Issue 63 | June 2014

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Although recent figures confirm the pace of economic growth in the first quarter was weaker than expected, particularly in the US, our outlook for the world economy remains positive. An increase in capital spending should drive growth across the developed world and stabilise emerging economies. Notably, in developed markets capacity utilisation is high, the current stock of capital is ageing, and leading indicators of capital expenditure are pointing upwards.

However, there are two main risks. The first is that core inflation in the US could increase faster than the Federal Reserve (the Fed) expects due to higher rents and medical costs as well as an acceleration in wage growth. In addition, despite being at an all-time high, there is some indication that businesses have started to widen their margins by increasing prices. The $2.5 trillion in excess reserves US banks have with the Fed are another inflation risk. Could the US central bank come under pressure to start increasing short-term interest rates sooner than markets expect?

At the same time, markets have not yet fully adjusted to Janet Yellen taking over from Ben Bernanke as the Fed’s head. Many people are struggling to understand Ms Yellen’s monetary policy intentions as well as the timing. As a consequence, we believe the current period of low volatility across most asset classes is a short-term phenomenon. Investors should be prepared for more volatile conditions.

Dirk WiedmannChief Investment OfficerRothschild Wealth Management

Issue 61 | April 2014

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Cover: Walking Past Two Chairs – detail (lithograph and screenprint) by David Hockney © 2008. David Hockney.

© 2014 Rothschild Wealth Management & TrustPublication date: June 2014Values: all data as at 3rd June 2014Sources of charts and tables: Rothschild and Bloomberg unless otherwise stated.

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Rothschild Market Perspective | June 2014 | Page 1

Rothschild Market Perspective | June 2014 | Page 2

Equities

Although valuations are starting to look stretched following an extended period of strong returns, we continue to favour equities as the most attractive asset class for the following reasons:

¡ Abundant liquidity and repressed interest rates in our “muddling through” and “economic renaissance” scenarios continue to support the markets (see the latest edition of Our Big Picture Outlook for more information about our scenarios).

¡ Improved earnings prospects in our “economic renaissance” scenario should also boost equity prices despite the prospect of higher interest rates.

¡ This pattern applies particularly to the US market. It is the most overvalued region but equity prices could continue to rise if our “economic renaissance” scenario becomes increasingly likely.

Fixed income

¡ We are avoiding long-maturity nominal bonds because they would be negatively affected by a return to more normal monetary policy in the “economic renaissance” scenario.

¡ Within fixed income we continue to like shorter-maturity corporate bonds. This part of the market has two attractive features. First, there is still a decent yield advantage relative to government bonds. Second, the short maturity offers some protection against rising interest rates.

Real assets

The still sizeable probability of the “new monetary world” scenario lies behind our ongoing exposure to real assets. They can include allocations to gold, real estate and inflation-linked bonds.

¡ We are also confident that over an economic cycle equities continue to offer protection against inflation.

¡ Additionally, we are focusing on hedge funds that have the flexibility to adjust to an unexpected rise in inflation.

Hedging strategies

We believe our “depression” scenario is the least likely but its impact would be so disruptive that it must be considered within our investment strategy. Although equities remain the most attractive asset class, they are vulnerable to stretched valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero.

¡ Therefore, we include hedging strategies that can limit the potential losses from our portfolios if the equity markets suffer a material correction.

¡ We have an allocation to hedge funds that can provide significant protection in a bear market or which are not affected by adverse movements in equity markets and therefore provide true diversification.

¡ Additionally, we have direct equity hedges usually in the form of out-of-the-money put options on broad equity indices.

Our investment preferencesAlthough equities remain the most attractive asset class, valuations are starting to look stretched, particularly in the US.

Rothschild Market Perspective | June 2014 | Page 3

The US economy remains on track

The latest data confirms the pace of economic growth in the US was weaker than expected during the first quarter. But it is likely to be a temporary setback caused by severe winter weather conditions. These figures do not change our view that the US recovery remains on track. There are a number of positive signs to support this outlook. For example, capital goods shipments were revised up in February and March. In addition, expectations for capital expenditure remain strong according to recent surveys by the Fed and Institute for Supply Management (ISM).

Housing market supports the US recovery

Conditions in the US housing market also appear to be improving. New starts and building permits were both stronger in April. Meanwhile, housing supply across many cities remains tight and demand is high. Therefore, it is no surprise that the S&P Case-Shiller Home Price Index, a leading measure of US residential real estate prices, was 12% higher in March than a year ago. Notably, the 20-City Composite Index has risen every month since February 2012. We believe this momentum can continue.

Growth is returning to Japan

Meanwhile, economic growth in Japan is likely to have been weaker in the second quarter owing to the VAT increase in April. But we believe growth should pick up again in the third quarter, driven by higher private consumption, capital expenditure and public investment. The Bank of Japan probably holds the key to short-term market developments. Given export volumes remain sluggish, more supportive policy actions from the central bank in the summer are increasingly likely.

France pushes ahead with reforms?

