Global Strategic Outlook

Transcription

1 Allianz Global Investors Global Strategic Outlook 1st Quarter 2013 Understand. Act.

2 ContentQui leno suspicor Amor quibus mido Consido noster luvabrum 5 Section one: Strategy summary 9 Section two: Thematic piece 15 Section three: Equities outlook 23 Section four: Fixed income outlook 28 Section five: Multi asset outlook 30 Section six: Sustainability Research - long term trends 32 Section seven: Economic forecast and valuation review 35 Section eight: Global Policy Council biographies 2

3 The world is overloaded with information but to have value it needs to be understood. Once information is understood, we then need to act. At Allianz Global Investors we follow a two word philosophy. Understand. Act. Andreas Utermann Global Chief Investment Officer, Allianz Global Investors 2013: The beginning of the end of the great financial crisis? Although risks remain and volatility will continue, Andreas Utermann is more positive about the world in 2013 than at any point since US growth could surprise on the upside and markets could see the beginning of the end of the great financial crisis. Key Takeaways: There are signs of green shoots in the eurozone periphery, China s robust growth should continue and a turnaround in the US housing market could lead to an upside surprise Global central banks will continue their ultra-loose monetary policies until economic growth is firmly established With nominal bond yields at record-low levels, we do not expect their returns to match inflation over the next 10 years We expect equities to continue outperforming bonds; although it is likely there will be continued volatility, any significant weakness should be used to establish longer-term positions Emerging market assets should continue performing well 3

4 Economic outlook and the eurozone What we predicted for 2012: We do not expect most developed economies to fall into recession and we expect emerging markets growth to remain solid. However, growth risks are increasing particularly in Europe, where a recession in the core eurozone economies is now almost certain. Our medium-term outlook remains unchanged: in times of high public sector debts, and private and public sector de-leveraging, trend growth will be lower than before the bubble burst. This period is likely to last for several years. Our current view: While remaining positive, global growth did remain below trend again in 2012, as expected. This was primarily driven by a sharp growth slowdown in Japan, a continued near-recessionary environment in Europe, slowing emerging market growth and a continued below-par recovery in the United States. The key macroeconomic factors contributing to this continue to be excessive private-sector debt in many economies, rising public-sector debt in almost all economies, the continued stressed bank financial sector in Europe and the political problems surrounding the eurozone. Owing to the decisive action by the European Central Bank (ECB) in the summer of 2012, followed by a reinvigorated political process in Europe, it is possible to envision a more benign middle-term scenario for the eurozone for the first time in a number of years. While growth is still expected to remain in near-recessionary territory for most of 2013, there are tentative signs of green shoots in the eurozone periphery, notably the elimination of current account deficits and Greece remaining in the eurozone. Encouragingly, Ireland the first country to receive a eurozone bailout may regain access to capital markets in the course of Problems remain, though, including elections in Italy and a French programme of economic reforms that may exacerbate rather than remediate France s structural problems. Fears about China s hard economic landing and political uncertainty have not materialised, and we are likely to see continued robust growth in China in Most encouragingly, the United States could surprise on the upside in This is primarily based on our conviction that the US housing market has turned, and that there is a broad base housing market recovery underway that will increase consumer confidence and also possibly encourage corporations to spend some of their large liquidity surpluses. Budget deficits and central bank policy What we predicted for 2012: A quick fix is unlikely. Realistic political actions take a long time to be implemented and even longer to be effective most likely too long for financial markets. The longer the debt crisis looms, the bigger the political risk. As recent developments in Greece show, there is a real threat of a break-up of the eurozone if political processes get out of control. Debt monetisation is already on the agenda in the US and the UK but not in the European Monetary Union (EMU), even though the ECB has become more Fed-like. Medium-term, we think a more active and aggressive role for the ECB is likely. Our current view: The fiscal situation in most economies has continued to deteriorate in 2012, as expected. As a result of this, central banks have continued with their ultra-loose monetary policies. In many cases such as in Japan, the US, the eurozone and the UK those policies have been reconfirmed and reinforced. Most importantly, and as we had hoped, the ECB made a decisive step in the summer of 2012 toward becoming a more credible lender of last resort, which led to a broad-based rally in risk assets in the final part of

5 Should growth surprise on the upside in 2013 as expected, the rate of increase in government debt globally should slow. Nevertheless, we predict a continued ultra-loose monetary policy regime for OECD economies for 2013 and beyond. This should continue until such time as trend or above-trend economic growth is firmly established. Inflation What we predicted for 2012: We believe the cyclical moderation will trigger a moderation in inflation rates again. Given the low level of real interest rates, ongoing central bank balance sheet expansion and our expectations of continued solid growth in Asia, we do not expect a return of deflationary fears, despite weakening growth. On the other hand, with demand for money strong in the current period of de-leveraging, inflation is unlikely to be a threat in the foreseeable future. Our current view: As expected, neither inflation nor deflation concerned markets significantly in For 2013, we do not expect either one to be a major topic of market concern. While global growth remains below trend and private sector debt levels stay elevated, inflation is unlikely to be a major issue while aggressive quantitative easing policies will keep deflation at bay. Interest rates and bonds What we predicted for 2012: We expect rates to come down further in the eurozone and emerging markets. In the US, the UK and Japan, we expect the policy of extremely low interest rates to continue. The downside to bond prices in the UK and US clearly is limited. As long as political uncertainty persists and economic data remain weak, we expect risk aversion to prevail. Bunds are likely to remain safe haven assets for the time being. A risk-on trade within the European bond markets is only likely once economic data start to improve or the ECB takes a more active role in solving the debt crisis. Longer term, we remain cautious on sovereign bonds at current yields. Even if nominal returns may turn out to be positive, we expect real inflation-adjusted returns to be disappointing. Our current view: EMU bond markets continued to be driven by political events in the first half of As predicted, a risk-on trade in European peripherals kicked in once the ECB had emphatically stated it was not going to let the EMU fail statements that were then later confirmed by European policymakers. We expect aggressive quantitative easing policies to continue through 2013 and thus limit the downside; however, with nominal bond yields throughout the yield curve now at record low levels, we do not expect nominal returns to match inflation over the next 10 years. Benchmark bond yields (Japanese government bonds, US treasuries, German bunds and UK gilts) appear overvalued. For 2013, we continue to favour selective corporate and high-yield issuers, other spread products and, notably, selected emerging market global currency debt. Equities What we predicted for 2012: With economic activity slowing globally and with moderate equity returns, we prefer stocks with relatively high dividends and payout ratios. Dividend payments should offer investors some protection in the current environment. A lasting rebound in equity markets is expected only if markets can start to price in a credible solution to the EMU debt crisis and/or when economic data point toward a stabilisation in economic activity. Political tensions or sovereign debt fears would be another buying opportunity for those who want to establish longer-term positions. Our current view: For the first seven months of 2012, equity markets were very volatile with dividend stocks performing particularly well as we anticipated. Also, as expected, equity markets rebounded following decisive action by the ECB, with most major equity markets ending the year in double-digit territory. In local currency terms, as of 27th December 5

