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For professional investors and advisers only Schroders Investment Outlooks 2016 Welcome to Schroders Investment Outlooks 2016 Schroders Investment Outlooks 2016 brings together the views of Schroders’ global experts as they share their thoughts on the coming 12 months. We hope that these outlooks will provide an informative snapshot of what to expect in 2016 and beyond. For more articles, please visit www.schroderstalkingpoint.com 2 Contents 01 2016: Asian ex Japan Equities Robin Parbrook Head of Asian ex Japan Equities 02 2016: Asian Fixed Income Rajeev De Mello Head of Asian Fixed Income 03 2016: Business Cycle (Europe ex UK Equities) James Sym Fund Manager, European Equities James Rutland Research Analyst, European Equities 04 05 06 07 08 2016: Business Cycle (Pan-European Equities) Steve Cordell Fund Manager, European Equities 2016: Business Cycle (UK Equities) Matt Hudson Head of Business Cycle 2016: Commodities Geoff Blanning Head of Commodities 2016: Convertible Bonds Dr. Martin Kuehle Investment Director, Convertible Bonds 4 13 2016: Global Corporate Bonds Rick Rezek Co-Fund Manager, US Fixed Income 34 7 14 2016: Global Equities Alex Tedder Head of Global Equities 36 15 2016: Global High Yield Wes Sparks Lead Fund Manager, Global High Yield 38 16 2016: Global Real Estate Securities Hugo Machin Co-Head of Global Real Estate Securities 41 17 2016: Greater China Equities Louisa Lo Head of Greater China Equities 43 18 2016: Japanese Equities Shogo Maeda Head of Japanese Equities 47 19 2016: Multi-Asset Johanna Kyrklund Head of Multi-Asset Investments 49 20 2016: Multi-Asset Income Aymeric Forest Head of Multi-Asset Investments Europe 51 21 2016: Multi-Manager Marcus Brookes Head of Multi-Manager Robin McDonald Fund Manager 53 57 10 12 14 17 20 2016: Emerging Markets Debt Absolute Return Abdallah Guezour Head of Emerging Markets Debt Absolute Return 22 09 2016: Emerging Markets Debt Relative James Barrineau Co-Head of Emerging Markets Debt Relative 26 10 2016: Emerging Market Equities Allan Conway Head of Emerging Market Equities 11 2016: European Equities Rory Bateman Head of UK and European Equities 12 2016: Global Bonds Bob Jolly Head of Global Macro 28 22 2016: UK Commercial Real Estate Duncan Owen Head of Real Estate 30 23 2016: US Equities Matthew Ward Portfolio Manager, US Equities 59 32 24 2016: US Multi-Sector Fixed Income Andrew Chorlton Head of US Multi-Sector Fixed Income 61 3 01 Outlook 2016: Asian ex Japan Equities Robin Parbrook, Head of Asian ex Japan Equities Looking back on 2015, Asian stockmarkets have had a challenging year as slowing global and emerging market growth, particularly in China, have weighed on investor sentiment. However, in retrospect, the beginning of 2015 bore striking similarities to the previous year when brokers were also recommending clients buy into China. In 2015, the advice came at the start of a clearly unsustainable run-up in Chinese A-share markets. We look with interest to see what recommendations will be for 2016. – Demographics, deflation and disruption are challenges to returns in Asia. – Valuations are not as cheap as they look on paper, with many quality domestic and consumer names we like still expensive. – Making money in Asia has always been about investing in good quality companies not countries or sectors. But we can still find enough investment ideas to fill our portfolios. In our view, the key is to ignore the market noise in Asia. Our warnings of a bubble driven by margin lending were vindicated when stock prices duly collapsed in the middle of the year. This further reinforced our view that investing in the region requires seeking out quality companies that provide consistent shareholders returns and which trade at reasonable valuations. Asia continues to offer significant structural advantages in terms of growth potential over the longer term, but there are short-term headwinds that need to be factored into investment decision making. Asian companies are faced with three key global trends which will impact the landscape: demographics, deflation and disruption. Disruption in Asia The Volkswagen (VW) diesel emissions scandal that was uncovered in September may at first glance look like an issue that only impacts European car manufacturers, but we believe this is part of a wider global trend where watershed moments for industries can be the ringing of dire warnings for certain companies. It is also a prime example of an event where “disruptors” can benefit from the downfall of industry incumbents. In the case of autos, the VW scandal has the potential to accelerate the long-term shift of the “old” car industry, dominated by petrol and diesel, to one where electric vehicles and hybrids dominate. In a world where technological change is moving increasingly fast, this shift is just as applicable in Asia as it is in Europe. Long-term winners could include Taiwanese and Hong Kong technology companies (as electric cars are electronic products) while losers may end up being the current original equipment manufacturers (OEMs) that provide autos with parts, and oil companies. If our predictions end up being correct, then OEMs and oil companies could turn out to be value traps – much like Asian department stores and supermarkets that have seen their market shares, and profits, eroded by online competitors. The point is that anticipating this disruption will be key to long-term returns and no industry in the region will be immune from it. 4 Outlook 2016: Asian ex Japan Equities Surely Asian markets are cheap? The main question we keep getting asked by clients is “are Asian markets cheap?”. Our response remains “not as cheap as you probably think”. This has been treated with some incredulity given the disappointing performance of Asian markets this year and indeed for the last five years, where returns on the main MSCI All Country Asia Pacific ex Japan index have effectively been zero in US dollar terms. When a lot of the banks and commodity stocks, of questionable value, are removed from indices, the resulting price multiples are in line with long-term averages (see charts below). Furthermore, many of the quality consumer and domestic names that we are really keen on are still expensive. Chart 1: Stockmarkets look cheap on paper MSCI Asia Pac ex JP – 12m Fwd PE (x) 20 Robin Parbrook, Head of Asian ex Japan Equities Robin Parbrook has 24 years’ experience covering Asia, all of it with Schroders. Robin is currently the Head of Asia ex Japan Equities and also a Regional and Alternatives fund manager, based in Hong Kong. In 2008 he moved to Edinburgh to focus on managing Asian investment strategies with a focus on absolute returns, and returned to Hong Kong in August 2010 to continue to manage Asian Total Return as well as other Asian equity strategies. In his career he has successfully managed a range of Asian funds. 18 +2SD, 16.9 16 +1SD, 14.9 14 Avg, 12.8 12 -1SD, 10.8 10 -2SD, 8.8 8 6 Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 Source: Datastream, MSCI, CLSA, 16 October 2015. Chart 2: But unfortunately not that cheap when questionable banks and commodity stocks are removed MSCI Asia Pac ex JP ex JP ex financials and materials – 12m Fwd PE (x) 20 18 +2SD, 16.2 16 +1SD, 14.9 14 Avg, 13.0 12 -1SD, 11.4 10 -2SD, 9.8 8 Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: Datastream, MSCI, CLSA, 16 October 2015. The problem remains that a combination of overinvestment, excessive leverage, weak end demand and major technological disruption has, and is still, causing significant headwinds for Asian corporate earnings. This has caused a major compression in return on equity (ROE) in the region. To get a sustained recovery in Asian stockmarkets we are going to need better earnings and returns on invested capital. For this we are going to have to see a return of inflation and economic growth, and some creative destruction of excess capacity. 5 Outlook 2016: Asian ex Japan Equities “Our preferred areas for investment are companies with strong cashflows and, in this low earnings-growth environment, low cost producers that also have a flexible cost base.” Where are the opportunities? We continue to be relatively cautious on the Asian equity outlook as we head into 2016. We can still find enough ideas to remain close to fully invested, however, clients should be reasonable about likely returns given rerating potential is low. Our caution stems from our view that deflationary forces and the sluggish global economy are headwinds for Asian stockmarkets. Deflation is also not good if you have excessive amounts of debt – significant leverage have been added since the Global Financial Crisis, particularly in the corporate sector in Greater China. We do not see Asian stockmarkets enjoying a deflationary boom as sluggish investment and consumption mean return on invested capital (ROIC) is likely to remain under pressure. Asian stockmarket returns have been disappointing as too many companies focus on growth rather than ROIC. We can find quality investment opportunities in the region but it is difficult and involves ignoring large parts of the market index or “beta”. Our preferred areas for investment are companies with strong cashflows and, in this low earnings growth environment, low cost producers that also have a flexible cost base. We continue to like companies that are able to tap into the growing trend of urbanisation and the rise of the middles class. The views and opinions contained herein are those of Robin Parbrook, Head of Asia ex Japan Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 6 02 Outlook 2016: Asian Fixed Income Rajeev De Mello, Head of Asian Fixed Income The coming year will lay the foundation for attractive entry points to add risk in Asian bond markets, particularly once the US Federal Reserve (Fed) signals its trajectory for interest rate hikes. News in 2015 was, and still is, very much dominated by the growth slowdown in China and the collapse in oil and commodity prices. The collapse has been driven to a large extent by a combination of oversupply as well as the moderation in Chinese demand. Furthermore, relatively larger debt loads in certain emerging markets, when compared to developed markets, and mixed signals from the major G3 central banking policymakers, have unsettled investors. – The best opportunities in 2016 are likely to be found in sectors that stand to benefit the most from a slow growth environment. – Lower oil and commodities prices should continue to support Asian countries, on the whole. – History tells us that once the US Federal Reserve’s timetable for rate hikes has been priced by the markets, emerging markets tend to perform. Against this backdrop, market participants have not been able to make up their minds. The uncertainty centres around five positive developments: 1. Chinese reform programmes and policymakers’ concerted push towards economic growth dependence on services rather than manufacturing Firstly, China wants to avoid the “middle income trap”, whereby a country does not reform its economy after having grown rapidly, and instead gets stuck in activities that stop it from achieving wealth comparable to an advanced country. For this reason, Chinese policymakers have engaged in a significant push towards moving the economy away from being the “factory of the world” towards one that focuses on moving up the value chain towards more high-tech, value-added services – in a similar vein to the transition of other Asian countries such as Singapore and South Korea. Providing services to its increasingly affluent consumer and the rest of the world is the long-term goal and should result in higher revenue generation, further development and enhanced wealth creation. This ties in neatly to debt. As most investors are aware, China has a debt problem and, by some counts, has the third-highest debt burden in the emerging world behind Hungary and Malaysia – if you ignore the financial sector – at over 200% of GDP. Although the desire to avoid the middle income trap can partially explain the willingness to take on debt, Chinese authorities have recognised the drawbacks of excessive borrowing and are engaged in deleveraging through reforms of central and local government finances, dealing with debt in state-owned enterprises (SOEs) and the private sector, and pulling the plug on leveraged activities. The short-term effect of these two reforms has historically resulted in slowing GDP growth in other countries. China appears to be no different. What this implies is that the winners in the old economic model will now be the losers, such as basic manufacturing industries, steel companies and firms that consume vast amounts of commodities. The winners in the new economy are likely to be well-run technology, healthcare and infrastructure firms, amongst others. 7 Outlook 2016: Asian Fixed Income For bond investors, a slower/lower growth model is a good thing. Chinese government bonds become the choice instruments for investors looking for safety and high quality investment grade corporate bonds benefit from investors’ de-risking bias towards safer and less leveraged firms. In the long run, Chinese deleveraging and a push towards a higher value-added economy point to stability and arguments for a lower risk premium. Rajeev De Mello, Head of Asian Fixed Income Rajeev De Mello is Head of Asian Fixed Income, based in Singapore. He joined Schroders in July 2011 and previously worked at Western Asset Management as Senior Investment Officer, Country Head of Singapore, and member of the Global Investment Strategy Committee. Prior to that, he was Head of Asian Fixed Income at Pictet Asset Management. Until 2005, he was Head of Fixed Income with specific responsibilities for European bonds and Global bonds. He started his investment career in 1987 and has a Bachelor of Science in Economics (Hons), London School of Economics and an MBA from Georgetown University. 2. Beneficiaries of low oil and commodity prices Lower commodity prices are proving painful for commodity-producing countries and companies, as revenues and profits fall whilst servicing debt burdens rise. The reverse is true for commodity consumers. The US, eurozone and Asian countries, bar Malaysia and Indonesia, are big consumers of both oil and hard commodities. Any reduction in the cost of these imports has a positive effect on the current accounts of commodity importers and the wallets of commodity importing nations’ consumers. In Asia, where growth has slowed, this is a welcome respite for economies and consumers. It also allows governments and central banks in the region the much-needed wiggle room, in terms of monetary/fiscal policy, to mitigate the slowdown being caused by a lower growth rate in China. There is also the inflation effect. Lower food, commodity and energy prices translate into lower inflation in Asia. This implies that central banks in the region have the flexibility to cut interest rates, which should be supportive of bond markets in the region. 3. An increasingly resurgent US economy and a eurozone that appears to be stabilising Asia is the manufacturing hub of the world. Even though numerous studies have suggested that global trade has reversed, a resurgent US and a stabilising eurozone are both likely to translate into better prospects for Asian companies – particularly those who have good links to these economies. Good quality investment grade companies stand most to benefit from this phenomenon. 4. Japan’s renewed internationalism For too long the Japanese have been focused on investing their vast savings into the domestic Japanese bond market. Following the push by the Japanese government to diversify away from Japanese bonds and into overseas bonds and equities, capital from Japan is flooding financial markets and Asian bonds are turning out to be a beneficiary of this trend. 5. The end of easy (destructive) monetary policy Many can point to historical instances where a period of tightening in US monetary policy is typically accompanied by pain in emerging markets. This time is no different. Since 2013, the Fed’s intention to disengage from easy monetary policy has been a contributing factor to weak performance in the emerging market complex. However, if historical precedent is anything to go by, Asian and emerging markets tend to recover once the tightening actually occurs. So while the anticipation of rising US rates tends to have a negative impact on Asian markets, the actual point at which rates are raised and when clarity around the pace of rate hikes begins to emerge, tends to result in a stabilisation of returns for Asian investors. Although many expect the US dollar to keep strengthening on the back of rate hikes in 2016, we believe that once the path of Fed hikes is priced into the dollar, the currency may top out. It is already a crowded trade and a stronger US economy should lead to a greater US trade deficit and therefore, an increase in the supply of dollars. As a result, we expect there to be some viable opportunities in 2016 to go long Asian currencies versus the greenback. 8 Outlook 2016: Asian Fixed Income Conclusion All of the above imply that good quality Asian government bonds hedged or partially hedged to the US dollar will benefit – given lower inflation and the likelihood of central banks easing monetary policy in the region. Furthermore, Asian US dollar-denominated investment grade bonds will be in demand on the back of the low growth environment and also as investors de-risk away from the high yield sector amidst rising defaults. The yield spread between Asian government bonds and other markets continues to be high, especially after the decline in European yields, and we see this trend continuing into 2016 as monetary policy in Europe looks set to be in easing mode for a while yet. The views and opinions contained herein are those of Rajeev De Mello, Head of Asian Fixed Income, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 9 03 Outlook 2016: Business Cycle (Europe ex UK Equities) James Sym, Fund Manager, European Equities James Rutland, Research Analyst, European Equities We do not see a major turning point in the business cycle at this point, but the potential for inflation to return in Europe could see some currently out of favour areas of the market perform better in 2016. The outlook for European equities in 2016 is more nuanced than it has been for several years, particularly given the potential for incremental stimulus from the European Central Bank (ECB) and its knock-on impact on bond yields and therefore equity prices. Whatever the short term effects might be, quantitative easing has the implicit aim of embedding inflation. This has important implications for portfolio construction. – The European Central Bank is trying to stimulate reflation; should this occur it could benefit value areas of the market that have been out of favour. – The economic outlook for Europe looks reasonable and pent-up demand could lend support. – We see potential opportunities in energy producers, even without an upturn in oil prices. “We think we now need to encompass value more broadly, making sure to avoid value traps. This will not change our core positioning since we do not see a major turning point in the business cycle currently.” 10 For the past few years we have been making a call on recovery, essentially by comparing equity valuations today to what we would consider a normalised level of profitability. We favoured those stocks where the risk-reward looked to be the greatest, were economic recovery to take hold in Europe. This process has served us relatively well, but has led us into the value compartment of the market. As we look into 2016, and despite the fact the “recovery” profit pool has nowhere near recovered to historical levels, we think we now need to encompass value more broadly, making sure to avoid value traps. This will not change our core positioning since we do not see a big turning point in the business cycle currently. We still favour limited exposure to growth which is approaching bubble valuations. The risk is that bubbles can grow bigger. Having said that, we remain open-minded and would consider opportunities within this compartment of the market should we find them at attractive valuations. Value and consumer stocks could perform well Our positioning is heavily influenced by our belief that inflation will return as the ECB is committed to it. We think we are in the process of shifting from one investment paradigm to another i.e. from “lower for longer” to reflation. The key beneficiaries of “lower for longer” have been growth stocks, which have outperformed value by 15%/19%/31% over the past one/three/five years respectively. The key beneficiaries of reflation should be value stocks, in particular financials and this is one pocket of the market where we think absolute value remains. For us, the other key driver is economic momentum. We continue to see a relatively reasonable outlook for Europe. We think the market underestimates the recovery potential of the European consumer and the level of pent-up demand that exists. Before 2015, Europe had been through six years of credit crunch. That said, we cannot discount an impact in Europe from the weakness in the US and China. Recent data has been more encouraging with the US Economic Surprise Indicator moved back to positive for the first time this year recently and Chinese data picking up more broadly. We remain watchful. Outlook 2016: Business Cycle (Europe ex UK Equities) Opportunities in energy producers One area of the market we have been focusing on is oil and gas producers. We see the potential for an enormous step change in cash generation, without an improvement in the oil price. In fact one thing we are sure of is that we have no ability to predict the future oil price! “We still favour limited exposure to growth which is approaching bubble valuations.” James Sym, Fund Manager, European Equities James Sym is a member of the PanEuropean Equity team at Schroders. James graduated from St John’s College, Cambridge with a degree in Natural Sciences and is a Chartered Financial Analyst. James has eight years of investment experience. Like other commodities, oil went through a massive bull market for 15 years (excluding the financial crises) during which time the price more than quadrupled. Despite this, the cash generation of the sector remained flat. Where did all that value accrue? The value went to the oil service companies (still unattractive in our view, incidentally) as the bottlenecks across the supply chain endowed these widget makers with pricing power. The level of operating expenditure and capital expenditure (capex) required per barrel of oil rose significantly. “One area of the market we have been focusing on is oil and gas producers. We see the potential for an enormous step change in cash generation.” There is a historical precedent for “lower for longer” with respect to oil prices. Between 1987 and 1997, oil remained roughly flat in nominal terms and declined 3% in real terms per year. During this time, upstream profit margins grew from 6% per year as, amongst other things, costs fell. Looking at expectations in the market today, the extent of cost reduction that is possible (20%? 