QUARTERLY REVIEW

This issue: Flows and fundamentals US: Data dependency Europe: ECB activism Asia: Chinas shadow banks Special focus: Active xed income management
Summer 2013

EFG International

Comment
If anyone doubted the importance of central banks to the worlds financial markets, events of the early summer should lay their doubts to rest. The hint that the US Federal Reserve would taper its programme of asset purchases assuming that the US economy particularly jobs growth was strong enough sent markets into a tailspin in June. Japan, however, is keenly embracing US-style quantitative easing (QE) policies. And, in early July, the ECB adopted the US approach of giving forward guidance on shortterm interest rates. The Bank of England is thought likely to adopt a similar approach. So, although the precise details vary, the US model of post-crisis monetary policy seems to have been effectively exported to the rest of the world. Comparisons with the US, of a less favourable nature, are also being made in China. Concerns about its shadow banking system are being likened to the conditions which preceded the US subprime crisis. There are important differences, and we do not think this is Chinas Lehman moment, but clearly Chinas banking system will remain a source of concern for some time. Fixing banks, the last five years tells us, is a slow process. For investors, however, much bad news already seems discounted in the Chinese equity market.

Quarterly Review Summer 2013

Overview
After more than four years of very easy monetary conditions in the US, nancial markets are starting to adjust to a different environment. However, the phasing out of expansionary policies in the US will be a long, slow process and will be conditional on the strength of the economy it will be data-dependent. Furthermore, other countries are only now embracing US-style monetary policies (QE in Japan and forward guidance on rates in Europe). Expected changes in policy have led to some large fund ows, out of assets previously considered safe, such as gold, core government bonds and ination-protected securities. Recent capital losses on such assets have challenged the notion of their safety. The summer is often a volatile time in nancial markets and in that context such uncertain conditions may be expected to continue. This, however, is an environment in which a careful assessment of fundamentals needs to be set alongside the short-term vagaries of fund ows.

What sort of growth?

It is commonplace to describe economies as being at various positions in their economic cycle recovery, recession and so on. Such an analysis is, however, somewhat inappropriate in current circumstances: different economies are better described as being at varying stages in their post-crisis and structural adjustment.

In these circumstances there is a heightened sensitivity to data releases. Better than expected data has typically seen the price of safe haven assets, such as US government bonds, fall with their yield rising. The US is making a good recovery from its credit and housing crises. Even so, economic growth still remains weaker than longrun historic averages and the labour market is not yet strong enough to support an early withdrawal of monetary stimulus. The UK recovery lags that of the US but data revisions have seen the double dip disappear and growth seems to have recovered well in mid-2013. Japan has posted strong growth so far in 2013: probably helped by Abenomics, at the very least with regard to the positive inuence on condence. However, the jury is still out on whether or not that set of policies will ultimately succeed in boosting growth and eliminating deation. In the Eurozone, many structural challenges remain to be addressed, austerity fatigue can be seen in some countries and there is slow progress on the structural reforms which were designed to bolster the Eurozone. Economic activity has, at best, stabilised. China, meanwhile, continues to strive for a rebalancing of its economy away from export and investment dependence and toward more consumer-orientated growth. Growth is rm but the perennial fears of a hard landing have not been dispelled.

Economic surprises and bonds

Citigroup Economic Surprises Index for major economies (lh axis) US 10-year government bond yield (rh axis) 60 Index, += better/-=worse than expected 40 20 0 -20 -40 -60 -80 -100 -120 2007 Economic data weaker than expected Economic data better than expected 5.5 5.0 4.5 4.0 3.5 % 3.0 2.5 2.0 1.5 1.0 2008 2009 2010 2011 2012 2013

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 1

Contents

03

04

Asset market performance

US: Data dependent QE tapering

05

UK: Double dip disappears

06

Europe: ECB activism

08

Asia: Chinas shadow banks

09

Special focus: Active xed income management

EFG International

GDP: Japan vs US and Eurozone

Japan 109 108 107 Index, Q1 2009 = 100 106 105 104 103 102 101 100 99 2009 US Eurozone

Current account balance: ten-year downtrend

Brazil 2 Forecast 0 India Turkey South Africa

-2 % of GDP

-4

-6

-8

2010

2011

2012

2013

-10 2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Source: IMF World Economic Outlook database. Data as at 2 July 2013.

