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Welcome – Prospect WM annual investment seminar

MNH - introduce

Order – MNH, then Philomena Gibbons will give a short presentation on the history of the Wellcome Collection. Then drinks and buffet, and you will be able to go on one of the tours we have arranged.

The team are all here so I hope you’ll take the opportunity to talk to your account manager and quiz the investment analysts.

Update on Prospect. We have recently moved into new offices in Eastcheap

Prospect is now in 14th year and now has some 600 clients and £150m assets under management. Welcome some 140 clients today.

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Our theme is the investment outlook for this year, but helps to have the perspective of where we have come from.We tell you it’s difficult to predict the future, so I’ll start by reviewing the conclusions we reached at our last seminar

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As usual our forecasts were broadly correct, with growth starting the year strongly and then weakening in the second half, a pattern that was reflected in equity markets.Our surprise was that the US stock market continued to perform well – even though it was expensive.Falling momentum did indeed turn into a downturn in equity markets in the second half. We did raise cash going into Q4.I’ll now remind you remind you what happened last year to place our outlook in context.

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• We started the year with a downturn as US interest rates were raised in December 2017 and that led to a wobble in markets.

• Markets recovered as growth picked up, largely led by the tax cuts announced in the US that boosted company earnings growth.

• Nobody expected that the US would jeopardize the strong growth prospects by increasing trade tariffs, but in July Trump imposed tariffs on $200m of Chinese imports to the US and equity markets progressively became unnerved.

• Exacerbated by another interest rate rise to 2.3% in September.

• The positive news was that the oil price started to fall from a high of $85 / bl in October as Trump waived the sanctions on Iran.

• So how did markets respond……

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• 2018 was not a good year for returns in general. 61% of assets had negative return, amongst the worst outcomes in more than 100 years. Normally some asset classes do well whilst others do badly.• How did the assets we invest in fare?

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• Most markets produced negative returns in 2018.

• Currency and property were the winners. We were overweight in Japan and in property, but underweight in the dollar.

• Bonds provided a small positive return, so they did provide the protection that we expect at a time when equities are weak.

• Of the equity markets, US proved to be the best performer, despite being the most expensive of the major markets.

• Europe and Japan suffered from the fallout of the US – China trade war as China devalued the renminbi to offset the impact of tariffs. That made the major exporters to China, Germany and Japan uncompetitive. So these went from strong growth to no growth over the course of 6 months. Unfortunately we were overweight in Europe and Japan, so our international investments

suffered in the latter half of 2018.

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• Over three years the one negative return has been from China. Despite China having the fastest growth of any major economy. This is the result of the Chinese market being overvalued at the start of the period and then seeing

a slowdown in growth as the government cut back on excessive investment and credit. Valuation matters!

• The best performing equity market has been the US, even though it has been substantially overvalued. Prices have kept rising because of the tax cuts and

deregulation.

• Returns from other equity markets have been modest, though the UK has done well because the currency has devalued as a result of Brexit.

• Note that the strong currency in Japan has meant the Japanese equity market has been weak.

• Property has produced good results, and we have been overweight there throughout this period.

•Bonds have produced a solid 15% return over the period, with low volatility.

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• It was not easy to perform well in the UK last year. • Prior to Brexit we were overweight in the consumer sector as that was what was driving economic growth in the UK. • In the aftermath of Brexit that has been the worst performing sector and we have sold out and moved into, amongst other things, Pharma.• Last year that was the best performing sector.• Oil and gas & mining ok• Defensive sectors like utilities were hit by the threat of nationalisation in the event of a Corbyn govt.• General industrials, which have been very undervalued and where we have a presence, were hit by the Brexit fears.• Housebuilders also performed poorly despite having strong demand and earnings growth – fears of labour shortages, higher costs in future.• Retailers were worst, not surprisingly.

•Performance by model portfolio – building blocks

• The LVP and Bond investments produced small positive returns.

• Our UK equity portfolio had a disappointing year – the undervalued stocks suffered in the second half .

• The Alpha portfolio, our high risk UK equity portfolio, underperformed by

10%, but then it has outperformed by 5% in the first 4 week of this year.

