Investment Strategy Webinar. January 15, 2014

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1 Investment Strategy Webinar January 15, 2014

2 Presenters Max Kotary, Partner Investment Consulting Phone: Tapan Datta, Partner Global Asset Allocation Team Phone: Duncan Lamont, CFA, Principal Global Investment Practice Phone:

3 Improvements to the Format for the HEK Monthly Calls Beginning in February, the monthly one-hour live webinars will be replaced by several shorter recorded webinars The advantages of this include: You can listen on your own schedule You can listen to only the topics of interest to you The historical webinars will be available online and labeled by topic Although there will not be live Q&A, listeners are always welcome to have follow-up discussions with their consultants 3

4 Discussion Topics Opening Remarks Market Outlook with a Focus on Bonds Closing Remarks Q&A Session 4

5 Market Outlook with a Focus on Bonds Tapan Datta & Duncan Lamont

6 Medium-Term Market Environment: A Bird s Eye View Markets are entering a much more challenging, lower return environment Equity Returns are squeezed by monetary normalization and lack of valuation headroom Fixed Income Returns will continue the volatile low return path already seen Yields are too low and credit spreads have done all the heavy lifting already Alternative Asset Classes look better but at the price of greater complexity and more attention to fund selection 6

7 Economic Outlook: Glass Half Full 10 US CONSUMERS HANG IN THERE AND KEEP SPENDING (Growth in retail sales, % over previous year) U.S. consumers are hanging in there, despite the tax hikes of Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13-5 Consumer confidence continues to build slowly. Consumers will lead economic improvement, companies will follow by raising investment. -10 Source: Datastream OPTIMISM THAT GLOBAL GROWTH IS PICKING UP? Or is third time lucky? Source: IMF GDP growth Crisis conditions in Europe have eased - Some improvement is expected. The IMF is forecasting economic improvement worldwide over Though we have to note that it has done so before.! 7

8 Economic Outlook: Glass Half Empty WAGE STAGNATION? (Median real household incomes, constant $) The glass half empty view points to weak growth in real incomes. Median incomes are back to levels in the mid 1990s. Nominal GDP (GDP with inflation effects allowed for) has really slowed in the U.S. Growth of this aggregate is substantially below long-term and pre-crisis averages. Source: FRBSL LOOK HOW FEEBLE US GROWTH REALLY IS (US nominal GDP growth over previous year %) 0 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 The half empty glass will also point to Europe growing at far lower rates than a few years ago (even if there is a mild recovery) and to the emerging world where growth rates are sharply lower. The same view will also point to the fact that demographics are unhelpful. The U.S. is aging less fast than Europe, but it is aging too. Slower growth in employment and weaker productivity suggests GDP growth could be weaker too. 3 per. Mov. Avg. (Series1) 8

9 Markets are Too Complacent! 50 EQUITY MARKETS ARE COMPLACENT (ViX volatility index) 200 BOND MARKETS MORE NERVOUS RECENTLY (Merrill Lynch MOVE index) Jittery Yields fell, bonds looked great More volatile recently Confident Feb90 Feb92 Feb94 Feb96 Feb98 Feb00 Feb02 Feb04 Feb06 Feb08 Feb10 Feb12 40 Jan09 Jul09 Jan10 Jul10 Jan11 Jul11 Jan12 Jul12 Jan13 Jul13 Equity markets show overconfidence Rising interest rates will challenge this The fall in bond yields also went too far A change in mood is already with us 9

10 Markets have Moved Ahead too Strongly 250 THE STOCK MARKET HAS GONE WAY AHEAD OF THE ECONOMY 7 CREDIT HAS LITTLE ROOM TO RUN (US Corporate Bond Credit Spread %) 200 US equities (S&P 500) Economy ('Nominal US GDP) Jun Jun Jun Jun Jun Market has run ahead of economy a lot. Economy could take a while to catch up. This means low stock market returns at best. Credit offers no shelter. Yields are too low and spreads becoming unattractive. Yet another example of markets heading for a challenge! 10

