NO 3JULY 2018

OUTLOOK&CONVICTIONS

EDMOND DE ROTHSCHILD, BOLD BUILDERS OF THE FUTURE.

# (Geo)political risks strike back

ROUNDUP

› The US could be one of the few major economies to see growth accelerate further in 2018...

› ...but the struggle with China for global leadership will continue to weigh on the outlook...

› ...particularly in the eurozone where political instability has risen sharply and diverging levels of loan growth are reinforcing financial volatility.

› Allocation: focus on equities rather than bonds while remaining tactical › Equities: adopt a thematic, rather than a purely geographical, approach › Bonds: long rates are still too low while credit risk now offers slightly

improved rewards

› Falling bond markets have made valuations a little more attractive › Volatility is still being driven by US economic policy shifts and monetary

normalisation › Local political risk is higher than normal but looks fairly well discounted to us

› Relatively benign macro conditions are still supportive for equities › Corporates remain in good shape – we see limited signs of peak market CEO

exhuberance › However, peak cycle earnings growth is behind us and exogenous risks are

significant

› There are three ways to manage currency exposure: systematic hedging, passive acceptance and active management. We prefer the third solution

› Both in terms of risk and performance, it is impossible to ignore a portfolio’s currency exposure

› Depending on the investment scenario, being exposed to a foreign currency like the US dollar, Japanese yen or Swiss franc can make portfolios more robust

› Inflation trends are increasingly determined by subjective investor perceptions, thereby accentuating volatility

› As a result, investors are moving away from traditional tools to hedge portfolios against a surge in inflation

› Active investment strategies should help portfolios weather inflationary phases

› Indices and products which replicate index returns are booming › So much so that market structures are changing › Investment diversification is more than ever essential

MACRO OUTLOOK

ASSET ALLOCATION

FIXED INCOME

EQUITIES

CURRENCIES

INFLATION

IDEAS

2

MACRO OUTLOOK

The US could be one of the few major econo-mies to see growth accelerate in 2018. The US tax reforms voted in at the end of 2017 are not only considerable but will also profoundly revamp the US tax system. They will encourage US companies to invest in productive capacities but make borrowing more expensive. We esti-mate that large and small companies together will enjoy $11bn in tax cuts. Consequently, corpo-rate investment should accelerate further after rising 4.7% in 2017 on the back of a recovery in the energy sector. Households would fare less well as lower income tax is to be partially offset by the end of certain tax deductions. Net tax cuts should only amount to $17bn in 2018, or not enough to offset inflation which could hit 3% in July if oil prices were to stabilise at May 2018 levels of $70 a barrel.

As a result, US growth would accelerate to 3% on average in 2018 but our expectations of soft consumer spending and no change in labour availability should prevent this fuelling exces-sively high inflationary tensions. Note that com-pared to the beginning of the 2000s, 3.2 million Americans are still unemployed -and therefore available for work- and the number of hours worked per week is still one hour less. The Fed should therefore continue to raise rates gradually so as to prevent a growth driver like consump-tion stalling in a period of US dollar appreciation.

Any acceleration in US import growth would automatically exacerbate the already acute ten-sions between the US and China. That, in turn, would increase the risk premium and volati-lity, dampening investment in vulnerable areas like Europe and Latin America. Growth in the eurozone could slow due to weaker momentum in construction after 2 years of robust activity driven by a recovery in lending to the private sector, particularly in Germany and France.

Yet France has decided on macroprudential measures to curb lending. And exports are likely to struggle due to the euro’s appreciation - it gained 7.6% in 20171 against all other currencies- as well as higher US customs duties. The political risk premium has also risen to reflect politi-cal developments in Italy, Spain and Germany. For all these reasons, we expect growth in the eurozone to slow from 2.5% in 2017 to 1.8% this year and 1.6% in 2019.

Any disruption caused by the global economy ceasing to enjoy synchronised growth would result in highly volatile interest rates. The seeds for a deterioration in global growth prospects are still in place.

IS US SUPREMACY BACK?

MATHILDE LEMOINEGROUP CHIEF ECONOMISTEDMOND DE ROTHSCHILD

The US could be one of the few major economies to see growth accelerate further in 2018...

...but the struggle with China for global leadership will continue to weigh on the outlook...

...particularly in the eurozone where political instability has risen sharply and diverging levels of loan growth are reinforcing financial volatility.

1 Source : ECB.

3OUTLOOK & CONVICTIONS

(GEO)POLITICAL RISKS STRIKE BACK

PHILIPPE UZANCHIEF INVESTMENT OFFICEREDMOND DE ROTHSCHILDASSET MANAGEMENT

ASSET ALLOCATION

Allocation: focus on equities rather than bonds while remaining tactical

Equities: adopt a thematic, rather than a purely geographical, approach

Bonds: long rates are still too low while credit risk now offers slightly improved rewards

POLITICAL CLOUDS ARE GATHERING

The global economic recovery continued in the first half of 2018 but at a slightly reduced and less synchronised pace. The US economy went it alone by accelerating, thanks to the tax reform approved at the end of 2017, while Japan and most European countries slowed. In the emer-ging zone, China has continued on its controlled moderate slowdown trajectory while a minority of more fragile countries like Brazil, Turkey and South Africa suffered significant capital out-flows. The Fed has resumed its monetary policy normalisation by raising rates by 25bp in each

