Quarterly Investment Outlook January 2016

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Quarterly Investment Outlook January 2016 January 29, 2016 Summary The struggle for return in asset markets in the past year is payback for the earlier multi-year period of performance far above

1 Quarterly Investment Outlook January 2016 January 29, 2016 Summary The struggle for return in asset markets in the past year is payback for the earlier multi-year period of performance far above normal. Global growth is headed a little weaker, though a slump is unlikely. Adding to this worry is more pain from currency divergences. Markets are again pushing back the timing of interest rates rises. Cheap oil alone will not ensure a big delay, so some caution is due. Yield curve flattening at such low short-term interest rates is overdoing the pessimism. US credit has re-priced more attractively than equities, even though the benefits for investors will only surface when risk aversion fades. Changed Chinese currency policy has been a spoiler for emerging currencies recently. It will delay, not prevent a rebound. Value's trouncing as an equity style has its counterpart in the long life of low bond yields. Its comeback needs a clear ascent in yields. Equities are still not a buy from a medium-term risk-adjusted return viewpoint. Valuations are a little lower but not a draw yet. The US dollar is no longer a one-way bet. We expect a bit more strength and more volatility was a 'no return' year Last summer's falls in equities were quickly recovered in October but it has been a bumpier ride since. Another large drop arrived at the turn of the year. Triggers for the summer turbulence and now are similar sliding commodities, China and potentially weaker growth. The correct view is that these were just catalysts for the inevitable, a challenged period for asset returns. Stellar performance over required some payback. Last year's flat returns were disappointing but not unexpected. Is global growth starting to slow? Clouds have gathered over the global growth outlook. We know that global growth is weaker in the post-crisis era, but now there is a bit more fragility, coming from the cumulative impact of China's slowdown since 2012 and the commodity collapse in Global investment, trade and manufacturing have slid over the past year. This may just be starting to hit overall economic growth now, going by recent economic data disappointments in the US. China has not decelerated much in the past year, and is far from a 'hard landing'. However, its contribution to global growth is clearly far lower than the past, with only a stabilization expected from here. All this adds up to some slowing in global economic activity, though talk of a slump or recession is too alarmist. Cheap oil will ultimately help the global economy and low interest rates are supportive. 1

2 'currency war' strains are a major cause of risk aversion The other key player in market concerns is currency. Growth challenges where interest rates are very low and government debt at high levels, mean that currency has become far more important as a policy lever to secure economic advantage, a disguised 'currency war'. Japan and Europe, using extraordinarily easy monetary policy have been 'winners'. The US, the UK (more so since 2013) and China are 'losers' (see chart). These divergences are now being challenged. The pound has begun to weaken; in China, the authorities now prefer mild depreciation to more strength; the US central bank says it is now looking at the US dollar in setting interest rates. Why is this? Because such large currency moves have had large economic effects. Dollar strength has dampened the US economy and hurt corporate profits with similar impacts for the UK. China is more complex, but currency strength is hurting already sluggish growth. We think a breaking point will come when divergences narrow sharply, which will bring the dollar down again, but this is unlikely to happen in the near term. What is very apparent is that currency uncertainties are likely to continue to weigh on risky assets. Zero interest rate world continues? Bond markets are at increasing odds with the US Federal Reserve's guidance. The first interest rise has come, but markets strongly disbelieve the Federal Reserve's view of several rate rises arriving in Weaker global growth could vindicate markets, but there are two way forces at work here. US unemployment has fallen markedly and inflation, excluding energy prices, has crept up. Yes, low oil prices will pull inflation lower for now, but once oil stabilizes, inflation will rise. If alarm over global growth proves overdone, rate views could adjust quickly, reversing the recent drift towards lower global bond yields. Yield curve flattening Recent market turmoil and signs of a mild US growth slowdown are contributing to a further flattening in the yield curve. The slope of the 10 year duration Treasury yield relative to a 2 year duration yield is now very shallow (see chart). What is this telling us? In the pre-crisis world, with interest rates well above zero, it usually signaled the approach of economic weakness and the growing likelihood of interest rate cuts. However, with rates currently only just above zero, the message is rather extreme. It implies the Federal Reserve either staying on hold or even reversing the small rate increase seen late last year. This is a very different message to what the Federal Reserve has communicated only very recently. This dichotomy of interest rate views signals further volatility. The problem is that this bond market view is also consistent with a fairly negative outlook for risky assets. Alternatively, the market is proven to be a bit too pessimistic. Our view inclines towards the latter, though we think the pace of rate increases will still be very gradual. Source: DataStream US credit markets are better placed than equities The energy sector shock to credit markets, more so in the US, has led to an early and stronger re-pricing of credit relative to equities. Credit spreads now appear cheap against history, whereas even after recent market falls, equities appear at best neutral. 2

