Market Pulse · difference (or dispersion) between returns has also been low. Therefore, picking the “right” assets has been less important because the distance between “winners”

Second quarter 2014

Market Pulse 2 — Investment strategy

Which way next?As central banks begin to drain their liquidity from the financial

system, performance between asset classes should become

less correlated. The return to more “normal” conditions creates

opportunities and risks for investors.

www.kleinwortbenson.com

In this issue

4 — EquitiesEquity markets have enjoyed a bull run that celebrated its fifth anniversary in March. Valuations remain reasonable.

5 — Government bondsYields fell (and prices rose) slightly over the first quarter owing to a suppressed appetite for risk. We expect them to rise gradually over the rest of the year.

6 — Corporate bondsCredit spreads have tightened to the point where any further compression is probably limited. But rating agency upgrades can help boost returns.

7 — CurrenciesThe dollar is likely to remain one of the strongest major currencies this year, supported by improving economic conditions across the US.

8 — CommoditiesMost commodity prices fell during 2013 but have performed better so far this year. These markets can provide exposure to the global recovery.

9 — Real estateAnalysing the pattern of performance in the property markets can indicate when they are approaching a peak or a trough in the cycle.

10 — Markets at a glanceThe first quarter of 2014 has been a volatile period for markets owing to an increase in risk and uncertainty.

2 — Kleinwort Benson — Second quarter 2014

The greatest concern for investors is the possibility that the value of their investments will fall. Yet over the five years since March 2009 that risk has been low. In that unforgettable month, global equity markets hit their post-crisis low as fears of a complete disintegration of the global financial system peaked. However, an investor entering the market at that time would have been well rewarded. As the financial crisis induced nearly all assets to crash simultaneously, the subsequent volleys of liquidity fired by policymakers unleashed a fortuitous tide that raised all investment boats.

Since March 2009 global equities have risen by 109 per cent (according to DataStream’s World Series Index based in sterling). Less volatile investments such as UK government bonds and global investment grade bonds have risen by 27 per cent and 31 per cent respectively. Global listed real estate has had spectacular returns of 136 per cent. Even commodities are 9 per cent higher over the period. These returns are remarkable considering that global economic growth has been lacklustre and even negative in some regions.

Most asset classes have delivered a positive return over this period. A diversified portfolio invested equally

in each of the five main asset classes (equities, government bonds, corporate bonds, commodities and real estate) would have returned 63 per cent.

Challenging conditionsFor a number of reasons, these conditions are not ideal for active investment managers. First, when all asset classes tend to rise and fall together, there are limited opportunities to diversify investment risk. Second, not only has the direction of asset classes been highly correlated over the past five years but the difference (or dispersion) between returns has also been low. Therefore, picking the “right” assets has been less important because the distance between “winners” and “losers” is narrower.

However, as the old Bob Dylan song goes, “the times they are a-changin”. The prevailing paradigm shifted dramatically following a speech given last May by Ben Bernanke, then Chairman of the US Federal Reserve. He said that economic growth in much of the developed world had become increasingly sustainable. In response the central bank announced it would begin to reduce its monthly asset purchases. As a result, financial markets have been displaying more typical behaviour. For example, government

Sink, swim or glide

Market Pulse — Investment strategy

bonds and equities have been moving in opposite directions. Central bank support is draining from the system and will dry up completely at some point.

This has important implications for the future: as correlation between asset classes continues to decline, getting “lucky” essentially by selecting any set of assets and making money is less likely. In the absence of a friendly rising tide, the boats that investors choose will determine whether they sink, swim or glide. A tried and tested process for selecting investments will become increasingly important as market fundamentals reassert themselves.

Reasons to be positiveAlthough the US central bank is reducing its support for financial markets, there are still plenty of reasons to be positive on risk assets. Global equity markets are generally more expensive today than they have been over the past five years but valuations are not overly stretched. Price momentum is strong and investor sentiment is within acceptable levels. We believe value remains in global equities, especially compared with the other main asset classes.

Therefore, our investment positioning remains “risk on”. However, as we are in an increasingly mature bull market with falling levels of central bank liquidity, it is prudent to consider our next moves. We expect to reduce our exposure to equities if valuations become overly extended, momentum turns negative or sentiment becomes overly bullish. Those conditions are not quite here, so we will stay the course for now.

Figure 1: Annual performance of the five main asset classes (%)Over the past five years, performance across the financial markets has been closely correlated owing largely to central bank monetary policies.

