MARKET INSIGHTS Quarterly Perspectives · latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment

Quarterly Perspectives UK | Q1 2017

THIS QUARTER’S THEMES

1 Have US equities rallied too far?

2 Lower no longer: where are yields going?

3 Emerging markets recovery: cancelled or on hold?

4 A reduction in deflation fears, implications for European investors

STRATEGISTS

Stephanie Flanders Managing Director Chief Market Strategist for the UK & Europe

Tilmann GallerExecutive DirectorGlobal Market Strategist

Vincent Juvyns Executive Director Global Market Strategist

Dr. David Stubbs Executive Director Global Market Strategist

Maria Paola Toschi Executive Director Global Market Strategist

Michael Bell, CFA Vice President Global Market Strategist

Alex Dryden, CFA AssociateMarket Analyst

Nandini Ramakrishnan Market Analyst

J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.

Guide to the MarketsUK | |

MARKET INSIGHTS

Q1 2017 As of 31 December 2016

MARKET INSIGHTS

1 Have US equities rallied too far?

US economy heating up, 2017 recession risk falling

• Company profits have fallen in much of 2016, causing some concern that companies would look to cut costs by cutting business investment and workers, which normally leads to a recession. But the fall in profits has been concentrated in the energy industry. The rest of the economy has remained strong and now profits are recovering again, helped by a rising oil price.

• Other key economic indicators are also showing signs of improvement, with consumer confidence hitting a post-crisis high and the number of people signing on for jobless benefits at very low levels.

• The housing market is also showing signs of renewed strength, with the number of new homes being built picking up. The Conference Board Leading Economic Index, which has successfully given an early warning signal for every recession in the last 50 years, also continues to rise.

• All in all, the economy appears to be heating up and the near-term risk of recession falling.

Source: Guide to the Markets – UK, page 27

2 | QUARTERLY PERSPECTIVES | Q1 2017

OVERVIEW

• US equities have rallied strongly, helped by improving economic data and hopes of tax cuts and infrastructure spending from the Trump administration.

• We think the rally has so far been justified by the improving economic data and the associated reduction in recession risk for 2017.

• We still expect positive returns from US equities in 2017 but they should be moderate given that equities have already moved to price in part of the likely improvement in the outlook.

• We expect the performance of value relative to growth stocks and financials relative to “bond proxies” to remain positively correlated to the direction of US bond yields.

US consumers are feeling more positive about the outlook.

MARKET INSIGHTS

27

GTM – UK |

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% change year on year

US growth monitor

Corporate profits, business investment and employment growth

Initial jobless claims vs. consumer confidence Housing starts and Conference Board Leading Economic Index Index level (LHS); thousands (RHS)

Source: (All charts) Thomson Reuters Datastream, J.P. Morgan Asset Management. Light grey columns in all charts indicate recessions determined by NBER.Guide to the Markets - UK. Data as of 31 December 2016.

Jobless claims in thousands (LHS); index level (RHS)

Recession

Consumer confidenceJobless claims

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J .P. MORGAN ASSET MANAGEMENT | 3

Will rate rises hurt equities?

• With an improving growth outlook comes a greater likelihood of higher interest rates.

• Historically, interest rate rises have not derailed the US equity market as long as the rate rises come off a low base. In the past, it has only been once short-term interest rates rise significantly higher than their current levels that equities have started to suffer from higher interest rates.

• The bond market has already moved to price in two rate rises for 2017 and equities have responded well to this move with higher interest rate expectations.

51

GTM – UK |

-0.6

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0 2 4 6 8 10

Interest rates and equities

Correlations between weekly equity returns and interest rate movementsRolling two-year correlation of weekly returns of the S&P 500, MSCI Europe Index and the 2-year Treasury yield, 1983-2016

Source: MSCI, Standard & Poor’s, Thomson Reuters Datastream, US Treasury, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Data for each of the rate hikes: '88-'89 is March 1988 to June 1989, '94-'95 is February 1994 to February 1995, '99-'00 is June 1999 to May 2000, '04-'06 is June 2004 to June 2006, '15-'16 is December 2015 to December 2016. Guide to the Markets - UK. Data as of 31 December 2016.

Cor

rela

tion

2-year Treasury yield

S&P 500

MSCI Europe

Positive relationship between yield movements and equity returns

Negative relationship between yield movements and equity returns

Equi

ties

Market reaction when the US Fed raised rates

'88-'89 '94-'95 '99-'00 '04-'06 '15-'16

Change in Fed funds 3.13% 3.00% 1.75% 4.25% 0.5%

Change in 10-yr yields 0.85% 1.89% 0.49% 0.51% 0.17%

Initial market reaction -7% -10% -7% -8% -8%

Subsequent market reaction 24% 7% 18% 20% 19%

Total reaction 17% -2% 10% 11% 10%

51


MARKET INSIGHTS

Equities and short-term bond yields often rise together when interest rate rises start from a low level.


