Tipping points global perspectives on navigating the great divergence

With this goal in mind, we partnered with the Economist Intelligence Unit for our third survey of more than 400 capital markets participants to gather sentiment as the industry moves awa

A survey and report created with

Tipping Points

Global perspectives on navigating “The Great Divergence”

About RBC Capital Markets

RBC Capital Markets is a Premier Investment Bank that provides a focused set of products and services to institutions,

corporations, governments and high net worth clients around the world With over 3,300 professional and support staff,

we operate out of 75 offices in 15 countries and deliver our products and services through operations in Asia and

Australasia, the U.K and Europe, and in every major North American city

We work with clients in over 100 countries around the world to help them raise capital, access markets, mitigate risk, and acquire or dispose of assets According to Bloomberg, we are consistently ranked among the top 20 global investment banks RBC Capital Markets is part of a leading provider of financial services, Royal Bank of Canada (RBC) Operating since 1869, RBC has more than USD711 billion in assets and one of the highest credit ratings of any financial institution – Moody’s Aa1 and Standard & Poor’s AA-

About The Economist Intelligence Unit

The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of The Economist Through its global network of 650 analysts, it continuously assesses and forecasts political, economic and business conditions in more than 200 countries As the world’s leading provider of country intelligence, it helps

executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies

Printed January 2011

Table of Contents

Our economic landscape has been evolving at a rapid pace over the last three years As the global community becomes more intertwined, institutional investors and corporate executives must address the increasingly complex implications

of local and regional challenges around the world At RBC Capital Markets, we strive to provide our clients with the most relevant information and insightful perspectives to help them navigate the markets and find opportunity

With this goal in mind, we partnered with the Economist Intelligence Unit for our third survey of more than 400 capital markets participants to gather sentiment as the industry moves away from the legacy mindset of the past 30 years The purpose

of our poll was to gauge the consensus outlook, examine deviations from the consensus and discover how investors plan

to turn these expectations into action

This white paper is the result of survey work conducted at the turn of the New Year It reveals interesting insights into

a “Great Divergence” in our global economy, fundamentally driven by opposing scenarios in economic growth, sovereign debt, currencies and fiscal policy By capturing market sentiment via survey results and interviews, this report illuminates

the intricacies of these issues and their implications for investors

We would like to thank the individuals who are quoted in this report for their valuable time and insights:

Michael Ben-Gad, Professor of Economics, City University London

Quentin Fitzsimmons, Executive Director and Head of Government Bonds and Foreign Exchange, Threadneedle

Lena Komileva, Head of G7 Market Economics, Tullet Prebon

Jonathan Lemco, Principal, Vanguard

Pippa Malmgren, President and Founder, Canonbury Group and Principalis Asset Management

Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management, Prudential Financial

Andrew Rozanov, Managing Director and Head of Sovereign Advisory, Permal

Robert Talbut, Chief Investment Officer, Royal London Asset Management

We hope you will find the report insightful

Co-Head of Global Research Co-Head of Global Research

Foreword

It is a truism that the planet’s economy has become more connected even as global imbalances have grown more severe In today’s volatile world – which combines abundant liquidity with extreme and potentially long-lasting divergences across markets – investors are pondering both the outlook for the coming year and the intermediate-term end-game

They are specifically questioning:

• To what extent will the large gap in growth between emerging and developed markets – with its attendant effects on capital flows and asset prices – continue?

• Sovereign debt restructuring on the European periphery and elsewhere appears inevitable When will it occur and what market fallout will

it generate?

• Looking out five years or more, a large proportion of market participants expect the dollar to relinquish its role as the primary global reserve currency Will the euro’s problems enable the dollar to retain its primacy beyond this horizon?

• Can the U.S continue to borrow and spend while almost all other developed countries embrace austerity? If so, for how long? What would be the effect of another economic downturn on deficits in developed countries?

