The Fragile Equilibriuminbest.cl/chileday2016/wp-content/uploads/2015/09/... · The Fed is guiding us to expect 2 hikes in 2016. And a very gradual cycle –The bond market continues

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The Fragile Equilibrium

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For professional clients only

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Lessons from History

What Happens Now?

The “Fragile Equilibrium”

Agenda

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Chart shows historic, inflation-adjusted total returns for a range of asset classes

The world we have been in over the past 40 years has been one of high returns in many fixed income

and risky asset classes

Why have investors experienced such high returns? And what does this perspective imply for prospective

returns?

Historic Returns

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Asset Class (real return (%)

in USD unless stated) 5-year 10-year 20-year Since 1980 50-year 75-year 100-year

Cash -1.7% 0.2% 0.1% 1.5% 1.0% 0.1% 0.4%

US Treasuries (10y) 2.5% 3.0% 3.4% 5.7% 3.1% 1.6% 2.0%

UK Gilts (10y) (£) 1.0% 1.8% 3.2% 5.4% 4.4% 3.0%

ILB -TIPs 2.5% 2.8%

ILB - UKILGs (£) 6.9% 5.5% 5.2%

Credit - IG 2.9% 3.3% 3.7% 5.8%

Credit - HY 4.2% 5.4% 4.7%

EMD Hard currency 3.1% 4.6% 8.0%

US Equities 9.8% 4.8% 5.7% 7.9% 5.4% 7.3% 6.6%

UK Equities (£) 3.4% 3.2% 4.3% 8.4% 7.7% 7.9% 6.7%

Global Equities 6.1% 3.4% 4.2% 6.7% 4.9% 5.6%

EM Equities -5.5% 2.4% 3.4%

Commodities -11.9% -7.2% -3.4% -4.3% -2.9% -1.9% -1.8%

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Bond yields have compressed over the last thirty years driven by a number of factors:

– (1) inflation de-risking, (2) monetary policy independence, (3) reduced trend growth, (4) global savings glut,

and (5), bond demand/supply imbalances

This has had a material effect on realized returns across safety and risky asset classes

Bull Market Anatomy

Source: HSBC AMG Multi Asset

Past performance is not indicative of future returns

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Significant fall in long bond yields since double-

digit yields of 1980s

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0

2

4

6

8

10

12

14

16

18

1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

US

Trea

sury

Yie

ld s

ince

18

00

6

-2

-1

0

1

2

3

4

5

6

1985 1990 1995 2001 2006 2012

UK 10y IL Gilts US 10y TIPSInd

ex li

nke

d b

on

d y

ield

s (%

US

and

UK

)

Like nominal bonds, real bond yields have also declined sharply since the 1980s

10-year IL Gilts now yield -0.9%

Bull Market Anatomy



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Falling real yields from 4-5% in early 1980s to close to

zero (US) and to negative levels (UK)

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This yield compression has supported the pricing of credits, equities, and other risky asset classes

Strong dividend growth since the 1980s has supported strong investment returns in equities

Bull Market Anatomy



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US annualised real dividend growth 1871-today = 1.3%

US annualised real dividend growth 1984-today = 3.1%

0

2

4

6

8

10

12

14

16

18

20

1919 1929 1939 1949 1959 1969 1979 1989 1999 2009

US UK

US

and

UK

Co

rpo

rate

Bo

nd

yie

ld (

%)

0

5

10

15

20

25

30

35

40

45

50

1871 1891 1911 1931 1951 1971 1991 2011

US

Re

al D

ivid

en

d

8


Source: HSBC AMG Multi Asset. The information above is provided by, and represents the opinions of, HSBC Global Asset Management and is subject to change without notice.

Conventional wisdom says that financial markets are efficient and that, at the medium-term horizon,

investment risk is appropriately rewarded

– Unfortunately, this is not true

History is a very poor guide to future returns

Conventional measures of valuation are not always useful, especially in today’s highly unusual

environment

Effective investment strategy requires a good understanding of valuations, the returns likely to be

available and the risks

Portfolio strategy is about finding the combinations of assets which deliver the best risk-adjusted

returns

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What Happens Now?