6 2012, German equities had performed best with a near-30% return, followed by Asian markets at around 20% and the S&P 500 at approximately 15%. For 2013, we expect equities to continue to outperform bonds with overall returns in the region of 8% 10% possible. There will be continued volatility and any significant weakness should again be used to establish longer-term positions. Currencies What we predicted for 2012: Strategically, we will hold on to our expectation of appreciating emerging market currencies due to superior growth and productivity gains. We are waiting for an attractive entry point to re-enter this asset class. We expect some appreciation of the US dollar due to the still-unsolved eurozone debt crisis. In addition, the US dollar looks somewhat undervalued relative to the euro. Our current view: For the major currencies the euro, US dollar and sterling the year brought much volatility but, as expected, no major changes in their relative values. As expected, the renminbi has continued to appreciate against both the US dollar and the euro, and the yen appears to have started its long-anticipated relative decline. For 2013, we expect a very similar picture. Emerging Markets What we predicted for 2012: Emerging markets remain strategically important and the slowdown in economic activity will end, in our opinion, in a soft rather than hard landing. The reasons for our relative optimism are negative real interest rates, a rather low level of total indebtedness and strong underlying demand. Our positive view on emerging markets leads us to a strategically positive view on emerging market assets whether equities, bonds or currencies. Our current view: Most emerging market assets have, as expected, outperformed in 2012; in a relatively benign market environment they should continue to perform well in Conclusion What we predicted for 2012: We expect 2012 to be similar to 2011: bouts of risk aversion followed by increases in risk appetite, all against a background of relatively low growth and great political uncertainties in all regions. Countercyclical and long-term orientated investment behaviour will be imperative for market participants. Our current view: 2013 could well be the year when growth in the US surprises on the upside and markets begin to anticipate the beginning of the end of the great financial crisis. Clearly, many risks remain and continued volatility in risk assets is certain to be a defining feature. However, overall we are feeling more positive about the world at the start of the 2013 than at any point in the last five years. Let s hope this turns out to be correct. Our upcoming Investment Forum in mid-january will delve into some of these themes in more detail notably the question of asset-class valuations, China s growth story and the medium- to long-term inflation outlook. We will bring you more on these themes in the coming weeks. 6

7 1. Strategy summary Our market expectations for Q have turned out to be very much correct. Equity markets globally have been trending sideways, confirming our neutral equity allocation, after a strong run in Q The only market that has showed a strong performance, much to our surprise, has been Japan. Sovereign bonds issued by the US, Germany, UK and Japan have continued to show positive albeit very low returns. Spread products, whether corporate bonds or EMU periphery bonds, outperformed. Emerging market assets, both bonds and equities, also outperformed developed market assets. How can we explain this pattern and what is our outlook going forward? It is a combination of better economic data and ongoing efforts to solve the EMU debt crisis on one hand, as well as still-prevailing political risks, especially in the US regarding the fiscal cliff, on the other hand, which have been driving capital markets. Going forward, we think that positive news could ultimately gain the upper hand. We reiterate our constructive view on risky assets provided that risks, mainly political, do not materialise. Three months ago, we observed a gap between economic surprise indices and hard economic data. Surprise indices measure the difference between reported data and expectations as expressed by consensus. Surprise indices for global developed markets had already started to improve in June 2012, indicating that economic data released were not as bad as negative consensus expectations. However, this was not enough for equity markets to rise for more than just a few weeks: data actually needed to turn up. Most high frequency data, though, continued to deteriorate until late summer. The gap between surprise indicators and actual data releases only started to close during late autumn, when many leading indicators started to turn up once more. In the US, we take particular comfort from the fact that the labour market continues to improve and that house prices have also started to stabilise. Both markets are, in our opinion, crucial to a lasting recovery in the US economy. The most recent deterioration in some high frequency data, notably the Institute for Supply Management Manufacturing Index and the NFIB Small Business Confidence Indicator, are in our opinion explained by super storm Sandy, which caused massive damages on the US East Coast in late October. The biggest risk for the US economy going forward and probably the biggest risk for the global economy is a failure to solve the fiscal cliff. In a worst case scenario, US fiscal policy would drag down US growth by $607 billion (Congressional Budget Office, as at 22nd May 2012). In the event that the fiscal multiplier in the US turns out to be larger than 1, which can t be ruled out in an environment of close to zero interest rates, the damage inflicted on the US economy could be substantial. At the time of writing, a temporary solution has been found, including higher taxes for the very rich and an end to the Bush payroll tax cuts. The fiscal cliff has been averted for now. However, Democrats and Republicans have only postponed a decision on cutting government expenditures for two months. After an agreement at the turn of the year on tax incomes, an agreement on expenditure seems likely. Nevertheless, there is no guarantee. European data, too, are showing first signs of improvement. PMIs are off their 2012 lows, albeit still at recession levels for most countries. Our proprietary leading indicators, though, suggest that growth in the eurozone could turn out to be marginally positive, while consensus estimates are in negative territory. Two factors could actually explain why growth in the eurozone may actually surprise on the upside; both illustrate that economic policy decisions can be key in stabilising or even improving confidence in an economy. First, continued progress in the solution of the debt crisis is likely to have positive spillover effects on the real economy. As outlined in previous Global Strategic Outlook (GSO) documents, the willingness of policy makers to move ahead with a banking union as well as the European Central Bank (ECB) becoming effectively a lender of last resort for sovereigns in well-defined circumstances are key to a lasting solution of the EMU Stefan Hofrichter, CFA Head of Global Economics and Strategy Group 7

