In vestm ent Views. August 2016

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1 Global strategy Equities Fixed income Is inflation dead? Banks lead the way The feedback loop In vestm ent Views August 2016

2 Global strategy Is inflation dead? The Consumer Price index in the US currently stands at 0.8% year over year. The UK version of CPI is 0.6% and the EU is even lower at 0.2% and hasn t been greater than 0.5% for two years. In Japan, the inflation rate spiked above 2% in 2008 and 2014, but has averaged 0.0% over the last 18 years (18!) and is currently -0.4%. Global developed market Central Banks like to believe that they can target a 2.0% inflation rate. In support of that goal, the European Central Bank is pursuing a policy of negative interest rates and massive credit quantitative easing, the Bank of England recently restarted its quantitative easing programme, whilst the Bank of Japan is even buying equity Exchange Traded Funds (ETFs). Based on those statistics, it might not be obvious that this is the opportune time to think about rising inflation. We disagree, particularly as it pertains to US inflation. Inflation in the US is unquestionably rising, as opposed to stagnating or falling in Europe, the UK and Japan. In particular, inflation is rising in important and broad-based parts of the services portion of the economy and services comprise 31% of the overall CPI. For example, medical care inflation is running at an annual 4.1% rate and utilities are running at a 3.5% pace; both are items that exhibit a lack of demand elasticity (i.e., if medical care costs rise, the necessity of the service to one s well-being keeps one from consuming less of it or adjusting spending to target other items). Housing is another important part of the inflation picture, representing 32% of the pie. The CPI on Rent of Shelter, as the statisticians blandly call it, is rising at a 3.3% pace and has risen to that level consistently over the last two and a half years. With import prices weak and a strong dollar, goods price rises have been very subdued, but forward-looking indicators of future inflation, like wage growth, are also rising at a more elevated rate in 2016.

3 Global strategy Is inflation dead? (continued) The Fed has recognised that inflation should be moving toward their targeted higher level and will eventually react by reducing policy accommodation. That statement obviously assumes that markets remain calm and if there is one thing we have learned about the Yellen Fed, it is that it will be very cautious in times of what they like to call uncertainty. We are not sure what a certain economy looks like, but that is a topic for a different Investment Views. The point is, the time to buy protection against future inflation is when the implied cost of doing so is low. The only time inflation protection was much lower was during the depths of the great recession, when most were worried about the collapse of the financial system and protecting against future inflation was truly a free option.

4 Equities Banks lead the way Equity markets in August were characterised by historically low trading volume and relatively low volatility. The average daily volume on the S&P 500 was the lowest since November 2014, and there were zero trading sessions where the S&P 500 moved more than 1% in either direction. This lack of volatility stands in stark contrast to August 2015, when one out of every three trading days saw moves of more than +/- 1%. Summer trading is notoriously slow, but this year has seemed like one of the slowest we have seen in quite some time. The S&P 500 finished the month mildly positive (+0.14%), narrowly outpacing the MSCI World (+0.08%). Regionally, returns were also range-bound, with Japan (+0.54% in USD terms), Europe (+0.77% in USD terms) and the FTSE 100 (+1.01% in USD terms) up marginally. Emerging Markets (+2.52%) continued a strong rebound that began in June, driven by strong Chinese markets. Economic data looked relatively robust in August and consequently cyclically sensitive sectors outperformed the defensive sectors. Defensive sectors typically have higher dividend yields and an increased probability of a Fed rate hike put downward pressure on these stocks (higher interest rates make the dividend yields less attractive). Utilities (-5.0%) and Health Care (-4.1%) trailed all other sectors, whilst the Financials sector (+3.3%) was the best performer, reacting positively to expectations of higher interest rates. Within the Financials, UK banks all advanced 12-15% (yes for one month) as Brexit fears subsided, but for context, the US was still strong as Bank of America, for example, advanced +11.9%.

5 Fixed income The feedback loop The summer lull was firmly entrenched throughout August as low trading volumes, mixed economic data and low volatility caused US rates to trade within a tight range until the Fed Chair delivered a wakeup call during the Jackson Hole Symposium. Whilst nothing was explicitly promised, the Fed is actively testing the water for a rate rise in September may be a little early, but a strong set of data and stable equity markets in the coming weeks would likely tempt at least a few members to support a near-term rate rise. Fixed Income markets reacted swiftly, volatility spiked and yields on short US Treasuries underperformed long bonds. The two-year US Treasury rose to 0.84% and the probability of an interest rate rise in calendar 2016 rose from 36% at the start of the month to 65% immediately after Mrs. Yellen spoke. These recent events are now becoming a recurring theme commonly referred to as the feedback loop. As the US economy gradually improves, the Fed would like to increase interest rates gradually. However, whenever the Fed implies that borrowing costs will increase equity markets decline, credit spreads widen and the US dollar strengthens. This indirectly tightens financial conditions and the Fed has seemed inclined to delay policy normalisation when this occurs. With the Bank of England, the ECB and the Bank of Japan continuing to inject liquidity far into the foreseeable future, the Fed should be comfortable reducing liquidity in the system. The US domestic economy is currently growing at the best rate amongst developed market economies and is able to absorb a 25bps increase in rates; the markets just need to let them get on with it.

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