All of these questions are unresolved, but one thing is certain: Building a portfolio that generates excess returns requires stepping outside the legacy mindset of the past 30 years Two previous RBC Capital Markets white papers examined the transition from the “great moderation” that began in the 1980s through the financial crisis to the post-crisis world of today.1

To discover how institutional investors, financial institutions and large corporations are emerging from the old and adapting to the new, RBC Capital Markets enlisted the Economist Intelligence Unit to interview a range of investors and survey 461 financial market participants The objective was

to gauge the consensus outlook, examine deviations from the consensus, and discover how investors intend to turn these expectations into action Key findings are as follows:

Emerging markets and their risks In both the survey and the interviews, location predicts sentiment Optimism abounds on prospects for emerging and resource-rich economies, with the highest hopes focused on the non-BRIC

Executive Summary

1 Raising Capital in a New Era

(September 2009) and

The New “Normal”: Implications of

Sovereign Debt and the Competition

for Capital (June 2010).

frontier markets The consensus is so strong that it lends credence to the idea

of an emerging markets bubble, with a fire hose of capital aimed at a limited

pool of financial assets If the emerging markets are flooded with more capital

than they can immediately use, valuations will outrun fundamentals and the

markets will eventually drop

New skill sets are required In contrast to the situation a year ago, much of

today’s portfolio risk is driven by sovereign risk Prudential Financial Managing

Director Arvind Rajan points out that as sovereign risk rises, it tends to become

the common factor that drives all other portfolio risks Therefore, the ability

to analyze sovereign risk is essential – and it requires a broader base of skills

than many portfolio management firms currently possess The skill set includes

expertise in government financing strategies, multilateral lending agencies, the

banking sector, the CDS market and political scenarios In addition, the loss of

credibility by rating agencies has contributed to a trend of bringing more credit

analysis in-house

Sharper pricing of risk Risk has not been priced accurately in the past, to put

it mildly, and skepticism has grown around traditional methods of evaluating

risk, including snapshots of fundamentals, rating agency judgments, confidence

intervals and assumptions about government backstops Capital preservation

requires a more conservative approach to the potential for extreme events

The impact of fiduciary frameworks Downgrades could limit the ability to

hold sovereign debt among large institutional investors facing investment

mandates On the other hand, the new Basel III accord will require banks

to hold more capital and liquidity buffers, which will result in a mandate to

hold more asset classes that have historically presented low risks, such as

sovereign debt This change would boost the demand for bank holdings of

government debt, even if the credit quality is below that of sovereigns

Assigning a value to liquidity The dollar may not be the best measure of value,

but it is undeniably the most liquid medium of exchange This liquidity has

a higher value than it used to, which explains the reluctance of many sovereign

wealth funds to dramatically scale back their holdings of the dollar and

U.S Treasuries Portfolios are judged to be more volatile than they used to

be, with a wider range of scenarios on either side of the expected value

The funds also face a wider range of potential calls on their liquidity – for

instance, to bail out local banks, companies or governments Fund managers

are building in more diversification to stabilize values, and they are placing

more weight on liquidity

In today’s volatile world – which combines abundant liquidity with extreme and potentially long-lasting divergences across markets – investors are pondering both the outlook for the coming year and the intermediate-term end-game.

About the Survey

• Within financial

services, 31% are

from commercial

banks, 26% from asset

management firms

or institutional

investors and

18% from investment

banks; the rest work

at hedge funds or

private equity funds

The average asset

size is US$275bn

• The top industries among non-financial respondents are manufacturing, the public sector, professional services, energy and technology

Average annual revenues are US$3-4bn, with a range of US$750m to over US$100bn

• The executives polled are quite senior, with 36% coming from the C-suite and another 58% at or above the VP/Director level

