Global Markets - Arbuthnot Latham · roller-coaster Brazil has experienced in the past two years has culminated in the impeachment of recently re-elected Dilma Rousseff. We take a

Arbuthnot Latham & Co., Limited is wholly owned by Arbuthnot Banking Group PLC with roots extending back to 1833. We have offices in London, the South West, the North West, and Dubai, and provide four core services: Private Banking, Commercial Banking, Investment Management and Wealth Planning.

Our thoughts on

Global MarketsJuly 2016

Introduction Page 3

Market Moving Themes Page 5

Around the World Page 20

The Asset Markets Page 22

Our report discusses general developments within global markets over the second quarter of 2016, with a focus on the issues influencing portfolios. Following an economic and market summary, we expand upon a number of themes before concluding with a review of the major asset classes.

Economic and Market Summary: A broad overview of developments in the global economy and markets over the past quarter, highlighting our thoughts from a macro perspective.

Post-Brexit Trading Options: The UK has many challenges and opportunities ahead as it prepares to leave the EU. Post-Brexit, the UK’s relationship with the EU aims to be one of mutually beneficial trade and inter-governmental co-operation. EU trade is important to the UK and a bespoke UK-EU trade agreement is in everybody’s interests. Arbuthnot Banking Group’s Economic Adviser, Ruth Lea, discusses the UK’s trading options and implications post-Brexit.

The Two Races in Washington: As Hillary Clinton and Donald Trump are confirmed as the Democratic and Republican Party Candidates, we analyse their respective policies should they win the Presidential Election in November. With the race to the White House often taking the media spotlight, we also look at the importance of elections in the Senate and House of Representatives, where the Democrats aim to take back some control from the Republican Party.

Negative Interest Rate Policy & the Helicopter Drop: The bounds of monetary policy continue to be pushed into the extreme, with negative interest rates being adopted in Japan, and talk of ‘helicopter’ money becoming a realistic possibility for the future across the developed world. Here we examine the process for and economic implications of both.

Brazil – Lessons from a Divided Country: The political and economic roller-coaster Brazil has experienced in the past two years has culminated in the impeachment of recently re-elected Dilma Rousseff. We take a step back and a look through the economic and political history that led us to the recent government ‘stand-off’ and look at repercussions for the future.

Around the World: A snapshot of the more esoteric financial and economic news that UK investors may have missed over the quarter from around the globe.

A Quarterly Review of the Major Asset Classes and Outlook: This section records some of the key data for the major asset classes within portfolios, combined with our outlook for each. We conclude that equities continue to look favourable compared to fixed income investments, and briefly discuss the relative attractiveness of hedge funds and UK property.

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Economic and Market Summary

April to June 2016 was broadly devoid of much news or excitement other than that which surrounded the run-up to and immediate aftermath of the EU referendum in the UK. Following on from the first quarter, we had continued to see a lot of risks to markets, not least the unprecedented quantum of government and domestic debt in many countries, but most notably in China, with deflationary pressures and negative interest rates in the western world appearing hard to shift. One of our articles in this edition delves into this phenomenon and the quirky concept of ‘helicopter money’! Whilst easier monetary conditions revived and continue to maintain investor confidence, there remain concerns over weak ‘top-line’ sales growth, as productivity improvements prove elusive. Indeed, a distillation of share price movements during 2015 shows that ‘refinancing’ (companies borrowing funds by issuing bonds to deploy in buying back their own shares) had been a significant contributor to equity market growth, rather than ‘real’ corporate advancement, which is an area of concern.

"Whilst easier monetary conditions revived and continue to maintain investor confidence, there remain concerns over weak ‘top-line’ sales growth."

In response to this poorer outlook, we reduced our global equity overweight and shifted towards a more neutral allocation across the main asset classes to reduce risk. More specifically, and anticipating the uncertainty related to the outcome of the Brexit vote, we reduced our exposure to UK equities and also to sterling by removing euro and yen currency hedges. Funds raised were allocated partially to hedge and absolute return funds, raising our allocation in non-property based alternative investments, with the balance left as cash to provide us with some dry powder for opportunities as they arise in the post-vote aftermath.

A full account of the trading options following the UK’s vote to leave the European Union can be found within our main article in this Global Markets Report and so I will not attempt to recount or summarise the detail here, save to say that in all periods of uncertainty and forthcoming change, there are risks to be avoided and opportunities to be embraced, and your team is actively assessing these.

"Anticipating the uncertainty related to the outcome of the Brexit vote, we reduced our exposure to UK equities."

Indeed, with a more neutral asset allocation and our belief that investment returns will henceforth be lower than those previously enjoyed (see our article on ‘Changing Assumptions’ in the April edition of this Global Markets Report) we see active management in picking particular stocks, themes, sectors, currencies and/or countries as now crucial to finding the elusive pockets of untapped value and in controlling risk.

One key theme that is keeping us busy is that of the ongoing impact of huge recent advancements in technology. IT infrastructure is being radically changed to embrace the cloud and remote hosting of analytics and security to enable mobility and efficiencies in maintaining the most up to date operating framework. This has implications for old technology such as servers, hard-drives, mainframes and PCs which are all in decline. The significant shift towards online shopping is wreaking havoc in the high street with top names such as Austin Reed and BHS failing and those that have adopted e-commerce-based models thriving. In tandem, ‘fintech’ and payments platforms are finding the market for their software very buoyant and the ‘blockchain’ (a digital ‘distributed ledger’ platform that records and verifies transactions in a tamper and revision-proof way that is public to all) is only just beginning to be evolved beyond Bitcoin to other uses.

StJohn N R Gardner MBA, FCSI, FCII, DipPFS

Head of Investment Management

Global Markets

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Whilst the falling oil price has made wind farms unprofitable and reduced solar uptake, the improvement in battery capabilities is giving birth, not just to electric cars, but a whole host of viable power storage uses. In conjunction with Panasonic, Tesla is at the forefront of this, developing autonomous vehicles. Factory automation continues and may shortly take a significant step forward with the development of ‘intelligent’ robots, capable of working alongside humans at a fraction of the cost. More detail on how I see this impacting our standard of living, without being particularly inflationary and indeed ultimately the future of jobs, is the subject of my article in the next edition of Private Life.

These developments are just some of the trends that are shaping our investment thinking, beyond taking advantage of pricing anomalies in the equity and credit markets, or investing in undervalued assets, for example. So, in conclusion, we do see many individual opportunities for investors and believe investment returns can be made even in a scenario where equity and bond indices generally tread water.

Economic & Market Summary

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Market Moving Themes

Post-Brexit trading options for the UK

Introduction: The UK votes for Brexit

The UK voted to leave the EU by referendum on 23rd June, with 51.9% voting leave and 48.1% voting to remain. All but one of the English regions vote to leave, the exception being London, as did Wales. Scotland and Northern Ireland, on the other hand, voted to remain.

Prime Minister David Cameron resigned on 24th June, leading the way to a Conservative Party leadership campaign. At time of writing there are currently three candidates: Theresa May, Andrea Leadsom and Michael Gove. Unless there is an outright victory for one of these candidates in the next stage of the contest, the Parliamentary Party will decide two names which will go to the Party membership who will choose the new leader by postal ballot. The closing date for the postal ballot is 8th September and the new leader will be announced in on 9th September.

"The UK will probably leave the EU on or before 1st January 2019."

Once the new Prime Minister is in office, it is widely expected he or she will invoke Article 50 of the Lisbon Treaty fairly shortly afterwards. Invoking Article 50 formally notifies the EU of the UK’s decision to leave the EU. There then follows a period of negotiations “setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union”.

The UK will cease to be a member of the EU within two years of notification of intent to leave, unless the period is extended. As a working assumption, the UK will probably leave the EU on or before 1st January 2019.

Just how comprehensive the withdrawal negotiations under Article 50 will prove to be is presently being debated. One key concern is, of course, whether the negotiations will cover the UK’s post-Brexit trading relationship with the EU.

Global Markets

Ruth Lea CBE

Economic Adviser to Arbuthnot Banking Group

Left: Theresa May

© Daniel Leal-Olivas

MIddle: Andrea Leadsom

© Department of Energy and Climate Chage

Right: Michael Gove

© Wellington College

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Trade Commissioner Cecilia Malmstrom has said that detailed talks shaping the trading relationship should not start until after the political process of leaving (under Article 50) has been completed. Under these circumstances, the UK on leaving would, therefore, operate under World Trade Organisation (WTO) rules until a new trade arrangement is agreed sometime later. Whilst the WTO option would be far from catastrophic – many key countries trade very successfully with the EU without any trade agreement – it is arguably sub-optimal. Many commentators would prefer a bespoke trade agreement in order to minimise trade disruption for both UK exports to the EU, and EU exports to the UK, on Brexit. Malmstrom’s stance is, therefore, unhelpful. She has, however, been contradicted by Slovakian PM Robert Fico who takes the view that “…it’s our duty to find a mutually-agreeable settlement for both sides”.1 Slovakia currently has the Presidency of the Council of EU.

