Issued in May 2016
For Financial Intermediary, Institutional and Consultant use only.
Not for redistribution under any circumstances.
Schroders Multi-Asset Investments
Views and Insights
Section 1: Monthly Views – May 2016
Equities
Government bonds
0
Category
+
View
Investment
grade credit
High yield
Commodities
+
+
0
Comments
0
We maintain our neutral view on equities this month. Valuations remain fair while
momentum has somewhat improved. However, we note that the soft economic
environment and lacklustre earnings growth remain key headwinds to future
performance.
US
+
Relative to its global peers, we believe the low beta, high quality nature of the US
market should provide more stable return prospects than other markets given the
uncertain state of global growth. We therefore remain positive on the US as the
qualitative outlook and positive momentum offset the present lofty valuations.
UK
0
Our qualitative view causes us to maintain a neutral score on UK equities. While the
sharp depreciation of the pound is supportive for the export-orientated FTSE 100, the
binary outcome of Brexit presents a compelling reason to stay cautious.
-
We continue to view European equities negatively as, despite attractive valuations,
negative interest rates and the flattening of the yield curve will likely impair profitability.
With the possibility that rates could decline further, we believe that the region will
continue to suffer from weak momentum, which could force prices even lower.
0
Despite some of the most attractive valuations in our country modelling, we believe
that the rebound in the yen will cause a greater headwind to earnings than is currently
priced in by earnings consensus. However, the prospect of more policy easing from
the Bank of Japan (BoJ) prevents us from becoming negative on the market.
0
We remain neutral on Pacific ex-Japan equities, as weak momentum in Hong Kong
and Singapore is offset by more attractive valuations in Australia. The current more
dovish stance by the Federal Reserve (Fed) and additional stimulus from China are
expected to be supportive factors in the near term.
0
We maintain our neutral view on emerging markets (EM) this month. The weaker US
dollar, higher oil price and fading tail risk around China have supported a rebound in
prices. However, this is not the first rebound since the EM bear market began in 2010,
which leads us to stay neutral while we wait for further confirmation that the recent rally
is sustainable.
Equities
Europe
Japan
Pacific exJapan
Emerging
markets
Schroders Multi-Asset Investments
Category
View
Comments
Government
bonds
+
We maintain our single positive score on duration as central banks continue to
struggle, paring back their rate normalisation actions in an environment of uncertainty
around growth and inflation.
US
0
We maintain our neutral score on the US this month. Uncertainty around growth is
currently offsetting higher inflation expectations, which is keeping the US curve
anchored for now.
UK
0
While we acknowledge that gilts are one of the main beneficiaries of low eurozone
interest rates, we expect higher volatility as the June EU referendum approaches. For
these reasons we remain neutral despite early signs that growth is slowing.
Germany
+
We remain positive on Germany this month. We have re-introduced a 2/30 year curve
flattener, which we expect to benefit as euro strength keeps a cap on inflation
expectations and European Central Bank (ECB) policy focuses on credit supply rather
than a weaker currency. Uncertainty about the effectiveness of monetary policy is
likely to result in a reduction in long-term yields.
Japan
0
Despite unattractively low and negative yields, we continue to hold a neutral view on
the medium and long duration bonds given aggressive BoJ support and stubbornly low
inflation expectations.
US inflation
linked
0
We remain neutral on the US market as the latest rally, driven by a sharp rise in
commodity prices, has resulted in valuations becoming less attractive.
Emerging
markets
0
We remain neutral on EM US dollar bonds as we expect that returns will solely be
driven by income (carry) for now. Following a sharp narrowing of spreads, we note that
momentum is slowing with the potential for volatility to increase.
Category
View
Investment
grade credit
US
Europe
Category
Comments
+
0
US credit continues to appear moderately attractive relative to other risk premia.
However with the valuation argument now fading and the lack of support from
fundamentals, we have downgraded the premia to neutral this month while we wait for
a better entry point.
0
Spreads have tightened considerably following the announcement of the ECB’s
Corporate Sector Purchase Program (CSSP), making valuations less attractive than
earlier in the year. Although we believe that the CSSP effectively puts a cap on how
far spreads can widen, the current elevated level of valuations means we remain
neutral.
