEE)

AUG. 29, 2008FORECAST

AUG. 29, 2009CHANGE FROM SUMMER 2008

1-YEAR TOTAL RETURN ESTIMATE (%)

CURRENCY MARKETS AGAINST USD

USD–CDA 1.06 1.07 0.03 (0.1)

EURO–USD 1.47 1.40 N/C (2.7)

USD–JPY 108.80 112.00 2.00 (4.8)

GBP–USD 1.82 1.80 N/C 1.5

FIXED INCOME MARKETS

U.S. Fed Funds Rate 2.00 2.50 N/C 2.3

U.S. 10 Year Bond 3.81 4.50 N/C (0.1)

Canada Overnight Rate 2.42 3.00 (0.25) 2.8

Canada 10 Year Bond 3.53 4.25 N/C (1.0)

Eurozone Repo Rate* 4.32 3.50 N/C 4.0

Eurozone 10 Year Bond* 4.42 4.25 N/C 6.0

U.K. Base Rate 5.20 4.25 N/C 4.8

U.K. 10 Year Gilt 4.48 4.50 N/C 4.7

Japan Overnight Call Rate 0.57 0.50 N/C 0.5

Japan 10 Year Bond 1.41 1.75 N/C (0.6)

EQUITY MARKETS

S&P 500 1283 1475 (125) 17.4

S&P/TSX Composite 13771 14500 (1000) 8.0

MSCI Europe 1688 1950 (250) 20.0

FTSE 100 5637 6200 (600) 14.6

Nikkei 13073 14500 (500) 12.7


GLOBAL ASSET MIXBENCHMARK

POLICY PAST

RANGEREVISED

SEPT. 18, 2007NEW YEAR

2008SPRING 2008

SUMMER 2008

FALL2008

CASH 5.0% 1.5% – 16% 2.5% 5.0% 7.5% 7.5% 7.5%

BONDS 40.0% 25% – 54% 35.0% 32.5% 32.5% 32.5% 32.5%

STOCKS 55.0% 36% – 65% 62.5% 62.5% 60.0% 60.0% 60.0%

REGIONAL ALLOCATION

GLOBAL BONDS CWGBI*AUG. 2008

PAST RANGE

REVISED SEPT. 18, 2007

NEW YEAR 2008

SPRING 2008

SUMMER 2008

FALL2008

North America 22.6% 9% – 46% 18.7% 18.1% 24.7% 19.3% 17.6%

Europe 49.2% 40% – 90% 49.3% 49.7% 51.7% 52.2% 51.7%

Asia 28.2% 0% – 29% 32.0% 32.2% 23.6% 28.5% 30.7%

Note: Based on anticipated 12-month returns in $US hedged basis

GLOBAL EQUITIES MSCI**AUG. 2008

PAST RANGE

REVISED SEPT. 18, 2007

NEW YEAR 2008

SPRING 2008

SUMMER 2008

FALL2008

North America 53.3% 15% – 60% 52.5% 52.5% 54.0% 53.0% 54.3%

Europe 32.3% 30% – 70% 33.5% 33.5% 32.5% 33.0% 33.0%

Asia 14.4% 10% – 39% 14.0% 14.0% 13.5% 14.0% 12.8%

GLOBAL EQUITY SECTOR ALLOCATION

MSCI**AUG. 2008

RBC ISCSUMMER 2008

RBC ISCFALL 2008

CHANGE FROMSUMMER 2008

WEIGHT vs. BENCHMARK

Energy 11.38% 13.00% 12.50% (0.50) 109.84%

Materials 7.22% 8.25% 7.50% (0.75) 103.88%

Industrials 11.34% 11.75% 11.25% (0.50) 99.21%

Utilities 4.79% 5.50% 4.25% (1.25) 88.73%

Consumer Discretionary 9.10% 8.75% 8.25% (0.50) 90.66%

Consumer Staples 9.45% 8.25% 9.50% 1.25 100.53%

Health Care 9.99% 7.00% 11.00% 4.00 110.11%

Financials 21.21% 21.75% 20.00% (1.75) 94.30%

Information Technology 11.23% 11.25% 12.00% 0.75 106.86%

Telecom. Services 4.29% 4.50% 3.75% (0.75) 87.41%

Asset mix – the allocation within portfolios to stocks, bonds and cash – should include both strategic and tactical elements. Strategic asset mix addresses the blend of the major asset classes offering the risk/return tradeoff best suited to an investor’s profi le. It can be considered to be the benchmark investment plan that anchors a portfolio through many business and investment cycles independent of a near-term view of the prospects for the economy and related expectations for capital markets. Tactical asset allocation refers to fi ne tuning around the strategic setting in an effort to add value by taking advantage of shorter term fl uctuations in markets.

Every individual has differing return expectations and tolerances for volatility, so there is no “one size fi ts all” strategic asset mix. Based on a 35-year study of historic returns and the volatility of returns (the range around the average return within which shorter-term results tend to fall), we have developed fi ve broad profi les and assigned a benchmark strategic asset mix for each. These profi les range from income through balanced to aggressive growth. It goes without saying that as investors accept increasing levels of volatility, and therefore greater risk that the actual experience will depart from the longer-term norm, the potential for returns rises. The fi ve profi les presented below may assist investors in selecting a strategic asset mix best aligned to their investment goals.

Each quarter, the RBC Investment Strategy Committee publishes a recommended asset mix based on our current view of the economy and return expectations for the major asset classes. These weights are * Citigroup World Global Bond Index **MSCI World Index Source: RBC Investment Strategy Committee

RECOMMENDED ASSET MIX

further divided into recommended exposures to the variety of global fi xed income and equity markets. Our recommendation is targeted at the Balanced profi le where the benchmark setting is 55% equities, 40% fi xed income, 5% cash.

A tactical range of +/- 15% around the benchmark position allows us to raise or lower exposure to

specifi c asset classes with a goal of tilting portfolios toward those markets that offer comparatively attractive near-term prospects.

This tactical recommendation for the Balanced profi le can serve as a guide for movement within the ranges allowed for all other profi les. If, for example, the recommended current

Continued on next page...



ASSET CLASSBENCH-MARK

RANGELAST

QUARTERCURRENT

RECOMMENDATION

CASH & CASH EQUIVALENTS 5% 0-15% 8.3% 8.3%

FIXED INCOME 75% 55-95% 67.5% 67.5%

TOTAL CASH & FIXED INCOME 80% 65-95% 75.8% 75.8%

CANADIAN EQUITIES 10% 5-20% 9.4% 9.4%

U.S. EQUITIES 5% 0-10% 9.0% 9.0%

INTERNATIONAL EQUITIES 5% 0-10% 5.8% 5.8%

TOTAL EQUITIES 20% 5-35% 24.2% 24.2%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 60% 40-80% 51.6% 51.6%



U.S. EQUITIES 10% 0-15% 15.2% 15.2%


TOTAL EQUITIES 35% 20-50% 40.4% 40.4%

equity exposure for the Balanced profi le is set at 62.5% (i.e.: 7.5% above its benchmark of 55% and part way toward its upper limit of 70% for equities), that would imply a tactical shift of + 5.02% to 25.02% for the Income profi le (i.e.: a proportionate adjustment above the benchmark equity setting of 20% within the allowed range of +/- 15%).

The value-added of tactical strategies are, of course, dependent on the degree to which the expected scenario unfolds.

Regular review of portfolio weights is an essential part of the ultimate success of an investment plan as it ensures that current exposures are aligned with the level of long-term

INCOME

CONSERVATIVEConservative investors will pursue modest income and modest capital growth with reasonable capital preservation, and be comfortable with moderate fl uctuations in the value of their investments. The portfolio will invest primarily in fi xed-income securities with some equities to achieve more consistent performance and provide a reasonable amount of safety. The profi le is suitable for investors who plan to hold their investment over the medium to long term (minimum fi ve to seven years).

Income-oriented investors will seek income with maximum capital preservation and the potential for modest capital growth, and be comfortable with small fl uctuations in the value of their investments. This portfolio will invest primarily in fi xed-income securities and a small amount of equities to generate income while providing some protection against infl ation. Investors who fi t this profi le generally plan to hold their investment for the short to medium term (minimum one to fi ve years).

RETURN VOLATILITY

35-YEAR AVERAGE 9.8% 7.8%

LAST 12 MONTHS AVERAGE 2.7% 3.3%

RETURN VOLATILITY


LAST 12 MONTHS AVERAGE 4.9% 2.2%

1. Average Return: The average total return produced by the asset class over the period 1973 – 2008, based on monthly results.

2. Volatility: The standard deviation of returns. Standard deviation is a statistical measure that indicates the range around the average return within which 2/3 of results will fall into, assuming a normal distribution around the long-term average.

...Continued from previous page

returns and risk tolerances best suited to individual investors.

Anchoring portfolios with a suitable strategic asset mix, and placing boundaries defi ning the allowed range for tactical positioning imposes a discipline that can limit the damage caused by swings in emotion that inevitably accompany both bull and bear markets.




RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 40% 20-60% 32.5% 32.5%



U.S. EQUITIES 20% 10-30% 25.3% 25.3%


TOTAL EQUITIES 55% 40-70% 60.0% 60.0%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 25% 5-40% 19.5% 19.5%



U.S. EQUITIES 25% 15-35% 31.7% 31.7%


TOTAL EQUITIES 70% 55-85% 76.4% 76.4%


RANGELAST

QUARTERCURRENT

RECOMMENDATION


FIXED INCOME 0% 0-10% 0.0% 0.0%



U.S. EQUITIES 30% 15-45% 33.1% 33.1%


TOTAL EQUITIES 95% 80-100% 96.7% 96.7%

BALANCED

AGGRESSIVE GROWTH

GROWTH

The Balanced portfolio is appropriate for investors seeking balance between long-term capital growth and capital preservation, with a secondary focus on modest income, and who are comfortable with moderate fl uctuations in the value of their investments. More than half the portfolio will usually be invested in a diversifi ed mix of Canadian, U.S. and global equities. This profi le is suitable for investors who plan to hold their investment for a medium to long-term (minimum fi ve to seven years).

Investors who fi t the Growth portfolio profi le will seek long-term growth over capital preservation and regular income, and be comfortable with considerable fl uctuations in the value of their investments. This portfolio primarily holds a diversifi ed mix of Canadian, U.S. and global equities and is suitable for investors who plan to invest for the long term (minimum seven to ten years).

Aggressive growth investors seek maximum long-term growth over capital preservation and regular income, and are comfortable with signifi cant fl uctuations in the value of their investments. The portfolio is almost entirely invested in stocks and emphasizes exposure to international equities. This investment profi le is suitable only for investors with a high risk tolerance and who plan to hold their investments for the long term (minimum seven to ten years).

RETURN VOLATILITY


LAST 12 MONTHS AVERAGE -0.4% 5.2%

RETURN VOLATILITY



RETURN VOLATILITY




Over the latest three-month period, the U.S. dollar reversed its declining trend against most major global currencies. The greenback appreciated most relative to the British pound, against which it gained 8.68%. The dollar also strengthened against the euro, the Canadian dollar and the yen, rising 6.04%, 6.91% and 3.23%, respectively. Since September 1, 2007, the dollar’s biggest gain was against Sterling at 10.6%. In that period, the greenback dropped 7.15% versus the euro and 6% versus the yen, while remaining virtually fl at against the Canadian dollar.

With global equity markets remaining volatile, fi xed-income markets resumed their positive trend. The TSX DEX Overall Universe Bond Index, a measure of the performance of the broad Canadian bond market, returned 1.56% over the past three months. In the same time period, the Citigroup World Government Bond Index lost 1.36% in U.S. dollar terms. Among major regions, Japan decreased 0.86%, measured by the Citigroup Japan Total Return Index, while Europe declined 3.06% measured by the Citigroup Europe Total Return Index, respectively, both in U.S. dollar terms. U.S. bonds, measured by the Citigroup U.S. Total Return Index, outperformed Europe and Japan, returning 2.51%. On a one-year basis, European and Japanese bonds remained strong, gaining 10.54% and 9.17%, respectively, in U.S. dollar terms. For the same period, the U.S. fi xed income market returned 8.64%.

The S&P/TSX Composite index has fallen considerably since

EXCHANGE RATES (USD RETURNS) PERIODS ENDING AUGUST 31, 2008

Current USD

3 months (%)

YTD (%)

1 year (%)

3 years (%)

5 years (%)

USD–CAD 1.0631 6.91 7.03 0.73 -3.59 -5.14

USD–EUR 0.6818 6.04 -0.50 -7.15 -5.61 -4.55

USD–GBP 0.5491 8.68 9.00 10.60 -0.37 -0.28

USD–JPY 108.8187 3.23 -2.35 -6.00 -0.56 -0.09

CAPITAL MARKETS PERFORMANCEMILOS VUKOVIC, MBA, CFA

V.P. Investment Policy – RBC Asset Management Inc.

Source: Bloomberg/MSCI

CANADA (CAD $ BASIS)PERIODS ENDING AUGUST 31, 2008

Fixed Income Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

DEX Overall Universe Bond Index 1.56 3.86 7.48 3.82 5.67

U.S. (USD $ BASIS)PERIODS ENDING AUGUST 31, 2008


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Citigroup US 2.51 3.93 8.64 5.10 4.97

LB Aggregate Bond Index 0.79 2.00 5.86 4.26 4.61

GLOBAL (USD $ BASIS)PERIODS ENDING AUGUST 31, 2008


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Citigroup WGBI -1.36 3.14 9.81 5.32 6.77

Citigroup Europe -3.06 2.53 10.54 7.23 9.72

Citigroup Japan -0.86 3.72 9.17 1.85 2.88

June 1, 2008, with a drop of 5.76%. The performance of the smallest companies in the index, measured by market capitalization, was even worse, down 8.05%, while the largest companies in the index posted a decline of 5.87% as measured by the S&P/TSX 60 Index. The S&P 500 Composite Index also fell signifi cantly, losing 7.89% over the past three months and 11.14% over the past year. The period from June 1, 2008, to August 31, 2008, was a diffi cult period for both mid cap and small cap stocks in the U.S. The S&P 400 Index, used as a measure of performance of small caps, lost 7.20% during this period, while the S&P 600 Index, a gauge of small cap

performance, outperformed its mid cap and large cap counterparts, with a 1.71% drop. Since September 1, 2007, the S&P 400 lost 4.22%, and the S&P 600 dropped 6.21%. Over the past three months the Russell 3000 Value Total Return Index fell 7.75%, compared with a 7.49% loss for the Russell 3000 Growth Total Return Index. The Russell growth index also outperformed its value counterpart on a one-year basis. The growth index recorded a loss of 6.56%, compared with a 14.11% drop for the value measure.

All major world equity indices continued to decline through the summer months. The MSCI World

Note: all changes above are expressed in US dollar terms

Note: all rates of return presented for periods longer than 1 year are annualized


CANADA (CAD $ BASIS)PERIODS ENDING AUGUST 31, 2008

Equity Markets: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

S&P/TSX Composite -5.76 1.32 3.51 11.55 15.36

S&P/TSX 60 -5.87 3.22 6.00 13.32 16.49

S&P/TSX Small Cap -8.05 -7.24 -9.41 3.25 7.01

Source: Bloomberg/MSCI

GLOBAL EQUITY SECTORS (USD $ BASIS)PERIODS ENDING AUGUST 31, 2008

Sector: Total Return3 months

(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

Energy -14.58 -6.94 4.99 11.95 22.24

Materials -17.38 -8.95 -0.43 21.70 21.52

Industrials -13.09 -13.94 -13.57 8.98 12.35

Utilities -9.84 -11.34 0.05 14.09 19.92

Consumer Discretionary -10.14 -15.43 -19.42 0.76 5.23

Consumer Staples -6.16 -8.38 -0.52 10.19 11.73

Health Care 1.74 -4.95 -3.01 3.80 7.31

Financials -15.61 -23.70 -27.86 -1.26 6.00

Information Technology -9.75 -12.90 -10.62 5.21 5.61

Telecommunication Services -13.08 -20.83 -14.28 6.12 9.53

Index declined 11.49% in the three months ended August 31, 2008. Declines for major world regions ranged from 14.53% for Asia Pacifi c to 20.29% for Emerging Markets. The worst performer among major European markets was France, where the MSCI France Total Return Index lost 14.78%. Between September 1, 2007, and August 31, 2008, the MSCI U.K. Index declined 16.68% measured in U.S. dollars, while the MSCI Japan fell 15.81%. For the same period, the MSCI Emerging Markets Index lost 10.09%, indicating the wide dispersion of negative returns around the globe.

Since the last publication of the Global Investment Outlook in June of this year, Health Care has been the only global sector to provide investors with gains, notching a 1.74% return. The worst performer was the Materials sector, which lost 17.38%, followed by Financials, down 15.61%, and Energy, down 14.58%. Since January 1, 2008, the Financial sector lost the most, with a decline of 23.70%, followed by Telecommunication Services, with a 20.83% fall, and Consumer Discretionary, which lost 15.43%. For the one-year period ended August 31, 2008, the best performing sectors were Energy, with a gain of 4.99% and Utilities, which was essentially fl at.

* Net of Taxes

GLOBAL (USD $ BASIS)PERIODS ENDING AUGUST 31, 2008


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

MSCI World* -11.49 -13.98 -12.07 5.99 10.21

MSCI EAFE* -14.73 -17.31 -14.41 8.08 13.86

MSCI Europe* -14.82 -18.28 -14.54 9.12 15.11

MSCI Pacifi c* -14.53 -15.08 -14.15 5.92 11.13

MSCI UK* -13.01 -17.62 -16.68 5.93 12.87

MSCI France* -14.78 -16.71 -11.81 9.38 15.23

MSCI Germany* -14.48 -19.98 -9.66 16.26 19.61

MSCI Japan* -13.57 -12.38 -15.81 3.23 8.28

MSCI Emerging Markets* -20.29 -21.87 -10.09 19.03 23.50

U.S. (USD $ BASIS)PERIODS ENDING AUGUST 31, 2008


(%)YTD (%)

1 year (%)

3 years (%)

5 years (%)

S&P 500 -7.89 -11.39 -11.14 3.66 6.92

S&P 400 -7.20 -4.07 -4.22 5.97 10.80

S&P 600 -1.71 -1.21 -6.21 4.72 10.78

RUSSELL 3000 Value -7.75 -11.54 -14.11 3.17 8.67

RUSSELL 3000 Growth -7.49 -9.43 -6.56 4.51 6.30

NASDAQ Composite Index -6.15 -10.74 -8.81 3.24 5.52

CAPITAL MARKETS PERFORMANCE • MILOS VUKOVIC, MBA, CFA

Note: all rates of return presented for periods longer than 1 year are annualized


On August 9, 2007, BNP Paribas announced that due to “the complete evaporation of liquidity” in certain sectors of the

securitization market, it was no longer able to value three of its money-market funds. The date marks the unoffi cial start of

what has become a deeper and more prolonged credit crunch than most forecasters imagined, including ourselves. One

year later, market conditions remain deeply depressed. What began as a valuation problem in the sub-prime housing and

securitization market has touched virtually every lending and borrowing pocket of the fi nancial system. Credit conditions

remain historically tight and spreads are once again fl irting with the extremes set at the time of the Bear Stearns collapse

last March.