Post-Brexit trading options for the UK: Introduction

Despite Commissioner Malmstrom’s strictures, there is a high probability that there will be negotiations on the UK’s new trading relationship before Brexit. Broadly the options are:

• Staying in the Single Market as a non-EU member of the European Economic Area (EEA). Non-EU members of the EEA are currently Norway, Iceland and Liechtenstein. Whilst they comply with the rules of the Single Market, they retain control in many key policy areas, including farming and fishing, and they can negotiate their own trade deals.

• Negotiating a bespoke trade agreement for the UK.

• Trading under World Trade Organisation (WTO) rules, as a default.

"Given that the Leave campaign majored on the need to control immigration, it would be surprising if the UK stayed in the Single Market on Brexit."

Single Market

The Single Market comprises the “four freedoms”:

• Goods: companies can sell their products anywhere in the member states and consumers can buy where they want with no penalty.

• Services: professional services such as banking, insurance, architecture and advertising can be offered in any member state.

• Capital: currencies and capital can flow freely between the member states.

• People: citizens of the member states can live and work in any other country and their professional qualifications should be recognised.

Advocates of staying in the Single Market emphasise the importance of membership in order to gain “access” or, even more mysteriously, “full access” to the Single Market. But the commercial reality is that all non-EEA countries which trade with the EEA, whether with a trade agreement or under WTO rules, have “access” without being Single Market members.

Single Market membership comes with, arguably, two large drawbacks: the obligation to adopt Single Market regulations and the inability to control immigration from the EU. Given that the Leave campaign majored on the need to control immigration, it would be surprising if the UK stayed in the Single Market on Brexit.


1 Daily Mail, “No deal, says nurse in charge of EU trade”, 2 July 2016.

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Bespoke trade deal

There is much to recommend in a bespoke trade deal in order to minimise trade disruption for both UK exports to the EU, and EU exports to the UK, on Brexit. Specifically, this would, at the minimum, seek to include:

• A Free Trade Agreement (FTA) with the r-EU (“remaining EU”) in order to retain tariff-free goods trade with the EU. Whilst the EU’s trade-weighted average Common External Tariff (CET) is currently low2, it is running at 10% for motor vehicles. At the very minimum, tariff-free trade should be negotiated for the car industry.

• An agreement on “regulatory equivalence” for financial services, which would act much as “passporting” does now for EEA members.3 Helpfully, MiFID II (Markets in Financial Instruments Directive II), which will be implemented in January 2018, contains equivalence provisions. Special arrangements could be made for other services, but these are not as significant for the UK as financial services, and they should not be regarded as priorities.

It is sometimes claimed that the UK would be obliged to pay into the EU Budget and/or accept freedom of movement of people if there were to be a trade deal. But neither of these is necessary. Granted, Norway and Switzerland contribute to EU programmes, but they do not pay into the EU Budget as they are not EU members. And the UK may or may not contribute to EU programmes after Brexit. Granted, too, Norway and Switzerland have freedom of movement of people (Norway because it is in the EEA and Switzerland has a bilateral agreement), but the EU has around 35 trade agreements with 3rd countries that do not involve freedom of movement. These agreements include those with Turkey, Korea, Mexico and Chile.4

Another question that frequently arises is whether this British “bespoke deal” would be feasible to negotiate if the UK were not prepared to “pay” for “access”. Some argue that UK markets matter comparatively little to other EU Member States because the ratio of their exports (goods and services) to the UK as a % of EU GDP is only around 3% whilst UK exports to the EU accounts for around 12-13% of UK GDP. This fact, so it is said, would weaken the UK’s position in any trade negotiations with the EU after a Brexit vote. The UK would, in effect, be a supplicant. But this is to ignore the significance of the UK’s sizeable deficits with the EU in general, and the political significance of the EU countries with which the UK runs large deficits, in particular.

In 2015 the UK had a visible trade deficit of £88.7bn with the EU, £31.5bn with Germany alone (the Netherlands, Belgium, France, Italy and Spain all had goods surpluses with the UK).5 No German exporter would want any disruption in their trade with their lucrative British markets because, quite simply, it is not in their commercial interests. Assuming a German Government would wish to promote German economic interests, and Germany is Europe’s hegemon, a deal would surely be agreed expeditiously. Another factor favouring the likelihood of an expeditious settlement is that the UK, an EEC/EU member since 1973, is also fully harmonised with the EU.

Concerning financial services, European financial institutions benefit from locating key global operations in London, Europe’s undisputed premier global financial centre with an unrivalled talent pool and global reach in Europe. There is no EU alternative centre of such importance. European financial institutions would, therefore, be commercially disadvantaged if their trading activities currently located in London were hampered and/or disrupted after Brexit.


2 House of Commons Library, “The economic impact of EU membership on the UK”, SN/6730, September 2013, reported that the EU average (trade-weighted) tariff was about 1%. 3. The ‘passport’ means that financial services firms authorised in the UK can provide their services across the EU/EEA, without the need for further authorisations. It also means that the main regulatory responsibility for UK firms’ activities across the EU/EEA remains with UK regulators rather than moving to other EU/EEA regulators. The EU’s financial services passport is currently only available to firms authorised in EU/EEA countries. Other international firms, therefore, need to establish a subsidiary in at least one Member State, such as the UK, in order to benefit from the passport. 4 Ruth Lea, “Britain would benefit from new trade deals capitalising on Britain’s trading strengths”, Arbuthnot Banking Group, 15 February 2016, discussed the EU’s and EFTA’s trade agreements. 5 ONS, “UK trade, April 2016”, 9 June 2016.

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It is in the commercial interests of these institutions, as well as the City’s, that trade continues unhampered and undisrupted after Brexit. “Regulatory equivalence” should be all but automatic given the UK currently complies with EU regulations.

WTO default option

As already indicated, trading under WTO rules has proved very satisfactory for many of the EU’s trading partners that currently do not have dedicated trading agreements with the EU. But the UK would face the EU’s Common External Tariff which is 10% for cars, as already indicated. If trading under WTO rules, the UK government could well decide to impose similar tariffs on the EU’s exports to us in order to maintain a

“level playing field” for the UK car industry, raising import prices. Similarly, if there were no comprehensive “quasi passport” for financial firms, financial institutions located in London would be incentivised to establish economically significant subsidiaries in EEA countries in order to continue to benefit from the EEA passport. The City would lose business.

Leaving the EU: other trading implications

There are four other aspects to the UK’s trading relationships on Brexit:

• The first relates to the EU’s FTAs with 3rd countries. Providing there were mutual agreement, these FTAs could continue for the UK on Brexit. They are, however, not economically important except for Switzerland, Norway, Korea and Turkey.

• The second relates to the new freedom the UK would have to recalibrate its future trading patterns towards the world’s growth markets. Outside the EU’s Customs Union, the UK will once more be able to negotiate its own trade deals with favoured trade partners including the US and key Commonwealth countries.

• The third relates to the freedom the UK would have to apply to re-join the European Free Trade Association (EFTA), which comprises Switzerland, Norway, Iceland and Liechtenstein. Not merely would this be mutually beneficial in itself, but the UK could also have access to EFTA’s suite of trade agreements (again, providing there were agreement). EFTA’s trade agreements are more comprehensive and more in tune with the UK’s trading patterns than the EU’s.


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• And, finally, once outside the EU’s Customs Union, the UK will be able to decide its own external tariffs, though note they would have to be non-discriminatory between third countries under WTO rules. The EU has relatively high tariffs on agricultural products and clothing and footwear, as it seeks to protect these industries against low cost producers. A future UK government could decide to slash the tariffs on these products, giving a boost to consumers, preferring instead to support its domestic producers directly.

Leaving the EU: other trading implications

Finally, on Brexit, there are three other issues to consider:

• Even though the British Government would probably continue to comply with EU regulations on Brexit (there would be no immediate “big bang”), after Brexit the UK would be in a position to amend/repeal business-impeding regulations in order to give the economy a competitiveness boost. (This assumes the UK leaves the Single Market.)

The UK could, for example, decide to choose a more liberal regulatory path vis-à-vis financial services to boost non-EU financial services trade, though this would risk “regulatory equivalence” with the EU/EEA. Exporters to the EU would, of course, have to continue to comply with EU product regulations and standards, as indeed exporters to the US have to comply with US product regulations and standards.