3 Our long-held caution on risky assets has been tempered since late last year by the reassurance that higher credit risk premiums now available in both investment and sub-investment grade (high yield and loans) should support medium-term performance, provided a recession is avoided. So far, this is more a US, not a European/UK story. Of course, in a risk-averse environment, even better valuations should merit only a mild pro-us credit stance. Emerging currency pressures linger Emerging currencies have fallen to lower levels than we expected, largely because of the massive commodity collapse. Does this improve the potential for a rebound? The answer is yes but it may not be immediate. Near-term, the changed Chinese RMB currency stance is a drag. Later, if, as we expect, broad dollar strength starts to be challenged, emerging currencies could gain support. Our view is that a rebound will come, but it looks to be coming from lower levels and at a later date. Sovereign dollar debt preferred to corporate Within dollar emerging debt, sovereign credit is better placed than corporate credit given weaker growth and pressured corporate cash flow. Equity 'value' will only come back when bond yields rise 'Value' as a style has been persistently trounced in equity markets in recent years. It is not difficult to see why. Given the poor attractions of cash and bonds, investors have stayed with equity markets, but sought to hedge their equity risk by being defensive with sector exposures. Poor news flow in energy, resources and financials, pillars of the value style, have aborted each attempted recovery. By contrast, so-called 'bond proxies', stocks with steadier profits and attractive dividend yields, are in brisk demand. The contrasting fortunes of two 'smart beta' style indices a global value (RAFI) index and a minimum volatility index with a good proportion of bond proxies, shows value's struggle well (see chart). When will value return to favor? A key indicator to watch is bond yields. As and when there is a concerted rise, and we are still waiting, it will be value's turn to shine. Bond proxies will then be far less sought after. US commercial property less hot We see US commercial real estate now entering a mature phase of the cycle with lower returns now likely. Though rents should still be supported by high occupancy rates, price appreciation has probably run its course in the aggregate though sizable regional variations will of course continue. Valuations now appear expensive on a standalone basis from looking at capitalization rates, even though they appear attractive relative to bond yields. We still expect reasonable returns in the mid-single digits over the next few years. These will still look good on a risk-adjusted basis, but overall a more defensive approach in real estate selection looks reasonable to consider. The dollar is now more finely balanced We see the drivers of the US dollar more finely balanced now. Tighter monetary policy and stronger growth in the US relative to other regions are the main supports to the dollar. On the other hand, the dollar now looks somewhat expensive, US interest rates are likely to rise more slowly than was thought likely a year ago, and the US continues to run a current account deficit. Overall, we think the dollar will strengthen more, though the majority of the appreciation is probably behind us. Even if the dollar does not strengthen much more, currency volatility is likely to stay high. 3

4 Appendix: Index Definitions S&P 500 Index The market-cap-weighted index includes 500 leading companies and captures approximately 80% of available market capitalization. Russell 2000 Index - The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. MSCI EAFE Index $ - The MSCI EAFE Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in USD dollar terms. MSCI EAFE Index (Hedged) - The MSCI EAFE hedged Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in hedged dollar terms. MSCI Emerging Markets Index The MSCI Emerging Markets Index captures large and mid-cap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country and is measured in USD terms. Barclays Capital Aggregate Index - The Barclays U.S. Aggregate Index represents securities that are SECregistered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and assetbacked securities. HFRI: The Hedge Fund Research, Inc. Monthly Indices (HFRI) are fund-weighted (equal-weighted) indices. Unlike asset-weighting, the equal-weighting of indices presents a more general picture of performance of the hedge fund industry. Any bias towards the larger funds potentially created by alternative weightings is greatly reduced, especially for strategies that encompass a small number of funds. All single-manager HFRI Index constituents are included in the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database. 4

5 Contact Information Tapan Datta Head of Aon Hewitt Limited +44 (0) Legal Disclosures and Disclaimers Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. ( AHIC ). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC s understanding of current laws and interpretation. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon AHIC s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. AHIC disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. AHIC. reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of AHIC. Aon plc All rights reserved. About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.7 trillion as of June 30, More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $3 million to $310 billion. AHIC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. AHIC is also registered with the Commodity Futures Trade Commission as a commodity pool operator, and is a member of the National Futures Association. The AHIC ADV Form Part 2A disclosure statement is available upon written request to: Aon Hewitt Investment Consulting, Inc. 200 E. Randolph Street Suite 1500 Chicago, IL ATTN: AHIC Compliance Officer 5

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