30%? 50%?) is nowhere near being reflected in current share prices. Further, during 1987–97, free cash flow more than covered dividends, which grew at 9% per year, despite capex rising 6% per year. In short, we have identified a section of the market which is very un-consensual and offers 50–100% upside over the next three years. James Rutland, Research Analyst, European Equities James Rutland is a member of the Pan-European Equity team at Schroders. He graduated from University College London with a degree in Economics and is a Chartered Financial Analyst. James started his career at Evercore, before moving to Goldman Sachs as a research analyst. He has six years of investment experience. The views and opinions contained herein are those of James Sym, Fund Manager, European Equities, and James Rutland, Research Analyst, European Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 11 04 Outlook 2016: Business Cycle (Pan-European Equities) Steve Cordell, Fund Manager, European Equities Steve Cordell sees the business cycle remaining in the expansion phase in 2016 and discusses why domestic consumer cyclical stocks should fare well in Europe. Central bank divergence complicates market backdrop For the global economy, the business cycle looks like remaining in the expansion phase in 2016. This will allow the US Federal Reserve (Fed) to raise interest rates for the first time since 2006. The expectation is currently that rates will rise 0.25% in December 2015 and thereafter it is seen as less than 50% likely that rates will rise any further! This is understandable perhaps when the US economy is struggling to grow over 2% in real terms and inflation is barely above zero. – The global economy looks set to remain in the expansion phase of the business cycle in 2016. – Diverging monetary policy in the US and eurozone is likely to complicate the picture. – Economically-sensitive consumer stocks should be among the winners in Europe, along with selected industrials. “Consumers should be the winners again in 2016 as wages grow in real terms and unemployment falls further in Europe.” The growth rate and inflation picture is very similar in Europe, but here the European Central Bank (ECB) is taking a completely different monetary stance by expanding money supply. Recent commitments to remain in a phase of monetary easing have been extended to March 2017, by which time the ECB’s balance sheet will have expanded by €1.4 trillion. This transatlantic divergence in monetary policy makes forecasting 2016 very tricky. The policy moves are even more confusing in the light of the recent economic data, which has surprised on the downside in the US and on the upside in Europe. Earnings expectations for Europe are expected to benefit from monetary policy easing, a weaker euro as a result, and stronger demand for credit. Yet the latest announcement from the ECB was met by a stronger euro, an ECB survey of small businesses that said availability of credit was no longer an issue, but demand for credit was just not there! The money supply may be expanding at around 11–12% per annum, but demand for credit is not, and with negative interest rates for cash left with the ECB, banks are struggling to grow earnings this cycle. Consumption to boost Europe’s domestic recovery The domestic European recovery may therefore not be best played through the banks this cycle, especially if the US credit cycle continues to deteriorate as the Fed tightens policy. Ironically, the US dollar usually peaks as soon as the US raises interest rates, so the export sector in Europe may not find a tailwind from a weaker euro either this year. Consumers should be the winners again in 2016 as wages grow in real terms and unemployment falls further in Europe. This continues the trend of the last few years, but with fewer governments pretending to hit budgetary targets, thanks to elections on the horizon in Italy and France in 2017, maybe consumption will accelerate in these two countries after years of lagging their German and Spanish neighbours. This should allow domestic growth to match or even exceed the rate of 2015 in the eurozone. 12 Outlook 2016: Business Cycle (Pan-European Equities) Consumer stocks may perform well; commodities remain unpredictable The wild card is what happens to commodity prices in 2016. Currently depressed by excess supply globally and slowing demand in China, commodities could see a rebound if the Chinese manage to run down their excess inventories, but supply has yet to contract meaningfully, and it is the contraction of supply that could send prices higher. Oil is the most likely commodity to see such a discipline return first, but with little sign of real distress other than in parts of the US shale oil and gas industry, we may be bobbing along the bottom for some time. Steve Cordell, Fund Manager, European Equities Steve Cordell is a European equities investor with over 21 years’ investment experience. He joined Schroders following the acquisition of Cazenove Capital in July 2013. He was a senior member of the panEuropean equity team at Cazenove, having joined in 2002. Prior to Cazenove, he was at HSBC Asset Management (Europe) Ltd where he was responsible for several retail and institutional pan-European portfolios. It is the slow speed of nominal global growth that makes this an unusually protracted cycle, and this has driven multiples of growth stocks to high levels. Next year the trends are likely to remain in place, and if the growth stocks tumble it will be because bond yields finally move higher. The US Fed has started that process, but in doing so has made slower growth even more likely. A flatter yield curve in the US would put even more pressure on value stocks and expand the multiple on growth stocks. Easier policy in Europe should, on the other hand, lead to a steeper curve and lower multiples for growth stocks and defensives. For this reason we continue to favour domestic cyclicals over global plays but we have shifted our preference from banks, where low rates are a hindrance, back to consumer cyclicals where earnings estimates are rising as well as selected industrials. We have moved overweight commodities via oil but with low expectations of a quick return. “We have shifted our preference from banks, where low rates are a hindrance, back to consumer cyclicals where earnings estimates are rising.” The views and opinions contained herein are those of Steve Cordell, Fund Manager, European Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 13 05 Outlook 2016: Business Cycle (UK Equities) Matt Hudson, Head of Business Cycle Do investors face showdown or slowdown in 2016? Investors have endured a volatile ride in 2015 as the economic slowdown in China and emerging markets more generally has weighed on global activity. Despite aggressive monetary easing, European growth has also disappointed some of the more bullish expectations and while US GDP growth has been more robust, activity has faded recently as the oil industry has contracted due to the fall in the oil price. – Capital returns will be harder to sustain and therefore income such as dividends and special returns of capital will become an even more important factor in overall returns. – A preference for growth over value will likely remain an important theme going into 2016 and domestic consumer-focused companies could maintain their run of outperformance. – UK base rates remain low, and any tightening is probably going to be gradual, and so unlikely to derail the British economic recovery. “After a more turbulent year for markets and the global economy in 2015, to us it seems clear that the business cycle has shifted to the slowdown phase.” Despite this, some areas of the FTSE All-Share have enjoyed strong relative returns in particular domestically-facing sectors (for example consumer cyclicals such as house builders) as they have been seen by investors as beneficiaries of a robust UK economy, low interest rates and falling commodity prices. However, other sectors, especially those exposed to global trends (such as commodities or Asian Financials) have been under pressure in 2015 and have underperformed materially, with large-cap UK listed oil and mining companies the most obvious examples. Market confidence was undermined in the summer by a combination of the devaluation, albeit small, of the Chinese currency and the prospect of rising interest rates in the US. Together these developments suggest that the status quo of ultra-loose monetary policy in the US and a pegged currency in China is coming to an end. In this respect, the underlying economy in China is perhaps less resilient to an appreciating renminbi than previously thought and is going through a period of profound structural change. Slowdown not showdown? Given this context, we are compelled to ask whether investors face showdown or slowdown in 2016. In our view 2016 is more likely to represent a slowdown phase in the business cycle, a period in which equities overall will still generate positive returns, although with wider dispersion and more volatility, a trend already well established. In addition, capital returns will be harder to sustain and therefore income such as dividends and special returns of capital will become an even more important factor in overall returns for equity investors. We will return to the subject of UK dividends more specifically later on. Our contention was always that this would be an extended business cycle. It is extended because aggressive monetary policy measures used to stave off a deeper recession in 2008 have been prolonged, helping to offset some of the downside, but in so doing, these policy measures have prolonged the life of unproductive capital and this has meant that nominal growth rates have been substantially below those seen in previous creditdriven cycles. Meanwhile, governments have retrenched and remained fiscally tighter, thereby constraining investment and growth. This cycle is already long in the tooth and showing increasing signs of tiredness. One of the more obvious aspects of the cycle’s maturity has been the collapse in commodity prices as the Chinese economic “miracle” has run into problems. Investors have clearly recognised this factor in their negative view on commodity related sectors such as mining and oils which have experienced substantial falls year to date. The decline 14 Outlook 2016: Business Cycle (UK Equities) in commodity prices also undermines a much wider part of equity markets’ earnings base. In general, rising commodity prices support corporate pricing power especially in the industrial sector of the market, be it direct beneficiaries of the commodity boom (such as mining suppliers) or indirect users of those commodities (such as chemicals). At the same time wage inflation is starting to accelerate in both the UK and US, putting further pressure on corporate margins and profitability. With the loss of “air cover” from rising input prices to raise headline prices, the outlook for corporate pricing power and profitability has already deteriorated. Matt Hudson, Head of Business Cycle Matt is Head of the Business Cycle equity team at Schroders and is directly responsible for running UK equity funds including the Schroder UK Alpha Income Fund and the Schroder UK Opportunities Fund. He joined Schroders as part of the Cazenove Capital acquisition in July 2013 and is responsible for research in the banks, construction, electricity, mining, utilities and nonlife insurance sectors and has 17 years of investment experience. Prior to Cazenove, Matt worked for AIB Govett Investment Management before which he was a chartered accountant at PriceWaterhouseCoopers. He graduated from Cambridge University with a degree in History. “Investors will need to be particularly vigilant about balance sheet strength going in 2016, especially if a tightening rate cycle precipitates a further widening in credit spreads.” It seems likely that the Federal Reserve will start to raise interest rates in 2016 as a result of an improving labour market where wages are going up. Normally the start of a rate tightening cycle coincides with corporate margins expanding as demand recovers and companies benefit from operational gearing. However, this time we feel that margins are already at elevated levels, particularly in the industrial areas and the rising cost of finance will put further pressure on earnings and capital investment. In essence a rising rate cycle may well coincide with a peak in margins this time. It looks to us that the period of peak earnings on a global basis are behind us and while year-on-year growth in earnings will remain positive, the rate of growth is falling. As usual, the US looks to be leading the global business/earnings cycle with Europe someway behind, though potentially enjoying a much-awaited later cycle recovery. The UK seems to be somewhere in the middle. A key concern for investors has been the trajectory of inflation generally and wage inflation specifically. While headline inflation in 2015 has been very low, core inflation (excluding energy and food) in the US and the UK has been more resilient. A failure to raise interest rates in September looks unlikely to be repeated in December 2015 after some very strong labour market data. Focus from doves on the Federal Open Market Committee seems to have shifted to the trajectory of interest rates rather than the timing of ‘lift-off’. Credit spreads have already started to widen and financing for corporates, particularly those with stretched balance sheets, will get more difficult. Offsetting this, the economy is sustaining high employment levels, while a tightening labour market is set to drive real wages higher. Consumption is the strongest driver of real end demand, meaning this should serve to dispel deflation fears. For equity markets these conditions are likely to result in a preference for growth over value remaining an important theme going into 2016. We also expect the domestic consumer-focused companies to maintain their run of outperformance. UK base rates remain low, and any tightening is probably going to be gradual, and so unlikely to derail the British economic recovery. End demand in developed economies is robust, unemployment rates are low and falling and wage inflation is accelerating. A return of some inflation, while concerning for central bankers, would be helpful for total demand and we still see opportunities for selected corporates to make good returns. In addition, recent market volatility has opened up a number of shorter-term value opportunities. However, it is prudent to continue to tilt portfolios to a defensive skew – with key areas for the portfolio in Growth Defensives and Value Defensives (see graphic over page) on a selective basis. 15 Outlook 2016: Business Cycle (UK Equities) The seven style groupings of the Business Cycle equity team – Commodity Cyclical Revenues linked either directly or indirectly to a commodity product such as oil, steel, gas, mining or bulk chemicals e.g. BHP Billiton – Industrial Cyclical Manufacturing capital goods or with revenues linked to industrial production. Includes engineering, aerospace and construction e.g. GKN – Consumer Cyclical Revenues reliant on consumer spending. Includes retailers, automotives, house builders and leisure e.g. Marks & Spencer – Financial Revenues depend on interest rate spreads, financial markets and asset valuations. Includes banks, insurers and real estate e.g. Barclays – Growth Revenues well in excess of GDP but sometimes with a degree of uncertainty or volatility. Includes luxury goods, medical technology and IT e.g. ARM – Growth Defensive Grow revenues in excess of GDP with low volatility and high visibility. Includes pharmaceuticals and support services e.g. Compass – Value Defensive Grow revenues at or below GDP with low volatility and high visibility. Includes telecoms, utilities, tobacco, and food retailers e.g. Imperial Tobacco. Source: Schroders. For illustrative purposes only and not to be considered a recommendation to buy or sell securities. Our portfolios While our overall tilt in portfolios is towards a more defensive and/or stable income skew we have maintained some higher-beta exposure in the form of Consumer Cyclicals and Financials, in order to benefit from the ongoing recovery in domestic demand. After a more turbulent year for markets and the global economy in 2015, to us it seems clear that the business cycle has shifted to the slowdown phase. Rising wage inflation, interest rates and peaking corporate margins are all hallmarks of this phase of the cycle. GDP growth will remain positive with developed markets more robust than developing markets. However, credit spreads while still at historically low levels, have already started to widen and not just in the more obviously troubled sectors e.g. oil, mining and related industrials, but also in previously more resilient areas. This, to our minds, is confirmation that the slowdown phase has begun. There are still good returns to be made from equities, but a more defensive skew is prudent. Dividend dynamos One of the brighter spots for the UK may be dividends, although we anticipate pressure on the UK market’s total aggregate cash dividend. There were two notable disappointments in 2015, with British Gas owner Centrica and mining group Glencore both reducing their dividend payments, and we expect more disappointments to come. In light of these potential risks, investors will need to be particularly vigilant about balance sheet strength going in 2016, especially if a tightening rate cycle precipitates a further widening in credit spreads. There are still a good number of companies in the UK market that are able to sustain dividend growth of 5–6% over the next few years, in line with the long-term nominal rate of UK market dividend growth. In a low growth, low inflation environment, dividends and dividend growth in particular will still offer attractive returns for investors in the face of potential capital losses from fixed interest securities. The views and opinions contained herein are those of Matt Hudson, Head of Business Cycle, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 16 06 Outlook 2016: Commodities Geoff Blanning, Head of Commodities After five years of declines, the commodity bear market is long in the tooth and we certainly expect bullish surprises, when they occur, to trigger strong recovery rallies in 2016 and beyond. Commodity investors suffered in 2015 as major headwinds continued, primarily the strengthening dollar and the weakening Chinese economy. In the energy market, the new Saudi-led OPEC market share policy drove oil prices much lower than many expected, while weather played an unusually important role too, reducing demand for both oil and gas in the US and Europe and supporting near-record production of grains and oilseeds worldwide (to date the effects of the record-breaking ‘El Niño’ have been benign). – Energy looks like the sector with the greatest potential for price appreciation in 2016, although risks remain in the short-term. – We remain cautious on base metals, although the potential exists for shortcovering rallies, particularly in nickel. – Gold could benefit from an increase in geopolitical or macroeconomic concerns, or from any weakening of the dollar. – 2016 is expected to be a turnaround year for major agricultural commodities. “With oil priced at $31/ barrel, it is more likely than ever that US production will fall steeply in 2016, and commence declines in many other regions too.” Looking ahead, three key catalysts for bullish surprises can be highlighted: 1. Geopolitics: historically important to commodity investors but now almost completely forgotten. It is a matter of time before disruption to commodity trade flows occurs again – most likely energy or food-related in the Middle East and/or Russia. In the past quarter, Turkey joined the list of countries in dispute with Russia, while pressure on Saudi Arabia’s rulers continues to grow. 2. US dollar: with currencies being difficult to forecast, the confident consensus of further dollar gains seems inappropriate, even foolish, especially when observing the Federal Reserve’s tortuous interest-rate deliberations. When the dollar turns, commodities could surge. 3. Supply/demand balances: this extended period of declining prices is setting the stage for a return to supply/demand balance across a range of commodities. Distress amongst miners and energy producers accelerated in Q4 and the inevitable adjustment to supply will likely be extended. US natural gas, which has recently been trading below the cost of production of even the most efficient producers, is a prime example. Energy Energy looks like the sector with the greatest potential for price appreciation in 2016, although risks remain in the short-term. The big surprises for the oil market in 2015 came on the supply side: first, production in the US and other non-OPEC nations held up much better than expected; and second – more significantly – OPEC production actually increased, led by Saudi Arabia and Iraq. With oil priced at $31/barrel, it is more likely than ever that US production will fall steeply in 2016, and commence declines in many other regions too. Further potential gains from OPEC producers – primarily Iran but possibly Libya too – will be insufficient to 17 Outlook 2016: Commodities outweigh non-OPEC declines in the medium-term. Assuming global demand continues to grow at a modest rate, therefore, it is logical to forecast a solid price recovery as the year progresses. The problem for oil remains in the short-term. The recent disastrous OPEC meeting, which confirmed a production “free-for-all” (no quotas nor overall target), gives rise to the possibility of higher OPEC output in Q1 2016. The favourable shift in the supply-demand balance that we foresee in 2016 could, therefore, be delayed. Thus further downside risk remains in the short-term but an eventual strong recovery towards $60 (i.e. +70%) appears inevitable once supply gains have peaked out. Geoff Blanning, Head of Commodities – Head of Commodities; Energy Fund Manager. – Head of Emerging Markets Debt and Commodity Group since December 1998, member of the Schroders Group Management Committee. – Geoff conceived and developed Schroders Commodity businesses from 2003. – Investment career commenced in 1985 at NM Rothschild. Mild weather killed any chance of a rising US natural gas price in recent months. However, there is a clear shortage of gas developing in the medium-term (1–2 years) – a bullish outlook reinforced by the recent fall in price. We project a severely undersupplied market by the end of 2016, offering gains of 30–40% on a 12-month view. EU gas could also benefit from renewed Russia-Ukraine tensions. Base metals The outlook for base metals remains dominated by China. We remain cautious, although the potential exists for short-covering rallies, particularly in nickel. Base metals stabilised recently as short positions were covered due to signs of supply adjustment. However, a constructive view will not be justified until we can be confident Chinese demand has bottomed, or supply cuts are deep enough to engineer deficits and inventory drawdowns. We are some way from this point and thus we believe prices can still make new lows. Potential downside remains highest in copper; largest upside potential is in nickel. In China we face a backdrop of a still-high investment/GDP ratio, high housing inventory and limited deleveraging. As a result, the risk that demand again disappoints market expectations in 2016 is high. However, as the central government makes aggressive efforts to reduce overcapacity in 2016, the reduction of credit to loss-making productive capacity will become an important offset to weaker demand. Indeed, announced closures in the zinc and copper industries, combined with closure of high-cost, small-scale supply is leading to a tightening in underlying concentrate markets. Supply-side behaviour highlights that we are much closer to the bottom of this cycle than a year ago. Aggressive debt cutting, cancelled dividends, and spot prices below costs of production all suggest a clearing market. “Gold could gain anytime there is pressure on major equity indices, stress in high-yield markets or a further ratcheting up of China’s financial crisis.” 