• Again assuming the UK leaves the Single Market, the UK would resume control over immigration policy. It could then implement a bespoke policy that does not discriminate between EU and non-EU nationals, and one more appropriate to the country’s economic needs and social pressures.

• And the UK would continue to benefit from non-payment to the EU’s Budget, though as indicated above it may decide to contribute to some of the EU’s programmes. The Treasury estimated that net contributions (after the rebate and public sector receipts) were about £8.5bn in 2015. By any standards, this is a useful saving on the balance of payments and contribution to the Exchequer’s coffers.


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The Two Races in Washington

The 2016 United States of America Presidential Election is set. On one side, the Democratic Nominee and former Secretary of State, Hillary Clinton, aims to extend her party’s seat in the Oval Office and become the first ever female President. Meanwhile the Republican Nominee, Donald Trump has his sights set on a transition from the Boardroom to the Situation Room to complete a truly astonishing political ascent. In this article we aim to strip back the posturing and bravado to evaluate the underlying policy behind each campaign and the likely route to victory whilst also analysing another key battle: United States Congress.

The ideologies documented in Hillary Clinton’s manifesto paint her as a progressive liberal. The issues she addresses in her candidacy cover 31 topics ranging from early childhood education to seeking a cure for Alzheimer’s disease by 2025. As former Secretary of State, National Security should, in principle, be a strength in Clinton’s campaign. She emphasises the need to restore America’s leadership in the world with a framework that includes ‘establishing a strong foundation, keeping our homeland secure, making sure that our military is on the cutting edge and following a vision for America that is centred on our core ideals.’

Whilst there is no denying Hillary’s experience and efforts in such crusades she is likely to come under significant pressure from Democrats for her support of the Iraq War as a Senator, U.S. intervention in Libya and proposals to ‘double-down’ in the Syrian conflict by imposing a no-fly zone. Mishandling of classified information via a personal email account is likely to come to the forefront of the debate on security.

"Clinton outlined five goals to mitigate ‘dysfunction’ in Washington and boost economic growth and jobs.

In a recent speech delivered from Rayleigh, North Carolina, Clinton outlined five goals to mitigate ‘dysfunction’ in Washington and boost economic growth and jobs. Her plan begins with a promise that her first 100 days in office will be utilised to form a ‘jobs package’, the heart of which will be the ‘biggest investment in new good-paying jobs since World War II’ by establishing an infrastructure bank designed to stimulate private sector investment. Other pledges include a 15% tax credit for companies that share profits with employees, and raising the minimum federal wage to $12.


Mats Arthursson Director, Investment Management

Sam Carleton Investment Manager

Left: Hillary Clinton

© Jared Polin

Right: Donald Trump

© Matt A.J.

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Most interesting is Hillary’s new stance on the Trans-Pacific Partnership (TPP), a trade agreement with 30 chapters of policy between twelve Pacific Rim counties which she endorsed in 2012 as the ‘gold standard’. Her U-turn comes amidst worry that there is no premise for currency manipulation in the agreement. The North American Free Trade Agreement, signed by Bill Clinton in 1996, is still widely criticised for its frailty which could explain the hesitation to attach her campaign to any similar agreement.

"Healthcare is likely to be fiercely debated following the implementation of the Affordable Care Act."

Healthcare is likely to be fiercely debated following the implementation of the Affordable Care Act during Barack Obama’s tenure, which Republicans have aggressively repealed. The act, otherwise known as ‘Obamacare’, has been publicly supported by Clinton who has ambitions to extend its reach to put pricing pressure on Pharmaceutical companies. Further expansion includes tax credits of up to $5,000 per family to cater for premium costs above 5% of income.6

Under the slogan ‘TRUMP – MAKE AMERICA GREAT AGAIN!’, Donald Trump’s policies are simplified into seven categories. One of these is named ‘Pay for the Wall’, which cites the Patriot Act and leads into a three-day provision to restrict wire transfers and prevent ‘$24 billion a year in remittances from Mexican nationals working in the United States.’ These restrictions will be lifted if Mexico makes ‘a one-time payment of $5-10 billion’ to construct the wall. According to Mr Trump this is an ‘easy decision for Mexico’. Perhaps we should begin analysing cement producers along the Mexican Border!

Like Clinton, Healthcare reform is also high on the Republican candidate’s agenda. However, Donald wishes to repeal Obamacare and allow insurance premiums to be tax deductible.

Intentions to ‘remove barriers to entry into free markets for drug providers that offer safe, reliable and cheaper products’ and ‘price transparency from all healthcare providers’ are both aimed at reducing costs in addition to a ‘block-grant’ to individual states for management of the Medicaid system. The Trump campaign also plans to restrict the use of healthcare services by illegal immigrants, which they believe has cost the United States $11 billion.

One of Donald’s key actions to ‘make America great again’ is to ‘reform’ trade relations with China, whom he accuses of ‘the greatest theft in the history of the world’, blaming current leaders for being ‘grossly incompetent’. The plan to combat such ‘theft’ is to firstly declare China as a ‘currency manipulator’ and fight intellectual property violations which Trump estimates to have cost Corporate America over $300 billion. He then plans to hold China to account for ‘illegal export subsidies’ and their ‘disregard for WTO rules’. Part of the strategy to achieve favourable trade terms with China is to deploy the military in the East and South China Seas. Subsequently the corporate tax rate will be lowered to 15%.

"One of Donald’s key actions to ‘make America great again’ is to ‘reform’ trade relations with China."

Other tax reforms proposed by Trump are quite drastic. In his view, simplification of the tax code and tax relief is key. The simpler version comes in the form of four tax brackets, 0%, 10%, 20% and 25% instead of seven currently in place whereby the highest rate is 39.6%. ‘If you are single and earn less than $25,000, or married and jointly earn less than $50,000, you will not owe any income tax.’ Instead of paying any income tax Mr Trump proposes those eligible will be able to complete a form to Inland Revenue Service saying ‘I win’.


6 https://www.hillaryclinton.com/issues/ - all policy references attained from Campaign Website.

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Following the tragic events in Orlando one of the more controversial stances Donald takes regards Gun Reform. He categorically supports protecting the second amendment right to bear arms and believes enforcement on gun violence should be stricter. He also notes that the mental health system is broken, blaming current politicians for ignoring ‘red flags’ that lead to gun crime. Finally, he does not advocate the need for more extensive background checks to purchase arms, instead prefers a 'National Right to Carry’, whereby concealed carry permits are valid in all 50 states.7

The latest polling data has Clinton ahead of Trump by a margin of 45.3 to 39.1*. With 270 Electoral Votes required to win, she has strong support from Democratic strongholds such as New York (29), California (55), Illinois (20) and Washington (12). Louisiana (8), Montana (3) and South Dakota (3) are viewed as concrete votes for Trump, whilst states that lean to his side such as Texas (38), Missouri (10) and Indiana (11) will be crucial to catch Hillary. 13 states are currently classified as ‘swing states’, whereby there is no indication on how the vote will go. If we analyse these states against the 2012 Election, out of the 13, 10 of these states voted for the Democrats and 3 for the Republicans.

Key areas to target on the campaign trail will be Florida, Pennsylvania and Ohio where a total of 67 votes could build valuable momentum. Whilst Clinton is generally viewed as the likely successor, Donald Trump should not be written off. After all, he conquered greater odds to become the Republican candidate.8

The battle for U.S. Congress control is also set to be intriguing. A total of 469 seats are up for election in November, 34 Senate seats and 435 in the House of Representatives, with the Republican Party holding control in both houses. However, this cycle looks to be a challenging one for the GOP. Out of the 34 seats in the Senate up for re-election, 24 are held by Republicans. The Democrats require 4 seats to take a majority if Clinton wins the Presidency, as the Vice President is Chairman of the Senate and will have the deciding vote in the event of a tie. Interestingly, three swing states (Pennsylvania, Ohio and Florida) outlined earlier in the Presidential Race are also key battle grounds in the Senate.

In Florida, Marco Rubio, former Republican Presidential Candidate, faces a battle with relatively unknown Democrat, Patrick Murphy, a Certified Public Accountant who has the backing of Vice President Joe Biden and well-respected Congressman, Barney Frank.