Value tends to outperform growth when US government bond yields rise.

MARKET INSIGHTS

INVESTMENT IMPLICATIONS

• How much fiscal stimulus is actually delivered will be important for markets in 2017, but at least some is likely and the economy is already picking up anyway. We expect moderate positive returns for equities, with the exact magnitude and relative sector performance being driven by the extent of the stimulus and the reaction of bond yields along with the US dollar.

• We favour a value and income approach to US investing but with a focus on avoiding expensive “bond proxy” income stocks in favour of sectors that benefit from higher interest rates.

• This positive outlook could be derailed if negative, protectionist trade policies offset any new fiscal stimulus in 2017. Clearly this is an aspect that investors will need to watch closely as 2017 proceeds.

US equities in a reflationary environment

• As inflation picks up and interest rates rise, the multiple that investors are willing to pay tends to contract slightly. But it is only when inflation really starts to get out of control that valuations have tended to be badly damaged. We don’t expect US inflation to rise so high that it becomes a significant drag on equity performance.

• That’s because, although valuations might fall, equity prices should continue to rise as higher inflation feeds through into higher revenues and thus higher earnings, hopefully offsetting any fall in the price-to-earnings ratio.

• Historically, a reflationary environment with rising bond yields has tended to favour value as a style over growth. The other implication of a reflationary environment with rising bond yields has tended to be that financials outperform “bond proxy” stocks such as consumer staples and utilities.

49

GTM – UK |Equity markets and reflation

S&P 500 average P/E ratio in various inflation environments US bond yield vs. value/growth performance*Relative index level (LHS); % (RHS)

US bond yield vs. banks/staples performance**Relative index level (LHS); % (RHS)

Source: (Left) Robert Shiller, J.P. Morgan Asset Management. (Top right) FactSet, Russell, Tullett Prebon, J.P. Morgan Asset Management. (Bottom right) FactSet, MSCI, Tullett Prebon, J.P. Morgan Asset Management. *Value index is the Russell 1000 value index. The growth index is the Russell 1000 growth index.**MSCI USA index used for both banks and consumer staples indices. Guide to the Markets - UK. Data as of 31 December 2016.

US 10-year yield

Value/growth

US 10-year yieldBanks/staples

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-1 to 0 0 to 1 1 to 3 3 to 5 5 to 7 7 to 10 10 to 15 >15US inflation ranges (% CPI y/y)

S&P

500

trai

ling

P/E

Equi

ties

1872-2016

Period 2 yrs 10 yrs

Correl. 0.87 0.36

49


OVERVIEW

• Rising yields in core fixed income in the fourth quarter have made investors question whether further losses are possible in the near term.

• While polices that foster growth and inflation could well force bond yields higher in coming years, the structural forces of demographics, debt levels and deep-rooted investor caution should keep yields at relatively low levels by historical standards over the medium term.

• Even if investors avoid further losses in coming quarters, the long-run outlook for returns on core fixed income remains poor. Investors should consider diversified multi-asset investing to meet their income and return goals.

An increase in both inflation and growth expectations has driven bond yields higher and their prices lower.

MARKET INSIGHTS

J.P. MORGAN ASSET MANAGEMENT | 5

2 Lower no longer: where are yields going?

A bad end to 2016 for government bonds

• The fourth quarter was a turbulent one for global fixed income markets. Yields had started to drift up from the summer onwards, especially after the Bank of Japan altered its bond-buying programme, making it clear that it did not want to see 10-year yields head into negative territory.

• Donald Trump’s victory in the US presidential election significantly accelerated the rise in yields, as investors bet his polices would lead to higher growth and inflation—both of which are the enemy of bond prices. When inflation rises, the fixed payments of regular bonds become worth less in the future than investors had expected.

• To find buyers in the market, owners have to offer a higher yield, through lowering the price of the bonds. In addition, when growth expectations rise, the opportunity cost of staying in an asset like a bond—which has no exposure to that growth—rises and the price investors are willing to pay falls, causing yields to rise.

• The recent increase in yields seems to be driven almost equally by higher growth and inflation expectations, which has not always been the case during other periods of rising yields. Optimists about the global economy could be forgiven for predicting more losses for investors in government bonds as inflation expectations rise further.