Conditions in the Eurozone have been improving steadily this year. France had been a weak spot but it now appears to be taking positive steps to improve its economy. They include tackling structural problems through labour market liberalisation and corporate tax cuts. These reforms are well

needed because France’s economy has not picked up much this year compared with the rest of the region. Composite PMIs for the first quarter slipped to 49.3 (a three-month low) and export orders dropped from 51.2 to 48.3.

The outlook for the second half is brighter. However, if France does not continue to reform then the disparity with Germany is likely to widen. This gap could complicate the ECB’s monetary policies as well as risk undermining the relationship between the region’s two largest economies.

Election results dent the European project

In the recent elections for the European Parliament political parties that are opposed to the EU and austerity measures increased their share of the vote to around 30% from around 20% previously. These results are unlikely to trigger any significant change in policy for the moment. However, we cannot ignore the impact they will have on the confidence of some European institutions, which will have to consider their reactions carefully.

The global economy and financial marketsThere are a number of reasons to remain positive about the US recovery. Meanwhile, France is making progress in Europe but the recent elections are a warning.

Rothschild Market Perspective | June 2014 | Page 4

Investment viewsImplied volatilities in the equity market are back at depressed levels yet this is a global phenomenon across all major asset classes. In fixed income markets there have been strong credit returns so far this year as investors search for yield.

Have investors become more complacent?

After spiking above 21 at the beginning of February, the VIX Index (a popular measure of equity market volatility) has fallen to around 12 recently. Yet low volatility is a global phenomenon that includes all major asset classes at the moment. This trend suggests investors around the world remain complacent of any potential risks. The situation is a cause for concern because previous periods of complacency have often been followed by less benign conditions in financial markets.

One of the drivers behind these recent conditions in equity markets is rising confidence in a gradual economic recovery in both the US and Europe. It is plausible that this better outlook is supporting equity prices. But the behaviour of interest rates recently is more puzzling. Instead of rising, in particular at the long end of the curve, rates have actually fallen. This pattern is unusual because rates tend to rise when economic recovery expectations improve.

A recovery in emerging markets

Over the past three years emerging market (EM) equities have underperformed developed markets (DM) by almost 40%, as measured by MSCI. EMs had a difficult start to 2014 but then started to recover sharply around the middle of March. The year-to-date gains from EMs have now outpaced DMs. Part of the reason is that EM currencies have stabilised. In addition, demand for EM equities has increased due to more favourable valuations relative to DMs. Issues related to individual countries have also helped, such as the relaxation of geopolitical tensions in Russia and the pro-reform Indian election result. Yet the recent performance of EM equities would not have been possible without favourable external liquidity conditions.

US Treasuries still in strong demand

During May 10-year US Treasury yields fell slightly to end the month at around 2.6%. Markets remain captivated by dovish comments from the Fed. US inflation rose to 2% in April and second-quarter growth is likely to hit 3.5%. Yet markets still expect rates to remain below 2% all the way to the end of 2016.

Even if rates do stay at a “new neutral” level (close to zero in real terms) in a “new normal” world economy (characterised by below-average growth, excess private savings and economic slack), the risk-reward profile in the belly of the US Treasury curve (5 to 10 years) is not compelling at current valuations.

Credit markets have performed well

Credit valuations are near their 2007 highs, supported by strong fundamentals – healthy balance sheets, positive growth and subdued inflation expectations. Central bank policies remain supportive of the “hunt for yield”. Credit spreads could tighten further but liquidity risks have increased significantly, in our view, and valuations offer little room for mistakes. Although we remain positive on fundamentals, we have started to take selected profits in portfolios where we hold credit in order to reduce liquidity risk. Should Treasury yields rise and market volatility increase, spreads could widen on higher beta credit.

Markets expect the ECB to act

In Europe 10-year Bunds touched a low for the year so far of 1.3% in May, which is only 13bp above their lows of July 2012, when the euro’s existence was in doubt. This time weak growth and the policy outlook are the key drivers. Inflation in the Eurozone remains well below 1% and economic growth was also less than 1% in the first quarter. In reaction, the ECB appears likely to loosen monetary policy through a rate cut and some form of quantitative easing (QE). These measures would support Eurozone credit, high yield and peripheral sovereign debt.

Rothschild Market Perspective | June 2014 | Page 5

Sector rotation impacts hedge fund returns

The HFRX Global Hedge Fund Index fell by 73bp in April after losing 23bp in March, and is now up by slightly less than 40bp for the year so far. Global equity markets increased by 2.3% over the same period (as measured by the MSCI Daily Total Return Net World Index). All hedge fund strategies except CTAs (managed futures) lost money in April. The largest losses occurred in equity long-short and event-driven funds owing largely to ongoing sector rotation.

With equity markets at elevated levels, we believe investors will reward companies that over-deliver on expectations and punish laggards. This environment should be good for stock pickers but it is also likely to be volatile. We like equity-related funds with the ability to take advantage of current conditions. Notably, the healthcare sector has interesting opportunities for skilled investors to deliver superior returns.

Real estate benefits from falling bond yields

Listed real estate has outperformed equity markets substantially over the second quarter. US Treasury yields have fallen steadily over the period even though the outlook for the US economy has improved. In reaction, investors have shifted towards income-producing assets, including real estate.