The first half of 2018 is good illustration of the dilemma facing investors after an exceptional 2017 across the board. Despite robust econo-mic indicators, inflation under control and still largely accommodating central bank policy, most bond and equity markets are now in negative territory year to date. Sharply posi-tive returns have been rare and volatility has rebounded. After the sigh of relief on Emma-nuel Macron’s presidential election victory in Spring 2017, political risks have made a strong comeback, reviving or creating new uncer-tainties. This situation will probably persist in coming months due to the election schedule so it would make sense to remain highly vigi-lant. Nevertheless, the US economy has re-ac-celerated, China’s economy is still strong and there is high visibility on monetary policy in the second half of the year, all of which justifies maintaining an upbeat outlook.

quarter. The ECB managed to announce it will stop asset purchases at the end of 2018 without sending the euro higher but at the cost of giving very strong indications that its current interest rate policy would remain in place for more than a year. Even so, market sentiment has changed markedly from 2017 and equity returns in the first six months of this year were up and down as investors alternated between considering the glass as half full or half empty. The first spell of turbulence at the end of January and beginning of February looked like the end of the fairy tale conditions that we had flagged 6 months ago. Upbeat macroeconomic news triggered a rise in bond yields and caused valuations to fall and volatility to rise.

But the increasingly uncertain mood in place since March is primarily down to political risk. In our view, the subsequent rise in the oil price is partly due to increasingly influential hawks in the Trump administration and the US exit from the Iranian nuclear agreement. The 50% rise in prices over 12 months1 constitutes a mini oil shock and almost certainly had some part in the economic slowdown outside the US. Italy’s parliamentary elections resulted in an unprece-dented 5-star/Lega coalition government, show-casing the strength of populist movements and the European Union’s persistently fragile foun-dations. And then Donald Trump, fresh from pleasantly surprising business leaders with a sweeping tax reform bill, decided to focus on the protectionist side of his programme, reviving fears of a trade war not only with China but also with the traditional allies of the US.

4

EQUITIES: UNDERPINNED BY UPBEAT RESULTS

Faced with mounting political risk, investor opti-mism was mainly fuelled by strong company results. Upward earnings revisions have main-tained strong momentum year to date on major developed markets (although Japan has lost a little steam in the last 3 months). The trend is par-ticularly strong in the US and not only because of reduced corporation tax: consensus expec-tations for S&P 500 companies are for average 2018 sales to rise by close to 10%2! Europe’s improvement is probably due to a slight fall in the euro’s effective exchange rate in the second quarter. At the sector level, energy unsurpri-singly leads the field in estimated growth rates and upward revisions but global sectors as a whole are seen growing this year; only some defensives (consumer staples, telecoms and utilities) and financials saw revision momentum turn negative in the second quarter. Note that emerging markets have also seen downward earnings revisions, essentially due to countries with sharply depreciated currencies tightening monetary policy in an attempt to reverse the trend.

We need to be cognisant of the current optimis-tic assumptions, especially during the summer earnings season as cautious statements from companies, and even profit warnings, have started rising in June amid mounting threats over a trade war. Most markets in the first half posted mixed returns while earnings rose further, thereby helping multiples to fall and assuaging one of our worries back in January. Our analy-sis of investor positioning also makes us think that equity market optimism/complacency has fallen sharply. The momentum approach, i.e. overweighting outperforming stocks, has, just like 2017, delivered excellent stock picking results but failed completely in 2018 as a guide to equity market exposure.

WE HAVE SCALED BACK OUR

PREFERENCE FOR EUROPEAN

RATHER THAN US EQUITIES

As a result, our geographical differentiation is getting less marked. We remain cautious over emerging country equities due to exter-nally fragile cases like Turkey, Argentina, Brazil and South Africa where monetary and finan-cial conditions have turned very negative but also because of US-China tensions which seem pivotal to the ongoing rise in protectionism. But we have scaled back our preference for

European rather than US equities. UK, German, Spanish and Italian government fragility and the political instrumentation of the migrant crisis have highlighted weak aspects of the European Union’s construction, put the brakes on timid efforts to move forward and complicated talks over a post-Brexit agreement. And although the ECB succeeded in its Quantitative Easing (QE)3 exit communication, expectations for bank sector earnings will be hit by its decision to prolong negative deposit rates for 5 more quarters. In the US, we prefer technology (in its post-September 2018 sector revision defini-tion) as it will benefit from a strong investment recovery. We also like the financial and energy sectors for their earnings growth and reasonable valuations.

STILL SELECTIVE ON BONDS

As we expected, long yields rose at the begin-ning of 2018 but only briefly for German bonds which then rallied to last autumn’s levels. The upward trend in US yields also slightly fell back at the end of the first half as risk aversion rose. This historically high Bund/Treasury spread is due to the sizeable lag between the ECB’s monetary policy cycle and the Fed’s and is, in any case, completely wiped out by the cost of currency hedging. The situation for European holders of corporate bonds has been less favou-rable. Sales by nervous investors in the run-up to the end of the ECB’s quantitative easing, a pro-gramme which also includes corporate bonds, caused spreads to widen from their very tight levels at the end of 2017, even if fundamentals remained strong. And spreads tightened even more for hard currency emerging country issues as the US dollar returned in force.