61

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Inflation implications for fixed income

10-year breakeven inflation%

Breakdown of US Treasury yield increases% yield change

US Treasury and inflation-linked bond returns% total return

Source: (Left) Bloomberg, J.P. Morgan Asset Management. Breakeven inflation is the difference in yield between nominal and inflation protected government bonds. (Top and bottom right) Bloomberg, J.P. Morgan Asset Management. The 10 year Treasury return is the return of the Merrill Lynch 10-year U.S. Treasury Futures Total Return index, the 10 year TIPS return is the return of the S&P 10 year US TIPS Total Return Index. 2009 reflation is 1 Jan 2009 to 31 Dec 2009; Taper Tantrum is 14 Apr 2013 to 5 Sep 2013; 2016 Reflation is 8 July 2016 to 31 Dec 2016. Guide to the Markets - UK. Guide to the Markets - Europe. Data as of 31 December 2016.

Fixe

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10-year US breakeven inflation change

10-year US real treasury yield change

US 10-year TIPS (inflation-linked) return

US 10-year Treasury return

UK

US

Germany

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2009 reflation Taper Tantrum 2016 reflation

2009 reflation Taper Tantrum 2016 reflation


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'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16

0

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Historical yields of government bonds

10-year bond yields%

Source: FactSet, Tullett Prebon, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 December 2016.

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com

e

Fed QE32012

Fed QE22010

Fed QE2008

Oil shock1981

Black Friday1987

Asian currency crisis1997

9/11 attacks2001

Dot com bubbleFeb 2000

Fall of Berlin Wall1989

ECB QE2015

BoE QE2009

UK

Germany

US

JapanBritain leaves European Exchange

Rate Mechanism1992

Brexitvote2016

63

USelection

2016


Most of the factors which have pushed bond yields down remain in place

• If productivity remains depressed, then growth will remain slow and bond prices will remain high to reflect that. Certainly, with the growth in the labour force likely to remain anaemic, a surge in productivity is the only game in town when it comes to increasing the growth component of government bonds—at least over the medium term.

• While it is perfectly plausible that we have now entered a difficult period for bond investors as yields rise, the scale of the potential increase is a key question. Despite the rapidly changing policy landscape, the fundamental forces that have driven bond yields lower in recent decades remain largely in place.

• Rising inequality, high savings rates, lower desired investment levels and increased perceptions of equity and credit risk have all played a significant role in dragging yields lower in recent decades. Most of these forces remain in place and will be enhanced by the higher debt levels we observe today in both advanced and emerging economies.

MARKET INSIGHTS

Central bank buying has been just the latest in a series of factors that has driven yields lower.



• Recent sharp rises in bond yields have led to losses for some investors, and worries are building that further losses are around the corner.

• It seems unlikely that yields will return to the level of previous decades. This suggests that losses to investors will be capped in the medium term, but risks remain. This is another reason for investors to consider diversifying into other types of fixed income as their first line of defence.

• Today’s low-yield environment necessitates a more restrained outlook for returns from core fixed income over the coming years. Multi-asset investing can potentially improve expected risk-adjusted returns in such an environment, but investors should still expect returns to be lower in the future than they have been in the past.

Asset markets are unlikely to produce returns investors have enjoyed in the past

• Every year, J.P. Morgan Asset Management publishes a set of projections for a range of asset classes. The 2017 version of those projections predicts less than a 1% average annual return for world government bonds over the coming decade.1

• Work undertaken by the McKinsey Global Institute has arrived at a similar conclusion.2 It is hard to argue with that assessment, given the analysis above, and this highlights the importance of multi-asset investing for both income and total return seeking investors.

76

GTM – UK |

Expected return in next decade

Asset markets in coming decades

Past and expected returns Past asset class returns and future expectations% per year % per year

Source: (Left) 2017 Long-term capital market assumptions, J.P. Morgan Multi-Asset Solutions, J.P. Morgan Asset Management, October 2016.(Right) Diminishing returns: Why investors may need to lower their sights by McKinsey Global Institute, J.P. Morgan Asset Management.

Guide to the Markets - UK. Data as of 31 December 2016.

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Return in past decade

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Last 30 years

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Next 20 years (Slow recovery)

EM equity

Private equity

UK large cap

Eurozone large cap

EM local currency debt

UK core direct real estate

US large cap

Global direct infrastructure equity

Diversified hedge funds hedged

Commodities

UK investment grade corporates

UK cash

UK gilts

World government bonds

UK government inflation linked 0

3

6

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US equities Europeanequities

US govt. bonds European govt.bonds


1 2017 Long-Term Capital Market Assumptions, J.P. Morgan Asset Management, 24 November 2016. 2 Diminishing returns: Why investors may need to lower their sights, McKinsey Global Institute, 1 May 2016.