18 Precious metals In 2016 gold could benefit from an increase in geopolitical or macroeconomic concerns, or from any weakening of the dollar. In gold, a key question is whether the market’s focus will shift in 2016 from its recent obsession with US interest rates and the dollar to a focus on demand and supply. Although this is likely to be delayed, a greater focus on US real rates is probable; recovering inflation will keep real rates suppressed, supporting gold. We also believe the macro risk environment is underestimated; gold could gain anytime there is increased pressure on major equity indices, stress in high-yield markets or a further ratcheting up of China’s financial crisis. Outlook 2016: Commodities Platinum fundamentals remain neutral. A very weak rand (moving from 11.5 to over 15 to the dollar in 2015) has delayed supply adjustments in South Africa (70% of global platinum mine supply). Moreover, investor sentiment was seriously impacted by the VW scandal (implies less demand for diesel vehicles) and sizeable ETF liquidations followed in September/October. The impact of the VW scandal, however, is likely to be less than initially feared. Nevertheless, the market is carrying high inventories; evidence of inventory draws and confidence that the market is in deficit ex-investor demand is a pre-requisite for a sustainable price recovery. Agriculture 2016 is expected to be a turnaround year for major agricultural commodities, and prospects for price rises in some are already good: rapeseed, palm oil, cocoa, sugar and rubber. Three key themes will be supportive for agricultural markets in 2016: 1. Weather: the strong El Niño, currently being experienced, will likely turn into La Niña in 6–12 months. Periods of La Niña are typically associated with lower agricultural yields. 2. India: current planting difficulties for grains, oilseeds and sugarcane could result in the country turning into a major importer of agricultural commodities once again. 3. China: meat production fell recently and could result in a rise in pork and poultry imports. The negative fundamentals for the grains and oilseeds markets (i.e. large global crops and inventories, export competition, slowing Chinese demand, freight disadvantage for US products and the strong US dollar) are continuing, but are now largely factored into prices. The fundamentals for vegetable oils are turning bullish due to lower palm oil yields and growing Indian imports. We expect palm oil to continue to be the outperformer in the oilseeds subsector, followed by European rapeseed and Canadian canola. We rate cocoa as neutral-to-bullish as low supplies are balanced by lower grinding. The coffee market should continue to trade sideways barring any changes in the prevailing weather in Latin America or in other major growing countries, though we favour Arabica compared to Robusta, where stocks remain high. Fundamentals for sugar, which rose 20% in Q4 2015, are turning supportive for prices given crop reductions in some major producing countries and there are expectations of a global deficit in 15/16, the first in six seasons. An increasing number of animals, growth in their average weight and low US exports shaped the negative picture for meats in 2015. Bearish factors appear now to be reflected in prices and we expect these markets to trade sideways during Q1 2016. However given the fall in Chinese meat production, a sudden increase in imports of pork and poultry is likely in 2016 and could well be bullish for this subsector, especially if the Dollar weakens. The views and opinions contained herein are those of Geoff Blanning, Head of Commodities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 19 07 Outlook 2016: Convertible Bonds Dr. Martin Kuehle, Investment Director, Convertible Bonds After the financial crisis, stockmarkets entered a sustained bull market. Convertible bond investors were rewarded with a prolonged period of strong returns. The Federal Reserve’s (Fed) massive quantitative easing programme lifted markets and revived the US economy. The Fed’s asset purchase scheme was then followed by the Bank of England, European Central Bank and the Bank of Japan. The latter two are still supplying the global economy with vast quantities of liquidity. – The market environment in 2016 is expected to remain volatile. – Sudden market setbacks could be triggered by negative shifts in sentiment, swings in market liquidity or unanticipated shocks in fundamental economic data. – Convertible bonds, with their in-built stabilisers, should be well suited as an asset class for volatile markets. “With low but positive economic growth there are good reasons to stay invested in risk assets.” 20 The Fed is now on the verge of lifting interest rates for the first time since it implemented the ‘zero rate’ policy in 2008, but the size of the financial experiment still makes the decision a first in financial history. Quantitative easing will continue to have direct and positive implications for equity and convertible markets. Cyclically adjusted equity valuations in Europe and Asia still look reasonable which, combined with a booming monetary base, continues to support the outlook for equities. That said, we believe we are without doubt in the later stages of a long-running bull market. Sudden and strong equity market setbacks are now a normal occurrence. During the summer, Chinese stockmarkets entered a nose dive, with share prices shedding some 40% before levelling out. In August and September, global stock exchanges lost more than 10% before recovering in October. Each time, convertibles protected investors from about half of the equity market losses. Convertible bonds, with their in-built stabilisers, proved to be ideally suited as an asset class for the year’s volatile markets. We believe convertible bonds should continue to reduce equity risk for investors in 2016. Convertible bonds offer this protection through a characteristic called ‘automated timing’. The automated timing function means that equity exposure decreases automatically when the underlying equity falls. Importantly though, the equity exposure accelerates again in rising markets. Successful active exposure management and good security selection could add significantly to outperformance over the longer term. Outlook 2016: Convertible Bonds Our most likely scenario for 2016 is for higher volatility to persist. Sudden market setbacks could be triggered by either a negative shift in sentiment, a shock in fundamental data or swings in market liquidity, especially at the lower end of the credit curve. Does that bode ill for risk assets in general? No, we do not believe it does. We believe that ‘recovery rallies’ that often follow a break in a bull market mean that these periods of weakness could offer attractive entry points. “In an age of unconventional monetary policy interest rates are likely to remain unnaturally low on a global scale.” Dr. Martin Kuehle, Investment Director, Convertible Bonds Dr. Martin Kuehle started his career as a trainee with Westdeutsche Landesbank in Germany in 1990 and went on to study economics and management at the Universities of Münster in Germany and St. Andrews in Scotland. He graduated from St. Andrews with a Master Degree in Economics (MLitt) and a PhD in Management and Economics. In 2000, he joined Credit Suisse Asset Management in London as a Risk Manager. He went on to head the priority client team of Deutsche Bank’s German and Austrian institutional brokerage and clients from 2003 to 2006. From 2007 to 2013, he was a Senior Partner at Fisch Asset Management with sales and product responsibility among others for two Schroders funds. In November 2013, Martin joined Schroders as an Investment Director for convertible bonds. Martin is a Member of the Chartered Institute for Securities and Investments in London and serves on CISI’s national Advisory Committee in Switzerland. In an age of unconventional monetary policy interest rates are likely to remain unnaturally low on a global scale. This will hold true in spite of slow and very carefully orchestrated moves in the US interest rate. Elsewhere, interest rates should stay low and may even fall further. With low but positive economic growth we believe that there are good reasons to stay invested in risk assets. The question for us is not whether to hold equity exposure at all, but how much equity exposure investors should keep in their portfolios. “We believe convertible bonds should continue to reduce equity risk for investors in 2016.” Over the last few years, I have been repeatedly asked if the time for convertibles was over, but we believe investors should stick to this asset class. Over the longer term, convertible bonds should continue to provide investors with a compelling combination of smart equity exposure while retaining bond-like downside protection. The views and opinions contained herein are those of Martin Kuehle, Investment Director Convertible Bonds, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 21 08 Outlook 2016: Emerging Markets Debt Absolute Return Abdallah Guezour, Head of Emerging Markets Debt Absolute Return After yet another challenging year for emerging market debt characterised by a collapse in currencies and a spike in a number of local bond yields, attractive investment opportunities are starting to appear. The recent bear market has led to an improvement in valuations and to some positive policy inflexions, with Argentina becoming the latest country to embrace change. – Pockets of value should currently be seized with caution, flexibility and a focus on liquid assets. – The recent collapse in EM currencies has probably gone too far. – Expected returns in EM external debt are likely to disappoint. “The recent bear market has led to an improvement in valuations and to some positive policy inflexions, with Argentina becoming the latest country to embrace change.” However, the pockets of value in emerging markets (EM) should currently be seized with caution, flexibility and a particular focus on liquid assets. While local currency bonds in countries such as Indonesia, India, Russia, South Africa, Argentina and Brazil could perform reasonably well in 2016, other sectors of the market should be avoided. This is particularly the case in EM hard currency debt (i.e. US dollar-denominated sovereign and corporates) which remains the next shoe to drop for the EM re-pricing cycle to be complete. Outlook clouded by Fed actions and China’s economic woes The US Federal Reserve (Fed) finally initiated its monetary tightening cycle in December. This recent decision to hike rates was widely anticipated and is long overdue. The key concern now is that this slow process of monetary normalisation may have started too late and in an already unfavourable environment of depressed global credit conditions, persistent deflationary pressures and decelerating global growth. While the Fed has started to tighten, other key central banks (European Central Bank, Bank of Japan and People’s Bank of China) are continuing to pursue activist monetary policies but with very limited impact so far on global economic activity. Judging by the continued elevated level of capital flight from China, we are particularly concerned that the recent measures implemented by Chinese authorities appear to be failing to restore confidence in the country’s economic outlook. Therefore, China’s deflating credit system remains the most serious structural threat to global financial stability. The chart below highlights China’s contribution to global money supply. This shows the extent to which China’s credit cycle remains dangerously overextended. China’s Credit cycle remains dangerously overextended 35% China 30% 25% 20% 15% US Eurozone 10% Japan 5% 0% 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 Key Contributors to Global Money Supply M2. Source: Thomson DataStream, Schroders, Bloomberg – October 2015. 22 Outlook 2016: Emerging Markets Debt Absolute Return We returned from our recent research trip to China with the view that some encouraging policy initiatives were starting to be taken in order to reduce inventories and excess capacity in some sectors of the economy. However, these initiatives are still at the early stages and remain underwhelming, especially given the extent of the credit problems which continue to accumulate. Total credit outstanding remains unsustainably high and is on the verge of exceeding 300% of GDP. Following the market panic of August 2015, various monetary measures, financial repression, moral suasion and the tightening of capital controls led to some stabilisation in China’s financial markets. This period of relief appears to be ending given the current renewed pressures on the renminbi and on the stock market. The charts below highlight how China exhausted in succession key sources of financial liquidity during the course of the last few years and the current difficulties faced in restarting these engines of credit creation. China: Source of liquidity 1 2000–08: Reserves Accumulation FX Reserves – Annual Growth (%) 60 30 25 20 20 0 15 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 10 -20 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 China: Source of liquidity 3 2011–14: Foreign Borrowing Commercial Banks Foreign Liabilities – Annual Growth(%) 7,000 120.00 6,000 80.00 5,000 40.00 0.00 China: Source of liquidity 4 2014–15: Stock Market Shanghai Stock Exchange – Index Level 4,000 3,000 2,000 -40.00 1,000 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Abdallah joined Schroders in 2000 and is lead fund manager for Schroder ISF Emerging Markets Debt Absolute Return. He created the fund’s quantitative models and is responsible for Asian country analysis and global quantitative analysis. Abdallah’s investment career commenced in 1995 when he joined Fortis Investment Management. 40 35 40 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Abdallah Guezour – Head of Emerging Markets Debt Absolute Return China: Source of liquidity 2 2008–11: Domestic Credit Boom Bank Credit – Annual Growth (%) Sources: Thomson, DataStream, Bloomberg, Schroders. The deflationary pressures emanating from China, as highlighted by the charts above, have become widely publicised and a number of EM local debt markets have already cheapened accordingly. Key EM countries have also now adjusted, to some extent, to the new reality of collapsing demand from China. While EM local debt has become cheap... Currencies served as a shock absorber during the bear market of the last three years. These devaluations allowed most EM countries to improve competitiveness and to restore balance of payments sustainability. This can be seen in the improvements in EM trade balances (albeit mostly as a result so far of contracting imports) and in the lower reliance on short-term foreign capital. Therefore, the recent collapse in EM currencies has probably gone too far. We believe that major EM countries have witnessed in succession what appears to be the final “overshooting” phase of their currency devaluation cycle. This was the case of India in 2013, Russia in 2014, Brazil, Turkey and South Africa at different points in time during 2015. We cannot yet say with strong conviction that this apparent domino effect is complete, especially given the risk of further dislocations which could result from the potential failure of Chinese authorities 23 Outlook 2016: Emerging Markets Debt Absolute Return “We believe that major EM countries have witnessed in succession what appears to be the final “overshooting” phase of their currency devaluation cycle.” to contain the persistent pressures on the renminbi. However, the compelling valuations of selected currencies and the high yields on offer in a number of local bonds could lead these markets to generate US dollar returns in excess of 10% in the next 12 to 18 months. …External debt remains the next shoe to drop In contrast, expected returns in EM external debt are likely to disappoint. The challenging growth backdrop highlighted above and the deteriorating credit quality has yet to be fully reflected in the level of EM sovereign and corporate spreads, which remain far too tight (see chart below). A low exposure to EM external debt remains warranted, especially given the illiquid nature of this sector and the potential acceleration in outflows. EM sovereign and corporate credits: the next shoe to drop? External Debt Spread (EMBI+ Index) vs. EM Currencies (JPM EM Currency Spot Index) 120 EMBI+ Spread in bps 200 100 400 80 600 The 5 year range for spreads is being tested 800 1000 60 50 07 08 09 10 11 JPM EM Currency Spot Index – RHS 12 13 14 15 JPM EM Currency Spot Index 0 16 EMBI+ Spread Inverted Scale – LHS Source: Schroders, Bloomberg – January 2016. Selected opportunities for 2016 Asia: India and Indonesia still offer the most attractive investment opportunities India and Indonesia have not yet fully seen the rewards from their better policy frameworks, ameliorated external accounts and lower inflation. We retain small exposures to Indian and Indonesian local bonds (unhedged) and stand ready to increase these positions when they show more resilience to external shocks. Valuations in most other Asian fixed income and currency markets remain unappealing and do not compensate investors against the downside risks emanating from China’s economic woes. The main exception is the Malaysian ringgit, which has already experienced a substantial devaluation. Emerging Europe Middle East and Africa (EEMEA): Russia and South Africa are our top 2016 picks The recent Russian ruble weakness is challenging the outlook for additional monetary easing. Given the large gains already achieved by Russian local government bonds in 2015, it is now warranted to take some profits with the view to reinstate this position at higher yield levels in Q1 2016. Russia is experiencing a protracted economic downturn as a result of the collapse in oil prices. Authorities have shown a strong commitment to maintaining a tight fiscal policy and the central bank is likely to regain its ability to cut rates during the course of 2016. In South Africa, the recent shocking mismanagement of the appointment of a new Finance Minister by President Zuma has been severely punished by the markets with a spike in bond yields and a currency collapse. These moves appear to be overdone, especially given the recent attempts of the leadership to regain some credibility. We are looking for opportunities to re-establish exposure to South African local rates (which recently paid 10.5% on 10-year bonds). 