Private Banking Global ‘Wrap Up’ · Private Banking Global ‘Wrap Up’ Bank of Ireland Private Banking Developed Economies improve but markets ease back in Q2 Last quarter we

Private Banking Global ‘Wrap Up’Bank of Ireland Private Banking

Developed Economies improve but markets ease back in Q2

Last quarter we highlighted a number of factors (stronger US dollar, poor weather, a port strike on the west coast and lower energy related investment) which checked US economic momentum early in 2015, culminating in a contraction of 0.2% in the first three months of the year. This resulted in slight downgrades to US (and world) economic growth forecasts for 2015 (see chart 1 overleaf).

Thankfully US economic news has improved a little of late, particularly from the middle of the second quarter onwards. Consumer spending indicators firmed up slightly as did manufacturing data. Furthermore, investors saw continued progress in unemployment rates which fell to 5.3% in June from 5.7% in January. In our view if the US economy was showing clear signs of slowing down, investors would see some evidence of this in the jobs market. Finally, as yet we’ve seen little evidence of low oil prices helping consumer spending. However we think this will eventually boost household spending and consequently US growth. The improving US data pushed up the Atlanta Federal Reserve’s forecast for Q2 GDP to 2.4% - although this is at the lower end of consensus forecasts for the period, it still represents a marked improvement on growth in the first quarter.  The picture in Europe and Japan also brightened in the second quarter of 2015. The Euro area recovery continued in Q1 with the region expanding by 0.4% helped by a surprisingly strong French performance and improving conditions across the rest of the periphery. In Japan stronger business investment accounted in large part for the 1% quarterly growth rate posted in the first quarter. Conditions in both economies continued to improve in the second quarter which points to a solid outlook for the second half of 2015.

Investor Overview

Tom McCabeGlobal Investment Strategist

2nd Quarter 2015

In the developing world growth remains sluggish. China’s 7% growth rate in Q2 was a little better in the first quarter and did seem to mirror the slight improvement in hard data in the period. However the economy will need further help in the form of looser fiscal and monetary policy if it is to get close to the 7% government target for the year. This is especially the case since the recent A-share stock market volatility could also hurt consumer spending and even the housing market in the short term. Outside of China growth has also disappointed in economies like Singapore, Australia and South Korea although central banks have again tried to cushion this by cutting interest rates.

Inflation and inflation expectations improved over the past few months although we don’t think it dramatically alters the short term outlook for interest rates. The Federal Reserve in the US look set to begin hiking interest rates in the second half of the year (we still see the first move in September although this could drift into December). Despite hawkish recent comments from Bank of England Governor Mark Carney, we think the Bank is unlikely to ‘front run’ the Fed and is more likely to move in early 2016. Meanwhile the ECB reaffirmed its commitment to Quantitative Easing during the quarter – as long as this is the case interest rates will remain ultra-low in the region.  On the currency front the delay in the start of the US rate hiking cycle coupled with some dovish comments from the Federal Reserve over the quarter caused the dollar to pull back. For example, it lost 2.2% on a trade weighted basis and 3.8% versus the euro over the period. Going forward we expect the dollar to make modest progress through the rest of the year, particularly as the first rate hike increasingly comes into view. Overall we see the currency closing in on $1.03-05 towards the end of 2015.  .

Source: Consensus Economics, July 2015

2.6%   2.4%  

1.5%  

6.8%  

1.0%  

4.7%  

2.7%   2.9%  

1.5%  

6.9%  

1.0%  

4.7%  

0%  

1%  

2%  

3%  

4%  

5%  

6%  

7%  

8%  

World   US   Euro  Area   China   Japan   Asia  Pacific  Forecast  Now   Forecast  3  Months  Ago  

Chart 1: Consensus 2015 Economic Growth Forecasts

Despite the steady improvement in the developed economies in the second quarter investment markets gave back some of their strong early year gains. Chart 2 below showed that both bond and equity markets produced negative returns. Government bonds in particular suffered a sharp selloff on the back of the better than expected inflation data mentioned above. Equities consolidated for most of the period but weakened as concerns around Greece and the Chinese stock market grew while the stronger euro hurt returns for euro based investors.

Looking into the second half of the year, our view is that risk assets (for example property and equities) can grind higher as long as long as the world economy ‘delivers’. Impending rate hikes from the Fed will absorb more and more investor attention but as table 1 shows, historically US equities have continued to rally following the start of the US tightening cycle. The outlook for China and geopolitical issues such as Greece are other currently visible risk factors. All of these factors could make equity markets more volatile in the second half of the year but generally we think stocks are capable of making further gains over the next year or so. Equities should also outperform government bonds, especially if economic and inflation data continues to stabilise.

