What s in store for investors in 2018?

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1 What s in store for investors in 2018? If the previous 18 months brought political upheaval, the next could bring an equally significant shift in the financial landscape. With inflation and interest rates starting to lift off their historic lows this could fundamentally affect portfolios for a huge range of investors. In the following short outline, we consider what those changes might be, and where investors could consider looking for potential opportunities in a turbulent world.

2 Inflation could be on the rise SPENDING RISING INTEREST RATES on the increase AGEING POPULATIONS UNEMPLOYMENT Inflation and interest rates have been very low for a long time. That is just starting to change for a number of reasons. The number of people available for work is falling. With fewer potential employees available, there is pressure on employers to offer higher salaries in order to fill roles. High salaries mean both higher costs for the employers and more spending money for employees. These factors combine to increase costs and prices. SAVING Meanwhile, with President Trump pushing his America first policy and other countries adopting a similarly separatist approach, the barriers to international trade are increasing. This also sends the costs of imports up and discourages international trade. In the UK, the situation is even more pronounced because the value of the pound has fallen since the Brexit vote in June 2016 making imports more expensive. This meant inflation in the UK reached 3.0% in September 2017, a significant increase on its -0.1% rate two years earlier. TRADE BARRIERS INCREASING CENTRAL BANK STIMULUS The target rate of inflation in the UK is 2.0%, so the Bank of England is now starting to bring interest rates up from their historic lows. But there s a twist. The current measure of inflation compares how much a set basket of goods costs today against what that same basket of goods cost one year earlier. So if the basket of goods cost 100 last year and now costs 103, then inflation is at 3%. To put it another way (which helps to explain the implication for investments) 100 buys less this year than it did last. The trouble is, that particular basket of goods might not show the whole picture. It doesn t include some of the online purchases that many people make, so the true level of inflation might be even higher than the official statistics suggest. What s more, there is a delay of several months between a central bank making an interest rate change, and that change taking effect by helping to limit borrowing and spending and, as a result, slowing inflation down. Therefore, the Bank of England has to estimate what is likely to happen, and take action in the knowledge that the effects of such action will take time to make a difference. CENTRAL BANK TARGET INTEREST RATES SINCE % 6% 5% 4% 3% 2% 1% 0% -1% Source: Bloomberg, September US Eurozone UK Japan

3 BAD NEWS for bonds INFLATION & INTEREST RATES FEWER BUYERS of bonds Many investment portfolios include bonds as they are often used to provide an income stream or a relatively low-risk rated asset. Unfortunately, rising inflation and interest rates can undermine the returns provided by bonds. This is because most bonds pay a fixed return or coupon. If this coupon were, say, 3 a year on a 100 bond, then that 3 a year will not change regardless of whether interest rates or inflation rise or fall. As inflation rises, that 100 and annual payment of 3 becomes worth less more quickly in terms of what it can buy. Meanwhile, as interest rates rise, other investment opportunities such as bank savings deposits might increase the returns that they pay, potentially making them more attractive than bonds. Bonds can be bought and sold in much the same way that company shares can. So if investors expect interest rates or inflation to rise, then they might be less keen on bonds as a potential investment. This fall in demand leads to a fall in the price that investors are prepared to pay for bonds. In short, the value of those bonds could fall. CENTRAL BANK BOND-BUYING & BOND PRICES DOWN UP In addition to changing interest rates, central banks have also been buying huge quantities of bonds on the secondary market. This was done in order to help make money available to businesses and people wanting to borrow during the aftermath of the financial crisis when many banks were unwilling or unable to lend. This meant that central banks replaced commercial institutions as the biggest buyers of bonds. What s more, since the financial crisis, increased regulation has led to those commercial institutions reducing the amount of bonds that they had been buying. While central banks continued to buy lots of bonds, that wasn t a problem. But now that the global economy has staged something of a recovery and inflation could rise, central banks are either looking to reduce the amount of bonds they are buying (as is the case with the European Central Bank) or even start selling the bonds that they own (which is what the Federal Reserve in the US is doing). This, too, will contribute to downward pressure on bond prices.

4 IMPLICATIONS for investments BEYOND BONDS Potential OPPORTUNITIES Not all bonds will be affected in the same way. The longer the repayment period left on a bond (known as its duration ), the more likely it is to be affected by changes in interest rates or inflation. Therefore, we expect to see a shift among investors towards shorter duration bonds. Also, the outlook varies across different regions. For example, UK government bonds are considered by many to be fully valued and unlikely to rise in price much further. In contrast, some international bonds might offer better prospects, though the levels of risk associated with any alternative would have to be taken into account by an investor. So, we anticipate that there might be better prospects in 2018 for bonds issued by select international governments with political stability and positive economic prospects. Inflation and interest rates might be the big story as far as financial markets are concerned, but there are plenty of other issues to keep in mind, not least of which is politics. The UK is undergoing sometimes fractious negotiations over its departure from the European Union, US President Donald Trump has yet to persuade Congress to accept any of his reforms on immigration, healthcare and taxation, while Catalonian separatists have shaken the stability of Spanish politics. The potential for politics to create further turbulence in economic markets remains as strong as ever. As a result, we favour a cautious approach to investing over the coming year, with a readiness to withdraw some investments should the political climate worsen. That said, there s no avoiding risk when considering investments. For example, if an investor were to cash-in all their investments, that cash would become less valuable over time because of inflation and, as we have seen, with inflation potentially on the rise, that could be an increasing risk. So where might there be investment opportunities? In the developed economies, we still see potential for returns in Western Europe, North America and Japan. However, after sustained growth in stock values across these regions, we feel that the potential for further growth might not be quite as substantial as it was at the beginning of Elsewhere there are potential opportunities albeit with likely high risk. For example, we favour companies in countries that have political stability, positive reform programmes and solid economic prospects, which could include the likes of China, India and Argentina. Having considered such countries in the initial search, we would then favour shares in companies that have good risk profiles, cash-flow and order books. Sniffing out companies that fulfil such a demanding set of criteria takes a great deal of research. That s why we choose to work with specialist active managers to find opportunities. This is something that we do not see in passive funds (those that typically track an index and the stocks within it) that, by their nature, blindly follow a usually broad sweep of companies or countries.

5 CONCLUSION In summary then, as well as the political uncertainty, we see an increased risk of rising inflation. This could lead to a broad increase in interest rates across western economies. These factors lead us to believe that the outlook for bonds is less positive than before, though should there be a hard Brexit, UK government bonds might benefit from investors seeking a low-risk rated investment opportunity. However, there are potential opportunities offering more attractive returns in both bonds and equities overseas. We believe that the chances of delivering positive returns are greatly increased through in-depth research across a range of stocks and bonds, something that we do not see being offered by passive investment opportunities. More information To find out more about our thinking, ask your Private Banking and Advice Manager for a copy of the full 2018 Outlook document. Alternatively, you can download a copy from lloydsbank.com/outlook2018 Important information making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein. Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at October 2017 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent. Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales no Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number WIO133 LIGHT / 10 17