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Valuation is Key


We build forward-looking estimates of asset class returns (“discount rates”).

These discount rates are generated from three elements: (i) current valuation, (ii) economic

fundamentals, (iii) mean-reversion in valuations

Calibrated over a 10-year forecast horizon

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Bonds Credits Equities Cash

Yields reflect

average cash rate

and a bond risk

premium

Estimate starting

risk premium from

current bond yields

(forward curve)

Model “equilibrium”

bond risk premium

Calculate bond

return based on

yield + roll + capital

gain/loss

The credit risk

premium is an

additional reward

over duration-

adjusted bonds

We assume a

scenario for how

spreads will evolve

We model recovery

and default rates

The market-

implied credit

premium reflects:

carry pick-up -

default loss +

capital gain/loss

from spread move

Intrinsic value

given by PV of a

given dividend

scenario

3-stage DDM

Model short term

dividend growth

Mean-revert

market to

equilibrium pay-out

ratio & growth rate

Calculate implied

equity risk

premium, given

country cash

scenario

Model reversion to

equilibrium policy

rates over time

using a ‘one-factor’

interest rate model

Trajectory of future

policy interest rates

is based on

expected interest

rate in ten years’

time

Medium term

interest rate

scenario is based

on economic

modelling and third

party forecasts

Assume spot FX

rate will move to

fair value over time

Fair value

determined by

Purchasing Power

Parity, adjusted for

productivity

differentials

Reversion to fair

value is slow. Mis-

pricings correct

over time.

Total returns reflect

asset class returns

combined with FX

views.

Currencies

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Delong, B. (Fourth Quarter 2015). The Scary Debate Over Secular Stagnation: Hiccup...or Endgame?. The Milken Institute Review, 34-51

Caballero, R. J., E. Farhi, and P.-O. Gourinchas (2015), On the global ZLB economy, American Economic Review 98 (1), 358–93

The “Slow and Low” Monetary Cycle

Relative to historic experience, we assume the coming interest rate

cycle will be “slow and low”

A low inflation (“low-flation”) environment persists. There is a

shortfall of aggregate demand relative to aggregate supply.

Consequently, inflation should surprise on the downside and growth

will be subdued versus recent decades.

There are multiple forces that act as a drag on macro performance:

– Secular Stagnation – weakened animal spirits

– Global savings glut – excess savings relative to investment demand.

A shortage of “true” safety asset classes.

– Debt Supercycle – deleveraging weighs on multi-year growth, with

differential impacts across economies

Over time, we anticipate these multiple forces will unwind. We assume that there will be no growth

catastrophe. As headwinds subside, growth trends may be higher than some expect.

We are sceptical of the “supply side” story around a structural collapse in trend productivity.


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“Slow & Low” Monetary Cycle

Secular

Stagnation

Global

Savings

Glut

Debt

Supercycle

MACRO FACTORS

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Our scenarios for policy rates

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AMG Multi Asset rate scenario: Major economies

AMG Multi Asset rate scenario: Major EMs

We calibrate an interest rate scenario for each economy

based on the cyclical macro, stance of policy, and longer-

term economic relationships

We embed an assumption that interest rates will be “lower

for even longer”. The interest rate cycle is set to be “slow

and low”

Recent policy activism challenges the idea that policy

makers are “out of ammunition”.

– Today, the ECB is the world’s most creative and ingenious

central bank.

The Fed is guiding us to expect 2 hikes in 2016. And a

very gradual cycle

– The bond market continues to discount a more pessimistic

rate scenario than us

– We are sceptical that the growth/inflation mix is as weak as

bond investors seem to think.

The risks to the rate outlook remain two-sided.

