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Wealth and Investment ManagementGlobal Research & Investments

June 2013

Market outlook: taking stock

AUD: not so wizard in Oz

Global bond update

Cash and the Goldilocks principle

What is risk?

Compass

Wealth and Investment Management Global Research & Investments

COMPASS June 2013 1

Contents

Market outlook: taking stock 2

Again, the winner is… ................................................................................................................. 2

Numbers don’t lie… do they? .................................................................................................. 3 I’ll cross that bridge when I come to it.................................................................................. 3

The game changer ...................................................................................................................... 4 China – Quality of growth matters more ............................................................................. 4

Inherent systemic instability .................................................................................................... 5 The lifting of the veil ................................................................................................................... 6

Barclays’ key macroeconomic projections 7

Interest rates, bond yields, and commodity and equity prices in context 8

TAA: stocks’ ascent is still not outlandish 10

AUD: not so wizard in Oz 11

Fundamentals? What fundamentals? ................................................................................ 11 What would change market views on AUD? ................................................................... 12

Where does AUD fair value lie? And what drives it? ..................................................... 12 Outlook for iron ore and China demand ........................................................................... 13

Equity and bond markets ....................................................................................................... 14 Conclusion: investment implications ................................................................................. 14

Global bond update 15

Government bonds: too soon to call the breakout in yields ...................................... 15 Investment grade: ticking along at expensive levels .................................................... 15

High yield: carry on ................................................................................................................... 16 Emerging markets: spread picking...................................................................................... 16

Cash and the Goldilocks principle 17

Too risky, too safe, or just right?.......................................................................................... 17 “That portfolio is too safe!” exclaimed Goldilocks ......................................................... 17

“That portfolio is too risky!” exclaimed Goldilocks ........................................................ 19 “Hmmm…that portfolio is just right!” exclaimed Goldilocks ..................................... 20

What is risk? 21

Volatility is merely a turbulent journey .............................................................................. 21

Risk is the chance of a poor final outcome ...................................................................... 21 Don’t weed out the flowers ................................................................................................... 22

Global Investment Strategy Team 23


COMPASS June 2013 2

Market outlook: taking stock Recent economic data suggests that the global economic upswing

remains on track. As the recovery becomes more entrenched, the

strong performance of the equity markets should broaden out.

Concerns of interest-rate hikes and the withdrawal of quantitative

easing (QE) seem premature for now. We maintain the view that a

market pullback is possible, and advise clients to capitalize on the

correction to migrate more risks from fixed income to equity.

Again, the winner is… Easing uncertainty in the market has brought respite to risk assets at the expense of safe havens. For instance, gold – perceived to be a conduit of safety – has lost at lot of its luster. Bond yields have also backed up: the US 10-year treasury yield has retraced from a low of 1.4% in summer 2012 to above the key-resistance level of 2%. In contrast, the MSCI global equity index is steadily moving up. At the point of writing, it has risen approximately 15%, year-to-date.

More specifically, US stock markets have clung to historic highs, with the Dow Jones and the S&P indices delivering returns in excess of 15%. Japan, meanwhile, has lived up to its title as the ‘land of the rising sun’ as the country’s equity market surged 45% and 25%, in local currency and US-dollar terms respectively. Even the major European bourses have been positive – delivering single-digit returns – in the face of continued macroeconomic strife.

In Asia, countries in the south east of the region – the Philippines, Indonesia and Thailand – continued to be the star performers while both China and South Korea lagged the region (despite posting only marginal absolute declines (see Figure 1)).

Figure 1: Performance of major equity markets year to 22 May 2013

-15%

-5%

5%

15%

25%

35%

45%

55%

Dow

Jone

s (U

S)

S&P

500

(US)

NA

SDA

Q (U

S)

Euro

Sto

xx 5

0 (E

U)

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K)

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kei 2

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JP)

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(HK)

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EI (H

K)

ASX

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(A

US)

Nift

y (I

ND

)

Stra

its T

imes

(SG

)

SET

(TH

I)

JCI (

IND

O)

KLC

I (M

ALA

Y)

TAIE

X (T

AI)

KOSP

I (SK

)

PSEi

(PH

IL)

US Europe Asia

Local Currency Returns YTD USD Returns YTD Source: Bloomberg, Barclays

Benjamin Yeo, CFA +65 6308 3599

[email protected]

Equity market

performance has yet to

be more broad-based.


COMPASS June 2013 3

Figure 2: Economic data surprises across major countries since 1 Apr 2013

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US EU China India Japan Singapore Thailand HongKong

Indonesia Malaysia Taiwan SouthKorea

Philippines

Positive Surprises (% of total) Inline (% of total) Negative Surprise (% of total) Source: Bloomberg, Barclays

Since we last discussed the strong likelihood of a correction in developed equity markets, no meaningful pullback – defined by a fall of 5% or more – has occurred. Should we, therefore, expect a pullback in the summer months? With the exception of a few indices, the recent rise in global equities has not broadened out across the countries – and rightly so – as this trend is in line with the initial stages of an economic upswing. We maintain the view that a muted correction – if it happens – is normal and even healthy, as the primary uptrend remains intact.

Numbers don’t lie… do they? Since our May update on the economic data surprises (for the period from 1 to 10 April 2013), the global economy had continued to hold up well despite expectations of an economic moderation. For the review period – from 20 April to 25 May 2013 – 62% of the data came in either in-line with or above expectations, while 38% was clearly below. This was a slight deterioration from the previous period, when 65% of data was in-line with or above expectations, while 32% of surprises were negative.

In fact, of the major economies, the US registered a marked improvement in the number of in-line to positive data surprises: 64% (versus 38% previously). The other most-improved economy was Hong Kong, which saw a 50% rise in in-line to positive data releases. Conversely, countries that reported an increase in negative surprises included China, Malaysia and Taiwan. For instance, the flash reading for the HSBC Purchasing Managers’ Index for China surprised on the downside, with a reading of 49.6 for May (the last time the reading came in below the 50 mark was seven months ago). As for Malaysia, the weaker reported numbers were largely driven by weaker business sentiment following the uncertainty of the general election. As for Taiwan, the competitiveness of its exports has been threatened by the weaker Japanese yen of late. Most other countries remain broadly unchanged in terms of overall data surprises.

I’ll cross that bridge when I come to it Recent economic data releases reinforce our view that the worst of the global downturn is behind us. Evidently, investors are more predisposed to assuming incremental portfolio risks – away from cash and fixed income, and into equity. In addition, improving economic sentiment has also placed the global economy on a firmer footing for a more

The global economy

remains resilient and

recovery remains

underway


COMPASS June 2013 4

sustainable recovery. Nonetheless, after a strong first quarter, any economic moderation on the horizon is likely to be seasonal and would also be typical of an economic bottoming-out phase. Suffice to note, there remains a good modicum of growth and inflation in the system, akin to the “goldilocks” scenario postulated in the mid 1990s – in which economic conditions were neither too hot nor too cold – and this tends to bode well for global equity markets.

Notwithstanding the tentative outlook, investors appear to have gone ahead of themselves by shifting their focus from the eurozone to the central banks (i.e. when will interest rates rise and QE end?).The implicit argument is that central banks will proactively normalize their policies in the mid of a recovery economy, never mind about its sustainability. Such an assumption is not always supported by historical precedence and, more importantly, even recent economic data. On the contrary, global policymakers tend to err on the side of caution, and are more likely to cross that bridge when they come to it. Besides, investors may have also underestimated the potential resurgence of euro-related risks, which could moderate the speed of recovery.

