FOR WHOLESALE CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. EXUBERANT MARKETS JUNE 2018

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1 FOR WHOLESALE CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. EXUBERANT MARKETS JUNE 2018 > Equity and credit markets show strong signs of exuberance, and the clock is ticking on a potential reversal of recent trends. We believe that investors should be considering risk re-allocation strategies.

2 EXECUTIVE SUMMARY SECTION ONE: EXUBERANT MARKETS Contrarian investors will likely see the current environment of excessive equity and credit market valuations as an opportunity to re-allocate risk. To test whether markets are approaching a potential turning point, we have analysed risk markets using an objective three-stage framework. We analyse: A. Maturity of current market trends B. Potential catalysts for a reversal C. Potential accelerants of a reversal Our analysis indicates that market conditions are exuberant in equities and, to a lesser extent, in credit markets. The clock appears to be ticking on a reversal as central bank support declines. SECTION TWO: STRATEGIES TO NAVIGATE MARKET EXUBERANCE We believe it is now time to consider re-allocating risk before it is too late. We outline four strategies for investors to consider: A. Focus on sources of reliable cashflows to meet specific outcomes B. Target alpha rather than beta C. Manage tail risks D. Seek out relative value SECTION THREE: THE END OF GOLDILOCKS? Markets are resilient until a critical threshold is reached, but accurately predicting a tipping point is close to impossible. With signs of market exuberance and irrationality, we believe that investors should heed the warning signs and consider re-allocating risk. For more information on this analysis, please contact your Insight representative to have a more detailed conversation on actions specific to your investment portfolio.

3 SECTION ONE: EXUBERANT MARKETS Is this period of buoyant asset prices and low volatility drawing to a close? In recent years, markets have occupied a `Goldilocks zone in which growth and inflation have been `just right. This environment has been supportive for corporate earnings and asset prices. This environment emerged partly as a result of central banks unconventional policies after the global financial crisis. Historically, central banks have used interest rates as the primary method to manage economic activity but many of the channels that traditionally transmit easier monetary policy to the real economy became blocked or ineffective since the crisis (see Figure 1). This forced central banks to explore unconventional policy options, including quantitative easing. This drove global bond yields to historically low levels in order to stimulate economic growth. Yield-starved investors, comforted by the benign environment, were gradually pushed into increasingly risky assets. Fixed income investors reallocated into longer-maturities, increased their allocations to credit, and some even raised exposure to developed market and even emerging market equities. This has implications for long-term investors, who may wish to consider a contrarian approach after such a sustained period of gains. Good contrarians do not just rely on long-term value calls but also develop objective processes to measure the risk of a reversal. Overleaf, we introduce a three-part framework to help investors assess whether markets are approaching a potential turning point. Timing an exact peak or trough in markets is difficult, but actively managing risk when market conditions become stretched is prudent, as experience of past investors suggests. When financier J.P. Morgan was asked about the secret of his long-term success, he was rumoured to have answered, I always sold too soon. Figure 1: Traditional channels of monetary policy transmission became blocked How central bank easing stimulates growth Post-crisis reality Money and credit creation Banks were busy repairing balance sheets and deleveraging to meet new capital requirements Exchange rate depreciation The global nature of the crisis made it hard for one region to gain a relative advantage Improving expectations and economic confidence The severity of the downturn meant economies took much longer to recover than normal Rising asset prices and risk appetite Asset prices benefited as ultra-low interest rates pushed investors into higher-risk assets

4 Good contrarians do not just rely on long-term value calls but also develop objective processes to measure the risk of a reversal ABDALLAH NAUPHAL

5 INSIGHT S THREE-PART FRAMEWORK FOR TESTING MARKET EXUBERANCE A RISK-REWARD PROFILE Determine excesses within the system by assessing various measures to establish how stretched markets have become. MATURITY OF CURRENT MARKET TRENDS Valuations Sentiment Leverage Credit quality B TIMING OF A REVERSAL Provide a sense of when a market reversal might occur by identifying potential catalysts for a trend reversal and how they may trigger a turning point. POTENTIAL CATALYSTS FOR A REVERSAL Central bank policy Economic conditions Fiscal policy C MAGNITUDE OF A REVERSAL Identify whether there may be factors which can act as potential accelerants in any reversal, increasing the speed and magnitude of any repricing. POTENTIAL ACCELERANTS IN A REVERSAL Market liquidity Forced selling We analyse each part of this framework in more detail overleaf.