View
Comments
High yield
credit
US
+
We remain positive on US high yield, which is still attractive from an historical valuation
perspective despite considerable spread tightening in recent weeks, and because of
more positive technicals. We acknowledge the downside risk from deteriorating
fundamentals but we believe this risk is currently priced attractively.
Europe
0
European high yield spreads remain firmly anchored around their long-term averages.
As a result, we do not consider valuations to be attractive at these levels and we
remain neutral.
Schroders Multi-Asset Investments
Category
View
Comments
Commodities
+
We have upgraded commodities to positive as the fall in prices has started to
cause a meaningful adjustment to supply in some markets.
Energy
+
We believe longer-term pricing is too pessimistic as capital spending (capex) cuts
have been dramatic and we believe that supply and demand will move into balance in
the second half of the year. With inventory dynamics improving and supply growth
slowing, prices should recover, leading us to maintain our positive view.
Gold
+
We maintain our positive view on gold. Real rates continue to push lower as downside
risks to global growth have lead to an asymmetric approach to inflation risks by the
Fed.
0
The market remains oversupplied and prices remain above the marginal cost of
production. We remain cautious on the Chinese economy over the medium-term but
believe that prices are likely to be supported in the short term. We therefore remain
neutral with a downside bias.
+
We have upgraded agriculture to positive this month. Major grains are in abundant
supply, with a third record harvest in 2015. The fourth strongest El-Niño since 1950,
and an increasing likelihood of an intense La Niña in 2016, could be disruptive to
future crop yields. Farmers are also coming under increasing financial pressure from
low prices, which may also impact supply.
Industrial
metals
Agriculture
Category
View
Comments
Currencies
US dollar
British
pound
Euro
Japanese
yen
Swiss franc
0
We remain neutral, but with a bias for a moderate recovery in the dollar. We expect
that higher inflation will encourage the Fed to hike interest rates, and that there is a
higher probability of this happening than financial markets are currently pricing in.
However, we have not upgraded our view on the dollar because of (i) uncertainty on
global growth, (ii) concerns that other central banks (ECB, BoJ) can no longer induce
significant currency depreciation, and (iii) political risks (Brexit, US presidential
elections, Greek bailout).
0
We remain neutral on sterling this month. Brexit risk is dominating market movements
with fundamentals being ignored. The market does not expect the Bank of England to
raise interest rates until 2018, which is significantly more dovish than our economists’
view, although growth is showing signs of slowing due to Brexit uncertainty.
0
Euro area growth has surprised to the upside but inflation has continued to trend
lower, prompting the ECB to discuss more stimulus measures. This summer’s UK
referendum decision, Spanish general elections in June and Greek debt payments due
in July are all binary events that are likely to exaggerate currency fluctuations. For
these reasons we stay neutral for now.
0
We remain neutral on the Japanese yen this month. The April BoJ meeting did not
result in any additional easing, as the market had expected, which caused the yen to
rally sharply. We believe that the central bank is waiting for a more opportune moment
to launch further stimulative efforts. We believe that such action could be announced
at the same time as the decision to implement the 2017 sales tax hike.
0
The Swiss National Bank continues to be active in the foreign exchange market, as it
seeks to implement its view that the Swiss franc is overvalued and should fall. Recent
macro data has been slightly more encouraging but inflation remains comfortably
below zero meaning that further monetary policy actions are unlikely. We therefore
remain neutral.
Source: Schroders, May 2016. The views for corporate bonds and high yield are based on credit spreads (i.e. duration-hedged). The views for currencies are relative
to US dollar, apart from US dollar which is relative to a trade-weighted basket.
Schroders Multi-Asset Investments
Section 2: Multi-Asset Insights
A lower term premium despite higher
inflation expectations
Despite the recent recovery in inflation expectations,
US nominal bond yields have remained in a tight
trading range. As a consequence US long-term real
yields have dropped sharply. However, the real yield is
often associated with growth expectations and thus the
interpretation of a drop in real yields would be to
assume uncertainty around growth is offsetting the
effects of higher inflation expectations. This month we
provide more insight into this relationship and offer
views on what other factors drive real yields.
