Multi-asset research Uncommon truths

Uncommon truths

The bond bear bug

Government bond yields have risen in unison in most Even if the Italian government survives a “No” vote, markets since the US presidential election. Indeed, the French elections could be the next focal point for end of QE and tightening monetary policy suggest we markets and those worrying about the survival of the might have seen the end of the bull market in EU. With Nicolas Sarkozy out of the picture, it Treasuries. Even if that is the case, we think a US bond increasingly looks like Francois Fillon will fight it out with sell-off will be limited. Also, only our “Boom” scenario Marine Le Pen. Interestingly, he is not trying to beat implies negative returns in the next 12 months, thus we the populists at their own game. He is tipped to win, are comfortable with our recent move to Overweight. but it is early and Emmanuel Macron running as an independent can be a dark horse. The interesting Politics has still occupied centre stage this week and aspect of the election and one that makes it difficult the economy has remained second fiddle. Perhaps to compare it to either Brexit or Trump, is that there when politics has such a significant impact on where are not really any fresh, non-establishment candidates the economy is heading, it is just as well (though around. Even Marine Le Pen comes from a well-known recent economic data flows have been supportive of “dynasty”. market moves). How we hope for politics to return to its “boring” old ways! On the other side of the English Channel, Philip Hammond presented his first (and the last ever) The blackout period ahead of the Italian referendum Autumn Statement setting out a budget to tackle next Sunday means we will get no more indication of Brexit’s impact. We were not surprised that he has not where popular opinion is heading. It is doubtful taken a radically different course from his whether it would have much value considering how predecessor’s. Those hoping for a bigger infrastructure many people were still undecided, but a “No” vote push were disappointed, but he might release more seems likely in our view. Italian government bonds and funding if the economic impact of the departure equities seem to be positioning for that. Ten-year proves more serious than currently imagined (see yields have doubled from 1.05% – their low in more detail here). September – and Italian banks are down 12% in the past month. However, European equities seem more In the meantime Donald Trump continued to name sanguine about it, and if we are right, they can sell- members of his future cabinet and retreat from more off, while Bunds would be an obvious “safe haven”. campaign promises, no doubt angering some of his core voters.

Figure 1 – Change in 10-year government bond yields since 8th November 2016 (basis points) 60

40

20

0

-20

-40

-60

Source: Datastream and Source Research

27 November 2016 For professional investors only 1 - Multi-asset research Uncommon truths

Figure 2 – US 10-year Treasury yields since 1790 (%) 14

12

10

8

6

4

2

0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Source: Global Financial Data and Source Research

Considering all this uncertainty, it is all the more Even though many have made that call in the past surprising how weak sovereign debt markets have few years, may now be the time? In our view, the been since the US presidential elections (Figure 1). In answer is not that simple. Market turning points are fact, the only country where benchmark bond yields hard to recognise at the time as shown by repeated dropped (in the universe we are looking at) is Greece. attempts at calling the peak of the Japanese Although this signals a more “risk on” asset allocation government bond rally (dubbed the “widowmaker”). environment in general, we see reasons behind these Admittedly, the case for a bond bear market in the US moves in a similar fashion to Tolstoy: “Happy families is stronger than ever since the onset of the Global are all alike; every unhappy family is unhappy in its own Financial Crisis. The Fed has stopped adding to its way.” balance sheet and is on course to continue raising rates in the near future (albeit at a glacial pace). First, the periphery seems to be pricing in more political risk in Europe, which for the moment, seems to have a However, demographic trends will likely limit inflation in stronger effect than ECB purchases, although central the coming decades and therefore we think ‘normal’ bank buying will cap any significant rise in rates. In fact, levels of Fed rates will be around 2% rather than 3% they might find more willing sellers in the market. (see Pictures of distress for more details). The inflation and yields we saw in the 1980s was in fact the result of Second, a Trump presidency is assumed to be extraordinary population growth. In addition, we do negative for global trade and thus negative for not expect that the Fed will actively reduce its assets Emerging Markets. Less globalisation coupled with by selling off its bond holdings. Central banks in the higher rates, makes the US a relatively more attractive past have relied on GDP growth to adjust their balance destination for outside investors, and therefore sheet/GDP ratios, which normally takes five or six strengthens the dollar. Less and more expensive decades. These factors make sudden and sizeable investment is a headwind for EM assets, including moves unlikely. sovereign debt. Figure 2 suggests that even if this is indeed the start Finally, markets have completely changed their views of a structural bear market, we might struggle to on a Trump presidency. More infrastructure spending, a recognise it. In our view, it is unlikely to be as severe less hawkish fiscal and a more hawkish monetary policy as the one between the 1950s and 1980s. A return to is the consensus now, arguing for higher rates. the long-run average of 4.6% (since 1790) would not even double yields from current levels of 2.4%. Indeed, apart from Brazil, a country with its own set of unique issues, US Treasury yields clocked in the biggest Considering the five scenarios we outlined in our increase in absolute terms at almost 50 basis points Outlook for 2017, US Treasuries look attractive at since the election. That is also a one percentage point current levels. Our forecasts imply positive returns for rise since the low point of 1.36% in July this year. We all but the Boom scenario (we assign a 25% only dare to whisper it: is this end of the three-decade probability to that). We also consider sovereign debt bond bull market? a useful diversifier in times of uncertainty. On a one- year view, we are certainly comfortable with our Overweight.