NOT SO HAPPY ANNIVERSARY, BUT CHECKING OUT COULD BE COSTLY

INVESTMENT OUTLOOK

DANIEL E. CHORNOUS, CFAChief Investment Offi cer – RBC Asset Management Inc. and

Phillips, Hager & North Investment Management Ltd

JASON STORSLEY, CFASenior V.P., Institutional Portfolio Management &

Director, Global Equity Research – RBC Asset Management Inc.

There’s no question that the credit crisis remains a serious challenge to the economy. While a negative real fed funds rate is accommodative, borrowing costs, credit availability, asset prices, risk preferences and the capital needs of fi nancial intermediaries are all imposing varying degrees of restraint. In our view, risks now tilt toward a mild recession heading into the fi nal quarter of 2008 and the fi rst half of 2009. But while the market remains fi xed on the possibility of recession, we remain focused on the deeply discounted valuations that currently exist in capital markets. Global equity markets have endured one of the worst ever post-rate cut periods in history, and while the problems are acute, they are not insurmountable. At current levels, stocks appear to refl ect a long and deeply entrenched contraction in the economy, together with complete impotence on the part of central banks and monetary policy to eventually resolve the fi nancial crisis.

In our view, the turmoil has created signifi cant investment opportunities in stocks. The ultimate resolution of the credit crisis and

the normalization of risk aversion present a compelling return profi le for global equity markets. At the same time, an end to the crisis would pose substantial risks for fi xed-income investors – especially those who have ejected corporate credit from their portfolios to weather the current storm.

The continued decline in housing • prices and negative feedback loops in markets have broadened the credit crisis far beyond most forecasters’ expectations, including our own. Identifi cation and isolation of problem loans, monetization of non-performing mortgages and losses, continued strides in balance-sheet repair and the eventual unclogging of the monetary-policy transition mechanism will ultimately restore the fi nancial system and economy to good health. Recent fi scal relief in the U.S. and the possibility of a second stimulus package, together with a variety of market-stabilizing initiatives, should prove suffi cient to bridge the economy and thwart a severe recession until balance is restored in the second half of 2009.

Economic growth so far this • year has shown surprising resilience, defying even the loftiest expectations. While the consensus initially swung to statistical recession for 2008, fi rst-quarter U.S. GDP grew at a 0.9% pace followed by a second-quarter spurt to 3.3% – both more than double the median expectation on the back of surging net exports and a declining inventory drag. Strength in the fi rst half of the year as well as further improvement in the terms of trade leave us comfortable with our 2008 U.S. growth forecast of 1.75%. Nevertheless, with the impetus from fi scal relief partly burned off and a lower fed funds rate not yet refl ected in lending markets, the outlook for the second half of this year and beginning of next year looks bleak. As weakness at the tail end of 2008 and early 2009 stalls the economy, we’ve cut our 2009 forecast to 1.5%, with fi rming conditions and the full extent of prior rate cuts not expected to fully impact the economy until the second half of next year.


Canada’s economy has begun • to feel the strain of a stronger currency on its trade balance, while the labour-market engine that has been powering domestic demand appears to be losing steam. We expect Canada to grow at a 1% pace this year and 1.5% next year. We expect Eurozone growth to slow to 1.25% this year and 1% next year, as the economy is plagued by declining business and consumer confi dence, a rising currency and a stubborn central bank choosing to strong-arm infl ation rather than stimulate growth. Accelerating weakness in the U.K. housing market and consumer spending have led us to pare our U.K. GDP forecast to 1.25% for this year and next. Japan’s domestic demand remains anemic at best, while moderating growth in China and weakness in the U.S. and Europe will put further strain on Japanese exports. Japan's economy should eke out growth of 1% in 2008 and 1.25% in 2009.

Only a quarter ago, global • infl ation had become central bankers’ biggest concern, as oil and commodity prices soared almost vertically to record highs. Headline infl ation spiked well above central-bank comfort levels, to 5.6% in the U.S., 4% in the Eurozone, and 4.4% in the U.K. With oil having backed off to $115 from $147, along with similar declines in broader commodity and food prices, we expect headline infl ation will converge to the core reading rather than the reverse. Excluding Japan, CPI

INVESTMENT OUTLOOK • DANIEL E. CHORNOUS, CFA • JASON STORSLEY, CFA

in most regions should be in the range of 2.5%-4% this year, easing to 2.25%-2.75% next year. Japan’s CPI is expected to hit 1.5% this year and 1% next year. As before, realizing these targets for the next year is critical to achieving our forecasts for monetary policy, bond yields and stock prices.

With commodity prices likely • past their peak, and with headline infl ation rates set to fall sharply by year-end, policymakers have rightly turned their attention to the weakening growth outlook. In the U.S., where the Federal Reserve has already cut rates by 325 basis points to 2%, the lagged effect of the rate-cut impact should fully materialize in the second half of next year and shore up growth, prompting higher policy rates late in 2009. Canada is likely to stand pat with a small bias to cut rates as weak U.S. demand coupled with a stronger Canadian dollar increase the drag on GDP from deteriorating trade conditions. Japan, too, is expected to remain sidelined, as GDP growth continues to be tenuous and erratic. Our models indicate that the BoE and ECB still have plenty of fi repower at their disposal, and monetary policy will be infl uenced by declining infl ation and slower growth. We expect three rate cuts in both regions in the year ahead.

Fueled by a fl air-up in concern • over the health of the fi nancial system, massive risk aversion and downward revisions to

global growth, bond yields have plunged in near straight-line fashion over the past quarter. Valuations remain at extreme levels, lying below their equilibrium bands in all major regions. In the U.S., the drop in yields is the second largest on record of any easing cycle since the early 1950s and implies a much deeper and prolonged slowdown than is likely to emerge. As the credit crunch begins to abate, risk premiums normalize and the economy responds to lower rates, bond yields should move to levels consistent with moderate growth, leaving them vulnerable to signifi cant upside pressure. Our forecast for 10-year U.S. bond yields is 4.5% by this time next year. We look for U.K. yields to reach a similar 4.5%, while yields in Canada and the Eurozone should sit 25 basis points below their U.S. counterparts at 4.25%. We expect Japanese yields to reach the upper band of their nine-year trading range of 1.75%.

With the exception of Canada, • the fi nancial crisis has pushed global equity markets toward or even through the bottom of their fair-value bands – a level that is inconsistent with our base-case forecast for a return to moderate growth and contained infl ation. The ultimate resolution of the credit crisis will open scope for signifi cant returns in stock markets, and we expect valuations to eventually return to the midpoint of our fair-value bands. Remaining sidelined could be costly, as an analysis


of our equilibrium models through similar economic and valuation environments reveals a pronounced tendency for positive 12-month returns. In the few periods where losses appeared, they tended to be comparatively small.

Since the fall of 2002, and right • through the credit crisis, we have held our allocation to stocks above the neutral point of the allowable range. Our decision has refl ected the superior return profi le that emanates from the passing of a crisis, especially at a time of deeply discounted valuations. While the crisis is more severe than originally anticipated, the problems aren’t insurmountable and a “new news,” “not-priced-in” catalyst to cut our equity position at this stage of the cycle is not apparent. Our research shows that when markets turn, the move is swift and decisive, handsomely rewarding those who are invested. We remain comfortable with our overweight position in equities and have held our asset allocation steady at 60% stocks (allowable range 40%-70%), 32.5% bonds (allowable range 30%-60%) and 7.5% cash. When the market internals improve and signs that the crisis has passed become more conclusive, we stand ready to deploy a portion of the cash position into stocks.

IT’S BAD, BUT HOW BAD IS IT?

Capital markets have come through a very unusual year, and the experience in stocks and bonds has


708090

100110120130140

-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18Months Prior to & Following Fed Fund Rate Cut

Index

Leve

l as a

% of

Leve

l at D

ate of

First

Rate

Cut

1954 1957 1960 1970 19741980 1981 1989 2001 Current Cycle

Source: RBC AM

EXHIBIT 2. S&P 500 and the Fed Funds Rate

Recession Cycles, Following First Rate Cut

been nothing short of extraordinary. Since the Fed fi rst cut interest rates on September 18, 2007, markets have endured the second-worst period ever for stock-market returns of any easing cycle reaching back to the early 1950s. At the same time, extreme risk aversion and concern that the issues facing the economy and fi nancial system are insurmountable have delivered the best period for bonds in 10 cycles.

Exhibits 1 and 2 feature our roadmaps for 10-year Treasury bond

yields and the S&P 500 through periods surrounding an initial cut in the fed funds rate across nine periods of recession reaching back over half a century. In these, we have indexed the T-bond yield and stock-market index to 100 at the date of an initial rate cut (middle of the road map) and tracked month-end levels for these series relative to that mark through the 12 months preceding and following the initial rate action. While each cycle has been driven by different catalysts and faced different economic and

708090

100110120130140

-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18Months Prior to & Following Fed Fund Rate Cut

Bond

Yiel

d as a

% of

Leve

l at D

ate of

First

Rate

Cut

1954 1957 1960 1970 19741980 1981 1989 2001 Current Cycle

Source: RBC AM

EXHIBIT 1. U.S. 10-Year Bond Yield and the Fed Funds Rate

Recession Cycles, Following First Rate Cut


policy encumbrances, a lot of insight can be drawn from overlaying the current cycle (boldface line on the charts) overtop past periods of recession. What strikes us in the current cycle is that, in the year following the September 2007 cut in the fed funds rate, bond yields have tumbled almost as much as they did in the 1980-81 recession and more than in any other prior recession. At the same time stocks have been pummeled to the point where they’ve closely tracked returns in the 1981-82 bear market and are just shy of matching losses through the Tech Wreck in 2000-01.

By no means do we intend to understate the severity of the current credit crisis, or suggest that the problems jamming the fi nancial system don’t have the potential to take a serious bite out of the economy. Three to four quarters of tepid growth and a borderline “slow-motion recession” have left the economy stuck in suspended animation and going no where fast. What got us here is part of history – painful as it may have been. But what’s needed to keep us here or push markets lower will be a continued downward spiral in house prices, soaring mortgage delinquencies, even-tighter lending standards, large scale fi nancial failures and a global recession that virtually cripples U.S. exports. Said differently, one needs to essentially lose faith in monetary policy and give up on central banks’ coordinated ability to restore balance and ultimately sow the seeds for the resolution of the credit crisis.


-60

-40

-20

0

20

40

60

80

100

Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08

Basis

Poin

ts

Source: RBC AM

EXHIBIT 3. 3-Month LIBOR Spread

3-Month LIBOR Minus the Fed Funds Rate

-1.00.01.02.03.04.05.06.07.0

2004 2005 2006 2007 2008 2009 2010

%

Spread: LIBOR-OIS 3-month $US LIBOR 3-month Overnight Index Swap

Source: RBC AM, Haver Analytics

EXHIBIT 4. LIBOR-Overnight Index Swap Rates

CHALLENGES REMAIN IN CREDIT MARKETS…

The resolution of any crisis is not without its twists and turns. Where only a quarter ago there were tentative signs that risk aversion was subsiding, renewed concerns surrounding the health of the fi nancial system and the state of the global economy have caused a course correction in some of the metrics we’ve been monitoring. Exhibit 3 shows the 3-month LIBOR-fed funds spread,

which had been improving until recently but has since blown out to retest previous levels. The LIBOR-OIS spread in Exhibit 4 is perhaps a more useful measure of lending confi dence as it eliminates the term premium embedded in the LIBOR-fed funds spread and isolates the perceived credit risk and liquidity needs within the interbank lending market. Under normal lending conditions, LIBOR tends to be fractionally higher than the OIS rate, refl ecting a very small interbank risk premium and a


healthy level of liquidity. In periods of fi nancial duress, the perceived risk of interbank default increases and banks become reluctant to lend at the same time as they hoard capital to meet their own funding needs, causing spreads to gap. At 80 basis points, the current LIBOR-OIS spread is a far cry from its historical average of 23 basis points, indicating considerable strain in the interbank lending market.

The credit default swap (CDX) market shown in Exhibit 5 is a little more encouraging. CDXs are contracts for insurance on bonds where, in exchange for a fi xed premium, investors can buy protection against default. In a sense, it is like buying a put option on a corporate bond that can be exercised in case of a credit event. While CDXs have been on the rise over the past quarter, spreads are well below their March 2008 peaks and have recently begun to show signs of moderating. Nonetheless, spreads are more than double pre-crisis levels.

…AND HOUSING

Housing remains mired in deep recession. As Exhibit 6 indicates, new and existing home sales are down 63% and 31% from their peaks in July and September 2008. While existing home sales have leveled off in recent months, prices continue to fall in some areas and estimates suggest a further 14% drop in prices will be necessary to restore equilibrium with incomes. Thus far, depending on the choice of index, home prices are down anywhere between 6.3% (new home sales) to 15.9% (Case-Schiller). Whatever


-20-15-10-505

101520

2000 2002 2004 2006 2008 2010

% Ch

ange

in M

edian

Pric

e

Existing Homes New Homes S&P/Case-Shiller 20-City Price Index

Source: National Association of Realtors, Existing Home Sales

EXHIBIT 7. U.S. Housing

Median Sales Price

4000

4500

5000

5500

6000

6500

7000

7500

2000 2002 2004 2006 2008 2010

Units

(Tho

usan

ds)

400

600

800

1000

1200

1400

1600

Existing Homes (LHS) New Homes (RHS)

Source: National Association of Realtors


New and Existing Home Sales

0

50

100

150

200

250

Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08

Source: Bloomberg

EXHIBIT 5. CDX North America Investment Grade Index


the number, the hit to households and consumer wealth is signifi cant. Compounding the problem, the number of months supply of unsold inventories continues to climb, now at 10.1 months for new homes and 11.2 months for existing homes. With many prospective sellers patiently waiting on the sidelines until prices stabilize, housing supply data is likely to get worse before it gets better.

Still, the worst of the price decline may now be behind us. As seen in Exhibit 7, prices on all three indices, while at their lows, appear to have slowed their descent. At the same time, Exhibit 8 suggests that the necessary preconditions for recovery are already dropping into place. Plunging prices and falling mortgage rates (however small) have dramatically improved affordability. Before the recent setback in the affordability index as a result of tight credit conditions and diffi culty obtaining fi nancing, affordability had reached a point not seen in nearly 18 years. The steep adjustment in prices, resolution of the credit crisis and bailout of Fannie Mae and Freddie Mac will set up a recovery in affordability and U.S. housing. It will just take time.

…AND LENDING

The Fed’s Senior Loan Offi cer Survey (Exhibit 9) reveals tighter lending standards across every major category of loans, with the share of banks tightening at the highest level in the 18-year history of the series. Not surprisingly, the number of small businesses reporting that credit has become more diffi cult to obtain continues to creep higher.


-30

-10

10

30

50

70

90

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

QoQ

% Ch

ange

Mortgage Loans to Individuals Commercial & Industrial Loans

Source: Federal Reserve

EXHIBIT 9. Senior Loan Offi cer Survey on Bank Lending Practices

Loan Offi cers Reporting Tightening Standards

90

100

110

120

130

140

150

1990 1994 1998 2002 2006 2010

Index

Leve

l

Source: National Association of Realtors, Existing Home Sales

Average: 124

Last Plot: 119


Affordability Index

10

12

14

16

18

20

1998 2000 2002 2004 2006 2008 2010

%

Source: Mortgage Bankers Association, ISI

EXHIBIT 10. U.S. Subprime Loan Delinquencies

As % of Subprime Loans Outstanding


While the total amount of outstanding subprime mortgages as a percentage of the overall mortgage market has declined to around 7% from its high of nearly 23% back in June 2005, delinquencies and foreclosures continue to underscore the vulnerability in home lending. Subprime loan delinquencies as a percentage of subprime loans outstanding are growing exponentially and show no signs of abating (Exhibit 10). The accelerating trend of delinquencies for prime mortgages looks equally bleak (Exhibit 11). These numbers are staggering, and while we think that the situation will stabilize (i.e. those who were going to default have largely done so), it’s taking longer than we expected. According to Fannie Mae’s regular summary for the month of July, the mortgage lender’s book of business rose at its slowest pace in a year, suggesting that even the lender of last resort to the U.S. mortgage market is becoming a less reliable source of fi nancing. And lenders’ desire to bolster their own balance sheets and protect themselves from random hits has gummed up lending. The credit crunch is blunting the transmission mechanism of stimulative monetary policy and encouraging the persistence of negative feedback loops. Clearly, the problems in lending will take further time to mend.

…AND EMPLOYMENT

The string of consecutive employment losses has now extends to seven months, while the average workweek has declined from its peak of 33.9 in June 2007 to 33.6 hours in July. Put in the context of


200

250

300

350

400

450

500

550

1990 1995 2000 2005 2010

Source: Global Insight

Median: 351.0

Last Plot: 440

EXHIBIT 12. U.S. Initial Unemployment Claims Filed

Four-Week Moving Average

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1998 2000 2002 2004 2006 2008 2010

% Se

rious

ly De

linqu

ent

Conventional Prime Fixed Rate Prime Adjustable Rate Prime

Source: Mortgage Bankers Association, Haver Analytics

EXHIBIT 11. United States Seriously Delinquent Mortgages

Prime Mortgages in Foreclosure Plus 90-Day Delinquencies

past economic downturns, however, job losses are far milder than in the prior two recessions. Payrolls peaked at a record 138 million in December 2007 and have since fallen 463,000 so far this year. During the fi rst seven months of the previous two labour market downturns, the comparable job losses were 1.01 million (from March to September 2001) and 816,000 (from July 1990 to January 1991). While payrolls tend to be revised downward during recessions, it will take steep downward revisions

to bring the current cycle to the point of even remotely resembling past slumps. Nevertheless, the jump in initial claims is somewhat worrisome, with the four-week moving average now at 440,000 and approaching levels seen in the two previous recessions (Exhibit 12). We suspect that a good portion of the recent spike relates to the introduction of a federal program that extended unemployment insurance benefi ts to eligible individuals for an additional 13 weeks. Sizeable seasonal factors


in the auto sector due to summer shutdowns and retooling new car lines are also at play. If the recent claims numbers have, in fact, been exaggerated, evidence of an adjustment in future claims should appear within the next month.