7 https://www.donaldjtrump.com/positions - all policy references attained from Campaign Website. 8 http://www.realclearpolitics.com/, accessed June 2016

139 http://www.270towin.com/2016-senate-election/, accessed June 2016

In such a political mismatch Murphy should really not be a significant threat to Rubio, however polling suggests a tight race, 43.7-41.7* in favour of Rubio in what would be a big fall should he lose. The Ohio Senate seat is seen to be even tighter, with Republican incumbent Rob Portman leading Democratic challenger Ted Strickland 41.0-40.5*. Key to this race is Portman’s support of free trade agreements with China which many believe have hurt middle and lower class citizens in Ohio. Strickland has capitalised on this labelling Portman as ‘the best Senator China has ever had’ in a TV Advert. Finally, Katie McGinty aims to be Pennsylvania’s first female Senator; she has a strong track record serving as Secretary to the Department of Environmental Protection whilst also acting as Chief of Staff to the state’s Governor. The incumbent is Republican Pat Toomey, who holds a 44.5-39.5* margin in the latest poll. One of the interesting facets of this race is Barack Obama’s nomination of Judge Merrick Garland to the Supreme Court. Pat Toomey, with other Republican colleagues, wish to delay such action in case Donald Trump wins the Presidential Race whereby they will then have the ability to nominate a judge more akin to their views. Importantly, Public Policy Polling in Pennsylvania has shown that Toomey’s opposition has meant 40% of those surveyed would be less likely to vote for him.9

In the House of Representatives, the Republican Party have a majority of 247 seats to 188 for the Democrats, a much more secure margin. So why is all this important? Barack Obama’s two terms shows how difficult it can be to pass new legislation when opposing parties hold each position. During this period, 614 closure motions were filled to block new bills. If we compare this to George W Bush’s tenure only 340 motions were filled. Therefore, it is reasonable to conclude that not controlling Congress can have a huge impact on a President’s power and effectively cause ‘gridlock’ for up to 8 years.

"Barack Obama’s two terms shows how difficult it can be to pass new legislation when opposing parties hold each position."

As Investment Managers, our role is to analyse the potential outcomes of these two elections and evaluate the likely impact on markets. History has shown that equity markets generally respond well to the Republican Party victory as their ‘business-friendly’ mantra is seen a positive in the eyes of Wall Street. This time however, with Donald Trump as candidate, perception could be very different. His hostile rhetoric on free trade is anything but business-friendly. Opposing the Trans Pacific Partnership and North American Free Trade Agreement could have profound economic implications. Meanwhile, deporting millions of illegal immigrants will not only be very difficult to do, but would also likely damage a key source of labour for small businesses across the country. On the other side of the argument, a Hillary Clinton victory could also spell drastic change. Such effects have been evident from her pressure on Pharmaceutical Companies to lower prescription drug prices. Whilst we would not argue the merits of such action for the consumer we need to be cognisant of the impact to research and development and how lower margins are likely to affect employment. In general, businesses (and therefore markets) prefer consistency. Drastic change in policy creates a level of uncertainty which hampers accurate budgeting and therefore has the potential to stifle growth. Therefore, we believe that a Hillary Clinton victory with the Republican Party holding Congress will allow the ‘status quo’ to continue and provide the best political landscape for economic growth.

*All polling data accurate as of 30.06.2016 according to Real Clear Politics.


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Negative Interest Rate Policy & the 'Helicopter Drop'

The concept of negative interest rates is in itself counterintuitive as many struggle to wrap their heads around a policy that essentially penalises savers and pays borrowers. With negative interest rate policy (NIRP) implemented by the central banks in Japan, Denmark, Sweden, Switzerland and Europe, it is worth exploring what it is and why it has become an increasingly prevalent monetary policy tool for central banks.

Simply put, NIRP is a decision to set nominal target interest rates at a negative value with the aim of stimulating aggregate demand by encouraging lending. Whilst the concept of negative nominal interest rates is somewhat unconventional, negative real rates (i.e. the difference between the nominal interest rate and the rate of inflation – negative when inflation is greater than the prevailing interest rate) are fairly normal.

"Cash might quite literally ‘go under the mattress’."

Before going any further, it is important to stress that negative interest rates will not be coming to the high street with consumers being charged to deposit cash. Rather, the purpose of NIRP is to promote interbank lending by making it cheaper for banks to lend to corporates than place cash, above their reserve requirement, on deposit with the central bank. It also encourages banks to buy alternative assets, putting upward pressure on prices.

The availability of more and cheaper credit should encourage borrowing, increase consumption and aggregate demand, hence stimulating economic growth. Furthermore, negative interest rates can be used to weaken the domestic currency; as ‘hot money’ flows to other regions with higher returns, exports become increasingly attractive and the price of imports rises causing inflation (or perhaps more accurately in today’s world, reducing deflation).

Theoretically, negative interest rates should stimulate growth but it is important to note that this is somewhat of an ‘experiment’ for central banks who find themselves battling stagnant growth coupled with a deflationary environment, a scenario not substantially encountered before. Perhaps the most obvious consequence of NIRP is that cash might quite literally ‘go under the mattress’, however this is unlikely insofar as banks remain reluctant to pass on negative rates to their customers.

"The purpose of NIRP is to promote interbank lending by making it cheaper for banks to lend to corporates."

Other implications of NIRP include the spill-over effect into fixed income securities; the introduction of negative policy rates have already been accompanied by negative yields on government bonds, particularly at the shorter end of the yield curve. Additionally, negative rates may erode bank profitability by narrowing banks’ net interest margins (the difference between the interest they charge on lending and the interest they pay on deposits), as well as encouraging excessive risk-taking by banks and investors in search of a positive yield.

"Some worry that lower rates may not be the solution to our global economic problems."

As with any policy, unforeseen circum-stances may still come to light and undoubtedly there must be a floor to the extent which rates could fall. Whilst it is too early to judge the effectiveness of NIRP, some worry that lower rates may not be the solution to our global economic problems, and that rather they may be to our detriment. If this is indeed the case, what ammunition are the world’s central banks left with?


Farah Hertog Investment Managers’ Assistant

Richard Mitchell Senior Investment Manager

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Helicopter Money

With traditional policy options looking increasingly limited for governments and central banks to stimulate their faltering economies, more extraordinary measures must be considered.

Helicopter Money (more formally referred to as monetary financing) is a concept first popularised by economist Milton Friedman in 1969. In his paper, “The Optimum Quantity of Money”, he articulated the following thought experiment:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of this community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”

However appealing this notion may sound, particularly if you foresee yourself as one of the individuals fortunate enough to be underneath this benevolent helicopter, one would assume that in reality it is a rather fanciful idea. In truth though we are already in uncharted waters with regard to expansionary fiscal and monetary policy, and Helicopter Money actually shares many common traits with another, more familiar (albeit still extraordinary) policy, Quantitative Easing (QE). Helicopter Money can be equated in broad terms to QE plus fiscal stimulus, with a permanent expansion of the monetary base (the central bank’s balance sheet).

In essence, Helicopter Money, as it would likely be applied in the modern economy, would be implemented as follows:

1) The Central Bank creates a new deposit balance, say $100 billion (effectively

“printing money”).

2) The Central Bank uses this newly created balance to purchase an equivalent amount of debt from the Treasury, effectively transferring the $100 billion balance to the government.

3) Any interest earned by the central bank from this debt will be returned to the treasury, and the debt will be held until maturity, with the principal amount at some point remitted back to the government as well. Essentially this will serve to move the newly created money to the treasury whilst permanently expanding the monetary base.

4) The government will use this $100 billion to fund tax cuts, infrastructure projects or other meaningful public works.

5) This should serve to transfer the money created by the central bank (via government and fiscal policy) to the consumer, consequently increasing demand and consumption, as well as stoking inflation.


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The crucial difference between this process and QE is that with QE the newly

“printed” money is used to purchase financial assets in the secondary market, with a view to them being sold at some point, and the newly created money eventually withdrawn from circulation. With Helicopter Money, this newly created money remains in circulation, permanently expanding the central bank’s balance sheet and the monetary base. Helicopter Money in theory should provide a more effective transmission mechanism for transferring central bank stimulus into private sector demand.

One of the greatest challenges for implementing this theory in practice is the co-ordination of action and co-operation between the central bank and the government. Whilst theoretically this doesn’t seem to present too great a challenge, it cannot be overlooked that the independence of a modern central bank from its home government is a central tenet to the effective working of the modern financial system.

In addition, the aims of these two participants can be markedly different, with central banks generally looking to provide long-term financial stability and manage inflation; whilst elected governments are more inclined to look for shorter-term gains within the electoral cycle.

However, the fact remains that the policy tools applied so far don’t seem to have had the desired effect of significantly stimulating consumption or growth. Traditional QE could be argued to have achieved little more than asset price inflation, and NIRP is yet to demonstrate any real positive effects beyond anchoring the yield curve lower.