We continue to believe that interest rate risk in core eurozone countries offers very poor rewards and that investors should steer clear. Even if the ECB has decided to move very cau-tiously towards monetary normalisation, the process has begun and will gain traction in the second half. Real interest rates and the term premium do not, in our view, accurately discount the ECB’s apparent readiness to be behind the curve. Credit markets are now looking less expensive so we are minded to be a little more optimistic on spread assets up to the end of the year and focus on segments which lost the most ground in the first half despite their good fun-damentals.

Finally, given low carry levels4, at least for Euro-pean investors, we continue to prefer equities to bonds and are sticking with our tactical and contrarian management of exposure.

1 Source : Bloomberg. 2 Source : Factset. 3 The term «quantitative easing» refers to an unconventional type of monetary policy that central banks can use in exceptional economic circumstances. 4 The carry strategy consists in holding the securities until maturity in order to benefit notably from coupons.

5OUTLOOK & CONVICTIONS

THE VICE SLACKENS A LITTLE ON BOND MARKETS

BENJAMIN MELMANHEAD OF ASSET ALLOCATION AND SOVEREIGN DEBTEDMOND DE ROTHSCHILDASSET MANAGEMENT

FIXED INCOME

Falling bond markets have made valuations a little more attractive

Volatility is still being driven by US economic policy shifts and monetary normalisation

Local political risk is higher than normal but looks fairly well discounted to us

With bond markets looking expensive and the Fed, the ECB and the Bank of England moving towards monetary normalisation, investors have reduced duration risk by selling emerging country bonds -which is generally the case in this sort of environment- but also corporate debt, a rarer occurrence. Private bond maturities had lengthe-ned in recent years and many yield-seeking inves-tors had accumulated duration risk which needed to be reduced as soon as serious worries over inte-rest rate trends surfaced. In fact, widening spreads since January were more the result of shifting per-ceptions of monetary policy than a downturn in upbeat fundamentals. The notable exception is emerging country debt where poor returns were exacerbated by a serious of specific problems in countries like Brazil and Turkey.

May’s Italian crisis amplified peripheral country and company spreads, making yields more attractive and causing us to slightly up exposure to these segments in our bond funds. Previously, markets had completely brushed off Italian poli-tical risk, even when the populist parties formed a ruling coalition, but then overreacted at the first signs of friction between the President and the new administration. And yet the risk of Italy leaving the eurozone is still virtual as none of the

We have been underweight bonds and overweight equities since the beginning of 2018. And our bond portfolios have a defensive bias. Bond market returns have generally justi-fied our caution. We continue to think equities will outperform bonds but our bond portfolios have assumed a little more risk as over-deman-ding bond valuations have tended to fall back.

parties in power had campaigned for this in the lead-up to elections. A majority of Italians are attached to the single currency and any euro exit would mean leaving the European Union, a very costly move that no administration is likely to risk.

OVER-DEMANDING BOND VALUATIONS

HAVE TENDED TO FALL BACK

Negative pressure on emerging country debt per-sists. Looking beyond local political risk in leading countries, the US economic policy shift marks a serious break for emerging bonds. Some of the liquidities from the Fed’s quantitative easing were invested in the emerging zone. But now the Fed’s balance sheet is to shrink -which means that investors will have to mop up the bonds the Fed had been buying- and US Treasury issuance is set to rise to fund the economic stimulus plan. Emer-ging debt could well be penalised by a Treasury bond avalanche that private investors will have to take up. Spreads have duly widened by around 75bp year to date, an indication that the environ-ment has changed.

All in all, we believe bonds are starting to offer more attractive yields and we have marginally re-exposed portfolios. We believe that by redu-cing exposure to corporate debt, investors have, at least partly, discounted the end of European quantitative easing and the new US policy stance. But we think it is too early to return to significant exposure levels as a powerful capital pull towards the US is looming and there will be the usual dis-ruption that follows the end of ultra-expansionist monetary policy. Bond markets could still see some choppy trading ahead.

6

VOLATILITY IS UP, BUT TALK OF THE END OF THE EQUITY BULL IS PREMATURERICHARD BEGGS

GLOBAL HEAD OF INVESTMENT STRATEGY PRIVATE BANKS INVESTMENTS & ADVISORYEDMOND DE ROTHSCHILD

EQUITIES

Relatively benign macro conditions are still supportive for equities

Corporates remain in good shape – we see limited signs of peak market CEO exhuberance

However, peak cycle earnings growth is behind us and exogenous risks are significant

In January, we were reasonably sanguine about the equity outlook, believing that the strong eco-nomic and corporate fundamentals would lead to higher prices. We thought that European shares would have the opportunity to do better and that EM assets were vulnerable to global FX risks, which they have certainly proved to be.