24 Outlook 2016: Emerging Markets Debt Absolute Return Latin America: Mexico and Chile remain strong; elsewhere, crisis is starting to bring change Given the continued strong macroeconomic fundamentals of Mexico and Chile, the recent depreciation of their currencies appears overdone. This weakness should be used to accumulate positions in exchange rates of Mexico and Chile. Recent elections in Argentina and Venezuela highlight that the region is moving away from left-wing populism. While Venezuela is still at the early stages of accomplishing this transition, change has already occurred in Argentina following the recent election of President Macri who is in the process of introducing market friendly reforms. This opening up and the recently announced devaluation of the Peso should provide attractive multiyear investment opportunities in Argentina’s local bond market. Brazilian local bonds and currency have started to show some resilience in the face of escalating negative news headlines. This shows that the attractive valuations on offer (10-year government bond yield at 16.4%) are now providing an important cushion. We maintain a small core exposure to Brazilian local bonds and we stand ready to increase the position to significantly higher levels in 2016. We expect inflationary pressures to show signs of abating during the year. Political uncertainties, which remain another key concern for investors in Brazil, have already been discounted to a large degree. The views and opinions contained herein are those of Abdallah Guezour, Head of Emerging Markets Debt Absolute Return, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 25 09 Outlook 2016: Emerging Markets Debt Relative James Barrineau, Co-Head of Emerging Markets Debt Relative In 2015, the challenges for emerging market debt were mostly internally generated, coupled with the headwinds from a strong dollar and volatility surrounding the divergences in developed country monetary policy. Moving into 2016, we see the internal issues for the asset class as slowly healing. Given the universally negative sentiment surrounding the asset class, an improvement in factors externally would bring a much better environment. – As a consequence of the challenges surrounding the asset class, emerging market dollar spreads to US Treasuries are attractive relative to their five-year history. – Even if the Federal Reserve pulls the trigger on a rate hike as expected in December, it is hard to argue that this has not already been well priced into markets. – Unless the Fed embarks on a surprisingly aggressive course, modest positive returns are achievable next year simply if spreads return to historical means. “For local currency bonds, the dollar will tell the tale.” It’s (largely) about growth Growth issues took precedence in 2015, especially for the major countries of Brazil, Russia, and China. For Brazil, no end to a deep recession is currently in sight, but a much weaker currency will eventually improve external accounts and competitiveness for a long, slow return to expansion. In Russia, a favourable policy mix has mostly successfully managed the economy through the steep drop in oil prices, and there are encouraging signs that growth has seen the worst. China has been most impactful, and growth challenges will remain, but the transition to a consumer-led model is underway within the constraints of slower global growth, and we expect stable growth with low odds for a hard landing. Outside these countries, investors have mostly ignored the fact that emerging market growth, while moderating, has been consistently better than the developed world. Latin America, outside of Venezuela and Brazil, is growing between 2.5 and 3%, while European emerging markets outside Russia are showing similar numbers. Asia ex-China and India is showing over 3% growth and India remains the star at around 7% growth. Investors spent 2015 anticipating that the slowdown in emerging market growth would precipitate a crisis in the asset class. However, fiscal policy remained prudent across countries, monetary policy was not excessively loosened to stimulate growth, and while foreign exchange reserves declined, they were not spent in a futile attempt at stemming currency depreciation. That policy mix provides the necessary, if not sufficient, conditions for a modest recovery in overall growth in the coming year. The macro environment will matter greatly Negative sentiment surrounding emerging markets was also largely fuelled by global factors. The steep slide in commodity prices became correlated with negative emerging market prospects in the eyes of many investors. Even if prices only stabilise rather than recover, we expect that would feed into more stability across assets, especially currencies. Significantly lower investments for exploration should improve the odds of this scenario playing out. 26 Outlook 2016: Emerging Markets Debt Relative But the major driver for emerging markets has been the strong dollar. Since the “taper tantrum” of May 2013, emerging market currencies have lost about 40% of their value on average. This was accompanied by liquidity into the asset class drying up, credit default swaps widening significantly, and currency volatility picking up. Even if the Federal Reserve (Fed) pulls the trigger on a rate hike as expected in December, it is hard to argue that this has not already been well priced into markets. If the rate hiking cycle proves modest and the strong dollar simply treads water, currencies should stabilise or appreciate. That would create a small virtuous cycle, where policymakers can eventually respond to the resulting lower inflation pass-through with modestly lower rates, reserve levels would likely cease falling, and growth prospects would improve. James Barrineau, Co-Head of Emerging Markets Debt Relative James Barrineau joined Schroders in April 2012 as Co-Head of Emerging Market Debt Relative. Prior to joining Schroders, he worked as a Senior Portfolio Manager-Sovereign from 2010 to 2012 at ICE Canyon, an alternative investment firm specialising in emerging market debt. James worked as an emerging market debt and currency strategist for Alliance Bernstein from 1998 to 2010, with primary responsibility for Latin America. From 1996 to 1998, James was the Latin American equity strategist at Salomon Smith Barney, and from 1994 to 1996 he was the emerging market debt strategist at the same firm. From 1988 to 1994, he was a senior economist for the US government. Asset prices reflect subdued prospects for recovery As a consequence of the challenges surrounding the asset class, emerging market dollar spreads to US Treasuries are attractive relative to their five-year history; now about 80–90% cheaper than historically, depending upon credit rating. Those higher spreads have allowed dollar, sovereign and corporate debt to produce about a 3% positive return this year despite ongoing fears about the asset class. Unless the Fed embarks on a surprisingly aggressive course, modest positive returns are achievable next year simply if spreads return to historical means. For local currency bonds, the dollar will tell the tale. However, aggregate yields are near their five-year highs and investors are well compensated now for currency risks. Real exchange rates are fair-to-cheap, so any positive surprise to the global outlook would potentially make emerging market local currency investing one of the top performers across global fixed income, in our view. “If the rate hiking cycle proves modest and the strong dollar simply treads water, currencies should stabilise or appreciate.” The views and opinions contained herein are those of James Barrineau, Co-Head of Emerging Markets Debt Relative, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 27 10 Outlook 2016: Emerging Market Equities Allan Conway, Head of Emerging Market Equities Allan Conway highlights the signposts investors should look for as drivers of emerging markets equity performance in 2016. Stabilisation in the US dollar One of the key headwinds facing emerging markets (EMs) has been the prospect of monetary policy normalisation in the US and uncertainty around the timing of the first rate hike has led to elevated market volatility. Heading into 2016 what has changed is the US dollar (USD) has strengthened 12% on a trade weighted basis over the past 12 months and all major currencies have weakened in comparison. So the ramifications of a tighter global liquidity backdrop look better priced into markets than a year ago. – The degree of bearish sentiment towards emerging markets has been unrelenting and has led some to question the investment rationale. – This appears short sighted, we believe, not least given the strategic case for an investment in these markets remains compelling. – Whether investors are able to refocus on the strong fundamental case for emerging markets in 2016, however, will be a function of whether key headwinds around the US dollar and Chinese growth in particular dissipate. “After three consecutive years of underperformance compared to developed markets, valuations across metrics look attractive, especially on a relative basis.” 28 The first rate hike, when it does transpire, will not resolve all concerns since decision making by the Federal Reserve (Fed) will remain data dependent. It should, however, subject to accompanying statements, serve to clear the air. We believe it is also likely to pave the way towards modest tightening with rates peaking at a lower level than in a more ‘normal’ cycle given sub-par US growth. Historically, the impact of rate hikes in the US on EMs has been mixed and ultimately dependent on the circumstances at the time; the past two tightening cycles led to net capital inflows into EMs. Notwithstanding the above, ongoing divergent policy between the US and developed peers may well keep the USD supported and a strong dollar has tended to correlate with weak EMs performance relative to developed markets. So until investors have greater confidence that the USD has already done much of its strengthening, this headwind may have further to run. Thus while a start to tightening in the US does not prevent EMs from performing in 2016, some stabilisation in the USD is likely necessary. No major negative growth surprises Developed world economic growth remains sub-trend but should benefit in 2016 from the ongoing lagged effect of a halving in energy prices. It should also be supported by further stimulus with the European Central Bank in particular looking to keep policy loose for longer. This in turn should be positive for EMs where economic growth surprises have been showing some signs of improvement after successive years of disappointment, although earnings have so far been slow to pick up. In 2015, growth and policy concerns in China were key headwinds for EMs so any signs of improvement here should be a positive in 2016. We maintain our view that the likelihood of a hard landing in China is overstated. Clearly ‘old China’ industrial-led growth is under strain and a reluctance by the authorities to restructure some industries, given social and political pressures, has led reform progress to disappoint. However, this is Outlook 2016: Emerging Market Equities only part of the story. ‘New China’ more consumer and technology orientated sectors are benefiting from strong structural growth and the economy is clearly moving away from a reliance on investment to drive growth. Indeed, growth in consumer spending looks set to outpace that of investment in 2015 for the first time in over a decade. Whether the property market continues to pick up in 2016 also bears close monitoring given property has a more direct impact on wealth and consumption than industrial activity. Importantly, the Chinese authorities have the tools at their disposal to support the economy when necessary. Indeed, the authorities have recently implemented both monetary and fiscal stimulus with more likely to follow. While we expect growth to continue to decelerate over the longer term to a more sustainable level, the implementation of expansive policy should help stabilise growth in 2016. Allan Conway, Head of Emerging Market Equities – Head of Emerging Market Equities, based in London. Joined Schroders in October 2004. – Head of Global Emerging Markets for West LB Asset Management from 1998 and then Chief Executive Officer of WestAM (UK) Ltd from 2002. From 1997 he was Head of Global Emerging Markets at LGT Asset Management. Joined Hermes Investment Management in 1992 as Head of Overseas Equities. In 1983 moved to Provident Mutual Life Assurance initially as an Investment Manager and later as Head of Overseas Equities. Investment career commenced in 1980 when he joined the Occidental International Oil Company as an accountant. – Fellow of the Securities Institute (FSI). Member of the Institute of Chartered Accountants (ACA). – BA (Hons) Degree in Economics, York University. Thus while hard landing concerns in China are unlikely to disappear, we expect them to ease over 2016 which should be a positive for EMs. Single country challenges and opportunities Aside from China, reform implementation is underway in several significant EM economies which could lift GDP. In India, for example, there is a strong political mandate for change and an opportunity for a step change to a higher growth rate over the long term; India has now overtaken China as the world’s fastest growing significant economy. However, elevated expectations are susceptible to disappointment and valuations are currently rich. Meanwhile the outlook for Brazil remains challenging. The authorities are trying to undertake necessary fiscal reform, but against a backdrop of restrictive monetary policy and weak commodity markets. Should orthodox policy be maintained and balance sheets adjust, Brazilian growth should recover but in the immediate term political risk remains elevated. There are a number of geopolitical risks around the world, including Syria and the related refugee situation in Europe, but should these events escalate they are likely to have more global than EM specific ramifications. Thus country allocation remains key and should only increase in importance as steps towards monetary policy normalisation in the developed world result in lower correlations between EMs. Stockmarkets The degree of bearish sentiment towards EMs has been unrelenting with record outflows from dedicated EM equity managers and after three consecutive years of underperformance compared to developed markets, valuations across metrics look attractive, especially on a relative basis. The MSCI Emerging Markets Index is currently trading on around 11.0x forward price-to-earnings which is around a 30% discount compared to the MSCI World Index. On balance then, EMs head into 2016 facing some of the same challenges they faced at the beginning of 2015. However, importantly we are further along in the adjustment process and should headwinds dissipate, could provide a basis for recovery. So in our mind, providing tightening by the Fed is modest and the USD shows signs of stabilisation, investors can refocus on the strong fundamental case for investing in EMs. Thus no hard landing in China, an ongoing recovery in developed world growth and reform implementation should help EMs earnings to pick up and given attractive valuations, EMs are well placed to perform much better in 2016. The views and opinions contained herein are those of Allan Conway, Head of Emerging Market Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 29 11 Outlook 2016: European Equities Rory Bateman, Head of UK and European Equities At the time of writing, the MSCI Europe equity index has delivered a total return of around 10% this year and we believe investors should see further gains in 2016 given the continued earnings recovery in Europe. Scope for profit margins to improve Corporate profit margins within the eurozone particularly remain at depressed levels relative to the US. This gap has been significant since the global financial crisis and a narrowing of the disparity would support European equities. At the same time, valuations are compelling versus historical levels and most other equity markets. – Earnings recovery should support further stockmarket gains in 2016. Trailing 12 months net profit margin %1 Cyclically-adjusted price to earnings ratio2 10 55 50 45 40 35 30 25 20 15 10 5 82 8 – Careful stockpicking will be needed as correlations within markets are likely to unwind. 6 – Eurozone economic recovery to continue, driven by the improving credit cycle and domestic demand. 0 95 97 4 2 1 2 “We believe the opportunities within equities for 2016 will require careful stock selection...” 99 01 03 05 07 09 11 13 MSCI EMU S&P500 15 86 90 94 Pan Europe 98 US 02 06 10 14 Asia-Pacific ex Japan Bloomberg. As at 31 October 2015. Thomson DataStream, Schroders. As at 31 October 2015. Stock selection crucial as correlations unwind Whilst we are constructive on European equities overall it is probable that there will be significant differences in terms of thematic and sector leadership. Correlations within equities have increased markedly since the summer when the Chinese devalued the yuan and intervened in the stockmarket. A possible US rate increase and concerns about a hard landing for the Chinese economy triggered a market sell-off across asset classes which reflected a ‘risk-off’ period of uncertainty. We believe the opportunities within equities for 2016 will require careful stock selection as correlations unravel, leading to more differentiation between stocks and greater opportunity to generate alpha. Correlations increased in 2015 0.80 0.75 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 Jan 05 Highly correlated market Low correlation Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Source: Schroders, Bloomberg. Based on the Eurostoxx 50 index. As at 31 October 2015. 30 Jan 14 Jan 15 Outlook 2016: European Equities In both the fixed income and equity markets, ‘quality, safe’ assets have seen a period of strong outperformance to the extent that the defensives versus cyclicals are back to levels seen through the eurozone crisis. Corporate bond yield spreads have significantly widened versus government debt despite the global deflationary pressures. These moves indicate nervousness across markets that the global economy may be entering a more difficult period. We would agree that the global economic outlook is more uncertain but the extreme moves we have seen in ‘growth versus value’ have opened up valuation anomalies as indicated by the chart on price/book value below. Rory Bateman, Head of UK and European Equities Rory joined Schroders in April 2008 and is Head of the UK and European Equity Team. His responsibilities now include co-managing Pan European Equity portfolios, including Schroder ISF European Large Cap, and management of the other portfolio managers and European research analysts. Prior to joining Schroders, Rory spent 12 years at Goldman Sachs Asset Management where he was the portfolio manager for Continental European Equities for eight years. In addition, Rory has 12 years of experience as an analyst covering numerous sectors across the European market. “The export market is clearly suffering but overall the data suggest to us that the eurozone economy has momentum...” World Growth vs Value return1 Price to tangible book value2 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% 84 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 97 99 01 03 05 07 09 11 13 MSCI Value vs MSCI Growth Average -1 Standard Deviation -2 Standard Deviation +1 Standard Deviation +2 Standard Deviation 88 92 96 00 04 08 12 MSCI World Value vs. MSCI World Growth 1 2 Thomson DataStream. As at 31 October 2015. Schroders, Bloomberg. As at 31 October 2015. Eurozone recovery has momentum From an economic perspective we are confident that the eurozone recovery will continue through 2016 despite the emerging market turmoil witnessed during the late summer. The export market is clearly suffering but overall the data suggest to us that the eurozone economy has momentum in its recovery phase driven by domestic demand, credit expansion and consumption growth. It’s worth noting that services and construction make up 75% of German GDP and these areas of the economy are performing well. The same can be said for other large eurozone member countries. Eurozone growth showing better momentum1 Credit cycle2 4% 4% 3% 3% 2% 2% 1% 1% 0% 0% -1% -1% -2% 1 2 2010 2011 2012 GDP growth, Y/Y BNB survey* 2013 2014 2015 PMI, EZ Composite* -2% Net balances % change y/y 50 5 40 4 30 3 20 2 10 1 0 0 -10 -1 -20 -2 -30 -3 -40 -4 Q1 Q3 Q1 03 Q1 Q3 Q1 Q3 Q1 03 04 06 07 09 10 12 13 15 Eurozone Bank Lending Survey: Expected credit demand next quarter (lhs) Euro area retail sales (rhs) Thomson DataStream, Markit, Schroders Economics Group. As at 23 September 2015. Thomson DataStream. As at 30 September 2015. The eurozone can also count on the ongoing support offered by the European Central Bank’s (ECB) quantitative easing (QE) programme. Recent surveys from businesses and consumers show that QE is having a positive effect on credit growth which is crucial if economic expansion is to be maintained. Additionally, ongoing QE will help keep the euro under pressure, especially if the US Federal Reserve does decide to raise interest rates. There could be more easing on the way in the eurozone: Mario Draghi recently warned that global forces may have a negative impact on GDP growth and suggested that further measures could be announced imminently. In summary, we see a positive outlook which is likely to be enhanced if the ECB takes further policy action. The views and opinions contained herein are those of Rory Bateman, Head of UK and European Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. 31 12 Outlook 2016: Global Bonds Bob Jolly, Head of Global Macro Throughout 2015, market turbulence made for choppy waters for investors to navigate. Central bank policy forecasts grew increasingly unreliable. Global manufacturing and trade slowed as emerging market growth – particularly in China – continued to weaken. Commodity prices also struggled, and currency markets only added to the wider volatility, as the US dollar’s strength persisted and China devalued its currency. – Central banks, which remain highly influential in market movements, have grown overly concerned with the international and market ramifications of their decisions. This means that potential policy errors are growing more likely. – Lacking clarity in the course of central bank policy decisions, we expect fixed income (bond) markets to be increasingly volatile. – Overall, we expect the environment to be better suited to smaller, tactical trades than large-scale strategic positions in the coming year. “The global economy should remain resilient over 2016, but global markets may be a very different story.” 