Source: Bloomberg and Kleinwort Benson. Data as at December 2013.

2007 2008 2009 2010 2011 2012 2013

commodities 14.7 commercial real estate 26.4 equities 21.5 real estate 33.4 government bonds 15.6 real estate 21.1 equities 20.6

equities 10.2 government bonds 12.8 real estate 20.9 commodities 21.0 commercial real estate 5.1 equities 11.0 commercial real estate -1.9

commercial real estate 5.8 commodities -12.5 commodities 7.3 equities 16.7 real estate -2.2 commercial real estate 6.0 real estate -1.9

government bonds 5.3 equities -21.4 commercial real estate 5.5 commercial real estate 9.4 equities -6.9 government bonds 2.7 government bonds -3.9

real estate -17.2 real estate -25.2 government bonds -1.2 government bonds 7.2 commodities -12.9 commodities -5.4 commodities -11.2

difference = 32% 52% 23% 26% 28% 27% 32%

Kleinwort Benson — Second quarter 2014 — 3

Market Pulse — Investment strategy

House views

Equities Positive We are positive on equities given reasonable valuations and good momentum. But we are also aware of increasingly bullish investor sentiment.

Europe (excluding UK) Positive Relative value still exists in some countries following strong performance over the first quarter, and positive price momentum continues. Actual company earnings will be increasingly important over the rest of the year owing to relatively high consensus expectations for earnings growth.

Japan Positive The Bank of Japan’s loose monetary policies continue to support equities. Demographics and the government’s fiscal position remain structural hurdles.

Pacific (excluding Japan) Neutral Momentum has turned positive but valuations are mixed. Performance remains closely tied to the fortunes of other developing Asian markets, particularly China.

UK Positive Valuations have improved compared with other markets and recent economic data has surpassed consensus expectations. Following recent strong performance in continental European markets, the UK is now better placed in a relative context. A strong dependency on the housing sector is a cause for concern.

US Neutral Relatively overvalued but momentum is strong and economic conditions continue to improve.

Emerging markets Positive Valuations are attractive. These regions are increasingly sensitive to investor concerns about a number of risks, particularly China’s credit situation.

Government bonds Negative Government bonds are expensive by most measures. We continue to hold them to reduce volatility in multi-asset class portfolios.

Conventional Negative Government bonds remain unattractive even though yields have been rising.

Index-linked Negative Inflation is muted and we expect index-linked bonds to trade in line with conventional government bonds.

Credit Positive We continue to prefer high-quality and cash generative corporate and emerging market issuers.

Investment grade (corporate) Positive Despite being expensive, we expect investment grade bonds to outperform government bonds.

High yield (corporate) Positive In the current environment, where yields are rising, combined with economic recovery and low default rates, high yield debt is likely to outperform investment grade debt.

Emerging markets Positive Valuations are favourable on both a yield and currency basis. Given that emerging market currencies have depreciated significantly in 2013, the downside of currency risk is more limited in 2014. Meanwhile, yields are at their long-term average (10 years).

Currencies

Sterling Positive Positive momentum behind the UK’s economic growth should continue to support sterling against other G10 currencies in the near term, apart from the US dollar.

US dollar Positive US macroeconomic conditions and the Federal Reserve’s plans to continue tapering quantitative easing should continue to support the dollar against other G10 currencies, except sterling.

Euro Neutral Markets believe the ECB is less likely to cut rates in the near term, which should support the euro in the near term. If the region’s central bank introduces looser monetary policy in the next two quarters, the euro’s recent appreciation against major G10 currencies could change direction.

Yen Neutral The yen is likely to continue to be weak against both the US dollar and sterling for a number of reasons. They include the Bank of Japan’s aggressive expansionary monetary policy and uncertainties about the effectiveness of structural reforms and measures to stimulate growth.

Real estate Positive Real estate continues to offer strong income returns and a high degree of inflation protection. We continue to favour the UK market. We also like investments in infrastructure.

Diversified commodities Neutral Attractive on a valuation basis. Momentum has been positive recently as well. However, volatility is high.

Gold Neutral Gold has defensive characteristics in times of financial stress and its sensitivity to inflation is better than most other asset classes. In addition, while a valuation and sentiment case can be made at present, momentum remains negative in sterling terms.


