VIEWS FROM THE DESK (VFTD) July When enemies become friends and friends become enemies

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1 VIEWS FROM THE DESK (VFTD) July 2014 When enemies become friends and friends become enemies In his 2008 inaugural address, Barack Obama challenged governments on the wrong side of history that we will extend a hand, if you are willing to unclench your fist. During his first weeks in office he reached out to Russia, Cuba and a number of other countries, including the US long time adversary, Iran. The unsettling events that have unfolded in Iraq in recent weeks, with the rise and brutal influence of ISIS, have been a further catalyst for the US to extend the hand of friendship to Iran. For a country long treated as a pariah by the international community and described by a former US president as part of an axis of evil being courted in this way illustrates a sharp change in diplomatic direction by the West. The reasons behind this shift are complex and the fast changing situation in the Middle East is not the core theme of this quarter end review. The concept, however, of enemies becoming friends on the diplomatic stage has prompted us to think about enemies and friends across financial markets. We believe we are seeing a very important change in direction whereby long term friends (to investors) may become enemies, and vice versa. The first of these and undoubtedly the most influential on asset prices are central bankers. Synchronized central bank policy must now be considered a thing of the past as we see clear divergence in actions and rhetoric. The traffic light graphic below is a useful representation of the changing paths being taken by the major central banks. Source: Blackrock June 2014 Since the Global Financial Crisis (GFC) QE, led by the Fed, has underpinned asset prices, with economic bad news being treated as good news by market participants, as this triggered yet more liquidity. Today, the first round of interest rate hikes in the US and UK is getting closer particularly for the latter and these will be dial movers. Market reaction is always difficult to judge and forward guidance is clearly in place to manage expectations, however, the events of last year s taper tantrum illustrate how investors are prone to overreaction. We would argue rising rates are a further sign of normalisation in the financial system and should be seen as a positive. Moreover, recent

2 communications from the Fed indicate to us the authorities stand prepared to reverse tack and be more accommodative should the US economy show signs of being too fragile to tolerate a higher cost for credit. It is, perhaps, more appropriate to describe the Fed - and the Bank of England too as becoming less friendly, or perhaps frenemies. Either way, it would be naïve to ignore the potential outcomes that lay ahead, although we agree with many that terminal rates will be lower than they have been historically. Rising interest rates naturally lead to us to focus on bond markets and the shape of the yield curve. It is interesting to reflect that exposure to intermediate bonds i.e. those most sensitive to rising interest rates was a damaging enemy to the performance of investment portfolios in year US Treasuries returned -1.63% and 10 year Gilts were down circa 4%. Consequently, moving into 2014 one of the most consensus trades was being short, or even, negative duration. However, as we discussed in last months VFTD (The calm before the storm?), this has proven anything but rewarding and the reverse being long duration has delivered positive returns. To everybody s surprise, last year s enemy has become this year s friend, with US Treasuries up 3.2% and Gilts 3.5% since the turn of the year. Returning to the taper tantrum one last time, it proved to be the year s nemesis for investors, with exposures to all things emerging markets (EM) related be it FX, debt or equities suffering the worst losses. A rising US yield curve and strengthening dollar are generally unhappy bed fellows for EM assets and investors desire to exit positions resulted in record outflows. 12 months on, and this story has begun to reverse. Many emerging market currencies have strengthened versus the US dollar, whilst within the fixed income universe emerging market debt (EMD) has become increasingly attractive. To calibrate this, hard currency EMD, which returned -6.89% in 2013, is up 7.22% (end of May). Looking at equities, performance has also been stronger than many had anticipated, with the broad EM index up 6.70% in Q2 versus developed markets at 3.55%. We sense contrarian investors, such as us, who chose to ignore the enemy tag pinned to EM assets may well have found a friend, particularly over the longer term.

3 Affinity portfolios their friends and enemies The performance of parts of the commodity complex through Q has been striking, driven by rising silver, copper and oil prices. The CRB Index is up 10% year to date and oil, measured by US WTI, has risen just over 7%. The global economy is growing and this, naturally, leads to expanding demand for commodities. Notwithstanding a slowing China, rising urbanisation, mechanisation and consumption across the developing world continues apace. Moreover, the last World Economic Forum's Infrastructure Report found that we face a global infrastructure deficit of $2 trillion per year over the next 20 years. Exposure to commodities has been a friend to Affinity clients in 2014, with the Guinness Global Energy up 20.61%, Lazard Global Listed Infrastructure up 13.55% and PIMCO Commodity Real Return up 11.33% (all numbers quoted in local currency). When we made our allocation to energy across higher risk portfolios late last year, we did so in the context of weak sentiment and compelling valuations. The shift from enemy to friend has been pronounced and we are delighted to have captured this for our clients. As good as these returns have been, for the US dollar denominated funds held, sterling s strength (see chart below) has impaired performance somewhat. We continue to test the rationale behind our overweight to the US dollar and our conviction remains. Whereas the UK has priced in a lot of good news already, the US - after a disappointing start to the year we anticipate will surprise positively in the second half. Consequently, whilst the exchange rate has proven an enemy, we are hopeful it will shortly become our friend.