• International portfolio, which outperformed strongly last year, was down 10% as we were underweight in the US and overweight in Europe and Japan. That looked good in the first half of last year but then was a casualty of the Trump trade war. We expect that a de-escalation of the trade conflict will lead to outperformance this year.

• The Alternatives, property, commodities and hedge funds, did what they are supposed to do - provide diversification and were only down 2.5%.

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•Result after blending together components, so this is more like your portfolios.•Bond heavy portfolios performed well, with a 50/50 portfolio down 5.4%. So far this year, this type of portfolio is up 3.7%, so much of last year’s fall has been recovered.

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•If we look back over a tumultuous period our bond portfolios have outperformed our benchmark but our weak UK equity returns since Brexithave dragged the performance on the equity heavy portfolios down relative to

the benchmark down.

• Notable that this 10 year period has been one where low risk assets have produced similar returns to higher risk assets. Will the next 10 years will see the opposite?

• The other side of the coin is risk

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• Important that we are not taking excessive riskat cost of higher risk. • Over last 12 years we have achieved our goal of producing lower volatility and this has been the case over all time periods, short or long.

• What about the future –

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Time for a short interlude, so we now have a review of the past year with an eye to the future

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• Video of events of 2017

• This can be seen by clicking on the link on the website.

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• Growth is slowing as interest rates have risen in the US and trade tariffs have disrupted global trade.

• The US is expected to grow at around the long term trend, UK, Europe and Japan well below trend.

• The assumptions here are that tariffs stay at current levels, of around 10%, and US interest rates do not rise further.

• The worry is that tariffs go up or that fears over a more severe slowdown lead to a downward spiral of cutbacks in investment and spending.

• Are there signs of that happening?

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• Business surveys are the best forward looking indicator we have. Above 50 and the manufacturing is expanding, below 50 and it’s contracting.

• We show the US, UK, Eurozone and Japan. They have been falling from high levels over the past year, due to the impact of interest rate rises, higher

tariffs, the depreciation in the renminbi and the slowdown in Chinese demand.

• All are in positive territory, but the trends are worrying.

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• The other side of the coin is that US unemployment is at a cyclical low

• There is clearly a relationship between unemployment and wages, the lower the unemployment the higher the wage growth.

• There has been a lag in wages rising but now it is happening and that should underpin consumer spending in the US

• The problem is that typically this leads to higher inflation.

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•And that’s why the US has put up interest rates.

• However, a good leading indicator of recession is when short term interest rates rise above the level of bond yields.

• This has been frightening markets and was part of the reason for the fall in equity markets last year.

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• And as interest rates rise, so consumer confidence tends to fall. • However, confidence has been very strong and has only recently started to fall from very elevated levels.• Car sales have come off a little, but it’s not looking like a recession.

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• In Europe, exports, which were a core part of the growth story, growing at 6% in 2017, have taken a tumble.• A large part of the reason is that demand from China has fallen, partly because the Chinese economy has slowed as the authorities cut back on lending for investment• But also because they devalued the currency to counter the tariff threat from the US

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• This is the renminbi vs the USD showing the extent of the devaluation, around 10% from peak to trough

• it has revalued somewhat recently, partly because the government is stimulating the economy again

• So the prospects for Europe and Japan are now looking brighter, assuming there is no further escalation in tariffs.

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• Monetary policy is still stimulative in Europe – interest rates are still at -0.4%

• What’s more, Europe has reduced it’s budget deficits, even Italy is only running a relatively low deficit, so there is scope for governments to turn on

the spending tap. That is already happening in France in response to the Gilets Jaunes demonstrations.

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• Growth forecast at 1.4% for 2018 and 1.4% for 2019.

• Consumers account for the bulk of growth,

• Government has committed to spending more to offset the weakness we have seen in investment and trade last year.

• Our assumption is that we don’t end up with a no deal Brexit and there is

some pent up investment demand that gives a boost to the economy in H2

• This remains an insipid rate of growth. Good for bond markets as inflation is unlikely to rise, but corporate earnings growth is likely to be around 5%.

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• wages now rising faster than inflation• Which should be supportive of growth

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• This gives a measurement of how consumer confidence has fallen and how retails sales have fallen sharply since brexit.

• Confidence below peak, but high employment and low interest rates mean confidence is well above lows of 2009.