Equity markets have enjoyed a prolonged bull run that marked its fifth anniversary on 9 March. Over this period global equity markets have rebounded from record lows in the wake of the financial crisis and delivered substantial returns (figure 2). The US has been one of the best-performing markets. Stockmarkets in Japan and most major emerging markets lagged but still managed healthy returns of 85 per cent and 117 per cent respectively.

The returns are impressive considering events including a European sovereign debt crisis; downgrades of government debt in many developed economies; the risk of a US debt default; social and economic unrest across the world; and

uncertainty about the pace of growth in China and the extent of problems in its shadow banking system. Most recently there has been an emerging market currency crisis and a political stand-off in Ukraine.

Central bank monetary policies have supported these returns but they do come with consequences. One of them has been the increase in correlation between various regions and sectors (figure 3), which reached record levels during the financial crisis and remained elevated since then. There are many factors that might have contributed to this increase, such as greater global economic and financial integration. But central bank quantitative easing (QE)

measures have played a central role.Correlation has important implications

for investors because it reduces opportunities to diversify portfolios. Specific attributes such as country, sector and even risks associated with specific companies are overshadowed by periods of “risk on” and “risk off” where markets move together. Concentration risk increases for equity investors. How can you diversify across regions or sectors if they are all heading in the same direction at the same time?

Since the US Federal Reserve first mentioned the idea of tapering QE last summer, conditions have changed significantly. Most central banks (except the Bank of Japan) have scaled back or stopped QE, and financial markets have become less correlated. With economic data sending no clear signal of weakness and central banks no longer easing the way, investors have been freer to focus on stock, regional and sector-specific factors and reconsider their allocations.

Regional selectionEquity valuations remain reasonable overall although they look stretched in some areas. We also consider momentum and sentiment when making investment decisions. On a regional basis continental Europe remains attractive although is less compelling on a relative basis following strong performance during 2013. Notably, we have recently upgraded our view of the UK relative to continental Europe.

Valuations also remain attractive in many emerging markets. But negative sentiment has continued to depress returns in those regions, particularly given concerns about the level of debt in China. While evidence suggests cheaper valuations are a good indication of higher returns over the long term, they are unreliable in the shorter term. Investor sentiment and price momentum can provide a more useful guide.

Within industry sectors, we continue to favour financials and technology, with the latter poised to benefit from renewed corporate spending. We have also recently upgraded certain UK miners, in light of their attractive cash flows and overly depressed valuations.

Equity markets celebrate the bull run’s five-year anniversary

Figure 2: Five-year cumulative returns (in US dollars)Equities have delivered stellar returns to investors over the past five years, supported by central bank policies that include quantitative easing and low interest rates.

Source: Bloomberg and Kleinwort Benson. Data as at March 2014.

Figure 3: Equity market correlationsPerformance across the equity markets became increasingly correlated as a result of central bank monetary policies. Regions and industry sectors have tended to move together over the past five years.


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Mixed economic data from the US and China along with an increase in political tensions between Russia and Ukraine suppressed the market’s appetite for risk during the first quarter. One result is that 10-year government bond yields fell (and prices rose) in the US and UK from around 3.0 per cent at the start of the year to end the period between 2.7 per cent and 2.8 per cent (figure 4). However, we expect bond yields to rise gradually and they could be back around 3.0 per cent in both countries by the end of the year.

In her first meeting as head of the Federal Reserve Janet Yellen reduced the central bank’s monthly asset purchases by a further $10 billion to $55 billion

in March. Looking ahead, the Fed reaffirmed its commitment to low interest rates and shifted the focus of its forward guidance policy away from a reduction in unemployment to 6.5 per cent towards a broader set of economic indicators. As a result, we believe any increase in US interest rates is now unlikely until the middle of 2015. Markets had already been expecting these announcements, and they do not change our views about the likely direction of bond yields.

In the UK, Chancellor George Osborne’s Budget focused on reducing the government’s debts and improving its finances despite tax cuts that could cost around £5.5 billion until 2018 to 2019. In our view, these latest policies

are negligible for the UK’s gilt markets. Meanwhile, the Bank of England’s monetary policies are unlikely to change in the near term. We believe UK interest rates will not rise until the middle of 2015 at the earliest.

Peripheral Europe recoversThroughout the first quarter core eurozone government bonds performed in line with the US and UK markets. Meanwhile, improving economic conditions in many peripheral countries has pushed their sovereign debt yields lower. For example, the difference (or spread) between 10-year German Bund yields and 10-year bond yields in Greece, Italy and Portugal has fallen by 86 basis points on average since the start of the year (figure 5).