Whilst global equities are up so far this year by over 3% at the time of writing, European shares have lagged the strongest global markets so far this year, despite patches of outperformance. In part, this is due to the difference in the secto-ral composition of the bourses, with the market leading technology sector in the US, for example, representing approximately 25% of that market vs a mere 5% in Europe. It is also true that momen-tum as a factor has proved powerful in explaining performance and that many of the current vogue stocks are US listed.

The Europe – US sector difference is not small. In fact, at current prices, the market capitalisation of Google, Amazon, Apple and Facebook com-bined with Tencent, Baidu and Alibaba (the last three being Asian tech giants) is bigger than the entire Eurozone market. That seven technology (or related) companies can be worth more than an entire region’s stock market tells a story that either equates to an over valuation of some shares on a scale not seen since the late 1990s or one where technological development and innovation

Following a year like 2017 in which the average volatility for the S&P 500 was just 11.1, it was a pretty easy call to predict that equity market volatility would pick up this year, which it has.

is now so rapid and widespread that it is disrup-ting and influencing traditional business models and thereby propelling growth to levels signifi-cantly and sustainably ahead of other sectors.

Inevitably, the answer is a bit of both, but there is little doubt as to the impact of technological development on both the improvement to and destruction of traditional business models across a very wide swathe of industries. Moreover, such is the pace of change that identifying the winners and losers has become increasingly important in determining the outcome for equity investors.

Europe has also had to contend with a near 20% in financial shares. Whilst this percentage is not wildly different to other countries including the US, the latter’s banking sector is benefiting from three growth catalysts which European compa-nies do not have. These are tax cuts, the winding back of burdensome regulation and a gradual rise in interest rates (albeit that the US yield curve is still very flat). In contrast, at its 14th June meeting the ECB announced that it would keep interest rates on hold until the summer of 2019. Having an extended period of effectively ‘emergency’ inte-rest rates is not a healthy backdrop and reflects a stubborn lack of belief in self-sustaining growth and inflation, which is not helping the banks. Com-bined with renewed concerns around the political situation in Italy (and the knock-on consequences for Italian banks and other holders of Italian debt) as well as idiosyncratic worries over Deutsche Bank and other bell-weather names, it is not sur-prising that the sector is down over 10% this year, which has certainly contributed to the region’s weaker performance.

7OUTLOOK & CONVICTIONS

Arguably, financials and technology are two of the most important market sectors and in that context investors need to understand whether the prevailing conditions above are likely to persist. We think it would take a large upwards shift in inflation expectations to drive a number of the global ‘value’ stocks sustainably higher. Currently, the bond market doesn’t think this is very likely and nor do we. This doesn’t mean that we can’t see good progress in industrials and capital goods names, for example, as business investment picks up, but it probably leaves the door still open for technology stocks to keep performing nicely.

LATE CYCLE DOESN’T NECESSARILY MEAN END OF CYCLE

We are often asked whether late-cycle basically mean end-of-cycle. The answer is important since equity returns at the end of the cycle have typically been harder to attain (weak breadth) and below the average returns of the entire cycle. Some data including US PPI and PMI certainly point to ‘late-cycle’, but several signals we monitor are at odds with the end of a bull market. First, we have earnings continuing to rise AND net earnings sur-prises in the top decile (suggesting that analysts haven’t yet got overly optimistic). Second, despite interest rate rises, US 2yr yields remain above the Fed Funds rate implying the Fed remains accom-modative, also not typical at cycle ends. CEO exhuberance is far from levels associated with end of cycles. Certainly, we are seeing healthy levels of share repurchases and M&A activity, but the sales to capex ratio is low by historic standards, reflec-ting the lack of confidence CEO’s have to reinvest in their businesses.

MANY OF THE EVIDENT TRENDS AND

THEMES WILL CONTINUE AND MAY

BECOME MORE ACUTE

On markets, copper remains in an uptrend, US transport stocks (road and rail) are near relative strength highs for the cycle and staples and uti-lities which typically start to improve as we enter the last innings of the cycle, continue to lag on a relative basis.

We believe that we’re in an extended cycle and that many of the evident trends and themes will continue and may become more acute. Technolo-gical change is one of them and it will continue to bring pain to companies not using it to adapt their businesses. IT has already transformed diverse

segments of the economy including communica-tions, retailing, medical therapies and many other. Mankind is addicted to data and instant access to it (wifi/mobiles). If you had bought shares in every App on your smartphone home screen a few years ago you would have done pretty well. Longer term, IT will transform much of what it hasn’t yet touched. Humans will be liberated from the chore of owning or driving their own cars and robots and AI will cause seismic alterations to our way of life over the next few decades.

Thanks to the capex required to keep up with the demand and the desire for many of these IT revo-lutions, company shares will continue to be floated by the rising tide. But for all the positive effects such as productivity gains, increasing standards of living and life expectancy, IT’s negative effects occur because it enables the rise of corporate monopoly power which help those companies maintain market leadership. This already appears to be the case and there has been little reaction by authorities to contain it. Moreover, this has occur-red after several decades during which the dis-tribution of added value moved towards capital and away from labour. It doesn’t take much to explain worker/voter disillusionment which, if left unchecked could be extremely damaging to an already unstable social state in our democracies.