Figure 2

Figure 4

Flows and fundamentals

Perhaps because economic growth does not yet seem to be on a secure footing, indications that the US Fed may taper its quantitative easing (QE) programme (that is, reduce then stop its programme of asset purchases) have caused a number of dislocations in nancial markets. As well as the impact on safe-haven bonds, fears of tighter global liquidity have adversely impacted emerging market bonds, currencies and equities that had been favoured in the hunt for yield. Fund outows from many of these previously-popular assets

have been substantial and, at times, disorderly. The drawbacks of passive, index tracking investing for such assets have been highlighted (see Special Focus on page 9).

Changing perceptions
In that context, a changed perception is, in some cases warranted. Japan has long been regarded as a structurally weak economy with entrenched deation and poor demographics. We are cautiously optimistic that the aggressive set of policy measures introduced by the new government will have a positive short term impact on the economy although the longer term implications are less clear. It is notable that, even before these measures were introduced, the Japanese economy had made a respectable recovery from early 2009 the trough of global activity. In the emerging economies, we need to be mindful of the fact that fund ows into these economies in recent years have had, in some cases, a very distortionary effect. Notably, they have driven up real exchange rates in a number of countries (for example Brazil, India, Turkey and South Africa), impairing their competitiveness and bringing a deterioration in their current account balances. Other emerging economies have not been as adversely affected. Although the importance of the emerging economies in driving global growth on a long-term basis remains intact. Variations around that theme also need to be considered. We return to these themes after a discussion of recent asset market performance.

Real exchange rates

BRIC 150 140 Less competitive 130 Index, January 2003=100 120 110 100 90 80 70 03 N11* Eurozone US Japan

04

05

06

07

08

09

10

11

12

13

*Bangladesh,Egypt,Indonesia,Iran,Mexico,Nigeria,Pakistan,Philippines,Turkey,South Korea, andVietnam Source: JP Morgan, Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 3

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Quarterly Review Summer 2013

Asset market performance

In all of the main developed markets, equities produced positive, and government bonds negative, returns in the rst half of 2013. In the main emerging markets, both bonds and equities posted losses in US dollar terms.
Bond market returns
Local currency terms US$ terms 5 Six months to end-June 2013

Asset market performance

Overall world equities produced total returns in the rst half of 2013 of 8.8% in US$ terms. The strongest performing countries were Japan, with a gain of 16.6% in US$ terms and the US (up 13.7%).

-5

-10

Asset market performance

Bonds, total return US$ terms Equities, total return, US$ terms 20 Six months to end-June 2013 15 10 5 % 0 -5 -10 -15

-15

Japan

Australia

UK

Switzerland

US

Eurozone

Source: Citigroup. Data as at 2 July 2013.

Figure 6

Past performance is not an indicator of future performance.

Equity markets
The four main emerging equity markets Brazil, Russia, India and China all recorded losses in US dollar terms in the rst half of the year. In contrast, all the main developed equity markets returned positive local currency returns, with Japans gains amounting to 34%. Currency weakness against the US dollar undermined the performance of almost all markets in dollar terms. That was most notable in Japan, with a sharp fall in the yens value. Even so, Japan still produced the strongest dollar-terms returns in the rst half. Australias gains in local currency terms were transformed into losses in US-dollar terms as the currency weakened sharply. Concerns about slowing Chinese growth and commodity prices weighed on the Australian dollar.

US

Europe

Japan

Emerging

World

Source: Citigroup (bonds); MSCI (equities). Data as at 2 July 2013.

Figure 5

Past performance is not an indicator of future performance.