– First, the inflation soft-patch in advanced economies could

be reflective of deeper macro problems, and persist,

– However, if recent pick-ups in US (and UK) wage inflation

bear out, rates may have to rise more quickly.

-1%

0%

1%

2%

3%

4%

0 12 24 36 48 60 72 84 96 108 120

Develo

ped M

ark

et

Cash C

urv

es

EUR JPY GBP USD

0%

2%

4%

6%

8%

10%

12%

14%

16%

0 12 24 36 48 60 72 84 96 108 120

Em

erg

ing M

ark

et C

ash C

urv

es

BRL CNY INR TRYSource: HSBC Global Asset Management, Global Investment Strategy

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Table shows market-implied risk premia in dollar (hedged) terms, as at end April 2016

Assessing market-implied odds 1

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Relative preference for Europe and Asia

Equity market premia is good relative to competing asset classes

Compressed bond yields push bond risk premium very negative

Credit premia look relatively high

Source: HSBC Global Asset Management, Global Investment Strategy Implied risk premia are expected asset class excess returns in USD hedged terms (for foreign asset classes) based on current market pricing relative to our USD cash rate assumptions

End April 16 Fixed Income Market Implied Risk Premia End April 16 Equity Market Implied Risk Premia

Implied Premium v Cash Implied Premium v Bonds Implied Premium v Cash Implied Premium v Bonds

US 10y TIPS -0.4% 0.6% AC World 3.4% 4.4%

UK 10y IL Gilts -0.3% 0.7% Developed Markets 3.4% 4.4%

European ILBs 0.4% 1.5% Emerging Markets 3.4% 4.5%

US 5y Treasury -0.4% 0.7% United States 3.1% 4.1%

UK 5y Gilt -0.5% 0.6% Canada 2.5% 3.6%

Germany 5y Bond -0.1% 0.9% United Kingdom 3.2% 4.3%

Europe ex UK 3.9% 4.9%

US 10y Treasury -1.1% 0.0% Germany 4.7% 5.7%

UK 10y Gilt -0.9% 0.2% France 3.4% 4.4%

Germany 10y Bund -1.3% -0.2% Switzerland 3.9% 4.9%

Japan 10y JGB -1.3% -0.2% Japan 4.9% 5.9%

Canada 10y Bond -1.0% 0.1% HK 4.2% 5.3%

Singapore 4.1% 5.2%

Brazil Bond -0.3% 0.7% Australia 2.8% 3.9%

Mexico Bond 1.6% 2.6%

Asia Local Bonds -0.7% 0.4% Asia Pac ex Japan 4.3% 5.3%

Local EM Debt 0.3% 1.3% Asia ex Japan 4.6% 5.7%

US Corporate 0.7% 1.8% China (USD) 6.3% 7.4%

US High Yield (B-BB) 2.6% 3.7% South Korea 4.7% 5.7%

US Short Duration HY 3.0% 4.0% Taiwan 4.6% 5.7%

GBP Corporate 0.7% 1.8% India 2.5% 3.6%

EUR Corporate 0.5% 1.6% Indonesia 0.9% 2.0%

EUR High Yield (B-BB) 2.2% 3.3% Brazil -1.7% -0.6%

Asia IG Corporate (USD) 1.7% 2.8% Mexico 0.9% 2.0%

South Africa 1.4% 2.5%

EM Sovereigns (USD) 1.8% 2.8% Russia 3.7% 4.8%

EM Credit CEMBI (USD) 2.6% 3.7% Turkey 3.5% 4.6%

European FRN ABS 1.3% 2.4% Commodities -1.3% -0.2%

Hedge Funds 1.1% 2.2%

Private Equity 4.0% 5.1%

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Chart shows the updated pecking order of asset classes (as at end April 2016)

Assessing market-implied odds 2

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Source: HSBC Global Asset Management, Global Investment Strategy

