Real Matters Breaking Bad 1 : Outlook and strategy 2015 Simon Doyle, Head of Fixed Income and Multi-Asset

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1 January 2015 For professional investors only Real Matters Breaking Bad 1 : Outlook and strategy 2015 Simon Doyle, Head of Fixed Income and Multi-Asset Overview The last few years have been good for investors. Asset prices have risen across the risk spectrum aided in large part by the actions of desperate central bankers. Investors have reaped the rewards and in doing so have been able to pay little attention to the risk they are taking to achieve these returns. But as markets rise and the policy dynamics that supported this broad based rise in asset prices come into question, valuations become more important and risk matters more. In this article we: review the performance of markets in 2014, highlighting the increase in volatility and the divergence of performance across markets (in contrast to the previous year); discuss the outlook for key markets, examining in particular valuation and cyclical drivers of asset returns. In particular we highlight that for many assets, current valuations imply low returns over the medium term and heightened risk of loss. From a cyclical perspective we argue that while the outlook for key global economies is mixed, that deflation risk is being overstated and the Fed will start edging towards a more normal policy environment this year; and finally, while the return outlook may have compressed, volatility is likely to increase. This is expected to provide us with the opportunity to capture opportunities at more appropriate prices. This has important implications for investors and is an important part of our strategy to achieve decent real returns over the medium term (especially in the context of our Real Return strategy). While risk has not mattered much as central banks have looked to suppress volatility it will matter more in future as the ability of central banks to continue to suppress volatility is tested. Pushing the envelope to keep returns up, yields high etc may well back-fire. While I can only admit to watching an episode or two of Breaking Bad on a recent return flight from the UK, the parallels in my mind were clear. Investors will push the envelope to generate returns. This can work for a time but at the end of the day it could prove very costly in review 2014 was a positive year for local investors. That said, there was plenty of grist for both the bulls and the bears to mill. Whereas in 2013 developed market equities were universally strong and credit spreads narrowed markedly, 2014 saw more divergent performance. Of the major developed markets only the US posted double digit price gains (in local currency terms) with major non-us markets posting returns ranging from low single digit positive price performance to losses in the UK and Korea (refer Figure 1). The appreciation in the USD has compounded the challenges of 2014 dragging down returns to non-us equity markets when measured in USD terms. While Australian dollar based investors have fared better, the contribution from the currency has been significant. 1 Breaking Bad is an American crime drama television series. The title of the show has been adopted from an American colloquial expression meaning to raise hell. The intended parallel is to the desperate lengths some will go to generate returns even if it is a really bad idea. Schroder Investment Management Australia Limited ABN Australian Financial Services Licence Level 20 Angel Place, 123 Pitt Street, Sydney NSW 2000

2 Figure 1: Equity market price returns in calendar Local currency USD's AUD's HK (Hang Seng) Germany (DAX) Japan (Topix) Switzerland (SMI) US (S&P 500) Source: Datastream / Schroders Euro (DJ Euro Stoxx 50) Aust (All Ords) France (CAC 40) UK (FTSE 100) Korea (KOSPI) US (S&P 500) Switzerland (SMI) Japan (Topix) Germany (DAX) HK (Hang Seng) Euro (DJ Euro Stoxx 50) Aust (All Ords) France (CAC 40) UK (FTSE 100) Korea (KOSPI) Against this, volatility in equity markets picked up, credit spreads widened, commodity prices declined sharply (especially iron-ore and oil) and sovereign bond yields again collapsed as deflation fears permeated investor thinking (refer Figure 2). To put this last point into context, Australian bonds 2 returned 9.8% in 2014, significantly above the 5.6% return (including dividends) from Australian equities. So much for the death of bonds! Figure 2: Gross 12 month returns from major asset classes in calendar % % 5.8% 5.6% % % -0.1% Australian Equities ¹ International Equities ² Emerging Market Equities ³ Property Trusts ⁴ Aust High Yielding Credit ⁵ Global High Yield ⁶ Cash ⁷ 10.3% Government ⁸ 8.1% Credit ⁹ -8.5% AUD/USD Source: Schroders/Datastream. 1. S&P/ASX 200 Acc; 2. MSCI World ex Aus TR (USD); 3. MSCI EM TR (USD) 4. S&P ASX300 A-REIT Acc; 5. Schroder Higher Yielding Credit Pool; 6. Merrill Lynch Global High Yield Index (USD); 7. Bloomberg Bank Bill Index; 8. Bloomberg Treasury Index; 9. Bloomberg Credit Index. * Past Performance is not a reliable indicator for future performance. 2 UBS Composite Bond Index / Bloomberg AusBond Composite 0+Yr Index Schroder Investment Management Australia Limited 2

3 Valuations Updating our return forecasts continues to highlight the risk emanating from stretched asset valuations. Figure 3 shows our return forecasts and for comparison, actual performance for key US asset classes: equities, high yield debt and treasury bonds. These forecasts are in turn derived from our valuation framework and primarily reflect reversion to our estimate of fair-value over a three year horizon. Figure 3: Schroders 3 year return forecasts through time 4 3 Yr Returns: US Equities Forecast v Actual 3 3 Yr Returns: US High Yield Bonds Forecast v Actual 14% 3 Yr Returns: US 10 Yr Bonds Forecast v Actual % 2 15% 12% 1 8% 1 1 6% 5% 4% -1-5% 2% % Forecast Actual Forecast Actual Forecast Actual Source : Schroders What is clear from this analysis is that current valuations imply low, perhaps even negligible prospective returns across key US markets. In terms of historical comparisons it s worth noting that while for equities and high yield debt prospective returns are similar to those prevailing immediately prior to the GFC, prospective returns from US treasuries are significantly lower (close to zero in fact) assuming a modest normalisation in 10 year yields over the next 3 years. Clearly, if these forecasts are close to being right, then in terms of broad asset class exposure there is nowhere really to hide. So while central bank policy has supported returns to investors over recent years, from current levels the outlook looks increasingly difficult. A second important point relates to risk. Low prospective returns mean a heightened probability of negative returns from major asset classes over this period. This is evident in Figure 4 which shows the implied probability of a negative return from the respective asset class over the coming year 3. While the probability of loss from US equities remains high at just under 4, the more notable is the nearly 5 probability implied in the US treasury market. As yields continue to decline, this risk grows. While still high, the risk of loss in the high yield debt market has moderated due to the oil induced widening in physical credit spreads. That said, on this basis, high yield credit remains far from good value. 3 This is estimated based on the expected distribution of returns around our return forecast. It highlights the probability of a negative return overa 12 month period but not the likely magnitude of this return. Schroder Investment Management Australia Limited 3

4 Figure 4: Heightened downside risk Probability of loss: US Equities Probability of loss: US High Yield Bonds Probability of loss: US 10Yr Bonds Source: Schroders This analysis focuses on US asset prices, and while this is clearly important it does not represent the investible universe. Figure 5 shows prospective 3 year returns against the probability of loss across the major asset classes within our universe compared to realised returns and volatility over the last 3 years. Figure 5: Expected 3 year return & risk assumptions To generalise, the overall return outlook across the universe looks tough and consistent with the rationale laid out for the US above. A number of issues impacting key asset classes though are worth drawing out: Schroder Investment Management Australia Limited 4

5 Australian equities look to be the best prospects for reasonable returns over this horizon. There are two main reasons. Firstly, valuations simply look better. Australia has underperformed the US over the recent years as the drag from declining commodity prices has impacted resources directly and more cyclically exposed sectors. In large part a softer economic prognosis has been priced in particularly into the major commodity plays. While the local market would be dragged lower by any material weakness emanating from the US, the starting point is better and on a medium term perspective this matters. Secondly, yields on the Australian market (especially on a tax adjusted basis) are still attractive - both in absolute terms and relative to both other equity markets and to other yield based assets. In contrast Australian REITs offer minimal future expected aggregate return as we believe their vulnerability to a capital repricing will offset the benefits of their steady yield. In a recent paper 4 we laid out these views in more detail but it comes down to three factors. Firstly, adjusted funds from operations (AFFO) are being flattered by unsustainably low financing cost and by paying out the benefits of these low rates today future distributions are likely to be clipped by higher funding costs. Consistent with this, A- REITs are starting to gear up to take advantage of low financing costs. Secondly, the growth assumptions embedded in the sector (and implicit in recent price performance) are too optimistic. Finally, that the risk premium required by REIT investors is currently too narrow given these risks put more simply we believe valuations are expensive and we d prefer broader domestic equities to REITs. In Emerging Markets (EM), while valuations in the sector do not look demanding (and are probably now back to around fair-value ), factors such as the dramatic falls in commodity prices and the appreciation in the USD are likely to lead to further outflows from EM assets (both debt and equity) implying that these markets are still high risk and require a significantly higher risk premium than is currently implied in pricing. This has been our argument for some time and has not changed despite of recent EM underperformance. While fixed income investors have reaped the benefits of collapsing yields, it is becoming increasingly difficult to see how anything other than very low returns are in prospect from fixed income assets over a three year investment horizon. This is especially the case given that key markets like Germany and Japan where yields on bonds out to say three years in Japan and five years in Germany are offering investors negative nominal starting point yields. While the maxim never say never in forecasting market returns remains valid, the mathematics implies the risks are heavily skewed to this being a disappointing investment over time. Furthermore relatively narrow credit spreads mean credit enhancement will not be sufficient to make a material difference to returns. Figure 6: Yield curve comparisons 3.0 % 2.5 % 2.0 % 1.5 % 1.0 % 0.5 % 0.0 % % 3mth 1yr 3yr 5yr 7yr 10yr Ger Japan US Aust Source: Schroders / Bloomberg (19/1/2015) We also expect volatility across markets to pick-up as central banks find it more and more difficult to supress volatility in markets. A clear example of this is the Swiss National Banks surprise departure from its currency peg to the Euro. This followed a significant and sustained defence of the peg which accompanied a significant expansion of the SNB s balance sheet. The subsequent appreciation of the 4 A wolf in REIT s clothing ; David Wanis, Schroder Investment Management Australia Ltd, November 2014 Schroder Investment Management Australia Limited 5

6 CHF and the ramifications of this for banks, hedge funds and currency trading houses is a potent reminder of the damage that can be unleashed once distortions are corrected. Iron ore prices, and the Russian Rouble also highlight this point. Cyclical and other considerations While valuations matter (and are ultimately in our view the key driver of medium term returns) cyclical factors play a key role in the timing and realisation of valuation anomalies and in the associated policy responses. On this front the outlook is particularly murky. Since the GFC interpreting the macro economy has been complicated by the unusual nature of the recession and subsequent recovery (ie. as a financial crisis with a deep trough and a modest recovery) and the unusual and experimental nature of the policy measures employed to foster recovery. Many of these measures have been pivotal in supporting asset prices and as described earlier, supressing risk. While a return to recession has been avoided in major economies, what s less clear is just how much underlying improvement has occurred. Clearly both the European and Japanese economies remain weak while the US economy appears to be on a more self-sustaining recovery path albeit question marks remain around the ability of the US economy to withstand a move towards a more normal policy environment. In framing our thinking around the cyclical influence on markets in 2015 and beyond the following factors are most relevant: Despite a hiccup or two lately, our base case is that the US recovery continues to unfold, the labour market continues to tighten and wage pressures slowly build. While the collapse in the oil price is negative for energy related investment, it is a clear positive for consumers and this will help support consumer demand and offset some of the negative effects on investment and of the strengthening US dollar. If we are right on this front the Fed should start to move rates up sometime this year. Low headline inflation probably means that they won t be in a hurry but core inflation and wages will ultimately be more important. The US treasury market is rapidly and prematurely in our view pricing out this prospect. We think the market is a notch or two too negative on Europe (reflected in the significant underperformance of European equities and the significant rally in European bonds). While we do not expect Europe to match the US s growth trajectory we do think European recession will be avoided in the near term. With the completion of the Comprehensive Assessment 5 by the ECB, it appears the European banking system is no longer an obstacle to recovery. On a more short term basis the decline in the Euro will provide a significant boost given the export intensive nature of the European economy, and the fall in oil prices will release real disposable spending power and add to activity. Also, QE will support broad money growth, which is a strong leading indicator of economic growth in Europe. While headline deflation now seems a reality in the short run, this would also seem to be priced in with the 0 5 year German bunds now offering negative nominal yields to investors. The surprise in Europe could well be that things aren t as bad as current pricing would imply. In Japan, the weaker Yen has failed to significantly shift inflation expectations as demand has remained patchy post the tax changes. Structural reform remains the missing ingredient and while we don t doubt the commitment, Japanese growth is unlikely to be a game changer for the global economy. China has seen a significant slowing of growth and a housing market under stress. However, this has seen a response by authorities to underpin activity. While we believe significant imbalances have built in the Chinese economy, while inflation remains low, policy makers have flexibility to push out the day of reckoning - it is when inflation is rising and authorities have no options but to slow growth when imbalances turn to crises. What has been different this time is that the policy response has been more measured, and the focus has been more on employment than on growth. However, structural growth will continue to decline as the benefits of urbanisation are seen relative to a larger base, seeing lower potential growth. 5 The Comprehensive Assessment was a financial heath check of 130banks in the Euro area (including Lithuania) covering approximately 82% of total bank assets. Schroder Investment Management Australia Limited 6

7 In Australia, the cross-currents are strong. The big negative is of course the declining terms of trade (down 18% since their peak in 2011), but this has been mitigated by a weaker exchange rate (down 18% in trade weighted terms), lower interest rates (both official and market rates) and more recently the declining oil price which will provide significant support to the consumer. In fact lower oil prices and a weaker exchange rate would be a much more palatable combination to the RBA than another rate cut to support mixed demand. On balance, we think the Australian economy is at or around trend and that it would require a further leg down in growth, or a shock (such as a sharp collapse in asset prices) for the RBA to make any major changes to monetary policy. In any case further modest easing is already priced into local rates. Portfolio construction implications Through 2014 we advocated increased caution with respect to asset pricing and risk levels and reflected this across our multi-asset portfolios by reductions in exposure to riskier assets, predominately high yield debt and equities 6. Our rationale reflected deteriorating valuations as asset prices climbed (particularly US equities and bonds but also yield based assets such as A-REIT s) and the increasing disconnect between risk defined as losing money, and volatility. This was reflected in our key Real Return strategy by holding both low exposure to equities (<3) and a high exposure to cash (>35%) for much of this period. Consistent with this, and despite poor valuations across fixed income assets, we advocated maintaining a material duration position to protect against the material risk of either deflation or at a minimum the emergence of concern about the possibility of deflation emerging. If this were to happen, bonds would be a clear beneficiary despite of their starting point yields as perhaps the only asset to see prices rise in this environment. We also advocated that currency realignment would play an important role in driving returns with our preferred play being Australian dollar depreciation supplemented by further Euro weakness. These strategies worked well to support returns in Figure 7: Estimated contributions to Real Return strategy returns in Contribution to Return % 1.79% 1.26% 3.17% 7.46% 0. Cash Duration FX Other Total Source: Schroders : The Year of the Boiling Frog, Simon Doyle, Schroder Investment Management June 2014 Schroder Investment Management Australia Limited 7

8 Our starting point for 2015 from a portfolio construction standpoint is very similar. Figure 8: Asset allocation of the Real Return strategy, 31 December 2014 At a broad level our overall risk allocation remains moderate. Expected portfolio volatility remains just shy of 4% and towards the lower end of the volatility bands (ex poste volatility has been closer to 2%). While the biggest contributions remain from equities (Australia in particular) this has to be seen against the overall moderate total risk contribution. As discussed above we remain cautious on equities particularly the US where valuations remain the most stretched of the major markets. While we have less concern from a valuation perspective on European and Australian equities, the US market will likely set the tone for the year ahead. While the core of our global equity exposure is in our QEP 7 Dynamic Blend Strategy, we have a short US S&P futures position in place to effectively reduce our aggregate exposure to US equities to less than 3%, leaving us overweight in a traditional sense Europe and Australia. 7 Quantitative Equity Products Schroder Investment Management Australia Limited 8

9 Figure 9: Composition of the Schroder Real Return CPI Plus 5% Fund equity exposure 1.87% Equities Allocation by Region 2.69% 0.64% 0.77% 1.36% 2.68% 14.87% Australia United States UK Europe ex UK Japan Other Developed Emerging Markets Source: Schroders. As at 31 December 2014 Regional Allocation - Real Return vs MSCI World % Regional Allocation % 11% 8% 5% 17% Australia United States UK Europe ex UK 8% 3% 3% Japan 11% 6% Other Developed 8% Emerging Markets MSCI World Benchmark Exposure Real Return CPI+5% Exposure Source: Schroders. As at 31 December 2014 While credit spreads have widened recently (mainly on the back of the implications for the US energy sector given the collapse in the oil price) we have only added modestly to our position (in global high yield). Compositional differences between the physical high yield market and the CDX index has meant that the physical market has widened significantly more than the CDX market on oil concerns and this has created a short term opportunity. That said, with overall yields and spreads low and volatility rising, we would need to see a more material widening in spreads before credit becomes attractive again. Schroder Investment Management Australia Limited 9

10 Figure 10: Physical vs CDX high yield spreads 2,000 1,800 1,600 1,400 HY Spread (bps) 1,200 1, Markit CDX NA HY Spread Merrill Lynch US HY Option Adjusted Spread Source: Schroders / Datastream Bond valuations remain extreme and unappealing on a medium term view, but we are retaining duration for the same reasons we have done so over the last year or so namely as our predominant deflation hedge. Given already low yields and the fact that this risk is significantly priced already, it is likely that this position will get wound back as the year progresses. We view our cash exposure independently to that of bonds. Should equity volatility continue to pick up and key equities deliver poor absolute returns cash returns will look good (in a relative context anyway). As we have argued for some time, holding cash in a period of rising volatility is attractive as it provides the optionality to take advantage of the changing market valuations and prospective returns. Achieving Real 5% against this backdrop The outlook and its implications presented above clearly suggest that achieving a 5% pa real rate of return over the next 3 years looks challenging. Figure 5 shows that on our numbers there are few assets with the potential based on current valuations with the potential to achieve solid returns. That said, we believe that the Real Return strategy s objective is achievable from here. As we have pointed out in the past 8 our objective has several facets: a target return of 5% pa above Australian inflation over rolling 3 year periods, minimising path and drawdown risk, and maintaining a high level of liquidity. In balancing these at times competing targets, implicit in our thinking is asymmetry in the risk equation as we believe the preservation of capital is critical in its own right but also that the portfolio is well positioned to exploit opportunities that the market presents after periods of volatility and disruption. This asymmetry is particularly important in the shorter run. Likewise, we believe the 3 year timeframe is important as it is a sufficient enough interval to allow significant mis-pricings to play out. Equally, risk premia are dynamic and this can and will drive changes to strategy, sometimes significantly over this timeframe. 8 Achieving a real return of +5% in the current environment Simon Doyle, Schroder Investment Management, June 2013 Schroder Investment Management Australia Limited 10

11 On the basis of our assumptions an asset mix that notionally matched our target return would require a much more risky portfolio than we are currently comfortable with. The current portfolio provides us with sufficient risk to get close to target without exposing the portfolio to substantial drawdown risk. While we have argued for some time that we will deploy cash on weakness we have not yet seen sufficient weakness (certainly not enough to alter our medium term return outlook) to warrant deploying this cash. It should be also noted here that while medium term return expectations have compressed (see Figure 5) we do expect volatility to pick-up, creating the opportunities for us to buy appropriately priced risk. We also expect positive contributions to returns to come from continued $A weakness (and more broadly US dollar strength), a positive contribution from security selection (this has been a drag over the last year). We expect that the positive contribution from duration has largely played out but in the absence of alternative deflation hedges, we are likely to retain some (albeit reduced) duration. In achieving our objectives we believe patience will be important and rewarded. Holding overpriced high risk assets while notionally may look more consistent with our objectives the reality is likely to be the opposite. High risk activity is unlikely in our view to be rewarded. Maybe I should watch some more episodes of Breaking Bad to see where it goes. Important Information: For professional investors only. Not suitable for retail clients. Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN , AFS Licence ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. For security reasons telephone calls may be taped. Schroder Investment Management Australia Limited 11