27 November 2016 For professional investors only 2 - Multi-asset research Uncommon truths

Figure 3 – Asset class total returns

Data as at 25/11/2016 Current Total Return (USD, %) Total Return (Local Currency, %) Index Level/RY 1w 1m QTD YTD 1w 1m QTD YTD Equities World MSCI 415 1.4 0.5 -0.5 6.5 1.4 1.7 2.0 7.3 Emerging Markets MSCI 856 1.3 -6.7 -5.2 10.4 1.3 -3.9 -2.1 9.3 US MSCI 2108 1.5 3.5 2.3 10.3 1.5 3.5 2.3 10.3 Europe MSCI 1400 1.3 -2.3 -5.2 -4.7 0.8 -1.4 -0.2 2.1 Europe ex-UK MSCI 1608 0.9 -3.4 -5.6 -5.2 0.7 -1.2 -0.2 -2.8 UK MSCI 1033 2.3 0.6 -4.4 -3.6 1.2 -2.0 -0.2 14.2 Japan MSCI 2813 0.5 -1.2 -0.6 2.3 2.7 6.7 10.9 -3.9 Government Bonds World BofA-ML 0.96 -0.5 -5.1 -8.0 2.6 -0.1 -2.5 -3.2 2.7 Emerging Markets JPM 7.52 -0.4 -9.1 -8.2 7.9 -0.1 -2.7 -2.5 8.8 US (10y) Datastream 2.37 0.1 -4.6 -5.7 1.3 0.1 -4.6 -5.7 1.3 Europe Bofa-ML 0.71 0.5 -4.3 -9.4 -1.9 0.2 -2.0 -3.9 0.4 Europe ex-UK (EMU, 10y) Datastream 0.16 0.7 -4.1 -8.6 2.9 0.4 -1.8 -3.1 5.4 UK (10y) Datastream 1.42 1.7 -0.3 -9.5 -9.2 0.5 -2.8 -5.6 7.4 Japan (10y) Datastream 0.04 -2.1 -8.3 -11.4 9.3 0.0 -1.0 -1.1 2.7 IG Corporate Bonds Global BofA-ML 2.77 0.1 -3.4 -4.9 3.7 0.0 -2.8 -3.1 4.9 US BofA-ML 3.41 -0.1 -3.4 -3.7 5.1 -0.1 -3.4 -3.7 5.1 Europe BofA-ML 0.97 0.5 -3.8 -7.3 1.8 0.2 -1.5 -1.8 4.2 UK BofA-ML 2.98 1.5 0.1 -9.0 -8.3 0.3 -2.5 -5.1 8.6 Japan BofA-ML 0.29 -2.1 -7.7 -10.8 7.1 0.0 -0.3 -0.4 0.6 HY Corporate Bonds Global BofA-ML 6.47 0.5 -1.9 -1.5 12.5 0.4 -1.6 -0.5 13.5 US BofA-ML 6.77 0.6 -1.6 -0.3 14.9 0.6 -1.6 -0.3 14.9 Europe BofA-ML 4.07 0.6 -3.7 -5.8 4.4 0.3 -1.4 -0.1 7.0 Cash (Overnight LIBOR) US 0.43 0.0 0.0 0.1 0.4 0.0 0.0 0.1 0.4 Euro Area -0.41 0.0 -2.8 -5.9 -2.8 0.0 0.0 -0.1 -0.3 UK 0.23 1.1 2.4 -3.8 -15.0 0.0 0.0 0.0 0.4 Japan -0.07 -1.9 -7.8 -10.4 6.4 0.0 0.0 0.0 0.0 Real Estate (REITs) Global FTSE 1657 1.2 -5.3 -8.9 1.1 0.9 -3.0 -3.5 3.6 Emerging Markets FTSE 1645 0.5 -8.0 -9.2 1.5 0.2 -5.8 -3.7 4.0 US FTSE 2813 1.5 -4.2 -8.1 2.4 1.5 -4.2 -8.1 2.4 Europe ex-UK FTSE 2765 1.8 -8.9 -14.5 -2.1 1.5 -6.7 -9.4 0.3 UK FTSE 958 0.1 -0.8 -9.8 -27.7 -1.0 -3.3 -5.9 -14.4 Japan FTSE 2524 0.1 -4.0 -5.7 2.5 2.2 3.7 5.2 -3.7 Commodities All GSCI 2234 1.5 -3.8 -2.2 2.9 - - - - Energy GSCI 376 0.9 -8.2 -6.1 2.0 - - - - Industrial Metals GSCI 1206 7.4 15.7 13.6 26.4 - - - - Precious Metals GSCI 1445 -2.3 -7.5 -11.0 11.3 - - - - Agricultural Goods GSCI 446 0.5 -2.1 0.2 -0.9 - - - - Currencies (vs USD)* EUR 1.06 0.0 -2.8 -5.8 -2.5 - - - - JPY 113.08 -1.9 -7.8 -10.4 6.4 - - - - GBP 1.25 1.1 2.6 -4.1 -15.5 - - - - CHF 0.99 -0.3 -1.9 -4.1 -1.1 - - - - CNY 6.92 -0.5 -2.0 -3.6 -6.2 - - - -