US TIPS UK IL Gilts US Tsy

UK Gilts Germany Bunds Japan JGBs

US Corp

US HY

GBP Corp EUR Corp

EM Sovs USD

EM Credit

US Equity

UK Equity Japan Equity

EM Equity

AC World Equity

Asia ex Japan Equity

Global Gov

Global Credit

Global ILBs

Global HY

Euro ABS

US 5y Tsy

UK 5y Gilts

Local EM Debt

Europe x UK Equity (H)

UK Equity (H)

Japan Equity (H)

Canada Equity

Canada Equity (H)

-2

0

2

4

6

8

10

0 2 4 6 8 10 12 14 16 18 20 22 24 26

Exp

ecte

d R

sik

Pre

mia

(%, N

om

inal

, USD

)

Expected Volatility (%)

Current pecking order of asset classes

*Global Fixed Income assets are shown hedged to USD. Local EM debt, Equity and Real Estate assets are shown unhedged

Sharpe Ratio = 0.25

Sharpe Ratio = 0.10

*Global Fixed Income assets are shown hedged to USD. Local EM debt, Equity and Real Estate assets are shown unhedged

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The Fragile Equilibrium

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“Severe Secular

Stagnation” “Fragile Equilibrium”

“Strong Demand

Recovery”

Description

• Very weak demand growth.

• Negative real interest rates are

required.

• Corporates face a problem with

top-line (sales) growth.

• There is a meaningful threat to

fundamentals and balance sheets.

• There is just enough demand

relative to supply.

• We have a low growth/low

inflation mix. The interest rate

cycle will be “slow-and-low”.

• To a certain extent, self-

equilibrating mechanisms pull

us back from low inflation or

rapid growth extremes.

• Demand is too strong relative to

available supply.

• Output gaps go positive (growth

is above potential) and pressure

on real interest rates rises.

• Bond yields move back to

historic levels.

Primary Source China / EM / Europe/ Japan US

Impact

Positive for: Developed Market

Government Bonds, IG Credits

Negative for: EM and commodity-

linked Equity, EM currencies

Fragile Equilibrium is maintained

USD overshoots,

May be positive for EM Equity and

EM Local FX Debt

Negative for: Developed Market

Government Bonds, Investment

Grade Credit


The Multi-Asset View: Fragile Equilibrium

PUBLIC

Our base case remains for a “Fragile Equilibrium”

Scope for asset class re-rating as market shifts between different priced scenarios.

Dec 2015

Market

Perceptions

Of Risk Environment …

Feb 2016

May 2016

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In core government bond markets, the case for preferring cash over bonds remains clear. We want to be

UW.

– The bond risk premium is very negative. The market is not rewarding us for taking long duration risk. But the removal of the zero bound creates some

ambiguity about the lower level of bond yields

– We prefer allocating to short duration bonds (i.e. 5 year segment) and cash. Break-even inflation still looks like an attractive risk-return opportunity

In credit, spread compression means that tactical de-risking now makes sense. On a medium term time

frame, we are still being paid a reasonable carry for credit risk. But it is no longer extreme.

– The default outlook has deteriorated and there will be market volatility, but the medium term outlook still looks good

– Coupon-clipping still makes sense. Investors should take a quality-bias. We want to harvest credit premium without over-exposing portfolios to rate

duration

– US HY fundamentals are gradually deteriorating, but there are still good opportunities for further spread compression over the medium term. We think

short duration HY and “Fallen Angels” offer the most attractive risk/reward

– European credits are supported by ECB purchases of IG and investor reach for yield into the BB market. We continue to favour this market

Reducing tactical risk in equities also makes sense.

– The rally means that the case for equities is less clear than it was. We still find a strong valuation signal to be OW relative to bonds, however.

– We are least comfortable with the outlook for US equities given smaller margin of safety and pressure on fundamentals. Prefer Rest-Of-World

– The relative attractiveness of Europe versus US reflects : (i) valuations, (ii) scope for profits catch-up, (iii) active ECB.