FINANCIAL INTERMEDIARIES GO OPEN KIMONOHiding loan losses is a sure way to drive a fi nancial system into long-term ruin and delay an economic recovery. With the lessons learned from Japan’s fi nancial crisis of the 1990s still fresh, U.S. fi nancial institutions are well on their way to monetizing bad loans and avoiding similar pitfalls. A study by Deutsche Bank indicates that total writedowns of $376 billion have already been recorded, while a Bloomberg tally fi nds that $353 billion in new capital (94% of total losses) from sovereign wealth funds and other investors has been raised to fi ll the gap, with an additional $70 billion-80 billion of capital expected over the next 12 months (exhibits 13 and 14). Filling balance- sheet holes and recapitalizing fi nancial institutions is a precursor to restoring the monetary-policy transmission mechanism and narrowing the gap between broader lending rates and the stimulative fed funds rate. As we approach the $400 billion mark in writedowns, we near the IMF’s damage projection of $435 billion-$490 billion and the Street’s expectation of around $500 billion, suggesting that we could be more than 75% of the way through. While we expect continued writedowns into the remainder of 2008 and the fi rst half of 2009, they will likely come at a decreasing rate as we approach the fi nish.


EXHIBIT 13. Global Credit Writedowns

Current as of August 14, 2008, $US billions

EXHIBIT 14. Global Capital Raised

Current as of August 14, 2008, $US billions

So far this year we’ve witnessed nine U.S. regional-bank failures, and there are likely to be more as the credit crisis unfolds. While bank failures can reduce confi dence in the fi nancial system, the nine failures so far this year are not particularly alarming by historical standards. Between 1994 and 2008, there were anywhere from zero to 14 bank failures per year. Reaching back to the period from 1984-1992, failures climbed well into the triple digits as indicated in Exhibit 15. We continue to monitor the health of the regional banking sector but at this stage, failures are not far above their recent average.

BEWARE NEGATIVE FEEDBACK LOOPS

We support, in principle, the 1999 changes to accounting rules that have greatly enhanced transparency and clarity of reporting. At the same time, we recognize that the rules are not without their shortcomings and have created a negative feedback loop that is contributing to the severity of the fi nancial crisis. Mark-to-market accounting requires that where market prices are available, they must serve as the basis for carrying values of all similar securities – regardless of whether the holder wishes to

TOTAL LOSSES

TOTAL SUBPRIME EX SIVS & CONDUITS

LEVERAGED LOAN

EXPOSURE

TOTAL UNITED STATES 254.7 200.0 109.7

TOTAL NON-U.S. 121.6 163.8 55.6

GLOBAL TOTAL 376.3 363.8 165.3

Source: Deutsche Bank

TOTAL CAPITAL RAISED

Q3 2008 CAPITAL RAISED

Q2 2008 CAPITAL RAISED

TOTAL AMERICAS 178.7 17.8 70.0

TOTAL EUROPE 153.6 9.6 94.3

TOTAL ASIA 20.9 3.8 13.7

GLOBAL TOTAL 353.2 31.2 178.0

Source: Bloomberg


transact. The result has been massive balance-sheet writedowns that refl ect marginal and distressed transactions rather than nonperformance or impairment. The unintended consequence of what seemed to be well-thought-out accounting principles now limits the ability of fi nancial institutions to initiate new loans and support old ones, essentially understating balance-sheet health when it’s needed the most. Later, when markets eventually thaw and prices are restored to refl ect the value of securities not traded in distress, holders will begin to recapture the writedowns and bolster their balance sheets with reversals of mark-to-market hits.

BUT SOME HOPE STILL, AS RATE CUTS AND FISCAL STIMULUS PROVIDE RELIEF…

The Federal Reserve has been swift and deliberate, reaching deep into its arsenal to inject liquidity into the market and minimize the credit-crunch spillover into the broader economy. Specialized funding vehicles ranging from TAFs to TSLFs to PDCFs, and most recently an innovative lending facility for the GSEs, have gone a long way to supporting a fragile fi nancial system. These tools are not long-term fi xes, but rather temporary bandage solutions to hold the markets together until such time as fi nancial balance-sheets can be recapitalized and the monetary policy transmission mechanism is unclogged.

The fi rst cut in the fed funds rate occurred a year ago, with a 50-basis-


40

45

50

55

60

65

1998 2000 2002 2004 2006 2008 2010

012345678

%

ISM Diffusion Index (LHS) Fed Funds Rate (Inverted, Adv 6 Months) (RHS)

Source: Institute for Supply Management

EXHIBIT 16. U.S. ISM Manufacturing Index and the Fed Funds Rate Fed Funds

Inverted and Advanced Six Months

0

100

200

300

400

500

600

1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: FDIC, Haver Analytics

EXHIBIT 15. U.S. Bank Failures

Annual Number of Failed/Assisted Institutions

40

45

50

55

60

65

1998 2000 2002 2004 2006 2008 2010

012345678

%

ISM Diffusion Index (LHS) Fed Funds Rate (Inverted, Adv 6 Months) (RHS)

Source: Institute for Supply Management

EXHIBIT 17. U.S. ISM Non-Manufacturing Index & the Fed Funds Rate

Fed Funds Inverted and Advanced Six Months


point adjustment. Since then, an additional 275 basis points of rate relief has been added. Exhibits 16 and 17 plot the fed funds rate (dotted line, inverted and advanced 6 months on the charts) overtop of the ISM Manufacturing and Non-Manufacturing diffusion indices (solid lines on charts). Both lines track each other very closely, suggesting that ISM indices track fed policy with an approximate six-month lag. The severity of the credit crisis has blunted the short-term effectiveness of monetary policy and increased the transmission lag for the time being. That said, the mere partial feed-through of monetary policy has supported the ISM indices thus far and has averted a fall to prior recession levels of 40.8. More recent rate cuts have yet to fi lter through, so the full impact of fed rate policy has not been felt. Recent releases of both ISM indices have shown encouraging signs of strength, and while they continue to fl irt with the 50 boom/bust line, these indices should conform to Fed policy as soon as signs of resolution to the credit crisis emerge. Similar to exhibits 16 and 17, Exhibit 18 tracks the fed funds rate (dotted line on the chart, inverted and advanced 18 months) overtop of non-farm employment growth. Non-farm employment tracks changes in the fed funds rate closely, but with a lag of about 1½ years. Exhibit 19 shows the contemporaneous relationship between changes in non-farm employment and consumption. For the nearly 70% of the GDP that comes from consumer spending, the initial impact of lower rates won’t likely reach maximum intensity until early 2009.


02468

10121416

1970 1976 1982 1988 1994 2000 2006 2012

%

-4-3-2-10123456

YoY

% Ch

ange

Fed Funds Rate (Inverted, Adv 18 Mos) Non-Farm Employment (RHS)

Source: ISI Portfolio Strategy

EXHIBIT 18. United States

Non-Farm Employment and the Fed Funds Rate

The U.S. Economic Stimulus Act funneled $152 billion in rebates to U.S. consumers at the end of the second quarter, averaging $1,000 per household. As seen in exhibits 20 and 21, fi scal relief gave a shot in the arm to real personal disposal income during the spring and summer but consumption remained weak, likely dulled by high energy costs and increased savings. In previous cycles, consumers have been cautious about spending tax rebates initially and have shown

a tendency to fi rst save and pay down credit-card and credit-line debts. If the relationship between fi scal relief and spending tracks that of past cycles, we would expect a jolt in consumption to occur later this year, with the spending thrust hitting in the third and, to a smaller extent, fourth quarter. In addition, the upcoming U.S. election has pushed aside all discussions of fi scal restraint and a second stimulus package is currently being considered.

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

1970 1975 1980 1985 1990 1995 2000 2005 2010

YoY

% Ch

ange

Non-Farm Employment Real Personal Consumption

Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Citigroup


Real Consumer Spending and Non-Farm Employment


…WHILE AUTOMATIC STABILIZERS KICK INTO HIGH GEARThe decline in the U.S. dollar now totals 25% from peak to trough (April 2002 to March 2008) and has dramatically improved U.S. competitiveness abroad, pushing the contribution from net exports up by 0.7% in 2007 and nearly fi lling the gap in GDP from housing (Exhibit 22). Recent international trade data has served to remind us of just how reliant U.S. growth has become on an improving trade position. In the second quarter alone, exports rose 13.2% while imports fell 7.6%. In fact, net exports have accounted for a staggering 85% of real GDP growth in the last four quarters (Exhibit 23). The transmission of changes in the value of a country’s currency to net exports is a long-term phenomenon. A country’s trade balance exhibits a J-curve-type profi le, initially deteriorating in line with a weakening currency due to fi xed contracts that lock in prices and volumes. As contracts are renegotiated and as the level of exports and imports adjust to refl ect the adjustment of currency spot rates, the trend turns swiftly and decisively. Only recently has a fi ve-year slide in the U.S. dollar begun to shine through to net exports. Barring a global recession, the trend is likely to continue.

…AS THE THREAT OF INFLATION WANES On balance, even as reported infl ation posts new highs, there are encouraging signs that one of several key threats to the economy is beginning to subside. The retreat


-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1980 1985 1990 1995 2000 2005 2010

QoQ

% Ch

ange

Source: BEA


Real Personal Consumption Expenditure

-700

-600

-500

-400

-300

-200

-100

0

100

1980 1985 1990 1995 2000 2005 2010

Trillio

ns $

Source: Bureau of Economic Analysis, Haver Analytics


Volume of Real Net Exports

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1970 1975 1980 1985 1990 1995 2000 2005 2010

YoY

% Ch

ange

Source: BEA


Real Personal Disposable Income


in oil prices has begun to steady the dollar, perhaps signaling a broader lift in investor confi dence that will be needed to put the economy back on track in 2009. With commodity prices likely past their peak, headline infl ation rates are set to fall sharply by year-end. Nonetheless, as long as interest rates remain low, infl ation remains a threat. Core rates have been well behaved, but remain slightly above the 2% level considered to be the upper limit of the Fed’s “comfort zone.”

Employment costs remain contained as seen in Exhibit 24, having settled at a 3.0% annual change, up slightly from the lows set in 2006 but well below the trend set earlier this decade. The precarious state of the U.S. economy will make the case for higher wages diffi cult, helping to cap infl ation expectations. The current expectations for infl ation embedded in the pricing of CPI infl ation-indexed bonds remain moderate and lie well below their long-term averages as seen in exhibits 25 and 26, confi rming the success of monetary policy, faith in central bankers, and the belief that the “fi x” for the economy will not result in a permanent spike in prices or wage spiral.

…AND SHORT RATES OFFER RELIEF IN NORTH AMERICACentral banks have gained considerable room to maneuver. Recent remarks from Fed speakers, including those who have been notably hawkish in the past, suggest that growth concerns are beginning to trump infl ation concerns. Dallas Fed President Fisher described the economy as facing a “sustained


2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

1985 1990 1995 2000 2005 2010

YoY %

Cha

nge

Source: Bureau of Labor Statistics

EXHIBIT 24. Employment Cost Index

Total Civilian Compensation

-2.0-1.00.01.02.03.04.05.06.07.08.0

2000 2002 2004 2006 2008 2010

Real

GDP

QoQ

% C

hang

e

Net Exports Domestic Demand Real GDP

Source: BEA, Credit Suisse


GDP Growth, Domestic Demand & Net Export Contributions

0.0

1.0

2.0

3.0

4.0

5.0

2002 2004 2006 2008 2010

%

U.S. 5-yr TIPS Spread Trailing 5-yr Avg U.S. CPI

US: 1.93%

3.10%

Source: Bloomberg, RBC Capital Markets, RBC AM

EXHIBIT 25. Implied Short-Term Infl ation Premium

Breakeven Infl ation Rate: Nominal vs. 5-year Real Return Bond



period of anemia” and that the second half of this year will [likely] broach zero growth.” Richmond Fed President Lacker recently spoke of a chance of recession in coming quarters, and noted that he has been “encouraged” by the recent decline in energy prices. Minneapolis Fed President Stern highlighted similar risks, expecting “only modest expansion in the economy, the likelihood of further increases in unemployment for a time, and a diminution of infl ation, absent a resurgence in energy and other commodity prices.”

STIMULATIVE INTEREST RATES TO REMAINOur valuation models (exhibits 27-31) indicate that policy rates lie below their equilibrium bands in the U.S., Canada and Japan. At the bands’ midpoints, the trendsetting interest rate is fi xed to provide the normal real (after infl ation) cost of funding at the 90-day maturity, plus an offset for expected infl ation. Pushing short-term rates below the lower boundary indicates an aggressive easing of interest rate policy as the real cost of funding has been driven to extraordinary low levels. While the current degree of stimulus in the current cycle falls short of that delivered through the recessions of 1990-91 and 2001, it is substantial. Across all 15 cycles of rate cuts reaching back over the past 50 years, the median change in the fed funds rate is 125 basis points. Not surprisingly, cuts during periods of recession (eight of the 15 cycles) were much larger at a median of 275 basis points. Since the Fed began slashing last September, the fed funds rate has plunged

0

4

8

12

16

20

24

1980 1985 1990 1995 2000 2005 2010

%

Last Plot: 2.00% Current Range: 3.12% - 5.31% (Mid: 4.21%)

Source: Federal Reserve, RBC AM

EXHIBIT 27. U.S. Fed Funds

Equilibrium Range

0.0

1.0

2.0

3.0

4.0

5.0

2000 2002 2004 2006 2008 2010

%

Canada U.S. Trailing 5-yr Avg U.S. CPI

Canada: 2.47%

U.S.: 2.19%

3.10%

Source: Bloomberg, RBC Capital Markets, RBC AM

EXHIBIT 26. Implied Long-Term Infl ation Premium

Breakeven Infl ation Rate: Nominal vs. 10-year Real Return Bond

0

5

10

15

20

25

1980 1985 1990 1995 2000 2005 2010

%


Source: RBC AM

EXHIBIT 28. Canada Overnight Rate

Equilibrium Range



325 basis points – greater than the norm for periods of recession.

Our view on the likely course for Fed policy hasn’t changed since early this year. We continue to believe that the fed funds rate has bottomed at 2%, and that as rate cuts percolate and breathe new life into the economy in the second half of 2009, the Fed will begin to remove the punch bowl and take the policy rate back to 2.5%. That view is not inconsistent with market expectations as seen in Exhibit 32, where fed funds futures ceased to price in rate cuts back in April of this year and are currently pricing in just over two hikes by mid 2009. The outlook for Canada is quite different, where the economy has seemingly stalled. First-quarter GDP fell 0.8%, and in the second quarter, the economy eked out a mere 0.3% gain as net exports and business capital investment clipped 2.8 percentage points and 0.45 percentage point off of GDP in the most recent quarter. Personal consumption has begun to moderate as well, and the slump in July employment, moderating housing activity and a weak outlook for U.S. growth in the second half of the year will keep the Bank of Canada on the defensive and ready to cut rates if needed. For now, our forecast one year out is for rates to remain unghanged at 3%.

Offshore, the slowdown is only now beginning to bite and central-bank hawks have plenty of room to retract their talons as indicated by our models. The slew of hawkish sound bites emanating from ECB members may soon begin to fade along-side oil and commodity prices, leading to a focused attack on its slowing

0

4

8

12

16

20

1980 1985 1990 1995 2000 2005 2010

%


Source: Bloomberg, Consensus Economics, RBC AM

EXHIBIT 29. Eurozone Repo Rate

Equilibrium Range

2468

1012141618

1980 1985 1990 1995 2000 2005 2010

%


Source: RBC AM

EXHIBIT 30. United Kingdom Base Rate

Equilibrium Range

-2

0

2

4

6

8

10

12

14

1980 1985 1990 1995 2000 2005 2010

%



EXHIBIT 31. Japan Overnight Call Rate

Equilibrium Range



economy. Infl ation has backed off to 3.8% from 4.1%, consumer confi dence is in rapid decline and GDP growth fell 0.2% in the second quarter. If the historical relationship holds between Eurozone confi dence and GDP growth as displayed in Exhibit 33, the region may be pushed to the brink of recession with no rate hikes thus far to cushion the blow. We expect three rate cuts over the course of the 12-month forecast period.

Similar conditions hold in the U.K., where a variety of housing and consumer data suggest that the economy may be heading for a harder landing than the U.S. or Europe (Exhibit 34). Already the Bank of England has cut the base rate once and will likely do so three more times to 4.25% within the next 12 months. In Japan, rates are likely to be steady as the economy moves sideways in its typical pattern of quarterly fi ts and starts.

MORE UPSIDE PRESSURE ON BOND YIELDS AHEADFurther out the yield curve, extreme risk aversion, declining food and energy prices and the prospect of slower growth has sent government bonds prices surging and yields plunging. Our equilibrium models for the largest global bond markets (exhibits 35-39) indicate that bond yields are at or below the lower boundaries of their fair-value ranges in each region. As with our other equilibrium models for short-term interest rates, the midpoint of each band indicates the level of yields that provides the “normal” real rate of interest at that maturity plus an offset for expected infl ation.

-38-127 -106 -76 -98

-31

75127 128 94 61

-400

-200

0

200

400

600

Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

bps

Fed Funds Rate Sep 2009 Fed Funds Futures Contract

Source: Board of Governors, RBC AM

EXHIBIT 32. Fed Funds Rate and Implied Expectations

12-Month Futures Contract

85

90

95

100

105

110

115

2000 2002 2004 2006 2008 2010

Index

Leve

l

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

YoY % Change

Economic Sentiment Indicator (LHS) Real GDP (RHS)

Source: European Commission

EXHIBIT 33. Eurozone

Consumer Confi dence and Real Gross Domestic Product

-10

-5

0

5

10

15

20

2004 2005 2006 2007 2008 2009 2010

YoY

% Ch

ange

0123456789

YoY % Change

Rightmove Housing Index (LHS) Retail Sales (RHS)

Source: O.N.S., Haver Analytics

EXHIBIT 34. United Kingdom

Housing Market and Retail Sales



Below that level, valuations provide a progressively smaller cushion against change in the outlook as the infl ation premium, real rate or both of these critical factors are situated below their longer-term norms.

As can been seen in our models, 10-year yields typically plunge toward the bottom of the bands during periods of economic or capital-market uncertainty. The 1990-1991 recession and the Asian Crisis of 1998 are two cases in point. As the crises were ultimately resolved, yields were drawn toward the band’s midpoint, or even above, as risk premiums normalized and investment capital left the safety of government bonds in search of higher returns elsewhere. Current yields on 10-year bonds suggest that the pendulum of doom and gloom has swung to an extreme. Unless the economy is in much worse shape than we think, and unless severe recession appears, yields remain vulnerable to a signifi cant correction – especially as the credit crunch clears. The speed at which markets adjust to equilibrium will be paced by the degree to which calm is restored, the economy improves and the outlook for intermediate and longer-term infl ation is clarifi ed. We look for 10-year U.S. bond yields to reach 4.5% by the end of the forecast period and 10-year Canada bonds to hit 4.25%, maintaining their yield spread advantage over their U.S. counterparts. The risk for bond yields is skewed toward even higher yields should energy prices continue their descent and put further downward pressure on infl ation while breathing life into consumer spending and broader domestic demand.