As such, Helicopter Money in some form is a significant possibility as governments and central banks strive to deliver policy solutions in an attempt to resolve the problems that continue to weigh on the global economy.


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Brazil – Lessons from a divided country

Brazil has been under the spotlight for a few months now. The country will host the Olympics in August and is facing significant political turmoil with elected president Rousseff having been removed from government. The impeachment process is still not finalised, subject to a final Senate vote expected for August. Impeaching a president is neither a trivial thing nor an easy process in a presidential system. As much as Ms Rousseff’s supporters make the point that her impeachment was a coup organized by the local elites, six million people went to the streets to protest against the government, and the impeachment process was triggered by the MPs and the Senators voting for an investigation to be made. To be impeached, the president must be involved in illegal activity, so the case being investigated was initiated by Rousseff’s party’s (PT) founder and it states that Rousseff concealed the country’s fiscal deficit to win the elections in 2014. Rousseff’s defence claims that window dressing is a common practice, also used by her predecessors. Of course, this does not absolve Rousseff of her responsibilities, so as the investigation commission accumulates evidences that she was aware of the window dressing, the most likely scenario is that the impeachment vote will go through successfully in the Senate.

"Over the course of 15 years Brazil had 2 external defaults, 5 currencies, 13 Ministers of Finance and an accumulated inflation of 13,342,346,717,617.70%."

Let’s go back in history to understand how we got here. Brazil lived in a military dictatorship from 1964 to 1985 and during the 70s it faced an “economic miracle”, posting double-digit GDP growth at the cost of hyperinflation ravaging the country over the coming years. Over the course of 15 years Brazil had 2 external defaults, 5 currencies, 13 Ministers of Finance and an accumulated inflation of 13,342,346,717,617.70%.10 In 1992, the second president elected of the

“New Republic”, Fernando Collor, almost faced an impeachment and resigned. The vice president at the time, Itamar Franco, succeeded him and after several unsuccessful attempts to contain inflation appointed Fernando Henrique Cardoso (FHC) as Finance Minister.


10 LEITAO, Miriam. Saga Brasileira, a luta de um povo por sua moeda. 2011

Aerial view of Rio de Janeiro

© dislentev Source: iStock

Thais Batista Senior Research Analyst

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FHC was the fourth Finance Minister in one year and was responsible for creating Plano Real, which took inflation down from 5,000% to under 10% per year. Inflation was an obsession for the Brazilian society and this durably marked the population’s mindset, and Brazilians’ consumption and savings habits.

FHC ended up running for elections in 1994, becoming the president for two mandates, from 1995 to 2003. The FHC government was replaced in 2003 by Luiz Inácio Lula da Silva, known (simply as Lula), a former trade union leader who scared the markets before he assumed power. His tenure was the inverse of what everyone expected - Lula invited Henrique Meirelles, a previous banker with an orthodox posture, to be the Brazilian Central Bank (BCB) governor. Lula hired a competent administration team and Brazil navigated the following eight years (two tenures) brilliantly. Those years coincided with the commodities boom; the BCB kept inflation under control, Brazil paid its external debt and the Workers Party (PT) put social policies in place that contributed to a significant improvement in social inequality. Lula’s obvious successor was his right-hand man, Jose Dirceu, previously an activist during the dictatorship days. Dirceu was caught in a corruption scandal in 2005 and Rousseff’s name appeared as someone loyal to Lula and to PT.

Rousseff was not a politician; she had never run an election, and held managerial posts in the government - Minister of Energy and Chief of Staff during Lula’s tenure. Rousseff also had an impressive life story – she was an activist during the dictatorship days, and was arrested and tortured. She won the 2010 elections promising a continuation of her predecessor’s success, but the reality played out differently from expected again.

"Operation Car Wash evolved with Federal Police uncovering a billionaire corruption scheme at Petrobras, the country’s largest oil company."

Rousseff’s first tenure marked the top of the Bovespa index and the bottom of the BRL-USD. Brazil firstly suffered with Chinese growth peaking and commodities prices going down, as more than half of its exports are commodities and primary products, whilst China is its largest trading partner. The government responded by cutting rates during 2011-12 to the historical minimum of 7.25%; it also cut taxes on sectors including autos and white goods, stimulated credit and fiscal spending. The hangover kicked in as the country’s fiscal deficit deteriorated, inflation accelerated and GDP growth has been negative since 2014. This should be enough to conclude that Rousseff’s life was not easy when she was running for re-election in 2014 and to make matters worse, one week before elections, a major corruption scandal involving Rousseff’s party (PT) surprised the country. The investigation called “Operation Car Wash” started looking at money laundering practices in petrol stations and evolved with the Federal Police uncovering a billionaire corruption scheme at Petrobras, the country’s largest oil company. Elections results were tight, Rousseff won with 51% of the vote and the narrow margin explains why the country has been divided ever since.


Brazilian President under impeachment,

Dilma Rousseff

Source: Flickr © Blog Do Planalto

Photo by Roberto Stuckert Filho/PR

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Rousseff’s advocates point to the decrease in inequality as the major achievement of the PT government, which is true and backed by the numbers, but the opposition sees with fear the destiny of Brazil as similar to Venezuela (please see Around the World on page 20). The populist governments of Chavez and Maduro took Venezuela to a state of calamity, despite the country sitting on the largest oil reserves in the world. Since elections in 2014 the “Car Wash” investigation evolved and took down a number of politicians; many were part of the government coalition parties PT-PMDB, but names from the opposition party PSDB were also involved. Looking at the news over the last two years, we had a daily feed of corruption schemes being revealed, accusations being made and Swiss accounts being uncovered, and this all heavily affected the population sentiment towards the government. So even if the specific case behind Rousseff’s impeachment is not cast in iron, the general dissatisfaction with the current government is so high that it took us to where we are now.

"A sovereign default scenario is not expected over the next few years."

The bad news is that the current government ruling Brazil is not very different from the previous one. Rousseff’s vice president Michel Temer (PMDB) has succeeded her as interim until the impeachment vote is confirmed in Senate. Just using common sense, one might think that whatever Rousseff is being accused of, Temer was likely complicit in as her deputy. Another impeachment request was made calling to annul the previous elections, but it did not get traction. The good news is that an interim government is probably the most adequate to take difficult decisions and to put hard measures in place. Temer has appointed Meirelles (Lula’s previous BCB governor) to be the Finance Minister and hired Ilan Goldfajn as the new BCB governor.

Markets cheered the two nominations as regardless of the size of the challenge; it was felt any option was better than what we had before.

"The bad news is that the current government ruling Brazil is not very different from the previous one."

In a world without inflation, the Brazilian national enemy is still the same. Despite 20 years of stability, hyperinflation has impacted three generations and Brazilians live with a deep-rooted fear of any risk of inflation coming back. This phenomenon gives investors a very good opportunity: Brazilian local base rates are 14.25% while the last inflation number was 9.3%, which means real rates of 5%. This is just lower than Uganda, Belarus, Ukraine, Ghana and Argentina. Despite the current political situation being far from ideal and the country’s fiscal balance facing a 10% deficit over GDP, government debt over GDP is still lower than most developed nations (69%), the level of international reserves is comfortable and Foreign Direct investment (FDI) is positive while the exchange rate adjustment is affecting positively the trade balance and the current account. Therefore, a sovereign default scenario is not expected over the next few years. Based on this and on the possibility of political change, Brazilian local government bonds looked rich a few months ago and have already enjoyed a rally on the back of the currency strength. Rate cuts should provide more upside in case inflation recedes, but the realisation of a rosy long-term scenario for equities is still a question mark. The domestic credit situation also requires some attention, given corporations and consumers were caught by the abrupt change of the macroeconomic environment.

More than ever, understanding and monitoring fundamentals and politics are essential for successfully investing in the country. As Tom Jobim correctly says, Brazil is not for beginners.


Around the World

Global Markets

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Germany Yielding to Pressure

The German 10-year bund yield has, for the first time ever, turned negative. This makes Germany the latest of several countries that have entered this territory, including Japan and Switzerland.

This phenomenon is thought to be due to a combination of factors, primarily the ECB bond-buying programme and the added uncertainty surrounding the ‘Brexit’ referendum.

It first dipped below zero on June 14th before rising slightly, but on June 24th it fell again and is now in solidly negative territory. There is now speculation that other countries’ medium to long-term debt yields, such as those of Belgium, Austria and the Netherlands, will follow suit.

Rajan's Departure

The governor of India’s central bank, the Reserve Bank of India (RBI), has been ruled out of a second term. Raghuram Rajan, a well-respected academic, took over in 2013 and will step down when his tenure expires in September.

