FUND COMMENTARY THREADNEEDLE UK ABSOLUTE ALPHA FUND

COVERING MAY 2018 FUND COMMENTARY THREADNEEDLE UK ABSOLUTE ALPHA FUND Summary UK equities (represented by the FTSE All-Share index) rose 2.8% in April. The fund rose 0.7%* during the month, using 12-noon dealing prices. The gross position of the fund was increased from 84% to 88%, while the net position was decreased from 42% to 34%. Both the gross and net exposures are in the middle of our historic ranges. Chris Kinder Portfolio Manager Mark Westwood Portfolio Manager Market Background UK equities performed well in May, with both the large-cap FTSE 100 and the mid-cap FTSE 250 scaling new peaks during the month. In total-return terms, the FTSE All-Share rose 2.8% and outperformed global averages for the second month in a row. The FTSE 100 led the market higher over much of the month as oil prices rallied and sterling weakened the index has a large weighting in energy companies as well as exporters and overseas earners. However, due to its relatively greater global exposure, the FTSE 100 was more impacted than the FTSE 250 by trade-war jitters in the second half of the month. These were particularly prevalent at month-end, when President Trump announced the US would press ahead with import tariffs against key allies, and threatened China with additional measures. UK stocks were also caught up in global selling pressure triggered by a political crisis in Italy, which investors feared could ultimately hand an even stronger mandate to eurosceptic parties there. Over the month as a whole, the FTSE 100 performed in line with the broader market and underperformed the FTSE 250, which posted a total return of 3.1%. In the broader market, technology stocks benefited from optimism around the strong earnings released by their US peers over the month. Materials and energy stocks also outperformed as the prices of Brent crude and other commodities trended higher. Banking stocks lagged amid concerns over potential knock-on effects from the events in Italy; falling sovereign yields were another headwind for the sector. Telecoms also underperformed, due in part to some disappointing earnings news. Sterling weakened over the month, pressured by uncertainties around the Brexit negotiations, dovish commentary from the Bank of England, and a steeper-thanexpected fall in inflation (the annual rate eased to 2.4% in April) all of which increased scepticism about the likelihood of an interest-rate rise this year. In other economic news, an uptick in consumer borrowing in April and a strongerthan-expected jump in retail sales suggested that the UK economy was gradually recovering from the weather-induced hit in the first quarter (Q1) of the year. Other data showed that wage growth outstripped inflation in Q1, while the employment rate in the same period was the highest on record. *In net terms, based on the Inst Acc share class FOR INVESTMENT PROFESSIONAL USE ONLY 1 Issued June 2018 Valid to end September 2018

Performance The fund was up 0.7% during the month, using 12-noon dealing prices. On a gross basis, using global closing prices, the fund gained 0.9% during the month, and was behind the FTSE All-Share index, which gained 2.8%. On a gross basis, the long book contributed 187 basis points (bps) while the short book detracted 96 bps. The long book, on average, was up 2.7%, virtually in line with the FTSE All-Share. Strong contributors to the fund s performance included Rio Tinto, RELX, CRH, Informa, Intermediate Capital, Diageo, DS Smith, Tesco, Johnson Matthey, Elementis and London Stock Exchange. Weak performers in the long book included British American Tobacco, which continues to de-rate, and Prudential. We have retained large weightings in both stocks as we see considerable upside to their intrinsic values. The short book, on average, was up 4.4%, against a FTSE All-Share gain of 2.8%. The only significant positive contributor over the month was our newly initiated short position in a global telecoms firm. The biggest short-book detractor was an online supermarket chain, which rallied sharply after announcing a large licensing deal with a US grocer. We learnt from previous experience and closed the bulk of our short position within a couple of hours of the market opening and thus minimised the damage. We no longer have any exposure to the stock and we note that it has subsequently rallied a further 30% from where we closed out most of our short position. Stating the obvious, risk management is always a crucial element of running a long/short product and we try to be emotionless with our investments as much as we can. This helps us to close positions ruthlessly when our investment thesis is proved to be incorrect, and so we lose the least amount of money when we are wrong. Overall, the performance of both books has validated our view that we are happy to have a net exposure in the middle of our typical 20-50% range, and that it is far easier to find successful longs than shorts in the current environment. Strategy During the month, the fund s gross exposure was increased from 84% to 88% while the net exposure was decreased from 42% to 34%. Both the gross and net exposures are in the middle of our historic ranges. A couple of months ago, we talked about the significant upside we were seeing in our long book after the sell-off in the first quarter this view has subsequently been confirmed by the strong market rally in April and May. We continue to believe that the greatest risk to the portfolio at this point is in the short book; consequently, we have continued to manage risk carefully in this portfolio. Activity April was a busy month for the fund. In the long book, we initiated two new positions. We bought back into the oil services firm John Wood, and started a new holding in technology firm Micro Focus following a dramatic fall in its share price. We believed the latter s shares have de-rated too far and offer an attractive yield; the company enjoys high margins, strong cash flow and has the option to break-up if trading deteriorates further. We also took some profit in several longs that have performed strongly in recent weeks such as Smith & Nephew, Melrose, London Stock Exchange, CRH and Sage. We sold our remaining position in inter-dealer broker TP ICAP as trading volumes remain subdued given the flattening of the US yield curve (more on this in the Outlook section). In the short book, we re-shorted a global telecoms firm. The rationale is summarised below: FOR INVESTMENT PROFESSIONAL USE ONLY 2 Issued June 2018 Valid to end September 2018