2

4

6

8

10

12

14

16

1980 1985 1990 1995 2000 2005 2010

%


Source: Bloomberg, Bureau of Labour Statistics, RBC AM

EXHIBIT 35. U.S. 10-Year T-Bond Yield

Equilibrium Range

2

4

6

8

10

12

14

16

18

1980 1985 1990 1995 2000 2005 2010

%


Source: Bloomberg, RBC AM

EXHIBIT 36. Canada 10-Year Bond Yield

Equilibrium Range

2468

1012141618

1980 1985 1990 1995 2000 2005 2010

%



EXHIBIT 37. Eurozone 10-Year Bond Yield

Equilibrium Range


Struggles offshore appear more severe than they are at home. Growth is deteriorating at a rapid pace in the Eurozone where quarterly GDP fell 0.2%, while growth in the U.K. was fl at. With oil prices abating and headline infl ation expected to follow suit, rate cuts are in the offi ng and there is scope for fi rmer bond prices in the short to medium-term. In the Eurozone, we expect 10-year yields to reach 4.25% and a move to 4.5% for 10-year gilts. Japan remains the most diffi cult region to forecast given its near random swings in growth. We expect JGB yields to move toward the top of their nine year trading range and hit 1.75% within 12 months.

Several of our technical models suggest a strong possibility that yields may have already passed their troughs, or are nearing that point. Exhibit 40 traces the sentiment of fi xed-income traders, which has traditionally served as a good contrarian indicator. When the sentiment survey is at extreme levels in either direction, as it is now, respondents have likely already positioned their portfolios to refl ect their views, diminishing the amount of capital available to support and sustain current yields. The last plot rose almost vertically to hit the 70% bulls line – a level that typically confi rms the formation of a dangerously positive consensus. Similarly, Exhibit 41 plots the year-over-year rate of change in 10-year T-bond yields. This simple momentum indicator signals a turn for yields when the trend pushes past the +20 oversold or -20 undersold mark and then hooks back through. The most recent “sell


0

2

4

6

8

10

12

14

1980 1985 1990 1995 2000 2005 2010

%



EXHIBIT 39. Japan 10-Year Bond Yield

Equilibrium Range

24

68

10

1214

1618

1980 1985 1990 1995 2000 2005 2010

%


Source: RBC AM

EXHIBIT 38. United Kingdom 10-Year Gilt

Equilibrium Range

0

20

40

60

80

100

1996 1998 2000 2002 2004 2006 2008 2010

% Bu

llish

Source: Market Vane/ RBC AM

Too Many Bulls

Last plot:70% Bulls

Too Many Bears

EXHIBIT 40. U.S 10-Year T-Bond Bullish Consensus


signal” was triggered at the end of June when yields were at 3.97%.

For valuations to remain at current levels, the financial crisis would need to intensify, causing a near crippling of the economy. Several time-tested technical models suggest that the lows have been set for the current cycle and that fixed-income markets are living on borrowed time.

STOCKS SHOW SOLID VALUE AND POTENTIAL

High energy prices, job losses, a severe housing recession and an extended credit crisis have pushed consumer confi dence near record lows. And while the recent correction in energy and commodities has lent some support, solid GDP growth remains unlikely as long as the credit and job outlook remain bleak and confi dence remains fragile. History shows that a bottoming in confi dence often coincides with the beginning of a new bull market in stocks, presenting less emotional investors with a signifi cant buying opportunity. Exhibit 42 shows that the Conference Board Measure of consumer confi dence has reached levels last seen in October 1974, April 1980 and February 1992. Each of these periods marked the onset of a sustained market rally, extending eight months to 6.5 years and returning between 43%-172%. Not being invested at this level of consumer confi dence could be costly.

Exhibits 43 through 47 plot our equilibrium models for the largest global equity markets. The midpoint of each channel refl ects our estimate


-60

-40

-20

0

20

40

60

1980 1985 1990 1995 2000 2005 2010

YoY

% Ch

ange

Source: RBC AM

Oversold

OverboughtLast Plot: -15.8%

Current Rate: 3.81%Sell bonds as yield moves above 3.62%

EXHIBIT 41. U.S. 10-Year T-Bond Yields

Rate of Change

0

20

40

60

80

100

120

140

160

1980 1985 1990 1995 2000 2005 2010

Source: BCA Research, Conference Board

of fair value, the product of the normalized earnings power and valuation range for these markets, with normalized levels for these statistics calculated as a function of their relationship with interest rates, infl ation and sustainable

profi tability through the past 20–50 years. Over the course of the bear market, stocks in every major market except for Canada have sunk to, or beneath, the lower boundary of their equilibrium channel.

100138190262361498687947

13061800

EXHIBIT 42. S&P 500 & Consumer Confi dence


Exhibit 48 helps put current global equity market valuations in perspective. The bars represent the combined distance that each of the largest nine stock markets trade above or below their respective fair values, with the contribution from each country GDP-weighted. At the horizontal line bisecting the chart, the world’s stock market, weighted by GDP, rests at fair value. Right now, equity markets lie almost as far below global fair value as at the trough of the last severe bear market in the fall of 2002, and aren’t that far above the most depressed valuations of the past three decades. The crisis environment of the past year shows few signs of clearing, so the way ahead is unusually murky. Nevertheless, valuations based on normalized profi ts and p/e ratios refl ect a level of pessimism that hasn’t been seen since the great bull market began in the early 1980’s. At a minimum, as confi dence is ultimately restored, stocks should return to fair value. Exhibit 48 shows world equity markets would return almost 25% in a climb back to that level.

CANADA OUT OF STEP

Canada’s major market index continues to stand out for its position far above fair value. It’s no secret that the TSX has delivered among the world’s best returns as its heavily weighted natural resource sectors powered ahead. Although down from a peak of 53%, energy and materials still make up 49% of the TSX against only 17% for the S&P 500. Canada’s fi nancial services make up a further 27% of the index, and with the bank sector down, only 18% from its peak


4063

100158251398631

100015852512

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010


Aug '08 Range: 1250 - 2003 (Mid: 1627)Aug '09 Range: 1362 - 2183 (Mid: 1773)Current (29-Aug-08): 1283

EXHIBIT 43. S&P 500 Equilibrium

Normalized Earnings & Valuations

398600903

13592047308246426989

1052415849

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010



EXHIBIT 44. S&P/TSX Composite Equilibrium


135201297441654970

143821323162

1980 1985 1990 1995 2000 2005 2010

Source: Datastream, Consensus Economics, RBC AM


EXHIBIT 45. Eurozone Datastream Index




compared to declines of 78% in the U.S., investors in Canadian equities have fared much better than most.

We can’t, however, ignore the risks that come with comparatively high valuations, and in recent weeks the TSX has come under signifi cant pressure as energy and other commodity stocks have given ground. For most, diversifi cation makes a lot of sense, and perhaps seldom more sense than in the current environment. A scenario where the TSX continues to dominate other markets isn’t inconceivable: global economic recovery should put a fl oor under commodity prices and stabilize energy prices at levels above those now refl ected in earnings and cash-fl ow projections. Nevertheless, the gap in valuations has grown so large that we continue to recommend close attention to diversifying positions globally. An alternative scenario where the economy remains weak and energy and commodity prices fall further would weigh especially heavily on the TSX. And in that scenario, Canadian dollar-based investors would likely earn additional relative rewards from international investing as less attractive terms of trade propel the still-expensive currency in the direction of fair value. To us, the U.S. stock market, with its depth, diversity of names and much more attractive valuations offers a natural hedge.

DEPRESSED STOCKS/LOW INFLATION ARE WINNING CONDITIONS

We have featured Exhibit 49 in several recent editions of the

204319500782

12241915299746897338

11482

1980 1985 1990 1995 2000 2005 2010

Source: Bloomberg, Datastream, Consensus Economics, RBC AM


EXHIBIT 46. United Kingdom Datastream Index


507097

136189264368514717

1000

1980 1985 1990 1995 2000 2005 2010



EXHIBIT 47. Japan Datastream Index


-60

-40

-20

0

20

40

60

80

1980 1985 1990 1995 2000 2005 2010

% Ab

ove/B

elow

Fair V

alue

Source: Datastream, Bloomberg, RBC AM

Last Plot: -23.9%

EXHIBIT 48. Global Stock Market Composite

Equity Market Indices Relative to Equilibrium



positive returns (85.4% of months vs. a norm of 73%) and the smallest worst-case 12-month returns over all scenarios (-13.8% vs. -41.4% for all 12-month periods since 1960).

Exhibit 50 lists all nine periods since 1960 where the S&P 500 fell below fair value while infl ation remained below its long-term

current position beneath fair value with infl ation below 4.2% (at least core infl ation) has happened in only 31.5% of months since 1960. These have generally proven to be good times to buy stocks, providing above-average returns over the year following (16.3% per annum vs. a norm of 8.2%, all returns net of dividends), a higher incidence of

Global Investment Outlook as we hoped to establish forward-looking return implications for such deeply depressed markets. Our comments have focused on the tendency for the S&P 500 to hold above fair value (i.e.: above the band’s midpoint) whenever infl ation falls below its long-term average of 4.2%. The market’s

EXHIBIT 49. S&P 500

Returns for Positions Established at Various Valuation Levels

ALL PERIODS IF POSITIVE RETURNS IF NEGATIVE RETURNS 12-MONTH RETURN

S&P 500 FREQ. AVG. 1 YR. FREQ. AVG. 1 YR. FREQ. AVG. 1 YR. BEST WORST

ALL MONTHS SINCE 1960 (N=568) 8.2% 73.0% 15.7% 27.0% -11.7% 53.4% -41.4%

MONTHS WHEN S&P ABOVE FAIR VALUE 42.0% 2.4% 58.2% 14.3% 41.8% -13.8% 49.1% -41.4%

MONTHS WHEN S&P BELOW FAIR VALUE 58.0% 12.4% 83.8% 16.4% 16.2% -7.6% 53.4% -29.7%

S&P ABOVE FAIR VALUE &

Infl ation is At or Below 4.2% 32.5% 5.5% 67.9% 14.8% 32.1% -13.4% 49.1% -27.5%

Inflation is Above 4.2% 9.5% -8.2% 25.9% 9.6% 74.1% -14.4% 33.2% -41.4%

S&P BELOW FAIR VALUE &

Inflation is At or Below 4.2% 31.5% 13.0% 85.4% 16.3% 14.6% -5.4% 39.1% -13.8%

Inflation is Above 4.2% 26.5% 11.8% 82.0% 16.5% 18.0% -10.0% 53.4% -29.7%Source: RBC AM

EXHIBIT 50. S&P 500

Returns from 1st Month Index Falls Below Fair Value & Infl ation Below Long-Term Average

Source: RBC AM

PERIODBEGINS

PERIODENDS

ECONOMICBACKDROP

3-MONTH RETURN FROM

BEGINNING

6-MONTH RETURN FROM

BEGINNING

9-MONTH RETURNFROM

BEGINNING

1-YEAR RETURN FROM

BEGINNING

3-YEAR COMPOUND

RETURN FROM BEGINNING

5-YEAR COMPOUND

RETURN FROM BEGINNING

DURATION (MONTHS)

JAN-60 DEC-60 RECESSION -2.2% -0.2% -4.0% 11.1% 6.0% 9.5% 12

MAY-62 FEB-63 -0.9% 4.4% 7.8% 18.7% 14.0% 6.1% 9

SEP-71 OCT-72 3.8% 9.0% 8.9% 12.4% -13.5% 1.4% 14

DEC-82 JAN-84 8.8% 19.5% 18.1% 17.3% 14.5% 11.9% 14

NOV-84 MAY-87 10.8% 15.9% 15.3% 23.6% 12.1% 15.1% 31

JAN-88 SEP-88 1.7% 5.8% 8.5% 15.7% 10.2% 11.3% 9

AUG-91 MAR-95 -5.0% 4.5% 5.1% 4.8% 6.4% 10.5% 44

JUN-02 SEP-03 RECESSION -17.6% -11.1% -14.3% -1.5% 20.4% 8.7% 16

JUL-04 MAY-08 2.6% 7.2% 5.0% 12.0% 9.7% 47

AVERAGE 0.2% 6.1% 5.6% 12.7% 8.9% 9.3% 22

MEDIAN 1.7% 5.8% 7.8% 12.4% 10.2% 10.0% 14

All returns not including dividendsData based on daily close pricesHigh inflationary environment defined as inflation exceeding 4.2% (long term average inflation since 1960)

Source: RBC AM



Half of 10 GICS sectors show positive year-over-year comparisons ranging from +1.4% for utilities to + 21.9% for information technology and 7 of the 10 are reporting profi ts above the September 2007 peak for the pool. The earnings pool is sluggish, but the decline is mostly contributed by a $34.14 fall in the contribution from fi nancial services. Elsewhere, we continue to be impressed by the durability of profi ts through a challenging economic environment.

average. Two of the nine periods occurred during recession, and it may be that recession appears in the current cycle. Depressed markets in the early 1990’s are a function of the fi rst Gulf War and mild recession of that period. Crisis also takes a toll. May 1962 – February 1963 contained two of these (the Cuban Missile Crisis and Kennedy’s freeze of U.S. Steel price increases). Sometimes, it’s simply the gradual process of adaptive expectations by which investors change their behavior. Unusually depressed stock prices through much of the 1980’s refl ect investors’ reluctance to embrace low infl ation and its impact on equity market valuations following the troubles of the 1970’s.

Whatever the reason, the data confi rms that periods of depressed valuations and low infl ation are generally good times to buy stocks. Even though these conditions persisted for periods ranging to 4 years, buying stocks at the end of the fi rst month that the twin constraints were satisfi ed produced positive 3-month returns in 5 of 9 cycles, 7 of 9 cycles produced positive 6- and 9-month returns and 8 of 9 were positive within a year. These were also periods of solid gains, averaging 12.7% over the fi rst year against a long-term average of 8.2% (both not including dividends). As we view the recent spike in infl ation to be transitory and primarily the result of sharp increases in energy prices which have now reversed, these winning conditions are very much apparent. Risks are evident, but so is the potential for superior returns.

PRESSURE ON THE INDICES FROM THE PROFIT CYCLE…

Although our equilibrium models are based in normalized earnings, we can’t entirely ignore the profi t cycle. As the crisis blew large holes in balance sheets and dampened growth in general, profi ts have slipped. In the U.S., for example, S&P 500 earnings dropped to $186.87 at July 31, 2008 from a peak of $209.88 in September of 2007. Still, the damage is confi ned to a small area.

0.6

0.8

1.0

1.2

1.4

1.6

1.8

1994 1996 1998 2000 2002 2004 2006 2008 2010-40-30-20-100102030405060

YoY % Change

Barra Growth Relative to Barra Value S&P 500 Earnings

GrowthOutperforms

Source: RBC CM

EXHIBIT 51. Relative Strength of Growth to Value

S&P Barra Growth to Barra Value

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

1994 1996 1998 2000 2002 2004 2006 2008 2010

Relat

ive S

treng

th

-40-30-20-1001020304050

YoY % Change

Russell Relative Strength (LHS) S&P 500 Earnings (RHS)

Source: RBC CM

EXHIBIT 52. Profi t Momentum vs. Style Leadership

Russell 1000 Growth Index Relative to Russell 1000 Value Index



We remain comfortable with our overweight position in equities and have held our asset allocation steady at 60% stocks (allowable range 40%-70%), 32.5% bonds (allowable range 30%-60%) and 7.5% cash. When the market internals improve and signs that the crisis has passed become more conclusive, we look to deploy a portion of the cash position into stocks.

ASSET MIX TILTED TOWARD EQUITIES, AWAY FROM BONDSSince the fall of 2002, and right through the credit crisis, we have held our allocation to stocks above our neutral point of the allowable range. Our decision has refl ected the superior return profi le that emanates from the passing of a crisis, especially at a time of deeply discounted valuations. While the crisis is more severe than originally anticipated, the problems aren’t insurmountable and a “new news,” “not-priced-in” catalyst to cut our equity position at this stage of the cycle is not apparent. Our research shows that when markets turn, the move is swift and decisive, handsomely rewarding those who are invested.

…AND ON VALUE IN PARTICULAR

The drop in earnings has clearly contributed to a rotation in investment style. Since June 2007, both the Barra Growth universe and Russell 1000 Growth Index have fared much better than the related Value composites. Exhibits 51 and 52 plot the relative performance of growth to value, and also the year-over-year change in S&P 500 earnings since the early 1990’s. The relationship isn’t very stable, but there appears to be a tendency for growth to dominate value during periods of weak or negative profi t gains. In the current cycle, growth’s ascendancy was well timed with the peak in S&P earnings. Recovery in value stocks likely awaits a firmer economy and rising earnings.


GLOBAL ECONOMIC OUTLOOKPATRICIA CROFT,

Chief Economist – Phillips, Hager & North Investment Management Ltd.

August 2008 marked the fi rst anniversary of the credit crisis, a milestone that elicited little in the way of celebration. One year ago, most investors expected the problems to remain confi ned to subprime mortgages in the U.S., that there would be a negligible impact on real economic activity, and that the fallout would affect mainly the U.S. What a difference a year makes. The impact of the credit crisis lingers (Exhibit 1), with total bank losses to date of around $500 billion. Credit has become considerably less available and more expensive to acquire. The crisis has proven to be global in nature, with large losses in Europe and the U.K., while Asia has emerged relatively unscathed on the credit front but not on the economic front. The credit crisis has had a signifi cant impact on real economic activity, as banks have tightened their lending standards while focusing on repairing battered balance sheets (Exhibit 2). This has rendered credit meaningfully less available for consumers in the U.S., U.K. and Europe, which are already challenged by higher prices for food and energy and deteriorating labour markets.

The pace of global growth has slowed markedly, with the U.S. the fi rst major economy to show signs of weakness in the fall of last year. Central bankers are struggling to come to grips with the combination of slower growth and soaring headline rates of infl ation (so-called stagfl ation), propelled by lofty prices for food and energy (Exhibit 3). Commodity prices have softened recently as economic data has surprised on the downside, and evidence of

0

2

4

6

8

10

12

14

1985 1990 1995 2000 2005 2010

Defau

lt rate

/ Yiel

d spre

ad

US HY Default Rate HY Spreads

Source: Moody's, Bloomberg

EXHIBIT 1. U.S. High-Yield Spreads vs. Default Rates

-40

-20

0

20

40

60

80

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Diffu

sion I

ndex

Mortgages* Credit card loansCommercial & Industrial Loans Commercial real estate loans

Source: Federal Reserve Senior Loan Officer Opinion Survey

Shaded areas indicate U.S. recessions

*2007 Q2 onward calculated by PH&N

EXHIBIT 2. U.S. Banks Tightening Lending Standards

Fed Senior Loan Offi cer Survey

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

1998 2000 2002 2004 2006 2008 2010

YoY

% C

hang

e

Source: IMF International Financial Statistics

EXHIBIT 3. World CPI Infl ation


GLOBAL ECONOMIC OUTLOOK • PATRICIA CROFT

near-recessionary conditions has mounted in the U.S., the U.K., Japan and Europe. This will alleviate some of the short-term concerns about infl ation in developed economies, but emerging-market nations face more durable infl ationary pressures.