Source: Bloomberg, July 2015

Chart 2: Asset Class Performances, Q2 2015

Trough Date Peak Date First Fed Hike Months from First Fed Funds Hike to Equity Market Peak

Sep-53 Aug-56 Dec-54 21 Dec-57 Jul-59 Aug-58 11 Oct-60 Dec-61 Feb-61 10 Jun-70 Jan-73 Mar-71 22 Oct-74 Dec-76 Jun-75 18 Aug-82 Aug-87 Jun-83 52 Oct-90 Mar-00 Feb-94 73 Oct-02 Oct-07 Jun-04 40

Average 30

Table 1: First Fed Hike and US Stock Market Peaks

Source: KKR, July 2015

-­‐2.7%  

-­‐5.4%  

-­‐3.5%  

5.8%  

4.7%  

-­‐0.8%  

-­‐2.7%  

-­‐5.4%  

-­‐0.7%  

3.6%  

-­‐0.06   -­‐0.04   -­‐0.02   0   0.02   0.04   0.06   0.08  

Bloomberg Commodity Index

HFR Global Hedge Fund Index

Euroarea Corporate Bonds

Euroarea Government Bonds

MSCI World (Equities)

UK IPD Total Return (Property)

Q2 2015 Returns (Local Currency) Q2 2015 Returns (€)

Global equities paused for breath in the second quarter, falling by 0.7% in local currency terms and 3.5% in euro terms. Despite this, global stocks were still up over 11% this year (euro terms) up to the end of June. Stock price weakness in the second quarter came against a backdrop of greater volatility in bond markets (Euro area government bonds lost 5% in Q2), unfolding events in Greece and on-going concerns about the pace of economic growth in China.

The Chinese stock market generated significant debate over the quarter. In the 12 months to the end of June the Shanghai A share market rose by 114% in local currency terms and by 160% in euro terms (see chart 3). The gains were targeted by the government as a way of increasing household wealth. The Chinese financial system is relatively underdeveloped with a market capitalisation to GDP ratio of only 66% (the comparable US number is 140%). If we consider that the Chinese state controls the free float of many state owned enterprises (SOEs) this actually falls to 30%.

Equities pause for breath Equity Market Outlook

Leona NicholsonHead of Investment Management

Chart 3: Shanghai Stock Exchange Composite Index (Local Currency)

Source: Bloomberg, July 2015

0

1000

2000

3000

4000

5000

6000

The market peaked in mid-June but fell by approximately 30% by mid-July, causing notable concern amongst investors, especially since the selloff coincided with worries about the pace of Chinese economic growth and its impact on commodity prices. The sharp falls in share prices led to widespread share suspensions, government bans on share sales by large shareholders (greater than 5%) and the postponing of Initial Public Offerings (IPOs). If anything this heightened short term concerns about the market.

Although most bond sectors have suffered some variability in performance in recent years, government bonds have tended to be the exception. The winning streak came to an end in the second quarter as Euro area government bonds lost around 5% (see chart 4 of 10 year yields in the period).

A number of theories emerged mid quarter but in truth the reason for the weakness was probably a combination of a number of these. The most likely ‘smoking gun’ for the bond selloff was second quarter inflation data in Europe and the US which was a little stickier than investors had expected given the disinflationary impact of lower oil prices. On top of this, inflation expectations also climbed off their lows for the year in the second quarter. Finally, the selloff could also have reflected investors’ desire to take some profits especially since government bonds in the Euro area returned 4%.

Government bonds’ winning streak finally ends in Q2

Bond Market Outlook

Tom McCabeGlobal Investment Strategist

Since then though the state controlled banks have lent $209Bn to the China Securities Finance Corporation to finance investments in shares and funds. It’s worth noting though that the swings in Chinese stocks primarily occurred in the small to midcap market – many of the large cap stocks were unaffected.

Looking to the broader equity market the Global P/E ratio is 16.2x forward earnings which looks reasonable relative to history – the average since the 1980s has been 15.8x. Dividend yields remain attractive at around 3% and we remain invested in lowly indebted conservative blue chip companies.

Chart 4: Euro Area 10 Year Bond Yields, Q2 2015

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Mar-15 Apr-15 May-15 Jun-15

Germany Italy

Source: Bloomberg, July 2015

Alternatives had a weak second quarter in what was choppy market for most asset classes. April and May were positive but a weak June dragged the performance into negative territory for the quarter. The European index for liquid alternatives delivered a loss of -0.9% for the quarter. Equity hedge strategies and event driven were the bright spots while macro strategies and managed futures disappointed. Managed futures, also known as trend following, fell in value. Assets classes and currencies that had performed strongly in the first quarter reversed sharply in the second quarter of the year and dragged performance down.

European liquid alternatives delivered a return of 3.7% year to date, outperforming European bonds but lagging global equity markets. Part of our rationale for recommending alternative strategies such as absolute return is an expectation that with current low yields in bonds, absolute return can act as part replacement helping to enhance returns without taking on too much additional risk. Over the last 12 months alternatives have enhanced returns for investors, we have seen alternatives outperformed European bonds by 1.9%. Chart 5 overleaf shows the performance over the last 12 months.