32 This has left a great deal of uncertainty for markets in 2016. We believe that underlying economic stability will endure, but that the shadow cast by central banks will remain large. Overall, we expect the environment to be better suited to smaller, tactical trades than large-scale strategic positions in the coming year. Is the Fed overcomplicating things? The US economy is fundamentally in good shape. Manufacturing is certainly feeling the pinch from lingering excess capacity and weakening external demand, but strength is persistent elsewhere. The labour market is strong, the US consumer is active and there is even some evidence of wage growth building. Our concern is that the Federal Reserve (Fed) seems increasingly preoccupied with international developments – chiefly those in emerging markets – in setting its policy terms. This muddled reaction function has left investors twitchy, and is likely to trigger significant market distortion in 2016 until greater clarity is restored. We still expect that the Fed will embark on its hiking cycle, possibly by the end of 2015, and would caution that short-dated Treasuries do not look ready for the move. We expect that as investors reassess the level of interest rate compensation offered by this portion of the market, prices are likely to cool off. Longer dated Treasuries – those in the 10-year bracket and beyond – look better supported. We expect institutional investors – particularly pension schemes – to lend sustainable demand to this part of the yield curve as these schemes look to de-risk. UK policy set to echo the US The US is not the only market susceptible to an overbearing central bank. In the UK, the growth outlook is similar. The stronger consumer sector is helping to sustain momentum even as deterioration in global trade impinges on the UK’s manufacturing sector. As in the US, short-dated gilts look more sensitive to the end of ultra-accommodative monetary policy and prices are likely to ease back as interest rate risk is reassessed. We do believe Outlook 2016: Global Bonds that the first rate rise from the Bank of England (BoE) is further away than in the US, but we also believe that the gap between rate moves is probably smaller than the market appreciates. Once the Fed moves, we anticipate that the BoE will shift its rhetoric, becoming increasingly hawkish to prepare markets for the tightening cycle ahead. This time, the ECB is taking no chances The European Central Bank (ECB) has responded to the increased downside risk to global growth by stating more clearly that it will be proactive in challenging any resurgence of deflation. The market has responded positively already. The exact policy measures that the ECB intends to use are not yet quite so clear, but we expect the deposit rate to be lowered again, and that the existing asset purchase scheme – currently running at a rate of €60 billion-a-month – will be extended either in term, pace, or both. The effect of the extended policy support would mean euro government bond valuations, already at historic highs, are likely to remain well supported. The euro is likely to weaken further against major currencies. Bob Jolly, CFA – Head of Global Macro Bob joined the Schroders fixed income team in September 2011, as Head of Global Macro. Prior to joining Schroders, Bob worked for UBS Global Asset Management, where he was Head of Currency, UK Fixed Income and Global Sovereign. Before UBS, Bob spent two years with SEI Investments, developing customised solutions for institutional pension fund clients. The majority of Bob’s investment career was spent at Gartmore Investment Management. He is a CFA charter holder. “Our concern is that the Federal Reserve seems increasingly preoccupied with international developments – particularly those in emerging markets – in setting its policy terms.” Tread carefully in corporate bond markets Corporate bond markets may offer a degree of shelter from the murky policy environment. In the US, the stream of investment grade supply has been torrential in 2015. Overseas demand has remained strong, but the extent of the supply has still pushed yield spreads outwards. We believe that pockets of value have now emerged in the energy sector, as well as more generally in financials. Euro investment grade corporate markets have also grown cheaper during the year. Although the region continues to expand, inflation and growth remain fragile, and the market has also had the Greek debt crisis and several negative issuer-specific developments to contend with. However, we have always been of the view that with market stress often comes value. On a selective basis, opportunities are available. High yield corporate bonds are even less exposed to policy changes, and as with investment grade bonds, the volatility and risk aversion of the third quarter has reset valuations to the point that certain areas look attractive. Commodity-sensitive sectors, particularly in the US, represent a range of prospects, provided the appropriate level of research has been undertaken. China’s new normal The key question then, is that if central banks are altering course (or not, as the case may be) due to China’s gloomy outlook, just how weak is the world’s second largest economy? China is clearly committed to the transition from its prevailing export and infrastructure-led growth model, to one of domestic consumption and service provision. We believe that China’s political will and policy tools are sufficient to support the economy as it traverses from one set of drivers to another. Furthermore, urbanisation and productivity enhancement are not over as growth themes, and will continue to contribute as the multi-decade transition unfolds. That said, while the process is set to continue, uncertainties remain regarding the timing and pace of the transition, as well as how China’s currency policy will develop. China’s official growth targets remain ambitious and misses on GDP figures are, as a rule, detrimental to risk appetite. Further, the risks associated with elevated debt levels, as well as a mounting deflationary threat, may spill over to the rest of the world. Finally, China’s surprise devaluation of its currency this year has resulted in concerns about the magnitude and timing of any future devaluations. Be cautious of bold trades The global economy should remain resilient over 2016, but global markets may be a very different story. Investors continue to focus intently on central bank moves, given how integral they were in shoring up the financial system in the wake of the financial crisis. As such, until central bank decisions are less clouded by external factors, we believe investors should be wary of taking large-scale directional positions. The views and opinions contained herein are those of Bob Jolly, Head of Global Macro, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 33 13 Outlook 2016: Global Corporate Bonds Rick Rezek, Co-Fund Manager, US Fixed Income We expect corporate bonds to outperform government bonds in 2016 although investors should brace themselves for periods of heightened volatility. The themes driving risk assets globally have shifted dramatically over the course of 2015 and should continue to do so next year. However, we believe that corporate bond markets should generate positive excess returns versus government bonds over the next twelve months, albeit with periods of extreme price volatility. In our view, the following key themes will have a significant impact on credit markets globally: – Growth should remain modest by historical standards for major developed economies – Developed economies are likely to see low levels of growth, but central bank divergence could result in volatility. – We believe US dollar credit markets offer attractive valuations and we see bank and finance sectors as representing lower risk than the broader market. – Amid a challenging environment, research will be crucial for uncovering attractively-valued opportunities. “We do not believe that a tightening cycle by the Federal Reserve will result in an adverse reaction by risk assets.” – Divergence in central bank policies will be a source of volatility. Importantly, we do not believe that a tightening cycle by the Federal Reserve (Fed) will result in an adverse reaction by risk assets – Emerging market economies will remain in the headlines. Despite the situation in China, we expect the trend of economic activity in many emerging economies to stabilize and even improve as we progress through the year – Corporate credit fundamentals vary by region and industry but should broadly remain stable. The credit cycle is much further advanced in the US than in Europe or the UK, but we do not see deteriorating fundamentals triggering a dramatic re-pricing of risk globally – The supply of bond issuance, which has been a major contributor to wider credit spreads during 2015, primarily in the US, should abate somewhat and become more supportive for valuations. 2015 has sown the seeds for a volatile 2016 China, and the potential contagion from its economic slowdown, has been and continues to be a major issue which must be confronted by investors. In spite of the initiation of a quantitative easing (QE) programme by the European Central Bank (ECB) late last year, the economic picture in the eurozone remains rather fragile. The persistent Greek drama, a refugee crisis not seen on the continent since the Second World War, multiple terrorist incidents and even a reassertion of more “nationalistic” tendencies all pose long-term challenges to Europe’s political union. Not to be outdone, the US has also embarked on the presidential election season which promises to add further volatility to markets. Fortunately, these events have yet to shake the confidence of businesses or consumers. However, we are vigilant of catalysts that could lead to a change in sentiment and will continue to focus on these and future developments that may impact credit markets in 2016. 34 Outlook 2016: Global Corporate Bonds US dollar markets Looking to 2016, we believe that US dollar credit markets offer attractive valuations, and the economic picture continues to be among the best of the developed economies. We see the bank and finance sectors as representing lower risk than the broader market. In the energy sector, we also believe a number of companies in the investment grade universe – those with attractive assets and fairly good balance sheets – are currently valued as high yield credits. We spent much of 2015 very cautious of emerging market debt, both sovereign and corporate, but this caution has receded in recent weeks. We see higher quality sovereign credits as offering a more attractive risk-reward profile than emerging market corporate bonds. Rick Rezek, Co-Fund Manager, US Fixed Income Rick joined Schroders in 2013 when we acquired a stake in STW Fixed Income Management, where he was a Portfolio Manager, joining them in 2002. Rick has previously held fund management positions at several firms including Loomis Sayles and Wells Fargo Bank IM. He has an MBA from DePaul University and a BS from St. John’s University. “We anticipate that the coming year will be another opportunity for us to capitalize on market dislocations.” Finally, US high yield bonds have become more compelling during the last three months of 2015. While we have generally avoided the energy and basic materials sectors – which we perceive to have significant default risks in the coming year – we look more favourably upon higher quality issuers. Euro bond markets The euro denominated corporate bond market looks to be among the more challenging of the major markets to decipher as we enter 2016. While the ECB’s QE programme is arguably supportive of risk assets in the eurozone, much of this appears to be fully reflected in valuations. Frankly, it is very difficult to be overly enthusiastic about a broad market that yields well below 1.5%. Sterling markets Similar to the US, the underlying economic fundamentals in the UK are reasonably sound, and valuations are more attractive than those in the euro denominated markets. Sterling corporate bond markets often pose challenges in terms of liquidity, but on balance we believe that some exposure could be warranted. Research remains essential 2016 should prove to be an interesting year for global credit markets as we continue to digest the events of the past year and their impact on the overall fixed income landscape. As we enter the year, the Fed has embarked on its first rate hiking cycle in over a decade. China will try to find its footing, while oil attempts to rebound after reaching a low not seen since the financial crisis. There will certainly be many significant decisions to be made and we anticipate that the coming year will be another opportunity for us to capitalize on market dislocations. While price volatility will undoubtedly be with us for the foreseeable future, we are confident that opportunities exist and that, with research, investors can uncover specific industries and issuers that offer attractive value amid this challenging credit environment. The views and opinions contained herein are those of Rick Rezek, Co-Fund Manager, US Fixed Income, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 35 14 Outlook 2016: Global Equities Alex Tedder, Head of Global Equities Alex Tedder discusses how an uncertain macroeconomic backdrop means that a focus on company-specific drivers that can deliver earnings surprise, is the best way to navigate 2016. In aggregate the backdrop for equities is challenging and the macroeconomic environment is highly uncertain. Low interest rates reflect massive quantitative easing by central banks around the world, artificially boosting many asset prices and creating a potentially dangerous situation when rates start to rise. Significant currency distortion, weak commodity prices, slowing growth in China and mixed economic data in Europe and the US have added to the uncertainty. For equities, this has meant low absolute returns and increased volatility. – The global macroeconomic environment is highly uncertain heading into 2016. Our approach remains the same: a focus on bottom-up drivers of return in our search for unanticipated earnings growth. – Technology is evolving at an unprecedented rate and disrupting an array of industries, providing a wide range of investment opportunities, as well as serious challenges in legacy industries. – We generally prefer service companies over those in the manufacturing sector, given more resilient pricing power and stronger growth. – Those firms that are able to reduce costs and strengthen balance sheets, particularly in highly competitive industries faced with overcapacity, will be rewarded in 2016. 36 It is therefore particularly relevant to take a selective approach to investing, focusing on those companies that can deliver unanticipated earnings growth despite the uncertain environment. We see a number of different dynamics at play that have the potential to surprise the market in 2016. Disruptive technology driving rapid change Technology is evolving at an unprecedented rate and new business models leveraging increased connectivity, particularly in the mobile space, are threatening to reshape industry dynamics in a number of different areas. Firms such as Amazon, Google, Facebook, Alibaba and Tencent are already household names in their respective end markets. The revenue and market capitalisation of these companies already rank amongst the largest in the world. However, the number of industries facing disruption is increasing rapidly and now extends well beyond the immediate e-commerce, social media and handset space. Disruptive technology is shaking up traditional industries such as autos (Tesla, Uber), apparel and food retail (Yoox, Zalando, Just Eat, GrubHub), hospitality (Priceline, Expedia, TripAdvisor, Airbnb) and recruitment (LinkedIn). Other industries that are about to experience significant disruption include healthcare and banking. We are focused on finding opportunities where the market has either overlooked or underestimated companies’ potential to disrupt. Service firms preferred for their pricing power The global economy is likely to be characterised by ongoing deflationary pressure in 2016. A lack of pricing power is already evident in the traded goods sector where competitive pressures and overcapacity make for a challenging pricing environment. By contrast, the services sector has been able to maintain pricing power, given a lack of tradability in many areas. The divergence between manufacturing deflation and services inflation naturally informs a bias towards service companies in our portfolios heading into 2016. Outlook 2016: Global Equities We still find some attractive opportunities among those manufacturing firms with a substantial component of high margin recurring revenue, such as maintenance providers and parts suppliers. These types of companies should prove more resilient to any decline in capital investment spending, particularly in industries that benefited from the capital spending boom in China over the last 10 years. Saving profits with “self-help” We are seeing evidence that companies in challenged sectors, such as industrials, energy and mining, are taking steps to support earnings and we expect this to be a key feature of 2016. There is an increasing focus on “self-help”, as companies seek to restructure by reducing costs and strengthening balance sheets in order to weather the uncertain demand and pricing environment. For example, firms like diversified miner BHP Billiton and oil and gas major Royal Dutch Shell have committed to substantial cost reductions and lower capital spending in the face of sharp declines in commodity prices and revenues. Alex Tedder, Head of Global Equities Alex re-joined Schroders in July 2014 as Head of Global Equities, having commenced his investment career at Schroders in 1990 with responsibility for promoting European Equity mandates alongside Schroders’ Private Equity operation. In 1994 he moved to Deutsche Asset Management Ltd, where he worked in various capacities including Managing Director and Head of International Equities/Portfolio Manager. He was lead manager of the Deutsche International Select Equity Fund (MGINX) from inception in May 1995. He also previously served as co-manager of DWS International Fund, DWS Worldwide 2004 Fund, Deutsche Global Select Equity Fund and Dean Witter European Growth Fund. Alex re-joins Schroders from American Century Investments in New York, where he worked from 2006 as Senior Vice President and Senior Portfolio Manager (Global and Non-US Large Cap Strategies). He was lead manager of the American Century International Growth Fund (TWIEX) from July 2006 to March 2014. In the industrials sector, earnings have been hurt by the combination of softer economic growth and excess inventories. However, inventories are now at levels such that even a modest upturn in end demand should translate into better profitability. Firms that have been able to reduce costs should show significant operating leverage even with a moderate uptick in revenue. Companies behind the curve in terms of expense management are likely to be de-rated. A focus on innovation Regardless of industry, however, we continue to focus on innovation as a driver of returns in 2016. Our emphasis is on companies that are committed to finding new, interesting and sustainable ways in which to grow their businesses, but whose efforts have not yet been fully recognised by the market. For example, in the healthcare sector, firms continue to gain insight into disease processes and are continuing to develop a variety of new treatments to improve mortality. Despite a more challenging regulatory backdrop, we expect the sector to continue to experience strong pricing power for therapeutical innovations. Another example is the food and beverage sector where firms have to differentiate their products and services to command pricing power in a highly competitive industry. Starbucks is a case in point where management is intent on finding innovative ways to improve the customer experience (such as the introduction of mobile payments) to sustain customer traffic and support average spend. Looking for earnings surprise As we have highlighted, the economic backdrop remains highly uncertain and we cannot predict with any accuracy what will happen in the global economy, markets, commodities or currencies in 2016. The best approach in our view, is therefore to focus on developments at the company level, to identify individual companies that can deliver earnings surprise and outperform in an uncertain and challenging environment. The views and opinions contained herein are those of Alex Tedder, Head of Global Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 37 15 Outlook 2016: Global High Yield Wes Sparks, Lead Fund Manager, Global High Yield Continuing volatility and an elevated risk premium mean that high yield bond returns could be in the mid single-digit range in 2016, but we expect this performance to be attractive relative to many other fixed income alternatives. 2016 will likely be another year when returns in the high yield bond sector are ‘coupon light’ (i.e. total returns are lower than the coupons on offer). Under our base case scenario, we expect a total return in the range of 4–5% for the global high yield index in 20161. Returns should be better for active managers and investors, who are able to take advantage of what we see as the likely continuing divergence of returns across issuers and industries. – We believe active investors will be better equipped to navigate what looks like a volatile year ahead for high yield bonds. – Defaults may rise, but should be clustered around a handful of industries. The market is also already pricing in a higher probability of default for a larger portion of the index. – Sentiment surrounding the energy sector and emerging markets is almost universally negative just now. Investor decisions on when to add exposure to these areas could be crucial in 2016. “Perhaps the most important strategic calls in 2016 will surround the decisions about when to add exposure in energy and emerging markets.” Positive technical factors – such as modest supply, an uptick in demand, light dealer inventories, high cash balances at mutual funds, and more conservative positioning among high yield investors after the market correction in the second half of 2015 – could lead to a market bounce in the first half of 2016. Several possible positive catalysts could emerge which would trigger a shift in sentiment and spark renewed investing interest by pension funds, insurance companies, and mutual fund investors. The brunt of any rise in the default rate is likely to be weighted towards the end of 2016, which provides a time horizon for the high yield bond market to bounce back from what we considered to be somewhat oversold levels as 2015 came to a close. Over the past two to three months, high yield strategists and investors have increased their expectations for defaults for 2016. It is difficult to assess with absolute precision what the implied default rate is based on current market valuations – whether using yields or spreads for high yield bonds – because there have been changes in two variables at the same time. Expectations for defaults in 2016, and the risk premium demanded by investors have both risen in recent months. Indeed, a good portion of the recent widening of spreads in the high yield bond market represents this wider risk premium. This partially reflects the investor belief that they need a higher ‘illiquidity risk premium’ in order to be enticed to invest, since press coverage on the topic of poor and diminishing liquidity in corporate bond markets has been so high. Referencing the Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capped Bond Index 1 38 Outlook 2016: Global High Yield Default rates to rise but not as much as currently feared Defaults should rise in 2016, but only moderately from the currently low level of defaults. Defaults should be clustered in a handful of industries – primarily in metals & mining and energy, as well as in retail and media – where the market is already pricing in a high probability of default for a number of issuers. The distressed debt ratio has risen after the late 2015 selloff; so the market is already pricing in a high probability of default for a larger portion of the index. We believe that the global high yield market now looks relatively cheap after the spread widening during the second half of 2015. High yield valuations appear to be relatively cheap in several ways: Wesley Sparks, Head of US Credit Strategies & Lead Manager, Schroder ISF Global High Yield Wesley Sparks has been with Schroders for 15 years. Wesley began his career in 1988 at Goldman Sachs as an analyst. From 1994 he held portfolio manager positions at three asset management firms before joining Schroders in 2000. In total, he has 26 years of investment experience. Wes is a CFA charter holder and also holds a Masters in Business Administration (MBA) from the Wharton School in Pennsylvania and a BA from Northwestern University. – Relative to the high yield market’s own valuations during historically analogous periods (at similar points in the credit cycle in past cycles, etc.) – Relative to other asset classes: Versus investment grade credit, for investors who have the risk tolerance to bear greater potential volatility; versus emerging markets; versus government bonds; and versus cash & cash equivalents – Relative to predicted valuations from fundamentally-based forecasting models – Relative to our sense of the severity of potential further downside risk, and relative to the probability of positive catalysts emerging which could improve valuations over the course of the coming year. Watch for key signposts as market conditions change during 2016 Rather than fixate on a total return forecast for the entire year, we believe that investors should instead focus on various signposts along the way to indicate whether the riskreward profile of the high yield asset class is attractive or not. As was highlighted clearly in 2015, the market can rally for several months at a pace that is unsustainable for the full year. The market can also become oversold. We believe that key market trends to monitor include the following: – The pace of M&A activity: We expect that acquisition activity will remain elevated and that many high yield companies will continue to benefit from larger, higher-rated issuers pursuing strategic mergers as they seek growth opportunities – The trajectory of oil and natural gas prices: We expect a recovery in oil prices to be delayed until the second half of 2016, given recent shale production and oil supply data “Investors currently expect fewer rate hikes in 2016 than the Fed itself is projecting.” – The pace of fallen angels: We expect the pace of investment grade companies being downgraded to high yield to rise, particularly in troubled sectors, versus rising stars. We also expect the pace of distressed debt exchanges and defaults to increase – The pace and mix of supply: We expect gross new issuance will likely be slightly lower in 2016 than in 2015 and may be split between refinancing activity and M&A financing, with very little for financing highly levered buyouts – Demand reversals: Extremes in mutual fund flows can often be contrarian signals as widespread mutual fund redemptions are often concurrent with market corrections – The pace of Federal Reserve (Fed) rate hikes: Investors currently expect fewer rate hikes in 2016 than the Fed itself is projecting – Changes in the strength of regional economic growth across the Americas, Asia and Europe. 