Revised data released over the summer showed that the U.S. economy contracted at a 0.2% annual rate in the fourth quarter of 2007 and grew at an anemic 1% in the fi rst half of this year. Indeed, excluding exports, the economy would have contracted in the fi rst half of 2008. Real consumer spending slowed to about 1% in the fi rst six months of the year from a 2.8% pace in 2007, despite support from the federal government’s stimulus package. This support will prove to be fl eeting, however, as all indications are that consumer spending will contract in the third quarter – the fi rst quarterly decline since 1991. We anticipate that consumption will remain muted for some time as consumers cope with substantial headwinds to spending.

House prices are down 18% from their peak in 2006, leaving many homeowners with properties that are worth less than their mortgages. The Mortgage Bankers Association estimates that one in 11 mortgages was either delinquent or in foreclosure in the fi rst quarter of 2008, the highest since records began in 1979 (Exhibit 4). At the same time, the labour market has deteriorated, with 463,000 job losses so far this year and an increase in the unemployment rate to 5.7%, up a full percentage point from year-ago levels (Exhibit 5). Real personal disposable income growth is being eroded by headline infl ation,

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1975 1980 1985 1990 1995 2000 2005 2010

% of

Total

% of US residential mortgage loans entering foreclosure during the quarterStock of loans in foreclosure, % of total mortgage loans outstanding

Source: Mortgage Bankers' Association

EXHIBIT 4. U.S. Residential Foreclosures

-2000-1500-1000-500

0500

1000150020002500

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Thou

sand

s

Source: U.S. Bureau of Labor Statistics

EXHIBIT 5. Monthly U.S. Employment Gains

6-Month Rolling Sum

30

50

70

90

110

130

150

1980 1985 1990 1995 2000 2005 2010

Index

Source: Conference Board

EXHIBIT 6. United States Consumer Confi dence Index



which touched a 17-year high of 5.6% in July, even as core infl ation (which excludes food and energy) remained fairly well behaved at 2.5%. Not surprisingly, consumer confi dence has plunged (Exhibit 6).

The consumer is key to the outlook for the U.S., as personal consumption accounted for a near-record 72% of economic activity in 2007 (Exhibit 7). The housing market remains a critical risk to the outlook – signs of stability in house prices would cause us to become more optimistic on the outlook for the consumer and capital markets, but housing cycles tend to be multi-year in nature. Government efforts to support the market have had little impact so far with growing concern as to the stability of Fannie Mae and Freddie Mac, which together own or guarantee about $5.3 trillion of residential mortgages - or roughly half of total housing debt outstanding. The U.S. Federal Reserve has aggressively cut its overnight interest rate to 2% from 5.25%, yet longer-term mortgage rates have increased owing to credit concerns. Meanwhile, banks have considerably tightened their lending standards for all types of credit, diminishing the impact of Fed easing. The risk of a negative feedback loop has grown, whereby the slowing economy results in further caution on the part of lenders, producing further economic weakness.

In our view, an improvement in the U.S. economy is not likely to be evident until the fi rst half of 2009, as the lagged impact of the aggressive easing by the Fed begins to feed into the real economy, while credit concerns lessen and a potential second fi scal stimulus package helps to boost growth. The 38% drop in

60%

62%

64%

66%

68%

70%

72%

74%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: US Bureau of Economic Analysis

EXHIBIT 7. U.S. Real Consumer Spending

Share of Real GDP

-2-101234567

2000 2002 2004 2006 2008 2010

YoY

% C

hang

e

Real GDP Final Domestic Demand

Source: Statistics Canada

EXHIBIT 8. Canadian Real GDP and Final Domestic Demand Growth

the trade-weighted value of the U.S. dollar over the past six years is supporting strong gains in exports, but this is not suffi cient to bolster the overall economy. Above all, we are keeping an eye on housing. Prices may stabilize within the next six to 12 months, as plunging starts have reduced new supply and soft prices may entice buyers, but there is a considerable inventory overhang to work off in the interim.

The focus of monetary policy has shifted back to the economy in

the aftermath of the recent sharp drop in commodity prices. Crude oil is down 20% from its peak of $147 in July and prices for corn, wheat and rice have also sharply corrected. Headline infl ation will slow in the second half of this year, and we expect core infl ation to remain well contained, as the rise in the unemployment rate and still-strong productivity gains diminish concerns of higher wage demands.

Canada’s economy has only recently begun to show signs of fraying,



as strong commodity prices have lessened the blow of a slowing U.S. economy. Beneath the surface, however, a two-tiered economy has developed, with sizeable variations in the pace of regional economic activity. Net trade has been a signifi cant drag on overall GDP, as the soaring Canadian dollar curbs export growth. In the fi rst quarter of 2008, the Canadian economy contracted at a 0.3% annual rate, but fi nal domestic demand (which excludes exports) rose at a 0.6% annualized pace (Exhibit 8). Domestic demand has remained quite fi rm, bolstered by strength in the labour market and buoyancy in residential real estate. More recent indicators, however, suggest that these two pillars of support are weakening. Canada’s economy shed 55,000 jobs in July, while housing starts and home price data weakened markedly.

The Bank of Canada moved to the sidelines in June, leaving its benchmark interest rate at 3% and citing balanced risks with respect to growth and infl ation. Strength in the Canadian dollar has largely insulated Canada from the imported infl ation pressures faced by many other economies. Headline infl ation remains elevated at 3.4% in July, but core infl ation is well contained at 1.5%. This affords the Bank the luxury of biding its time, monitoring developments both domestically and outside our borders. Canada may well experience a technical recession (defi ned as two back-to-back quarters of falling GDP) this year. The recession risk is higher in central Canada, where the strong Canadian dollar has left manufacturers and exporters reeling. This is offset somewhat by continued strength in resource-rich provinces,

-15-10-505

101520253035

1996 1998 2000 2002 2004 2006 2008 2010

YoY

% Ch

ange

United Kingdom Spain Ireland

Source: Nationwide, Ireland ESRB and Permanent TSB, Institdo Nacional de Estadistica

EXHIBIT 9. House Prices

0.01.02.03.04.05.06.07.08.09.0

2005 2006 2007 2008 2009 2010

YoY

% Ch

ange

Eurozone UK China India

Source: National Statistical Agencies, Datastream

EXHIBIT 10. Global Consumer Price Infl ation

but on balance we expect the pace of growth in the Canadian economy to slow over the remainder of 2008 before improving into the second half of next year. The greatest risks for Canada are the depth and duration of the U.S. downturn and any signifi cant decline in commodity prices.

Outside of North America, economic storm clouds are gathering. Housing markets in the U.K., Ireland, Spain and New Zealand are under considerable pressure, driving down

consumer confi dence and acting as a drag on economic activity (Exhibit 9). The contraction in Eurozone GDP in the second quarter was the fi rst decline for any quarter in fi ve years, but even France and Germany showed surprisingly tepid growth. The European Central Bank continues to voice concern on the infl ation front, with CPI at 4% and wage demands fi rm (Exhibit 10). We expect the ECB will ease later this year as economic growth continues to weaken.



is led by the developed economies, with signs of export weakness beginning to emerge in developing countries. We do not expect to see a marked improvement in the pace of world growth until well into 2009, as the credit and housing cycles continue to play out. Recovery in the U.S., in particular, is likely to be tepid and vulnerable to setbacks. Infl ation in developed economies will moderate over the remainder of the year as the economic cycle turns down (assuming commodity prices do not resume their rise), but the longer-term structural theme of mounting infl ationary pressures emanating from developing economies remains intact.

requirements, yet real interest rates remain negative for many emerging markets. This suggests more structural pressure on core rates of infl ation lies ahead, as central banks focus on growth rather than infl ation. Relatively strong growth in the BRIC economies (Brazil, Russia, India and China) remains a medium-term theme, but these economies face cyclical challenges as infl ation erodes disposable incomes and, with the exception of Brazil, monetary policy remains accommodative.

The pace of global growth slowed considerably in the second quarter, marking the end of a fi ve-year phase of above-trend expansion. Weakness

35

40

45

50

55

60

65

2005 2006 2007 2008 2009 2010

Source: NTC Research

EXHIBIT 11. China Purchasing Managers' Index The Bank of England faces a similar dilemma with headline infl ation at 4.4%, far above its 3% tolerance level, while at the same time the economy is losing steam. Economic growth ground to a halt in the second quarter and stands just 1.4% above year-ago levels, the weakest performance since 1992, with household expenditures registering an outright decline as house prices continue to defl ate.

Japan’s economy continues to limp along with subpar growth, led by weak consumer spending, which has been joined by waning export growth. Japan is experiencing a negative terms-of-trade shock whereby infl ation has returned through higher import prices, a further hurdle for consumers.

Emerging-market economic growth has held up quite well but is also showing signs of weakness. China’s purchasing managers’ index fell below 50 in June for the fi rst time in three years, as export growth slows, although consumer spending remains strong (Exhibit 11). India is challenged by soaring infl ation, with the wholesale price index hitting a 16-year high of almost 13% in July. Both countries have attempted to curb infl ation through interest rate hikes and increasing reserve


Global bond markets continue to sit at extreme valuations, as the credit crunch crosses its one-year anniversary. With headline infl ation above central banks’ comfort level and benchmark yields below infl ation in some markets, government bond investors are vulnerable to a resolution of the credit crisis. As the U.S. economy bottoms and the rest of the world eventually follows, the global fl ight to quality bid will fade, with bond yields moving higher as a result.

UNITED STATES

We believe that U.S. bond yields are headed higher as the credit crisis abates, risk premiums normalize and the U.S. economy recovers in the second half of 2009. Renewed growth will give the Federal Reserve the impetus it needs to move toward a neutral fed funds rate, as policymakers will be keen to avoid the mistake of leaving rates too low for too long, as they did in the previous cycle. Meanwhile, the eventual resolution of the credit crisis should lift some of the fl ight-to-quality-induced pressure that has caused a year-long bid across the yield curve.

Our forecast for the U.S. federal funds rate is 2.5%, unchanged from last quarter, and 50 basis points higher than the current setting. While rates are appropriate given the pressures currently being exerted on the economy, the Fed will be anxious to boost its benchmark lending rate once economic growth reasserts itself. We expect two 25-basis-point hikes over the next 12 months, likely beginning in the second half of 2009.

FIXED INCOME MARKETSROBIN GULLASON, CFA

V.P., Fixed Income Portfolio Advisory Group – RBC Dominion Securities Inc.

Further out the curve (exhibits 1 and 2), we forecast that 10-year Treasury yields will rise to 4.50% from the current 3.82%, due to a diminished risk-aversion bid and the unsustainability of a negative real yield for the benchmark Treasury. The 10-year yield has been lower than headline infl ation for all of 2008, a trend that is unlikely to continue once the economy recovers. The difference between the fed funds rate and the yield on the 10-year bond should steepen to 200 basis points from the current 182, as stronger

growth and a rising rate environment are priced into the curve.

Risks to our forecast include a continuation of the risk aversion seen for the past year if the credit crisis extends for longer than expected. Any acceleration in Financial sector writedowns or a continued tightening of credit conditions could cause investors to fl ee risky assets anew in favour of Treasuries, depressing yields further. Of equal risk would be a continued decline in commodity prices and in headline

29-AUG-08 BASE WORST BEST

3mo 1.72% 2.50% 3.50% 1.00%

2yr 2.38% 3.40% 4.40% 1.75%

5yr 3.10% 4.00% 5.00% 2.50%

10yr 3.82% 4.50% 5.25% 3.25%

30yr 4.43% 5.00% 5.50% 4.00%


12-Month Yield Forecasts

Source: RBC AM

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

3m 2y 5y 10y 30y

29-Aug-08ConsensusBaseWorstBestSource: RBC AM, Consensus Economics


Yield Curves: Current and 12-Month Forecast Levels


persist through year end, bond yields could face upward pressure.

JAPAN

With infl ation returning to Japan, one would expect rate hikes to follow. However, the food-and-oil-driven infl ation currently weighing on the country’s economy is not the kind of environment where policymakers can easily reverse their multi-year strategy of ultra-low interest rates. While the move from defl ation to

FIXED INCOME MARKETS • ROBIN GULLASON, CFA

infl ation, which could embolden investors to increase term.

EUROZONE

While the U.S. and EU have suffered from relatively high infl ation and slowing growth, only the U.S. economy has had the benefi t of lower benchmark rates to help ease the pain. The European Central Bank’s explicit adherence to its infl ation target led the Bank to actually hike rates as recently as July. As a result, Europe is weighed down by rates that are too high, as evidenced by the economy’s contraction in the second quarter. Despite continued hawkish rhetoric from the ECB, we see lower short rates in the Eurozone throughout the forecast period (exhibits 3 and 4).

Specifi cally, we expect the ECB to reduce rates by 75 basis points to 3.5% as the Bank is forced to provide stimulus to a moribund Eurozone economy. There is little doubt that the Eurozone is suffering at least as much as the U.S., as evidenced by very weak business confi dence readings and negative Q2 GDP growth. The effects of a strong Euro and the notion that few developed nations will escape the economic weakness emanating from the U.S. will keep bond yields at depressed levels across the curve. We see the 10-year benchmark at 4.25% in 12 months.

The biggest risk to our forecast is the possibility that we have underestimated the ECB’s resolve on infl ation. Recent comments from ECB council members suggest that rate cuts are not on their radar screen, and that should infl ation pressures

modest infl ation should, in theory, encourage additional spending, the Japanese consumer is now hamstrung by a higher cost of living without the wage growth to match. As a result, we expect the Bank of Japan to be on hold for at least the next 12 months. The resignation of Prime Minister Fukuda in early September adds another dimension of risk to the Japanese economy, and the BoJ is unlikely to take action during a period of political deadlock. Further out the yield curve we see

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

3m 2y 5y 10y 30y


EXHIBIT 4. Europe



3mo 4.36% 3.50% 4.25% 3.00%

2yr 4.12% 4.00% 4.50% 3.10%

5yr 4.10% 4.20% 5.00% 3.25%

10yr 4.17% 4.25% 5.25% 3.50%

30yr 4.57% 4.60% 5.50% 4.00%

Source: RBC AM

EXHIBIT 3. Europe




the Japanese 10-year bond yield rising to 1.75% as the fl ight-to-safety bid abates (exhibits 5 and 6).

The risk to Japanese short rates is to the upside. Though current infl ation pressures appear to be depressing growth without a major pass-through to core prices, that could change if wages begin to catch up. A wage-price spiral would force the BoJ’s hand and lead to higher short rates.

CANADA

Though the press has focused on the malaise affecting the U.S. economy, Canada’s GDP performance has actually been much worse. Canadian growth is in the red six months into 2008, while U.S. growth has remained surprisingly resilient, thanks to the stimulus package and an improving trade balance south of the border. Canada’s two-speed economy has been pumped up by high energy prices, though the resultant rise of the Canadian dollar has slammed the country’s manufacturing base. These opposing forces proved a challenge for David Dodge and will likely be so for Mark Carney, though Carney’s 100 basis points of rate cuts so far in 2008 now look prescient.

Our forecast for the Canadian overnight rate is a steady 3.0% (exhibits 7 and 8). The twin forces of sluggish growth and worrisome infl ation seen globally also resonate in Canada. With the infl ation outlook currently too cloudy for the Bank to justify cutting rates and the economy too weak for rate increases, the Bank is likely to take a wait- and-see approach.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

3m 2y 30y

29-Aug-08ConsensusBaseWorstBest

Source: RBC AM, Consensus Economics

EXHIBIT 6. Japan



3mo 0.58% 0.50% 1.00% 0.25%

2yr 0.73% 0.85% 1.35% 0.50%

5yr 0.98% 1.25% 1.75% 0.85%

10yr 1.42% 1.75% 2.25% 1.25%

30yr 2.29% 2.55% 3.00% 2.25%

EXHIBIT 5. Japan


Source: RBC AM


3mo 2.41% 3.00% 4.00% 2.50%

2yr 2.71% 3.50% 4.25% 2.50%

5yr 3.03% 4.00% 4.65% 2.75%

10yr 3.54% 4.25% 5.00% 3.25%

30yr 4.02% 4.60% 5.25% 3.75%

EXHIBIT 7. Canada


Source: RBC AM



Further out the curve, we see the Canadian 10-year bond yield rising to 4.25% from 3.54% currently. Given that Canadian growth should trough this year and our expectation of an abating fl ight to safety bid, we look for 10-year yields to drift higher with their U.S. counterparts. We see the spread between U.S. and Canadian 10-years narrowing to 25 basis points, as Canada’s more benign infl ation outlook and better fi scal position keep long-term rates relatively lower.

Risks to our forecast are to the upside throughout the yield curve. While the Canadian dollar has helped Canada’s infl ation picture by reducing import prices, we are close to the one-year anniversary of the loonie’s record run to C$0.9056/US$1. Any signifi cant selloff in the Canadian dollar will drive up prices of imported goods, leading to higher infl ation in spite of lower energy prices.

UNITED KINGDOM

With its economy currently on the ropes because of a sharp housing downturn and infl ation a constant worry, the Bank of England faces many challenges in the year ahead. Like much of the western world, infl ation is at levels that call for higher rates, while sluggish growth, on the other hand, suggests a need for stimulus. As infl ation wanes in the next year, we think the Bank will begin to favour growth concerns over infl ation.

Our forecast for the BoE’s base rate is 4.25% (exhibits 9 and 10), a continuation of the rate-cutting

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

3m 2y 5y 10y 30y


EXHIBIT 8. Canada



3mo 5.20% 4.25% 5.25% 3.50%

2yr 4.49% 4.20% 5.15% 3.50%

5yr 4.42% 4.35% 5.10% 3.75%

10yr 4.48% 4.50% 5.00% 4.00%

30yr 4.39% 4.65% 5.00% 3.75%



Source: RBC AM

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

3m 2y 5y 10y 30y

29-Aug-08ConsensusBaseWorstBest

Source: RBC AM, Consensus Economics





cycle that has been put on hold since April’s 25-basis-point reduction to 5.0%. British infl ation is set to decline from current levels given weak economic growth and falling house prices. The sharp turn in the infl uential housing and fi nance sectors give us further conviction in our call. Bond yields have already rallied sharply alongside deteriorating economic news and our forecast is 4.5% for 10-year gilts. Lower base rates and a steady 10-year yield will lead to a steeper U.K. yield curve as the market prices in a return to solid economic growth and rewards investors for taking on interest rate risk.

The risks to both our base rate and 10-year gilt forecasts are to the upside and both due to the same culprit – infl ation. Acceleration from already high levels of infl ation would cause the Bank of England to eliminate or at least slow the pace of any rate cuts currently in the pipeline. The long end of the yield curve would give back a lot of 2008’s gains should it become apparent that this bout of infl ation will be more than fl eeting.