Within EM, we prefer debt in Latam and equities in North Asia/EM Europe

– Latam local government bonds still offer an attractive risk/reward, despite strong recent performance.

– In EM equities, North Asia – principally China H-shares – remains the most attractively valued market. China faces some very real macro challenges,

but pricing looks attractive (H-shares). Selective EM Europe markets also look attractively-priced and are geared to the Euro macro & stabilising oil

stories

USD investors should continue to hedge DM exposures, but take EM exposures unhedged

– This is primarily about risk management.

Key Portfolio Conclusions

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Further Detail on House View

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Summary: Calm after the storm

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Risk assets have extended their rally in April, supported by gradually

improving macro data, dovish central bank policy and recovering

commodity prices

– Global equities are now positive year-to-date, but US 10-year yields are

still 40bp lower

– Reduced Fed rate hike expectations have allowed EM equities and FX to

outperform

– Crude oil prices up USD20/bbl (+70%) from February lows

The global growth environment continues to look lacklustre. But the

recent cyclical data is encouraging

– Global manufacturing surveys point to stabilisation

– China’s activity data have picked up noticeably (IP, retail sales, exports)1

– government stimulus is feeding through

The equity risk premia relative to DM government bonds remains

attractive. We are still being compensated for taking equity risk.

– But we need to be realistic about the sustainable returns available in a

low growth/inflation environment

‘Endogenous’ volatilty can present opportunities for asset allocators.

Policy puts provide a safety net for downside global growth risks

– But an overly-aggressive Fed presents a major challenge – there are few

places to hide

Source: HSBC Global Asset Management, Global Investment Strategy Any views expressed were held at the time of preparation and are subject to change without notice. 1. China’s March activity data benefits from favourable base effects as the Chinese New Year fell slighlty later last year

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Any forecast, projection or target contained in this presentation is for information purposes

only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability

for any failure to meet such forecasts, projections or targets. Any views expressed were

held at the time of preparation and are subject to change without notice.

1. See the Fed’s April FOMC statement here:

https://www.federalreserve.gov/newsevents/press/monetary/20160427a.htm

2. See Tim Duy’s blog (April 2016): “Warning: Hawkishness Ahead”

Theme #1: Major central banks are in “wait and see” mode

PUBLIC

Fed concerns over global risks have eased, leaving the door open for

a June rate hike1

– Recent dovish tone recognises the asymmetry of risks facing policy

makers

– Given the severity of downside risks, and several years of below-target

inflation, the Fed could tolerate an inflation overshoot in the near-term

– But financial conditions have substantially eased. Improvements in the

data over the next 6 weeks will strengthen the hawks’ case2

Bank of Japan disappointed in April. Further monetary easing likely

given slowing economy, lower inflation expectations and rapidly

appreciating JPY

– A more stimulative fiscal stance is gathering support despite high debt

burden; consumption tax hike is likely to be delayed

– Will the BOJ be the first major CB to adopt “helicopter money”?

ECB’s shift towards direct credit easing is a welcome development

– Corporate bond purchases and new TLTRO2 to begin in June 2016

– But inflation expectations remain low (5Y/5Y inflation swap: 1.45%).

– Like in Japan, structural issues need to be addressed for inflation to rise

meaningfully

https://www.federalreserve.gov/newsevents/press/monetary/20160427a.htm

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Theme #2: Term premia still very negative; remain UW core DM bonds

PUBLIC

Despite improving risk appetite, the bond market continues to price in

a very pessimistic scenario for long-term rates

– US 10y yields at c. 1.85% and very low in Germany (0.25%). 10y yields

negative in Japan

Bond term premia remains very negative

– We continue to not be rewarded for taking long duration risk

– Prefer cash and shorter duration bonds

Safe-asset scarcity and higher probabilities attached to “tail risk”

outcomes may anchor the bond risk premium in the short to medium

term1. This presents a key challenge to the tactical case for being

underweight core DM bonds

Deeper and more widespread negative rate cuts is another key risk

scenario. Particularly if this results in persistenlty lower longer-term

rate expectations

Breakeven inflation rates have rallied strongly since mid-February. It

makes sense to scale back our enthusiasm for inflation-linkers

– But TIPS still appear attractive relative to Treasuries, even though the

sustainable return is negative. Inflation expectations are still low relative

to history

Source: HSBC Global Asset Management, Global Investment Strategy Any views expressed were held at the time of preparation and are subject to change without notice.