The decision has dismayed international investors in light of the progress he has overseen, spearheaded by his monetary policy reforms which helped to harness inflation and attract significant inflows of foreign investment.

Rajan was subject to criticism from within Modi’s ruling Bharatiya Janata Party (BJP) who resented the rise in interest rates and the rules he introduced around banks’ lending in a bid to control the bad loans prevalent throughout the system.

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Around the World

Maritime Rivalry in the Far East

Tensions are continuing to run high in the South China Sea owing to territorial disputes between China, Vietnam and the Philippines, amongst others. These centre on potential natural resource reserves in the area, including rich fishing grounds, and control of critical shipping lanes: the Strait of Malacca between Malaysia and Indonesia carries around 25% of the world’s traded goods.

China continues to flex its muscles by reclaiming, building and operating air bases on islands in the region. Indonesia was recently accused of opening fire on a Chinese fishing vessel in disputed fishing grounds near Borneo; the US is keeping a close eye on developments whilst maintaining a Navy presence in the area.

Further Violence in Nigeria

The Niger Delta Avengers, a militant group in Nigeria, has denied entering into a ceasefire with the Nigerian Government, despite earlier reports to the contrary. The group have claimed responsibility for a number of attacks on the country’s oil facilities, and desire a larger proportion of the oil wealth that Nigeria earns to be invested in the delta region, as well as potentially an independent state. Nigerian oil output had fallen to around a 30-year low as a result of the attacks, to approximately 1.4m barrels/day in May, compared to 2.0m in 2014. The situation worsened when President Buhari cancelled a trip to visit the region, heightening local feelings of political and economic marginalisation.

Democratic Trouble in Venezuela

Political and economic strife endures in Venezuela. President Nicolas Maduro and his Socialist party continue to cling to power despite a recent petition that would set in motion the process for a recall general election being signed by almost two million Venezuelans. Verification of the signatures is ongoing, but guarantees are scarce.

Meanwhile, protests continue due to crippling shortages of basic goods including foodstuffs, spare parts, homewares, and medical supplies. Several global airlines have suspended flights to the capital, Caracas, citing the ongoing economic difficulties, whilst inflation is expected by the IMF to hit 720% in 2016.

Given the country’s reliance on hydroelectric power, a persistent El Nino-related drought has exacerbated the country’s electricity shortages, forcing an extension of the two-day working week for public sector employees and worsening existing blackouts.

Another Inconclusive Election

Although Spain’s second election has again produced a hung parliament, gains were made by acting Prime Minister Mariano Rajoy and his centre-right People’s Party (PP). They increased their share of the vote from 29% to 33%, resulting in a gain of 14 parliamentary seats to 137.

This was still short of the 176 seats needed to form a majority; however, the failure of Unidos Podemos, the new far-left party who surged into parliament in last December’s elections, to consolidate their growth by overtaking the more traditional Socialist PSOE, is considered as evidence of the success of Rajoy’s and the PP’s new policies.

Nobody wants a third election, so weeks of talks lie ahead as Rajoy continues to pursue a German-style “grand coalition “, which socialist leaders have previously rejected.

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The Asset Markets

A Quarterly Review of the Major Asset ClassesAll data sourced from Bloomberg unless stated otherwise.

Developed Market Equity

Performance: Global equity market performance in the second quarter of the year was dominated by the UK referendum held on 23rd June. UK equity markets suffered in the immediate aftermath of the result, albeit not as substantially as one may expect. The largest exchange traded companies in the UK are predominantly made up of multinationals, and with sterling weakness amplifying the value of overseas revenues, it is not surprising to see a rise in headline levels in Sterling terms, with large cap indices rising by over 5% in the quarter. This compared with a fall in value of domestically focused UK corporates, reflecting a heavier weighting to those most likely to be affected by BREXIT, and a better barometer of the UK corporate picture. US equities performed relatively robustly, particularly when viewed in sterling terms due to the appreciation of US assets after taking into account Sterling’s devaluation.

European markets were similarly affected, with economic and political uncertainty pushing out risk premia on equity assets leading to declines of around 3% in most European equity markets after reasonable gains had been made in the first two months of the quarter. Similar to the UK, the leading detractors were financial stocks.

Japanese equities suffered from the inverse effects of the UK referendum. The Yen strengthened materially at the end of the quarter, which in turn undermined valuations of Japan’s equities that had already suffered from a further delay in an expected increase in the government’s programme of Qualitative and Quantitative Easing (QQE).

The Topix 500 fell 9.7% in June, making Japan the worst-performing of all developed markets in local currency terms, however for UK investors, this was more than accounted for by a simultaneous 18% weakening of Sterling versus the Yen.

Valuation: In the UK, accurate valuation multiple assessment is difficult in an environment where currency rebased earnings have fluctuated so much. Without doubt the market has de-rated, but until we see clarity on underlying earnings and a stable FX rate it will be difficult to quantify market valuations at an aggregate level because of the extent of the UK market’s overseas exposure. Understandably, many individual stocks have seen substantial downgrades as growth potential falls away, in particular banks, insurers and housing market-exposed companies.

European equities were similarly affected, with earnings forecasts clouded by political and economic uncertainty. Forward Price to Earnings (P/E) multiples have dropped to near 14x on the European Stoxx 50 index, versus highs of over 16x in mid 2015.

In the US, median P/E valuations of circa 18x remain elevated versus all other developed markets, and the US remains the most expensive on a comparable basis. US large cap equities are expected to record their fourth straight quarter of year-on-year earnings decline and the jobs market has recently shown signs of weakness; however, investors have proved remarkably optimistic.

Japanese equities have cheapened more substantially, with a current P/E ratio of falling to 15x and a Price to Book (P/B) ratio that has fallen to a 4 year low of 1.11, but divergence is profound at an industry level.

Global Markets

Total Return % Change, Local Currency

3 month % change 6 month % change 12 month % change

MSCI United Kingdom +5.4% +4.2% -0.9%MSCI USA +2.0% +2.4% +1.0%MSCI Europe ex UK -2.7% -10.1% -12.7%MSCI Japan -7.9% -20.3% -25.0%

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The Asset Markets

Pharmaceuticals and Healthcare remain very highly valued on a P/E of almost 40x, having been the best performing sector in the last 12 months, whilst Financial Institutions and particularly Banks have seen the most pain as they try to adjust with the new negative rate environment. This is reflected in their valuation with a P/E of 7.5x.

Outlook: For some time to come we expect the outlook for UK corporate earnings and equity markets to be dominated by greater political and economic uncertainty. If we continue to see further currency volatility we can expect a sustained premium in companies with substantial overseas earnings, whilst without much clarity on the future economic outlook, UK-centric stocks can remain depressed for some time. Recent company guidance has been of understandably poor quality, with each focusing on foreign exchange and economic uncertainty over any substantial outlook. There will without doubt be substantial opportunities for areas of long-term investor returns, but with time horizons shortened substantially we are cautious on near-term prospects for UK equity investors, whilst noting that any substantial weakness in the UK economic picture could in fact provide a substantial tail wind for those internationally focused companies with overseas earnings.

As with the UK, the fortunes of European equity markets lie more heavily in the hands of the area’s political and economic future. We believe in the short term that the risk of further political contagion is muted, with Britain’s experience of Brexit likely to dampen rather than fuel further secessionist movements. Immediately after the referendum in the UK, Spain’s general election delivered another hung parliament, although the centre-right People’s Party increased its share of seats. Whilst valuations may appear relatively more attractive, this is not to say that Europe has avoided its fair share of economic concerns after Britain’s vote to leave.

In the US, the market appears to have reverted to its ‘bad news is good news’ psychology. Private payroll data has recorded three consecutive months of sub-200k growth, and although it could not have maintained its prior trend indefinitely the latest report of just 38,000 jobs added in May is somewhat concerning. Industrial production remains in contraction and consumer spending remains constrained. But investors are looking to the Federal Reserve to provide continued support and potentially reverse their 2015 rate hike valuations continue to push up.

Whilst it may be ill-advised to ‘bet against the Fed’ we can see only limited upside for investors in the asset class. Future returns for investors will be dependent upon underlying profit growth rather than continued margin expansion, and with November’s Presidential elections looming, we remain cautious on valuations at this point.

In Japan, all eyes remain on the Bank of Japan and their late July meeting, having failed to add to the Quantitative Qualitative Easing (QQE) programme in June. With the inflation target still some way off and the Yen strengthening notably against the BoJ’s wishes, further action would seem necessary. We believe that the market is pricing substantial further monetary easing and therefore see more limited upside heading into the meetings, but with an increasingly accommodative central bank, future prospects remain relatively attractive.