Bond markets
Most developed world government bond markets recorded negative total returns in local currency terms in the rst half of the year. Losses in capital value, as yields rose, outweighed coupon income. In US dollar terms, as the dollar appreciated against most currencies in the period, returns were further into negative territory: losses in the Japanese government bond market amounted to 12.4%. Behind the back-up in bond yields was a concern about the effects of a tapering of the US QE programme, which would entail a slower pace of Fed purchases of government and mortgage bonds.

Equity market returns

Local currency terms 40 US$ terms Six months to end-June 2013

30

20

% 10

-10

-20 Brazil Russia China India Australia UK Taiwan Switzerland Germany US Japan

Source: MSCI. Data as at 2 July 2013.

Figure 7

Past performance is not an indicator of future performance.

Japans equity market the star performer in the rst semester

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EFG International

United States
The health of the US economy will be carefully monitored during the summer as the US Federal Reserve has outlined that various economic criteria will be carefully assessed when judging the timing and pace of the exit from ultra-low interest rates and the scaling back and ending of quantitative easing (QE).

Trends in the labour market will be the key factor behind the tapering of the Feds asset purchases.

Tapering decisions
The importance of the US economy and monetary policy decisions to the entire world was underscored by the fact that all global nancial markets were affected by recent Fed comments that it would start to taper its QE programme. Tapering refers to scaling back the Feds monthly asset purchases from the current pace of $85bn. That is, the Fed will still continue to buy government and mortgage bonds but at a slower rate.

Labour market is key

However, the most important economic information behind the tapering decision will be labour market data and, more specically, the monthly change in non-farm payroll data. Over the rst six months of 2013, the increase averaged 190,000 jobs per month. If that pace in maintained, we think it will justify a gentle taper in asset purchases. If gains are above 200,000 per month a more rapid taper would be warranted, but less than 140,000 per month would signal no tapering. Importantly, gains at that rate are unlikely to absorb all the new workers entering the labour market and the unemployment rate is likely to rise. However, the link between job creation and the unemployment rate is far from direct as there has recently been a steady fall in the participation rate (the share of the population in work or actively seeking work). The exit route from the USs unorthodox policies will certainly take a long time and require a delicate balancing act.

Growth recovery
The fact that US GDP growth has recovered sufciently well enables such a step to be considered. In particular, the private sector is regaining momentum, offsetting the drag on overall GDP growth from lower government spending. As a result of the way GDP growth data are reported - quarter on quarter annualised changes - growth could well appear stronger in the third quarter as comparisons are made with the second quarter (in which the effects of government spending cuts were greatest).

US GDP: government and private sector

Overall GDP growth Federal, State and local government spending Private sector spending

US labour market
Participation rate (lh axis) Unemployment rate (rh axis) 65.5 10.0

% change on year

2 65.0 0 64.5 -2 % 64.0 8.5 9.0 % 9.5

-4

-6 2007

2008

2009

2010

2011

2012

2013

63.5

8.0

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 8

63.0 2010

2011

2012

2013

7 .5

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 9

04

Fed moves on monetary policy are data dependent

Quarterly Review Summer 2013

United Kingdom
There are some brighter signs with regard to the UK economy allowing the Chancellor of the Exchequer to claim recently that it is out of intensive care.

Double dip disappears as data turn more positive.

Economic surprises
In nancial markets it is so often the case that economic data are judged not in an absolute sense whether growth is positive or negative, for example but relative to expectations. It is the surprise element which inuences nancial markets. In the UK recently those surprises have been generally favourable, with data better than market expectations. Revisions to past data on GDP have also helped dispel some of the gloom. The double-dip recession the renewed drop in output in late 2011/early 2012 after the recession in 2008/9 no longer exists, thanks to such revisions. Even so, UK GDP in the rst quarter of 2012 was still 4% lower than at its peak four years earlier.