6 A RISK-REWARD PROFILE Determine excesses within the system by assessing various measures to establish how stretched markets have become. EQUITY MARKETS Equity valuations are around 100-year highs Investors remain optimistic despite valuations Leverage in equities is rising EQUITY VALUATIONS ARE AROUND 100-YEAR HIGHS US market cap-to-gdp, the Shiller CAPE ratio and our favourite measures, price-to-cashflow and price-to-sales, all show that stocks have only been more expensive once since the 1950s: during the dot-com bubble. Historically, when valuations have been at or near their most expensive, they have tended to be associated with negative three-year forward returns. Figure 2: US equity valuations (price/cash flow and price to sales) 1 Standard deviations relative to long-term mean Very expensive Expensive Neutral Cheap Very cheap While it is true that some other equity valuation metrics paint a more positive picture, we believe that they can be misleading because they tend to use projections of forward earnings, which can be easily distorted or manipulated. INVESTORS REMAIN OPTIMISTIC DESPITE VALUATIONS Despite historically high equity valuations, investor sentiment remains very positive, a telling signal of exuberance. For example, the University of Michigan s Consumer Sentiment Index shows the highest level of optimism since its inception in Similarly, a gauge of investment advisors compiled by Investor Intelligence 3 shows the percentage of investors with a negative outlook on equity markets at historically low levels, similar to those seen before the market crash of LEVERAGE IN EQUITIES IS RISING Margin buying and selling (as indicated by data from the New York Stock Exchange 4 ) has risen dramatically, coinciding with the rally in stocks. Corporates have also been increasing leverage on their balance sheets by buying back stock at particularly high levels over the last two years 5. In summary, investors are increasingly leveraging their portfolios by buying expensive stocks of companies that are themselves becoming increasingly leveraged. This should register as a major red flag for investors. 1 Average of the z-scores for price-to-cashflow and price-to-sales of the S&P 500. Bank of America Merrill Lynch and Insight February University of Michigan survey as at February Yardeni Research, Investor Intelligence and Insight as at January Advisor Perspectives, dshort.com as at February SG Markets as at December 2017.

7 CREDIT MARKETS Credit spreads are close to pre-crisis lows Issuance of leveraged structures is on the rise Credit quality is declining across the board CREDIT SPREADS ARE CLOSE TO PRE-CRISIS LOWS Credit valuations are around their narrowest since the global financial crisis (see Figure 3) and are trading near their narrowest levels since the mid-1990s, indicative of squeezed valuations. Figure 3: Corporate bonds are expensive 6 Corporate option-adjusted spread over Treasuries (bp) Mar 98 A 7-10yr Mar 02 Mar 06 BBB 7-10yr Mar 10 Mar 14 ISSUANCE OF LEVERAGED STRUCTURES IS ON THE RISE Mar 18 Issuance of leveraged credit structures, such as collateralised loan obligations 7 (CLOs) is on the rise. CLOs saw record global issuance in 2017, double any previous calendar year 8 and 2018 looks set to be even bigger. In the market underlying CLOs the bank loan market the share of covenant-lite issuance has been at a record 73% of all loan market issuance the last two years 9. Credit investors are increasingly accepting fewer structural protections, and there is undeniably strong appetite for leveraging credit risk. CREDIT QUALITY IS DECLINING ACROSS THE BOARD Credit ratings have fallen globally as corporate leverage ratios have risen. The average US investment-grade credit rating recently turned from A to BBB/Baa (Figure 4). Figure 4: The quality of the entire credit market has been falling 10 Credit score A Baa Average US investment-grade rating 6 Source: Datastream and Insight as at March This is not a comment on CLO structures themselves. CLO default rates are historically very low, and newer structures offer better credit enhancement. 8 S&P LCD, Intex, Deutsche Bank Global Research as at March LCD as at Bank of America Merrill Lynch, Insight as at February 2018.

