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INVESTMENT STRATEGY December 2017 CIO BLOG MOUHAMMED CHOUKEIR Tails of the Unexpected Source: Shutterstock INVESTMENT STRATEGY December 2017 CIO BLOG MOUHAMMED CHOUKEIR Tails of the Unexpected Source: Shutterstock Markets are exquisitely unpredictable, and each year, events – financial, economic, geopolitical, or otherwise – occur which few see coming, but cause powerful ripples to the prices of securities, and even entire asset classes. We continue an annual tradition of exploring what unlikely, but feasible, events are not priced by markets for the next year. These Tails of the Unexpected – they are pushed to the forgotten “tails” of probability distributions – have the potential for outsized impacts on portfolios. If they occur, how would our portfolios perform? First, we review the Tails from last year! 1. Anno Trumpini: Post-Trump expectations of US growth fall flat, but Europe is a champion. Markets were not adequately pricing in the risk the Trump administration failing to generate “guaranteed” annual economic growth of 3. 5%. While US growth has been spectacular – the second and third quarters of the year have seen an annualised rate of 3. 1% and 3. 3% – it has arguably been in spite of the Trump administration, not because of it. The second part of the Tail most certainly came through, and the Continent has had a breakout year, going from deflation and populist upheaval to the brightest place in the developed world. Either way, both sets of equity markets have had notable, double-digit years in 2017 in GBP terms. 2. Not so hard: Brexit negotiations go fabulously well. While “Brexit” negotiations were protracted throughout 2017, a late flurry of activity saw agreements reached on thorny issues such as the “Divorce Bill”, EU citizens’ rights and the Irish border, allowing negotiations to proceed to the "second phase", where trade will be discussed. The British pound rallied strongly versus the US dollar all year (+10%), and largely kept pace with a soaring euro (-3%). 1 | CIO BLOG – TAILS OF THE UNEXPECTED (VI)– DECEMBER 2017

3. Bone China: The long-awaited implosion happens this year. Far from imploding, the Chinese 3. Bone China: The long-awaited implosion happens this year. Far from imploding, the Chinese economy stabilised. Foreign currency reserves bottomed out at $3. 1 trillion early in the year, and have been growing since; Chinese equities rocketed upwards throughout 2017. This pushed Emerging Market equities to have a stand-out year, up over 30% in US dollar terms. Now on to 2018! The key question for investors centres on exactly when equity bull markets become bubbles, primed to fall into bear territory? When does healthy bovine morph to dangerous ursine? 1. Biff, Boom, Powell: US Inflation returns with a bang, forcing the Fed to raise rates five times, ending the year with Fed Funds rate of 3%. Everyone expects slow and steady, but inflation could well be Fast and Furious: US equities hit record highs again, but the difference between ten-year and two-year US government bond yields has dropped below 0. 60% for time since November 2007 as short-term yields are moving up as the Fed raises rates, but a subdued economic outlook is keeping long-term yields anchored. Few analysts see much shift in this paradigm, with eyes glued to see “when” the spread enters negative territory, a harbinger of recession. What the consensus view is not pricing in: Markets may well be missing the woods for the trees. US CPI is already at 2%, and core CPI ended the year at 1. 8%, finally breaking the spell of five straight months of 1. 7%. Indeed, with unemployment at 4. 1% – signalling a razor thin output gap in the economy, if any at all – the “mystery” of low inflation may prove not to be an enduring one. Moreover, with the Trump administration finally getting tax cuts passed, infrastructure spending, a rare area of bipartisan support, may be soon to follow. All of this could well see inflation surge to 3%, forcing “soft-spoken” Jay Powell to overcompensate with a roaring monetary correction. Potential Market Reaction: • Gold sells off given the re-emergence of yield; • Bonds plummet as rates go up, but then stabilise with yields at a new high of 4%; • Equities suffer a major drawdown as a much higher discount rate shatters both the perception of “There is no alternative” and scuppers discounted cash flow calculations; and • Cash becomes the asset class of choice in 2018 with a real yield and no risk of drawdown. Our positioning: We hold fair amounts of cash and are short duration across the fixed income complex. Further, we pay close attention to momentum in asset classes. Should momentum turn negative for gold and/or equities, we would take it a signal to cut exposure to either/both. 2. The Apple falls far from the tree: The world’s most powerful company falls by 20%, proving it is no exception to the rule. Gravity finally starts to weigh; and Apple’ never hits $1 trillion: In 2017, Apple stock hit repeated new highs as its star product, the i. Phone X, smashed sales forecasts. Apple experienced 2017 gains of 50%, and its market capitalisation now exceeds $900 billion, by far the world’s most valuable publicly-listed company. It is worth more than Exxon Mobil, Procter & Gamble, Coca-Cola and Goldman Sachs combined. What the consensus view is not pricing in: Sheer momentum, excitement, and shortsightedness resulting from Apple’s spectacular run of results have left the market complacent. But Apple does not have some secret, hidden magic. On the contrary, it owns virtually no physical assets, relying solely on intangible design and software assets – two of the most difficult strategic beachheads to defend. For Apple to defend this positon at the forefront of both fashion and tech simultaneously would almost be more remarkable than if not, particularly as it has not innovated much beyond the i. Phone. Surely, the history of Blackberry a decade ago, and Nokia 10 years before that, provide plenty of precedent that companies in this space can appear impregnable while being anything but. Potential Market Reaction: Apple’s sheer weight in the index makes its performance tremendously important to bellwether equity indices: it is 12% of the NASDAQ; 4% of the S&P 500; and 2. 3% of MSCI AC World. Moreover, Apple, Microsoft, Amazon, Alphabet (Google) and Facebook collectively make up more than 10% percent of the S&P 500. Given that Apple largely sets the tone for the “tech” complex, and the high degree of 2 | CIO BLOG – TAILS OF THE UNEXPECTED (VI)– DECEMBER 2017