Source: MSCI, Datastream and Source Research. Notes: *The currency section is organised so that in all cases the numbers show the movement in the mentioned currency versus USD (+ve indicates appreciation, -ve indicates depreciation).

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Figure 4 – Equity sector total returns relative to local market

Data as at 25/11/2016 US Europe 1w 1m QTD YTD 1w 1m QTD YTD Oil & Gas 0.8 0.8 0.5 10.6 1.5 -1.5 3.5 20.5 Materials 1.3 2.6 1.4 4.8 1.6 3.5 6.0 21.3 Basic Resources 5.4 14.1 8.0 46.7 6.0 12.0 18.3 70.6 Chemicals 1.0 0.3 0.0 -2.2 -0.8 -0.9 -0.3 3.3 Industrials 0.8 6.4 4.8 7.8 0.4 1.0 0.3 10.4 Construction & Materials 1.3 12.1 8.1 21.8 -1.3 -0.6 -1.0 10.9 Industrial Goods & Services 0.8 5.5 3.5 8.3 0.8 1.5 0.7 10.3 Consumer Discretionary 0.8 1.2 1.3 -2.7 -0.2 1.5 0.4 -5.9 Automobiles & Parts 1.0 1.9 0.2 -10.7 0.2 0.7 3.1 -5.6 Media 0.2 3.5 4.4 2.3 0.1 0.4 -5.5 -8.4 Retail 1.0 -1.7 -1.1 -4.2 -0.2 1.8 2.3 -2.6 Travel & Leisure 0.3 7.8 8.8 -3.7 -0.7 4.3 0.0 -10.2 Consumer Staples 0.0 -6.2 -6.1 -6.3 0.2 -3.5 -7.3 -0.8 Food & Beverages -0.3 -6.3 -6.4 -5.8 -0.1 -5.3 -9.0 -3.4 Personal & Household Goods 0.3 -5.5 -5.9 -5.4 -0.1 -2.2 -4.5 3.0 Healthcare -1.7 -3.3 -5.9 -11.5 -1.5 -1.1 -5.2 -8.4 Financials -0.2 10.2 13.5 6.8 -0.5 3.5 9.0 -5.2 Banks 0.1 14.2 20.6 6.5 -0.8 4.1 13.0 -6.3 Financial Services 0.1 8.9 11.3 5.0 -0.1 2.5 2.9 -2.6 Insurance -0.5 6.1 6.0 4.9 0.0 5.2 9.3 -2.9 Real Estate -0.2 -8.0 -10.3 -10.1 -0.2 -4.8 -8.9 -6.9 Technology -0.4 -3.6 -1.7 2.6 0.5 -0.8 -5.5 3.2 Telecommunications 3.2 2.5 -3.8 5.1 -0.3 -5.7 -5.3 -14.3 Utilities 0.5 -6.0 -6.0 1.2 0.9 -7.3 -9.5 -7.6