Elsewhere, we continued to reduce our short positions on stop-losses given the overall market strength. We believe the fundamentals for many of these businesses are not good and that prices will normalise at some point. However, we would prefer to let the strength in many of our long positions be the major driver of fund performance in the current environment. Finally, we slightly increased the FTSE 100 index short position, from 10% to 14%, as the market re-tested its highs. Outlook This month, our focus is on global market valuations and in particular, the US stock market, given that there is much debate as to how far through the economic cycle we are. The forward price-earnings (PE) multiple and cyclically adjusted (Shiller/CAPE) PE multiples for global equities are currently slightly below their longterm averages as shown below: Source: Exane BNP Paribas, June 2018. FOR INVESTMENT PROFESSIONAL USE ONLY 3 Issued June 2018 Valid to end September 2018

A fundamental premise is that the price you pay for an asset is by far the biggest determinant of future returns. The chart below shows that historically, when the market has traded at today s Shiller PE multiple of 20x, the global stock market has never declined over the subsequent three years: Source: Exane BNP Paribas, June 2018. However, if we look specifically at the US Shiller PE, then we find that the US has only been this expensive twice a month before the Great Depression in 1929 and during the TMT bubble in 2000: Source: Exane BNP Paribas, June 2018. It should be noted that there have been many changes to GAAP accounting standards which have reduced the earnings numbers used in calculating the Shiller PE. If we use national income and product account (NIPA) earnings where accounting regulations haven t changed at all over the last 50 years, then the US market valuation doesn t look nearly as stretched: FOR INVESTMENT PROFESSIONAL USE ONLY 4 Issued June 2018 Valid to end September 2018

Source: Exane BNP Paribas estimates, Datastream, NIPA US earnings have increased dramatically since 1990: Source: Exane BNP Paribas estimates, Robert Shiller s data, June 2018. While share buyback programmes have boosted earnings per share, the main driver has been rising pre-tax operating margins: Source: Exane BNP Paribas estimates, Datastream, NIPA, June 2018. Looking back through history shows very clearly that higher margin businesses should rationally trade on higher valuation multiples: FOR INVESTMENT PROFESSIONAL USE ONLY 5 Issued June 2018 Valid to end September 2018

Source: Exane BNP Paribas estimates, NIPA, June 2018. Interestingly, Exane hasn t factored in a further imminent rise in profit margins due to President Trump s corporate tax cuts; any such increase should justify a further increase in price-to-sales ratios. Although declining interest and tax rates have helped, Exane estimates that almost 80% of the improvement in US profit margins has been due to declining wage costs: Source: Exane BNP Paribas estimates, NIPA, Datastream, June 2018. History shows that company profits begin to decline once wage costs accelerate to the extent that companies are unable to pass them on to customers: Source: Exane BNP Paribas estimates, NIPA, Datastream, June 2018. FOR INVESTMENT PROFESSIONAL USE ONLY 6 Issued June 2018 Valid to end September 2018

Thus US wage growth versus corporate pricing growth is something to keep a close eye on. Indeed as we write, there are now more job vacancies in the US than unemployed workers to fill them! Data just released by the Labor Department shows a record 6.7 million job openings in the US in April but only 6.35 million people are currently categorised as unemployed. We will have to wait and see if this tight labour market finally triggers significant wage growth. Historically, the US profit cycle has only turned once average hourly earnings growth has hit 4%; this number is currently only at 2.7%: Source: Exane BNP Paribas estimates. June 2018. There has been a lot of debate around the flattening of the US yield curve. The key point is that equities have tended to peak only after the yield curve inverts: Source: Datastream, NBER, June 2018. The chart above shows clearly that the US yield curve has inverted before each of the last seven US recessions. Exane has estimated that if the Federal Reserve follows its current projected rate hiking path without any corresponding increase in the US 10-year yield from today s level, then the yield curve is likely to near inversion only in late 2019: FOR INVESTMENT PROFESSIONAL USE ONLY 7 Issued June 2018 Valid to end September 2018

Source: Exane BNP Paribas estimates, Datastream, June 2018. Finally, buybacks in the US should continue to underpin the market. In May, companies announced the largest ever volume of share buybacks, at $173.6bn, though this was largely due to Apple s mammoth $100bn stock repurchase plan: Source: Wolfstreet.com, June 2018 Conclusion We can t control economies, we can t control monetary policies and we certainly can t control politics. All we can do is control what we buy and sell, and the prices at which we transact. With that in mind, we see numerous opportunities to deliver solid absolute returns in the long book while the travails and challenges in global markets should give us decent opportunities to monetise the downside via our short book. Our long-term track record in doing this has been very strong and we look forward to another year of alpha generation. FOR INVESTMENT PROFESSIONAL USE ONLY 8 Issued June 2018 Valid to end September 2018

Important information: For internal use and for Professional and/or Qualified Investors only (not to be used with or passed on to retail clients). Source: The source of all index information is Factset unless otherwise stated. Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. Benchmark Index is 3-month LIBOR. Performance attribution source FactSet, calculated using a daily time-weighted methodology based on returns gross of fees as at global close on the last working day of the month. Threadneedle Specialist Investment Funds ICVC ( TSIF ) is an open-ended investment company structured as an umbrella company, incorporated in England and Wales, authorised and regulated in the UK by the Financial Conduct Authority (FCA) as a UCITS scheme. 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