MACRO MONTHLY LAST OF THE SAFE HAVENS

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1 MACRO MONTHLY LAST OF THE SAFE HAVENS OCTOBER 218 THE STORY SO FAR COMPENSATING FOR UNCERTAINTY Quantitative tightening has made it a difficult year for all asset classes with very poor liquidity amplifying market moves. Now, the last risky asset safe havens US equities and credit are in the firing line. Multiple macro stories are starting to come to a head the unifying factor for all of them is the rising term premium. HIGHER TERM PREMIUM The term premium is extra yield that an investor required to hold a long-dated bond, and it compensates for uncertainty. It s everything that can t be attributed to future central bank rate expectations. Historically, this has been a positive number as bond investors wanted compensation for upside inflation risks, but since late 215 it fell into negative territory (according to the model by Adrian, Crump and Moench). This occurred for two main reasons in our opinion: 1. Inflation risks gave way to deflation risks as secular stagnation theories took centre stage. 2. The European Central Bank (ECB) and Bank of Japan (BoJ), central banks in jurisdictions with large capital account surpluses, took rates negative and bought vast quantities of assets. Other central banks, meanwhile, such as the Federal Reserve (Fed), provided very strong forward guidance reducing policy uncertainty. WHAT DROVE UP ASSET PRICES Low term premiums made bonds a very unattractive asset class for a price sensitive investor, but central banks were not price sensitive. So term premia stayed low and investors looked for returns elsewhere-in equities, emerging markets, corporate debt, the rental market, leveraged loans etc. This drove many asset classes to expensive levels. ACM TERM PREMIA Source: Merian Global Investors, as at 31 October 218. Page 1 of 5

2 CENTRAL BANK BALANCE SHEETS SHRINK TAKING AWAY THE PUNCH BOWL With the global economic recovery, closing output gaps and a low level of unemployment, central banks feel they can now step back, endangering the financial assets that benefitted from the liquidity boom. The marginal benefit of more quantitative easing is negative at this point as it serves to create froth in financial assets so central banks are taking away the punchbowl. Developed market central bank balance sheets will actually shrink in November. FEDERAL RESERVE BALANCE SHEET 5E E E+12 3 USD, trillion 2E E E Source: Merian Global Investors, as at 31 October 218. HOW TO MEASURE REAL RATES Adding to the pressure on term premiums is the removal of forward guidance from the Fed, and speeches from Fed Chairman Powell and NY Fed President Williams were the key to the recent market selloff. The concept of R*, or the estimated natural real rate of interest where saving and borrowing are in balance, has driven Fed thinking in recent years (Williams co-authored a paper to estimate R*) and anchored the market s expectation of future Fed Funds rates. Chairman Powell stated in his recent post-meeting press conference, correctly in our view, that it s a hard to estimate the natural real rate of interest and has adopted more of a we ll know when we get there approach. Meanwhile, Williams admitted it is a cloudy measure. This saw the long-end term premium shoot up. THE IMPACT OF VOLATILITY When bond yields rise, things break, as everyone is learning this year, and this time US equities and credit have borne the brunt of it after a slightly underwhelming earnings season. US financial assets have been protected from the global sell off by President Trump s fiscal stimulus and due to problems elsewhere in the world, which led to capital inflows into the US. But as volatility in US assets increases and bond yields rise (particularly in Japan and Europe the major capital exporters) we d expect these inflows to at least slow, if not reverse. Page 2 of 5

3 Percentage Points Risk assets"melt up"; short volatility funds implode Term premium rises after Pow ell and W illiams' speeches; earnings and grow th softer USgrow th boom keeps volatility low Nov-217 Dec-217 Jan-218 Feb-218 Mar-218 Apr-218 May-218 Jun-218 Jul-218 Aug-218 Sep-218 Oct-218 Nov-218 VIX, lhs Source: Merian Global Investors, as at 31 October Year Term Premium, rhs KEEPING RISK LOW HOW WE ARE POSITIONED We continue to expect further bouts of volatility as we go into year-end as term premium normalises. This view dominates our portfolio positioning at the moment we stay short US and European credit via CDX, have curve steepeners in core markets, stay cautious on emerging markets and have reduced the scale of our duration short. Valuations in risk are becoming more attractive but until we signs that the Fed is ready to pause or we become more optimistic on global growth (essentially an end to the trade war), we ll keep risk low. Page 3 of 5