Following Ireland’s successful return to the capital markets this year, other countries that triggered the outbreak of the eurozone’s debt crisis are likely to attempt to follow its example. Meanwhile, the European Central Bank’s (ECB) monetary policies are likely to diverge from those followed by other developed central banks. The ECB could cut interest rates if the low level of inflation threatens to push the region into deflation.

Neutral on inflation-linked bondsWe remain neutral on both inflation-linked and conventional government bonds because the risk of lower inflation or deflation is present but not imminent. The bond market’s inflation expectations are broadly in line with the inflation outlook in the UK, eurozone and US.

Our portfolios are well positioned for rising bond yields in markets where we expect this risk to be a concern. For sterling and US dollar portfolios, we prefer bonds maturing in three to seven years. For euro portfolios we favour longer maturities owing to subdued inflation, which is likely to suppress euro bond yields in the short term.

Bond yields set to rise in the US and UK but fall in the eurozone

Market Pulse — Government bonds

Figure 5: The cost of government borrowing in peripheral Europe has also fallenEconomic conditions across Europe’s periphery have been improving. As a result, the difference between sovereign debt yields and German government bonds has continued to close since the start of the year.


Figure 4: US and UK government bond yields have fallenGeopolitical and economic concerns have suppressed the market’s appetite for risk. Government bond yields in the US and UK fell back slightly over the first quarter as a result.


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Conditions in the global corporate bond markets have continued to improve this year, boosting confidence about the creditworthiness of issuers. These markets delivered healthy returns in the first quarter despite mild volatility owing to some patchy economic data and political risk in Ukraine. Although yields remain low, investors are likely to continue to hunt for returns in this asset class over the rest of the year.

Credit spreads (the difference between corporate and government bond yields) continued to tighten over the quarter (figure 6). Although any further compression is probably limited, the income available from both investment grade (IG) and high yield (HY) bonds in

the form of coupon payments remains appealing.

We continue to prefer IG bonds issued by banks and insurance companies owing to their attractive valuations and improving quality of the underlying businesses. Additionally, economic conditions in southern European countries are improving, which is helping their businesses to recover. Companies in the industrials, utilities and financial sectors are performing particularly well.

Defaults remain lowCorporate bond default rates remain low in the HY market, which is keeping spreads tight. The main risk is a potential

setback in equities because performance in these two asset classes tends to be highly correlated. Investing in diversified funds or defensive HY corporates (such as utilities), which offer attractive valuations, is one of the few ways for investors to spread risk in an effort protect the value of their bond portfolios.

A consideration of idiosyncratic issues in the corporate bond markets is essential for managing credit risk as well as thinking about the relative value between bond issuers. In the short to medium term, we continue to monitor the potential systematic risk caused by rising government bond yields. This risk is not likely to go away any time soon, even if yields follow a gradual path to normal levels. Therefore, we recommend investors allocate to short-dated and floating rate bonds to mitigate against interest rate risk.

Upgrade downgradeIn North America credit rating upgrades continue to outpace downgrades across various industry sectors, and are even exceeding the peak of 2006 (figure 7). This pattern is also a feature in western European markets this year, reflecting the positive operating environment for the corporate sector.

We believe this trend is likely to continue and that spreads will tighten further for the rating agencies’ preferred bond issuers. In an environment with low yields that are likely to rise, selecting “rising stars” (corporate bonds that could enjoy a ratings upgrade) is a strategy that can help to boost returns.

Emerging market debtFollowing recent weak performance, emerging market bonds could begin to recover as capital outflows slow or reverse and foreign exchange markets stabilise. We continue to recommend holding emerging market bonds based in local currencies. In our opinion, they offer the best value in the bond markets. Additionally, as negative sentiment becomes more positive, yield-hungry investors are likely to be attracted.

Ratings upgrades help to boost returns from corporate bonds

Market Pulse — Corporate bonds



Figure 7: Rating agency changesThis chart shows the ratio of rating agency upgrades and downgrades on corporate debt in North America and Western Europe over the past decade. Upgrades are winning decisively at the moment.

Figure 6: Credit spreads have continued to fallThe difference (or spread) between corporate and government bonds has been falling for some time. Although valuations are looking stretched, the coupon payments on corporate debt remain attractive.