8 debt crisis, as both developments address the original weaknesses of the EMU financial architecture. In December, eurozone finance ministers agreed on the design of the new single supervisory mechanism (SSM). Accordingly, the ECB will take over direct supervision of around 200 EMU based banks the largest in absolute terms in the respective member countries and will oversee the national supervision of all other banks within the eurozone. An agreement has been found on the supervision of banks based in the EU but outside the eurozone. The SSM is supposed to be operational from March 2014 onwards. From this date, failing banks will be rescued by ESM funds directly. Also the introduction of the Outright Monetary Transactions plan (OMT) can be interpreted as a seachange in ECB s policy as the central bank is now effectively providing unlimited funds to governments with liquidity problems, provided they accept a memorandum of understanding and implement fiscal austerity and/or structural reforms. The pure announcement of the OMT has already been sufficient to soothe market concerns: even though the ECB has not yet invested a single cent in bonds issued by EMU sovereigns, EMU periphery bond spreads have already tightened substantially. What matters is the ECB s commitment to provide unlimited amounts and the expectation of market participants that, if spreads started to widen too much, any country could apply for ESM funds one pre-condition to benefit from the OMT. We are convinced that both measures in combination with ongoing structural reforms in EMU periphery countries as well as the increased harmonisation of EMU fiscal policy have significantly reduced the EMU break-up risk, as is also reflected in the tightening of EMU periphery spreads. Less stress in the financial system should also bode well for the growth outlook, as our research shows. There is a second positive effect for EMU growth coming from fiscal policy. To be precise, fiscal policy will be less of a drag on growth compared to previous years. Firstly, austerity measures in the EMU periphery have been very much front-end loaded, i.e. most of the measures have already been implemented. In addition, the Troika has stopped responding with demands for more fiscal austerity measures when a deficit target has been missed. This is quite important as it helps to reduce the head wind to growth stemming from fiscal austerity. In an environment of near zero interest rates, the fiscal multiplier tends to be high. We think that during the past three years, the fiscal multiplier in EMU has increased to more than 1.5, confirming IMF estimates. The reduction of tail risks in the EMU is likely to have positive effects not only in the region, but also in the rest of the world, as one major source of uncertainty has been reduced. Clearly, political risks remain within the EMU, as we can t rule out that electorates, whether in core countries or in the periphery, decide to stop supporting the process of a tighter monetary union. The decision by Mario Monti to step down as head of the technocrat government in Italy as a consequence of losing support from the parliament (from Silvio Berlusconi s party, to be precise), leading to irritations in both equity and eurozone periphery sovereign bond markets, was just a reminder that capital markets remain vulnerable to political turbulences in the region. In Japan, where nominal GDP has just contracted on a yearly basis for the eighth time since the bubble burst in late 1989, the new government of Shinzo Abe from the conservative Liberal Democratic Party (LDP) will try to push for more fiscal and, if possible, monetary easing. As things stand, it is still uncertain how far monetary policy can be eased in reality, as long as the Bank of Japan (BoJ) is independent from the government and as long as the LDP needs approval for the nomination of the new BoJ Governor in April 2013 from other parties. In addition, achieving an inflation target of 2%, as proposed by Abe, is much easier said than done, as inflation expectations are unlikely to change near term. Nevertheless, we are likely to get a positive growth impulse again in Japan in the course of In emerging markets, data have started to improve, notably in China. We have been expecting this for quite some time, as pointed out in the two previous GSO editions. The yield curve, as well as money supply (adjusted for inflation), have again proven to be reliable indicators with a long lead time. The positive news flow is not restricted to China, but can be seen in various countries in the Asia region, such as Korea and Taiwan. Overall, global cyclical data show signs of improvement while political risks, although still 8

9 prevailing, have slimmed down significantly. As a consequence, we think that the backdrop for risky assets is likely to be rather constructive, generally speaking. Whenever political risks mount again though, markets are likely to face a setback. Immediately following its election in early November, the US is a perfect example: even though the economy showed signs of relative strength, at least compared to other regions, US equities underperformed because of fears that policy makers would fail to find an agreement on the fiscal cliff. As of the day of writing, we recommend using market setbacks to add to risky assets. We are not, however, changing our long-term expectations of low trend growth in the developed world as we remain in a multi-year period of deleveraging of both the private and the public sector. A simple buy-and-hold strategy is not warranted in such a scenario. Investors need to react quickly to cyclical swings and changes in the political landscape; tactical allocation becomes ever more important. In such an environment, we also think that going for current yield as an important driver of total returns, as opposed to expecting superior price increases, is what investors should target. Similarly, we also think that alternatives with rather stable cash flows, notably in infrastructure, can offer interesting investment alternatives. Our thematic research note sheds some more light on this topic. Within equities, we retain our preference for emerging market equities, which do not seem expensive on our numbers. In addition, improving cyclical data in Asia, especially in China, should bode well for this asset class. We turned neutral on Japanese equities in November in expectation of the LDP winning the elections in December. We think that the market will expect further yen weakening as a consequence of potential economic stimulus packages as well as a potential policy of ultra-easy monetary policy in Japan. With the Topix again negatively correlated with the yen, Japanese equities could do well in local currency terms. Given Japan s structural problems an exploding debt burden, weak demographics and uncertainty with respect to a timely implementation of LDP s policy measures we are not currently willing to go long Japan s equities. We have also started to warm up to eurozone equities. With tail risks having diminished significantly and the region very much moving in line with sovereign spreads, the tighter spreads are, the higher the chance of outperformance of regional equities. On valuation grounds, eurozone equities look attractively priced. We therefore added to European equities in December. US equities, which we preferred during autumn, have been reduced in preparation for a more risk-loving environment. Regarding sectors, we have kept the balanced portfolio structure between cyclical and defensive sectors. By overweighting the materials sector at the expense of IT, we have moderately increased cyclicality. The materials sector combines reasonable valuation, the chance of improving commodities demand following a Chinese reacceleration and a bottoming out of earnings revisions momentum, especially in the mining segment. Within the cyclical space we also like industrials, which should profit from better order momentum in capital goods and a generally improving macro environment, which we foresee for the coming months. In the more defensive areas, we are sticking to our preference for consumer staples and health care over telecoms and utilities, which again negatively surprised investors with dividend cuts. Despite their bounce, we remain cautious on financials for structural reasons like regulation, however in the short term, improvements in financial conditions, the decline of global tail risk factors and the revival of the US housing market may support the sector a bit further. Against the backdrop of moderately improving cyclical data and, as our base case scenario, lower (political) tail risks as opposed to earlier in 2012, we continue to like spread products in the fixed income area. This includes corporate bonds, both investment grade and high yield, which are still reasonably priced even after several quarters of outperformance, as well as emerging markets bonds. Admittedly, spreads for hard currency bonds issued by emerging market sovereigns are tight in a historical comparison. However, fundamentals have improved substantially: sovereign debt ratios have fallen, while they have risen in the developed world. Credit risk, consequently, has come down. On our valuation measures, emerging market hard currency bonds are still attractively priced and bonds in local currencies offer attractive yields. We reiterate our long-term positive stance on Asian emerging market currencies. As outlined in our thematic note published in the Q GSO 9