UK employment

UK total employment (millions) 33 32 31 30

Recessions

UK economic surprises
UK Citigroup Economic Surprises Index 120 100 Index, += better/-=worse than expected 80 60 40 20 0 -20 -40 -60 -80 2007 Economic data weaker than expected 2008 2009 2010 2011 2012 2013 Economic data better than expected

Millions

29 28 27 26 25 1980

1985

1990

1995

2000

2005

2010

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 11

Policy change?
This all means that when Mark Carney took over as Governor of the Bank of England on 1 July, conditions were better than at the time his appointment was announced in November 2012. Nevertheless, his rst comments highlighted that the back-up in government bond yields could threaten continued growth and that they were unwarranted by prospects for short-term rates. That, in effect, amounts to forward guidance on policy interest rates.

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 10

Labour market
Nevertheless, the UK economy has been good at creating jobs. Numbers in employment reached a new peak of 32.3million in the rst quarter of 2012. The unemployment rate of 7 .8% is similar to that in the US. Employment levels fell only modestly in the recession by 2.5%, compared with 7% in both the early 1980s and early 1990s recessions. It is true that many of the jobs created are part time and lower-paid, but there is no doubt that conditions in the UK labour market are much better than almost everywhere in the Eurozone.

UK equities
Although UK 10-year gilt yields have risen to 2.5%, they are still low in a long-term historic context. UK equities, with a dividend yield of 3.5% (on the FTSE All-Share index), continue to provide attractive yield and total return prospects for longer-term investors.

The UK produces more jobs, even in hard economic conditions

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EFG International

Europe
In mid-2012 it was seen as essential to develop a new framework to strengthen the operation of the Eurozone. Moves towards banking union and the use of a common fund for bank recapitalisation were deemed urgent. One year on, little progress has been made on these issues.

Slow progress on structural issues

Perhaps most disappointing is the case of the ESM (European Stability Mechanism), the eurozones 500bn rescue fund. This was designed to be able to recapitalise banks directly. So far, that has not happened: concerns about the collateral requirements have been the main stumbling block and it is thought unlikely to be operational for another 18 months. Progress has been made on plans for banking union, entailing common supervision of large European banks, but concrete structures are unlikely to be in place for some time. Some see the German general elections on 22 September, because they distract German policy makers attention, as one reason for the delay. Although President Angela Merkel is widely thought likely to win, a new German government is unlikely to be in place much before end-2013. By that time the direct elections to the European Parliament (in late May 2014) will be looming. There is a realistic chance that parties broadly opposed to current EU policies will have a majority in that new parliament.

EU leaders have decidedthat when it comes to scal and economic integration within the eurozone, the decisions will be taken at a later date.
Peter Spiegel, Financial Times, 28 June 2013.
Eurozone unemployment
Unemployment rate, latest Previous peak (since 1990) 30

25

20

% 15

10

Eurozone economic surprises

Eurozone Citigroup Economic Surprises Index 150 100 50 0 -50 -100 -150 -200 2007 Economic data weaker than expected Economic data better than expected

0 Germany France Italy Ireland Portugal Spain Greece

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 13

Index, += better/-=worse than expected

2008

2009

2010

2011

2012

2013

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Figure 12

There are three main reasons for that. First, economic data have been no worse than (admittedly low) expectations. Second, current account decits in the peripheral countries have narrowed sharply or moved into surplus (to a large extent because of weak domestic demand, which has curbed imports). Third, and most important, the ECBs pledge to do whatever it takes to save the euro last July, the announcement of Outright Monetary Transactions (OMTs) last September and the commitment to maintain interest rates at present or lower levels for an extended period of time in July have calmed markets. Mario Draghi has described the OMT as probably the most successful monetary policy measure in recent times , despite (or because of?) the fact that it has never been used. Although Eurozone equity markets have recovered since their trough last June, valuations are still, overall, low and there are many interesting stock-specic opportunities.

but a more active ECB

Despite these concerns, tensions in the Eurozone have subsided and break-up risk is now considered a low probability.