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Global currency markets behaved erratically and somewhat irrationally over the first quarter owing to a number of concerns. They included a currency crisis in emerging markets; mixed economic data from the US and China; and ongoing tensions between Russian and Ukraine. However, we believe it is important to maintain a longer-term perspective when assessing the likely direction of the world’s currencies.

The decision by the European Central Bank (ECB) to leave its monetary policy unchanged so far this year has pushed the euro higher against the US dollar and sterling. However, the euro’s value could fall back at some point. Inflation across the eurozone has been worryingly low for

some time, which might encourage the ECB towards unconventional monetary policies. They could include outright asset purchases or a new round of liquidity injections into the European banking system. The euro would probably weaken against both the dollar and sterling this year if the ECB follows either or both routes.

Conditions in the US improveWe favour the US dollar among the G10 currencies over the medium to longer term. With an improving labour market, higher economic growth and higher short-term interest rate expectations, the dollar should remain strong (figure 8). In particular, we are likely to see the start of

A healthy US recovery should continue to support the dollar

Market Pulse — Currencies



a long-term appreciation by the dollar this year against safe-haven and high-yielding currencies, such as the Australian dollar and Swiss franc.

Meanwhile, the yen strengthened over the first quarter owing to weak economic data and concerns that the Bank of Japan could begin to reduce its aggressive quantitative easing programme. But we expect the central bank to introduce additional asset purchases to boost inflation towards its 2 per cent target. As a result, Japan’s currency could weaken against the US dollar over the rest of the year.

New Zealand’s central bank increased interest rates in March by 25 basis points to 2.75 per cent – the first central bank to tighten monetary policy this year. Further increases are likely in the second quarter, which would probably cause the New Zealand dollar to strengthen against the Australian dollar, Swiss franc and low-yielding currencies.

Despite weakness in the Australian dollar compared with the currencies of its main trading partners over the past 12 months, it remains overvalued. In the short term, stable commodity prices and confidence in Australia’s economy should support its currency against both sterling and the US dollar. Meanwhile, we remain cautious on the Canadian dollar because the country’s central bank is likely to cut interest rates later this year.

Emerging market weaknessConcerns about the major emerging market (EM) currencies eased as the first quarter progressed (figure 9). At the end of the period exchange rates reflected concerns about current account deficits in some of the larger economies. Markets seem to have accepted that these deficits tend to correct themselves over time, particularly when a currency has experienced significant weakness.

Some of the main EM currencies with large current account deficits should continue to depreciate, such as the South African rand and Indian rupee. But we remain cautious on the Brazilian real owing to stubbornly high inflation and anaemic growth prospects despite the economic boost from hosting football’s World Cup Finals this summer.

Figure 9: Change in currency value against the US dollarMost emerging market currencies have plummeted in value over the past year.

1 year (%) First quarter (%)

Indian rupee -12.4 1.2

South Korean won 3.2 -2.6

Czech koruna -0.1 -0.2

Russian ruble -18.1 -10.7

Turkish lira -22.6 -3.7

Argentinian peso -56.1 -22.0

Brazilian real -16.8 1.6

Mexican peso -7.4 -1.7

South African rand -16.7 -3.8

Figure 8: The US dollar against sterling and eurosImproving economic conditions in the UK pushed sterling higher against the US dollar over the first quarter. But the ongoing recovery in the US should support the dollar’s strength over the rest of this year.

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Diversified commodities1 began the year strongly, rising 5.5 per cent2 in the first quarter and establishing positive momentum at the end of February (figure 10). Inevitably investor sentiment began to improve as prices rose, with hedge funds increasing their long positions across a broad range of commodities.

The rally in February led to the 20-day Relative Strength Index3 breaking through 70, which indicates overbought levels. Although this move could reflect some short-term frothiness, overall we do not believe sentiment is particularly stretched. In addition, commodity prices remain around 8 per cent below their long-term average in real terms, suggesting valuations are not at extremes.

We continue to believe in a sustained global economic recovery and, combined with their positive momentum, that diversified commodities are an efficient way of investing in this theme. As a result, we are considering making an allocation to commodities for multi-asset portfolios over the next few months to increase our potential sources of returns and improve diversification.

Although our view on commodities as a whole is positive, we see scope for significant dispersion between the sub-asset classes over the rest of 2014.