10 document, we particularly like the renminbi. Our longterm cautious stance on the yen has started to pay off. Following the announcements of Abe before the elections in Japan, the yen has weakened to an 18-month high against the US dollar. We are holding on to this position. Our euro/us dollar position is currently neutral. Falling tail risks are supportive to the euro, while valuations and the relative growth outlook warrant a neutral position. Sector Allocation - Virtual GPC Portfolio Global Sectors Consumer Discr. Consumer Staples Energy Financials Health Care Industrials IT Materials Telecom Services Utilities Active Weight -1.0% 0.5% 1.0% -1.0% 1.5% 0.5% 0.0% 1.0% -1.5% -1.0% BMK Weight 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% Legend: Position added Position reduced Asset Allocation - Virtual GPC Portfolio* Global TAA MSCI World Citi Global BIG DJ UBS TR Euribor 1M Active Weight 0.0% 0.0% 0.0% 0.0% BMK Weight 60.0% 30.0% 5.0% 5.0% Equity Regions MSCI USA MSCI EMU MSCI UK MSCI Japan MSCI EM China A Shares Active Weight 1.0% -1.0% -1.0% 0.0% 0.0% 1.0% BMK Weight 35.0% 25.0% 10.0% 15.0% 15.0% 0.0% USA EMU UK Japan Cash EM FI Regions JPM USA ML US Corp HY Bonds JPM EMU ML EMU Corp HY Bonds JPM UK JPM Japan Euribor 1M JPM EMBI Active Weight -1.0% 2.0% 0.5% -1.0% 0.5% 0.5% -0.5% -2.0% 0.0% 1.0% BMK Weight 20.0% 15.0% 0.0% 20.0% 15.0% 0.0% 10.0% 10.0% 10.0% 0.0% Global FX EUR GBP JPY CHF AUD Emerging RMB Active Weight 0.0% 0.0% -5.0% 0.0% 0.0% 0.0% 5.0% BMK Weight 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% *Emerging markets are not included within the benchmark. The hypothetical or virtual portfolio has some inherent limitations. The asset allocation for a portfolio actually managed by Allianz Global Investors or its affiliates will differ from those presented here, due in part to a portfolio s investment objective and guidelines and market and economic conditions that would impact the decision-making when managing actual portfolios. There is no guarantee that these investment strategies will work under all market conditions. Each sector of the bond market entails risk. The guarantee of Treasury and Government Bonds is the timely repayment of interest, and does not eliminate market risk. Mortgagebacked securities & Corporate Bonds may be sensitive to interest rates. When interest rates rise the value of fixed-income securities generally declines. There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Equity investing is subject to the basic stock market risk that a particular security or securities, in general, may decrease in value. Investing in foreign securities may entail risk due to foreign economic and political developments and may be increased when investing in emerging markets. The securities of emerging markets may be less liquid and subject to the risks of currency fluctuations and political developments. 10

11 2. Thematic piece: Infrastructure The Backbone of the Global Economy In many places, global demographic change is creating the need for investment in infrastructure. This need is particularly great in the emerging countries, but investment is also required in the industrial countries to ensure quality of life and economic growth. November 2006: a breakdown in the German power grid leaves about 10 million people in Europe in the dark September 2011: a massive power outage leaves five million people without electricity, paralysing large sections of the south-western US and Mexico July 2012: India is hit by one of the largest power outages in more than 10 years. More than 600 million people are affected These examples show that electricity blackouts don t just happen in developing countries, they can also occur in the industrial countries of Europe and in the US. Why? The answer is globalisation. The global population is growing. People are increasingly mobile, demand for goods and services is increasing and energy consumption is on the rise. It is clear that the infrastructure in place cannot meet the challenge of these developments. Governments need to invest millions in new streets, bridges, clinics, airports and social services to meet these requirements. Globalisation: global trade as growth driver According to United Nations statistics, the world population was around 2.5 billion in 1950; it has now risen to more than 7 billion and is expected to exceed 9 billion by Global population growth continues inexorably, with five babies born every two seconds. Growth in the industrial countries is much less dynamic than in the emerging economies. The UN estimates that the share of the world population of the industrial countries will decline from almost 19% in 2005 to 14% in The share of the emerging countries will remain virtually unchanged at about 67%, while the developing countries share will rise from just under 12% to 19%. The increasing world population and growing globalisation are driving global trade. A steadily growing and increasingly prosperous society is demanding more goods and services. This can be seen in the fact that global trade has risen twice as fast as world economic growth since According to the World Bank, low-income countries will grow twice as fast as high-income countries in the coming decades. The future belongs to the city In 1980, 39% of the world s population lived in cities; now, more than half live in major cities and this figure is expected to rise to 67% by 2050, according to a United Nations forecast. The trend is clear: the future belongs to the city. The result of this urbanisation is the rise of megacities, a trend that now seems to be irreversible. While just five cities had a population of at least 10 million in 1975 (New York, which is the oldest megacity, Mexico City, Sao Paulo, Tokyo and Shanghai), the UN expects there to be 22 by 2015, 17 of which will be in developing countries. Asia is already home to seven of the world s ten largest megacities. The industrial and service metropolises will see a particular need for replacement investment in infrastructure facilities in the coming years. The emerging and developing countries, in contrast, are faced with severe congestion, environmental and socioeconomic problems, as well as an extreme infrastructure deficit. To counteract these developments, a wide range of investment is needed in utilities, construction, telecommunications, transport and social infrastructure. The example of China makes this especially clear. One billion people will be living in Chinese cities in 2030, according to McKinsey. By that time, there will be 221 Chinese cities with a population of more than a million people (in Europe the figure now is just 35). In the next 20 years, 40 billion square metres of living and working space will be created in 5 million buildings, 50,000 of which Stefan Scheurer Global Capital Markets & Thematic Research 11

12 will be skyscrapers (this corresponds to 10 times the volume in New York City) 1. Enormous need for infrastructure investment worldwide The OECD estimates average worldwide investment volume for new infrastructure, or for maintenance of existing infrastructure, to be around USD 1.8 trillion annually from 2010 to 2030: The water sector is expected to see the highest expenditure (USD 900 billion per year) Around USD 270 billion will be spent on road construction per year About USD 210 billion annually will go to the power supply Whether it s the energy supply, the improvement of utilities and transport infrastructure or telecommunications a country s infrastructure requires constant maintenance and renewal. Globalisation, coupled with worldwide demographic change, will make enormous infrastructure investments necessary in the coming decades in both the industrial countries and the growth countries. 1 Source: McKinsey Global Institute: Preparing for China s Urban Billion, Figure 1: Expected global expenditure on infrastructure per year in billion US dollar, USD bn Road Rail Telecoms Electricity Water Source: OECD (2006), Allianz Global Investors Capital Markets & Thematic Research 12