Emerging Market and Asian Equities

Performance: The emerging markets (EM) outperformed the developed markets (DM) by 5.6% as at 30th June 2016. In the recent quarter, the EM however slightly underperformed. When measured in local currencies, the top EM performers in the first half of the year were Peru (+40%), Argentina (+35%) and Brazil (+15%); while the worst performers were Greece (-25%), Czech Republic (-19%) and China (-8%).

The Latin American (LatAm) emerging markets have outperformed their EM peers and global equity markets significantly in the past six months. The positive political changes in Brazil has helped to enhance not only the country’s equity performance but also its currency value. As the US Federal Reserve (Fed) postponed its rate-hiking agenda, the LatAm was left with some room to breathe. This is because many EM companies have borrowings in USD; and when rates rise, the borrowings become more expensive for them to repay.

The emerging markets in Europe were a mixed bag. With Greece, Czech Republic and Poland underperforming on fears and realisation of Brexit, the rest of the EMs in the region were relatively insulated. Russian equities and its currency Ruble both recovered from a low base. Turkey is another example of an equity market rallying from a low base.

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The Asian emerging markets were overall flat in the first six months of the year. Chinese equity markets underperformed due to the growing concern over the economy’s highly indebted corporate sector and deteriorating growth outlook. The acceptance of currency depreciation from the central government discourages global and domestic capital flows into the equity markets.

Additionally, the unavoidable opening of the country’s capital account attracted billions of dollars’ worth of short-selling on the currency and the equity markets. The rest of the EM Asia has fared relatively well. Nevertheless, if we see the dollar strength resume, it could move commodity and energy prices lower, and put pressure on the RMB (Chinese currency), which would have knock-on effects on the majority of the EM economies.

Valuation: The overall EM valuation is as always cheaper than that of the DM. Investors typically demand higher compensation investing in the EM because it is perceived as riskier. As at the end of June, the EM was valued at 13 times its forward earnings, compared to 17 times that of the DM.

In LatAm, Mexico continued to be one of the most expensive EMs as investors remain confident in the country’s structural reform. Brazil’s valuation has risen since the beginning of the year alongside its price level; the country has had difficult times on the way as the political story evolved over time. Argentina enjoyed good performance since last December’s general election. The valuation is at a reasonable level given the amount of reform progress made. There are concerns though, as locals are finding it harder and harder to stomach President Macri’s “all-at-once” reform ambition. The heightened political uncertainty in the region could potentially bring volatility to the local financial markets.

The European EMs had lower valuations at the end of the second quarter, compared to that of the LatAm and Asia. Even after the rallies witnessed in Russia and Turkey, the two countries’ equity markets were among the cheapest in the EM. As Britain voted to leave the EU, it could potentially bring damages to both the economies of the UK and the rest of the EU. The idea of leaving the EU might attract more attention among other EU member states upon Brexit. Hence, the equity markets of the neighbour EMs, i.e. the most

“European sensitive” economies, got hit the most. Due to the extent of uncertainty ahead, we would not necessarily say that the valuation of the region is fair at the current levels.

The valuations among the Asian EMs are of divergence year to date. At the end of June, Philippines was the most expensive among all, with circa 19 times of its 12-month forward earnings estimate. The valuation was supported by the country’s strong private sector growth and the benign inflation conditions. China’s valuation, on the other hand, is among the worst. Although the MSCI China Index (a proxy used by many of the overseas investors) is biased towards the drivers of the new economy, the valuation is somewhat discounted by the weakness of the country’s sunset industries. The economic concern over corporate debt levels is also seen as constraining profitability prospects, and therefore restraining the capital inflow into the equity markets. Above all, South China Sea and East China Sea tensions have been increasing, with the ruling from the Hague on island disputes between Philippines and China fast approaching. We do not think this information has been priced in amongst the Asian equity markets.

Outlook: Before the UK’s EU referendum became a major concern, the EM was predominately nervous about the initiation of the US Fed rate hikes. In order for the EM to immunise the adverse impact of the US rate rises, they would have to either enlarge the growth differential versus the DMs, or reduce their risk perception for global investors.

The Asset Markets

Total Return % Change, Local Currency

3 Months % Change 6 Months % Change 1 Year % Change

MSCI Emerging Market -0.3% +5.0% -14.2%MSCI China -1.7% -6.3% -25.2%MSCI India +5.3% +2.3% -2.4%MSCI Russia +3.3% +19.4% -5.7%MSCI Brazil +13.3% +44.3% -9.0%

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The Asset Markets

As the Brexit certainty increases, the timeline for the US rate hikes has been postponed. This is, on one hand, good news for the EM as there is less of a catalyst for global investors to withdraw their EM allocations. On the other hand, the economic uncertainty around the Brexit event could discourage global funds investing in risky assets, in this case the EM assets. This, however, must be viewed to have a counter-balanced effect by the potential further easing global central banks and governments might undertake. As the EM typically underperforms the DM during DM drawdowns, the EM equities were surprisingly resilient after the announcement of the EU referendum results. This could be because the DMs’ “lower for longer” rates make EM carry trades extremely attractive, where investors can borrow at low interest rates in the DMs to invest in high yielding assets in the EMs.

The most concerning outlooks among EM countries are concentrated in the Central and Eastern European economies (CEE). Countries like Poland and Czech Republic have large exposures to the EU. Although the European Central Bank (ECB) might expand its Quantitative Easing (QE) programme, if we see a reasonable scale of downgrades among European corporate earnings due to the implication of Brexit or shallower output growth in general, the European peripheries could receive a severe hit. The Asian exporters like Taiwan, India and Korea could also be negatively impacted. Overall however, EM only has 5% sales exposure to Europe, so any negative impact should only be at a small scale from the trade point of view.

In summary, the EM equity markets have performed relatively well year-to-date. It is noted that the political risks have risen across continents. To counterbalance the global instability caused by weak demand and political uncertainties among other factors, major central banks have expressed their willingness to do what is necessary to stabilise their economies and financial markets. The net impact would depend on the balance between policy makers’ rescue efforts counterbalancing and the gloomy economic outlook we have today.

Global Government Bonds

Performance: The performance of government bonds in the second quarter has very much been dominated by the UK’s referendum on its membership of the EU. Global risk-free rates generally range traded- leading up until the vote, but once the result was clear to the market and investors sought safe haven assets, we saw yields move significantly lower in Europe, the US and of course the UK.

In the UK, gilt yields moved inversely with the prospects of a leave vote in the run up to referendum day. In mid-June, as the polls began to suggest the leave campaign was gaining the upper hand, we saw yields drop as low as 1.12% on the 10-year Gilt, from highs around 1.66% in late April. On polling day, with a remain vote very much priced into the market, yields were around 1.33% with risk assets very much in favour. However, as it became apparent that the leave campaign had triumphed, we saw yields collapse as investors dumped riskier positions and bought into risk-free, safe haven assets. As such, we saw the 10-year yield collapse down to an all-time low of 0.86% by the end of the quarter.

In Europe, sovereign bonds followed a very similar pattern to that seen in Gilts, with yields falling significantly as evidence of a Brexit filtered out. 10-year Bund yields touched -0.19% by the end of June, having been at 0.10% ahead of the vote. Whilst some expected periphery European yields to spike in the event of a leave vote, as a breakup of the Eurozone would become more likely and consequently place the credit-worthiness of the weaker nations into question, we actually saw these yields fall too. This action can be attributed to the hope of further loose monetary policy from the ECB, coupled with the likelihood that we may now see the remaining members of the Eurozone close ranks and push for even tighter integration and closer union, much to the benefit of the periphery.

Bond Yields % (10 year) 30 June 2016 31 March 2016 31 December2015United Kingdom 0.87% 1.42% 1.96%Germany -0.13% 0.15% 0.63%France 0.18% 0.49% 0.99%Europe -0.13% 0.15% 0.63%Japan -0.22% -0.04% 0.26%US 1.47% 1.77% 2.27%

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US Treasuries have followed a very similar trading pattern to their counterparts across the Atlantic. Yields on the 10-year Treasury started the quarter around 1.8%, but have since traded markedly lower to 1.47% by the quarter close. With even Federal Reserve Chairman Janet Yellen citing Brexit as a global headwind, the likelihood for further rate rises in the US look very unlikely, as least for the foreseeable future.

Arbuthnot View: With the UK public now having voted to leave the EU, central banks around the world are poised to do what they can to ease their economies through this trying time. BoE Governor Mark Carney has made several very supportive statements with regards to the supportive role the Bank will play during this transitional period for the UK. The market has interpreted this as meaning a potential resumption of the asset purchase programme, and maybe even a small cut to the Bank of England base rate. Similarly, investors in Europe and the US have seen their respective central banks strike a dovish tone in the wake of recent events, and make any monetary tightening in the short to medium term highly unlikely.