There is little debate that the period since 2009 has been kind to investors. As we look forward though, we should not lose sight of the factors behind the truly extraordinary equity bull market that has been in place since 1981. These include the rise in the level of aggregate earnings as a share of GDP, the growth rate of aggregate earnings and of earnings per share, the stunning decline in the level of interest rates (market discount rate) over the period and the de-equitisation of the market courtesy of corporate stock repurchases. That all these ‘equity positive’ factors have been in evidence together is historically remarkable. However, just as the joint probability of such an event is very small, the likelihood of a repeat from here is equally small, if for no other reason that we are likely to witness some sort of mean reversion in these fundamentals in the future. If true, then indexing could prove to be as problematic during the next few decades as it has been successful in the past few. Moreover, with the pace of business model obsolescence accelerating, there are likely to be more losers than winners, so in theory it should be easier to beat the index. Index investing through ETFs may have had its best days.

The information about the companies cannot be assimilated to an opinion of Edmond de Rothschild on the expected evolution of the securities and on the foreseeable evolution of the price of the financial instruments they issue. This information cannot be interpreted as a recommendation to buy or sell such securities.

8

UNDERSTANDING CURRENCY EFFECTS ON PORTFOLIO CONSTRUCTIONGILLES PRINCE

HEAD OF DISCRETIONARY PORTFOLIO MANAGEMENT & CIO SWITZERLANDEDMOND DE ROTHSCHILD (SUISSE)

CURRENCIES

There are three ways to manage currency exposure: systematic hedging, passive acceptance and active management. We prefer the third solution

Both in terms of risk and performance, it is impossible to ignore a portfolio’s currency exposure

Depending on the investment scenario, being exposed to a foreign currency like the US dollar, Japanese yen or Swiss franc can make portfolios more robust

THREE WAYS OF INTEGRATING CURRENCIES

We have highlighted three possible approaches to managing portfolio currency exposure. In the first case, currencies are part and parcel of the investment decision. This means a financial asset has dual positioning as a fund manager will take its base currency and its own merits into account. At the end of the day, a diversi-fied international portfolio comprises several, and even a mosaic of, currencies. This approach adds another, sometimes, significant layer which can seriously impact returns for a multi-asset class account. Periods of US dollar appreciation, as in 1995, 1996 and 2012-13 when few curren-

Currency markets are more liquid, global and, and to a certain extent, complex. They are intrinsically linked to the macroeconomy and international trade as well as being open to speculators and central bank intervention. Assessing a currency’s fair value is particularly tricky and it can significantly deviate from its equilibrium for some time. Currencies can also rapidly become highly volatile and entail serious losses. And yet direct or indirect currency expo-sure inevitably features in any diversified inter-national portfolio. This makes it essential in our opinion to analyse and manage currency expo-sure as if it were a major asset class. Understan-ding currency effects on portfolio construction is a key part of investing.

cies managed to resist the greenback, provide a convincing example. Note also that the impact of currency volatility is amplified when a portfolio has a defensive risk profile as foreign exchange volatility is stronger than contributions from other asset classes held. This aspect is often underestimated. As a result, a defensive portfo-lio should go for reduced currency risk.

THE IMPACT OF CURRENCY VOLATILITY

IS AMPLIFIED WHEN A PORTFOLIO HAS

A DEFENSIVE RISK PROFILE

The second case takes the opposite approach as the currency investment decision is unconnected with the underlying financial asset. This seeks to avoid having any currency exposure by systema-tically hedging any foreign currency. The basic premise is that over the long term, currencies do not create any value, or at least not enough, to offset their risk. Futures contracts are thus sys-tematically used for each currency and rolled over at each expiry date so as to eliminate any currency risk. But this hedging comes at a cost, or an advantage, which can be estimated by comparing short term interest rates on domestic and foreign markets. The higher the differential, the bigger the performance deviation. In a diver-sified portfolio, this approach looks extreme and deprives the fund managers of any additional sources of returns. Moreover, some currencies are less liquid or subject to currency controls and can only be hedged with difficulty.

9OUTLOOK & CONVICTIONS

The active approach is the nearest to our invest-ment philosophy and in some ways combines the first two approaches. We start by conside-ring that our international portfolio has neutral currency exposure, either because its takes no asset bets against the benchmark or because it has no absolute exposure. Each currency expo-sure is therefore a conscious, conviction-driven position. We separate our currency management from the investment decision and approach cur-rencies as an asset class in their own right, forcing us to analyse each currency pair and its impact on the portfolio but also taking hedging costs into consideration. For example, in a Swiss franc portfolio, investing today in currency-hedged US bonds is not very attractive because of the interest rate differential between the US dollar and the franc, currently more than 3%, and an almost flat US yield curve. The expected net returns are in fact almost identical. The real plus in our approach is that we separate investment convictions from pragmatic currency manage-ment. We specifically recognise that currencies are an asset class that can generate additional returns while acknowledging that they can also create portfolio volatility. That is why we need genuine investment convictions before exposing a portfolio to currency risk.