13 3. Equities outlook - US US equity markets produced solid returns in 2012, with the S&P 500 advancing just over 13% for the full year. The fact that US equity prices were able to deliver an above average gain, despite a notable slowdown in S&P operating earning growth to 3.3% year-on-year (YoY) (through Q3 2012), a continued shift in portfolio preferences of individual investors away from equities and virtually no change in the size of the Federal Reserve s balance sheet, suggests the nearly $230 billion (annualised, through Q3) reduction in shares outstanding played an unusually large role in supporting US equity prices. This year should produce more favourable fundamentals and demand conditions for the US equity market. Under our base case, earnings growth and Fed liquidity creation are both due to improve in 2013, while individual investors may be pulled back into the equity market. Yields in the debt market continue to remain historically low relative to inflation and also relative to returns that households require to achieve their targets. With the US economy showing the most signs of reacceleration of all the developed nations, foreign investor purchases of US equities may also gain momentum in Regarding earnings growth, US companies were able to hold profit margins near historical highs during the course of The deceleration in S&P 500 operating earnings growth was primarily the result of slower revenue growth, not profit margin decay. US total business sales growth peaked in the middle of 2011 at nearly 13% and shifted down to 3.1% by October 2012 about the same pace as earning growth through the end of Q3. With existing home prices up just over 10%, and double-digit returns in the equity market, US consumer spending has begun to mildly reaccelerate despite the labour market remaining lukewarm. More importantly, there are preliminary signs that capital spending has begun reviving. This, along with a $10 billion per month improvement in the trade balance since January, should support better top line growth for US based companies than in In addition, unlike in the eurozone, there are initial signs of a revival in labour productivity growth in the US. Business sector productivity is on the rebound, lifting from a low of 0.1% YoY growth in Q3 2011, to 1.6% YoY growth as of Q This in turn has led to a slowdown in unit labour cost growth for the business sector (see Figure 1). Indeed, labour cost deflation is likely to have returned to the US as of Q With pricing power holding steady, lower unit labour costs make profit margin expansion more likely in We are also finding an improved tone to capital spending indicators in the US. Institute for Supply Management new orders have moved back above the 50 level, marking expanding order books, while new orders for non-defence capital goods excluding aircraft have also begun to turn back up again after peaking in level terms back in the spring (see Figure 2). This development suggests that capital spending slowed with a delayed response to slower profit growth and that the fiscal cliff issue has not been the main factor holding back capital spending. Otherwise, had the fiscal cliff been foremost in the minds of managers, we would have observed a more rapid rate of decay in new orders for capital goods coming into the end of the year, not a rebound. Stronger capital spending not only improves the revenue growth for capital equipment producers, but should add more thrust to the labour productivity revival, while also supporting further improvements in the US trade balance. With a price-trailing operating earnings multiple close to 14, which is close to the lower bound of the range during the past 25 years, and a dividend yield above the 10 year US treasury yield, valuation remains reasonably cheap for the S&P 500. In addition, we know the Fed has committed to expanding its balance sheet by nearly a third in Sellers of treasury bonds and mortgage-backed securities to the Fed are unlikely to turn around and plough the proceeds back into asset classes offering historically low nominal yields. Riskier asset classes especially those offering Rob Parenteau, CFA Economist, External Advisor 13

14 a claim on a tangible asset are likely to once again find support from such large-scale balance sheet expansion by a major central bank. While no doubt some of this increased liquidity will be reallocated to emerging equity markets, it would be surprising if the US equity market does not benefit as well. The main risk to our US base case is that the tax hikes and expenditure cuts implemented in the 2013 fiscal consolidation prove to be too large a burden on household incomes and business revenue and profit streams, thereby slowing consumer and capital spending. As of the time of writing, with the last minute tax deal, the initial $607 billion of pre-planned fiscal contraction for 2013 has been reduced to an upper bound of $309 billion in fiscal drag. That assumes a worst case scenario, where negotiations break down in March, and all of the $109 billion in planned sequestration is implemented. More likely, another last minute compromise will be reached late in March, with more moderate reductions in both entitlement commitments and military spending, leaving the total fiscal drag in the $200-$225 billion range. Then the issue shifts to downgrades by rating agencies, since the trajectory of the public debt to GDP ratio will not look like it is flattening or even reversing soon enough for their preferences. However, since the Fed will be expanding its balance sheet by one third (roughly $1 trillion dollars) in 2013, the risk of an interest rate surge in the government and mortgage backed securities markets is quite mitigated. The second major risk to our US base case is a sharp decline in foreign growth. To date, both China and Germany are showing signs of a mild reacceleration, which should help to lift Asian and eurozone prospects. Commodity prices are also showing traction, so emerging market producers like Brazil and Indonesia should also begin to experience improved revenue streams. While both of these risks deserve to be monitored closely as the year unfolds, we believe the prospects of an earnings reacceleration, large Fed liquidity injections and favourable valuation metrics should all support very good results for US equities in Figure 1: US labour productivity reaccelerating Mar 92 Mar 93 Mar 94 Mar 95 Mar 96 Mar 97 Mar 98 Mar 99 Mar 00 Mar 01 Mar 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Business Sector: Real Output Per Hour of All Persons % Change - Year to Year SA, 2005=100 (LHS) Business Sector: Unit Labour Cost % Change - Year to Year SA, 2005=100 (RHS) Source: Bureau of Labor Statistics/Haver Analytics 14

15 Figure 2: US capital goods orders reviving Nov 07 Jan 08 Mar 08 May 08 Jul 08 Sep 08 Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09 Nov 09 Jan 10 Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov Mfrs' New Orders: Nondefense Capital Goods ex Aircraft 3-month Moving Average SA, Mil.$ (LHS) ISM Mfg: New Orders Index 3-month MovingAverage SA, 50+ = Econ Expand (RHS) Source: Census Bureau, Institute for Supply Management /Haver Analytics 15