Economic background on the term premium and
real yields
In its simplest economic form, the real interest rate is an
increasing function of (consumption) growth. In other
words, it is how people value current versus future
consumption, because the greater discount a
household places on future spending, the higher the
compensation that household
demands to delay
spending, resulting in higher real interest rates. This is
also affected by how willing consumers are to give up
spending today in favour of spending tomorrow, known
as the intertemporal elasticity of substitution. The latter
two are often proxied via savings and consumption data
and can be partly seen as consumers’ outlook or
preferences in the future.
Structural forces suppressing the term premium
Economic growth after the global financial crisis (GFC)
has been very low and real incomes have failed to
keep pace with asset price appreciation. This has
incentivised consumers to save and thus delay future
consumption, causing an excess supply of savings that
has not been matched by investment spending. It is this
excess supply of global capital, amplified by loose
monetary policy, that has put downward pressure on
real yields.
Table 1 – Stylised term premium drivers
Term premium driver
Short-term real yield
Inflation expectations
Correlation with risky
assets
Changes in income
Effect on term premium
Downward pressure
Upward
Downward
Downward
Source: Schroders, May 2016. These views are subject to change
over time.
Loose central bank policy and quantitative easing have
suppressed short-term nominal rates, which has put
downward pressure on short-term real yields. However,
the increase in commodity prices in 2016 has recently
increased inflation expectations, which should exert
upward pressure on the term premium.
In Figure 1, we show a model used by the Federal
Reserve for estimating the term premium (Kim-Wright
model). This is a statistical model that focuses on
forward curve moves rather than macroeconomic
variables, but presents a valuation consistent with our
fundamental assessment of the term premium in the
Table 1.
Figure 1: US term premium proxy last 10 years
1.5
1
0.5
0
-0.5
-1
-1.5
Apr Apr Apr Apr Apr 2006
2008
2010
2012
2014
US Term Premium on a 10yr zero coupon bond
The term premium reflects the extra return a lender
demands for holding a long-term bond over investing in
a series of short-term bonds. The term premium itself is
not directly observable but can be proxied based on
fundamentals or from the forward curve. If bonds are a
good hedge for risks that the investor faces, such as
inflation, changes in income or the returns on other
assets in the investor’s portfolio, then the term premium
can be very low or even negative.
Table 1 shows potential drivers of the term premium
that were highlighted by former Federal Reserve
governor Ben Bernanke in a 2013 speech, and our
views on how each driver will affect the premium:
Source: Bloomberg, Schroders, May 2015
Other term premium drivers
Table 1 suggests other risk drivers are impacting the
term premium. Investors buy bonds for both income
and diversification. It is this demand for diversification
that has contributed to the fall in the term premium. A
negative correlation between bonds and risk assets
implies bonds have more effective hedging properties,
which justifies a lower term premium. Changes in
consumer income may have also driven the term
premium lower. Consumers have increased their
savings rate in recent years as tighter fiscal policy and
lower interest rates have challenged consumers’ ability
to be sustained by investment income. A
macroeconomic consequence of excess saving can be
Schroders Multi-Asset Investments
seen in the structural current account surplus of nations
with excess savings. An example of this is Germany,
where economic growth is supported by substituting
exports for domestic demand, which is likely to lead to
flows into long-dated bonds.
Conclusion
Evidence from macro and financial data indicates that
higher growth uncertainty has been able to offset higher
inflation expectations. This has kept nominal bond
yields anchored. The downward trend in real yields can
potentially be traced back to structural drivers such as
higher risk aversion after the GFC, and lower real
income leading to a higher savings rate.
Important Information: These are the views of the Schroders’ Multi-Asset Team and may not necessarily represent views expressed or
reflected in other Schroders communications, strategies or funds. These views are subject to change rapidly as economic and market
conditions change.
Strategies mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. This newsletter is intended to
be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or
solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for
accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable
but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be
accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking
individual investment and/or strategic decisions. The opinions stated in document include some forecasted views. We believe that we are basing
our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any
forecasts or opinions will be realized. Schroders has expressed its own views and opinions in this document and these may change. Past
performance is no guarantee of future results. Portfolio holdings may change at any time. Schroder Investment Management North America Inc.
(“SIMNA Inc.”) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S.
and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies
registered with the SEC (the “Schroder Funds”). Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of
Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities
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