Industrial metal weaknessThree key themes from China are set to dominate industrial metal prices over the medium term. First, recent economic data continues to disappoint, pointing to the potential for a slowdown in activity that is deeper than expected. The fear that Chinese demand could fall significantly is likely to continue to depress industrial metal prices.

Second, Chinese authorities are looking to reduce and regulate the use of industrial metals as collateral for financing agreements. The level of restrictions is only likely to increase as the authorities try to control lending. These policies are likely to have a significantly negative impact on industrial metal prices, in particular iron ore and copper.

Third, China’s pollution policies could have far-reaching repercussions across a number of commodities. President Xi Jinping has emphasised reducing pollution and improving China’s air quality as key objectives over the next few years. Anyone doubting his sincerity need only look at the widespread discontent among Chinese citizens over appalling levels of air pollution. As ever, Chinese authorities can be expected to act decisively on the issues that have the greatest potential for social unrest and instability.

Commodities provide exposure to the global economic recovery

Market Pulse — Commodities

Figure 10: Most commodity prices have been falling over the past few yearsDiversified commodities moved above their 10-month moving average at the end of February, establishing positive momentum.

Source: Bloomberg and Kleinwort Benson. Data as at February 2014.

Air pollution regulation could further hit demand for iron ore. However, the impact is likely to be dispersed with lower demand for lower-grade products, more polluting iron ore “fines” and a boost to demand for higher-grade, iron-ore “lump”. Over the longer term, plans to move polluting plants away from the densely populated east coast could increase demand for copper as part of the expansion of the power grid.

Can gold continue its strong start to 2014?Gold has had the best start to a year since 2008 – prices had increased by 10 per cent by the end of February in US dollar terms. The rise was driven by a combination of weak US economic data, concerns over emerging markets and a rise in geopolitical risks due to the Ukraine crisis.

Sentiment does not seem to be overly bullish given the sharp price rise. Notably, net speculative long futures positions are 46 per cent off their September 2012 high. In addition, gold ETF investment flows seem to have stabilised and even improved following the large outflows experienced in 2013.

While gold may still offer some upside in the short to medium term, we believe it is likely to be limited. Poor US economic data is likely to be a weather-driven blip, and we expect the numbers over the next quarter to improve, putting downward pressure on prices. In addition, over the longer term, we expect real rates to continue to rise – this environment tends to result in poor returns for gold.

Overall, while gold continues to offer protection against crisis events, we do not see a strong enough case to hold it in our portfolios outright. Instead we prefer to have some exposure as part of a diversified commodities basket.

1) Using the Dow Jones UBS Commodity Total Return Index as our benchmark. 2) All returns in sterling unless otherwise stated. 3) The Relative Strength Index is a technical, price-based measure that can be used to judge to what degree an asset is oversold (when the RSI is below 30) or overbought (when the RSI is above 70).

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Analysing the pattern of performance in the property markets can indicate when they are approaching a peak or trough, and therefore provide a useful guide for investment strategy. Over the past 25 years the overall returns have closely matched the returns from each sector, including retail, office and industrial. The average correlation has been 0.841.

The dispersion of returns between sectors tends to drop when markets are stressed (figure 11). During bull markets, sectors tend to rise or fall together. Dispersion levels fell to their lowest for 25 years during the market’s peak in 2007, and again when all sectors were falling in value in 2011. The average dispersion since 2000 is lower than the average

since 1990. During the initial recovery phase in the UK market after 2008, there was a pronounced difference in returns from the various real estate sectors. The margin between prime and secondary assets widened to a record high.

Figure 12 shows the dispersion of property yields for various sectors. It compares the range of yields between the 2007 low, when the UK commercial real estate market peaked, and 2009, when property values were at their most depressed and yields at their highest. The low and high markers show the different ranges of correction experienced at the individual level. The yields from three sectors – prime central London shops, regional dominant shopping centres and

Market Pulse — Real estate

Figure 12: Property yields in December 2013 compared with previous highs and lowsOur analysis shows that three sectors are trading at or below their 2007 lows – prime central London shops, regional dominant shopping centres and London West End offices.

Figure 11: Correlation and dispersionReturns from the various sectors that make up the property markets (including retail, office and industrial) tend to become increasingly correlated during periods of market stress.

Source: Investment Property Databank (UK Data). Data as at March 2014.

Source: Cushman & Wakefield. Data as at December 2013.

London West End offices – are all trading at or below their 2007 lows. By contrast, secondary retail properties continue to trade at yields well above those in 2009, reflecting poor sentiment for this sector.