Still, we are cognizant that major central banks offered economic life support – the low interest rates and quantitative easing – to the global economy when it most needed it. The measures helped to avert a systemic global crisis and, to a certain extent, assisted in the resuscitation of the world economy. However, we are at the point where the recovery is increasingly bedding down and, for now, we expect interest rates to stay on hold for longer.

As for QE, its eventual withdrawal – even if it were to happen in the coming months – is unlikely to return the global economy to the brink of the abyss it escaped in 2009. Besides, the recent stock market surges have yet to broaden out and, with lower valuations and few excesses in the system now, a repeat of similar reversals seen in the aftermath of 2000 and 2007 is not likely. Instead, policymakers are more likely to time the withdrawal of liquidity in order not to derail the ongoing economic upswing. That said, the cessation of QE would undoubtedly give rise to some market volatility – akin to the mid 1990s – but such disquiet is unlikely to warrant a change in our strategic preference for global equity for now.

The game changer In view of our constructive outlook for both the global economy and equity markets, the rally still appears to have the legs to go further as long as risk continues to migrate from fixed income to equity. However – depending on one’s risk profile, investment style and current portfolio positions – there are several opportunities for investors across the range of time horizons. We see two obvious momentum equity trades: US and Japanese markets. The next two emerging equity trades on the horizon would be the stock markets of the eurozone and Asia’s exporting Tigers, especially Taiwan and Korea – refer to previous editions of this publication for more details. Strikingly for now, the most contrarian equity call – although not for the faint hearted – is Chinese equity. It could, however, turn out to be a highly profitable medium-term investment as most investors are unanimously underweight China.

China – Quality of growth matters more In the last three years, the relative underperformance of China’s stock market can be traced back to 2H 2010 when the central bank started raising interest rates to rein in inflation. This, in turn, fuelled investor concerns of an economic hard-landing in the country (see Figure 3). As it turned out, economic growth remained fairly high during the period; there was no whiff of a collapse in growth to suggest a soft landing, much

Talks of rate hikes

and withdrawals of

quantitative easing

remain premature

for now.

Types of equity trades

out there – momentum,

the next emerging and

the most contrarian call


COMPASS June 2013 5

less a hard one. So, why have investors been so lukewarm on China, given how strongly its economy is tied to the global economic upswing? And, if investors’ concerns on China are valid, is the economy on the verge of implosion?

Figure 3: Chinese equity market versus World and Asia from 2010 to 2012

60

70

80

90

100

110

120

130

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

MSCI China MSCI World MSCI Asia Ex-Japan Source: Bloomberg, Barclays

Negative sentiment towards China evolved largely out of the new leadership’s decision to target a medium term, sustainable growth rate at 7.5% and focus on shifting the growth from its current investment-intensive model to one that is more consumption oriented.

However, the corollary of China’s economic restructuring efforts has led some sceptics to argue that the proof of the pudding is in the components of growth, not just the headline rate, that matter. Specifically, investors questioned China’s continued reliance on investment spending and credit growth to drive growth. The debate also throws up systemic flaws and fragilities in the system that directly impact China’s ability to ramp up consumption to replace the high fixed-asset accumulation; the sceptics argue that if investment spending is not curbed, it will perpetuate current financial weaknesses and excesses.

Inherent systemic instability The weakening of China’s financial system can be traced to the excessive stimulation of the economy triggered by aggressive central-bank policies implemented since 2009. The low interest rate led to rampant “speculative” finance across all sectors. Alarmingly, credit growth for 1Q2013 continues to expand by a whopping 60%.

Faced with high and opaque local-government debt, doomsayers warn of an impending financial meltdown in China, akin to the “financial instability hypothesis” (FIH) theorized by economist Hyman Minsky. Essentially, the FIH describes the proliferation of “Ponzi” finance – borrowers assume new debt just to pay the interest on existing loans – in a capitalist financial system which will typically end in a crash. As concerns deepen, scare stories mount over China’s shadow banking system and the oversupply of real estate. Scaremongers point to massive overbuilding – the most oft-cited Chinese ghost town is Ordos in Mongolia, reportedly dotted with boulevards of empty commercial and residential buildings.

From an investors’ perspective, the choice between developed market equity and Chinese equity is clear: the former is backed by improving economic fundamentals, attractive valuation and, more decidedly, the investors’ home bias. “Better the devil you know” is the investment view that has largely led to the underweighting of Chinese equities.

Disbelief persists on

China’s ability to

rebalance its economy

for the long haul


COMPASS June 2013 6

The lifting of the veil Although the above concerns may not be entirely misplaced, the ‘bears’ have over-sensationalized the key issues, in our view. They underestimate the ability and wherewithal of the Chinese government to prevent a financial meltdown. Being the key shareholder of the big four local banks, the government has the power (via financial moral suasion) to influence the sector. Such powers of persuasion were evident in 2008 when banks were instructed to either roll-over, or extend old and new loans respectively.

Even in a worst-case scenario, the government has the financial means – more than $3 trillion of foreign currency reserves – to bail out the sector, as it did in 2003, by removing bad debts from banks’ balance sheets. With no foreign debt and with capital flows being tightly controlled, the rescue becomes merely a question of domestic resource re-allocation, from its people to the state. All in, we do not envisage a financial meltdown; more importantly, we think the real issue in China is one of proper capital allocation that should be based on economic efficiency.

For now, the lack of clarity on policy has exacerbated the already weak investment case for Chinese equity. Thus, for the stock market to sustainably recover, policymakers need to deliver a credible reform blueprint to resolve some – and not necessarily all – of the systemic excesses. Despite its lack of visibility, Premier Li Keqiang’s government has been preparing for structural reforms in several key areas – see table for details. Draft proposals will be presented for deliberation and approval at the Third Plenum of the Central Committee of the party in autumn 2013. While any conclusive programs may take several months, markets will begin to digest and discount the reform plans.

Figure 4: China: Key Areas of Reforms

Reform Area Key measures and changes needed

Financial sector Interest rates liberalization – deposit and lending rates to be determined by market forces. Chinese Yuan – eventually to be floated as capital controls are gradually being relaxed.

Fiscal system Further changes to the 1994 fiscal reform – essentially, involve either the centralization of some spending responsibility or the decentralization and rationalization of revenue collections (the introduction of VAT and nation-wide property tax next year).

Land tenure Reform to support the national urbanization drive. While land sales are an important source of revenue for local governments, it remains a major source of social tension. Key issues revolve round the issues of final land ownership and the possibility of land transfer.

Factor prices Primarily, input/factor prices would have to better reflect underlying market demand and supply conditions. With the liberalization of factor markets, it means the removal /reduction of the implicit SOE subsidies.

Administrative controls For now, various government bodies are already working on reducing red tape for businesses.

Income inequality While some preliminary efforts are seen on this front, the new government needs to focus on reducing income inequality among the government, corporate and household sectors, and among households.

Household registration system

To facilitate effective urbanization, the government may need to remove the household registration system.

Source: Barclays

Longer term, effective implementation of the reform programs will lead to accelerated liberalization of interest rates, the exchange rate and the capital account. The overall impact is that the expected changes would further facilitate the transition of the growth model, and consumption will likely become a bigger story. There will also be less government intervention in the economy leading to a more-balanced economic structure. The Chinese currency may then sustainably appreciate.