8 B TIMING OF A REVERSAL Provide a sense of when a market reversal might occur by identifying potential catalysts for a trend reversal and how they may trigger a turning point. Global central bank support has driven the market rally, but as this monetary stimulus is beginning to reverse, it is the most obvious potential catalyst of a change in market outlook. Monetary policy normalisation is set to accelerate over the next two years, meaning central bank asset purchases are scheduled to fall materially (Figure 5). This removes a key component of demand that has supported asset prices until now. Other potential catalysts of a market reversal include political risks that could threaten the perceived Goldilocks environment. The US is introducing a fiscal stimulus of 5% to 6% of GDP at a time when the economy is at full capacity, which could lead to economic activity overheating. The administration is also adopting a protectionist stance which may threaten economic stability by increasing inflationary pressures and negatively impacting competitiveness. Figure 5: Central bank support is being scaled back Peak asset purchases Projected Monthly change 6mm, ($bn) Federal Reserve Bank of England Bank of Japan European Central Bank Total 11 Bloomberg and Insight as at February Projections are estimates based on data that is currently available. As such, they are not a reliable indicator of future performance. Any projections contained herein are based upon certain assumptions considered reasonable.

9 C MAGNITUDE OF A REVERSAL Identify whether there may be factors which can act as potential accelerants to any reversal, increasing the speed and magnitude of any repricing. Regulatory changes in the financial sector since the financial crisis have the potential to exacerbate any sell-off. The ability of banks to cushion market moves through buying or warehousing securities in a downturn is now extremely limited, particularly in credit markets. Investment banking operations have reduced in size. The proprietary trading desks, which once would have counterbalanced large market movements, have disappeared. This creates the potential for an accelerated sell-off compared to previous downturns. Losses could be exacerbated by widening bid-offer spreads. Also, a downturn could lead to higher volatility, which may encourage further selling. The rise of volatility-based leverage could be another significant contributor to the magnitude of any decline, given the rise in short-volatility strategies, based on the view that volatility is set to remain low. A preview of the potential for stress occurred in February 2018 when a number of these strategies were wiped out following the largest one-day volatility spike on record. 12 There has been growth in strategies with implicit leverage (using volatility as an input) such as risk parity, volatility-controlled and risk premia strategies. This is perhaps the most worrying factor of all as these markets are worth over $1.5trn 13 and would be forced sellers during a rise in volatility. Ultimately, this means that once the downturn begins it could be difficult for an investor to exit without incurring material losses. In our view, the best time to re-allocate risk is before the reversal starts. THERE IS SOME SUPPORT FOR MARKETS IN THE SHORT TERM Our framework indicates that market conditions are stretched in equities and, to a slightly lesser extent, in credit markets. The risk-reward proposition in risk assets ranges from not-veryexciting to outright poor. Catalysts indicate that the clock has started ticking on a trend reversal and there is potential for a severe decline. There are some positives, however. Outside the US, equity and credit markets display fewer excesses. Although the ability of these markets to decouple from the US is questionable, they look in better shape. The current global economic upswing is also likely to be positive for corporate earnings, while banks are unlikely to be a systemic risk in a future crisis as they have undergone substantial deleveraging. Most significantly, US tax reform is likely to encourage a lot more corporate buy back activity, which could delay a trend reversal. Perhaps surprisingly, our framework does not show that the government bond market is subject to the same excesses as equity and credit markets. Many investors already have a negative outlook for government bonds. Government bond markets also generally represent a safe haven when risk assets sell off. We believe cyclical pressures, valuations, higher supply and retreating central bank support will weigh on government bonds in the shorter term. However, we do not believe the economy would be able to sustain materially higher government bond yields over the longer term, so it s our view that a broad trading range is likely to prevail for a long time. Although we believe markets are exuberant, several factors could extend the current bull run. However, we now believe it is time to consider strategies to re-allocate risk before it is too late. 12 Bloomberg as at June Bloomberg as at February 2018.