Yields and returns at the sector level reflect a combination of growth expectations, security of income and investor demand. Notwithstanding our analysis, we continue to prefer a diversified approach to investment in UK commercial real estate. But we have concerns about standard retail shops outside core locations, and actively monitor the breakdown of asset class holdings of our preferred property funds.

UK market update Following the huge market correction between 2007 and 2009, when UK commercial real estate values fell 44 per cent from peak to trough, there have been 10 months of positive capital growth. Values have recovered by 19 per cent from their lows but still remain 34 per cent below their peak.

We increased our allocation to diversified UK commercial real estate in the second quarter of 2013 when capital values stopped falling. Over the 12 months to February 2014, property returned 12.6 per cent, and delivered 10.9 per cent in 2013, outperforming both UK gilts and corporate bonds.

We are mindful of market signals, and note an increasing number of factors that could be considered early warning signs as the property market moves through its latest cycle. Investment activity during 2013 increased 50 per cent from 2012 – the highest annual figure since 2007. There have also been increasing investment flows into retail property funds – a 255 per cent annual increase.

The Investment Property Databank (IPD) initial yield for All Property has now fallen below 6 per cent to 5.9 per cent for the first time since August 2008. We are now back to initial yields at the sub asset class level last seen in 2007 and 2008, just before the market decline. However, we believe diversified UK commercial real estate continues to offer an attractive level of income, and should deliver a positive return this year. We expect capital growth to continue for the rest of this year, but could then start to fall.

Disparity and dispersion are a guide to real estate returns

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1) Correlation refers to the statistical relationship between two random variables, which ranges from +1.0 to -1.0. A correlation of +1.0 means they are perfectly correlated (when one goes up, the other goes up by the same amount). A correlation of -1.0 means they are perfectly negatively correlated (when one goes up, the other goes down by the same amount). A value of 0 means that two random variables have no correlation; they are completely random.


Market Pulse — Markets at a glance

A casual glance at the performance numbers in figure 13 suggests the first quarter has been a quiet period for most asset classes. Developed market equities returned around 1 per cent, which is far less than the near 10 per cent gains in the first quarter of 2013. Yet the reality behind these numbers is different.

In January equity markets plunged as fears of emerging market (EM) economic weakness grew. By February these fears had receded and most markets recovered these losses, with some even surpassing their record highs of last year. On the first trading day in March fear returned again and equity markets sold off aggressively as Russia seized control of the Crimean peninsula. Notably, Russia’s stockmarket has suffered a 10 per cent fall over the quarter. However, global equities rallied to end the quarter mostly unchanged.

Market volatility brought about a strong rally in traditional safe-haven assets. Developed government bonds and investment grade credit both outperformed equities even though markets believe rates can only go one way from their current low levels. Recent events have reminded investors than bonds can reduce volatility in portfolios. Gold also rallied sharply given the tensions. Although we have no allocation to gold in our portfolios, we do recognise its tendency to do well in crisis situations. We will reconsider the case for gold if its recent positive momentum persists.

While global equity markets see-sawed, the Chancellor of the Exchequer, George Osborne, delivered an upbeat Budget. He may feel vindicated by his policies as he outlined a UK economy with stronger growth, smaller deficits and lower debt. However, the Chancellor, stunned the pensions industry by announcing plans to give new retirees far more freedom to choose what they do with their pension pots.

Financial markets experience a relatively volatile quarter

Figure 14: Gold prices have ralliedThe price of gold tends to rise when there are geopolitical tensions, such as the recent crisis in Ukraine, or uncertainty about the global economic outlook. Prices spiked higher towards the end of the first quarter.

Figure 13: Investment returns (%)

First quarter 2014 Past 12 months

Developed market equities 1.1 18.9

Emerging market equities -0.8 4.0

Developed government bonds 2.0 1.2

Emerging market government bonds 1.8 0.3

Global investment grade corporate bonds 2.6 2.3

Global high yield corporate bonds 2.9 7.8

Oil (WTI spot price only) 3.2 4.5

Gold 6.5 -19.7

Agriculture (spot price only) 16.4 -5.9

Hedge funds 0.8 4.3

Global property 3.2 2.5

Listed private equity (in US dollars) 1.3 22.4

Source: Datastream and Kleinwort Benson. Data as at March 2014.


Returns are in local currency unless stated and assume net dividends and interest payments reinvested.