16 Equities outlook - Europe Neil Dwane Chief Investment Officer Equities Europe Markets have made dull progress since the autumn reflecting a challenging constellation of issues. Firstly, there are the politics of the EU regionally and domestically. At a European level, the EU is struggling to find accords that cover not only its next seven-year budget, where disagreements centre on the EU share rising during local austerity, but also on the banking union where it is increasingly clear that Germany will not pay nor transfer to solve the insolvency of many peripheral countries banks. Accordingly we have seen growing frustration from the IMF, who do not endorse the recent Greek III solution through a bond buy-back and cancellation, which leaves the EU isolated again from international investment flows. Importantly, the banking union is a key step to embracing a closer European union but involves over 30 trillion of deposits and is thus more of a political rather than financial decision. Breaking the sovereign and bank loop is crucial in calming markets further and sustainably. More immediately, Q will see the Italians return to elections after the withdrawal of support for the Monti technocrats, which may well unsettle investors even if Italians themselves expect little to change. Most importantly, it is now increasingly clear to us that all big decisions in the EU will be postponed until after the German elections in September, so we should expect little policy of any note until Secondly, there is the positioning of investors towards Europe. Across markets in general, it must be said that in the last few years, Europe has not tried to attract international capital as it has forced losses onto Greek bond holders and also certain bank debt holders. However Europe badly needs to attract this pool of capital so that there is more than just Germany capable of doing the heavy lifting. With EU suspicion of international banks still high and with rising taxes on international investment, as well as open hostility to large multi-nationals (as recently seen in France), this tide may take some time to turn. Nevertheless this is indeed the opportunity as both local and international investors are very underweight Europe, in spite of the relative strength of the euro which has been buoyed by de-leveraging and repatriation of banking assets. This positioning has still left Europe looking attractive on both longer term valuation metrics as well dividend yields. Thirdly, there is the tightening grip of European austerity, which is pushing more and more of the economy into recession. As we look into 2013, it is likely that much of Europe is entering recession and that, as the IMF have now proved, the negative feedback loops of austerity are much more serious than anticipated. This then is already in the mix for Europe and is being exacerbated by the financial repression, which is encouraging banks to fund their sovereigns rather than the real economy a credit crunch is underway that will impair investment and employment. While a measure of austerity is probably appropriate, it is clear that Europe needs to address some of its structural challenges in a more dynamic and thoughtful way such as the growing and unacceptable levels of youth unemployment that could have lasting effects on economic potential. Given the demographics challenge Europe already faces, it desperately needs to address this issue (see Figure 1). Lastly, we face the global challenges left unresolved by the global financial crisis that will have a dramatic impact on equities and their prospects. Banks in Europe remain less capitalised than their UK and US competitors and will suffer both from global banking regulations like Basel III as well as local changes to regulation that will afford more protection on a national level, such as the need to hold sufficient capital in the USA to be a US bank. This, combined with Swiss and UK separate ordinances to hold high and liquid levels of assets, will also challenge both the 16

17 returns banks are able to make as well as what they can lend within the economy. European economic growth badly needs the banks to be able to fund real economic activity as much as sovereigns but for now Europe is seeing the private sector squeezed out, which is undermining investment, employment and confidence. Elections will weigh heavy through the year and the effects of implementing agreed EU policies will add further additional volatility. Figure 1: Eurozone unemployment for those aged < Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 % of Workforce Source: Bloomberg, as at 31 October

18 Equities outlook - Asia-Pacific Raymond Chan, CFA Chief Investment Officer, Asia-Pacific A better 2013? Amidst the relatively weak, but seemingly not as bad, global economic environment, we expect Asia to have experienced a trough in growth through Q3 and Q and a slight uptick in activity as we enter The appearance of a clearer path toward structural resolution in Europe and political resolution in the US, combined with consistent easing monetary policies by developed market central banks, should at least help to place a floor on the pace of global economic growth. Reflationary tactics deployed by developed markets could potentially constrict the policy options available in Asia, but we expect asset markets in Asia will continue to benefit from liquidity inflows. As inflation in the region is still trending down, partly because the economies are still operating at below capacity, Asian economies may very well be poised to head into a Goldilocks environment, characterised by the ideal balance of stabilised growth and relatively benign inflation expectations, in the first half of China The 18th Party Congress was held on 8 November and ended on 15 November The composition of Standing Committee Members of the Politburo was unveiled with seven members, rather than the nine members making up previous committees. For the time being, details on the reform agenda have been rather limited. The new Standing Committee of Politburo (SCP) is generally considered politically conservative but economically liberal. It is anticipated that economic reforms should be much easier than political change for the new leadership as all eyes will be on the messages conveyed regarding the upcoming reforms. Financial liberalisation and pricing deregulation will likely be at the top of the economic reform agenda. A crackdown on state monopolies, or even privatisation, may also be on the agenda, albeit more challenging to implement. Securing economic growth and improving living standards will likely continue to be the Chinese government s near-term focus. A majority of the new SCP members have experience in heading fast growing coastal cities or provinces in the past. Many of them also held key positions in the Jiang Zemin s regime, during which some key economic reforms, such as China s access to the World Trade Organisation (WTO), banking reforms, privatisation of state-owned assets and managed floating rate system of the renminbi, were introduced. In the next five years, we expect further progress in economic and social development, especially capital market reform, private sector/sme development, urbanisation and health care reform. As for political reforms and economic rebalancing that involve redistribution of interest among different parties, the new leaders may adopt a more conservative approach of negotiation and compromise. Policy priorities of the new administration will become clearer after the Central Economic Work Conference in December 2012 and the National People s Congress and Chinese People s Political Consultative Conference meetings in March We are comfortable with our expectation that the economy has troughed and is likely to deliver stable growth in the near- to medium-term, as our view is that the current recovery represents a cyclical rebound driven by growth in fixed asset investment and, hence, a normalisation of economic growth. However, while economic data points to China having reached a cyclical bottom, it is unclear whether we are on another structural uptrend quite yet. Economic growth is unlikely to pick up significantly and on a sustainable basis unless the government starts introducing significant reform measures. However, we are not sure whether the government has the courage to deal with some of the structural issues on the political side. And time may not be on their side as we see increasing levels of public discontent. With respect to the renminbi, the market has been focusing on the sustainability of its appreciation, especially after the currency s strong performance during recent months. From our perspective, recent strength in the renminbi has been largely driven by technical factors with inflated demand from short 18