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• Despite the fall in sterling, we have seen little improvement in the trade balance and the overall current account.• So if we do have a no deal Brexit and sterling falls by another 15%, it is not realistic to expect this will boost exports.

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• Central banks target is 2%, US and UK are close. • Eurozone has been consistently at 1.0%.• the message is there is little inflation pressure globally.

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• Clear correlation between change in euro/stg exchange rate and the rate of food price inflation. The euro strengthened against stg in 2016 and food prices subsequently rose. The rate of appreciation in the euro has fallen back

close to zero and UK food price inflation has been falling. No sign of this changing direction.

• This should keep inflation around 2.0% over the course of this year.

• The caveat to stable inflation is that Brexit is causing an outflow of immigrants back to the EU and that may lead to higher wages. Arguably that may be happening already.

• Note that government has not reported commonwealth immigrants in the last

2 years.

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• Expect oil price to stay between $60 - $70 in 2019. •At $60 / bl UK inflation is 2.3%• At $70 / bl UK inflation is 2.5%• At $90 / bl UK inflation is 3.0%

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• These have been the drivers of the recent downturn and the cause of fears of recession.

• Whilst the worst case is possible, our expectation is that there will be a favourable outcome.

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• It is only US rates that have risen materially

• Now that short rates have risen above bond yields, the US central bank has indicated that rates are now on hold. That is what is behind the rally in stock markets recently. We wouldn’t be surprised to see a rate cut later this year.

• The other good news is that rates elsewhere are low, which is positive for growth.

• The bad news is that if we do head into recession, there is little the central banks can do from here to promote growth.

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•It is more likely that Trump will de-escalate the trade war because the US is already suffering from a slowdown in exports and Trump needs to get re-elected next year.

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•It is more likely that Trump will de-escalate the trade war because the US is already suffering from a slowdown in exports and Trump needs to get re-elected next year.

• They will find other means to control Chinese theft of intellectual property

other than tariffs, which are a very blunt instrument.

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•The fact is that inequality has not been addressed, as can be seen in France. There, a tax cut for the rich and higher taxes for the poor led to rioting in the streets.

• Brexit can be directly linked to austerity and the extreme wealth divide

• Populist policies have typically not helped to narrow the inequality gap –Trump’s tax cuts, tariffs, Greece’s policies. If populist leaders don’t deliver to their voters, they will lose their support. Populism may not last.

• The markets tend to limit the damage – in Italy bond yields rose and forced

politicians from implementing reckless spending plans

• But populism doesn’t follow economic principles so the unexpected can happen. Brexit!

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• That is good for sterling and good for the stock market.

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• The economics leave a lot of possibilities for where we go from here.

• What do valuations and momentum tell us?

• Real yield on 10 year government bond. • Well below the long term average. But has been for 7 years and there is little sign of inflation now.• We are positioned short duration and have still been able to make strong returns from corporate bonds.

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Cash flow yield

• market is still expensive – but has been for many years and the reason is that corporate earnings growth has been robust and now is supported by a $1.3 tntax giveaway.

• The tax give-away is fading and now earnings are likely to be squeezed by higher wages. There is no room for disappointment.

• Underweight

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Cash flow yield• In the UK there is room for disappointment by contrast• Any good news on a Brexit deal is likely to be very positive for the market• We are now starting to reinvest cash into the UK market•

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Momentum

•This is the classic buy signal. Momentum has turned up and cash flow yield is cheap.

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• Blue line shows purchasing power parity for sterling vs US dollar – the inflation adjusted long term equilibrium.

• Sterling is undervalued as a result of Brexit uncertainty.

• Also dollar strengthened on trade war and rising real interest rates.

• What will happen to trade – we already run a large current account deficit.

Modest tariffs are not a significant threat. Real issue is regulatory obstacles, but we already conform to European standards.

• Real threat is from Trump’s protectionist policies – may be difficult to increase trade with US.

• Rise in sterling also means lower inflation and an increase in consumer purchasing power.

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• These are the position at the end of December

• Now we have moved much of the cash into the UK equity market.

• Still overweight Europe

• Still underweight US

• We are reducing the property exposure

• We have, for the first time taken a small exposure to gold in expectation that the US dollar will weaken and as a hedge against disaster.

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