• Respondents came primarily from North America and Western Europe, with 38% from each region 14% reside

in the Asia/Pacific region, and 9%

came from Eastern Europe, Latin America, the Middle East and Africa

The Economist Intelligence Unit polled 461 capital markets participants on behalf of RBC Capital Markets in a survey

that closed in January of 2011 Of the respondents, 211 come from the financial services industry and 250 from

non-financial organizations

Although the economic crisis appears to have passed,

the nations of the world are diverging on multiple levels

From the dynamic BRIC economies to the debt-burdened

nations of the European periphery, economies are diverging

in terms of economic growth, creditworthiness and fiscal

policies And in this two-track global economy, it is the

slower-growing developed nations that are the most fiscally

constrained, have the greatest need for austerity and face the

most difficult prospects for regaining their economic health

As a result, investors are breaking free of past orthodoxy

and viewing alternatives in light of new realities One

manifestation is capital chasing higher yields, rising asset

values and appreciating currencies of emerging markets

Another is the skepticism around notions such as confidence intervals and mean reversion, which offer the promise of mitigating risk but become difficult to apply in the face of fundamental shifts in market conditions Also under fire is the notion of – in the words of a fixed-income executive at a large London asset manager – “a world where friendly, big-brother style bailouts always happen.”

The fuel for financial markets is confidence, an ingredient in short supply when asset values are diverging By assessing the fundamental factors driving this Great Divergence, and taking the pulse of the market via survey results and interviews, this report aims to clarify the decisions faced by global investors

The most obvious divergence is in economic growth rates In its December 2010

Global Outlook, the Economist Intelligence Unit highlighted the varying pace of

the recovery Although global growth is forecast at 3.8% in 2011, stark underlying

differences between developed and developing markets are expected to persist

While the advanced (OECD)2 economies are forecast to expand by 1.8% in 2011,

growth outside the OECD is projected to be 6.3% in the same period.3

Among respondents to the survey, a greater proportion expects conditions to

improve rather than deteriorate in major regions of the world – with the exception

of Japan (see Chart 1) But it is clear that the recovery will proceed at multiple

speeds While respondents are in strong agreement that the prospects for China,

India and developed Asia remain bright, there is much greater ambiguity about

the outlook for the rest of the world

Survey respondents are less sanguine with respect to the developed world

With the exception of Japan, pluralities – not majorities – expect better prospects

for 2011 in the developed world In Japan, a plurality expects no change, and

more think that the economy will deteriorate than improve

2 Organisation for Economic Co-operation and Development

3 Economist Intelligence Unit forecasts as of January 2011

Chart 1 Over the next year, what change do you expect to the prospects for economic growth in the

following regions?

Chart shows the proportion of respondents who expect an improvement in prospects minus those who

expect a deterioration

Japan Europe North America Middle East Africa Russia China

Other developed Asia

(Hong Kong, Singapore, South Korea)

71%

70%

65%

32%

31%

19%

4%

–3%

Proportion of respondents that expects an improvement in prospects minus respondents that expect a deterioration

30%

India

0%

The Great Divergence: Economic growth

Chart 2 From 1998 to 2008, the U.S economy grew in real terms at an average rate of about

2.7% per year Over the next decade, how do you expect this rate to change, if at all?

Much higher Higher

No change Lower Much lower Don’t know

2%

14%

18%

53%

12%

1%

Percentage of respondents

Chart 3 How do you expect the real growth rate in your country over the next decade to

compare with the rate from 1998 to 2008?

Chart shows the proportion of respondents who expect a higher than average rate minus those who expect

a lower than average rate

There is also a clear bifurcation between developed and

developing economies Chart 2 shows that most market

participants think that U.S growth in the coming decade

will be below that of the last decade Chart 3 confirms the

expectation of below-trend growth rates in the U.S., as well

as the European periphery and the rest of Western Europe The reverse is true for Asia-Pacific, Canada, the BRICs and other emerging markets

European periphery 16%

Europe ex-periphery 35%

U.S.

37%

U.K.