China has the power

and financial means to

contain any financial

meltdown

The next catalyst for

Chinese equity is the

unveiling of strategic

reform blueprint in

autumn 2013


COMPASS June 2013 7

If the above progresses smoothly, there will be major breakthroughs across the board from as early as 2014. Given the historically low equity valuation, share prices could easily and sustainably rebound, especially if the general investing environment remains conducive. For instance, China could also benefit from the rotation out of fixed income/cash, and possibly even developed equity markets, especially as equity valuation starts to normalize in the next stage of market performance.

Our overall investment view is that clients should capitalize on any pullback in global equities to normalize their asset allocation mixes, especially away from fixed income to equity.

Barclays’ key macroeconomic projections

Figure 3: Real GDP and Consumer Prices (% y-o-y)

Real GDP Consumer prices

2011

2012

2013

2014

2011

2012

2013

2014

Global 3.9

3.1

3.2

4.0

3.8

2.9

2.7

3.1

Advanced 1.4

1.2

1.1

2.0

2.5

1.8

1.4

1.9

Emerging 6.6

5.0

5.3

6.0

6.3

4.7

4.9

4.9

United States 1.8

2.2

1.8

2.3

3.2

2.1

1.6

2.2

Euro area 1.5

-0.5

-0.4

1.4

2.7

2.5

1.5

1.3

Japan -0.6

2.0

1.9

2.2

-0.3

-0.1

-0.1

2.2

United Kingdom 1.0

0.3

0.9

1.9

4.5

2.8

2.8

2.6

China 9.3

7.8

7.9

8.1

5.4

2.6

3.0

3.5

Brazil 2.7

0.9

3.0

3.5

6.6

5.4

6.4

5.7

India 7.4 ↑ 5.0

5.3 ↓ 6.9

9.5

7.5

5.6 ↓ 5.5

Russia 4.3

3.4

3.0

3.5

8.6

5.1

6.6

5.6

Note: Arrows indicate if current forecasts differ from previously by 0.2pp or more. . GDP weights reflect IMF PPP-based GDP. Consumer price weights reflect IMF nominal GDP. Source: Barclays Research, Global Economics Weekly, 24 May 2013

Figure 4: Central Bank Policy Rates (%)

Official rate % per annum (unless stated) Current

Forecasts as at end of

Q2 13 Q3 13 Q4 13 Q1 14

Fed funds rate 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

ECB main refinancing rate 0.50 0.50 0.50 0.50 0.50

BoJ overnight rate 0.10 0-0.10 0-0.10 0-0.10 0-0.10

BOE bank rate 0.50 0.50 0.50 0.50 0.50

China: 1y bench. lending rate 6.00 6.00 6.00 6.00 6.00

Brazil: SELIC rate 7.50 7.75 8.25 8.25 8.25

India: Repo rate 7.25 7.00 6.75 6.50 6.50

Russia: Overnight repo rate 5.50 5.50 5.25 5.25 5.00

Note: Rates as of COB 23 May 2013. Source: Barclays Research, Global Economics Weekly, 24 May 2013

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COMPASS June 2013 8

Interest rates, bond yields, and commodity and equity prices in context*

Figure 1: Short-term interest rates (global) Figure 2: Government bond yields (global)

0

1

2

3

4

5

6

7

8

9

Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10Global Government 10-year moving average± one standard deviation

Nominal Yield Level 3 Months (%)

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3

4

5

6

7

8

9

10

Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12Global Treasury 10-year moving average± one standard deviation

Nominal Yield Level (%)

Source: FactSet, Barclays Source: FactSet, Barclays

Figure 3: Inflation-linked real bond yields (global) Figure 4: Inflation-adjusted spot commodity prices

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0.0

0.5

1.0

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2.0

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4.0

Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11Inflation Linked 10-year moving average± one standard deviation

Real Yield Level (%)

70

100

130

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190

220

250

280

310

340

Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11DJ UBS Commodity 10-year moving average± one standard deviation

Real Prices (1991=100)

Source: Bank of America Merrill Lynch, Datastream, FactSet, Barclays Source: Datastream, Barclays

Figure 5: Government bond yields: selected markets Figure 6: Global credit and emerging market yields

0.5

1.0

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3.0

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Global US UK Germany Japan± one standard deviation Current 10-year average


2

4

6

8

10

12

Investment Grade

High Yield Hard Currency EM

Local Currency EM

± one standard deviation Current 10-year average


Source: FactSet, Barclays *Monthly data with final data point as of COB 27 May 2013.

Source: FactSet, Barclays


COMPASS June 2013 9

Figure 7: Developed stock market, forward PE ratio Figure 8: Emerging stock market, forward PE ratio

8

10

12

14

16

18

20

22

24

26

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11MSCI The World Index 10-year moving average± one standard deviation

PE (x)

68

10121416182022242628

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11MSCI Emerging Markets 10-year moving average± one standard deviation

PE (x)

Source: MSCI, IBES, FactSet, Datastream, Barclays Source: MSCI, IBES, FactSet, Datastream, Barclays

Figure 9: Developed world dividend and credit yields Figure 10: Regional quoted-sector profitability

0

1

2

3

4

5

6

7

8

Jan-01 Jan-04 Jan-07 Jan-10 Jan-13

Global Investment Grade Corporates YieldDeveloped Markets Equity Dividend Yield

Yield (%)

3

5

7

9

11

13

15

17

19

World USA UK Eu x UK Japan Pac x JP EM


Return on Equity (%)


Figure 11: Global stock markets: forward PE ratios Figure 12: Global stock markets: price/book value ratios

9

11

13

15

17

19

21

23

World USA UK Eu x UK Japan Pac x JP EM± one standard deviation Current 10-year average

PE (x)

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

World USA UK Eu x UK Japan Pac x JP EM± one standard deviation Current 10-year average

PB (x)



COMPASS June 2013 10

TAA: stocks’ ascent is still not outlandish

As noted above, the most obvious tactical bump in the road ahead is the prospective normalization of monetary conditions, but we doubt it is imminent. A shorter-term setback for stocks meanwhile still feels overdue, but we continue to doubt it will be big enough to warrant a tactical repositioning of portfolios. We stay overweight developed equities: markets are still not expensive, in marked contrast to most fixed income assets, where we advise a strategically small position in government bonds and a tactical underweight in investment grade credit (and cash). We remain neutral on emerging equities and on diversifying assets.†

Figure 1: Tactical Asset Allocation tilts and Strategic Asset Allocation Benchmark (moderate risk profile)

SAA Profile 3

StrongUnderweight Underweight Neutral Overweight

Strong Overweight

Cash & Short Maturity Bonds 7% Nominally safe, but rising risk appetite may make this less appealing. Real value at risk from inflation.

Developed Government Bonds 4% Not a bubble, and useful portfolio insurance, but very expensive: strategic weighting is low.

Investment Grade Bonds 7% Very expensive: at these relative valuations, we prefer to own companies than lend to them

High Yield & Emerging Market Bonds 11% Fully-priced, but a source of valuable income.

Relatively short duration restrains interest rate risk.

Developed Market Equities 38% Despite the rally, valuations remain undemanding. The business cycle still favours stocks.

Emerging Market Equities 10% Valuations are attractive, but the investment case is stale and BRIC economies have disappointed.