However, these assets could begin to suffer when the Fed turns its attention away from tapering QE and begins to focus on the timing of interest rate hikes. Meanwhile, policymakers in the UK are considering measures to cool its housing market and could increase rates soon. In contrast, the ECB may be about to launch a QE initiative, which could boost the region’s real estate market providing its economy does not suffer a period of deflation.

Gold suffers from negative investment flows

Gold prices are higher than they were at the start of the year. Yet net investment flows into ETFs have been negative and the outlook is uncertain. Looking forward, physical demand should pick up again following the Reserve Bank of India’s decision to relax the country’s gold import rules, which could support prices.

We continue to believe the long-term outlook for gold is connected closely to the global economy. If the US continues to recover and real yields normalise, gold prices should come under pressure. Yet gold remains a useful hedge against the uncertainties surrounding the end of QE as well as the risk that inflation is stronger than expected. Additionally, deflation is still a threat, particularly in the Eurozone.

WTI and Brent crude spread widens

West Texas Intermediate (WTI) prices have spiked higher recently owing largely to a fall in Cushing stockpiles, the largest US oil-storage hub. Meanwhile, other US crude stocks are at record levels. One implication is the difference (or spread) between WTI and Brent crude has narrowed significantly. Brent prices have been relatively stable despite various geopolitical tensions, most notably between Russia and Ukraine.

The balance between supply and demand is tight and is likely to remain in this state for some time. That is because Russia could suffer additional economic sanctions, summer tends to be a season of increased demand, and Libya, Iraq and Iran continue to experience disruptions to supply.

Investment viewsEquity market conditions are ideal for special situations hedge fund managers with the right skills. Meanwhile, physical demand for gold could pick up following a policy change in India.

Rothschild Market Perspective | June 2014 | Page 6

Chart bookThe charts below provide an overview of key trends in financial markets over the past 12 months. The table provides a snapshot of key economic indicators.

Interest rates %

Government bond yields Inflation %

Unemployment %

GDP growth %2 year % 10 year %

US 0.25 0.4 2.6 2.0 6.3 2.0

Eurozone 0.25 0.1 1.4 0.5 11.7 0.9

Switzerland 0.00 -0.1 0.7 0.0 3.2 1.7

UK 0.50 0.7 2.7 1.8 6.8 3.1

Japan 0.10 0.1 0.6 3.4 3.6 3.0

China 2.60 3.7 4.1 1.8 4.1 7.4

Source Bloomberg. All data as at 03/06/2014. Equity market indices are MSCI; figures are for Total Returns, net dividends, in local currency. Volatility is measured by VIX Index. GDP and inflation figures are annual and latest available. Chinese interest rates as measured by the three-month deposit rate . Eurozone bond yields shown are for Germany. Past performance shown is not a reliable indicator of future returns.

Equity market performance – 12 months to date

Volatility

10-year bond yields

Trade-weighted currencies (indexed)

US UK Eurozone Japan Switzerland

USD GBP EUR JPY CHF

0

1

2

3

4

June July

Aug Sep

Oct

Nov

Dec Jan

Feb

Mar

Apr

May

%

June July

Aug Sep

Oct

Nov

Dec Jan

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May 85

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110%

JapanUS Europeex-UK

UK SwitzerlandPacificex-Japan

%

20.116.8

8.713.8

8.112.4

0

20

40

60

June July

Aug Sep

Oct

Nov

Dec Jan

Feb

Mar

Apr

May

10

15

20

25

Rothschild Market Perspective | June 2014 | Page 7

ContactsRothschild’s Wealth Management business advises and invests for a wide range of successful people, charities and foundations. Wealth preservation is what we do best, with an investment approach that helps us to smooth returns and dampen risk across the market cycle.

BrusselsAvenue Louise, 1661050 BrusselsBelgiumTelephone: + 32 2 627 77 30

FrankfurtBörsenstraße 2-460313 Frankfurt am MainGermanyTelephone: + 49 69 40 80 26 15

GenevaRue du Commerce 31204 GenevaSwitzerlandTelephone: + 41 22 818 59 00

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Hong Kong16th Floor Alexandra House18 Chater RoadCentral Hong Kong SARPeople’s Republic of ChinaTelephone: + 852 2116 6300

LondonNew CourtSt Swithin’s LaneLondon EC4N 8ALUnited KingdomTelephone: + 44 20 7280 5000

MilanVia Agnello 520121 MilanItalyTelephone: + 39 02 4537 0955

Paris29 avenue de Messine75008 ParisFranceTelephone: + 33 1 40 74 40 74

SingaporeOne Raffles Quay, North Tower1 Raffles Quay #10-02Singapore 048583Telephone: + 65 6532 0866

Tokyo20F Kamiyacho MT Bldg4-3-20, Minato-kuTokyo 105-0001JapanTelephone: + 81 3 5408 8045

ZurichZollikerstrasse 1818034 ZurichSwitzerlandTelephone: + 41 44 384 71 11

Rothschild Market Perspective | June 2014 | Page 8

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