RETURNS AND RECOMMENDATIONSOur expected country returns are listed in Exhibit 11. With returns for most major government bond markets forecast to be less than the coupon rate, relative value takes on renewed importance. On the

LOCAL CURRENCY

U.S.HEDGED

U.S.

3MO 2.09% 2.09%

2YR 1.93% 1.93%

5YR 0.74% 0.74%

10YR -0.06% -0.06%

30YR -3.03% -3.03%

ALL 0.28% 0.28%

EUROPE

3MO 3.94% 1.77%

2YR 4.51% 2.33%

5YR 4.05% 1.88%

10YR 3.54% 1.38%

30YR 4.04% 1.87%

ALL 4.06% 1.89%

JAPAN

3MO 0.55% 2.54%

2YR 0.78% 2.77%

5YR 0.41% 2.39%

10YR -0.54% 1.42%

30YR -2.34% -0.42%

ALL -0.15% 1.81%

CANADA

3MO 2.73% 2.14%

2YR 2.19% 1.61%

5YR 0.26% -0.31%

10YR -1.11% -1.67%

30YR -4.53% -5.08%

ALL -0.73% -1.30%

U.K.

3MO 4.74% 1.79%

2YR 4.71% 1.77%

5YR 4.81% 1.86%

10YR 4.52% 1.57%

30YR 1.28% -1.57%

ALL 2.95% 0.05%

EXHIBIT 11. Expected Return

12 Months

duration front, we have chosen to be short ¼ year in each market due to what we expect will be subpar total returns versus cash. The continued unwind of the fl ight-to-quality trade and risk of sustained infl ation both argue for reduced exposure to government bonds, specifi cally longer-dated securities.

Our forecasts indicate that signifi cant relative-value opportunities exist among the U.S., Japan and Europe. U.S. returns are forecast to be slightly negative, while we expect both the Eurozone and Japan to return 1.9% in U.S. dollar terms, according to our models. To capture these opportunities, we recommend a 5% underweight in the U.S., offset by 2.5% overweights in both Europe and Japan. While all three economies will likely perform poorly this year and next, it is beginning to appear that the U.S. is relatively better off than most of its trading partners. As risk aversion has been strongest in the U.S., we see it unwinding more forcefully there than elsewhere, leading to underperformance versus Europe and Japan.

A total return analysis of expected global bond market returns reveals that the performance between bullet and barbell strategies varies widely by country. As we are not able to make a blanket recommendation that applies to all regions, a summary of our analysis is posted in Exhibit 12.

Source: RBC AM


2/30-Year vs. 10-Year

EXPECTED BASE WORST BEST

LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED

U.S.

2yr – 30yr -0.86% -0.86% -1.42% -1.42% -5.75% -5.75% 8.45% 8.45%

10yr -0.06% -0.06% -0.49% -0.49% -6.04% -6.04% 9.39% 9.39%

EUROPE

2yr – 30yr 4.27% 2.10% 4.40% 2.22% -2.40% -4.44% 9.91% 7.61%

10yr 3.54% 1.38% 3.61% 1.45% -3.13% -5.15% 9.62% 7.33%

JAPAN

2yr – 30yr -0.68% 1.28% -0.57% 1.39% -4.81% -2.93% 2.59% 4.61%

10yr -0.54% 1.42% -0.54% 1.42% -4.57% -2.69% 3.50% 5.54%

CANADA

2yr – 30yr -1.21% -1.77% -1.46% -2.02% -6.47% -7.01% 6.05% 5.45%

10yr -1.11% -1.67% -1.39% -1.95% -6.49% -7.03% 6.55% 5.94%

U.K.

2yr – 30yr 3.42% 0.51% 3.07% 0.16% 0.49% -2.34% 9.17% 6.10%

10yr 4.52% 1.57% 4.52% 1.58% 0.58% -2.26% 8.43% 5.38%


2/10-Year vs. 5-Year

EXPECTED BASE WORST BEST

LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED LOCAL CCY USD HEDGED

U.S.

2yr – 10yr 0.98% 0.98% 0.75% 0.75% -2.40% -2.40% 6.27% 6.27%

5yr 0.74% 0.74% 0.52% 0.52% -3.03% -3.03% 6.32% 6.32%

EUROPE

2yr – 10yr 4.07% 1.89% 4.10% 1.93% 0.69% -1.41% 7.19% 4.95%

5yr 4.05% 1.88% 3.96% 1.79% 1.47% -0.65% 7.41% 5.16%

JAPAN

2yr – 10yr 0.20% 2.18% 0.21% 2.19% -1.84% 0.10% 2.15% 4.17%

5yr 0.41% 2.39% 0.45% 2.43% -1.47% 0.47% 1.96% 3.97%

CANADA

2yr – 10yr 0.73% 0.15% 0.61% 0.03% -2.14% -2.70% 4.53% 3.93%

5yr 0.26% -0.31% 0.07% -0.50% -2.36% -2.92% 4.40% 3.80%

U.K.

2yr – 10yr 4.63% 1.68% 4.64% 1.70% 2.36% -0.52% 6.78% 3.77%

5yr 4.81% 1.86% 4.87% 1.91% 1.94% -0.93% 7.21% 4.19%

EXHIBIT 12. Scenario Analysis – 12 Months

Barbell vs. Bullet (Duration Weighted)

Source: RBC AM


CURRENCY MARKETSDAGMARA FIJALKOWSKI, MBA, CFA

V.P. & Senior Portfolio Manager – RBC Asset Management Inc.

Our contention in the Spring 2008 issue of Global Investment Outlook that the dollar had entered an extended bottoming cycle found strong validation in the past quarter, with the greenback’s gains since the middle of July almost unprecedented in the past 35 years. The dollar’s trade-weighted index rose more than 7% in one month, a move of such magnitude that it put the rate of change at the 99.8 percentile of dollar moves (Exhibit 1).

IS A LONG-TERM RALLY REPLACING THE LONG-TERM DECLINE?

The downtrend in the U.S. dollar has lasted 6 ½ years and, at its worst, the dollar lost 39% of its value against major trading partners (Exhibit 2). On a trade-weighted basis, the dollar tested undervaluation by 18%, which was beyond its “line in the sand” of 16.8%¹. Deutsche Bank research has found that the average time that the dollar spends at such extremes is nine months (based on data from 1973 to 2006). Moreover, the reversal of the dollar’s fortunes was confi rmed by most major currencies (Sterling, euro, Australian dollar, New Zealand dollar and Canadian dollar), which all crossed their respective lines in the sand before retreating. From this very long-term valuation perspective, expecting the dollar to rally is a much better bet than expecting it to decline further.

65

75

85

95

105

115

125

135

145

Jan-

71

Jul-7

3

Jan-

76

Jul-7

8

Jan-

81

Jul-8

3

Jan-

86

Jul-8

8

Jan-

91

Jul-9

3

Jan-

96

Jul-9

8

Jan-

01

Jul-0

3

Jan-

06

Jul-0

8

USD TWI (Nominal, Major Currencies)

USD Downtrend8 yrs-26%

USD Uptrend6 yrs+66%

USD Downtrend10 yrs-46%

USD Uptrend7 yrs+42%

USDDowntrend

6.5 yrs-39%

Source: Bloomberg, Deutsche Bank

EXHIBIT 2. U.S. Dollar Cycles

50

60

70

80

90

100

110

0 50 100 150 200 250 300 350 400 450 500Weeks into bear market

2002-Present 1985-95 1971-79


EXHIBIT 3. Comparison of USD Bear Markets

¹Reference to extreme PPP under/overvaluation is borrowed from DB research publication Fair Value Lines in the Sand, March 2006. We discussed it in detail in Fall 2007 issue of the Global Investment Outlook.

Historical Frequency Distribution

0%1%2%3%4%5%6%7%

-8% -7% -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8%Size of Dollar Move

% of

Obs

erva

tions


EXHIBIT 1. 1-Month Moves in U.S. Trade Weighted Dollar

January 1971 – August 2008


CURRENCY MARKETS • DAGMARA FIJALKOWSKI, MBA, CFA

Even so, the velocity of the dollar’s recent recovery makes us suspect that the market is getting carried away in the short term. When we analyzed the way the two previous dollar bear markets ended (Exhibit 3), we observed that in both cases it took 10 years before a sustainable rally developed. Assuming a similar pattern this time around, most of the dollar’s decline would be behind us, although we should expect a period when the market wanders in a fairly broad range of 10% rather than continuing on a rapid ascent. One of the fundamental assumptions behind a slow-motion recovery is that it will take time for the U.S. current-account defi cit to shrink. In the fi rst cycle studied, the dollar started falling in 1985, but the trade balance did not start improving until 1988, and the dollar stayed cheap through 1995 while the adjustment took place. Similarly, when the dollar started appreciating in 1995, the trade and current-account defi cits started worsening only in 1997. This time, the trade balance bottomed at the end of 2005 and has been improving since, but still remained at an unsustainable level of -4.8% in June (Exhibit 4). The bottom line is that there are long lags (between three quarters and two years) in the current-account response to exchange-rate cycles, and we can expect further improvement in the current account over the coming years even if the dollar stops weakening.

POSITIONING

We have observed in previous editions of this publication that money managers have been accumulating dollar exposure

(40,000)

(30,000)

(20,000)

(10,000)

0

10,000

20,000

Oct-0

2

Apr-0

3

Oct-0

3

Apr-0

4

Oct-0

4

Apr-0

5

Oct-0

5

Apr-0

6

Oct-0

6

Apr-0

7

Oct-0

7

Apr-0

8

Oct-0

8

Posit

ions (

Millio

ns, U

SD)

60

70

80

90

100

110

USTW

$ Exc

hang

e Rate

Net Speculative Positions (LHS) US Trade Weighted Dollar (RHS)

Source: CFTC, RBC AM

EXHIBIT 6. Speculators Reducing $ Shorts

-15%

-10%

-5%

0%

5%

10%

15%

2000 2001 2002 2003 2004 2005 2006 2007 200825% M e d i a n 75%


EXHIBIT 5. USD Exposure of Institutional Investors

% Over/Underweight vs. Citigroup WGBI

-8%

-6%

-4%

-2%

0%

2%

1992 1994 1996 1998 2000 2002 2004 2006 2008US Trade Balance (% of GDP) US Trade Balance ex Petroleum (% of GDP)

October 2005Source: Bloomberg, RBC AM

EXHIBIT 4. U.S. Trade Defi cit (% of GDP) – Improving


-5-4-3-2-101234

2001 2002 2003 2004 2005 2006 2007 2008

Source: Lehman Brothers, Market Vane

Bullish USD

Bearish USD

EXHIBIT 7. USD Sentiment – Lightning Speed Adjustmentfor some time. Exhibit 5 is the Deutsche Bank positioning survey of institutional managers showing not only that the most bullish manager is long dollars, but also that the average manager has been reducing dollar shorts since the end of 2006. On the other hand, short-term speculative money represented by Chicago traders has been short dollars (Exhibit 6). It was this speculative money that recently got caught during the less liquid summer months and thereby contributed to the extraordinary short-term dollar rise when forced to quickly unwind positions. Finally, the Market Vane survey of investor sentiment toward the dollar shows that sharp adjustment (Exhibit 7). Now that the positions are adjusted, the market can take a step back.

THE IMPETUS FOR AN EXTRAORDINARY DOLLAR RALLY

What triggered the ferocious dollar rally at a time when the U.S. economy is clearly in the doldrums? It seems that the abrupt decline in continental Europe’s economic indicators has dashed hopes that global growth would steam ahead despite a weak U.S. economy. Whether we look at the price of oil (and most other commodity prices) or the Baltic Freight Index, there is ample evidence of weaker global growth. Interestingly, it is not only developed economies that are slowing, but the so-called BRIC economies that are decelerating as well.

Earlier this year, we took the contrarian view that the European


0%

1%

2%

3%

4%

5%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Period of ECB cuts with high and rising inflationEurozone All Items Inflation, 3m Mov. Avg.ECB Target Inflation RateECB Refi Rate


EXHIBIT 8. Infl ation and the ECB – Precedent?

Central Bank would have to start cutting interest rates. While most of the economic data for Eurozone turned down drastically in the past quarter, what is holding the ECB back from cutting rates is infl ation. However, it wouldn’t be unprecedented for the ECB to cut rates while infl ation is on the rise – that’s what happened in May 2001 (Exhibit 8). The market has come to recognize the possibility of a rate cut, so expectations of interest rate hikes by the ECB went out the window during July and

August. That adjustment was the main reason behind the euro sell-off. With infl ation continuing to rise, the euro’s drop has become a safety valve for Europe’s economy.

The global slowdown came hand in hand with a peak in commodity indices, which was closely followed by slower growth of international reserves (Exhibit 9). Both had been important to the European currency, which was benefi ting from the oil rally in two ways. The fi rst was the increased use of the



euro in foreign-currency reserves, and second was lower cost of oil imports relative to the U.S. and other economies. Europe, which exports more than the U.S. to oil- producing countries, has been able to offset a signifi cant portion of its oil bill with those exports. According to Deutsche Bank, proceeds from exports cover 63% of the cost of any increase in Eurozone crude-oil imports, but only 15% of a jump in the U.S. oil bill. It’s only natural then, that a turn in commodities would be followed closely by a turn in the euro.

U.S. data have also contributed to the rally in the greenback, if only because, while bad, they have been in line with or better than very weak expectations. The U.S. has so far avoided a technical recession – two straight quarters of declining GDP – mostly thanks to higher net exports. Moreover, considering the U.S.’s greater sensitivity to oil, falling crude prices benefi t the U.S. more than other developed economies. Still, market expectations in mid-August for rate hikes of 75 basis points were excessive. These expectations were not sustainable, and as the market revises them down, the dollar rally will lose momentum in the short term.

THE CANADIAN DOLLAR

Having appreciated 80% in fi ve years versus the greenback, the Canadian dollar took an eight-month pause and traded in a well defi ned range of between 0.97 and 1.03. Interestingly, the Canadian currency has not benefi ted in 2008 from the continuation of the commodity bull market that started

-1.2%

-0.7%

-0.2%

0.3%

0.8%

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-080.90

1.00

1.10

1.20

US-CA 2yr spread (LHS) USD/CAD (RHS)


EXHIBIT 10. USD/CAD vs. Interest Rates

90100110120130140150160170180190

Feb-75 Feb-80 Feb-85 Feb-90 Feb-95 Feb-00 Feb-050.800.850.900.951.001.051.101.151.201.251.30

Canadian dollar REER (LHS) Canada terms of trade index (RHS)

Source: State Street, OECD, IMF

EXHIBIT 11. CAD Lagging the Improving Terms of Trade

10%12%14%16%18%20%22%24%26%28%30%

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

Source: Bloomberg

EXHIBIT 9. International Reserve Assets – Growth Slowing

52-week Change



in 2002. Once oil toppled from its July highs, the “loonie” succumbed to negative sentiment and broke out of that range, weakening along with other major currencies. Its value is now in line with what is suggested by interest rate differentials (Exhibit 10), but still lags based on terms of trade (Exhibit 11). Now that the Canadian dollar is well within the 20% PPP band, the currency is likely to appreciate in the short term as the market re-evaluates the assumed divergence of monetary policy (e.g., at one point the market priced in 50 basis points of cuts from Bank of Canada versus 75 basis points of Fed hikes over the next 12 months), especially if oil prices hold the long-term trend line (which comes between $107/barrel and $110). In the longer term, “the loonie” may weaken somewhat, but a healthy fi scal situation and potential exposure to a recovering U.S. economy should help it against the euro and other European currencies. One factor that may help the Canadian dollar over the next three to six months is a series of mergers and acquisitions that are expected to close in the fourth quarter (Exhibit 12). Another is the pattern of positioning/sentiment indicators, with the real-money managers signifi cantly underweight Canadian dollars (Exhibit 13) and sentiment in negative territory (Exhibit 14).

OTHER CURRENCIES

While the yen is undervalued on a PPP basis, we don’t expect it to strengthen against the dollar. It should, however, be somewhat stronger versus the euro. Among the things holding it back is Japanese economic weakness,

-4-202468

101214

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08Net announced M&A flow (with cash component) into Canada US$bn 4wma

Source: RBC Capital Markets, BEA

EXHIBIT 12. M&A Announcements Bullish CAD

-4%-3%-2%-1%0%1%2%3%4%5%6%7%

95 96 97 98 99 00 01 02 03 04 05 06 07 0825% Median 75%


EXHIBIT 13. CAD Exposure of Institutional Investors

% Over/Underweight vs. Citigroup WGBI

-5-4-3-2-1012345

2001 2002 2003 2004 2005 2006 2007 2008

Source: Lehman Brothers, Market Vane

Bullish CAD

Bearish CAD

EXHIBIT 14. CAD Sentiment



likely based on the positioning of money managers and speculators. Third, the market got ahead of itself in its expectations for Fed interest rate hikes, since a steeper yield curve and low rates are needed to alleviate the problems faced by fi nancial institutions and U.S. consumers. It will be a while before the Fed can hike rates, and when that happens, bond yields will increase signifi cantly and the curve will start fl attening, both of which are dollar-positive. Only then will we have our sustainable rally in the dollar.

With the aggressive sell-off in currencies experienced in the last 30 days, we could be setting up for a stronger euro, Sterling and Canadian dollar in the short term (one to three months). From the long-term

which prevents the Bank of Japan from raising interest rates. This is offset by the possibility of lower oil prices, which would be positive for the currency. We expect these offsetting trends to lock the yen in a range against the dollar.

Sterling has weakened more than 12% from its cyclical high. Sentiment continues to be extremely negative, and the market is expecting the Bank of England to cut rates by 75 basis points within the next 12 months. We believe that the pound will weaken in line with the euro in the longer term but could have a signifi cant short-term bounce from here. Since the euro generally moves in tandem versus the dollar and the pound, (Exhibit 15), and we expect euro depreciation in the longer term, the euro could actually underperform Sterling.

IN CONCLUSION

Our review supports the stance that the dollar will trade in a range for an extended period before beginning a longer-term recovery. However, we believe that it is unlikely that the dollar will recover in V-shape fashion. A historical analysis suggests that the dollar needs to stay weak to effect the needed adjustment in the current-account defi cit. Second, the recent rally has made signifi cant additional short-term gains less

1Speaking in Berlin on November 19, 2004: “…despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is signifi cantly superior to tossing a coin. I am aware that, of the thousands who try, some are quite successful. So are winners of coin-tossing contests.”

perspective, the rallies would provide us with a better opportunity to sell these currencies and buy the dollar. This brings us to our forecast.

A. Greenspan has likened forecasting exchange rates to a “coin toss,”¹ and we are still waiting for a currency-forecast quotable from Ben Bernanke. We are asked to forecast for a 12-month horizon, and we attempt to deliver to the best of our current state of knowledge and information. We have moved signifi cantly toward our 12-month forecast levels over the last three months, but we will adjust them only slightly, in line with our expectation of range-trading. Our forecasts are: Euro $1.40; Yen 112; Canadian dollar 1.07; Sterling $1.80.