Commodities 5% Supply is capping price gains, and cyclical correlations are loosening. A diversifying asset.

Real Estate 4% Attractive yield, but a fragmented and illiquid market.

Alternative Trading Strategies 14% Lower correlations across and within assets should assist this diversifying asset class.

We are simplifying how we report our asset allocation views. We now use qualitative descriptions of our Tactical positions relative to their Strategic benchmarks, ranging from ‘strongly underweight’ to ‘strongly overweight’. This is a shift away from the percentage-based reporting method we used in the past. Our Strategic Asset Allocation (SAA) models offer a mix of assets that over a five-year period will in our view provide the most desirable mix of return and risk at a given level of Risk Tolerance. They are updated annually to reflect new information and our evolving outlook. Our Tactical Asset Allocation (TAA) tilts these five-year SAA views to reflect our shorter-term cyclical views. For more detail, please see our Asset Allocation at Barclays white paper and the February 2013 edition of Compass. Source: Barclays

Figure 2: Total returns across key global asset classes

4.7%

9.7%

-5.1%

-1.6%

12.5%

1.8%

1.3%

0.7%

0.1%

3.5%

27.7%

-1.1%

18.2%

15.8%

17.4%

10.9%

4.5%

0.1%

Alternative Trading Strategies**

Real Estate

Commodities

Emerging Markets Equities

Developed Markets Equities

High Yield and Emerging Markets Bonds

Investment Grade Bonds

Developed Government Bonds

Cash and Short-maturity Bonds*

2012 2013 (through 27 May 2013)

* As of 24 May 2013; ** As of 23 May 2013 † Diversification does not guarantee against losses. Note: Past performance is not an indication of future performance. Index Total Returns are represented by the following: Cash and Short-maturity Bonds by Barclays US Treasury Bills; Developed Government Bonds by Barclays Global Treasury; Investment Grade Bonds by Barclays Global Aggregate – Corporates; High-Yield and Emerging Markets Bonds by Barclays Global High Yield, Barclays EM Hard Currency Aggregate & Barclays EM Local Currency Government; Developed Markets Equities by MSCI World Index; Emerging Markets Equities by MSCI EM; Commodities by DJ UBS Commodity TR Index; Real Estate by FTSE EPRA/NAREIT Developed; Alternative Trading Strategies by HFRX Global Hedge Fund. The benchmark indices are used for comparison purposes only and this comparison should not be understood to mean that there will necessarily be a correlation between actual returns and these benchmarks. It is not possible to invest in these indices and the indices are not subject to any fees or expenses. It should not be assumed that investment will be made in any specific securities that comprise the indices. The volatility of the indices may be materially different than that of the hypothetical portfolio.

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AUD: not so wizard in Oz As the cyclical attractions of the US dollar are rising, those of the

Australian dollar (AUD) are fading. An expensive valuation and

shaky fundamentals make it vulnerable over the medium term.

Other Australian assets may also underperform from here.

The Australian dollar has been a star performer among the world’s ten big currencies (G10) over the past decade. Since 2003, it has risen around 71% against USD and 49% in trade-weighted terms. However, we believe its fortunes are likely to change. We see a weak AUD as the flipside to a strong USD: while the USD may gain pro-cyclical attributes and benefit from positive local economic news, the reverse should be true for AUD, which could lose its status as a “go-to” cyclical currency as markets become more concerned about the Australian economy. Figure 1 shows that AUD’s historically stretched correlation with global equity markets has already started to normalise. Australian assets generally may decouple from the ongoing increase in risk appetite.

Fundamentals? What fundamentals? In our view, fundamentals suggest that the AUD is living on borrowed time. Investment in the country’s mining sector is likely to peak soon (and decline thereafter), while public demand is likely to slow due to planned fiscal consolidation and the exact path to a rebalanced economy remains uncertain. Our economists expect the economy to grow by 3% and 2.3% this year and next. While these rates are respectable compared to some G10 countries, they are not particularly high historically. The growth differential with the US is likely to fall to zero by 2014, below its 20-year average (Figure 2), calling to mind the late 1990s, when robust US relative economic performance drove the USD to outperform AUD (and most other G10 currencies). Probably the most striking part of Australia’s outlook is its persistent current-account deficit. Despite being the beneficiary of China’s strong growth this last decade, Australia still manages to import more than it exports. The deficit has averaged 4.3% of GDP since 2000.

As a result, Australia has become a net debtor to the rest of the world. Its net liabilities, at 58% of GDP, are the second largest in the G10 FX space, after New Zealand at 67%.

Petr Krpata, CFA +44 (0)20 3555 8398

[email protected]

Tanya Joyce, CFA +44 (0)20 3555 8405

[email protected]

Despite benefiting from

China’s strong growth,

Australia runs a large

and persistent current

account deficit

Figure 1: AUD correlation with risk has been normalising

Figure 2: Australia-US growth differential to fall to zero

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AUD/USD AUD Trade Weighted Index

AUD correlation with risk (gauged by MSCI World equity index), 1-year rolling correlation

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Source: Barclays, EcoWin Source: Barclays, EcoWin



Admittedly, the third worst is the US, but its net liabilities are just 27%, and the USD is of course the world’s reserve currency (and will be for the foreseeable future).

Furthermore, the bulk of Australia’s net foreign liabilities (Figure 3) have been accumulated via portfolio flows (specifically debt), which tend to be more volatile and less sticky than other types of financing such as direct investment (which forms only a small part of its Net International Investment position). Foreign investors own around 70% of all government securities.1 This dependence on potentially volatile flows poses a risk to AUD over the medium to long term. Should investors turn bearish on AUD, a fall in the currency could be further magnified if these existing positions are liquidated.

What would change market views on AUD? Most market participants appear well aware of AUD’s shaky fundamentals, but selling AUD has proved to be one of the ‘pain trades’ of recent years. Attractive rates, flows chasing remaining AAA assets (Australia still has its rating), underpinned commodity prices, and central-bank liquidity have all supported the currency. However, three of these four factors now look exhausted.

First, as Figure 4 shows, AUD/USD has massively decoupled from levels suggested by the relative rate spread. Second, foreign investors as noted may now be heavily exposed to AUD bonds, making any material increase in positions less likely. Third, we now see AUD decoupling from commodity prices, the outlook for which is in any case now less optimistic. The fourth factor, central bank liquidity, is the only one likely to remain intact.

Global liquidity, however, on its own is not enough to support assets/currencies that look fundamentally unattractive. The experience of the South African rand (ZAR) – formally a high beta currency – is a prime example. It is, therefore, not surprising that AUD correlation with risk has started to fall from overstretched levels.

Where does AUD fair value lie? And what drives it? Our bilateral AUD/USD Behavioural Equilibrium Exchange Rate model (BEER) suggests a medium-term fair value of around AUD/USD 0.90 (Figure 5), a 7% overvaluation from current levels. Moreover, the details show that fair value has been, by and large, driven by an increase in Australia’s terms of trade, the ratio of export to import prices, relative

1 The Reserve Bank of Australia, Statement on Monetary Policy, 10 May 2013

The AUD may be

running out of support

Figure 3: Portfolio flows form a bulk of foreign liabilities Figure 4: 2-year rate spread suggests weaker AUD/USD

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Net Direct Investment Financial DerivativesOther Net Investment Net Portoflio InvestmentReserve assets Total Net liabilities

Decomposition of Australia’s Net International Investment position, as % of GDP

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AUD/USD 2 Year Rate Spread (rhs)

AUD/USD 2 Year Rate Spread

The gap between AUD/USD and the rate spread opened

materially

Source: Barclays, EcoWin Source: Barclays, EcoWin

http://www.rba.gov.au/publications/smp/2013/may/html/index.html�



to the US.2 This is depicted by the blue-shaded area in Figure 6. Australia’s exports are heavily skewed to commodities, and to commodities that we are not particularly upbeat on (see below). Hence, its terms of trade are likely to deteriorate, pushing estimated fair value down further, below its current AUD/USD 0.90, making AUD even less attractive.