4 Source: Bloomberg What about those whom we trust, who change spots and become enemies, only to reverse to be friends once more? When reviewing portfolios on a quarterly basis, it would appear that prices have gently drifted higher. However, intra month, the reality is very different. April saw the start of a very sharp rotation in equity leadership; high momentum Growth stocks sold off aggressively as investors took profits and sought refuge in more defensive, Value stocks. Source: Blackrock June 2014 Within Affinity portfolios, this manifested itself in sharp falls across our tech and healthcare holdings GAM Star Technology declined 11.01% in April/May and Polar Healthcare Opportunities was down 9.07%. When long time friends suddenly become aggressive enemies, it is clearly important to sit down with them and chat things through! What was the message we were being sent? Did it reflect a regime shift or was it simply a storm in a tea cup? After a lengthy review, we concluded nothing had

5 fundamentally changed. From time to time, the equity market sends signals that are not endorsed by the bond market. The latter is inhabited by investors who can be collectively described as natural worriers and the fact that, over this period, credit spreads were continuing to tighten and bond yields were still falling convinced us equity markets had overreacted. With this in mind, we maintained our exposures to tech and healthcare and for new mandates, put cash to work. Our actions were rewarded; in May and June these two funds have rallied sharply 14.12% and 9.18% respectively. Renewing friendships in this case, maintaining our conviction is typically a fulfilling thing to do. On the look out for potential enemies? Whilst the rise in the oil price has been a boost to our investment returns, the geopolitical risks developing across Russia/Ukraine and, particularly, the Middle East are clearly a cause for concern. Geopolitical risks are an ever-present for global investors, but they are heightened at this current time. The breakdown of national borders, drawn up by Britain and France in 1918, is pulling the governments of Iraq, Iran, Syria, Jordan, Saudi Arabia, Turkey and Lebanon into the mêlée of the Sunni/Shia conflicts. These unfolding events will have significant consequences beyond the region and are likely to remain a focus for market participants throughout these summer months. For political leaders across the divide, identifying friend from foe is challenging enough and perhaps never has the adage keep your friends close and your enemies closer been more appropriate. Although important, we do not have space here to discuss the on-going China-Japan tensions and acknowledge that we will have no influence over such events. What we can do to protect our clients is to ensure their portfolios are well diversified and we remain focused on valuations and market liquidity. For some, these rising risks may prove the catalyst especially given the strong asset price performance year-to-date - to crystallise profits and sit on the side-lines. If this view becomes more widely held, given current low volatility and thin volumes, we may face a challenging liquidity environment. This is not our base case, but it is important we consider the implications. Investment banks, perceived as the enemy post the GFC, have long been an essential source of market liquidity via their trading desks. The valuable role they played in capital markets has been significantly curtailed due to regulatory capital demands and the role of liquidity provider has effectively been passed to the asset management industry. Regulators are, quite rightly, expressing concerns that most open-ended funds promise daily liquidity, but invest in assets that may not be redeemable at, or close to, quoted valuations. It is truly startling to note that, according to Phil Wagstaff Head of Global Distribution, Henderson Global Investors - 90% of net UK investor inflows last year went to just ten funds. Aware of these issues, our routines ensure we rank the risks associated with liquidity, capacity constraints and risk management for all funds we buy for our discretionary portfolios. The table below illustrates the full matrix of factors we use in this assessment. Funds with strong investment returns and low volatility may disguise an enemy in hiding and our Fund Risk Scores (FRS) are designed to help us identify these where possible.

6 Finally, one long time friend of investors, namely credit - the provider of extremely attractive risk-adjusted returns post the GFC has reached a point where our friendship is starting to wear a bit thin. We are not about to sever all ties and selective opportunities remain. However, the number of companies able to issue high yield debt with limited restrictions on the debt-service obligations of the borrower - know as covenant-light is sharply on the rise. Moreover, whilst defaults remain low, corporate leverage is on the rise and this is something we should keep an eye on. It would seem we are not alone in our concerns Fed Chair Janet Yellen noted that corporate bond spreads have fallen to low levels, suggesting that some investors may under-appreciate the potential for losses and volatility going forward (July 2nd 2014). Our exposures in this space have been reduced and those remaining are managed by experienced practitioners, who have been carefully selected and who provide us with excellent access to their thinking and positioning. Friends, enemies and frenemies abound this is nothing new - but identifying and aligning portfolios with those investments that will stand by us, over the long-term, will help avoid disappointments and deliver sustainable returns. Julia Warrander and Russell Waite

7 Performance of discretionary strategies Income Strategy ( ) Model Composite Composite Real Return Strategy ( ) Model Composite Composite Real Return Strategy ($) Composite Composite Growth Strategy ( ) Model Composite Composite Equity Growth Strategy ($) Composite Composite Last month s composite performance numbers are currently being calculated and will be provided on request. The performance detailed above is for illustrative purposes only and reflects the returns across Affinity Private Wealth s Income, Real Return and Growth model strategies, net of 0.95% management fees. This does not constitute investment advice and past performance should not be viewed as an indicator of future performance. Affinity Private Wealth is a trading name for APW Investors Limited, which is regulated by the Jersey Financial Services Commission. Registered office 24 Seale Street, St Helier, Jersey JE2 3QG.