06

Decision making stalled

Quarterly Review Summer 2013

Asia
Chinas shadow banks have been known to pose a potential problem for some time. Events in late June, however, propelled the sector into the spotlight.

Chinas shadow banks

The term shadow banking refers to three main types of nancial activity: off-balance sheet activity by the banks themselves; activities of non-bank nancial institutions such as trust and leasing companies; and lending by retail money lenders to small companies and individuals. The expansion of credit by the Chinese shadow banking sector has been rapid, trebling in size to RMB23 trillion in the four years to the end of 2012.1 The expansion of lending by the shadow banking system has magnied the expansion of credit by the banks themselves. The consequence has been that overall lending to the private sector, which was stable at about 120% of GDP from 20032009, has risen by a third since then. Many see echoes of the USs credit crisis in Chinas current problems. Growth of lending has nanced construction spending (infrastructure as well as housing); it has helped drive a surge in property prices; some of the investment has been excessive (building roads to nowhere) and, most recently, nancial institutions stopped lending to each other, with interbank interest rates briey soaring to 25%. Even so, the parallels go only so far and we do not see this as Chinas Lehman moment. First, banks are already state-owned,

Spotlight falls on Chinas shadow banks. But this is not a Lehman moment.

with limited transparency so cleaning up any problems posed for the regulated banks by the shadow banks can be done more quietly. Second, China still has strong economic growth, so to some extent it can grow out of its problems. Third, savings levels are high and banks themselves have not lent excessively the loan to deposit ratio is only 75% whereas it was well above 100% for US banks before the crisis. For investors, the other major difference is that an equity market bubble has not gone hand in hand with the growth of lending. Indeed, the domestic Chinese equity market (the Shanghai Stock Exchange A share index) is no higher than it was ten years ago. In China, as in some of the other more export-orientated Asian markets, we still see good value in equities.

China: bank lending to the private sector

Bank lending to the private sector Bank plus 'shadow' bank lending to the private sector 170 160

China & Hong Kong: stockmarket indices

Shanghai Stock Exchange 'A' share index (restricted to mainland China domestic investors and qualied foreign investors) Hang Seng China Enterprises 'H' shares index (mainland China enterprises with H-share listings in Hong Kong) Hang Seng (main Hong Kong index) 1200 Index, 1 January 2000 = 100 2014

150 % of GDP 140 130 120 110 100 90 2000 Shadow banking

1000

800

600

400

200

2002

2004

2006

2008

2010

2012

0 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Thomson Reuters Datastream; Hang Seng Indices (www.hsi.com.hk). Data as at 2 July 2013.

Source: Thomson Reuters Datastream; Joe Zhang 'Inside China's shadow banking', Enrich Professional Publishing (2013).

Figure 14
1

Figure 15

See Jo Zhang Inside Chinas shadow banking; the next subprime crisis? Enrich Professional Publishing (2013).

Could problems with Chinas shadow banks result in a hard landing for the economy?

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EFG International

Japan
Although there has been a setback in the Japanese stockmarket after the initial sharp rise which accompanied the launch of Abenomics, we still see it as cheaply valued relative to the trend in prots.

Abenomics and the stockmarket

It will be many years before the success or otherwise of the set of policies known as Abenomics can be assessed. The three arrows of the policy are: renewed scal stimulus, amounting to 13 trillion ($150 billion, about 2.7% of GDP); a 2-2-2 monetary policy a doubling of the monetary base in 2 years to reach a 2% ination target; and a series of structural reforms to help improve competitiveness. As a by-product of that set of policies, the yen has weakened sharply. The pass-through from a weaker yen to higher imported goods cost has improved the outlook for ination but reaching the 2% target remains some distance away. Furthermore, as noted above, Japans GDP growth since 2009 has been on a par with the US and strong 2012 rst quarter growth was recorded. The stockmarket has responded well to the measures with the Japanese equity market being the best performing developed market in the rst half of 2013, despite a setback after its initial surge. It still remains, however, below the previous peaks recorded in 2000 and 2007 .