1. See, for example, R. Hall (April 2016), “Understanding the Decline in the Safe Real Interest Rate”

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Any views expressed were held at the time of preparation and are subject to change

without notice.

Theme #3: Risky FI exposure remains attractive – High Yield credit

PUBLIC

HY spreads have compressed further over April and so the tactical

case is less appealing. But the carry for Global HY still looks

attractive, especially relative to DM government bonds. It makes

sense to maintain a strategic OW

– The expected return for US HY stands at 5.0% and for Europe is 4.6%

(USD hedged)

Corporate fundamentals continue to deteriorate gradually in the US.

Leverage ratios are rising, top-line growth is falling and bank lending

standards are tightening

– Moody’s expect default rates to rise from 4% to 6% by the end of the year

for US HY

– Prefer Europe given more benign macro outlook and resilience of

fundamentals

Relative preference for lower duration HY to focus exposure on the

well-rewarded credit risk factor (US Short Duration HY ER: 5.3%)

– US rate duration vulnerable given scope for Fed to tighten policy more

aggressively than currently priced by financial markets

A key source of price volatility is the USD150-200bn of “fallen angels”

that will drop into the HY index over the next 12-18 months

– But this creates an opportunity for contrarians. Fallen Angels have a

historically attractive risk/return profile

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Theme #3: Risky FI exposure remains attractive – Local EM debt

PUBLIC

Local EM debt has continued to rally in April. It makes sense to fade

our enthusiasm given the compression in the implied sustainable

return.

Selectivity remains key. The carry remains high, particularly in LatAm

local currency debt

– EM local currency bonds expected return: 6.2%; Brazil local currency

bonds: 10.3%

Brazil’s economic and political crisis continues to unfold. The Lower

House vote in favour of Rousseff’s impeachment has driven further

outperformance

– Recession is severe, but recent activity data (IP, retail sales) show signs

of bottoming-out

– Inflation appears to have peaked, but favourable base effects from

administered price hikes have almost played out (see chart).

– COPOM kept on hold in April, but may shift towards looser policy if

currency can sustain its recent strength

Mexico’s implied local currency bond return is little changed and offers

reasonable carry at 6.4%

– Latest activity data suggests an acceleration in growth momentum, while

inflationary pressures remain in check

– Central bank action in February has supported MXN rally (now flat ytd)



without notice.

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EM equities and FX have rallied strongly since mid-January, materially

outperforming DM. This is particularly impressive given global growth

concerns at the start of the year. Can this rally be sustained?

Perceptions of reduced central bank divergence has been a key

performance driver

– USD has depreciated by over 6% in trade-weighted terms since mid-

January

– But will the Fed soon shift to a more hawkish tone given easier financial

conditions and improving macro data?

Recovering commodity prices have provided support. But other

fundamentals have not improved meaningfully

– PMIs show little evidence of a pick up in economic activity; ROEs are

little changed; and leverage risks remain

Idiosyncrasies have also been a feature of the rally (e.g. Brazil

equities up c.40% year-to-date in USD, total return terms)

Taking advantage of EM carry still makes sense, particularly given

negatives rates in DM. But the recent rally tempers our enthusiasm

slightly. The universe remains heterogenous - we need to be selective

Theme #4: Is the EM rally sustainable?

PUBLIC



without notice.