Whilst Gilt yields have now moved to new lows never seen before, the future uncertainty for the UK economy makes this price action somewhat understandable. Despite credit downgrades from various ratings agencies based on their negative outlook for the UK, there is potential for yields to grind even lower, especially if we look to Germany or Japan, where rates are negative even beyond 10 years on the yield curve, suggesting that 10 year Gilts yields at 0.86% could have notably further to fall.

Global Corporate Bonds

Performance: The second quarter of the year has witnessed a continued high level of volatility in the global corporate bond markets. This has been a culmination of Brexit worries, political uncertainty across the world and fears of a global economic slowdown.

Yields over the quarter have been compressed across the board with the average EUR investment grade corporate bond yield falling below the 1% mark.

April saw the ECB announce the details of its corporate sector purchase programme (CSPP) that began at the end of June. One of the key points from the announcement is the ECB’s use of a market-weighted approach, which should in theory make it less disruptive for markets, but less supportive for spreads.

In May the opportunity offered by a more benign risk environment and a strong demand for yield led US investment grade companies to issue sizeable amounts of debt, recording the highest monthly issuance since mid-2015.

Following the EU referendum vote in June bond spreads widened across the US, UK and European bond markets, with GBP investment grade debt widening the most. Credit markets across the world still struggle to assess the implication of the referendum result moving forward. The US investment grade credit market benefitted from the safe haven demand for USD assets. European investment grade credit didn’t fare as well with spreads widening by 10bp over the month. The CSPP is now in full swing with estimates suggesting that the ECB is purchasing €8billion of investment grade corporate debt per month which is at the upper end of the forecasted scale.

High Yield markets across the globe have shown sign of weakness with spreads widening across US, EUR and GBP. This is following the uncertainty the Brexit vote has forced upon the market.

Arbuthnot View: The volatility that has been seen in markets recently is unlikely to dissipate anytime soon. As investors flock to debt in order to de-risk their portfolios in the hope to provide some security, yields are likely to be compressed; this will only be exacerbated by the ever-apparent ‘hunt for yield’. As the understanding of how the UK will leave the EU and what it might look like the credit markets will continue to be under pressure.

The Asset Markets

Corporate Bond Yields % 30th June 2016 31st March 2016 31st December 2015Global Investment Grade 2.41% 2.68% 3.09%US Investment Grade 2.92% 3.22% 3.70%US High Yield 7.55% 8.58% 8.90%Europe Investment Grade 0.85% 1.02% 1.34%Europe High Yield 3.24% 3.46% 4.32%UK Investment Grade 2.84% 3.25% 3.60%

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The Asset Markets

In summary, we are cautious of the fixed income markets – particularly high yield which is more highly correlated to equity markets – and will continue to take a proactive approach to take advantage of opportunities as and when they arise.

Property

Performance: In the three months to May 2016, UK Commercial Property provided investors with a total return of 0.9% according to the IPD UK Monthly Property Index. Industrials were measured as the best performing sector as a result of continued high demand for modern warehousing in key logistic networks thanks to the rise of the online presence of retailers. The Office sector experienced a high degree of uncertainty in the run up to the EU Referendum resulting in a distinct lack of investment and business confidence in committing to leases, providing a total return of 0.9%. Finally, the retail sector continued a trend of polarisation with stronger return profiles in retail warehousing and shopping centres to satisfy underlying consumer demand. As a whole the sector returned 0.5%. The whole market is still characterised by rental value growth, with capital values likely to come under downward pressure as a consequence of the lack of investment and stagnant activity, especially yields pushing all-time lows.

Valuation: Pockets of the London Office Market and South East Industrial Units show signs of being expensive on an income basis, with yields viewed as quite thin. However, the regions still provide an interesting dynamic for development and investment for income, especially with the spread to Government Debt. Despite the impressive returns on Commercial Property over the last three years, Secondary Property has only just hit the spread over prime property seen during the Global Financial Crisis. For example, the yield for London City Offices come in at 4% whilst Secondary measures at 9%. The lack of supply, especially in the regions, has meant tenants need to look further afield for the type of commercial property required.

Outlook: Following the UK decision to leave the European Union it is increasingly likely, if not inevitable, that capital value will come under significant pressure. Immediately after the decision, listed Real Estate Companies with London Office exposure were amongst the biggest fallers in the stock market.

Subsequently, we have been informed of property funds decreasing prices in anticipation of lower valuations with these valuations also being requested on a weekly instead of monthly basis to ensure correct and fair pricing for investors. Whilst uncertainty is high in the Occupier Market thanks to reluctance to commit to any long term expenditure, it will be interesting to analyse the reaction of the Investment Market. The UK Property Market is likely to keep the legal framework and transparency that benefits the landlord, whilst Sterling at a weaker level could attract foreign capital inflows.

*Performance measured by MSCI IPD Monthly Property Index

Hedge Funds

Dispersion was high amongst Hedge Funds in the second quarter of 2016. One group posted positive performance in April to May, while a different group benefited from the Brexit vote in June. Overall the asset class delivered positive returns, with the HFRX Global Hedge Fund Index up 1.31%, recovering part of the losses from the first quarter. Macro and Commodity Trading Advisors (CTAs) posted strong performance, as they held gold, bonds or long volatility positions in GBPUSD. Event Driven funds also had a good quarter, which is unexpected given the increasing number of deals breaking in the US and the volatile markets. Equity Long-Short funds had at best a flat quarter, with Market Neutral funds facing losses of 2.5% according to HFRX Equity Market Neutral Index. With zero net exposure to stocks, Market Neutral funds were negatively impacted by equity markets behaving irrationally and the arbitrage those funds are playing not materializing. We expect challenges to prevail in 2016, uncovering more opportunities for Macro and CTAs during the second half of the year.

Commodities

The Bloomberg Commodity Index had a very strong quarter returning circa 12.7%, making commodities the best performing asset class so far this year; a stark contrast to its poor performance in 2015.

The energy market has been characterised by unexpected supply disruptions which has led to oil balances tightening more rapidly than expected. Wild fires in Canada removed between 30 and 40 million barrels of oil from the market and in Nigeria, oil production has dropped by about 1 million bpd because of attacks on oil pipelines.

28

Despite an offsetting surge in Iran’s oil exports since the beginning of the year, bringing them close to pre-sanction levels, the oil market has seen one of the largest ever ‘in quarter’ revisions in global surplus levels; estimates of excess supply have been cut from around 2m bpd to 0.74m bpd. In addition, we have seen stronger-than-expected demand in India and China, confirming that the 26% oil price rally seen in Q2 is well supported by fundamentals.

Following news of Brexit, oil fell 5% on the day, although has since recovered fairly robustly. The substantial hit to global GDP growth that is expected will likely reduce global demand forecasts. Oil traded above $50 for the first time since July 2015, and is currently trading at around $48.34.

In other news, Saudi Arabia’s longstanding and greatly respected oil minister Ali Al-Naimi was replaced by Aramco Chairman Khalid al-Falih; whilst the impact on oil prices were minimal, many wonder if we are about to see a significant shift in Saudi oil policy.

Gold closed the quarter at $1,321, its highest level in almost two years. Gold returned circa 7% over the quarter, extending its 16% rally in Q1. Unsurprisingly, given gold’s ‘safe haven’ status, prices rallied 5% immediately following the UK vote to leave the European Union. The added market uncertainty, increased financial volatility and potentially worsening global economic conditions that come with a Brexit provide a supportive backdrop for the gold price and potentially further upside.

The Asset Markets

Important Information:

The information given in this document is for information purposes only and is not a solicitation, or an offer to buy or sell any security. It does not constitute investment, legal, accounting or tax advice, or a representation that any investment or service is suitable or appropriate to your individual circumstances. You should seek professional advice before making any investment decision.

The value of investments and the income from them can fall as well as rise. An investor may not get back the amount of money invested. Past performance is not a guide to future performance. Fluctuations in exchange rates may affect the sterling value and any returns from investments. The facts and opinions expressed are those of the author of the document as of the date of writing and are liable to change without notice. We do not make any representations as to the accuracy or completeness of the material and do not accept liability for any loss arising from the use hereof. We are under no obligation to ensure that updates to the document are brought to the attention of any recipient of this material.

Please note that this commentary may not be reproduced, distributed, disseminated, broadcasted, sold, published or circulated without prior consent from Arbuthnot Latham & Co., Limited.

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July 2016

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