Expectations for government bond returns are rightly minimal.

MARKET INSIGHTS



3 Emerging markets recovery: cancelled or on hold?

Monitor the emerging markets investment drivers

• For most of 2016, growth momentum was shifting in the direction of emerging markets, after several years in which developed economies were in the lead. The balance could now shift back somewhat, if the US is likely to grow a bit faster in the next few years. But the implications of Donald Trump’s election victory for the various EM countries are not clear cut, and some could well benefit from a more reflationary environment in the US.

• Commodities are still strengthening. With oil prices on the rise after moderate coordination from OPEC, oil-producing nations should see their revenues stabilising, which is good for EM equity performance on the whole.

• Short-term US rate expectations are higher, but this could be a matter of simply moving faster to the same destination. The structural reasons for rates to be lower than in the past remain in place, and expectations for the US terminal rate are still low. There is little expectation that rates globally are heading to the kind of levels that have caused problems for EM economies in the past. The US dollar has strengthened, but whether this is the start of another big leg up is still in doubt.

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Source: (Left) Consensus Economics, J.P. Morgan Asset Management. “EM – DM GDP Growth” is consensus estimates for EM growth in the next 12 months minus consensus estimates for DM growth in the next 12 months, provided by Consensus Economics. (Top right) Bloomberg, MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) BIS, FactSet, MSCI, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 December 2016.

Equi

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% next 12 months’ growth estimates (LHS); index level (RHS)EM equity relative performance and commoditiesEM vs. DM growth and equity performance

EM growth & equity outperformance

EM growth & equity underperformance

EM minus DM GDP growth

MSCI EM relative to MSCI DM

MSCI EM relative to MSCI DM

Bloomberg Commodity Index

56

Relative EM / DM equity performance and USD REEREquity performance rebased to 100 at 1993 (LHS); index level (RHS)

USD REER (inverted)

MSCI EM / MSCI DM


OVERVIEW

• Sentiment turned against emerging markets (EM) economies in the weeks after the US presidential election, reflecting fears about the next president’s policies on trade and globalisation, and a renewed appreciation in the dollar. We believe that this reversal is probably premature and that it is too soon to give up on the recovery in EM assets.

• Most of the key factors that helped drive investor flows back into EM assets in the first 10 months of 2016 are still in place. Investors should also bear in mind that many EM assets are attractively valued relative to other global risk assets, and that the currency and other adjustments since 2013 make the potential downside for EM assets rather smaller than it was at the time of the taper tantrum.

MARKET INSIGHTS

US dollar strength will be key for EM equity performance in 2017.

EM currencies are far cheaper than they were in 2013.


EM economies have made strides in strengthening their financial positions

• Even if there is a more lasting turnaround in the global fundamentals (including the expected cost of money) for emerging markets, the downside is likely to be limited by the adjustments that have already occurred, especially to foreign exchange and current accounts, which are in a much better place than in 2013.

• EM currencies have strengthened compared to their weakest points in early 2016. Current account deficits in the “Fragile Five” (Brazil, India, Indonesia, Turkey, South Africa) have all fallen markedly since 2013, meaning these economies are now less reliant on foreign funds.

• As further protection against stormier weather, we should remember that EM economies have also bolstered their reserves over the past decades; and their levels of external debt are much lower than at the time of the EM financial crises in the late 1990s.

36

GTM – UK |Emerging market adjustments

EM currencies vs. US dollar% from fair value, relative to US dollar

“Fragile Five” current account balance% of GDP

EM foreign exchange reserves vs. external debt% of GDP

Source: (Left) J.P. Morgan Asset Management. Based on nominal exchange rates relative to PPP-exchange rates and adjusted for GDP per capita. EM currencies used are a weighted average of JPM GBI-EM Global Diversified Index countries. (Top right) Haver Analytics, J.P. Morgan Asset Management. “Fragile Five” are Brazil, India, Indonesia, South Africa and Turkey. (Bottom right) J.P. Economic Research, J.P. Morgan Asset Management. Guide to the Markets - UK.Data as of 31 December 2016.

External debt

EM reserves

+1 std. dev.

-1 std. dev.

Average

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to USD

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'11 '12 '13 '14 '15 '16



• A slightly faster path of US rate hikes and a stronger US economy in the near term pose challenges to the EM recovery story. However, already cheap EM currencies, improved current account balances and debt positions all underline that these economies are in a much better place than they were in 2013.