Looking at even longer-term valuations based on inflation differentials only (such as purchasing power parity), AUD looks even more overstretched. Most valuation measures suggest downside risks. The OECD estimates AUD/USD fair value around 0.66.

Outlook for iron ore and China demand Iron ore is Australia’s key commodity, accounting for more than 20% of its total exports. With China being the world’s biggest iron-ore importer (and Australia’s main export market), the outlook for Chinese demand remains pivotal for iron ore supply-demand dynamics (Figure 7). While we expect demand growth from China to remain healthy, we do not believe that it will be able to exceed the rate of supply growth in the market, which has recently increased in response to the higher prices that have followed decades of underinvestment in the sector.

The ongoing industrialisation and urbanisation process in China will continue to support demand for iron ore, but the government’s shift of focus from investment in infrastructure and fixed assets to domestic consumption should translate into a more moderate rate of demand growth for raw materials, including iron ore. The expectation that robust supply growth will not be completely absorbed by moderating demand growth suggests a more challenging outlook for prices. We expect that the market will remain oversupplied and prices are likely to trend lower, from the current value of about $120/tonne to perhaps around $100/tonne in coming years. With the outlook for Australia’s most important commodity doubtful, the key factor that has supported AUD over the past decade is likely to diminish, leaving AUD vulnerable, we think.

2 We do not include a relative productivity variable in the model (which we do for other currencies) as it lacks any explanatory power. This is because Australia’s labour productivity was virtually stagnant between 2003 and 2011, lagging the rise of AUD. This reflects a number of factors: investment in mining and utilities takes time to feed through to increasing output; the extraction of lower grade mineral deposits increases the difficulty of mining; environmental targets need to be met. In this respect Australia’s poor productivity performance differs from “Dutch disease,” because it was widespread, and included the mining sector itself.

Figure 5: AUD/USD trading above its BEER fair value Figure 6: Commodities by and large caused AUD’s rise

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Evolution of AUD/USD BEER fair value since 2000, fair value cumulative contribution decomposition among three contributing factors (inflation, terms of trade, long-term interest rates)

Source: Barclays Source: Barclays

Prices for iron ore,

Australia’s key

commodity export, are

likely to soften



Equity and bond markets The Australian stock market is up by about 10% in local currency terms this year, almost as much as the other developed markets, but it has underperformed markedly in dollars, in which terms its price relative is currently at the lowest level since mid 2009. Although the resource sector accounts for a relatively large portion of the index compared to other stock markets, the sector’s recent underperformance (due to falling commodity prices) has been muted by a strong rise in financials, which form around half of the index. While the overall index valuation does not look overstretched (it is mildly expensive on a price-to-earnings basis, but mildly undervalued on a price-to-book basis – Figure 8), this large financial sector (it accounts for “only” 21% of the MSCI World index, and 17% of the S&P500), banking in particular, adds to our wariness of the equity market. Our equity views are unhedged, and so the likely fall in the AUD also counts against it. Property prices have looked frothy for a long time, and with other countries coming out of the other side of a real estate crisis we think there are more attractive returns to be had from banking sectors elsewhere – for example, in the US.

Australian bonds look historically expensive. The 10-year yield, at 3.3%, is higher than in the US or Europe, and is actually positive in real terms, but the spread to US bonds is the lowest since 2007. As noted above the investor base is largely international, and a fragile currency could hit demand. We do often hedge bond positions, but Australia’s higher interest rates make that expensive, effectively cancelling the yield attraction.

Conclusion: investment implications We expect the decade-long AUD bull trend to come to an end. AUD materially overshot its fundamentals and with the last supporting factors easing the clock is ticking. We expect AUD/USD to fall towards the 0.90s levels on a one- to two-year time horizon.

But we recognize that it is expensive to short AUD against USD (it has the highest interest rates in the G10 FX space). Rather, we prefer doing so against the Canadian dollar (CAD). CAD’s higher rates make long positions less expensive. Moreover, for clients wishing to express the view via options, implied volatility on AUD/CAD is lower than on AUD/USD, and that implementation is cheaper too. We retain a constructive view on CAD and expect the currency to benefit from its exposure to the US economy and underpinned oil prices.

Generally, we would be underweight Australia relative to benchmarks in investment portfolios generally.

Australian stocks and

bonds also look

relatively unattractive

Figure 7: Australia’s ore exports to China Figure 8: Local stock market: not a valuation call

0%

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PE(x) PB(x)

Source: Barclays, Bureau of Resources and Energy Economics Source: Barclays, Factset



Global bond update Fixed income assets have again delivered positive returns year-to-

date, albeit at a lower level than investors have become used to.

We update our views and provide a checklist to help navigate

returns. We are wary, but more strategically than tactically.

Government bonds: too soon to call the breakout in yields We do not think government bond yields are about to break dramatically higher. The bellwether US 10-year yield has pushed above 2% (again), but we are not convinced that it has much further to rise just yet. Inflation as measured by the core personal consumption deflator – the Fed’s preferred indicator – is trading close to 1% and expectations have fallen. With growth likely to slow in the second quarter, we doubt the Fed will taper its QE imminently, and higher short rates are still many months away.

In Europe, core yields have remained fairly stable year-to-date, compared to their US counterparts. As expected, Spanish and Italian bonds have helped the wider indices outperform, because they trade as ‘risk-on’ assets. Their yields are back down at around 4% and could even move lower still if investors believe strongly enough in the ‘Draghi put’, i.e. that the European Central Bank will ride to the rescue of the bond market should the region’s crisis worsen. We prefer to take peripheral eurozone exposure through corporate bonds (see below). Meanwhile, the Bank of England is sounding less downbeat about growth, as noted above, but the data needs to firm up more before UK yields trade sustainably higher. Overall, rangebound trading for global government bond markets is likely for now. Further ahead of course we continue to expect a structural rise in yields on a multi-year view, as the global economy and markets slowly normalise.

Investment grade: ticking along at expensive levels Financials have led investment grade returns, particularly in the subordinated space. The changing regulatory environment makes it one of the most dynamic fixed income sectors. We remain overweight lower tier 2 debt of selected banks but have reduced our allocation to insurers which have rallied to fair value, in our view.

Amie Stow, CFA +44 203 134 2692

[email protected]

Government bonds

to remain broadly

rangebound

Careful credit selection

is paramount for

investment grade credit

Figure 1: Global valuation metrics for our fixed income asset classes

Figure 2: Investment grade spread differential by rating bucket

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Global Investment

grade

Global High Yield

Hard Crncy EM

Local Crncy EM



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Baa - Aaa Baa- Aa Baa - A

Barclays global IG corp spread, Bps

Source: Factset, Datastream, Barclays Wealth and Investment Management Source: Barclays Research, Barclays Wealth and Investment Management



The six-notch downgrade of the UK’s Co-operative Bank in May reminds us that credit selection is crucial. BBB-rated issuer spreads have compressed but there is still value, particularly in industrials and utilities which have lagged the recent rally (Figure 2). We advocate a barbell approach with higher-rated corporates: the incremental loss of yield is now relatively small. We expect total returns of 2-3% this year, below what is needed to compensate for risk, and remain tactically as well as strategically underweight.