53%

Proportion of respondents that expects a higher than average rate minus respondents that expect a lower than average rate

Higher growth Lower growth

The imposition of fiscal austerity measures, of the scale required to service debt

in Greece and Ireland, means that it will be difficult for those countries to grow

their way out of the crisis The concern is a persistent downward spiral of higher

levels of debt leading to slower growth and a further withdrawal of assets,

resulting in more losses on bank balance sheets

“What these EU and IMF bail-outs are essentially asking those countries to do

is to put their economies into permafrost for a very long period of time,” says

Robert Talbut, Chief Investment Officer at Royal London Asset Management

“What’s more, there is no guarantee that, in three years’ time, those economies

will be in a position whereby their citizens will be able to say that it was worth

taking the pain Ultimately it’s inevitable that some form of debt forgiveness will

have to occur.”

Even in countries less severely affected by debt problems, the poor state

of public finances means that the role of government is changing “The social

contract between the public and government is being renegotiated,” says

Pippa Malmgren, President and Founder of the Canonbury Group and Principalis

Asset Management “The scale of the problem means that many people will be

forced to retire later than they expected for a lower standard of living than they

ever anticipated Public services and benefits that people have come to expect

will no longer be available.” The confrontations involving trade union and public

sector workers in Greece, Portugal, Spain and Ireland may be just the beginning

Flat growth, or a tumble back into recession, will dramatically accelerate the

prospects of debt restructuring in these economies “Many people consider

a potential restructuring in the coming years to be inevitable, simply because

they don’t believe that Greece can grow its way out of such a large debt,

particularly with the fiscal austerity measures that have been forced upon it,”

says Arvind Rajan, Managing Director and Head of Quantitative Research and

Risk Management for the U.S.-based fixed income business of insurance and

investment management giant, Prudential Financial “While debt restructuring

may be more painful initially for existing bondholders, it is perhaps an outcome

that, combined with the budget consolidation in progress, provides a more

definitive solution to the long-term problem.”

So if debt restructuring is the inevitable outcome of crisis in the Eurozone, why

not embark on the process now, given that we don’t have a sustainable position?

The problem essentially comes down to an unwillingness to accept the inevitable

and the consequences that debt restructuring is likely to entail in terms of

further recapitalisation of the European banking system And the reluctance of

policymakers to adopt long-term measures aggravates the loss of confidence

in developed-world sovereign debt A funding crisis looks increasingly likely for

some sovereigns, particularly when the scale of debt that is maturing over the

next year is taken into account (see Chart 4)

“If you think it has been tough to secure funding in Europe this

year, it will be even tougher next year,” says Mr Talbut

“While [Greek] debt restructuring may

be more painful initially for existing bondholders, it is perhaps an outcome that, combined with the budget consolidation in progress, provides

a more definitive solution to the long-term problem.”

Arvind Rajan,

Prudential Financial

The Great Divergence: Sovereign debt

Source: IMF Global Financial Stability Report

Chart 5 In your country, will the national government experience a funding shortfall

over the next one to three budget cycles? If yes, how severe will it be?

Chart 4 Sovereign gross funding needs as percentage of projected 2011 GDP

U.K.

European periphery

Canada Other (MEA, Latin America, Eastern Europe)

U.S.

Asia/Pacific excluding India, China

BRICs European ex-periphery

11%

55%

6%

59%

17%

33%

12%

37%

14%

34%

7%

25%

9%

23%

9%

16%

Yes, and the government will fund the shortfall, but with difficulty Yes, and the government will be unable to fund the shortfall

60%

Percentage of respondents

Although almost all respondents believe that governments

will be able to finance themselves over the next one to three

budget cycles, they do not expect the fundraising process

to be easy More than half expect that the nations of the

European periphery will face difficulties in funding their shortfalls A similar proportion expects the U.K to face the same challenges (see Chart 5)

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

Korea

Australia Sweden Slovenia Austria Finland

New Zealand Denmark Slovak Republic

Germany Czech Republic United Kingdom

Canada Ireland Netherlands

Spain Portugal France Belgium Italy Greece

United States Japan

Debt Maturing Oct 2010 to Dec 2011 (% of projected 2011 GDP)

General Government Fiscal Deficit 2011 (% of GDP)

Norway