4 THE MODEL PORTFOLIO Alpha Factor Conviction Weights (per sector) Direction Exposure (weighted duration or %) Risk Cont. (TE,bps) Risk Cont. (%) CREDIT NET SHORT -.75yrs US / EUR Coco bonds 2% LONG.45yrs Hard Currency EM 2% LONG.1yrs Long protection HY 4% SHORT -.55yrs Long protection IG 2% SHORT -.75yrs Developed Market Rates NET SHORT -3.7yrs US 15% LONG 1.5yrs Canada 1% SHORT -.5yrs Germany 1% SHORT -1.2yrs Italy 1% LONG.45yrs France 1% SHORT -.95yrs Cyprus 5% LONG.4yrs UK 25% SHORT -1.3yrs Switzerland 5% SHORT -.3yrs Japan 5% SHORT -1.5yrs Australia 5% SHORT -.3yrs FX (vs. USD) NET LONG 9.5% Australia Dollar 1% LONG 3.% British Pound 25% LONG 4.% Euro 5% LONG.5% 1.4 Indian Rupee 5% LONG 1.% 1.4 Japanese Yen 5% SHORT -1.% 2.8 New Zealand Dollar 5% LONG 2.% Norwegian Krone 5% LONG 1.5% South African Rand 5% SHORT -1.% South Korean Won 1% SHORT -2.% Swedish Krona 1% LONG 2.% Swiss Franc 5% LONG 1.5% 2.8 Taiwanese Dollar 1% SHORT -2.% Inflation NET LONG 2.2yrs Japan Breakeven 25% LONG.6yrs European Breakeven 5% LONG.9yrs US Breakev en 25% LONG.7yrs Total Source: Merian Global Investors, as at 31 October 218. Page 4 of 5

5 FUND MANAGERS Mark Nash and Nicholas Wall have managed the Merian Global Strategic Bond Fund (GSB) since 1 August 216. MARK NASH Mark is head of fixed income at Merian Global Investors (MGI). He joined MGI on 27 June 216 from Invesco, where he had worked since 21. At Invesco, he was most recently head of global multi-asset portfolios. Mark is a CFA charterholder and has a chemistry degree from the University of Nottingham. NICHOLAS WALL Nicholas joined MGI as portfolio manager in July 216. Prior to joining the business Nicholas worked as a fund manager in the global macro team at Invesco, since 26. He is a CFA charterholder and has an economics degree from the University of York. Page 5 of 5 Past performance is not a guide to future performance and may not be repeated. Investment involves risk. The performance data does not take account of the commissions and costs incurred on the issue and redemption of shares. The value of investments and the income from them may go down as well as up and investors may not get back any of the amount originally invested.the value of investments and the income from them may go down as well as up and investors may not get back any of the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rate changes may cause the value of overseas investments to rise or fall. This communication is issued by Merian Global Investors (UK) Limited ( Merian Global Investors ), Millennium Bridge House, 2 Lambeth Hill, London, United Kingdom, EC4P 4WR. Merian Global Investors is registered in England and Wales (number: ) and is authorised and regulated by the Financial Conduct Authority (FRN: ). This communication is for information purposes only. Nothing in this communication constitutes financial, professional or investment advice or a personal recommendation. This communication should not be construed as a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the document. Any opinions expressed in this document are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or companies within the same group as Merian Global Investors as a result of using different assumptions and criteria. In Hong Kong this communication is issued by Merian Global Investors (Asia Pacific) Limited. Merian Global Investors (Asia Pacific) Limited is licensed to carry out Type 1 and Type 4 regulated activities in Hong Kong. This communication has not been reviewed by the Securities and Futures Commission in Hong Kong. In Singapore this document is issued by Merian Global Investors (Singapore) Pte Limited, which is not licensed or regulated by the Monetary Authority of Singapore ( MAS ) in Singapore. Merian Global Investors (Singapore) Pte Limited is affiliated with Merian Global Investors. Merian Global Investors is not licensed or regulated by the MAS. This document has not been reviewed by the MAS. In Switzerland this communication is issued by Merian Global Investors (Schweiz) GmbH, Schützengasse 4, 81 Zürich, Switzerland. This communication is for investment professionals only and should not be relied upon by private investors. MGI 11_18_57