19 covering activities, especially from exporters who accumulated US dollars in early 2012 when the renminbi depreciated. We believe fluctuations in the spot market would not lead to any significant change in China s exchange rate policy towards the US dollar. In addition, we see limited fundamental changes to support the appreciation story going forward. On the other hand, with the renminbi s trading band widening in April 2012, we believe the currency should have entered into a new regime with increasing twoway volatility driven by market demand and capital flows, instead of the predictable one-sided appreciation. Looking into the longer term, the internationalisation of renminbi should continue to support the currency, however, we expect the pace of appreciation will be slower than the market has previously experienced. India While concerns about slowing growth and the end of the investment cycle in India have persisted since late 2010, the government has finally started to take action to address these issues. Following the change in the finance ministry during the latter half of 2012, the government has now targeted a reduction in subsidies as well as a revival of the investment cycle. The aim would be to reduce the deficit while reviving GDP growth back to the levels India saw for most of the last decade. The finance minister has shown a serious intention to reduce the deficit by controlling the subsidy bill. He aims to reduce this by 0.5% of GDP every year for the next few years. The government has started with a fuel price hike in diesel and reduced the subsidised liquefied petroleum gas cap to six cylinders per year, per household. The budgeted fiscal deficit for the financial year of 2013 is 5.1% of GDP, but this is likely to slip past 5.5% by the end of the fiscal year. To help catalyse a revival of the investment cycle and market reforms, several important decisions have been implemented, including an increase on the limits on foreign direct investment (FDI) into multibrand retail, broadcasting services, insurance and pensions, power exchanges and the aviation industry. In addition, there are several projects in the pipeline awaiting approval (Figure 1). The government has formed a Cabinet Committee on Investments (CCI), which will be presided over by the prime minister and will comprise all respective ministers from the infra space. CCI will fast track all projects over $200 million that are awaiting clearance from ministries. From a monetary perspective, the Reserve Bank of India (RBI) has mentioned that they would start the easing rates cycle from Q amidst signs growth is slowing down. Therefore an easing rate cycle and a clear focus on investment and infrastructure, with the policies to back them up, should provide solid support for the revival of the investment cycle in Japan Following the recent election, Japan may very well be reaching a necessary inflection point toward turning the economy around. The election in December saw a landslide victory for the Liberal Democratic Party (LDP), which gives the Prime Minister Shinzo Abe the tools to rapidly implement campaign promises to boost growth. The Bank of Japan (BoJ) finally became a full member of the QE club and will increase the size of its balance sheet with an additional 25 trillion next year. All of this is positive for Japanese equities. However, it remains to be seen whether the BoJ s aggressive move will finally weaken the currency on a sustainable basis and help end deflation. We will pay attention to the BoJ in case it starts to explore inflation targets or other forms of less orthodox policy in upcoming meetings. While we would like to see Japan embrace more aggressive structural economic reforms, we would see near-term fiscal and monetary policy support as also being conducive to at least nearterm economic growth in Japan. ASEAN ASEAN economies have been at an economic sweetspot for some time now with the right balance of demographic and economic forces driving a number of structural developments. Strong investment and resilient consumption has been a key driver of a de facto decoupling of the ASEAN economies from the rest of the global economic stress. However, we are now reaching some stress points to the otherwise flawless story as the dependence on FDI flows and current account erosion are becoming increasingly apparent across much of the region. Indonesia is a good example. We still expect these economies to perform well; however, we would not expect the ASEAN story to remain quite as robust as it has the past few years. 19

20 Australia Although commodity prices have rallied recently on hopes of a resurgence in Chinese demand, the Australian economy is showing signs of slowing and we expect interest rates will be under pressure as we go into The near term buoyancy of the Australian dollar is a result of further diversification of their reserves by the global central banks. As we enter 2013 We are constructive on Asia Pacific stock markets for the next 12 months. The bottoming out of Asian economic growth, in particular, China, should set a stage for marginal positive economic momentum. The developed central banks continue to pursue a put option for investors to take risk. We believe a combination of modest earnings growth and some multiple expansions can set a scene for positive return for investors investing in the region. Figure 1: India Projects Announced vs. Projects Stalled (Rupees bn) INR bn 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000-25,000 20,000 15,000 10,000 5,000 - FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 Financial Year (FY) FY07 FY08 FY09 FY10 FY11 FY12 1HFY13 Projects stalled (LHS) New projects announced (RHS) Source: CMIE, Citi Research, AllianzGI Research as at 30 September

21 Equities outlook - style 2012: a decent year for style investors The past 12 months have been solid for style investors as most investment style favourites, such as stable growth, positive earnings revisions or high price momentum, were all ahead of the benchmark (see Figure 1). Among the long-term investment style winners only value lagged moderately. Risk-on/risk-off theme continued The performance of investment styles over the last few years was mainly driven by one investment theme, the risk-on/risk-off trade, and 2012 was no different in this respect. After January and February being risk-on, prompted by euro optimism after the launch of the long-term refinancing operations programme of the European Central Bank (ECB), March to July were risk-off again as euro pessimism returned with the escalation of the banking crisis in Spain and weaker economic data globally. Since late summer markets have been risk-on once more as investors reacted to Mario Draghi s pledge to do whatever it takes to save the euro and to new rounds of QE in the US, UK and Japan. This triggered a rotation out of lower-beta investment styles including (currently) price momentum, growth and quality into higher-beta investment styles like value. The mean reverting trade started tentatively in August, but has evolved forcefully since September. Does the strong recent performance of value mark the beginning of a major comeback for value? Since the end of the Great Moderation in 2007, value stocks have lost ground as investors demanded higher and higher risk premia for typically more cyclical value stocks in times of persistently higher macro-economic uncertainties. This has led to a de-rating of value stocks over the last five years. Is the de-rating of value stocks over now? Looking at the valuation of low price-to-book strategies (see Figure 2), the de-rating might indeed be over as value stocks have never been cheaper in the last 25 years in terms of price-to-book ratio, except at the time of the dot-com bubble and the Lehman collapse. Hence, there might be room for some mean reversion of valuations, in particular in Europe, and we wouldn t be surprised to see valuations revert to the average levels seen since the start of the global economic recovery post-lehman. This would imply an outperformance of low versus high price-to-book stocks in the mid-teens. However, we do not expect low price-to-book stocks to re-rate to the valuation levels seen during the Great Moderation any time soon as investors will continue to demand a higher risk premium for more cyclical value stocks in times of ongoing high economic uncertainties. But for now, as long as economic surprise indicators progress and are still off past peak levels, we expect the re-rating to continue and value to continue to outperform. Once we are approaching past peak levels in economic surprise indicators, however, the performance advantage of value stocks should gradually phase out and give way to a more balanced investment style performance profile with long term investment style favourites, such as price momentum, earnings revisions, stable growth and value, all performing reasonably well. Investment style seasonality favours value stocks at the expense of momentum stocks Controversial value stocks, low price-to-book stocks with high volatility and poor performance, often enjoy a fresh start in the new year during the first weeks of January, whereas past years winners often struggle in the first weeks of January (see Figure 3). This January effect for value stocks has been quite reliable, with only two misses for low price-to-book strategies in Europe since For the US and Japan, hit rates have been 67% and 83%, respectively. Therefore, taking investment style seasonality into account, it might be worthwhile to put more weight on controversial value stocks at the expense of consensus momentum stocks. Klaus Teloeken Chief Investment Officer Systematic Equity 21