10 SECTION TWO: STRATEGIES TO NAVIGATE MARKET EXUBERANCE We believe that investors should consider the following risk re-allocation strategies. RISK RE-ALLOCATION STRATEGIES Focus on sources of reliable cashflows Target alpha rather than beta Manage tail risks Seek out relative value A. FOCUS ON SOURCES OF RELIABLE CASHFLOWS TO MEET SPECIFIC OUTCOMES Investors with specific performance targets or payment requirements can look at strategies that seek to maximise the certainty of achieving these goals. Such an approach will focus on aiming to generate reliable cashflows, paying less attention to mark-to-market volatility and instead holding assets to maturity. In the current environment, we see value in high-quality secured finance assets, which can offer an additional risk premium, reflecting complexity and illiquidity risks (Figure 6). Figure 6: Secured finance assets look valuable 14 Yield premium relative to government bonds (%) A rated secured B rated high yield BBB rated A rated AAA rated Maturity (years) B. TARGET ALPHA RATHER THAN BETA We believe that market beta, in terms of risk and return, has had its decade. Going forward we believe there will be more opportunities in specifically targeting alpha. To target alpha effectively, we believe it is important for investors to understand that: Permanent market exposure is not alpha. Permanent market exposure needs to be treated as long-term beta exposure, where downside risks need to be managed Volatility is a necessary ingredient to drive long/short or relative-value opportunities. We believe volatility will continue to drive alpha opportunities in global markets, except in Japan where much of the market is owned by the central bank The timing of the delivery of returns from alpha-seeking strategies is uncertain, unlike accruing interest or contractual coupon income A diversified opportunity set, ideally across the full range of global opportunities, is crucial to help reduce the impact of individual decisions impacting a portfolio 14 Source: Bloomberg, Insight as at 16 March 2018.

11 C. MANAGE TAIL RISKS Accounting for tail risks is particularly important when we appear closer to a transition in the monetary policy regime. Central-bank accommodation can make markets appear stable or anchored, creating feedback loops such as buying on dips that lowers apparent volatility (or value-at-risk measures) and encourages excessive risk-taking. This stability, arguably artificial and monetary policy-induced, can cause markets to underestimate tail risks, particularly as that policy gets removed. Risk-management disciplines, such as stop-losses and hedges, become important tools for mitigating these risks, though they can give up potential returns in exchange. Risk management is particularly important because some risks cannot be insured against, such as global conflict, political risk or regulatory change. D. SEEK OUT RELATIVE VALUE Although global monetary policy has (either directly or indirectly) poured liquidity into most financial assets, not all asset classes have been lifted equally. One example is in local currency, as opposed to hard currency, emerging market debt. The performance of corporate hard currency assets has been linked to global credit risk, but local currency debt has been left behind and we believe real yields are now attractive in many markets. Outright absolute value is increasingly difficult to source in the current market, but investors can instead target relative-value trades. We believe that such a strategy can pay off even in falling markets. WHY CASH ISN T THE ANSWER During times of market exuberance, investors often increase allocations to cash. This reduces risk exposure and provides the greatest flexibility to purchase cheaper assets following any market correction. In our view, cash is a potentially expensive insurance policy in the current environment, particularly in Europe where returns from short-dated cash investments are still negative. Furthermore, the steep level of yield curves in some markets suggests to us that material future interest rate rises have already been priced in. By holding cash, investors could be subject to a large opportunity cost if interest rates do not rise in line with market pricing (to the tune of 5% to 10% over 10 years depending on the region).