39 Outlook 2016: Global High Yield Many of the themes that we expect to dominate in 2016 are similar to those in 2015, but perhaps the most important strategic calls in 2016 will surround the decisions about when to add exposure in energy and emerging markets, as sentiment about both market segments is nearly universally negative as the year begins yet valuations backed up materially in late 2015. High yield bonds could provide positive returns even as the Fed hikes rates The Fed raised the Fed funds rate by 25 bps in December, representing the first rate hike in more than nine years by the US central bank. Many investors hold the view that fixed income returns will inherently be negative during a period when the Fed is raising shortterm rates, but an analysis of the three most recent Fed rate hiking cycles shows that this is not the case. In fact, an analysis of the past three rate hike cycles shows that high yield bonds can produce positive returns over a six month or 12-month horizon after the Fed first raises the Fed funds rate. High yield can also outperform other fixed income asset classes, such as Treasuries and investment grade corporate bonds. This was especially the case during the 2004–2006 rate hike cycle but was also generally the case in the 1994–95 and 1999–2000 rate hike cycles. We believe that prospective returns in corporate bonds markets in 2016 could be much better than recent performance, and better than the bearish consensus view that seems to have developed over the past couple of months. While many uncertainties remain as 2016 begins, the risk premium embedded in high yield valuations is high. There are several signposts that we will be monitoring in the market to potentially become more constructive as the year progresses. Fundamental research and active risk management in the face of changing market conditions will continue to be key to outperformance. The views and opinions contained herein are those of Wesley Sparks, Lead Fund Manager, Global High Yield, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 40 16 Outlook 2016: Global Real Estate Securities Hugo Machin, Co-Head of Global Real Estate Securities Market commentators often refer to the ‘wall of worry’, and from the media alone it would be easy to believe that Armageddon is around the corner. Indeed, the world appears to be in a state of perpetual crisis, but is this because it is true, or because pessimism sells newspapers? Looking to 2016, our view is of a calmer real estate horizon than many would have you believe. While we recognise that risks are out there for real estate investors, we aim to quantify those risks; using the data and the facts available to make informed decisions. If 2015 has shown us anything, it is that the world isn’t perfect. We do expect some squalls from financial markets, but we don’t see evidence of a storm on the horizon. – Although there may be periods of turbulence in 2016, we believe some market commentators are overly pessimistic. – Low interest rates, regulatory changes and dwindling supply are all supportive of the asset class. – Investors should focus on assets with pricing power, which should be better suited to a tighter global policy environment. “If your assets lack pricing power, the tighter policy environment could pose a serious challenge.” Fair wind There are a number of reasons why we don’t think we are heading into a stormy 2016. The first is that interest rates remain very low. This means that finance costs and borrowing ratios should remain stable for companies with solid balance sheets. Secondly, banks simply won’t lend to speculative real estate development any more. Recent changes in the regulatory backdrop mean that the ‘cost’ of regulatory capital is exorbitant. The days of property developers risking other people’s money for self-enrichment are gone. The knock-on effect is that less development means less new space. Less new space means more stable, or even growing, rents. Demand for space – especially in higher barrier markets – is sufficient for the right companies to build considerable ‘pricing power’. Our view has long been that real estate is a commodity much like any other. If it is desirable, people will pay. We aim to invest in companies that own assets where people want to work, live, eat and shop as this is integral to defending your capital in turbulent markets. Grey clouds Not all real estate is created equally. The assets that most concern us are ones that lack this pricing power. These are assets that we describe as ‘commoditised’. Essentially, if there are plenty of them to go round, why should an occupier pay more for a building when a cheaper rent can be found next door? You need to give occupiers a reason to pay rents. The elephant in the room for investors in all asset types seems to be the prospect of higher interest rates. Real estate is no different. The edging up of interest rates traditionally signals that inflation and growth are back in the financial system. If your real estate assets have pricing power, higher rents can offset higher borrowing costs. If however, your assets lack pricing power, the tighter policy environment could pose a serious challenge. 41 Outlook 2016: Global Real Estate Securities In our view, exposure to commoditised real estate in inappropriate structures – where the fund is traded daily but the underlying assets are not – could provide the single biggest headache to real estate investors in the medium-term. If rates go up or the economy falters, then commoditised assets do not generate the rent growth to drive them through the storm. Choose carefully We cannot say with any certainty what the next year will bring. However, we are reasonably optimistic about how the real estate companies we invest in will fare. Pricing power and a lack of new supply should bode well for positive returns. Where we are concerned is the impact of rates and shifting market dynamics on ‘bog standard’ real estate assets. Hugo Machin, Co-Head of Global Real Estate Securities Hugo joined Schroders in July 2014 as fund manager for Global Real Estate Securities, with over 15 years of real estate experience. Prior to joining Schroders, Hugo was Head of European Listed Real Estate at AMP Capital where he was responsible for setting up the London office for the AMP Global Property Securities Fund. Hugo has also worked at ING Investment Management in Sydney and Welcome Trust. Hugo is a Member of the EPRA Report and Accounts Committee. He holds a BA (Hons) in English Literature from Durham University, a MSc in Real Estate Finance and Investment from Reading University and a Diploma in Cross Border Valuation from Oxford Said Business School. “We do expect some squalls from financial markets, but we don’t see evidence of a storm on the horizon.” The views and opinions contained herein are those of Hugo Machin, Co-Head of Global Real Estate Securities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 42 17 Outlook 2016: Greater China Equities Louisa Lo, Head of Greater China Equities Against a backdrop of sluggish economic growth and anaemic earnings, the importance of bottom-up stock selection becomes even more imperative for 2016. Although Chinese GDP growth broadly held steady at the 6.5–7% level in 2015, the real economy paints a much weaker picture as various indicators have pointed to increasing sluggishness. Despite this, China’s A-share market, fuelled by record margin lending and expectations of continued support by the Chinese government, saw an extraordinary run-up that began in Q4 2014 and culminated in a spectacular collapse in share prices halfway through 2015 as the unwinding of these margin trades sparked a heavy sell-off. – A ‘two-speed economy’ in China has emerged in a number of areas, including the contrasting fortunes of the private sector and state-owned enterprises (SOEs). – The continued liberalisation of China’s financial markets should open up further opportunities in the investable China stock universe. – Amidst sluggish economic growth and anaemic earnings, the importance of bottom-up stock selection becomes even more imperative. Back in May, we wrote about our concerns over unsustainable valuations in Chinese A-share markets and discussed our thoughts on navigating volatile markets amidst a slowing economy. We have always maintained the view that there continue to be longterm, bottom-up opportunities in China, as reflected in our investment strategy. China’s two-speed economy Although recent data for China have been soft, the services sector of the economy is generally in far better health but the pick-up is not sufficient to offset the slowdown in the manufacturing sector. Consumer demand has been hit hard by the anti-corruption campaign, across luxury and even consumer staple products, and for both local and multinational players. The pace of fixed-asset investments, which previously functioned as a counter-cyclical tool, has also shown signs of deceleration on the back of slower property starts and a lack of incentives for local governments to do fiscal stimulus. Figure 1: China Industrial Output, Investment and Retail Sales – % YoY 35 30 25 20 15 10 5 0 May 05 May 06 May 07 Retail Sales May 08 May 09 May 10 May 11 Industrial Output May 12 May 13 May 14 May 15 Fixed Asset Investment Source: MSCI, IBES, Rimes, Morgan Stanley Research, October 2015. Perhaps one of the most relevant divergences, at least for investors, has been the differing fortunes of the private sector and state-owned enterprises (SOEs). The former have seen 43 Outlook 2016: Greater China Equities growing sales and net profits, with a notable example being some of the large players in the internet sector, while SOEs such as banks, industrial companies and oil companies have seen declining profits on the back of weak economies and commodity prices. The private sector/SOE divide is set against the broader divergence between the manufacturing and services sector in China (i.e. the secondary and tertiary industries respectively, illustrated in figure 2). Continued weakness in manufacturing data for China has persisted but the consumer services sector maintains a healthy rate of growth, incrementally making up a larger share of GDP growth. This is part of a long-term transition that many feel is necessary for the Chinese economy to obtain sustainable growth. Figure 2: China GDP composition – Tertiary Industry versus Secondary Industry Louisa Lo, Head of Greater China Equities Louisa Lo has 22 years’ investment experience, with 19 years at Schroders. She is currently the Deputy Head of Asia ex Japan Equities team and responsible for the overall aspects of the Greater China Equities business, based in Hong Kong. She is a specialist fund manager for Greater China mandates and lead manager of the Schroder ISF Taiwanese Equity. Prior to joining Schroders, she spent three years working as a research analyst with two securities firms, focusing on Asian electronics stocks. She is a CFA charterholder and has a Master’s degree in Applied Finance, Macquarie University. % share of total GDP, 4-quarter moving average 50 48 Secondary industry 46 44 Tertiary industry 42 40 01 03 05 07 09 11 13 15 Source: NBS, JP Morgan, November 2015. Mixed record on reforms Reform and restructuring have long been heralded as the key for the Chinese government to enhance corporate efficiency and optimise resource allocation. However, the reform initiatives have so far disappointed, especially amongst big SOEs. In contrast, some progress has been made amongst smaller SOEs given a higher level of flexibility to change and reform. Going into 2016, the government is likely to further encourage overseas mergers and acquisitions, especially in the much-needed technology sector. However, some of these deals may not enhance earnings and require close monitoring. Continued liberalisation of financial markets Where we have seen the greatest progress has been in financial market liberalisation. The renminbi’s (RMB) recent inclusion in the Special Drawing Rights (SDR) basket is a notable milestone for the RMB’s internationalisation. Furthermore, the continued liberalisation of the stockmarkets, first through the Shanghai-Hong Kong Stock Connect and to be followed by a similar upcoming scheme for Shenzhen, should open up further opportunities in the investable China stock universe. In addition, index provider MSCI’s recent inclusion of the China-based ADRs (US-listed) companies to its MSCI China and MSCI Emerging Markets indices, due to be completed by May/June next year, should have a more profound impact on the development of China’s market. This rebalancing will also better reflect the reality of China’s ‘new economy’, where education, internet, e-commerce, travel and consumer names are all playing a larger part in growth. Valuations see bad news priced in Valuations in Chinese markets, as represented by the MSCI China index, are trading at levels seen in the past few crises, including the Global Financial Crisis in 2008, with the trailing price-to-book (PB) ratio close to 1.1x. We believe a lot of the bad news has already been reflected in share prices. Market liquidity should remain supportive as the deflationary environment allows for further monetary stimulus measures such as RRR/ interest rate cuts. 44 Outlook 2016: Greater China Equities Figure 3: MSCI China valuation in terms of P/B 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Sep 05 Sep 06 Sep 07 Sep 08 Sep 09 Sep 10 MSCI China Trailing PB Average Sep 11 Sep 12 Sep 13 Sep 14 Sep 15 MSCI China ex. Banks Trailing PB Avg.+1Stdev Source: Datastream and Citi Research, September 2015. “We focus on investing in companies that have sustainable business models and strong cash flows, for example in the service sectors such as internet, tourism and education.” Potential risks for Greater China markets? The potential risks for China include policy mistakes by the Chinese government, earnings risks for corporates on the back of weak top line growth in a deflationary environment and a further increase in non-performing loans (NPLs) in the banking system. Although restructuring may continue to exert pressure on the economy in the near term, we do not foresee a major systemic collapse in the financial system. Another key risk for the China/Hong Kong market will be the US Federal Reserve’s timetable for interest rate hikes, while the unwinding of the US dollar carry trade will dampen investor risk appetite and put pressure on Asian markets. As for Taiwan, the political headwinds of a presidential election scheduled for next year, where the opposition Democratic Progressive Party (DPP) is expected to win, could cause uncertainty to the cross-strait dialogues given the party’s less engaging relationship with Beijing. Currently, the market has probably priced in a relatively pragmatic approach of the DPP towards China. Where do we see opportunities? Against the market backdrop of sluggish economic growth and anaemic earnings, the importance of bottom-up stock selection becomes even more imperative. We remain focused on investing in companies that have sustainable business models and strong cash flows. China – maintain overweight in consumption/service stocks We continue to be overweight in the consumer/service sectors including internet, tourism and education on the back of our positive long-term outlook for consumption demand in China. We have also selectively invested in companies that can benefit from supportive government policies, including railway equipment, environmental protection and renewable/alternative energy stocks. On the other hand, we continue to remain cautious of the banking sector given the rising asset quality risk and declining net interest margins. Meanwhile, we are broadly underweight oil and commodities stocks. 45 Outlook 2016: Greater China Equities Hong Kong – favour more traditional Hong Kong names The sluggish Chinese economy and the continued drop in tourists from mainland China is having a knock-on impact on Hong Kong retail sales that has been a key driver for Hong Kong economic growth in the past few years. Despite the more subdued outlook for the local economy in the near term, we continue to see good value in more domestic names including commercial property investors, diversified regional and global conglomerates, regional insurers and selective manufacturing exporters, on a longer-term view. Balance sheets are typically very conservative, franchises robust, dividends supportive and management quality is well known to investors. Taiwan – political headwinds and the technology product cycle After a major earnings upgrade in 2014 led by Apple’s iPhone 6 new product cycle, we are struggling to see another visible catalyst to drive the re-rating of the technology sector, especially after the lukewarm reception to the iPhone 6S. Looking ahead, the prospects of old economy stocks (such as materials and banks) remain lacklustre where selective technology companies and telcos still offer investors with attractive valuations and decent dividend support. China A-shares – slowly bottom fishing China’s A-share market has witnessed a major short-term correction, as expected in Q3 2015. The market is expected to range-trade in the near term as liquidity remains buoyant and margin positions have declined to a more reasonable level. Although market upside is capped by the government stock overhang, some of the better quality names have become more attractive after the recent correction whilst valuations of many small/mid cap stocks remain excessive. Within our broad Greater China strategy, we took profit in most A-shares in Q2 and will selectively buy into this market on further weakness. The views and opinions contained herein are those of Louisa Lo, Head of Greater China Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 46 18 Outlook 2016: Japanese Equities Shogo Maeda, Head of Japanese Equities The Japanese equity market has seen optimistic economic forecasts continue to be scaled down as the year has progressed, but it has still managed to post gains over 10% year-to-date in what has been a challenging environment. Although the Japanese economy has entered a technical recession after negative growth in the third quarter, the headline numbers have disguised the fact that a broad-based economic improvement is underway in Japan. – Growth has been weaker-thanexpected but overall the trend for Japanese economy remains positive. – Improving corporate earnings and governance will provide support for Japanese stock prices. – We continue to adhere strictly to our bottom-up stockpicking approach and focus on sustainable mid- to long-term earnings growth and valuation. “Japanese companies’ earnings have been growing at a solid pace and are still expected to rack up positive year-on-year growth for the current fiscal year.” There have been a number of factors that have contributed to the continued solid long-term outlook for Japanese equities. It has also been encouraging to see that the previously strong correlation between the Japanese yen’s weakness and rising stock prices has started to subside. Significant challenges for the Japanese economy remain in the short- to medium-term and the slowdown in Asian growth, in particular, has weighed on investor sentiment, reflecting the contribution to Japan’s external trade. The economy: heading in the right direction Investors have been closely watching short-term data releases in Japan but, in general, we believe Japan’s economy is heading in the right direction. Although recent inflation data have been weaker-than-expected and far below the Bank of Japan’s (BoJ) 2% target, Japan does seem to have achieved a sustainable exit from deflation. The labour market remains tight, with the unemployment rate at 3.1% – the lowest in 20 years. Growth in real wages is rising and recent talk of a hike in the minimum wage should provide a further boost to consumer confidence. In addition, we should remain cognisant of the fact that inflation data have been held down by lower oil prices and slower growth in China. The direction of the economy remains positive, despite the fact that progress is happening at a slower-than-expected pace. Looking further ahead, there is a potential obstacle to growth from the next planned increase in consumption tax from 8% to 10%, due to be implemented in April 2017. If this goes ahead as planned it will, at best, cause additional short-term disruption to economic data and, at worst, could create another period of contraction for the economy for one or two quarters afterwards. While we expect a smaller impact this time around for the economy, it will be worth monitoring closely for its potential ramifications. Some signs of policy progress A lot of controversy has surrounded Japanese Prime Minister Abe’s eponymous ‘Abenomics’ programme and whether it is having the desired effect on the economy. The much-touted ‘three arrows’ have so far failed to impress investors due to a perceived 47 Outlook 2016: Japanese Equities lack of policy reform initiatives. However, one area where Mr Abe can justifiably claim credit is in pushing through the Trans-Pacific Partnership (TPP) trade agreement that encompasses 12 Pacific Rim countries including Japan and the US. Covering about 40% of global GDP, this agreement could bring enormous benefits, although the market has yet to fully digest what these might be and we remain realistic on the timetable for ratification, especially given potential hurdles in the US. Mr Abe has also made substantial progress in cutting the corporate tax rate, which is likely to