The global alternatives market continues to grow and we are continuing to see many new entrants into the liquid alternatives market in Europe. In a recent report by PWC, they predict that he global alternative market will increase to $15.3 trillion by 2020, up from $3 trillion today. This increase in the market is expected to be as a result of increased allocations to the asset class by pension funds and sovereign wealth funds.

Choppy markets key to weaker quarter for alternatives

Alternative Market Outlook

John Byrne Investment manager

The increase in yields over the quarter has prompted comments in some quarters that the long awaited bear market in government bonds has finally begun. While we’d acknowledge that yields may have hit an inflection point, we’d be slow to ascribe to the theory that they will rise sharply in an uninterrupted manner from here on. We believe the asynchronous business and monetary cycles around the world should help cap bond yield rises. Furthermore, in a historic context this economic recovery has been a weak one, another factor which should keep bond yields contained. Finally, debt levels around the world remain very elevated and much higher bond yields will only make it more difficult for developed economies to finance these debt burdens.  In terms of fund positioning we remain underweight bonds across our multi-asset portfolios although we retain a preference for credit given more supportive valuations. Furthermore, credit spreads have risen slightly over the past few months which has enhanced the potential returns from credit for long term investors.

The improving economic conditions across Europe seem to be filtering into stronger property occupier demand judging by the latest batch of quarterly data. EMEA (Europe, Middle East and Asia) prime rents were up 0.9% in Q1 and were 1.5% higher over the past year. Dublin was again a star performer (prime office rents were up 6% pushing them to their highest levels since Q1 2008). Rents in other locations like Helsinki and London also firmed up while gains of 1-2% in Barcelona and Madrid suggested that the brighter economic picture in Spain is finally bearing fruit for the property market. In contrast the French market remains mixed due to uncertainties around the economy.

The take-up of space in the first quarter was up 3.9% in Q1 compared to a year earlier according to CBRE. Furthermore, the vacancy rate across the EU-28 countries dropped 0.2% to 11.1% which should help support rents. Yields across Europe also tightened a little in the period as declines in European bond yields over the past twelve months highlight the better relative value in commercial property. This phenomenon has also begun to help the secondary market in Europe even if spreads between prime and secondary assets remain elevated. For example, yields on secondary office stock in France, Germany and Spain have contracted by around 50 basis points over the past year. This yield compression has been starker in the UK though where secondary office property yields have eased by around 250 points in the past twelve months.

Signs of better economic performance filtering into property fundamentals

Property Market Outlook

Paul McKeeSenior Property Asset Manager

Chart 5: Annual Performance, Liquid Alternatives vs Government Bonds

-­‐4%  

-­‐2%  

0%  

2%  

4%  

6%  

8%  

10%  

Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15

European  Liquid  AlternaMves   European  bonds  

Source: Bloomberg, July 2015

CBRE (preliminary figures) show nearly €56 billion of CRE investment in Europe in Q2 2015, up 15% on Q2 2014. The rate of growth in investment activity has slowed slightly, but is still substantial. In particular, Spain, Portugal, Finland and Norway all saw investment activity more than double compared to Q2 last year.  Of the largest European markets, Germany led the way with investment of €12 billion, up by €5 billion (62%) on Q2 2014.

REITs enjoyed more mixed fortunes in Q2 compared to the first quarter of the year when they were one of the strongest performing sectors. US REITs in particular underperformed (see chart 6) the S&P 500 with increasing focus on interest rate hikes later in the year a likely factor behind this.

Chart 6: Q2 2015 REIT Performance (Rebased to 100)

Source: Bloomberg, July 2015 - Performances in local currencies

80  

85  

90  

95  

100  

105  

Mar-­‐15   Apr-­‐15   May-­‐15   Jun-­‐15  S&P  REITs  Index   FTSE  EPRA  Index  

Bank of Ireland Private Banking Limited

PO Box 1247840 Mespil Road, Dublin 4+353 1 637 8600Fax: +353 1 637 8631

Dockgate House, Dockgate, Galway+353 91 566 301Fax: +353 91 565 437

32 South Mall, Cork+353 21 425 1527Fax: +353 21 425 1539

www.privatebanking.ie

Bank of Ireland Private Banking Limited (BOIPBL) believes any information contained in this document to be accurate but BOIPBL does not warrant its accuracy and accepts no responsibility whatsoever for any loss or damage caused by any act or omission made as a result of the information contained in this document. Any investment, trading or hedging decision of a party will be based on their own judgement and not upon any view expressed by BOIPBL. Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. You should obtain independent professional advice before making any investment decision. Any expression of opinion reflects current opinions of BOIPBL as at August 2015. Any opinion expressed (including estimates and forecasts) may be subject to change without notice. This publication is based on information available as at August 2015. For private circulation only. Not to be reproduced in whole or in part without prior permission.

Bank of Ireland Private Banking Limited is regulated by the Central Bank of Ireland.

Bank of Ireland Private Banking Limited is a member of Bank of Ireland Group.

RC089-15

Warning: Past performance is not a reliable guide to future performance