correlation between these five companies – poor results at Apple’s have the ability to correlation between these five companies – poor results at Apple’s have the ability to scupper global equities – more so than any single company has ever had – even as the wider asset class may be doing just fine. Our positioning: We remain wary of exposure to any one sector, geography or style of investment; diversification is one of the few free protections investors are afforded. Moreover, we are wary increasing tech sector valuations, finding better value in financials and energy. 3. Drill, fill, overkill: Oil slips back to $40 The immutable laws of supply and demand combine with the ages old Prisoner’s Dilemma: One of the highest areas of consensus in markets is that oil prices will oscillate in the $50 to $60 range. It is perfectly logical. Higher prices will draw in more US shale production, leading to oversupply and falling prices. The falling prices will help correct the oversupply. The supply and demand dance should keep oil prices range bound. What the consensus view is not pricing in: There are good reasons this logic may not pan out. The International Energy Agency (IEA) has lowered its oil demand forecast for 2018, blaming a 60% rally in prices since June. On the supply side, the IEA expects non-OPEC production – mostly from US shale producers – will increase again next year by 1. 4 million bpd. A rightward moving supply curve and a leftward moving demand curve lead to a lower equilibrium price, particularly in tight, elastic markets. Furthermore, a pillar of the crude rally though 2017 has been the OPEC-led production agreement. It has been a tremendous success: prices were languishing in the mid-$40 s when it was initially agreed; now they are in the mid-$60 s. However, the success was predicated on two critical factors. One, the participants to the deal not cheating. The other was US shale producers not increasing production in response to higher prices to the degree the cut was mitigated. The latter has already happened. The former may well happen in 2018: Russia, Saudi Arabia and others are running huge budget deficits, the urge to cheat on the agreement may well prove irresistible. Potential Market Reaction: Early in 2016, at the peak of Chinese meltdown fears, the three month rolling correlation between oil prices and the FTSE 100 hit a multi-year peak of about 60% (i. e. the two moved largely in tandem). However, as China stabilised and focused shifted to issues closer to home over the summer, the correlation between oil and UK equities fell back down towards its longrun average of 15%. This correlation is now at 1%: essentially oil prices have had little impact on surging equity markets. However, there is plenty of precedent for that to change. Our positioning: We have little current exposure to the commodities complex directly, either through basic metals or energy. We continue to believe the benefits of this exposure is outweighed by the volatility. To Conclude… Pollsters, prognosticators, pundits and punters will be wrong about many of their expectations for 2018. Even if they are right, there is no way to know how markets will react. In 2016, no one saw Brexit or a Republican clean sweep. At the advent of 2017, populism was a huge risk; few expected the benign markets conditions which helped lead to powerful returns from global equites. In 2018, markets may be surprised by some of the hypotheticals we put forward, or by innumerable others. Some of the favourites that didn’t make our list: bitcoin becoming a genuine asset class worthy of consideration or even a major incident of cybercrime. We remain optimistic, expecting the current momentum in equity markets to continue, supported by a strong global economic backdrop. However, current valuations temper our expectations of future returns, keeping us wellgrounded and well-diversified. We wish you all the Happiest of Holidays and a Wonderful New Year! *All Data sourced from Bloomberg and Factset on December 10 th 2017. 3 | CIO BLOG – TAILS OF THE UNEXPECTED (VI)– DECEMBER 2017

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