CURRENCIES MAY PLAY DIFFERENT

ROLES DEPENDING ON THE ECONOMIC

CYCLE OR PREVAILING MARKET

SENTIMENT

CONVICTION-DRIVEN EXPOSURE

It follows quite logically that our economists and strategists play a particularly important role. Financial models based on economic fundamen-tals, an econometric approach or simply purcha-sing power parity can help us assess the deviation between a currency pair’s intrinsic value and its current trading levels. However, these models are not always optimal at times of extreme valuation deviations and do not guarantee the timing of a return to fair value. Currencies like the Norwe-gian krone or the Swiss franc are famous for remaining systematically over or under valued. To arrive at a short, medium or long term tactical vision, analysis must accordingly be rounded off with more subjective aspects like financial flows, traders’ speculative futures positions or by tech-nical analysis. Recent US dollar moves show that a market may attach more or less importance to specific factors like budget or current account deficits before switching to, say, real interest rate differentials. For example, after treading water in the 1.22-25 range, the EUR/USD ended up drop-ping to around 1.16. In the end, we consider eco-nomic reasoning, and the direction and extent of an expected movement, as the motors behind an investment conviction.

CURRENCIES AS AN ASSET CLASS

Not all currencies have equal importance in the portfolio construction process. They may play different roles depending on the economic cycle or prevailing market sentiment. Their corre-lations and sensitivity to other assets can also undermine a particular conviction, hence the need to separate currency and investment deci-sions. For example, some currencies will move on commodity prices. The Russian rouble, the Norwegian krone and the Canadian dollar have some sensitivity to oil price shifts so investors should be aware that investing in roubles means de facto exposure to oil. The US dollar is gene-rally seen as anti-cyclical, tending to appreciate when economic growth is on the wane and even when global trade slows. With this in mind, the risk of a trade war and the economic growth differential between the US and the rest of world could provide a little support for the US dollar to go higher. But emerging country currencies are negatively impacted by any dollar strength as they have significant foreign debt levels. It is the same negative sensitivity story for gold, and to a lesser extent, other metals are traded in dollars. Being exposed to the dollar can thus create some stability in a portfolio. So, what should be the US dollar allocation in a portfolio exposed to emerging countries and gold when the dollar is rising? The question is not at all trivial as zero-dollar exposure is, statistically at least, the same as having negative, albeit variable, sensiti-vity. Ultimately, investors should know that other currencies like the Japanese yen and the Swiss franc often act as safe havens when financial markets are going through a turbulent phase. Recent episodes of financial market stress, for example when the yen moved from 121 to 100 against the dollar in the first quarter of 2016, saw investors retreating to these havens and triggering a rise in their currencies. We recom-mend being exposed to these currencies during unsettled markets.

To sum up, we believe it is impossible to sepa-rate portfolio construction from currency expo-sure analysis. One the one hand, we look for strong ideas to generate additional performance and, on the other, we use currencies to stabilise diversified portfolios. More than ever, today’s highly volatile markets require, intelligent, res-ponsive and tactical portfolio management. In our opinion, US dollar exposure currently helps stabilise portfolios and gain from any possible upside while a Japanese yen allocation will help attenuate the impact of any financial market tur-bulence.

10

CROSS MACRO/MARKET ANALYSIS. AND WHAT IF INFLATION WERE TO RETURN?

BENJAMIN MELMANHEAD OF ASSET ALLOCATION AND SOVEREIGN DEBT

INFLATION

Inflation trends are increasingly determined by subjective investor perceptions, thereby accentuating volatility

As a result, investors are moving away from traditional tools to hedge portfolios against a surge in inflation

Active investment strategies should help portfolios weather inflationary phases

As a result, consumer prices are now moving in line with investor expectations on inflation. In other words, companies are raising prices because investors expect inflation to accele-rate. Both macroeconomic developments have made us cautious over inflation trends as they now depend on subjective factors which are a far cry from the labour market analysis that used to prevail in the 20th century. Inflationary trends could now resurface at any moment, independently of the actual economic situation. At the same time, investors have never been as sensitive to oil price fluctuations so any rapid surge could have a much bigger impact on asset prices and therefore consumer prices, and that might send the global economy into a recessio-nary cycle.

Two major developments have changed infla-tion trends. First, globalisation has driven inter-national competition, helping create global prices. This means that each country’s prices are less sensitive to its domestic labour market and are instead influenced by the global eco-nomic situation. Second, financial markets have grown in importance and the trend is likely to continue as both the eurozone and China are promoting direct funding of companies.

SHOULD INVESTING STYLES ADAPT TO THESE STRUCTURAL CHANGES?

As inflation expectations in the last 35 years have essentially trended lower, recent history provides insufficient examples to establish a reliable comparison over a full cycle.

But two points stand out:

› High inflation has never been good for finan-cial portfolios as it hits both bond and equity returns. Its supposed role as a protection for real assets is a myth. In the 1970s, real returns on US bond indices were -1.7% a year com-pared to -0.7% for equities, or only slightly better than Treasuries (-1%)1. Financial model-ling confirms that inflationary periods appear to hit equities less than bonds over the first three years but the impact lasts longer for equities as rising interest rates end up protec-ting bond performance. Equity market ana-lysis shows that PEs historically peak when inflation is between 1% and 3%2.

