INVESTMENT UPDATE // QUARTER 3, 2013

Just as economic data on the state of the US economy started to consistently show improvement, the US Federal
Reserve began to muse out loud about how it might start the undoubtedly tricky process of reining in its monetary
support to the markets.

This happened even as the Bank of Japan was getting into its newfound stride of
showeringmoney onto world markets. Needless to say markets have not taken at all kindly to the prospect of their
liquidity staple being removed, even if gradually, and seem to refuse to regard the offering from the Japan central
bank as a substitute for US Dollar liquidity in the global economic system.

Despite the prevailing mood of caution in markets, there are still grounds for reasoned optimism on the progress
of recovery in the US economy, although markets are likely to price this a little less exuberantly in future. However,
the so-called ‘central bank for central bankers’ – the Bank for International Settlements – has recently warned in its
annual report that central banks are reaching the limits of what they can do for the global economy and it is now
down to governments to make the necessary adjustments to their economic management for more long term
progress to be made.

It is fair to say the equity markets did get a little overstretched as the liquidity provided by the central bankers
needed to find a home and undoubtedly the rapid rise of the Japanese stock market was too far too fast. Bond
markets offered extraordinarily low yields, so both asset classes are in essence undergoing a process of
normalisation which surely must be a good thing in the greater scheme of things, although a painful adjustment at
the moment. Emerging markets, both debt and equity, have been particularly badly hit of late. However, these
global market conditions are starting to throw out good investment opportunities in equities. Bond markets will take
a little more adjustment to achieve sensible yield levels. It is how this adjustment proceeds that will dictate the
market mood over the Summer.

Meanwhile, investors should, in many respects, take heart from these gyrations. Even here in Europe there are
genuine signs of economic improvement starting to embed itself and the ECB does not have the same problems
of adjusting Quantitative Easing as do the Fed and the Bank of England – although a rapid rise in global rates
could destabilise the recent calm in peripheral bond markets. Whilst we are still far from the sunlit economic
uplands, at least we can see them in the distance now! And conditions for many companies mean that we might
see a positive progression on earnings in the near future.

Key Points

■Just as investors were congratulating themselves that this year was not the year to follow the old adage: ‘sell
in May and go away’, Japanese equities tumbled, taking other markets down too. Such was the severity
of the Japanese fall that it is easy to lose sight of just how much that market was up in the last six months.
Since the initial fall persistent talk by the governors of the US Federal Reserve (‘the Fed’) about tapering
Quantitative Easing (‘QE’) has further rattled markets.

■ Monetary policy is making all the headlines. In Japan, very aggressive QE is now underway fuelled by the
exceptional rise in equity markets, as the central bank plans to double the monetary base in two years by
creating swathes of new Japanese Government Bonds (‘JGB’). After the rise of almost 85%, equities
pulled back dramatically at the end of May as JGB yields finally recognised the government’s plan by
rising strongly. This was coupled with the announcement of Prime Minister Abe’s fiscal and
structural economic reforms which underwhelmed markets.

US & JAPAN INFLATION EXPECTATIONS HAVE FALLEN Source: Bloomberg

■ In the US, QE was to the fore but for the opposite reasons. Fed governors have been musing out loud,
Chairman Bernanke included, about the ending of QE if the current economic recovery continues and the
unemployment target they set is almost reached. Much discussion about tapering is taking place which
is unsettling the US Treasury market and also raising yields. To some extent, this is also affecting equity
markets too.

■ US mortgage rates recently rose to two year highs. Should they rise further this will threaten the housing
market recovery. US manufacturing data is less convincing on the strength of the recovery but
consumption does seem to support the recovery story.

QE IS DRIVING EVERYTHING

Source: Business Insider/data from Bloomberg

■This Spring, Europe has been quiet relative to previous years. Gradual moves continue to further
integration in banking, although this seems to taking longer than markets hoped – no change in European
habits there. The EU Commission has taken a step back from brutal austerity programmes allowing more
time for debt levels to be dealt with alongside taking some steps to stimulate growth. In addition, there are
improving signs in the recent economic data and the European Central Bank (‘ECB’) forecasts a gradual
recovery in the second half of this year.

■ Although there is a wide variety in emerging economies, these mostly continue to show reasonable
growth compared to developed markets but less sparkling than in the past. After the regime change in
China, great things were expected from the new authorities but so far there is little of substance and
the new rulers seem content with a lower growth rate. Investors are now concerned about the health of the
banking sector and preponderance of bad loans in the regional banking sector, with worries that China may
itself experience a serious banking crisis in the near future.

Original Article with courtesy 7IM : q3_2013_client_investment_update

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