Figure 15: Deficit down, debt down and growth upThe Chancellor used his recent Budget to outline healthy conditions in the UK economy with strong growth, smaller deficits and lower debt.

Source: Datastream and Kleinwort Benson. Data as at March 2014.

momentum (10-month moving average)

500

1000

1500

2000

2014201320122011201020092008

gold spot price ($ per ounce)

$

0

1

2

3

4

5

6

7

8

Estimate one year agoCurrent estimate

2014 GDP growth 2014 de�cit peak debt-to-GDP (2015/16)

2.7

6.6

1.7

7.1

79

86

Key risksThis publication is intended to give an insight into the thought processes that lie behind our investment views and our investment strategy. They do not necessarily reflect the current investment policy of Kleinwort Benson.

The information in this publication is provided for information purposes only and does not take into account the investment objective, the financial situation or the individual needs of any particular person. It is not an offer to buy or sell any particular security or investment. In no event will any entity of the Kleinwort Benson group assume any liability for loss or damage of any kind arising out of the use of information contained in this publication.

This publication does not constitute advice. All potential investors should seek and obtain advice specific to their circumstances from a qualified financial adviser before making investment decisions. The value of investments, and the income from them, may fall as well as rise and the investor may not get back the amount initially invested. Past performance does not guarantee future performance. Fluctuations in exchange rates may cause the value of investments denominated in currencies other than sterling to fall or rise. The effects of charges and an investor’s personal tax circumstances may reduce any returns. Tax treatment depends on an investor’s individual circumstances and may be subject to change.

Regulatory informationThis publication is a financial promotion. It has been approved and issued in the United Kingdom by Kleinwort Benson Bank Limited. Kleinwort Benson is the brand name of Kleinwort Benson Bank Limited. Kleinwort Benson is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, reference number 119269 and is a member of the London Stock Exchange. Kleinwort Benson is a company incorporated in England and Wales with company number 2056420.

Kleinwort Benson is the brand name of Kleinwort Benson (Channel Islands) Investment Management Limited which is a company incorporated in Jersey with company number 13270. Registered Office Kleinwort Benson House Wests Centre St Helier Jersey JE4 8PQ. It is regulated by the Jersey Financial Services Commission, the Guernsey Financial Services Commission for the conduct of investment business and is also regulated by the South African Financial Services Board as a licensed Financial Service Provider.

Kleinwort Benson is the brand name for Kleinwort Benson (Channel Islands) Limited which is a company incorporated in Guernsey with company number 52103. It is regulated by the Guernsey Financial Services Commission for Banking and Investment Services. Kleinwort Benson places all client deposits with a spread of approved counterparties and other parts of the Kleinwort Benson Group. As such their financial standing is linked to that of the Kleinwort Benson Group. Depositors should form their own view of the

financial standing of the Bank and the Group based upon publicly available information. Kleinwort Benson is a participant in the Guernsey Banking Deposit Compensation Scheme. The Scheme offers protection for ‘qualifying deposits’ up to £50,000.00 subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000.00 in any 5-year period. Full details are available on the Scheme’s website www.dcs.gg or on request. Kleinwort Benson is authorised and regulated by the Financial Conduct Authority in respect of UK regulated mortgage activities and its firm reference number is 310344. Registered Office Dorey Court Admiral Park St Peter Port Guernsey GY1 2HT. Telephone number +44 (0)1481 727111.

Kleinwort Benson is the brand name of Kleinwort Benson Fund Services (SA) (Pty) Limited which is a company incorporated in South Africa with a company registration number 2006/028378/07. It is regulated by the South African Financial Services Board as a licensed Financial Service Provider. It is a wholly owned subsidiary of Kleinwort Benson (Channel Islands) Fund Services Limited which is registered in Guernsey and regulated by the Guernsey Financial Services Commission for the conduct of investment business and the provision of fiduciary services. Both are subsidiaries of Kleinwort Benson Channel Islands Holdings Limited the ultimate parent of which is RHJ International SA which is listed on the Brussels stock exchange. Directors: Mark Bright*, Jacobus Cronje, Jan Louw, Adam Moorshead*, *BRITISH.

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Market Pulse

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For details of our services and general information about Kleinwort Benson please visit www.kleinwortbenson.com CN

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Documents

Market Pulse · difference (or dispersion) between returns has also been low. Therefore, picking the “right” assets has been less important because the distance between “winners”