• Long-term investors should also note that these assets have historically often delivered healthy returns when purchased at these valuations.

• In conclusion, the EM recovery is neither in full swing nor cancelled. Caution is warranted, given that many parts of the EM universe are still waiting to see a significant recovery in domestic demand and profits. But a more bearish attitude to the asset class would not be justified, at least without further clarity on the policy direction and global impact of the incoming US president.

MARKET INSIGHTS


4 A reduction in deflation fears, implications for European investors

From deflation fears to hopes of reflation

• The sharp fall in oil prices that started in 2014, as oil production rose faster than demand, led to a dramatic fall in global and European inflation. This left investors and central bankers fearing deflation for much of the last two years.

• With the oil price now meaningfully higher than in January 2016, inflation is likely to pick up this year, reducing global deflation fears.

• Inflation is likely to rise most where unemployment is low, encouraging wage growth, and where the local currency has been weak, increasing the price of imported goods. Although unemployment is still high in some countries in the region, eurozone inflation should rise, albeit less so than in the US and UK.

• Higher inflation forecasts should lead to further interest rate rises in the US. The prospect of somewhat higher inflation may also have contributed to the European Central Bank’s decision to reduce the monthly amount of bond purchases under its quantitative easing programme. However, the Bank of England is unlikely to raise interest rates immediately in response to higher inflation, due to the uncertain economic effects of its exit from the European Union.

11

GTM – UK |

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Global inflation dynamics

Developed economy inflation Headline inflation and forecasts% change year on year % change year on year

Average Jan 1993 to Dec 2008: 2.0%

Average Jan 2009 to Nov 2016: 1.2%

Glob

al e

cono

my

Source: (Left) Haver Analytics, J.P. Morgan Asset Management. (Right) BLS, Eurostat, J.P. Morgan Economic Research, Ministry of Internal Affairs and Communications, ONS, Thomson Reuters Datastream, J.P. Morgan Asset Management. *Inflation forecasts are from J.P. Morgan Economic Research. Guide to the Markets - UK. Data as of 31 December 2016.

UKEurozone

US

JapanForecasts*

Policy target

11

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OVERVIEW

• We expect inflation to rise globally next year after several years of little or no growth in prices in the developed economies. Though high unemployment is likely to keep eurozone inflation below target, improving growth and a higher oil price should still reduce fears of global deflation.

• Higher inflation could lead to higher government bond yields and should also support European corporate profits, including in the financial sector.

Eurozone inflation is expected to rise.

MARKET INSIGHTS

J .P. MORGAN ASSET MANAGEMENT | 11

European equities in a reflationary regime

• European corporate profits have been held back by a consistently weak growth backdrop, with weak inflation depressing nominal GDP.

• Purchasing managers’ indices suggest that real GDP is picking up, and a better inflation outlook in 2017 should also boost nominal GDP. European companies could thus deliver decent earnings growth for the first time in six years in 2017. Operating leverage should multiply even moderate revenue growth into stronger earnings growth.

• One effect of higher inflation expectations has been a rise in 10-year Bund yields and a steepening of the yield curve. European financials struggled during the period that bond yields fell, dragging on the performance of European equities. If bond yields have already seen their lows, it could reduce the headwinds for European financials—though this will need to be weighed against the broader economic consequences of tighter financial conditions.

40

GTM – UK |

Real GDP growth

MSCI Europe ex-UK performance and drivers

MSCI Europe ex-UK earnings and performanceIndex level, next 12 months’ earnings estimates (LHS); index level (RHS)

MSCI Europe ex-UK 12-month EPS growth and real GDP growth% change year on year

Source: (Left and bottom right) FactSet, MSCI, J.P. Morgan Asset Management. EPS is earnings per share. (Top right) FactSet, Eurostat, MSCI, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 December 2016.

MSCI Europe ex-UK index level

MSCI Europe ex-UK EPS

Equi

ties

EPS growth

40

MSCI Europe ex-UK banks relative performance vs. German 10-year yieldsRebased to 100 in 2009 (LHS); % (RHS)

MSCI Europe ex-UK banks relative to index

German 10-yr yields



• Rising inflation and improving real GDP should see European earnings rise for the first time in many years in 2017. This should provide some support for European equities.

• The potential for even moderately higher bond yields could support the performance of European financial equities, and underpins our broad preference for equities over government bonds.

MARKET INSIGHTS

The weak oil price caused corporate earnings to fall despite improving growth. This drag on earnings should now be removed.

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MARKET INSIGHTS Quarterly Perspectives · latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment