Global Investment Committee Allocation Views

Transcription

1 Investment Team Update 5 September 2017 Global Investment Committee Allocation Views PERSPECTIVE FROM FRANKLIN TEMPLETON MULTI-ASSET SOLUTIONS This investment team update describes the views of the Franklin Templeton (FT) Multi-Asset Solutions Global Investment Committee (GIC) an experienced team of investment professionals who specialize in equities, fixed income, cross asset and absolute return investments. The committee meets regularly to share multiple viewpoints, debate implications and assess risks. This process generates key investment themes, which can be expressed in a variety of portfolios that FT Multi-Asset Solutions offers to clients. The text below describes the views of the FT Multi-Asset Solutions GIC as at the date of this publication. These views are for general information only, are subject to change, apply solely to FT Multi-Asset Solutions strategies and are not representative of the views or strategies of other Franklin Templeton investment groups. Executive Summary as at 5 September 2017 On a main asset class level, we held a favorable view of global equities and commodities. We have a negative view of developed-market (DM) government bonds. Our preference is for assets, such as European and Japanese equities, we believe should benefit from investors shifting their focus from regional concerns to improving economic conditions and attractive relative valuations. The persistent momentum for global equity markets and the business cycles in certain countries suggest to us muted bond performance potential, and we prefer short duration in global bond markets, particularly outside the United States. We prefer emerging-market (EM) bonds relative to the broader universe of bonds, given historical and relative valuations, the yield advantage of EM debt, more flexible EM central bank policy and fewer headwinds from potential US policy. Asset Class Preference* Major Themes That Frame Our Tactical Asset Allocation 1. Continued Global Growth: Many macro indicators have suggested a positive growth outlook. We see prospects for economic rebalancing in EMs, but would like to see more evidence of long-term structural reform. 2. Inflationary Pressures: We see the overwhelming deflationary pressures in DMs during the past few years moderating. DM central banks are departing from unconventional operational tools and, in some cases, have reduced support. However, financial conditions remain easy across DMs, in our view, supporting risk assets. *Based on our analysis of market factors. Direction Shift 3. Business Cycle Remains Positive: The output gap, the US Treasury yield curve, negative real short-term interest rates and low recession risk (especially in the United States) suggest to us that the business cycle, even in its late stage, should remain positive in the near term. All information presented herein represents solely the general views of the FT Multi-Asset Solutions GIC as at the date of this publication and is for illustrative purposes only. Any statements about strategy positioning are as at 5 September 2017 and are subject to change without notice. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio. Not intended as investment advice or an investment recommendation. There is no assurance any forecast, projection or estimate will be realized.

2 FIXED INCOME SECTORS EQUITY REGIONS MAIN ASSET CLASSES Current Convictions from the FT Multi-Asset Solutions GIC Asset Class Equities Corporate Bonds Government Bonds Commodities Hedge Funds Cash Developed (DM) United States Europe Japan Canada Emerging (EM) US Treasuries Ex-US Govt. Bonds High Yield Investment Grade (IG) EM Debt (-) N (+) Represents month-over-month change Our Viewpoint Positive business cycle with room to continue, improving global growth, corporate earnings increasing and financial conditions accommodative across DMs led us to maintain a favorable view of global equities. European and US labor markets, consumer and business sectors supportive. Second-quarter earnings strong. Valuations relative to history present risks to our favorable view. US Congressional deadlock, North Korean worries, White House concerns, uncertainty on appointment of next US Federal Reserve (Fed) chair led us to reduced conviction. We favor EM debt relative to investment grade, given stronger relative valuations and fundamentals, and bank loans due to their highest yield with least amount of duration. Healthy interest-rate coverage ratios and low recession risk are supportive of high-yield bonds. Spreads relative to history present moderate risk. Given notably low yields for US Treasuries and other DM government bonds, recovering inflation data and improved growth, we have a less favorable view of DM government bonds broadly. Central bank policy should also be a headwind for government bonds as unconventional policy support is gradually removed. Improving global capital expenditures survey, falling equity price-to-earnings (P/E)-to-volatility ratio historically bearish for US Treasuries. The Europe Citi Economic Surprise Index rising historically bearish for 10-year German Bunds. Expected increases in capital expenditures, an uptick in global manufacturing, attractive composite leading indicators in China, favorable fundamentals support commodities. However, technical indicators weak. Valuations at August-end were also attractive to us, given fairly negative sentiment. We also consider a negative roll return. 1 Sector-level dispersion among US equities has continued to widen. The performance spread between the best and worst S&P 500 sectors increased in 2016 after remaining relatively narrow for the previous several years. Historically, hedge funds have demonstrated generally healthy performance when the spread has widened and interest rates rise. Hedge fund universe sentiment notably optimistic on equity, which suggests caution on exposure to equity market beta. Macro indicators increasingly supportive of risk assets such as equities, commodities and EM debt. Recovery in earnings, profit margins, productivity and manufacturing all strengthened, leading us to favor risk assets over cash. However, seasonal weakness and near-term risk led us to raise our view on cash. Economic indicators attractive relative to history, driven by upside economic surprises, purchasing managers indexes (PMIs), industrial production and retail sales. Monetary policy supportive. Corporate fundamentals strong relative to history due to revenue data, earnings data, noticeably strong and improved profit margins. Return on equity (ROE) weak but improving. Valuations elevated, with most metrics over one standard deviation higher than 10-year history. Economic indicators are attractive relative to history but deteriorated some over the past three months, driven by decreased revenue growth and earnings momentum. Valuations elevated, with most metrics over one standard deviation rich relative to 10-year history. However, revenue, profit margins and earnings momentum remained strong. Economic indicators, corporate fundamentals favorable relative to history due to industrial production, PMIs, gross domestic product (GDP) forecasts, retail sales, upside economic surprises, revenue growth, earnings revisions, earnings momentum. European profit margins and Citi Economic Surprise Index both positive and rising historically supportive of European equities. Valuations expensive, but still attractive compared to DM peers. Economic indicators are attractive relative to history, driven by greater upside economic surprises, OECD leading indicators, industrial production and retail sales. Central bank policy supportive, and money growth strong and attractive relative to history. Corporate fundamentals are strong relative to history, including revenue growth, earnings revisions. Profit margins are strongest relative to DM peers. Relative valuations attractive compared to DM peers. Positive economic surprises, leading indicators, industrial production and PMIs supportive. Money growth deteriorated. Revenue growth, earnings growth, earnings revisions moderately strong. Valuations stretched relative to history, but improving across most metrics and less expensive than DM peers. Corporate earnings revisions, revenue growth, earnings revisions and earnings momentum slightly attractive. Valuations are high, but more attractive than DMs. Economic fundamentals are mediocre due to weak industrial production, which is unattractive relative to history but improved noticeably. Tightening labor market, low term premium and potentially reduced Fed balance sheet may cause yields to rise. Attractive and improved house price-to-income ratio, strong consumer confidence, attractive terms of trade bearish for US Treasuries. Positive and rising global capital expenditures survey, positive and falling equity P/E-to-volatility ratio historically bearish for US Treasuries. Higher relative yields, fiscal uncertainty, geopolitics support US Treasuries. High valuations, low term premiums, improving economic growth led to unfavorable view of German Bunds. Some expectations for the European Central Bank (ECB) to announce taper in fall Capacity utilization and industrial production attractive relative to history and improved. IFO capex current conditions improved. Consumer confidence and retail sales improved and attractive relative to history. Terms of trade improved and attractive relative to history. Lower unemployment. Europe Citi Economic Surprise Index in positive regime historically bearish for 10-year German Bunds. Potential for US deregulation, favorable tax reform, increased fiscal spending supportive of sector due to high expectations for corporate earnings to improve. Strong US equity performance and OECD composite leading indicators have historically supported high yield. Our fair value model indicates high-yield valuations elevated relative to history. Bank loans preferred due to highest yield for least amount of duration. Rising rates present risks for IG duration and total return potential. For IG credit, the last 12 months of net leverage has increased well above the 8-year average as of 4Q16; however, the last 12 months of interest coverage decreased meaningfully compared to the 8-year average as of 4Q16. Relative yields are attractive compared to other fixed income sectors. EM growth and economic fundamentals improving and vulnerabilities lower than in the past. EM GDP growth recovering, domestic demand picking up and exports recovering. With falling inflation in EMs, central banks have more flexibility compared to DM peers. Increasing uncertainty over Trump trade policies presents less of a headwind. EM currency risk has fallen recently, which supports EM bonds. No arrow = No change from the previous month The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. All viewpoints reflect solely the views and opinions of the GIC. Equity regions and fixed income sector totals roll up to the main asset classes. Global Investment Committee Allocation Views 2

3 Cross Asset Many of the core themes supporting risk assets such as global equities in the first half of 2017 have persisted as we approached August. Although we continue to have a favorable view of risk assets, several short-term factors led us to lower our conviction in August. Some risks from the first half of 2017 remain, including elevated equity valuations relative to history, along with low equity volatility and the equity risk premium suggesting market complacency. Additionally, there is the unknown impact of Fed balance sheet normalization. A few additional short-term risks have also emerged. The US debt ceiling is likely to be the first agenda item for the US Congress after its summer recess, and policymakers also have the fiscal year 2018 budget resolution and expected tax reforms to address. We see little sign of cooperation within the Republican Party and across party lines. Furthermore, worries about North Korea have not completely faded, an investigation into collusion between US President Donald Trump s campaign staff and Moscow continued to cast a shadow over the current administration, and the Fed chair appointment scheduled for the end of 2017 appears uncertain. However, the pace of global growth has remained on track for continued improvement for the calendar year, and leading economic indicators strengthened in August, led by EMs (see Chart 1). Global PMIs remained in expansion territory in recent months, despite some slowing and a narrower breadth of expansion across regions. An environment of positive and accelerating (albeit at a modest pace) composite, manufacturing and services PMIs globally suggests favorable global equity performance potential in the near term, following healthy performance in the first half of In addition, inflation pressures appeared to have picked up, based on our analysis. Stronger income statement corporate fundamentals, robust global liquidity and potential inflows into global equities also represented tailwinds. Corporate performance and tailwinds for capital expenditure spending also supported risk assets, in our assessment. Measures of corporate profit margins and earnings momentum have trended upward recently. A survey of expected capital expenditure spending over the next six months for US firms showed plans for increased spending. Recent upticks in global profit margins, revenues and business confidence also bode well for capital expenditures, and for global equities. Furthermore, US companies (outside the financials sector) have decreased share buyback activity in 2017 as markets seemed to have rewarded capital expenditure and research and development spending. Confidence has been a common theme supporting equity markets. The Fed has expressed continued confidence in the improving US economy, and global financial conditions remained accommodative following the Fed s interest-rate GIC Asset Class Views Equities Corporate Bonds Government Bonds Commodities Hedge Funds Cash The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month N + hike in June, which also suggests healthy performance potential. A measure of sentiment, the IFO Economic Climate Survey, found in the past few months that optimism among national and global organizations improved considerably from earlier in Manufacturing and consumer confidence have also trended up in recent months. Although the potential for robust US fiscal policy remains somewhat uncertain, the possible upside surprise of successful policy implementation would support risk assets, in our estimation. We also see the possibility for gains in US productivity, should proposed tax changes take effect. However, some geopolitical risks remain. For example, tensions remained elevated between the United States, along with its allies, and North Korea, Syria and Russia, among others. We balance these equity tailwinds with sentiment, valuations and seasonal factors, as these factors appeared less favorable to us. The global equity risk premium was below its rolling five-year average and falling as of mid-august, although our analysis indicated the risk premium had room for further decline (a bullish indicator for equities). Given the continued uncertainty surrounding political and legislative events, the risk premium did not sufficiently compensate investors for these risks, in our opinion. Another cautious indicator for global equities was an environment of high P/E ratios and low volatility (see Chart 2), which suggests to us a level of investor complacency. From a tactical perspective, equity performance relative to fixed income has historically been the weakest in August and September. Nonetheless, we see more supportive factors than possible hurdles for global equities. With the Fed s June interest-rate increase and the Bank of England s unexpectedly close decision on the next day to keep interest rates unchanged, we see the potential for less accommodative central bank policy during the remainder of 2017 as DM economies continue to expand. Even with less accommodative central bank policy in select DMs, financial conditions remain supportive. With Global Investment Committee Allocation Views 3

4 The Pickup in Composite Leading Indicators Has Been Broad-Based and Was in an Environment That Historically Has Supported Equities Chart 1: OECD Composite Leading Indicators August 2012 June Global Equity Regime Statistics PORI POFA NERI NEFA Agnostic Average 3M Fwd. Return 5.2% 2.5% 6.5% 0.0% 2.7% Median 3M Fwd. Return 5.0% 3.0% 6.2% 0.9% 3.1% Std. Dev. of Return 6.3% 6.9% 10.6% 10.6% 8.1% Level of Confidence 100% 25% 100% 100% N/A Count % of Time in Regime 24% 24% 21% 30% 100% Global G7 BRIC Source: Thomson Reuters Datastream. Data as at 15/8/17. Data reflects two-month lag. OECD is the Organisation for Economic Co-operation and Development. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. All statistics calculated using monthly data (MSCI World Index and MSCI All Country World Index). Past performance does not guarantee future results. expectations for slightly higher interest rates moving forward, investor cash flows have started to tilt more toward equities as opposed to bonds. This trend may signal a pivotal investor shift away from government bonds following a 30-year period of inflows. Although ECB President Mario Draghi and fellow ECB members kept a dovish tone on monetary policy during August, positive economic reports and low unemployment in Europe may lead to an eventual taper. We remain in an environment with a positive business cycle, normalizing global growth, improving corporate earnings, and accommodative financial conditions across DMs. We maintain a favorable view of global equities. However, in light of seasonality factors and short-term risks, we favor a tactical approach that involves buying on market weakness. In comparison to global equities, we held a less favorable view of DM global bonds. Our analysis of relative valuations between the two asset classes found equities more attractive to us. We also evaluated global bond markets by employing a model that considers factors such as the business cycle, the slope of the yield curve across markets, momentum for 10-year government bonds and price momentum in equity markets (which we view as a contrarian indicator for bonds). We evaluate these indicators to assess the performance potential for global bonds over the next one to two months. While bond price momentum appeared supportive to us in most major markets, other areas suggested caution with regard to duration. For example, we regarded German Bunds as expensive, given their negative term premium. Even a small rise in Bund yields would likely have a pronounced adverse impact on Bund prices. Similarly, the business cycle appeared to be a headwind in countries such as Japan, Australia and the United Kingdom, based on our analysis. The combination of low term premiums for global government bonds and the persistent momentum for global equity markets also has suggested to us caution with regard to bond performance potential. Furthermore, our base case scenarios for monetary policy from major central banks were generally supportive for global equities, and neutral or slightly bearish for global government bonds. The significant asset purchases in recent years from central banks in the United States and the eurozone should shift to tapered levels and a focus on balance sheet normalization, in our estimation (see Chart 3). Many investors have been waiting for the ECB meeting on 7 September for possible changes in policy. The potential for expansionary fiscal policy in the United States and Europe, which could bolster interest rates, represents another headwind. After evaluating these factors and weighing related considerations, we maintained a preference for short duration in global bond markets. Elsewhere, we continued to observe areas of support for commodities. Global capital expenditure spending has risen in recent months, based on its six-month moving average. Furthermore, several fundamental indicators remained supportive of commodities. Relative and long-term valuations and China s composite leading indicators appeared to be tailwinds for commodities, according to our analysis. In addition, global manufacturing showed improvement in August. Global Investment Committee Allocation Views 4

5 With regard to oil, the supply/demand outlook reflects more normalized conditions, in our opinion. Although technical indicators remained generally weak for commodities in August, fundamentals were more supportive of the asset class. Commodities still face some headwinds. September is part of a seasonable period that has historically seen constrained performance for commodities. Investor sentiment has also climbed over the past month to a level that reflects robust optimism. Instead, from a contrarian standpoint we prefer more investor pessimism. At the same time, we have observed some contradictory trends. First, the crude oil rig count has been slowing over the past 12 months. Second, shale production, which has been prolific, has been facing rising production costs. Combining these attractive macro growth fundamentals against mixed signals from indicators led us to a favorable view of commodities. We balance the favorable factors with a negative roll return. 1 High P/E Ratios and Low Volatility Suggest Investor Complacency Chart 2: MSCI All Country World Index (ACWI) Trailing P/E Ratio Divided by VIX October 1995 July 2017 Global Equity Statistics MSCI ACWI Trailing P/E Divided by VIX (3MMA) Upper and Lower Bounds (0.75 Std. Dev. from Median) Above Threshold Below Threshold Regime Agnostic Average 3M Fwd. Return 0.4% 2.6% 2.0% Median 3M Fwd. Return 1.1% 4.9% 3.0% Std. Dev. of Return 6.4% 12.0% 8.6% % of Time in Regime 20% 32% 100% Source: Thomson Reuters Datastream. Data as at 21/8/17. Statistics calculated using monthly return data (MSCI ACWI). Past performance does not guarantee future results. Balance Sheet Normalization Appears Imminent Effects Are Unknown Chart 3: Total Central Bank Assets and Quarter-over-Quarter Change in Central Bank Assets October 2008 August 2017 March 2009 July 2017 USD Trillions USD Billions United States Japan Eurozone Source: Thomson Reuters Datastream. Data as at 21/8/ Total Assets Global Investment Committee Allocation Views 5

6 Equities We continue to see encouraging economic data in the eurozone. Corporate performance in the region was particularly strong over the past few months, as demonstrated by healthy levels of positive surprises for earnings, as well as for revenue growth. Retail sales in the eurozone showed marked improvement on a year-over-year basis. Expectations for higher loan demand, according to a survey of senior loan officers at euro area banks, further enhances the appeal of eurozone stocks (see Chart 4). The overall favorable trends appeared more impressive to us when compared to other DMs. Leading economic indicators for many eurozone countries strengthened in August, particularly on a year-over-year basis. For example, the rising and positive trend for indicators in Germany and France has historically been followed by positive equity market results. Manufacturing activity has trended upward in both countries, while the United Kingdom has seen activity weaken. Similarly, consumer sentiment and retail sales have improved in the eurozone in recent months, compared to lower levels in the United Kingdom. We also see continued growth in corporate performance. Profit margins of European firms have begun to converge with those of their US peers. Historically, an improving trend for profit margins in Europe has been followed by solid performance for European equities. Eurozone earnings-pershare (EPS) growth has also demonstrated improvement. From a valuation perspective, European equities were attractive to us on price-to-book, last 12-month and next-12- month earnings ratios, particularly when compared to DM peers such as the United States. Furthermore, we believe investors are likely to focus more on the eurozone s economic growth and emergent inflation as the economic backdrop continues to improve. They also may take a more measured assessment of potential ECB policy moves. Following an extended period of political uncertainty weighing on European stocks, investor concerns surrounding populist politics in the region have largely faded. European equities enjoyed a healthy rally following French run-off election results in May and parliamentary election results in June, as well as encouraging economic data. Although a broad range of economic data and developments support eurozone stocks, we remain cognizant of potential headwinds. Greece may encounter future challenges in meeting large debt payments, although the country received approval from the International Monetary Fund in July for a large loan. From an economic standpoint, while we see European demand as the primary driver of the region s economy, deceleration in EM economies, particularly China, could weigh on eurozone growth. The short-term outlook for Europe turned down in late June, based on sentiment and technical indicators. GIC Views of Equity Regions Developed United States Europe Japan Canada Emerging N + The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month However, in our estimation these concerns were already priced into eurozone equities, and we find many more tailwinds than headwinds for the region s bourses. We believe the improving business cycle will trump politics, which led us to maintain a favorable view of European stocks. In Japan, corporate EPS revisions, along with ROE and profit margin momentum, have all been robust in recent months. Japanese profit margins have continued to climb and reach a multi-decade high, which supported the convergence of the country s ROE with that of other DMs. Furthermore, ROE momentum was higher than in most DMs. Additionally, a tight labor market has been supporting wage growth and lowered deflation concerns. Significant central bank support in Japan and a large rebound in global trade have also served as notable tailwinds. Industrial production in Japan has demonstrated significant expansion over the past two years. Money growth was robust in Japan, providing what we see as further support for Japanese equity performance potential. Economic reports published in August provided further evidence of the country s health. Japan s second-quarter GDP expanded at its fastest pace in more than two years and exceeded consensus forecasts. The country s economy has expanded for six consecutive quarters. Consistent with this growth, capital expenditures increased in the second quarter at the fastest pace since the first quarter of The wide breadth of favorable economic data also included industrial production, which benefited from a pickup in global activity, and retail sales, which recovered to normalized levels. We view the higher levels of retail sales in Japan as particularly favorable, as EPS sensitivity to retail sales has historically been acute in Japan relative to its DM peers (see Chart 5). Despite these strengths, our analysis indicated to us that analyst expectations and guidance from Japanese corporations have continued to underestimate EPS growth. Valuations also seemed to us to underestimate improved corporate profitability in Japan. As of mid-august, Japanese Global Investment Committee Allocation Views 6

7 Demand Expectations Supportive of European Equities Chart 4: Loan Demand Proxy, ECB Bank Lending Survey January 2003 June Increasing Decreasing Loan Demand Proxy European Equity Statistics Agnostic Increasing Decreasing Signal Bullish Bearish Average 2.2% 3.1% 0.5% Median 3.4% 3.7% 2.3% Standard Deviation 8.1% 6.3% 10.7% Count % of Time in Regime 66% 34% Source: IBES, Thomson Reuters Datastream and Goldman Sachs. Data as at 18/7/17. Past performance does not guarantee future results. equities offered lower valuations compared to other DM equities across most measures, including P/E, despite less political risk in Japan. Although we find the supportive factors for Japanese equities far outweigh the risks, regional geopolitical risks concerning North Korea also remain. Japanese Prime Minister Shinzo Abe s approval rating has declined in recent months. However, the broad strength across Japan s economy, including tailwinds from the labor market and central bank support, and broadly attractive valuation metrics relative to DM peers led us to hold a favorable view of Japanese equities. Japan Has Historically Provided Higher Leverage to Sales Growth Chart 5: Next-12-Month EPS Growth Sensitivity to NTM Sales Growth As at 31 July % 3.5% 3.0% 2.5% 2.0% 1.5% 1.77% 2.56% 3.45% 1.0% 0.5% 0.0% United States Europe ex United Kingdom Japan Source: IBES, Thomson Reuters Datastream and Goldman Sachs. Data as at 31/7/17. Past performance does not guarantee future results. Global Investment Committee Allocation Views 7

8 Fixed Income Despite higher expectations for growth and future interest-rate increases, the US Treasury market appears to us to be pricing in sluggish growth and a conservative path of interest-rate hikes, particularly past Strong US economic data across the labor market, as well as business and consumer sectors, and financial conditions broadly easing suggest the case for interest-rate tightening has strengthened modestly. Headline employment in the United States has continued to improve, even with a small uptick in August, and has remained strong for some time. The rise in US nonfarm payrolls and the US economy adding a healthy amount of jobs have also started to benefit wage gains. We see further improvement in wage gains over the next six to 12 months. In addition, the gap between the unemployment rate and the nonaccelerating inflation rate of unemployment appears to us to have closed. A tighter labor market in the United States supports our view of strengthening inflationary forces, and core inflation has trended higher over the past 12 months despite a recent pullback. US consumption also supports firming inflation the house price-to-income ratio showed improvement from already strong levels, and consumer confidence was near a 16-year high. The Fed may also announce a change to its policy of reinvestment of payments of principal for US Treasuries and agency bonds. This potential action could provide upward pressure on US Treasury yields and spreads for mortgagebacked securities. US GDP accelerated in the second quarter of 2017 from the previous quarter s pace, also indicative to us that US growth was more robust than many recognized. Strong terms of trade attested to healthy contributions from exports. Given the difference between strengthening inflationary factors and market pricing, we viewed term premiums in the US Treasury market as low and unattractive. Outside of the United States, overall economic data in the eurozone have demonstrated broad and, in many cases, substantial improvement recently. Both manufacturing and services PMIs notably improved in the past few months, although the region s services PMI remained unchanged in July. Healthy and improved levels of both capital expenditures and capacity utilization in the eurozone also indicated strength. With wage growth rising and a lower unemployment rate in the past few months, consumer confidence has climbed, accompanied by higher demand, including rising retail sales, housing starts and new car registrations. Many of these economic measures were coming off of low levels, which suggests to us room for further growth. Easier credit standards in the eurozone (based on surveys of consumer, business and housing credit markets) appeared to us as supportive of economic growth over the next few quarters (see Chart 6). The strengthening economic picture in the eurozone GIC Views of Fixed Income Sectors US Treasuries Ex-US Govt. Bonds High Yield Investment Grade EM Debt N + The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month should dampen demand for eurozone government bonds. In addition, rising consumer demand in the eurozone should support inflation, which could curtail real interest rates and, therefore, the appeal of government bonds. As a result of upward economic trends, fiscal policy in Europe has been turning expansionary, or at least less contractionary. The eurozone s terms of trade have demonstrated its economic strength and demand for exports relative to the region s global peers. The transmission mechanism of monetary policy is showing gradual improvement. Consequently, we view German Bunds as overvalued, resulting in asymmetrical risk and reward. For example, the term premium is currently quite negative for German Bunds, and a small rise in yields could wipe out years of carry. Easier Credit Standards in the Eurozone Supportive of Economic Growth Chart 6: Net Percentage of Banks Reporting Tightening Credit Standards July 2012 June 2017 Net % 20% 15% 10% 5% 0% -5% -10% -15% Firms Tightening Standards for Business Loans Firms Tightening Standards for Business Loans to Large Companies Source: Thomson Reuters Datastream. Data as at 15/8/17. Improving Global Investment Committee Allocation Views 8

9 Given our assessment of improved growth in Europe, low term premiums for US Treasuries and other DM government bonds, and the increased potential for major central banks to curtail stimulus, we have an unfavorable view of DM government bonds broadly, especially those outside the United States, and most notably German Bunds. Increasing uncertainty over President Trump s ability to enact proposed trade restriction policies has resulted in less of a headwind for EM debt in recent months, in our opinion. EM debt also offered a yield which we have regarded as attractive relative to US IG bonds. This healthy yield has also supported investor inflows into EM debt year-to-date. Although some investors expressed concern for a substantial slowdown in China, the country s growth indicator suggests real GDP is likely to improve in the medium term (see Chart 7). China s PMIs remained in expansion in recent months. Leading economic indicators were also positive and strengthening in China and India, and this PORI regime highlights improving economic fundamentals. In Latin America, the headwinds of high inflation have lessened over the past 18 months. The combination of positive interest rates and positive-but-falling inflation led us to conclude that EM central banks have more flexibility in monetary policy than many DM peers (see Chart 8). Our analysis also weighed considerations such as absolute valuations and spreads for EM debt, which were near their historical average. Yields for the EM bond sector were more attractive to us relative to IG credit, and we held a favorable view of EM debt. Another area of concentrated focus for us is evaluating what stage credit markets have entered. In the US credit market, we found spreads tight across bond sectors, particularly optionadjusted spreads for IG bonds. Our analysis of consumption expenditures and demand levels led us to conclude US credit markets were a bit extended, as leverage has trended higher over the past several years. The Fed was widely expected to continue with measured increases in interest rates amid a strong labor market and firming inflation. Though some possibility remains that proposed fiscal policies in the United States could extend the credit cycle, our analysis concluded US credit markets lie in the later stage of the credit cycle. We also favor bank loans within the corporate bond sector, since they currently offer the highest yield in this sector for the least amount of duration, or sensitivity to interest rates. China s Economic Indicators Suggest Upcoming Improvement in Real GDP Growth Chart 7: China Growth Indicator and Real GDP January 2005 August 2017 Z-Score Growth Indicator Z-Score Real GDP YOY % Change Z-Score Source: Calculations by FT Solutions using data sourced from Bloomberg. Data as at 14/8/17. A z-score indicates how many standard deviations a data point falls above or below the mean, or expected value. The higher or lower the z-score, the further the data point falls from the normal distribution. It is useful for comparing multiple series of data. The Projected Path of Central Bank Rates Looks Encouraging for Emerging Markets Chart 8: Relative Central Bank Rates June 2005 June 2018 (Forecast through June 2018) 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Central Bank Rate EM minus DM Bloomberg Consensus Forecast Source: Bloomberg and National Sources. Data as at 1/8/17. There is no assurance that any forecast will be realized. Global Investment Committee Allocation Views 9

10 Alternatives Several tailwinds for hedge fund managers emerged in the first half of 2017, particularly in the long short equity space US stock correlations fell, dispersion increased and stocks increasingly traded on fundamental news. Fundamentally weak companies typically face increased pressures on their financials amid a rising rate environment, which we believe enhances opportunities for hedge fund managers to identify both winners and losers. We expect the quantitative easing-driven equity beta tailwind that has been evident over the past few years to have less impact on equity performance potential, and company-specific developments should continue to have more influence on equity performance potential going forward. The inverse environment was characteristic of the past few years, and hedge fund performance has been modest over this period. However, when hedge fund performance has improved from below-average levels, as both the economic environment and recent performance suggest, the asset class historically has exhibited strong performance potential. Additionally, less competition in the hedge fund space may support managers, as investor net outflows were substantial in 2016, representing the first year of net outflows since Investor net inflows resumed in 2017 as of July-end, which we believe reflected recognition of the growing tailwinds for the asset class. Accordingly, we maintained a favorable view of hedge funds. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. Investments in smaller-company securities that may have limited liquidity involves additional risks, such as relatively small revenues, limited product lines and small market share. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolio s initial investment. A strategy may not achieve the anticipated benefits, and may realize losses, when a counterparty fails to perform as promised. Currency rates may fluctuate significantly over short periods of time and can reduce returns. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investments in REITs involve additional risks; since REITs typically are invested in a limited number of projects or in a particular market segment, they are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector prices of such securities can be volatile, particularly over the short term. Investments in hedge funds are speculative investments, entail significant risk and are suitable only for persons who can afford to lose the entire amount of their investment. Global Investment Committee Allocation Views 10

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