We use a sector classification created by merging the two main systems used by Standard & Poors (S&P) for the US and Stoxx for Europe. We have decided to classify our 10 top level industries using categories that most closely resemble the Global Industry Classification Standard (GICS) and at the level below that (super sectors) we are using the Industry Classification Benchmark (ICB). The former is used for the S&P 500 index and the latter for the Stoxx 600, our benchmark indices. The two systems overlap in most cases and the only material difference seems to be in the consumer sectors. Therefore, we define consumer staples as the aggregate of personal & household goods and food & beverage, while consumer discretionary includes automobiles & parts, media, retail and travel & leisure. For the rest, we assume 100% overlap for the corresponding top level sectors.

Source: Datastream and Source Research

27 November 2016 For professional investors only 4 - Multi-asset research Uncommon truths

Figure 5 – Upcoming macro events

Country Event Name Period Unit Consensus Prior Monday – 28th November Eurozone Economic Sentiment Nov 107.0 106.3 United States Dallas Fed Mfg Bus Idx Nov -1.5 Tuesday – 29th November Japan All Household Spding YY Oct % -0.6 -2.1 Japan Unemployment Rate Oct % 3.0 3.0 Japan Retail Sales YY Oct % -1.2 -1.9 France GDP Detailed QQ Q3 % 0.2 0.2 Spain HICP Flash YY Nov % 0.4 0.5 Germany HICP Prelim YY Nov % 0.8 0.7 United States GDP 2nd Estimate Q3 % 3.0 2.9 United States Case-Shiller 20 YY Sep % 5.2 5.1 United States Consumer Confidence Nov 101.1 98.6 Wednesday – 30th November Japan Industrial output prelim mm Oct % -0.1 0.6 Germany Unemployment Rate SA Nov % 6.0 6.0 Eurozone Inflation, Flash YY Nov % 0.6 0.5 Eurozone Core Inflation Flash YY Nov % 0.8 0.7 United States ADP National Employment Nov k 165.0 147.0 United States Personal Spending Real MM Oct % 0.3 United States Personal Income MM Oct % 0.4 0.3 United States PCE Price Index YY Oct % 1.2 United States Core PCE Price Index YY Oct % 1.7 United States Chicago PMI Nov 52.2 50.6 United States Pending Sales Change MM Oct % 0.3 1.5 Brazil Selic Interest Rate Nov % 13.75 14.00 Thursday – 1st December Japan Nikkei Mfg PMI Nov 51.1 China NBS Manufacturing PMI Nov 51.2 China NBS Non-Mfg PMI Nov 54.0 China Caixin Mfg PMI Final Nov 51.2 India Nikkei Markit Mfg PMI Nov 54.4 Eurozone Markit Mfg Final PMI Nov 53.7 53.7 United Kingdom Markit/CIPS Mfg PMI Nov 54.5 54.3 Eurozone Unemployment Rate Oct % 10.0 10.0 United States Markit Mfg PMI Final Nov 53.9 United States ISM Manufacturing PMI Nov 52.2 51.9 United States Total Vehicle Sales Nov m 17.8 18.0 Friday – 2nd December Eurozone Producer Prices YY Oct % -1.0 -1.5 United States Non-Farm Payrolls Nov k 175.0 161.0 United States Unemployment Rate Nov % 4.9 4.9