MATHILDE LEMOINEGROUP CHIEF ECONOMIST

INFLATIONARY TRENDS COULD NOW

RESURFACE INDEPENDENTLY OF THE

ACTUAL ECONOMIC SITUATION

1 Source : Triumph of the Optimists / 101 years of global investment returns by Elroy Dimson, Paul Marsh and Mike Staunton. 2 Source : Edmond de Rothschild Asset Management.

11OUTLOOK & CONVICTIONS

› Any significant rise in inflation expectations would cause central banks to raise real rates. And the impact on global growth would be aggravated by current levels of indebtedness. All of which suggests that equities would no longer act as a safe haven asset as they did in the 1970s.

Inflation-indexed bonds and gold should manage to do well but their returns too would suffer from any increase in real rates, leaving a ques-tion mark over how they would perform across a full inflationary cycle. Physical property appears to offer reasonable protection but REITS3 strug-gle to perform as well. Commodities offer satis-factory protection against inflationary risk but are rather volatile and would not necessarily act as a sustainable refuge.

Recent developments show that inflation could all of a sudden get out of hand. This is not, however, our preferred core scenario. But were inflation to resurface, we should beware of investment platitudes as there are no obvious, sustainable solutions. Instead, investors should opt for active investment strategies to weather inflationary phases and focus on certain invest-ment styles.

For more on this subject, all our macroeconomic analysis features in “The financialisaton of consumer prices” N° 3 (March 2018).

3 Real Estate Investment Trusts are listed property vehicles.

12

INDICES/BENCHMARKS/ETFS: A HUGE SUCCESS OR A WORRYING DEVELOPMENT?MURIEL TAILHADES

CHIEF INVESTMENT OFFICEREDMOND DE ROTHSCHILD (FRANCE)

IDEAS

Indices and products which replicate index returns are booming

So much so that market structures are changing

Investment diversification is more than ever essential

Investing in the 19th century meant becoming a shareholder in companies which were conside-red to have interesting businesses, prospects and results. Investing today can take many forms but increasingly consists in buying the market, an approach which is infinitely more short term than that adopted by our great grandparents. It is a commendable goal but if indices make the simple and attractive promise to represent the market, do they really reflect what they are supposed to?

INVESTING TODAY CAN TAKE MANY

FORMS BUT INCREASINGLY CONSISTS

IN BUYING THE MARKET

A LITTLE HISTORY LESSON

In 1896, two New York-based journalists, Charles Dow and Edward Jones, hatched the novel idea of representing the US stock market with an index. Its construction was simply the 30 stocks weighted by their unit price and the index featured one share of each company. It had strong construc-tion bias because, apart from the initial accent on creating an index to reflect the new industrial economy, a share price bears little resemblance

Indices shape investor behaviour and play an important part in how markets work. Let’s step back a little and look at their construction and the emergence of index investing. Equity indices have been amply researched because they have been around for some time so this article will restrict itself to them.

to a company’s actual economic situation. Their approach also favoured companies with high unit share prices. The Dow Jones is a strange beast, an unquestionably subjective representation of the US stock market.

Did you know that there are now more indices than listed stocks?

The 1950s saw the arrival of the S&P500 index which ushered in a new form of index construc-tion which weights stocks for their market cap and their free float. It remains the most popular format and most of the European indices created in the 1980s use the same model. Indices have become so important in recent years that the only conceivable way of describing moves on national markets is to cite their flagship index.

And yet market cap-weighted indices also have some bias, especially if the index comprises only a limited number of stocks. For example, Switzer-land’s SMI is heavily influenced by Nestlé’s perfor-mance while France’s CAC 40 tends to move in line with shifts in luxury stocks or Total.

Like the Dow Jones, market cap-weighted indices have their own bias and act as pro-cyclical tools. Before the tech bubble burst at the beginning of the 2000s, technology, media and telecom (TMT) stocks were over-represented. (A number of them subsequently fell out of the indices). It was the same in 2007 with the banking and energy sectors.

13OUTLOOK & CONVICTIONS

Buying index stocks often means buying shares in companies which have already posted excep-tional returns and which are trading at much higher valuations than those which have not been honoured with inclusion.

BENCHMARKS

The arrival of indices was followed by the emer-gence of benchmarks. In the 1990s, pension funds and other institutionals started to give very precise instructions to the asset managers they had selected. Managers now had to comply with given tracking-error levels (or leeway vis-à-vis the index). The objective was crystal clear: limit any potential fund manager damage which might turn into a default. The advantage for fund managers was that this allowed them to easily quantify their personal contribution.

It may look like a win-win situation for both sides but the approach is also biased in that that fund manager must be careful about holding positions in stocks which are not index heavyweights. The trouble starts if the heavyweights start to rise as the fund manager will be forced to buy them to comply with tracking error limits. The dilemma hits value1 managers with over-strict constraints as they are forced to buy bubble stocks2 which they consider are outrageously overvalued. The end result is that some stocks become even more overvalued and bubbles start to form.