Japans stockmarket has risen sharply since Abenomics was launched in late 2012 but it still offers good value.

Corporate prots rebound

Corporate prots, however, have already risen and are generally expected to grow strongly this year, to some extent as a result of the yens more competitive level. A new peak level for prots in 2013/14 looks a realistic prospect. Indeed, on the basis of consensus twelve month forward earnings expectations, Japans equity market is no more expensive now than it was in late 2012.

...but higher highs for prots

Corporate prots and forecast (Yen trillions) 2000 peak 2007 peak 20 Forecast 18 16

Japan: lower highs for the stockmarket

Yen trillions

14 12 10 8 6 4 2 2000

22000 20000 18000 16000

Index points

Nikkei 225 index 2000 peak 2007 peak

2002

2004

2006

2008

2010

2012

2014

14000 12000

Source: Thomson Reuters Datastream; EFG forecasts. Data as at 2 July 2013.

Figure 17
10000 8000 6000

Scepticism questioned
00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Thomson Reuters Datastream. Data as at 2 July 2013

Figure 16

Perhaps because Japans equity market has been such a poor performer for such a long period of time, and because Japans economy has repeatedly disappointed, scepticism about Japans prospects is widespread. For the short term at least, we are taking a more optimistic view with regard to the outlook for Japanese equities.

08

Strong prot growth in prospect

Quarterly Review Summer 2013

Special focus:

Active xed income management

The announcement that the US Federal Reserve would start tapering its purchases of xed income securities under its Quantitative Easing programme led to a sharp sell-off in many xed income instruments around the world. Flows out of many bond funds were substantial. The experience emphasises to us the importance of active xed income management and underscores the problems of passive, index-tracking investing in this market.
At the start of the year we were concerned that there was little value in many government bond markets that were viewed as safe. We were concerned that many investors in such bonds were not paying adequate regard to the risk of a rise in yields and the consequent decline in capital values.2 That risk has materialized, with 10-year US Treasury yields rising from 1.72% in late-December 2012 to 2.50% in early July 2013. That has brought an almost 7% fall in the price of such bonds. Safe bonds have been far from safe. The sell-off in government bonds has seen other bond markets, such as emerging market bonds, weaken as well. That is unsurprising given that such bonds typically trade on the basis of a yield spread over Treasury bonds, which act as the benchmark.

The advantages of active, rather than passive, xed income management.

The sell-off demonstrates to us one technical drawback of investing in xed income instruments via a passive fund. Such passive funds seek to replicate the behavior of one of the widelyused xed income indices, but they failed to do so. The outow of funds was so substantial that, on an intra-day basis, they often traded at a discount to the underlying value of the bonds held in the funds. Essentially, the problem is that the liquidity offered to investors in the passive fund was greater than in the underlying investments. Funds tracking the index failed to do so with the precision that investors expected. Additionally, and more fundamentally, we remain skeptical of the merits of such passive investing in xed income markets. In bond indices, a government or corporate issuer has a larger weight the more debt that is outstanding. That means a greater amount is invested in poorer credits. Our approach to active xed income investing is to focus on fundamental value. That is the philosophy behind our EFG New Capital Wealthy Nations Bond Fund*, for example. The emphasis is on investing in bonds issued by countries which have strong national balance sheets and external asset positions. In turbulent conditions, as seen recently, our active management allows us to reposition toward bonds that have underperformed due to technical, liquidity and ow-related developments. Investors, such as ourselves, with the focus on longer-term structural factors can benet from such an environment.

Emerging market bond spreads

Emerging market bonds yield spread over US Treasuries (based on actual historic weights in Emerging Markets Bond Index) 16 14 12 10 8 6 4 2 0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: EFG. Data as at 2 July 2013.

Spread based on current weights in EMBI index

Figure 18

* The value of your investment may fall as well as rise and you may not get back your original investment.

Basis points

See EFGs Quarterly Review, 2013 Q1 Investing in safe government bonds.

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Source: Bloom berg
1

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