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Across EM Asia, we prefer taking equity exposure over bonds. The equity risk premia relative to cash looks

attractive, while bond risk premia are negative for most markets

But in LatAm it makes sense to allocate towards fixed income or cash. We are being better rewarded for taking

advantage of the carry and being exposed to duration, rather than equity, risk

In Eastern Europe and South Africa, the valuation signal is typically stronger for equities versus bonds

Theme #4: EM equities vs bonds

PUBLIC

Being selective in the EM Universe

Country MSCI EM Equity

Weight

JPM GBI-EM GD

Weight

Equity RP vs

Cash

Bond RP vs

Cash Cash Asset Allocation Decision

Asia

China 24% - 6.3% -1.7% 2.4% Equity

Korea 15% - 4.7% -1.6% 2.6% Equity

Indonesia 3% 11% 0.9% 0.6% 7.5% Equity

Taiwan 12% - 4.6% - 2.8% Equity

Malaysia - 10% 2.6% 0.0% 3.7% Equity

Thailand - 10% 2.9% -0.6% 3.4% Equity

India 8% - 2.5% 1.7% 6.2% Equity

LatAm

Brazil 7% 11% -1.7% -0.3% 11.2% Fixed Income/Cash

Mexico 4% 10% 0.9% 1.6% 4.9% Fixed Income

Colombia - 6% 0.1% 0.4% 5.9% Fixed Income

Other

South Africa 8% 9% 1.4% 0.9% 7.0% Equity

Turkey 2% 10% 3.5% 0.4% 8.3% Equity/Cash

Poland - 11% 5.1% 0.0% 2.4% Equity

Russia 4% 5% 3.7% -0.2% 8.2% Equity/Cash

Hungary - 6% 5.8% -0.4% 2.5% Equity



without notice.

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Theme #5: Equity risk premium looks fair; prefer non-US equities

PUBLIC

We remain neutral global equities. The implied sustainable return has

fallen slightly to 5.6%. This is not incredibly inspiring, but still looks

attractive relative to core bonds

We are the least optimistic on the outlook for US equities. The margin

of safety is narrow here and, although most of the weakness in the

hard data can be attributed to energy, the corporate profit share is

elevated

– Margins may come under pressure as the US labour market strengthens

– “Winner-takes-all” mega caps are disproportionately boosting index-wide

profitability

Prefer Rest-of-the-World equities (hedged for USD investors)

– Euro zone looks good value (e.g. Germany has an implied premium of

4.7%) and cyclical macro backdrop should be supportive for profits

– Japan also looks attractive (ERP of 4.9%), but the profits picture has

deteriorated recently (see chart)

Within EM, we continue to prefer North Asian equities and also EM

Europe selectively



without notice.

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Theme #6: Endogenous volatility provides opportunities for asset allocators

PUBLIC

The central challenge for investors is that current pricing is not

especially generous. Picking-up the carry in credits, EM and equities

is better than the alternative of sitting in zero (or negative) yielding

cash

But the margin of safety is diminished and so volatility can damage

the overall return experience. It is therefore essential to be active and

focus on exploiting episodes of endogenous market volatility

Market perceptions of downside growth risks flared up in the summer

of 2015 and again at the start of this year. But the underlying macro

fundamentals were little changed. In these instances, we want to take

advantage of “market misbehaviour” as the odds of backing a benign

growth outcome often improve meaningfully

– “Policy puts” provide a safety net. Policy makers are not out of

ammunition yet

But volatility associated with a more hawkish Fed responding to a

“Strong Demand Recovery” is perhaps harder to exploit – there

appears to be few places to hide

– Long USD seems the prime candidate

– Potentially long EM assets if the slow and low monetary cycle persists



without notice.

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For Professional Clients only and should not be distributed to or relied upon by Retail Clients.

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The Fragile Equilibriuminbest.cl/chileday2016/wp-content/uploads/2015/09/... · The Fed is guiding us to expect 2 hikes in 2016. And a very gradual cycle –The bond market continues

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