12 Predicting a tipping point is close to impossible. The best we can do is to use common sense and pay attention to the warning signs ABDALLAH NAUPHAL

13 SECTION THREE: THE END OF GOLDILOCKS? CONCLUDING REMARKS Markets are resilient until a critical threshold is reached Investors should pay attention to the warning signs Exuberance and irrationality is evident today It could be time to re-allocate risk THE END OF GOLDILOCKS? Much can be gleaned from old proverbs. The Arabian parable of the straw that broke the camel s back is applicable to pretty much all mathematically complex ecosystems, including financial markets. They tend to be resilient until a critical threshold is reached, but accurately predicting a tipping point is close to impossible. The best we can do is to use common sense and pay attention to the warning signs. These signs include not only growing exuberance, but also irrationality. In the world today, we can observe a number of parallels with past incidents of market euphoria. Developments in the name of blockchain (for all the technology s potential merits) are reminiscent of the dotcom era. In 2017, the US companies Long Island Iced Tea and Online plc changed their names to Long Blockchain and Online Blockchain plc respectively, leading to respective threefold and fivefold share price increases. Bitcoin euphoria has arguably eclipsed the tulip mania of the Dutch golden age. Other warning signs exist in corporate bonds, where a high-yield company recently issued a 1,000-year bond paying a coupon of just 2.25%. Yet the deal was five times oversubscribed. In the original version of the fairy tale of Goldilocks and the Three Bears, there was no Goldilocks. Instead, the tale was of a badly-behaved old woman entering the home of three well-mannered and harmless bachelor bears. Upon being discovered, she flees, and breaks her neck. What was originally a cautionary tale about greed and self-control has since become a cosy story about discovering what is just right. This is perhaps a fitting metaphor for today s market environment. As Benjamin Franklin famously said an ounce of prevention is worth a pound of cure. It could be time to re-allocate risk rather than wait.

14 An ounce of prevention is worth a pound of cure BENJAMIN FRANKLIN

15 CONTRIBUTORS Abdallah Nauphal, Chief Executive Officer, Insight Investment Andrew Wickham, Head of Global Rates, Insight Investment FIND OUT MORE Insight Investment Level 2, 1-7 Bligh Street, Sydney NSW Bruce Murphy Director, Australia and New Zealand bruce.murphy@insightinvestment.com Rob Thompson Head of Adviser Distribution rob.thompson@insightinvestment.com This document is a financial promotion and is not investment advice. This document must not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or otherwise not permitted. This document should not be duplicated, amended or forwarded to a third party without consent from Insight Investment. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. For a full list of applicable risks, and before investing, investors should refer to the Prospectus or other offering documents. Please go to Unless otherwise stated, the source of information and any views and opinions are those of Insight Investment. Telephone calls may be recorded. For clients and prospects of Insight Investment Management (Global) Limited: Issued by Insight Investment Management (Global) Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number For clients and prospects of Insight Investment Funds Management Limited: Issued by Insight Investment Funds Management Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number For clients and prospects of Insight Investment International Limited: Issued by Insight Investment International Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number Insight Investment Management (Global) Limited, Insight Investment Funds Management Limited and Insight Investment International Limited are authorised and regulated by the Financial Conduct Authority in the UK. Insight Investment Management (Global) Limited and Insight Investment International Limited are authorised to operate across Europe in accordance with the provisions of the European passport under Directive 2004/39 on markets in financial instruments. For clients and prospects based in Singapore: This material is for Institutional Investors only. This documentation has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, it and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of Shares may not be circulated or distributed, nor may Shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 304 of the Securities and Futures Act, Chapter 289 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. For clients and prospects based in Australia and New Zealand: This material is for wholesale investors only (as defined under the Corporations Act in Australia or under the Financial Markets Conduct Act in New Zealand) and is not intended for distribution to, nor should it be relied upon by, retail investors. Both Insight Investment Management (Global) Limited and Insight Investment International Limited are exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services; and both are authorised and regulated by the Financial Conduct Authority (FCA) under UK laws, which differ from Australian laws. If this document is used or distributed in Australia, it is issued by Insight Investment Australia Pty Ltd (ABN , AFS license number ) located at Level 2, 1-7 Bligh Street, Sydney, NSW Insight Investment. All rights reserved

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