be lowered again next year to below 30% from the current rate of 32%. For the BoJ, the weaker-than-expected inflation numbers have restricted its policy options. Although Governor Kuroda remains upbeat, at least officially, it is clear the BoJ’s original target of 2% inflation is virtually unobtainable. As a result, there is mounting speculation about further easing moves by the bank and the central bank’s credibility remains in the spotlight. Shogo Maeda, Head of Japanese Equities Shogo Maeda is Head of Japanese Equities, based in Tokyo, and joined Schroders in January 2006. He has previously worked at Goldman Sachs Asset Management, where he was Head of Japanese Equities, before becoming Managing Director and Chief Investment Officer for Asia Pacific equity fund management. Shogo is a CFA Charterholder and has a Masters in International Affairs from the School of International Affairs, Columbia University. He also has a BA in Economics from Wesleyan University. Improving corporate earnings and governance Domestically, Japanese companies’ earnings have been growing at a solid pace. Despite the weaker global picture, earnings are still expected to rack up positive year-on-year growth for the current fiscal year. Although expectations have had to be scaled back slightly, growth has been well-balanced and dependency on the external global economy is now lower. On the corporate governance front, the greater pressure being exerted by shareholders on management is beginning to pay off. The introduction earlier this year of the Corporate Governance Code is, without doubt, a positive long-term development in Japan and is another success story for Mr Abe. Changes already underway include better board structures which will ultimately lead to improved accountability and more efficient allocation of capital, all of which should benefit shareholders. This trend of improving governance is unlikely to be reversed and we are already seeing the positive effects of this change via increased dividends and share buybacks by Japanese companies. We have stepped up our own efforts to engage with company management with a focus list of companies and have seen encouraging results. Sticking to the fundamentals Although growth data have been weaker than anticipated, the overall trend for the Japanese economy remains positive. In an environment of low growth and low inflation, we see the Japanese market being supported by firm corporate earnings growth and growing returns to shareholders. Furthermore, the price-to-earnings multiple of the Topix benchmark (based on forward earnings) is still at a reasonable level of 15–16 times. We feel that lower global economic growth has been sufficiently discounted in share prices and in some cases the negative impact from China’s slowdown may have been overestimated. As always, we continue to remain disciplined and strictly adhere to our bottom-up stockpicking approach, leveraging our in-house fundamental research platform on the ground. The views and opinions contained herein are those of Shogo Maeda, Head of Japanese Equities, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 48 19 Outlook 2016: Multi-Asset Johanna Kyrklund, Head of Multi-Asset Investments After years of liquidity-driven markets, investment trends look tired and we expect muted returns in 2016. Cyclical assets present the main source of potential ‘pent up returns’ and could be a wild card for investors. Many 2015 themes remain in place Looking into 2016, we thought about ‘cutting and pasting’ from our 2015 outlook when we said: – The US continues to lead the recovery but growth momentum elsewhere is weak. As such, we favour assets that can cope with subdued levels of growth – Many of the economic trends that prevailed in 2015 look set to remain in place in 2016 with global growth reliant on central bank activity. – Our return expectations are lower as quantitative easing has inflated the prices of the assets we have liked and the trends look tired – we prefer to be patient at these levels, reduce risk and wait for better opportunities. – Value is most apparent in the more cyclical areas of markets – potential catalysts for unlocking this value would be strongerthan-expected economic growth or a weaker US dollar. “Generally our outlook is more muted than in previous years, reflecting the fact that quantitative easing has inflated the prices of the assets we have liked.” – Equities performance is likely to remain narrow; we prefer those areas of the market where corporate earnings trends are most well-established – The outlook appears tough for commodities although there could be opportunities after recent steep price falls. Certainly economic data would suggest more of the same; measures of manufacturing activity remain subdued and global GDP growth remains stuck around 2.5% with the US being the main bright spot. We remain focused on developed economy growth and have avoided cyclical assets. This has been the right call but the challenge we now face is that quantitative easing has inflated the prices of the assets we have liked and the trends look tired. Accordingly we have reduced the risk in our portfolios compared to previous years. Economically-sensitive assets have fallen in value What would enable us to refresh our portfolios and position for potentially stronger returns? Certainly assets exposed to the more cyclical areas have fallen significantly in value; emerging market equities are down 15%, commodities are down 26%, US energy stocks are down 24% and local emerging market debt has fallen by 15% this year (Schroders, DataStream, 31 December 2014 to 22 December 2015). This could be a potential source of ‘pent up returns’ and we see two potential catalysts. Firstly – the economic ‘pie’ may grow more quickly than is currently expected. Here we would expect surprises to come from US and European consumption given the fall in the oil price. Secondly, the economic ‘pie’ may be sliced differently depending on currency movements. In recent years, the Europeans and the Japanese have been the winners of the currency wars. With the Federal Reserve now starting to raise rates it looks like 49 Outlook 2016: Multi-Asset this trend could continue as higher US rates could support further strength in the US dollar. However, we do see a scenario where the US dollar could weaken, particularly if European inflation picks up and the Japanese choose to desist from further quantitative easing for political reasons. In summary, it seems to be too late to add to the beneficiaries of quantitative easing and a bit early to add to the cyclically sensitive assets. Patience is a virtue. Johanna Kyrklund, Head of Multi-Asset Investment Johanna Kyrklund joined Schroders in March 2007. She is Head of Multi-Asset Investments and a member of Schroders’ Global Asset Allocation Committee. Before joining Schroders, Johanna specialised in asset allocation strategies. She has worked at Insight Investment and Deutsche Asset Management. Johanna is a CFA Charterholder and has a Degree in Philosophy, Politics and Economics from Oxford University. “The economic ‘pie’ may grow more quickly than is currently expected. Here we would expect surprises to come from US and European consumption.” The views and opinions contained herein are those of Johanna Kyrklund, Head of Multi-Asset Investment, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 50 20 Outlook 2016: Multi-Asset Income Aymeric Forest, Head of Multi-Asset Investments Europe 2015 has been a challenging year for asset prices; however, following the widening of credit spreads, large swings in government bond yields and the recent equity sell-off, many income sources are offering attractive yields again. Demand for income is still strong The demand for income remains global and structural, driven by low interest rates and by an ageing global population. – Demand for income remains high and many income sources now offer attractive yields. Despite this ongoing demand, the environment has been challenging for income strategies. First, the appreciation of the dollar is impacting liquidity and some interest rate sensitive assets. Second, the normalisation of real rates happened as inflation expectations dropped both in the US and Europe. Real yields are the discount rates of financial asset prices. If they increase, growth needs to be strong enough to offset this negative effect. – Economic cycles are diverging; active management of regional risks is required. So what should we expect going forward? Investors will have to adapt to a fast changing environment as valuation may not be a sufficient guarantee of a successful investment strategy. – High dividend stocks and high yield bonds offer opportunities. Regional divergences are more apparent Global economic cycles are diverging across regions and are expected to continue to do so in 2016. Recent divergences have been mostly driven by exchange rates and central banks’ guidance. As such, we favour regional asset classes in Europe and Japan, which are both supported by loose monetary policies. Europe is now accelerating thanks to a weaker euro. “Central banks and real rates will remain key drivers in 2016.” Elsewhere, there are some signs of slowdown in the US manufacturing sectors whilst emerging economies remain under the stress of a strong dollar and decelerating Chinese growth. The Federal Reserve (Fed) is expected to raise its key rates. However, regardless of the timing of the first hike, this cycle is unique and the Fed may lack room for manoeuvre in the future and could reverse its course of action if imbalances grow. Typically, tighter monetary policy tends to generate lower expected returns and this requires investors not only to focus on total return but also on strategies which are dynamically managed. For this reason, we expect volatility to normalise higher. Asset prices will be more dependent on the realisation of growth to deliver future returns, whilst fair-to-expensive long-term valuation levels may cap equity price appreciation. 51 Outlook 2016: Multi-Asset Income High dividend stocks and high yield bonds look attractive In this context, high dividend stocks could offer some defensive characteristics with more regular and robust cash flows. They have been underperforming for more than two years versus a standard global equity universe and now offer an attractive entry point. We are also finding some value in high yielding bonds although security selection matters. It is our preferred fixed income asset class given the attractive yield and high implied default rate. Regarding emerging market assets, we are cautious despite attractive valuation because of a strong dollar and a low growth environment. Aymeric Forest, Head of Multi-Asset Investments Europe To conclude, central banks and real rates will remain key drivers in 2016. The first rate hike by the Fed in the coming months is not likely to be followed by an aggressive tightening cycle because of the dollar appreciation impacting US exports and of a weak Chinese growth. Government bonds are therefore unlikely to run out of control but are unlikely to offer attractive returns. This could benefit actively managed income strategies. Aymeric joined Schroders in May 2011. His investment career began in 1996. Aymeric is the lead manager of Schroder ISF Global Multi-Asset Income and responsible for investment on behalf of European Multi-Asset clients and complex segregated mandates. He is also a member of the Global Asset Allocation Committee and the Volatility Risk Premia group leader. Prior to joining Schroders, Aymeric was Global Head of Investment Solutions at BBVA in Madrid, responsible for the multi-asset products. He was also Head of Tactical Asset Allocation quantitative strategies and senior fund manager at ABN AMRO. The views and opinions contained herein are those of Aymeric Forest, Head of Multi-Asset Investments Europe, and may not necessarily represent views expressed or reflected in other communications, strategies or funds. 52 21 Outlook 2016: Multi-Manager Marcus Brookes, Head of Multi-Manager Robin McDonald, Fund Manager Sometimes these outlooks differ significantly from year to year. This is not one of those times. Many of our thoughts from a year ago still stand. Here, we revisit some of these views as well as introducing a few new ideas. What we think we know We devote a lot of our time to assessing risk/reward opportunities. In our view, the rewards on offer to the Federal Reserve (Fed) and the US economy in keeping interest rates at zero were exhausted some time ago. The risks, however, particularly in financial markets, have continued to build. – Our general view is that almost all assets are priced for continued low growth, low inflation and low (if not negative) real interest rates. – We expect the trend of US equity leadership to flip in 2016 and for international equities to begin to outperform in both local and common currency terms. – We believe cash will become more desirable over the course of 2016 as the headwinds for fixed income intensify. I’m writing this piece in the second half of November, and as things stand it is anticipated that the Fed will begin the process of normalising monetary policy at its mid-December meeting, albeit in exceptionally dovish fashion. So, here are a few things we consider to be relevant: – The global economy has not delivered. At the end of 2007, the global stock of outstanding debt was $142 trillion. Since then the world has added an additional $57 trillion of debt to its balance sheet – This record debt burden has been encouraged by global central banks and supported by near zero rates – Most financial assets have re-rated significantly on the back of near zero rates as it has encouraged investors to take more risk. What we believe to be true Every economic cycle is different and in many ways this one has re-written the rule book. Undoubtedly, the 2008 financial crisis was deserving of a radical response and in 2009 the US led the world in dramatic fashion, employing aggressive measures to rebuild its balance sheet. A little over two years ago, in 2013, total net worth of the US household sector hit a new record high. A reasonable question therefore is whether US rates have remained unnecessarily low ever since, and what will the consequences ultimately be if that proves to be the case? Here are a few things we observe: – A US central bank that is desperate to move away from zero rates without distressing financial markets – An international economy trying to digest a stronger US dollar (global GDP growth is down 5% year-on-year in dollar terms) 53 Outlook 2016: Multi-Manager – A corporate sector that has engaged in aggressive financial engineering by issuing huge volumes of low-yielding debt in order to retire massive volumes of equity – Global bond yields close to record lows – Global equity markets close to record highs. Marcus Brookes, Head of Multi-Manager Marcus joined Schroders in July 2013 following the acquisition of Cazenove Capital. Prior to the acquisition he was the Head of MultiManager at Cazenove Capital, which he joined in January 2008. During his career Marcus has held MultiManager linked roles at Gartmore, Rothschild Asset Management, and his investment career commenced in September 1994 when he joined Friends, Ivory and Sime. Marcus qualified from University of Stirling with a MSc. in Investment Analysis. What we know we don’t know Sadly, what we know we don’t know with certainty is how financial markets will absorb this inflection point in US monetary policy. Fortunately, what we can evaluate is how financial markets are currently priced in a historical context, and broadly what investor expectations are. This is a decent starting point for making reasonable judgments about the outlook. Our general view is that almost all assets are priced for continued low growth, low inflation and low (if not negative) real interest rates. If that’s the outcome – no great shakes. If the outcome is higher growth and/or particularly higher inflation, then we could see some big swings in the absolute and relative prices of bonds, equities, currencies and commodities. We are very much alive to this prospect as we are beginning to observe accelerating wage growth in a number of economies whose labour markets have tightened meaningfully. Below are some thoughts on the major asset groups as we enter 2016: Fixed income and cash Traditional fixed income tends not to do well in a rising rate environment. Our bias is for history to repeat itself in this respect considering how low current yields are. If we are wrong, and longer-term yields fall when the Fed hikes, it would be suggestive of a policy mis-step, making us more cautious on the economy. Either way, our suspicion is that weaning investors from such loose policy conditions will not be straightforward, so we expect bond markets in 2016 to be fairly turbulent. Corporate credit spreads have widened over the past year suggesting, increased investor concerns about the potential for credit stress among highly leveraged borrowers. This is something we’re watching closely as history suggests that credit spreads often narrow when the Fed begins to raise rates. Importantly, however: 1. The Fed doesn’t usually wait seven years into an economic cycle before raising rates. Typically the Fed starts normalising one-to-two years into a recovery when earnings growth is strong. Robin McDonald, Fund Manager Robin joined Schroders in July 2013 following the acquisition of Cazenove Capital. Prior to the acquisition he was a fund manager at Cazenove Capital, which he joined in October 2007, responsible for co-managing the Multi-Manager fund range. Robin has previously held Multi-Manager linked roles at Gartmore, Insight Investment Management and Rothschild Asset Management. Robin began his career in September 1999 when he joined Bank of New York (Europe) Limited as a Client Relationship Executive. He is a CFA charterholder. 54 2. A key reason why risky assets have done well this cycle is that investors have been encouraged to move out along the risk curve. How many investors have unwillingly bought investment grade credit and high yield this cycle in pursuit of a higher return; and how many will retreat to less risky assets when the Fed begins normalising? 3. We strongly believe that when this credit cycle ends, the lack of liquidity will be a major issue. The latest data from the New York Fed shows US corporate debt inventories amongst primary dealers having turned negative for the first time on record. Until these markets are properly tested we don’t know how they will cope under such poor liquidity conditions. So, although we can be modestly more positive on credit than we were a year ago as the degree of compensation has theoretically gone up, we have opted to retain a healthy cash balance across the Multi-Manager portfolios. Cash has been the hot potato asset of the last seven years. We believe it will become more desirable over the course of 2016 as the headwinds for fixed income intensify. Outlook 2016: Multi-Manager As a final point, 12 months ago we were rather more optimistic than we are today about the US dollar. Once again, history suggests the dollar tends to peak early into a Fed hiking cycle. This is contrary to popular wisdom, which suggests that in spite of a 25% rally in 18 months, the dollar remains a one-way bet. We tend to be wary of one-way bets as invariably they disappoint. Equities appear richly priced Our overriding view of the equity market is that it’s richly priced and has dubious internal dynamics, such as very narrow breadth (i.e. a small number of stocks leading the overall market higher). This combination doesn’t guarantee it will go down a lot. But nor do we believe our base case should be that it shoots up a lot either. Of greater curiosity to us at present is the relative opportunity set that’s emerged within the market. “We are trying to resist the urge of becoming too contrarian too early here. Being different is often crucial at turning points, but can also prove a drag in the latter stages of a cycle when momentum investing typically works best.” We expect the trend of US equity leadership to flip in 2016 and for international equities to begin to outperform in both local and common currency terms. This reflects US economic, margin and valuation cycles that are more mature than elsewhere. In addition, Fed tightening is historically not good for US equity valuations. The reason why Fed tightening cycles haven’t historically assured outright equity weakness is because they usually get underway early enough in the cycle such that earnings growth effectively trumps the de-rating that almost always occurs (the tech sector in the late 90s was an exception). With the level of US profit margins close to record highs and with earnings growth already having moderated, we ought to be able to garner a greater return elsewhere. Our preference remains Japan and Europe where the above cycles are earlier in their evolution. We consider investor positioning within the equity market to be heavily skewed in favour of the low growth – low inflation narrative. Yet, with US core inflation just a smidgen below target at 1.9% and a tight labour market, it may not take much of a spark from wages for the pendulum to swing away from this crowded group of ‘secular stagnation’ stocks towards higher inflation beneficiaries. The oil price bottoming around current levels would clearly be beneficial to this idea as well. We are trying to resist the urge of becoming too contrarian too early here. Being different is often crucial at turning points, but can also prove a drag in the latter stages of a cycle when momentum investing typically works best. As ever we remain disciplined and patient, but equally open-minded to change. Blending alternatives We ask for the same degree of pragmatism from our underlying managers, particularly those running absolute return funds (one of our alternative asset classes). 2015 has been a challenging and in many cases frustrating year for even the most experienced investors we monitor in this space. We have no reason to believe the current higher volatility regime will not persist into 2016. It has been the correct decision for us to stand aside of the commodity markets in recent years. This initially drew some criticism on the basis that we run (amongst other things) mandates benchmarked against inflation, and commodities are generally considered an effective inflation hedge. Inflation hasn’t been a risk the market has seen fit to hedge in recent years. As indicated earlier, we’re mindful that this could change in 2016. 