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-080.60

0.65

0.70

0.75

0.80

EUR/USD (LHS) EUR/GBP (RHS)

Source: Bloomberg

EXHIBIT 15. EUR/USD and EUR/GBP are Well Correlated



SUPPORTIVEYield advantage as the ECB is on hold amid concern about • still-strong monetary growth (average 10.0% in the three months ended June versus target rate of 4.5%), rising import prices and infl ation (Eurozone CPI at 4.0% in July).

Gradual changes in central bank and sovereign wealth • fund reserve targets leading to demand for euros.

High oil prices leading to continued demand from Middle • East accounts protecting the purchasing power of their oil receipts through diversifi cation.

European fi scal defi cits reduced, while U.S. trade and • current-account defi cits, despite improving, are still at unsustainable levels.

Long-term dollar downtrend.•

NEGATIVEConcern about resilience of European growth, especially • in smaller economies, due to combined impact of fi scal and monetary tightening and currency appreciation; leading indicators, business and consumer confi dence all point lower.

Risk of lower oil prices, which would weaken demand for • euro from the Middle East.

Market expectations of rate cuts. •

Cheap dollar and attractive valuations trigger M&A • outfl ows from Europe.

U.S. current-account and trade defi cits improving since • the end of 2005.

Euro is extremely overvalued versus yen, and still one of • the more overvalued currencies versus the dollar based on purchasing power parity.

Exposure to political risk due to Eurozone’s relative • proximity to the Middle East and the Russia/Georgia confl ict.

SUPPORTIVECore CPI positive and rising after a long period of • defl ation.

Global recession worries leading to risk reduction.•

China, a major trading partner, is in good economic • health.

Trade and current-account surpluses. •

Potential of tax breaks for Japanese corporations to • repatriate retained earnings from overseas.

Real money managers turning more bullish yen.•

NEGATIVEMonetary policy tightening on hold and low interest rates • make the yen a favourite short when risk aversion eases.

Domestic growth expectations declining and growth in • bank lending is slowing.

Export growth is slowing, not only to the U.S., but also • to China, Asia ex-China and Europe. Trade surplus deteriorating.

Vulnerability to high oil prices.•

Pressure on fi scal policy due to high government debt • and pension liabilities.

Japanese retail investors buying foreign equities and • bonds on an unhedged basis as their risk appetite increases.

EURO

YEN

THE CURRENCY OUTLOOK: KEY FACTORS

12-MONTH FORECAST: 1.40.

12-MONTH FORECAST: 112.

>>

>>


SUPPORTIVEStrong terms of trade, currency movement lagging the • increase in energy prices.

Largest budget surplus in the G7 (surplus for 10 years in • a row).

Interest rate advantage as Fed cut rates more • aggressively than the Bank of Canada.

BOC ending the easing cycle in anticipation of higher • infl ation.

M&A pipeline fi lling up again.•

Housing market and fi nancial sector in better shape than • their U.S. counterparts.

Tight labour market and strong job creation in the west. •

Potential for additional fi scal stimulus (windfall profi t • from wireless licenses auction?) in the pipeline.

Unemployment at 6.1% is near a 30-year low.•

NEGATIVEManufacturing sector hit by the double whammy of a • strong currency and the U.S. slowdown.

Job losses mounting since May.•

Vulnerable to weakness in energy prices and slowdown • in global growth.

Canadians buying foreign assets, taking advantage of • strong Canadian dollar.

Overvalued on PPP basis, any moves beyond parity take • it into extreme overvaluation territory.

Political risk related to minority federal government. •

CANADIAN DOLLAR

SUPPORTIVEYield advantage. The pound is one of top three high • yielders among the major currencies.

Contrarian bet as sentiment and positioning are • extremely negative.

Unemployment low at 2.7% (June).•

Easing cycle interrupted by infl ationary pressures; • headline infl ation increasing since September 2007 (3.8%) and expected to have reached 5% in the second half of 2008.

Likely to bounce once vulnerability in the fi nancial • system recedes.

NEGATIVEBank of England started a new easing cycle with a cut in • December, followed by one in February and April.

PMI services dropping to new lows (usually a good • indicator of real GDP growth), and second-quarter GDP fl at.

Signifi cant vulnerability to fi nancial system stress.•

Pound is signifi cantly overvalued on a PPP basis.•

Current-account defi cit is widening (4.3% of GDP for • 2007) and foreign direct investment is fading.

Budget defi cit at 2.4% of GDP (March) and will increase • as downturn deepens.

House prices down and mortgage approvals hit a record • low.

Weakness in retail sales, consumer and business • confi dence.

POUND STERLING




>>

>>


UNITED STATES RECOMMENDED SECTOR WEIGHTS

RBC INVESTMENT STRATEGY COMMITTEE

AUG. 2008

BENCHMARKS&P 500

AUG. 2008

ENERGY 14.5% 13.6%

MATERIALS 3.0% 3.6%

INDUSTRIALS 11.5% 11.5%

UTILITIES 3.5% 3.6%

CONSUMER DISCRETIONARY 7.5% 8.5%

CONSUMER STAPLES 12.0% 11.7%

HEALTH CARE 14.0% 13.1%

FINANCIALS 13.0% 14.2%

INFORMATION TECHNOLOGY 18.0% 17.1%

TELECOMMUNICATION SERVICES 3.0% 3.1%

REGIONAL OUTLOOK – U.S.

RAY MAWHINNEY – Senior V.P., U.S. & Global Equities RBC Asset Management Inc.

BRAD WILLOCK, CFA – V.P. & Senior Portfolio Manager RBC Asset Management Inc.

4063

100158251398631

100015852512

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010



S&P 500 EQUILIBRIUM Normalized Earnings & Valuations

Source: RBC AM

ECONOMIC BACKDROP

After hitting a high in mid-May, U.S. equity markets moved sharply lower through mid-July as rising energy prices stoked investor concerns about rising infl ation and slowing global growth. Since mid-July, energy prices have receded somewhat, as have prices for most metals and agricultural commodities. As a result, the risk of infl ation appears to be diminishing, while the risk of a signifi cant slowdown in global growth appears to have moved to the forefront of investors’ radar screens. In the U.S., the focus remains the housing market, where conditions continue to worsen as unemployment and foreclosures rise, borrowing rates remain stubbornly high and access to credit deteriorates. The housing market, and the outlook for the economy, are unlikely to improve until some or all of these conditions show signs of improvement.

We expect modest GDP growth in the third quarter, thanks in part to tax rebates that helped support retail sales at the beginning of the period. However, economic activity will likely weaken in the fourth quarter and into early 2009. As a result, S&P 500 earnings should remain under pressure through the end of 2008 given the headwinds of high energy prices, slower economic activity, and continued credit losses and writedowns recognized by fi nancial companies. Despite the grim economic backdrop, earnings for non-fi nancial companies remain surprisingly robust, debt levels are low and cash levels are near all-time highs.

the coming months. Until then, we expect the market to trade in a wide range bounded by the high set in May and the low from mid-July.

SECTOR ANALYSIS

The ENERGY sector peaked in mid June 2008 as crude prices skyrocketed to $145/ barrel. Since that time, energy prices have fallen as investor focus shifted from inadequate supply to the potential for falling demand given the high prices and

While the indexes have rallied some from their lows hit in mid-July, the underlying quality of the advance has been underwhelming, as volume has been weak and breadth has been poor. We continue to believe the U.S. equity market needs more time to digest the full extent of the credit crisis and the resultant economic slowdown. The good news is that the markets have already discounted a more diffi cult environment and, absent a torrent of negative news, we expect markets to improve over


slowing global growth. In response, energy stocks have experienced a sharp correction of 30%-40% leaving the sector attractively valued on a cash-fl ow basis. Over the next several months, we expect the market to begin to discount an economic recovery in the latter half of 2009, which should result in outperformance for the Energy sector. We remain overweight.

While the stocks in the CONSUMER STAPLES sector appear fairly valued based on the fundamentals, falling prices for some agricultural commodities may give a boost to profi ts for some packaged-food-related companies. We remain selective within the group. However, given the uncertainty in the market, we are upgrading our exposure to a slight overweight, as the sector has proven to be a safe haven during periods of market turbulence.

The CONSUMER DISCRETIONARY sector experienced the anticipated rally, as U.S. consumers spent a portion of their rebate checks on discretionary items. However, for many retailers, sales did not live up to expectations because a signifi cant portion of the stimulus was used by consumers to get current on their mortgage payments and to pay for sky-high gasoline prices. With the government stimulus in the past, attention is likely to focus on energy prices, unemployment, credit availability and the housing market for clues as to the strength of future consumer spending. Maintain underweight status.

After an extended period, the U.S. HEALTH CARE sector has begun to outperform. With economic and foreign policy issues grabbing most

REGIONAL OUTLOOK – U.S. • RAY MAWHINNEY • BRAD WILLOCK, CFA

of the attention of the presidential candidates, many investors feel health-care reform may be put on the back burner until well into 2009. We are upgrading our exposure to overweight given the attractive valuations and relative stability of the group’s earnings.

Rotation within the INDUSTRIALS sector has begun to pick up as global economic headwinds are becoming more evident. Companies in areas of greatest cyclicality such as construction, aerospace, machinery, and electrical equipment have seen increasing pressure. Meanwhile, early cycle groups such as the rails and truckers have outperformed, in part because of better fundamentals and more lately due to falling energy prices. Given the weaker economic environment, we are moving from a slight overweight to a neutral stance.

Of all the S&P 500 sectors, the FINANCIALS were the only group to exhibit true capitulation during the most recent market decline in July. In fact, since the recent low, the group has outperformed the market by a substantial margin and we would expect some consolidation to occur over the near-term. Though the worst for the sector is likely behind us, the credit environment has continued to deteriorate. As such, we are reducing our slight overweight back to underweight to reduce our risk in what is likely to be a volatile fall earnings period.

The MATERIALS sector has underperformed over the last three months as concerns about inadequate supply have given way to concerns about the prospects for a slowdown in demand as global growth slows. In addition, a sharp rally in the U.S. dollar

contributed to a sell-off in commodity prices and encouraged most investors to take some money off the table given the signifi cant outperformance the group has experienced over the past few years. We are lowering our rating to underweight from a slight overweight.

The INFORMATION TECHNOLOGY sector has outperformed over the last three months despite the overall slowdown in economic activity. In general, management teams have run their businesses conservatively since the bursting of the tech bubble and this has resulted in limited capacity expansion, low inventories, low debt and high cash levels. Valuations remain very attractive and expectations for most companies appear conservative. We maintain our overweight bias toward the group.

While remaining neutral toward the TELECOMMUNICATION SERVICES sector, it is clear the group is undergoing considerable turmoil as the threats of price competition heat up while the economic environment weakens. The stocks have underperformed by a considerable amount and already discount a good deal of negative news.

Although the long-term outlook for the UTILITIES sector remains compelling, we are downgrading our view to a slight underweight given the prospects for lower-than-expected power demand over the near-term as the economy slows. The long standing themes remain: the replacement of an aging power infrastructure, signifi cant need of more power generation capacity, and an increasing focus on clean, renewable energy.


REGIONAL OUTLOOK – CANADASTUART KEDWELL, CFA – Senior V.P. & Senior Portfolio Manager

RBC Asset Management Inc.

CANADA RECOMMENDED SECTOR WEIGHTS


AUG. 2008

BENCHMARKS&P/TSX COMPOSITE

AUG. 2008

ENERGY 31.1% 30.8%

MATERIALS 17.7% 17.3%


UTILITIES 1.6% 1.5%







398600903

13592047308246426989

1052415849

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010



S&P/TSX COMPOSITE EQUILIBRIUMNormalized Earnings & Valuations

Source: RBC AM

ECONOMIC BACKDROP

Price declines for many commodities and the abrupt rise in the U.S. dollar that occurred in the middle of the second quarter weighed signifi cantly on the performance of the Canadian equity market. Of note, oil and copper peaked mid-quarter at all-time highs around US$145 a barrel and US$4 a pound, and subsequently fell about 20% and 15%, respectively. The change in momentum in these commodities and others had a negative impact on the S&P TSX.

Estimates for economic growth around the world have been marked down again. In Canada, we now forecast underwhelming growth of 1%-2% for 2008 and 2009. While Canada faces harder year-over-year comparisons on the infl ation front as the defl ationary impacts of the GST decrease and stronger dollar subside, our expectations for infl ation remain subdued over the intermediate term. Regional disparities in economic growth remain a dominant theme, with central Canada and its manufacturing focus lagging Newfoundland and the western provinces, where petroleum predominates.

We think the fi ve-year period of Canadian dollar appreciation versus the U.S. dollar has largely run its course, although the impact on many Canadian businesses continues to be digested. Given the magnitude of the Canadian dollar’s recent pullback, we would not be surprised to see a near-term reversal.

After the recent correction in the Canadian equity market, we now

forecast attractive 12-month returns. In a period of elevated commodity prices, we continue to believe that Canadian equities can trade at the top end of our estimate of fair value.

SECTOR ANALYSIS

We are maintaining our neutral stance in the Canadian FINANCIALS sector. On the positive side, the pace and impact of negative headlines should slow as we are

now many months into this credit crisis. Further, valuations and dividend yields are attractive, and we believe the Canadian fi nancial system is weathering the storm quite well. Nevertheless, revenue headwinds are likely to persist for some time as retail banking activity looks set to slow with weaker Canadian economic growth. As before, higher loan losses and weaker wholesale activity will also continue to hold back earnings.


We are recommending an overall neutral stance in the MATERIALS sector, with a slight overweight position in basic materials and chemicals, and an underweight position in the gold sector. The MATERIALS sector was hit hard this quarter, as questions about the sustainability of the global expansion sparked concern that growth in demand for some commodities would decline. Regardless, whether it be power shortages, severe weather or government interference, the ability of companies to deliver supply anywhere near historical price levels appears limited. In addition, valuations in the sector appear to overly discount a slowdown scenario while offering a fair amount of upside when growth resumes.

Although positively positioned on a global basis, our outlook for ENERGY remains neutral given the size in the Canadian market. This quarter, oil and natural gas prices declined signifi cantly, taking the

REGIONAL OUTLOOK – CANADA • STUART KEDWELL, CFA

share prices of producing companies down with them. Valuations in the sector now refl ect levels that we believe are very close to the marginal cost of production and below current commodity prices.

INDUSTRIAL heavyweights SNC-Lavalin, Canadian National, Canadian Pacifi c and Bombardier have been strong stocks so far this year, powering through economic-slowdown concerns. While our intermediate-term beliefs remain in place – railways stand to benefi t from increased global trade and a global upswing in aerospace and infrastructure investment - our long-standing overweight in INDUSTRIALS has been tempered.

We are moving back to a neutral stance in the TELECOMMUNICATION SERVICES sector from slightly overweight. BCE rallied signifi cantly following a Supreme Court decision that paved the way for the company’s takeover to proceed,

and fi nancing was confi rmed. Competitive threats in wireless remain a credible challenge and a neutral stance balances this concern with the reasonable valuations and high levels of free cash fl ow provided by the sector.

In line with our global view on INFORMATION TECHNOLOGY, we are moving to a slight overweight in the sector. With a number of new products on shelves and a widening variety of vendors in an increasing number of countries, Research In Motion’s subscriber momentum looks set to continue. The company’s most recent product,

“The Bold,” is now available and has received strong reviews. Research In Motion, with its combination hardware and subscription business model, combines attractive and rising levels of free cash fl ow with a strong balance sheet.


REGIONAL OUTLOOK – EUROPEVITTORIO FEGITZ – Senior Portfolio Manager

RBC Asset Management UK Limited

ECONOMIC BACKDROP

The MSCI Europe Index fell more than 20% in the second quarter of 2008. In June alone, European stocks lost 1/10 of their value. Reductions in earnings forecasts did not explain the size of the fall. Although there were some high-profi le earnings misses, particularly in Financials and Consumer stocks, multiple compression, rather than profi t downgrades, accounted for the bulk of the decline. The reduction in valuations coincided with a reversal in interest rate expectations following a sharp pick-up in infl ation. The ECB raised rates while the Bank of England held rates steady, despite a 9% year-on-year fall in house prices. Evidence of a sharp slowdown reverberated across the region.

After Germany reported exceptionally strong fi rst-quarter GDP, hopes were high that continental Europe was relatively well placed to ride out the rest of 2008. But in June energy costs pushed Eurozone infl ation up to 4%, a 16-year high, while economic activity slowed across the board. The ECB appeared to confi rm that the trade-off between growth and infl ation had taken a turn for the worse when it raised rates in July by 0.25% to 4.25%, despite data showing that, in May, Eurozone industrial production had experienced its biggest monthly drop since 1992.

The strong euro and weaker global demand are crimping German exports at the same time as high oil prices are preventing the rebound in consumption that was expected following last year’s gains in investment and employment. But

Jean-Claude Trichet, the president of the ECB, remains upbeat with his prediction that the Eurozone economy will bottom in the third quarter before making "a progressive return to ongoing moderate growth" beginning in the fourth quarter. He argues that, with the exception of Spain and Ireland, corporate and consumer fi nances remain strong and that the region has largely avoided the effects of collapsing housing markets. The fi scal position

is roughly neutral, with healthy German fi nances offsetting weaker trends in France and Italy. Implicitly, he seems to welcome the slowdown in the belief that it will help prevent infl ation from feeding into pay deals. The squeeze on disposable income is desirable and inevitable if infl ation is to meet medium-term targets in the face of weakening terms of trade.

Negative economic news points to lower profi ts and earnings. On

EUROPE RECOMMENDED SECTOR WEIGHTS


AUG. 2008

BENCHMARKMSCI EUROPE

AUG. 2008

ENERGY 11.5% 10.6%

MATERIALS 9.5% 9.1%


UTILITIES 6.6% 6.9%







135201297441654970

143821323162

1980 1985 1990 1995 2000 2005 2010



EUROZONE DATASTREAM INDEX EQUILIBRIUMNormalized Earnings & Valuations

Source: RBC AM


the other hand, if the slowdown is sharp enough, interest rate expectations may swing back to neutral. Perhaps, however, what is happening in Europe is a side-show to developments in emerging markets, whose strong growth has fueled commodity-led price infl ation in developed economies. A typical example of a European developed market is the U.K., which released fi gures showing that, in June, consumer price infl ation rose to 3.8% from 3.3%. Food prices rose 9.5% year on year, and energy by 24%. Were commodity prices to fall back, so probably would U.K. infl ation.

It was therefore convenient that by mid-July commodity prices, including oil, had rolled over and investors in Europe started to move out of commodity stocks.

It is too soon to tell whether the correction in commodities will become a trend. Assuming the bull market in commodities is over, European equities offer good value. Furthermore, with the p/e of trend earnings (not actual earnings) back to levels prevailing just after the 1987 and 2001-2003 crashes, the stage is set for a sustainable rally, as multiple expansion can more than offset declines in earnings. For now, our screens favour safe sectors such as Health Care, Telecommunication Services and Information Technology.