High yield: carry on Fundamentals here are still robust. Global default rates are currently 2.6%; Moody’s forecasts them to remain below 3% this year. An increase in issuance in ‘covenant-lite’ and payment-in-kind notes hints at a deterioration in credit quality but, to date, volumes are small and unsurprising. The majority of debt issuance is still for refinancing. Average credit quality remains high and leverage low relative to historic levels. With the majority of the index trading above its call price, there is little room for further capital appreciation and it is probably too late for new allocations to this asset class. The carry still looks attractive, but our expected total returns in the region of 5.5-6.5% for 2013 imply some fall in price from here. Europe continues to look more favourable than the US, albeit by a smaller margin. Credit selection is key: we favour funds, or UK retailers and peripheral industrials that have demonstrated solid cash flow.

Emerging markets: spread picking Emerging market (EM) fundamentals look appealing: growth is subdued and inflation is under control – yields could move lower. Flows into EM should continue to remain positive as investors hunt for yield, though the pace is likely to ease. The majority of our hard currency benchmark is government related (74%), which underperformed throughout April: we prefer corporates. With a stronger dollar and some central banks trying to weaken their currencies, enthusiasm for local currency bonds has waned. Interest rates in this space may be appealing but investors need to be aware of FX risk.

Figure 3: Fixed income checklist – allocations in a balanced (multi-asset) portfolio

Asset Class Yield YTD return Comment

Government bonds 1.4% 0.7% Creditworthiness is generally good

Neutral

Offers diversification

Yields are low

High interest rate sensitivity

Investment grade 2.5% 1.3% Fundamentals are strong

Underweight

Good selection is crucial

Spreads and yields are at historic lows

Moderate interest rate sensitivity

High yield 5.7% 4.3% High coupon income

Neutral

Low duration

Creditworthiness modestly declining

Little room for capital appreciation

EM (hard currency) 4.1% -0.2% Credit quality has improved

Neutral

Prefer corporates to governments

Vulnerable to EM shocks

EM (local currency) 4.8% 0.2% Yield pick-up

Neutral

Credit quality is improving

FX volatility

Source: Barclays Research, Barclays Wealth and Investment Management Data as of 27 May 2013

Focus on coupons for

return generation

Be mindful of FX

volatility; EM corporates

look attractive



Cash and the Goldilocks principle Once upon a time, there was an investor named Goldilocks. She

went for a walk in the forest and soon came upon an investment

advisor’s house. She knocked and when no one answered, she

walked right in. Spread on the kitchen table there were three

investment proposals. Goldilocks was hungry to invest. She

started to examine the proposals…

Too risky, too safe, or just right? Just like Goldilocks found that the bears’ beds could be too hard, too soft, or just right, she would have an equivalent experience with the infinite ways to blend assets to create a portfolio. Some will be too risky – others too safe. She would hope to build the portfolio that is ‘just right’ to sleep as soundly as she did in the little bear’s bed.

The goal of any well designed portfolio is to maximize expected return relative to the level of risk that an investor is willing to take, and for Barclays, subject to the level of anxiety you are willing to suffer. Our choices around the allocation to bonds, equities, alternatives and cash have a large bearing upon this. At Barclays, we publish our ‘just right’ asset allocation guidance across five risk levels, suitable for investors from low through high risk tolerance. Cash is an important asset class. We stated in our white paper “Asset Allocation at Barclays”, published in February 2013, that:

This asset class plays a unique and essential role in Strategic Asset Allocations, especially for the most risk-averse investors. It is the only investment that fulfils the objective: ‘Make sure I retain my capital long term.’

Figure 1: Cash in the Barclays Strategic Asset Allocations

Risk level Cash allocation

Risk Profile 1 – Low Risk 46%

Risk Profile 2 – Medium-Low Risk 17%

Risk Profile 3 – Moderate Risk 7%

Risk Profile 4 – Medium-High Risk 3%

Risk Profile 5 – High Risk 2%

Source: Barclays

“That portfolio is too safe!” exclaimed Goldilocks Many clients look at the cash allocation in our low risk strategic asset allocation and think it is very high. However, ask yourself this question: if you were one of the most risk averse investors in the population, then wouldn’t you want about half your wealth in the safest asset class?3

However, there is a temptation to build a low risk portfolio without using so much cash – perhaps placing a restriction that you hold no more than 10% in cash. It is possible to apply this constraint to the portfolio construction process and learn where the cash allocation gets redistributed. This can be seen in Figure 2.

3 From our calibration of risk tolerance on a global population we expect the 10% most risk averse individuals to be classified as low risk investors.

Peter Brooks, Ph.D. +65 6308 2167

[email protected]




Figure 2: An optimal low risk portfolio versus a low risk portfolio constrained to a 10% cash allocation

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Optimal Constrained

Alternative Trading Strategies

Real Estate

Commodities






Cash and Short-maturity Bonds

Source: Barclays

Figure 2 shows that the effect of constraining cash is to increase the allocations to Developed Government Bonds (from 8% to 36%) and to Alternative Trading Strategies (from 11% to 18%). All other allocations are constant or change by only 1percent.

How does the cash constraint alter the characteristics of these portfolios? Figure 3 gives the details. Developed Government Bonds yield more and are riskier than our Cash and Short-maturity Bonds asset class. Because the cash constraint raises the proportion of assets in Developed Government Bonds, then the expected return of the portfolio is higher – albeit only marginally – and the expected volatility is also higher.

The crux of this comparison is whether the increase in risk is adequately compensated for by additional return. The crucial idea is this – for every level of risk, an investor needs a minimum level of return in order to be willing to invest. This balance between risk and return is dependent upon the level of risk tolerance. Lower risk tolerance investors need higher levels of return than a high risk tolerance investor for the same risk. We call returns above this minimum threshold our measure of Desirability – higher is better.4 Our analysis of the two portfolios suggests that lowering the cash allocation reduces desirability, meaning the increased risk of the cash constrained portfolio is not fully compensated for by the additional return.

Figure 3: Portfolio comparison

Strategic Asset Allocation Cash constrained allocation

Expected excess return5 2.0% 2.1%

Volatility 4.6% 5.1%

Worst month (Oct 2008) -6.8% -7.4%

Source: Barclays

4 More details on our desirability measure can be found in our white paper Asset allocation at Barclays, published Feb 2013. 5 Excess return is the return over and above the risk free return that can be achieved.




The increase in risk can also be seen in a much simpler metric; the worst single month performance. For both portfolios, October 2008 suffered the worst performance. Our low risk strategic asset allocation lost 6.8% that month, whereas the cash constrained allocation lost 7.4%.

There is one other more tactical consideration. If interest rates revert to levels closer to their historical norms, then Developed Government Bonds are going to be affected much more than cash holdings. A cash constrained allocation might currently be running significantly higher concentration risk than history suggests. It is not that history suggests that the cash constraint is massively more risky, but concentration into a currently high priced asset increases the risk that history will not be a good guide. Our Goldilocks investor may think holding cash is too safe but she is perhaps shifting risk around in an extreme way.