55 Outlook 2016: Multi-Manager For now, we continue to blend a number of fund managers in the alternatives portfolio who have historically proven adept at growing capital in weak markets. Sometimes this has been through contrarian positioning, sometimes through bold directional exposure, either long or short. Importantly the aggregate views expressed here are always in harmony with our wider portfolio themes. To summarise, these are to approach the bond markets with caution, to carry equity risk primarily outside of the US, and within equity markets to increasingly lean in favour of strategies that will benefit from a shift away from the low growth – low inflation beneficiaries. These views are expressed through both long only and long-short strategies. The views and opinions contained herein are those of Marcus Brookes, Head of Multi-Manager, and Robin McDonald, Fund Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 56 22 Outlook 2016: UK Commercial Real Estate Duncan Owen, Global Head of Real Estate After a strong 2015, we expect performance across different parts of the real estate sectors to be more polarised in 2016. 2015 has been another good year for UK commercial real estate and unleveraged total returns are likely to be close to 15%. Rental recovery Whilst one of the drivers for another strong year has been a continued favourable fall in real estate yields, the key difference to 2014 is that this year has also seen a broad-based recovery in rental values. While Central London offices have led the upswing, several other cities including Brighton, Bristol, Cambridge, Manchester, Leeds and Oxford have also seen a significant increase in office rents. Likewise, industrial rents rose in many locations, boosted by growing demand from on-line retailers and parcel couriers. – Office and industrial rents are now rising across the UK, not just in London. – The UK is finally seeing a recovery in productivity, which should support a steady increase in real disposable incomes and consumer spending. – New commercial development remains at a low point in most markets. – On balance, given that all the usual suspects have a good alibi, we think that capital values are likely to rise in 2016, but at a slower pace than in 2014–2015. “The best market returns will be achieved by real estate which is in the right city, the right location and which best suits occupiers’ requirements and maximises their productivity.” In contrast however, the retail sector is still adjusting to a world of multi-channel sales. While there are pockets of rental growth in London and some tourist destinations, most centres have a significant amount of vacancy and rents were either flat, or fell slightly in 2015. Top of the cycle? The outlook for 2016 is already categorised by some commentators asking whether we are now at the top of the cycle. The income from commercial real estate has historically been very stable, but capital values have been cyclical (albeit less volatile than equities). However, capital values have risen by 25% in less than three years so surely, this cannot continue? This sentiment is understandable, but not necessarily rational. The immediate trigger for previous downturns has been a recession, which has depressed rents and pushed up real estate yields as investors have withdrawn from the market and liquidity has dropped. In addition, commercial real estate has had a habit of contributing to its own downfall, either through excessive borrowing which inflated prices (e.g. 2005–2007), or because of a boom in development which left an over-supply of space (e.g. 1988–1990) and falls in rents. Supportive economic picture Fortunately, none of the usual suspects appear to yet be evident. Looking at the economy, the outlook is positive and the consensus is that UK GDP will grow by 2.25–2.50% through 2016–2017. The main reason for being optimistic is that the UK is finally seeing a recovery in productivity, which should support a steady increase in real disposable incomes and consumer spending. Furthermore, exporters stand to gain from faster growth in the rest of the EU, which accounts for 45% of total exports. Borrowing under control Similarly, there are few signs of excess borrowing. In general, banks and other lenders have continued to take a disciplined approach to commercial real estate and although total loan originations in 2015 are likely to be around £50 billion, they are still well below 57 Outlook 2016: UK Commercial Real Estate the peak of £80–90 billion reached in 2006–2007. Moreover, while the IPD All Property Index initial income yield is low by historical standards at 5%, it is still comfortably above the yield on 10-year gilts at 2% and the consensus is that 10-year gilt yields are unlikely to rise to 3% until at least 2018. Development low The final reason for being sanguine is that new commercial development remains at a low point in most markets. The only grounds for concern being the City of London, where a number of new offices are due to complete in 2018–2019. Even so, these levels of development are well below previous cycles. The lack of new development reflects in part the reluctance of banks to fund speculative schemes and in part the hollowing out of the development industry during the last financial crisis. Employment in construction is still 10% below its pre-crisis peak. Also, another constraint on development in the commercial sector is sites being instead used for residential development. Duncan Owen, Global Head of Real Estate Duncan Owen, Global Head of Real Estate, joined Schroders in January 2012. Duncan was previously CEO of Invista, having led its creation and IPO as a newly formed property fund management business listed in London. Invista was formed in 2006 from the fund management business of Insight Investment Management Limited. He Joined Insight in 2003 following its acquisition of Gatehouse Investment Management, the real estate investment management boutique which he co-founded. He was the Managing Director of Insight’s property division and a main board director at the firm. Previously he was a director at LaSalle Investment Management and a partner at Jones Lang Wootton. Polarised performance in 2016 On balance, given that all the usual suspects have a good alibi, we think that capital values are likely to rise in 2016, but at a slower pace than in 2014–2015. We anticipate that total returns will still be respectable at between 7–9%. There are, of course, risks around this outlook. One possibility is that 10-year gilt yields jump more sharply in 2016 than anticipated. A second risk is the EU referendum. If the UK were to leave, then UK real estate could be hit as various investment banks and institutions, as well as some manufacturers, switch to continental European locations. The best market returns will be achieved by real estate which is in the right city, the right location and which best suits occupiers’ requirements and maximises their productivity. The outlook from this point in the cycle is therefore set for more polarised performance across different parts of the real estate sectors. The views and opinions contained herein are those of Duncan Owen, Global Head of Real Estate, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 58 23 Outlook 2016: Outlook 2016: US Equities Matthew Ward, Portfolio Manager, US Equities A strong employment market and robust consumer confidence make for a positive outlook for the US, where we favour domestic exposure and sectors such as technology. There is little doubt that some of the biggest risks to equity markets last year – depressed commodity prices, slowing growth in China, and uncertain economic data points in Europe as well as the US, all accompanied by dollar strength – will affect 2016 as well. We continue, however, to be constructive about the outlook for US equities, encouraged predominantly by ongoing strength in the employment market, increased evidence of rising wages, better household balance sheets, and robust consumer confidence. – Strong employment market and robust consumer confidence make for a positive outlook. – Active fund management to differentiate itself against backdrop of increased volatility. – We are focused on sectors with secular expansion potential and prefer a domestic tilt where necessary. “We are optimistic about the prospects for US growth based on the strength of the consumer, which ultimately accounts for two thirds of the economy.” “We see continued investment opportunity in the technology sector, our biggest overweight, as cloud computing usurps traditional business models.” Strong consumer to drive US growth We are optimistic about the prospects for US growth based on the strength of the consumer, which ultimately accounts for two thirds of the economy. Based on current activity indicators, we believe the US economy is growing 2–3% annually, roughly in-line with trend-line GDP growth which, when combined with moderate increases in corporate profitability, 1–2% stock repurchases, and modest multiple expansion, can provide attractive equity returns. Other potential positives include an accommodative European Central Bank and Bank of Japan, China’s ability to engineer modest growth, and potential for dollar stabilisation and/or reversion in commodity prices/emerging markets driving greater overall global growth. Offsets include further earnings revisions associated with those companies more exposed to oil and other commodity prices, emerging markets, and/or further dollar strength. Certainly, slowing growth in China, subdued commodity prices, and uncertain economic data points in Europe and the US could lead to increased levels of volatility. But given greater levels of dispersion associated with this volatility, this should provide an environment in which active management could differentiate itself from an asset management industry, struggling to beat its benchmark over the last five years. Industry disruption creates secular growth opportunities We see continued investment opportunity in the technology sector, our biggest overweight, as cloud computing usurps traditional business models in areas like enterprise resource planning and human resources. The cloud offers lower total cost of ownership, faster time to market, and more flexible and user-friendly interfaces. Also, as consumers spend more time online and on mobile devices, historical means of monetisation and commerce will give way to newer, disruptive approaches. A stronger consumer, shopping online We’re also constructive on the US consumer, emboldened by upward pressure on wages associated with improving employment and lower gas prices. We believe in e-commerce over traditional ‘big box’ retailing as selection, price, and convenience drive market-share gains. Today e-commerce only accounts for 7% of overall retail sales, but it is growing at a compound annual growth rate of 19% versus 4% for traditional retail. Where traditional bricks and mortar will continue to prevail is through brand and merchandising and 59 Outlook 2016: US Equities categories that don’t lend themselves to online, and in service. Many of these names will also benefit from the resurgent consumer, when steady jobs growth over the last two years begins to manifest itself in improved wages and greater consumer expenditures. US pharmaceuticals offer hidden value but regulatory uncertainty tempers enthusiasm In US pharmaceuticals and biotechnology there are myriad, late-stage drug pipelines that are undervalued by Wall Street, in lieu of overvalued single-drug franchises that haven’t shown research and development efficacy and are a focus for competition/ generic substitutes. But our enthusiasm is tempered heading into an election year as the time of unchallenged pricing in pharmaceuticals is coming to an end. Direct government intervention is unlikely, but multiples will be constrained. Matthew Ward, Portfolio Manager, US Equities Matthew Ward is a Portfolio Manager for the Schroder US Large Cap Strategy and Schroder US All Cap Strategy. He is also an Equity Analyst for the US Large Cap team, responsible for the media, internet, software and telecommunications services sectors. Matthew joined Schroders in 2005 and is based in the New York office. Prior to joining Schroders he was an Equity Analyst at Phoenix-Engemann Asset Management and was responsible for covering internet, media, and cable/DBS. His investment career commenced in 1995 when he joined Franklin Resources based in California. He was an Equity Analyst and his responsibilities included coverage of capital goods, electrical equipment, natural resources and cable/new media. Matthew has a BA degree in Economics and English, Georgetown University and is a CFA charterholder. Industrials face multiple challenges As we look at depressed commodities, particularly oil and gas, and at China battling to shore up weaker growth, it’s difficult to be constructive on industrials, so we are underweight this sector. Instead, we focus on the secular growth evident in certain pockets such as environmental/analytics, auto manufacturing, residential construction/ HVAC (heating, ventilation and air conditioning). We’re also watching short-cycle and inventories intently as signs of dollar stabilisation, commodity, or emerging market economic growth would really drive positive earnings revisions in the group. Strong US dollar points to domestic exposure As interest rate differentials persist, the result of US Federal Reserve monetary policy tightening versus European and Japanese QE, dollar strength should remain a theme in 2016. Accordingly, we must be mindful of multi-national sales sensitivity in those areas of the S&P 500 (34% exposure to international overall) which have the highest overseas sales. These include the technology (roughly 50% exposed to international sales), materials (45%), and industrials (40%) sectors. In technology, we feel confident that our stronger secular growth will overwhelm headwinds from dollar strength, while in industrials and materials the impact to multi-nationals was quite evident in 2015. As such, at the margin, we’ve tried to emphasise domestic versus international exposure. Growth should outperform value Historically, in an environment with modest economic growth, growth stocks tend to outperform value. We are confident in the prospects for the consumer given strong monthly jobs data, good housing starts and robust consumer confidence. However wages and inflation are still fairly muted and the industrial economy is challenged. Against that backdrop and the resulting 2% or so GDP growth we’d extrapolate, investors should gravitate to those stocks where growth is more evident. This informs our penchant for secular growth (via overweights in technology and consumer discretionary and decent exposure in staples) and is notable in our growth premium to our S&P 500 benchmark. “As interest rate differentials persist, the result of US Federal Reserve monetary policy tightening versus European and Japanese QE, dollar strength should remain a theme in 2016.” The views and opinions contained herein are those of Matthew Ward, Portfolio Manager, US Equities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 60 24 Outlook 2016: US Multi-Sector Fixed Income Andrew Chorlton, Head of US Multi-Sector Fixed Income The market appears confident that Federal Reserve rate hikes will be gradual in 2016, and we believe this could be storing up some shocks for the new year. The Federal Reserve (Fed) is finally on the cusp of increasing interest rates, but despite the anticipation, market expectations for the future path of rates are extremely benign by historical standards. This complacency could sow the seeds of an interesting year in 2016 with plenty of potential for surprises. However, we also believe that there are a number of opportunities. – Market expectations for the future path of US interest rates are extremely benign by historical standards. – Corporate bond markets have endured a challenging 2015 and certain areas now offer compelling value. – Municipal bonds have had a very robust year and may struggle to carry this momentum into the new year. “Many commentators have spent time focusing on the timing of the Fed ‘lift off’ but probably not enough on the trajectory of rates thereafter.” Credit markets have tested investors over the last year. US corporate bond yield spreads have continued to widen, and the slightest disappointment on individual names has been met with intense reactions. Record breaking issuance, declining liquidity and deteriorating fundamentals have all contributed to a challenging market. However, valuations have become more attractive and reflect much of the bad news already. Conversely, the US municipal bond market has been a bastion of strength and stability recently, but looking ahead to 2016, it is hard to see it maintaining such strong relative performance. It’s not about the first Fed move; but the second, third, fourth and beyond Many commentators have spent time focusing on the timing of the Fed ‘lift off’ but probably not enough on the trajectory of rates thereafter. It is perhaps natural that after such a prolonged period of ‘zero’ interest rates – and multiple rounds of quantitative easing around the world – that the first major bank to tighten policy would get such focus. What really matters is what happens next. The current expectation – of just two 25 basis point (bps) hikes in 2016 – is much more benign than any recent rate hiking cycle. It predicts that the Fed’s dovish approach will continue even as it raises rates, and is coupled with fears that the slowdown in the rest of the world will persist. Making exact forecasts on either the Fed funds rate or 10-year Treasury yields is a fruitless task. Nevertheless, it does feel that market expectations are one sided. After years of excessively positive outlooks, the market has been beaten down; resigned to an extension of low growth with low inflation. Having been wrong for so many years, one could almost argue the consensus view is no view at all. Given where we are, any negative economic surprise could delay further rate hikes, but we believe it is unlikely to reverse or cancel the Fed’s hiking cycle altogether. On the other hand, any positive surprises to global or domestic growth – and yes, it is possible – could result in a more material impact on markets, as rate hikes are brought forward and the expectation of the terminal rate moves above 2%. Inflation could also present a surprise to the market, which is currently pricing in significantly below-trend inflation for the next ten years. 61 Outlook 2016: US Multi-Sector Fixed Income Corporate bonds are cheaper, but are they cheap enough? Our strongest held conviction remains the compelling value of US investment grade corporate bonds. Credit spreads have moved wider over the last 18 months in the face of record issuance, deteriorating fundamentals and declining liquidity. Current valuations in BBB-rated issuers have moved to levels consistent with previous recessions and, at longer maturities, are near 25-year lows. Since the summer we have slowly increased our exposure to credit and expect to do so as we head into 2016. One of the key elements of that decision has been the time horizon we are taking. In this market, credit spreads could go 25 bps in either direction over the next three months, but as a team we feel confident that taking credit risk could be rewarding over a 12-month horizon. The balance of positioning is crucial in this environment. While we have reasonable exposure to corporate credit risk, we have enough high quality assets to enable us to react to any surprises that create investment opportunities. Andrew Chorlton, Head of US Multi-Sector Fixed Income Andrew Chorlton is the Head of US Multi-Sector Fixed Income and based in New York. He joined Schroders in 2013 following the acquisition of STW Fixed Income Management, where he had worked since 2007. At STW, Andy was Principal, Portfolio Manager and a member of the team responsible for managing Multi-Sector portfolios including Core, Short and Long Duration and Tax-Aware strategies. Andy has also held senior positions at AXA Investment Managers and Citigroup Asset Management. Andy is a CFA charter holder and has a Bachelor of Social Sciences in Economics and Spanish, University of Birmingham. “Given where we are, any negative economic surprise could delay further rate hikes, but we believe it is unlikely to reverse or cancel the Fed’s hiking cycle altogether.” We favour investment-grade financial and broadly diversified industrial credits, including some higher quality energy issuers which are at what we consider to be very attractive valuations. It is our view that the financial sector will continue to benefit from a more supportive regulatory backdrop and is more immune from the merger (M&A) risk, which is affecting many industrial sub-sectors. How will municipal bonds react to a move from the Fed? There have been two material dislocations in municipals in the last five years. The most recent was two years ago, when ‘taper tantrum’ fears sent longer dated municipals to the cheapest levels seen in decades. Municipal bond yields rose rapidly, spreads between rating grades widened and liquidity evaporated. How times have changed. As we approach Fed ‘lift off’ the opposite has occurred. Municipals have delivered strong outperformance relative to other bond markets, despite a plethora of idiosyncratic noise ranging from the collapse of commodity prices to the well-publicized fiscal malaise in Puerto Rico. As we look forward to next year, expectations of negative net supply should support the market. We believe that municipals are fully priced while corporate bonds are more undervalued. Is liquidity going to come back? No; at least not any time soon. However, if investors have a longer-term time horizon, we think they can demand an attractive ‘liquidity premium’. As portfolio managers and investors we just have to come to terms with the new liquidity environment and manage accordingly. 2016: A year of firsts 2016 should prove to be an interesting year, and one of firsts. The Fed is embarking on the first rate hikes since 2006. It is also the first time the Fed has started hiking rates with a $4.5 trillion balance sheet and the first time they have raised interest rates with real economic growth running below 2.5%. There will certainly be many significant decisions to be made and we anticipate 2016 will be another year for capitalizing on market dislocations. We think that could be good news for those investors with a longer-term time horizon, as valuations in some areas currently look quite compelling. The views and opinions contained herein are those of Andy Chorlton, Head of US Multi-Sector Fixed Income, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. 62 S C H R O D E R S I N V E S T M E N T O U T L O O K S About Schroders €400.0bn managed across equities, fixed income, multi-asset, alternatives and real estate. An extensive global network of 3,700+ employees. 37 offices in 27 countries across Europe, the Americas, Asia and the Middle East. Over 200 years’ experience of investment markets. Source: Schroders, as at 30 September 2015. To find out more please visit www.schroders.com or speak to your local Schroders representative Important information: The views and opinions contained herein are of those stated, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. 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