SECTOR ANALYSIS

Following some high profi le re-capitalizations, many companies in the FINANCIAL sector rallied amid optimism that the nadir had been reached on losses from bonds linked to real estate assets. We fear, however, that as the economic slowdown gathers momentum, bad debts will start to increase in more traditional banking areas such as credit cards, auto loans and commercial real estate.

Despite appalling relative underperformance, the CONSUMER DISCRETIONARY sector continues to screen poorly. Valuations are not compelling because, so far, share prices have only just about kept pace with earnings downgrades. We are particularly concerned about the auto sector. First-half numbers triggered a relief rally but the combination of falling volumes (down 9% in June in the EU), adverse currencies and higher steel prices threaten to wipe out second-half profi ts at the same time as rising inventories hit balance sheets.

MATERIALS and ENERGY were among the biggest losers in the recent equity sell-off on pessimism that companies would experience a loss of earnings momentum as commodity prices fell. With valuations high, investors were concerned that any earnings disappointment would have

a disproportionate impact on stock prices. We still remain positive on both sectors because they continue to score well on both earnings momentum and technical screens, and the recent pull-back has not so far damaged their intermediate-term profi les.

Bull or bear market, UTILITIES have consistently outperformed since 1999 and continue to screen well. Earnings revisions remain robust thanks to rising power prices. In recent months, however, the correlation between power prices and stock prices has dropped sharply. This may refl ect rising political risk, as utilities are increasingly shouldering the blame for soaring infl ation and falling disposable incomes (referred to in the U.K. as the ‘eat or heat’ debate). In Spain, this has led to price controls, while Italy has applied a so-called ‘Robin Hood’ tax.

We have increased our exposure to HEALTH CARE. After years of relative underperformance, many sector constituents have formed a base and are now hitting three-month relative highs and, in some cases, 12-month relative highs. Many stocks have screened well on value for some time, but more recently relative earnings momentum has turned up (albeit this may refl ect slower earnings growth elsewhere).

REGIONAL OUTLOOK – EUROPE • VITTORIO FEGITZ


REGIONAL OUTLOOK – ASIAYOJI TAKEDA – Director & V.P., Asian Equities,

RBC Investment Management (Asia) Limited

are mindful, however, that producer prices rose 10% in July from a year earlier and that China’s post-Olympic economy will face challenges.

Australia is already experiencing weakness in domestic consumption after the country’s reserve bank tightened credit. However, strong commodity-related economies in the western part of the country have supported employment. Any slowdown in commodity demand from China and elsewhere would

ECONOMIC BACKDROP

Asian economies have slowed markedly in recent months, as exports weakened to all parts of the globe. While exports to the U.S. had already softened, June shipments to Europe fell for the fi rst time since 2005. This subdued volume growth, combined with higher costs, is eating into corporate profi t margins. While infl ationary pressure may be easing with lower commodity prices, central banks have not relaxed monetary policy amid concern that infl ation will take root.

Japan’s second-quarter GDP declined 2.4% on an annual basis, as exports fell year over year for the fi rst time since 2003. Exports to the U.S. and Europe are dropping and even Asian exports expanded by just 1.5% in June. CPI rose to 1.9% year over year in June, while wages remained stagnant and the employment picture continued to deteriorate. While the producer price index increased 7.1% year over year in July, the economic situation makes it diffi cult for retailers to pass along price increases to consumers. Under these circumstances, Japanese corporate profi ts are likely to decline more than 5%, matching the current analyst consensus for the fi scal year ending March 2009. However, stock prices have already corrected to levels that appear attractive in the longer term. While about half of Tokyo-listed stocks are trading below book value, the market’s average dividend yield is higher than the yield on the 10-year government bond. In addition, the government is considering policies to stimulate the economy ahead of the next general election.

In China, growth is fi nally moderating, with GDP falling for the past four quarters. Exports are slowing, although domestic consumption remained strong ahead of last month’s Olympic Games in Beijing. Since late last year, steps to fi ght infl ationary pressures have depressed the stock market and choked off credit to small and mid-sized companies and real estate markets. There are some signs that these policies are being eased to bring the economy to a soft landing. We

ASIA RECOMMENDED SECTOR WEIGHTS


AUG. 2008

BENCHMARKMSCI PACIFIC

AUG. 2008

ENERGY 2.4% 2.4%

MATERIALS 12.0% 11.7%


UTILITIES 4.3% 4.8%







507097

136189264368514717

1000

1980 1985 1990 1995 2000 2005 2010



JAPAN DATASTREAM INDEX EQUILIBRIUMNormalized Earnings & Valuations

Source: RBC AM


probably lead to interest rate easing in the near future. Medium term, this should have a positive impact, despite near-term concerns about the sustainability of economic growth.

In both Korea and Taiwan, positive expectations for the economy have not materialized after pro-business governments were elected early this year. Korea has suffered from higher energy prices, leading to a current-account defi cit this year. Moreover, the country’s president has faced tough opposition and failed to implement his aggressive promises. Taiwan’s new president is also having diffi culty meeting high expectations, and a recent scandal related to a former president may further slow policy decision-making. Both Korea and Taiwan will again depend on improvements in exports rather than a boost in domestic demand, and, as a result, growth will depend largely on global growth.

Under these circumstances, our investment stance remains generally cautious. Asian markets tend to be heavily affected by foreign investors, and while U.S. markets remain subdued, investors will be reluctant to invest more overseas. We suspect that any market recovery would be triggered by a regionwide easing in monetary policy made possible by a continued pullback in commodity prices and generally weak economic conditions. At the same time, regional growth opportunities, particularly in China and other emerging markets, may surface.

SECTOR ANALYSIS

We remain underweight the FINANCIAL SECTOR because of a weakening

REGIONAL OUTLOOK – ASIA • YOJI TAKEDA

economic backdrop. Although U.S. subprime-related losses are small, recent monetary tightening and slower exports are hurting small and mid-sized companies in the region, and many banks are dealing with increases in non-performing loans. Moreover, banks are not seeing the improvement in interest rate margins that we had expected. Brokerage and investment banking will also suffer from a decrease in capital-markets activity. The real estate sector is under particular pressure on concern that land prices may fall.

Our position in INDUSTRIALS remains overweight. Transportation services and niche products remain solid with strong cash fl ows, though we would avoid capital-investment-related companies because of weakening global economic growth.

INFORMATION TECHNOLOGY remains at overweight. The sector, which remains the key driver of Asian manufacturing, is the most sensitive to any sign of easing in monetary policy. Inventory levels appear healthy and valuations are attractive.

Things do not seem to be improving in the CONSUMER DISCRETIONARY and we remain underweight. Auto-related businesses face tough conditions in the U.S. and Japan, and retailers in the region must deal with stingier consumers. That said, valuations are becoming attractive, and it is important to keep in mind that Asian consumers are not as stretched as those in the U.S.

We remain overweight the MATERIALS sector, though we are not as optimistic as we were last quarter. With a global economic slowdown in process,

commodity prices are likely to remain in a range, at least for the near term, and stock prices have already fallen signifi cantly. Longer term, commodity demand from China and other emerging markets should remain strong. Mergers and acquisitions in the sector are likely to continue.

Our view of the CONSUMER STAPLES sector stays at neutral. While profi t margins are narrowing because of higher material costs, companies in this sector are generally considered defensive, especially those with the ability to raise prices without sacrifi cing too much in sales.

We are cutting our rating on the TELECOMMUNICATION SERVICES sector to underweight from neutral. Subscriber growth in China has slowed in a maturing market. Although earnings growth remains robust, momentum is fading. Markets in Japan and Australia are mature.

Our position in UTILITIES drops to underweight from overweight. Rising raw-material costs and regulatory price caps are eroding margins.

The HEALTH CARE sector moves to overweight from underweight. The sector presents growth potential regardless of economic conditions. High dividend yields make some companies in the sector attractive.

The ENERGY sector rating stays at neutral. Oil prices seem to have peaked in the near term, and refi ners in Asia continue to suffer from profi t-margin pressures amid tougher competition in many markets in the region.


DANIEL E. CHORNOUS, CFACHIEF INVESTMENT OFFICER,RBC ASSET MANAGEMENT INC. ANDPHILLIPS, HAGER & NORTH INVESTMENT MANAGEMENT LTD.

CHAIR, RBC INVESTMENT STRATEGY COMMITTEEDan Chornous is Chief Investment Officer of RBC Asset Management, Canada’s largest single mutual fund family, with over $94 billion in domestic and global equity and fixed income mandates, including the Royal Mutual Funds group of products. Effective May 1, 2008, Dan was also named Chief Investment Officer, Phillips, Hager & North following its merger with RBC AM, a combination that boosted total assets under management to $160 billion. Dan is responsible for the overall direction of investment policy and fund management. In addition, he chairs the RBC Investment Strategy Committee, the group responsible for global asset mix recommendations and global fixed income and equity portfolio construction for use in RBC Investments’ key client groups including RBC Funds, International Wealth Management, RBC Dominion Securities and RBC Private Counsel. Dan serves on the Board of Directors of the Canadian Coalition for Good Governance and is also chair of its Public Policy Committee.

Jim has been in the investment business for 38 years, as both a research analyst and portfolio strategist. He is currently a director of RBC Investments and also Vice-Chair of the RBC Capital Markets Investment Strategy Committee. Through his 33 years at RBC Dominion Securities (and predecessors), Jim has played a key role in developing investment policy for the firm and translating that into solutions for individual clients. He presents extensively on the topic.

Patti’s experience in the investment-management industry spans almost three decades. She spent 16 years on the sell side, and was a top-ranked sell-side economist before joining Canada Trust in 1996 as Chief Economist and member of the firm’s asset-allocation strategy committee. In 1998, Patti joined Sceptre Investment Counsel as Chief Economist. In this role, she managed portfolios for private and institutional clients, and later became head of the firm’s asset-mix committee. In 2004, Patti joined PH&N as Chief Economist. She is responsible for PH&N’s global macroeconomic research and outlook, is part of the asset-mix team overseeing $15 billion in balanced mandates and manages institutional portfolios. She is a frequent public speaker and commentator on economic issues, and is quoted regularly in print and electronic media.

MEMBERS


Janet has more than 24 years of experience in the securities industry. She joined Tucker Anthony, later RBC Dain Rauscher, in 1982. Over the course of her career, she has held the positions of Director of Equity Research for Sutro & Co. and Director of Equity Strategies for Tucker Anthony. In 2002 she was named Director of the Private Client Group at RBC Dain Rauscher, now RBC Wealth Management, where she is also a member of the Director’s Circle and the RBC Investment Strategy Committee.

Dagmara Fijalkowski joined RBC Asset Management's Global Fixed Income & Currencies Team in 1997, and has been a portfolio manager since 2000. During her tenure, Dagmara has developed an expertise in currency management. Today she oversees foreign-exchange hedging and active currency-management programs for RBC AM's fixed-income and equity funds, and co-manages several of the firm’s bond portfolios. Dagmara has been a member of RBC AM’s Investment Policy Committee, a key forum for the discussion and implementation of North American investment policy, since 2003. She is also a member of the RBC Investment Strategy Committee.

PATRICIA CROFT CHIEF ECONOMIST, PHILLIPS, HAGER & NORTH INVESTMENT MANAGEMENT LTD.

DAGMARA FIJALKOWSKI, MBA, CFA VICE-PRESIDENT & SENIOR PORTFOLIO MANAGER, GLOBAL FIXED INCOME & CURRENCIES RBC ASSET MANAGEMENT INC.

JIM ALLWORTHPORTFOLIO MANAGER, RBC ASSET MANAGEMENT INC.

JANET L. ENGELSSENIOR V. P. AND DIRECTOR, PRIVATE CLIENT RESEARCH GROUP RBC WEALTH MANAGEMENT


GEORGE RILEY, FSI HEAD GLOBAL INVESTMENT SOLUTIONS, RBC GLOBAL PRIVATE BANKING

Stu Kedwell began his career with RBC Dominion Securities in the firm’s Generalist program and completed rotations in the Fixed Income, Equity Research, Corporate Finance and Private Client divisions. Following this program, he joined the RBC Investments Portfolio Advisory Group and was a member of the RBC DS Strategy and Stock Selection committees. He later joined RBC Asset Management as a senior portfolio manager and now manages the RBC Canadian Dividend Fund, RBC North American Value Fund and a number of other mandates. He is co-head of RBC Asset Management’s Canadian Equity Team and a member of the firm’s Investment Strategy Committee.

Martin Paleczny, with 12 years of experience in the investing field, began his career at Royal Bank Investment Management, where he developed an expertise in derivatives management and created a policy and process for the products. He also specializes in technical analysis and uses this background to implement derivatives and hedging strategies for equity, fixed income, currency and commodity-related funds. Since becoming a portfolio manager, Martin has focused on global allocation strategies for the full range of assets, with an emphasis on using futures, forwards and options. He also serves as advisor to the RBC Investment Strategy Committee for technical analysis.

MEMBERS

STUART KEDWELL, CFASENIOR V. P. & SENIOR PORTFOLIO MANAGER, RBC ASSET MANAGEMENT INC.

George has more than 30 years experience in the Financial sector, with over 18 years of investment experience. He is a Fellow of the Securities and Investment Institute. Prior to joining RBC, he worked with Lloyds Bank International in their trust businesses in the British Isles and Monaco. George joined Royal Bank of Canada in 1985 and moved to Guernsey where he was appointed Director of Royal Bank of Canada Investment Management (Guernsey) Limited in 1993. In March 2000, he moved to Geneva, Switzerland, where he was appointed Chief Investment Officer of Royal Bank of Canada (Suisse) in June 2002. In January 2006 George was appointed Head Global Investment Solutions and relocated to Guernsey.

Jason joined RBC Asset Management in 2005 and is responsible for spearheading the Firm’s institutional-investment management business. His career at RBC Financial Group dates from 1998, when he joined the retail bond desk at RBC Dominion Securities. In 2001, Jason moved to the Fixed Income Portfolio Advisory Group, where he was responsible for structuring portfolios for high-net-worth clients, writing economic and credit commentary, and formulating trade recommendations. Jason was elevated to Vice President in 2003 and assumed management responsibility of the Fixed Income Portfolio Advisory Group and the retail bond sales and trading desk. He is a member of the RBC Investment Strategy Committee and the Investment Policy Committee.

MARTIN PALECZNY, CFAV. P. & SENIOR PORTFOLIO MANAGER, RBC ASSET MANAGEMENT INC.

JASON STORSLEY, CFA SENIOR V.P., INSTITUTIONAL PORTFOLIO MANAGEMENT AND DIRECTOR, GLOBAL EQUITY RESEARCH, RBC ASSET MANAGEMENT INC.


GLOBAL EQUITY HEADS

Ray Mawhinney Senior V.P., U.S. & Global Equities RBC Asset Management Inc.

Yoji Takeda Director & V.P., Asian EquitiesRBC Investment Management (Asia) Limited

Dominic Wallington Chief Investment Offi cer & Chief Executive Offi cerRBC Asset Management UK Limited

Paul Johnson V.P. & Senior Portfolio Manager, Global EquitiesRBC Asset Management Inc.

GLOBAL EQUITY ADVISORY COMMITTEE

Chris Beer, CFA V.P. & Senior Portfolio Manager, Canadian & Global EquitiesRBC Asset Management Inc.

Cameron Hurst Associate Portfolio Manager, U.S. Equities (Financials)RBC Asset Management Inc.

Henry Kwok Senior Analyst, Global Equities (Health Care & Consumer Staples)RBC Asset Management Inc.

Stuart Morrow, CFA Senior Analyst, Global Equities (Financials & Consumer Discretionary)RBC Asset Management Inc.

Martin Paleczny, CFA V.P. & Senior Portfolio Manager, Asset Allocation & DerivativesRBC Asset Management Inc.

Cameron Scrivens V.P. & Senior Portfolio Manager, U.S. Equities (Health Care & Technology)RBC Asset Management Inc.

Robert Silgardo, CFA Senior Analyst, Global Equities (Telecommunications & Technology)RBC Asset Management Inc.

Janice Wong, CA, CFA Senior Analyst, Global Equities (Industrials & Utilities)RBC Asset Management Inc.

GLOBAL FIXED INCOME & CURRENCIES ADVISORY COMMITTEE

Soo Boo Cheah, MBA, CFA Portfolio Manager, Global Fixed Income & CurrenciesRBC Asset Management Inc.

Patricia Croft Chief Economist Phillips, Hager & North Investment Management Ltd.

Dagmara Fijalkowski, MBA, CFA V.P. & Senior Portfolio Manager, Global Fixed Income & CurrenciesRBC Asset Management Inc.

Suzanne Gaynor V.P. & Senior Portfolio Manager, Global Fixed Income & CurrenciesRBC Asset Management Inc.

Robin Gullason, CFA V.P., Fixed Income Portfolio Advisory Group RBC Dominion Securities Inc.

Jason Storsley, CFA Senior V.P., Institutional Portfolio Management & Director, Global Equity Research RBC Asset management Inc.



This information has been provided by RBC Asset Management Inc. and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, fi nancial or other advice and such information should not be relied upon for providing such advice. RBC Asset Management takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed.

Due to the possibility of human and mechanical error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC Asset Management is not responsible for any errors or omissions contained herein. RBC Asset Management reserves the right at any time and without notice to change, amend or cease publication of the information.

Any investment and economic outlook information contained in this report has been compiled by RBC Asset Management Inc. from various sources. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC Asset Management Inc., its affi liates or any other person as to its accuracy, completeness or correctness. RBC Asset Management Inc and its affi liates assume no responsibility for any errors or omissions.

©Copyright 2008. This report may not be reproduced, distributed or published without the written consent of RBC Asset Management Inc. RBC Asset Management provides wealth management services and is a Member Company under RBC. RBC Asset Management Inc. and Royal Bank of Canada are separate corporate entities, which are affi liated. ® Registered trademark of Royal Bank of Canada. Used under license.

A NOTE ON FORWARD-LOOKING STATEMENTS

This report may contain forward-looking statements about the Fund, its future performance, strategies or prospects, and possible future Fund action. The words “may,” “could,” “should,” “would,” “suspect,” “outlook,” “believe,” “plan,” “anticipate,” “estimate,” “expect,” “intend,” “forecast,” “objective” and similar expressions are intended to identify forward-looking statements.

Forward-looking statements are not guarantees of future performance. Forward-looking statements involve inherent risks and uncertainties, both about the Fund and general economic factors, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made in relation to the Fund. These factors include, but are not limited to, general economic, political and market factors in Canada, the United States and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological changes, changes in laws and regulations, judicial or regulatory judgments, legal proceedings and catastrophic events.

The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith but without legal responsibility.



® Registered trademark of Royal Bank of Canada. RBC Asset Management is a registered trademark of Royal Bank of Canada. Used under license.

© RBC Asset Management, Inc. 2008. All rights reserved.

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