Source: Bloomberg and Thomson Reuters

27 November 2016 For professional investors only 5 - Multi-asset research Uncommon truths

Figure 6 – Source Multi-Asset Portfolio Neutral Policy Range Allocation Position vs Neutral Hedged Currency Cash 5% 0-10% 10% Cash 2.5% 10% Gold 2.5% 0% Bonds 45% 10-80% ↑ 44% Government 30% 10-50% ↑ 40% US 10% ↑ 18% Europe ex-UK (Eurozone) 8% ↑ 10% UK 2% ↑ 4% Japan 8% 4% Emerging Markets 2% 4% Corporate IG 10% 0-20% ↓ 4% US Dollar 5% ↓ 2% Euro 3% ↓ 0% Sterling 1% ↑ 2% Japanese Yen 1% 0% Corporate HY 5% 0-10% ↓ 0% US Dollar 4% ↓ 0% Euro 1% ↓ 0% Equities 45% 20-70% ↓ 40% US 25% ↓ 12% Europe ex-UK 7% ↓ 10% UK 4% ↑ 6% Japan 4% ↓ 6% Emerging Markets 5% 6% Real Estate 3% 0-6% ↑ 6% US 1% 1% Europe ex-UK 1% ↑ 2% UK 0.5% 0% Japan 0.5% 2% Emerging Markets 0% ↑ 1% Commodities 2% 0-4% 0% Energy 1% 0% Industrial Metals 0.3% 0% Precious Metals 0.3% 0% Agriculture 0.3% 0% Total 100% 100%

Currency Exposure (including effect of hedging) USD 49% ↓ 37% EUR 21% ↓ 24% GBP 8% ↑ 13% JPY 14% ↓ 13% EM 7% ↑ 12% Total 100% 100%

Source: Source Research Note: This is a simulated portfolio (See the latest The Big Picture for more details). Arrows indicate latest changes in allocation.

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Figure 7 – Source sector strategy

US Europe Preferred Neutral Source Neutral Source Region Oil & Gas 7.1% Underweight 5.5% Neutral Europe Materials 2.2% Overweight 7.2% Neutral US Basic Resources 0.4% Underweight 2.7% Neutral Europe Chemicals 1.7% Overweight 4.6% Neutral US Industrials 11.7% Overweight 14.0% Neutral US Construction & Materials 0.5% Overweight 2.8% Overweight Europe Industrial Goods & Services 11.1% Overweight 11.2% Neutral US Consumer Discretionary 14.9% Neutral 11.5% Underweight US Automobiles & Parts 0.9% Neutral 3.2% Underweight US Media 2.7% Underweight 2.7% Underweight Europe Retail 8.7% Neutral 3.9% Overweight Europe Travel & Leisure 2.7% Neutral 1.7% Underweight US Consumer Staples 10.1% Overweight 18.2% Underweight US Food & Beverages 4.5% Overweight 8.9% Underweight US Personal & Household Goods 5.6% Overweight 9.3% Underweight US Healthcare 13.5% Overweight 11.2% Overweight US Financials 16.9% Underweight 19.3% Neutral Europe Banks 5.3% Overweight 10.4% Overweight Europe Financial Services 5.0% Underweight 1.9% Underweight Europe Insurance 3.6% Neutral 5.2% Neutral US Real Estate 3.1% Underweight 1.8% Underweight US Technology 17.8% Underweight 3.7% Overweight Europe Telecommunications 2.6% Overweight 4.6% Overweight US Utilities 3.2% Underweight 4.6% Underweight US

Source: Datastream and Source Research. Notes: See the latest Source Sector Selector for more details. Arrows indicate latest changes in recommendations.

27 November 2016 For professional investors only 7 - Multi-asset research Uncommon truths

Authors

Paul Jackson Head of Research T. +44 (0)20 3370 1172 E. [email protected]

András Vig Director T. +44 (0)20 3370 1152 E. [email protected]

Important information

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27 November 2016 For professional investors only 8 -