This is not a minor event as some might think. Benchmarking has had such a powerful impact on markets that it has modified the risk hierarchy observed empirically before this period (see the paragraph on ETFs for more). The more a fund is constrained by low tracking error, the more marked the phenomenon.

ETFS OR TRACKERS

The benchmark offensive resulted in people proving more receptive to the emergence of passive investing products in the 2000s. These vehicles allow investors to buy the entire index. They have been spectacularly successful and now account for 35% of global managed assets. But there are significant differences between markets, with passive investing representing 40% in the US and 30% in Europe.

ETFS HAVE LED TO BUY AND SELL

DECISIONS BEING BASED ON THE

OVERALL MARKET TREND

The approach has the major advantage of offe-ring attractive prices and thus reducing invest-ment costs. However, ETFs have led to buy and sell decisions not being based on a company’s characteristics but on the overall market trend. All equity positions are bought and sold at the same time. This means that a market with an increasing percentage of passive investing will see correla-tions between index stocks rise, actually causing a reduction in diversification! And markets are also much more vulnerable to a downturn.

At the same time, various surveys show that these “co-movements” also impact investors’ expected returns, which tend to coalesce, and liquidity risk, which tends to increase.

WHAT ABOUT TOMORROW?

Increasing trading volume is unrelated to an asset’s fundamental value. Most of these deals are in fact short-term trading. Our 19th century inves-tors would be surprised at today’s brutal contrac-tion in investment horizons, never mind the very short intervals between asset valuations. They would quite naturally wonder what purpose this all served.

We, the 21st century fund managers, would be delighted to advise them to stick with their healthy attitude to investing and to hold most of their (unconstrained) equity portfolios for some time, endeavouring to spot companies which are not unduly exposed to the hazards mentioned above. We would recommend them to be res-ponsible, aware and active investors with a good grasp of each portfolio holding.

We would probably also tell them to have a look at new tools on today’s markets, trackers included, so as to diversify their investment approach. After all, a little momentum in an overall strategy is useful and also inexpensive.

Markets have taken all these developments on board and our industry has already changed. Benchmarking and tracking error are now less in vogue. Meanwhile, active investing is becoming, well, very active. But is not one of the aims of the budding alternative investment style precisely to break free of benchmarks?

At the same time, ESG (Environment, Social and Governance) themes, a less-constrained invest-ment approach, has been a hot topic of debate in the last 10 years.

1 Investing in reasonably priced stocks. 2 Share price levels that can no longer be justified by fundamentals.

14

But whatever the exact motivation behind ESG investing, all these reasons make this one of the rare areas where short-termism is banned. ESG is an excellent driver of genuinely active investing, a solution which allows our clients and partners to offer us the one thing that we, and companies soliciting capital markets, too often lack, namely time.

Sources :

Curse of the Benchmarks, March 2016 – Dimitri Vayanos, Paul Woolley - London School of Economics

Index-Linked Investing : A curse for the Stability of Financial Markets around the Globe? Spring 2016 – Lidia Bolla, Alexander Kohler, Hagen Wittig – Algofin AG, Deloitte Consulting

How Index Trading Increases Market Vulnerability, September 2011 – Rodney Sullivan, James X. Xiong – Financial Analysts Journal

ETF : Exchange traded funds

There are several reasons for investors to choose an ESG approach:

› they might wish to have a real impact on envi-ronmental and social issues

› they are convinced that, over the long term, companies which integrate these principles will be more successful than the others

› they can avoid being exposed for holding morally dubious companies

15OUTLOOK & CONVICTIONS

DISCLAIMER

This brochure was prepared by Edmond de Rothschild Asset Management (France). The following entities, including their branch offices and subsidiaries, limit themselves to making this brochure available to clients: Edmond de Rothschild (Suisse) S.A., located at 18 rue de Hesse 1204 Geneva, Switzerland, subject to the supervision of the FINMA, Edmond de Rothschild (Europe) S.A., located at 20 boulevard Emmanuel Servais, 2535 Luxembourg, Grand Duchy of Luxembourg, and subject to the supervision of the Luxembourg Commission de Surveillance du Secteur Financier (CSSF), and Edmond de Rothschild (France), Société Anonyme governed by an executive board and a supervisory board with a share capital of 83 075 820 euros – RCS Paris 572 037 026, located at 47 rue du Faubourg Saint-Honoré 75008 Paris.

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This document has not been reviewed or approved by any regulator in any jurisdiction. The figures, comments, forward looking statements and elements provided in this document reflect the opinion of Edmond de Rothschild Asset Management on market trends based on economic data and information available as of today. They may no longer be relevant when investors read this communication. In addition, Edmond de Rothschild Asset Management shall assume no liability for the quality or accuracy of information / economic data provided by third parties. Any investment involves specific risks. We recommend investors to ensure the suitability and/or appropriateness of any investment to its indivi-dual situation, using appropriate independent advice, where necessary. Past performance and past volatility are not reliable indicators for future performance and future volatility. Performance may vary over time and be independently affected by, inter alia, changes in exchange rates.

Edmond de Rothschild Asset Management refers to the Asset Management division of the Edmond de Rothschild Group. In addition, it is the commercial name of the asset management entities of the Edmond de Rothschild Group.

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