“That portfolio is too risky!” exclaimed Goldilocks Goldilocks may, like many investors, suffer from a problem of reluctance. Holding cash instead of a diversified portfolio provides emotional comfort but does so at a large opportunity cost – forgoing the expected return of that diversified portfolio. We discussed this in the February issue of Compass.6

Alternatively, Goldilocks may find herself maintaining the overall risk level of the portfolio by running a ‘barbell’ type strategy – one where a large cash holding is used to offset the risk of a higher risk investment portfolio. Some investors find this comforting, knowing that the low risk cash holding ‘secures’ their lifestyle and provides a buffer against the worst-case event. This strategy also has some downsides. Principally it reduces the diversification benefit by concentrating the investment portfolio in the riskiest asset classes. This can be particularly uncomfortable for low composure investors.

Figure 4 shows what happens to our high risk strategic asset allocation if you maintain the risk but choose to hold 30% in cash rather than the 2% ‘just right’ recommendation.

Figure 4: Optimal and cash boosted high risk portfolios

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Optimal Cash Boosted

Alternative Trading Strategies

Real Estate

Commodities






Cash and Short-maturity Bonds

Source: Barclays

6 What is your wealth doing while you’re waiting for the right moment?, Compass, Feb 2013



From Figure 4 it is clear to see that the riskiest emerging markets equity exposure has had to increase to keep risk and return high. Perhaps more important is the loss of the diversification benefit. Two of the bond asset classes do not feature in the cash boosted portfolio. The bond and alternatives asset classes collectively account for 30% of the strategic asset allocation but only 12% of the cash boosted allocation. This means that the performance of the portfolio is much more closely tied to equities with cash lowering the overall portfolio risk. More Figure 5 shows the effect this has on the portfolio metrics.

Figure 5: Portfolio comparison

Strategic Asset Allocation Cash boosted allocation

Expected excess return 5.9% 4.9%

Volatility 13.9% 11.8%

Worst month (Oct 2008) -19.3% -15.6%

Source: Barclays

By holding too much cash, investors may be giving themselves greater emotional buffers at significant costs to their portfolio efficiency. This may be a trade-off that makes sense if it helps to stay invested in all market conditions – but it may be one that leads to greater extreme outcomes in bad markets because diversification is reduced.

“Hmmm…that portfolio is just right!” exclaimed Goldilocks My colleagues in the Behavioural Finance team would have a lot of sympathy for Goldilocks. We see lots of portfolios that are too safe and too risky, while constantly striving for the ‘just right’ portfolio. The ‘just-right’ portfolio is one that maximizes return relative to the stress and discomfort the investor has to endure along the journey. Our strategic asset allocations are the starting point for that, but we should also consider strategies to further boost the anxiety buffer where needed. Cash is just one of the ways of providing an anxiety buffer, but as Goldilocks learnt, it is by no means a costless way of achieving it.



What is risk? Risk. An important but misunderstood word in finance. Important,

because investors should try to avoid it unless they are well paid

for taking it, so we need to be clear about what exactly ‘it’ is.

Misunderstood, because this clarity is seldom the case.

Volatility is merely a turbulent journey Frequently, we are told, risk is volatility, a measure of the amount that investments fluctuate along the journey at short horizons. But if this is what we expend effort avoiding, we’re focussing on the wrong thing. A good analogy might be an urgent sea voyage where every minute counts. Going full engine into waves creates turbulence along the way that is unpleasant, but is not risky unless this turbulence increases the risk of a slow journey.7 If your aim is a pleasant journey, then by all means take it slow; but if your chief aim is a getting there on time, then you are better advised to invest in tablets for seasickness.

Investment volatility is distressing. But it is not risk. Unless we need the money along the journey8 then the fluttering of sentiment along the way is not what matters at all. What matters is the chance our portfolio is not worth much when we need it. The potential for low values in the long-term increases the risk, while the potential for high values decreases risk… regardless of the volatility of the journey.

The three dotted lines in Figure 1 each show possible paths of investment returns. The bottom two are perfectly smooth, with no volatility, but end up with average, or negative returns respectively. The higher path offers high returns at the end of the investor’s time horizon, but is extremely volatile. Investors who represent ‘risk’ as volatility often weed out portfolios with good returns to avoid the temporary discomfort of turbulence. To get the best risk adjusted returns we need to focus on the outcome, not a smooth ride.

Risk is the chance of a poor final outcome Imagine all possible future paths a portfolio may take over the next five years. Risk is about how many of all those possible future paths end up with low values. If we mistake volatility for risk and seek to avoid it, we will weed out portfolios with rough journeys regardless of the outcome, good or bad. We have mistaken comfort for success.9

We should not take on risk unless it increases the average portfolio return sufficiently to compensate us for the chance of bad outcomes. To do this we need a precise way to measure the likelihood of bad outcomes. Armed with this, we can choose the portfolio that offers the best returns, after compensating us for the risk we are prepared to take.

The traditional way of measuring volatility is to calculate the standard deviation of fluctuations along the path. This looks at the return each period and compares it to the average returns. Deviations away from the average count as risky. The further away from the average, the more this adds to the standard deviation.

7 Or, of course the ship sinks altogether, which could happen if your ship is badly constructed and unsuited to the voyage. In a portfolio context this can happen when your portfolio is insufficiently diversified or highly concentrated: any one investment can be sunk by events along the journey. A diversified portfolio merely experiences turbulence. 8 In which case this is the destination, not the journey…and we should have minimised the chance of such unexpected needs through insurance and careful planning. 9 This is not to say that comfort is unimportant: a crossing could be so unpleasant that we despair and turn back or, worse, jump overboard. But this is about controlling our behavioural responses to the journey: volatility only matters insofar as we respond to it.

Greg B Davies +44 (0)20 3555 8395

[email protected]

Risk is the essence of

what investors should

try to avoid, but is often

confused with volatility.



Calculating risk of bad final outcomes frequently uses the same computation except that, instead of looking at deviations from the average path over time, the standard deviation is computed by looking at where the various paths can end up. Paths that end up at the average outcome, like the mid path in Figure 1, do not add to risk, but paths, like the upper and lower paths in the figure, that end away from the average outcome do. The further the deviation from the average, the more this possible path adds to the ‘risk’ of the portfolio.

So by choosing a portfolio with a low standard deviation of outcomes, we’re weeding out portfolios that have a high dispersion of possible future values, in favour of those that are likely to end up with a value close to the average. At first glance, this seems sensible.

Better than expected

outcomes are not ‘risky’

– risk is the chance of

something undesirable

happening

Figure 1: Distinguishing between volatility and risk

High ReturnHigh VolatilityNegative Risk

Average/Expected ReturnZero VolatilityZero Risk

Negative ReturnZero VolatilityHigh Risk

Source: Barclays

Don’t weed out the flowers However, when looking at the possible paths that we exclude by minimising standard deviation, we notice something less reasonable. We’re filtering out portfolios that offer a chance of ending up on a really good path as well as those that have bad outcomes. Standard deviation doesn’t distinguish between good and bad outcomes, it just penalises variation. According to this view, both the top and bottom path in Figure 1 add to risk, and should be avoided! This is like telling an investor that you’re “really sorry, but there may a terrible chance you’ll earn 5% more than expected next year. But not to worry, using our risk measure, we are minimising the chance of this undesirable outcome for you.”