11 Bonds: Treasury Yields on the Rise US 10yr Treasury Yield (%) 10yr Treasury yields up around 1.5% from the lows close to highest level for over 3yrs Interest Rate Projections Implied by Fed Funds Futures But forward guidance has been successful in pushing back expectations for Fed Funds rate Prior to non-taper decision in September Dec 31, Mar- 14 Jun- 14 Sep Mar- 15 Jun- 15 Sep Mar- 16 Jun

12 Bonds: We expect Treasury Yields to Move Higher Near-Term Factors Restraining Treasury Yields Primary Medium to Long-Term Factors Pushing Yields Upward Federal Reserve Presence still Being Felt Lessening Federal Reserve Support Uneven Trajectory for Economic Recovery Higher Short-Term Interest Rates Inflation Staying Low Inflation Risk & Government Debt Burden 12

13 Bonds: But this is Already Reflected in Market Pricing! Market Pricing for Level of 10yr Treasury Yield 5% 4% 3% 2% 1% 0% Current In 1yr In 3yrs In 5yrs Market pricing no longer looks unreasonable Bonds are no longer seriously unattractive but that is different to saying they are attractive! Uncertainty is high and heightened risk that markets overshoot as adjust to diminishing Fed support Return prospects remain poor, especially relative to risky asset classes such as equities 13

14 Bonds: Investment Grade Credit: Low Yields and Less Attractive Credit Spreads Decomposition of Corporate Bond Yield Underlying Treasury yield OAS Credit yields remain low, mainly because of low Treasury Yields 2 0 June-89 June-94 June-99 June-04 June-09 And recent strong performance means that credit spreads are no longer so attractive Credit spreads versus fair value (basis points) Fair Value Current Overall corporate bonds Intermediate credit Long credit 14

15 Bonds: Investment Grade Credit: Low but Positive Returns Expected Long Credit Spread - Intermediate Credit Spread Long credit spreads are elevated relative to Intermediate yr Annualised Return Forecasts Credit expected to outperform Treasuries due to additional yield Long credit expected to outperform Intermediate on a 3yr view 8% 6% 4% 2% 0% -2% -4% -6% -8% Aggregate corporate bonds Intermediate credit Long Credit Optimistic Central Pessimistic 15

16 Bonds: Better Bond Investments can be Found Bond yields are still low Pricing is now more reasonable but return prospects remain poor Credit Better than government bonds but carry interest rate risks and high sensitivity to economy/investor sentiment Emerging Market Debt Relative attractions improved - local currency preferred to dollar debt Bank Loans Reasonable credit pricing with no interest rate risk Bank Loans Emerging Market Debt Investment Grade, High Yield Government Bonds More Attractive 16

17 Bond MTVs and Potential Actions View Action and Implementation Government bond markets are no longer seriously mispriced Reduce short duration bets Corporate bond spreads less attractive but credit should outperform Treasuries over medium-term and long credit should outperform intermediate Rebalance out of large credit overweight positions Long credit preferred to intermediate Emerging market debt has become relatively more attractive than U.S. credit (EMD has become cheaper) Buy EMD: source of funds could be investment grade or high yield debt Bank loans preferred to high yield debt Maintain bank loan allocation as preferred sub-investment grade exposure 17

18 Equity MTVs and Potential Actions View Action and Implementations Global equity returns are turning lower less reward for more risk in equities Non-U.S. equity market regions are better value Take profits/rebalance Consider total equity risk how can you diversify some of this equity risk away using other asset classes e.g. long-short or defensive hedge fund strategies Rebalance out of U.S. Is it a good time to raise non-u.s. allocations? Other asset allocation changes? U.S. small cap is particularly expensive Rebalance large/small or consider global small cap or use for source of funds for raising overseas allocations 18

19 Alternative Asset Classes View Action and Implementations More volatility and less return expected in equity and credit markets. Hedge funds are going to be well placed to perform Consider whether hedge fund allocations could take the place of equities an intermediate de-risking. Longer-term less liquid alternative asset classes continue to offer portfolio enhancement, through more reliance on skill and with less market risk. Private Equity, Commercial Real Estate and Infrastructure investments are attractive. Where liquidity and governance considerations permit, allocations to these alternative asset classes should be considered. Commodities still have some downside medium-term. Do not rebalance yet. Still not a good time to consider raising allocations here. 19

20 Closing Remarks Max Kotary

21 Q&A Thank you. 21

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