The possibility of good outcomes is simply not risk: and we certainly shouldn’t be minimising it by filtering out portfolios with good upside outcomes along with those which have high potential for bad outcomes. Instead we need a risk measure that increases when there are lots of bad outcomes, but ensures that good outcomes have the effect of reducing risk. The possibility of encountering the lower path increases the risk of a portfolio, but the existence of the upper path should actually decrease risk.

Minimising such a measure means we weed out portfolios with lots of worse than expected outcomes, but doesn’t have the counterintuitive implication that we throw away portfolios just because they have variability in outcomes. At Barclays we have developed just such a risk measure, Behavioural Risk, which is grounded in the extensive evidence from the field of Behavioural Finance about how investors should actually think about risk when making risk-return trade-offs in their portfolio.

It enables us to build portfolios that focus on what really matters to investors: not volatility along the journey, but the value of our wealth at the destination; and not mitigating the dispersion of possible outcomes, but reducing the chance of bad ones.

Traditional risk

measurement filters out

portfolios with high

variation in outcome,

penalizing the good,

along with the bad.



Global Investment Strategy Team

ASIA

Benjamin Yeo Chief Investment Officer, Asia and Middle East [email protected] +65 6308 3599

Peter Brooks, PhD Behavioural Finance specialist [email protected] +65 6308 2167

Eddy Loh Equity Strategy [email protected] +65 6308 3178

Wellian Wiranto Investment Strategy [email protected] +65 6308 2714

AMERICAS

Hans Olsen Chief Investment Officer, Americas [email protected] +1 212 526 4695

Laura Kane Investment Strategy [email protected] +1 212 526 2589

David Motsonelidze Investment Strategy [email protected] +1 212 412 3805

Kristen Scarpa Investment Strategy [email protected] +1 212 526 4317

EUROPE

Kevin Gardiner Chief Investment Officer, Europe [email protected] +44 (0)20 3555 8412

Greg B Davies, PhD Head of Behavioural and Quantitative Finance [email protected] +44 (0)20 3555 8395

Emily Haisley, PhD Behavioural Finance [email protected] +44 (0)20 3555 8057

William Hobbs Equity Strategy [email protected] +44 (0)20 3555 8415

Tanya Joyce Commodities [email protected] +44 (0)20 3555 8405

Petr Krpata FX [email protected] +44 (0)20 3555 8398

Antonia Lim Global Head of Quantitative Research [email protected] +44 (0)20 3555 3296

Amie Stow Fixed Income Strategy [email protected] +44 (0)20 3134 2692

Christian Theis Macro [email protected] +44 (0)20 3555 8409

This document has been prepared by Barclays for information purposes only. Barclays does not guarantee the accuracy or completeness of information which is contained in this document and which is stated to have been obtained from or is based upon trade and statistical services or other third party sources. Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is made as to the reasonableness of the assumptions made within or the accuracy or completeness of any modelling or back-testing. All opinions and estimates are given as of the date hereof and are subject to change. The value of any investment may fluctuate as a result of market changes. The information in this document is not intended to predict actual results and no assurances are given with respect thereto.

The information contained herein is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person. The investments discussed in this publication may not be suitable for all investors. Advice should be sought from a financial adviser regarding the suitability of the investment products mentioned herein, taking into account your specific objectives, financial situation and particular needs before you make any commitment to purchase any such investment products. Barclays and its affiliates do not provide tax advice and nothing herein should be construed as such. Accordingly, you should seek advice based on your particular circumstances from an independent tax advisor. Neither Barclays, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of or reliance upon this publication or its contents, or for any omission. Past performance does not guarantee or predict future performance. The information herein is not intended to predict actual results, which may differ substantially from those reflected.

The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors. This document shall not constitute an underwriting commitment, an offer of financing, an offer to sell, or the solicitation of an offer to buy any securities described herein, which shall be subject to Barclays’ internal approvals. No transaction or services related thereto is contemplated without Barclays’ subsequent formal agreement. Unless expressly stated, products mentioned herein are not guaranteed by Barclays Bank plc or its affiliates or any government entity.

This document is not directed to, nor intended for distribution or use by, any person or entity in any jurisdiction or country where the publication or availability of this document or such distribution or use would be contrary to local law or regulation, including, for the avoidance of doubt, the United States of America. It may not be reproduced or disclosed (in whole or in part) to any other person without prior written permission. You should not take notice of this document if you know that your access would contravene applicable local, national or international laws. The contents of this publication have not been reviewed or approved by any regulatory authority.

Barclays Capital Inc., Member SIPC, Barclays Bank plc and / or their affiliated companies and/or the individuals associated therewith (in various capacities) may already have or intend to: (i) seek investment banking or other business relationships for which they already receive or will receive compensation from the companies that are the subject of this publication (“Researched Companies”), such as underwriting, advising, and lending – as such, it is possible that Barclays Capital Inc., Barclays Bank plc or their affiliated companies may have managed or co-managed a public offering of securities for any issuer mentioned in this document within the last three years.; (ii) have an interest in the Researched Companies by acting making a market or dealing as principal in securities issued by Researched Companies or in options or other derivatives based thereon, or otherwise hold personal interests in the Research Companies; (iii) appoint employees or associates as directors or officers of the Researched Companies; (iv) act upon the contents of this publication prior to your having received it; (v) effect transactions which are not consistent with the recommendations given herein.

Barclays offers wealth and investment management products and services to its clients through Barclays Bank PLC and its subsidiaries. Barclays Bank PLC is registered and incorporated in England and authorised and regulated by the Financial Services Authority. Registered No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP. Barclays Bank PLC is incorporated in England. Its members have limited liability. Barclays Bank PLC Singapore Branch is a licensed bank in Singapore and is regulated by the Monetary Authority of Singapore. Its members have limited liability. Registered address: One Raffles Quay, Level 28, South Tower, Singapore 048583.

Hong Kong – Barclays Bank PLC is registered with the Securities and Futures commission in Hong Kong (CE No. AAJ160) and is authorised and regulated by the Hong Kong Monetary Authority. Main business address in Hong Kong: 41/F Cheung Kong, 2 Queen’s Road Central, Hong Kong. India – Barclays offers wealth and investment management products and services to its clients through Barclays Bank PLC registered in England and operates in India through its subsidiaries, including Barclays Securities (India) Private Limited (BSIPL). Barclays Securities (India) Private Limited is a company incorporated under the Companies Act, 1956 and is regulated by the Securities and Exchange Board of India (SEBI). The registered office of BSIPL is at 208, Ceejay House, Shivsagar Estate, Dr. A. Beasant Road, Worli, Mumbai – 400 018, India. Singapore – Barclays Bank PLC Singapore Branch is a licensed bank in Singapore and is regulated by the Monetary Authority of Singapore. Its members have limited liability. Registered address: One Raffles Quay, Level 28, South Tower, Singapore 048583. Barclays Wealth Trustees (Singapore) Limited is registered and incorporated in Singapore. Registered No. 200906350R. Barclays Wealth Trustees (Singapore) Limited holds a trust business license from the Monetary Authority of Singapore and provides trustee and trust administration services. Registered address: 10 Marina Boulevard, Level 28, Marina Bay Financial Centre Tower 2, Singapore 018983.

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