22 Cheap valuations, positive economic news flow and investment style seasonality all suggest that the rotation into value could continue for a while, at the expense of price momentum, growth or quality The rotation could, however, instantaneously collapse, triggered by adverse political events like the US falling off the fiscal cliff or a re-escalation of the European debt crisis. In this case, a renewed risk-off trade would probably wipe out much of the outperformance of value since July and restore the pecking order of the last three years with the lowerrisk investment styles momentum, growth and quality leading and value lagging. How severely could momentum strategies suffer if the rotation into value continues? Should we expect a repeat of the 2009 collapse of momentum strategies? In the past, momentum crashes have occurred when default spreads were wide, market volatility was high and the market return was negative in the previous 12 months. These conditions generally prevailed in the depths of recession a few months prior to economic recovery. On a global scale, these conditions have not been met. Southern Europe and Japan, however, are in the depths of a recession and the policy responses of the ECB and the Bank of Japan might indeed revive the economy. Hence, the potential downside for trendfollowing strategies in Southern Europe and Japan is meaningful. Large caps versus small caps Historically, small caps have outperformed large caps throughout all phases of an economic recovery, with outperformance being strongest in the initial bounce at the beginning of a recovery, but continuing well into the muddling-through phase. However, currently small caps are trading at the upper end of their valuation range relative to large cap, which might limit their upside relative to large caps for the medium term. But in the shorter term, as earnings downgrades have probably troughed, small caps are expected to do reasonably well. Summary Last year was a solid year for style investors as most investment style favourites, such as positive earnings revisions, strong growth or high price momentum, were ahead of the benchmark. Among the long-term investment style winners, only value lagged moderately. Many investors have benefitted over the past three years from the strong performances of defensive investment styles, like growth, quality or momentum, but are also worried about losing performance in a sustained investment style reversal. Such reversals are always hard to predict or time, but given the recovery in economic surprise indicators, the substantial policy responses of central banks, the relative cheapness of low price-to-book stocks and investment style seasonality, we think investors should review an underweight in value stocks. Figure 1: Long/Short performance of global investment styles YTD Value Growth Revisions Momentum Quality Risk Small Cap Source: Allianz Global Investors research, as at 18 December

23 2012 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Value Growth Revisions Momentum Quality Risk Small Cap Source: Allianz Global Investors research, as at 18 December 2012 Figure 2: Relative valuation of low price/book-stocks Hist. average 0.10 Dec 87 Dec 90 Dec 93 Dec 96 Dec 99 Dec 02 Dec 05 Dec 08 Dec 11 Source: Allianz Global Investors, as at 30 November 2012 Reading Example for Price/Book The chart show the ratio of the average p/b-ratio for the quintile of global stocks with the lowest p/b-ratio divided by the average p/b-ratio for quintile of stocks with the highest p/b-ratio. The quintile portfolios are equally weighted and region neutral vs. the FTSE World index Figure 3: Average relative performance of investment styles by calendar month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Value Risk Size Momentum Revisions Growth Quality Source: Allianz Global Investors research, as at 6 December

24 4. Fixed income outlook - global Ingo Mainert Chief Investment Officer Balanced Europe Market Outlook Following an abrupt loss of global growth momentum at the beginning of Q4 2012, we stand by our view that the global economy is set for a modest acceleration of economic activity going forward, mainly in Asia, other emerging markets and the US. This view is supported by rising Purchasing Managers Index (PMI) data on a global level. Nevertheless, the positive momentum taking hold still leaves global growth near trend. Given the last minute agreement on the fiscal cliff, the worst case scenario of an immediate slide back into recession has been avoided. However, we had hoped for a more comprehensive agreement that would have prompted a wave of spending by households and businesses who are currently sitting on the sidelines due to uncertainty about fiscal policy. Instead, we have another potentially disruptive budget battle coming in a few weeks. Nevertheless, the outlook for the US economy looks brighter than for other developed markets. Private sector de-leveraging has advanced well, the housing market has been recovering for 18 months now and bank credit is increasing. Signs from the labour market remain mixed for the moment, but the previous downward trend appears to have come to a halt. As a result we expect the US to grow in 2013, albeit below potential. US government bonds continue to trade in their current trading range (1.5% 2%). As expected by our central bank analysts, the Fed continues its accommodative monetary policy. The decision to continue buying $45 billion of treasury securities per month next year, with the expiring Operation Twist programme being replaced like-for-like with an expansion of QE3, will boost the monetary base. The risk is that this expansion could eventually prove to be inflationary, although up to now the expansion in narrow money has had little impact on broad money or prices. The Fed dropped the calendar date reference to mid-2015 in favour of numerical thresholds to convey how long it expects to leave short rates at near-zero. Rates will likely be held at this level as long as the unemployment rate remains above 6.5% and as long as projected inflation is expected to remain below 2.5%. We expect the impact of QE3 to be lower compared to the previous two rounds of quantitative easing, but nevertheless to supply cash in the market that will likely be redeployed into better yielding financial assets (portfolio rebalancing effect). Nevertheless we expect US treasuries to continue to trade around the current low yield level. The Japanese economy remained in recession in Q3. The election on 16th December resulted in a new prime minister, Shinzo Abe from the Liberal Democratic Party (LDP). He has pledged to make significant changes at the Bank of Japan (BoJ) that will aim at supporting economic growth (with an inflation target of 2% and unlimited QE until this target is reached). At the same time more expansionary fiscal policy is likely. The latest incoming data suggests a stabilisation of the Japanese economy going forward. Annual CPI inflation will likely remain around zero for the time being. The BoJ is continuing with its near-zero interest rate policy and is set to implement an asset purchase program until the year-on-year rate of headline inflation trends higher, potentially targeting a new level of 2%. In this environment we expect the Japanese bond curve to show a steepening tendency. In Europe, it appears that the competitive gap across the eurozone is narrowing, as evidenced by an improvement in the trade balance in the periphery and a stabilisation in Target2 balances. We are also seeing a stabilisation in economic momentum, albeit at a low level. In line with the periphery, eurozonewide sentiment data recently ticked up slightly. Going forward, we expect European governments as well as the IMF and the Troika to shift their focus towards growth, accepting a more flexible and slower approach to fiscal consolidation. Overall economic 24

25 activity however, remains weak, which is why the ECB/ Eurosystem staff has revised their forecast for 2013 downward into negative territory (midpoint forecast 0.3% from 0.5% previously). As a result, the likelihood of the ECB cutting the main policy rate by another 25 basis points within the next few months has clearly risen. However, we expect the impact on economic activity as well as yields to be fairly limited as in the current environment of excess liquidity (full allotment open market operations, large excess liquidity after two LTROs), the deposit facility rate is more important. Following the comments at the recent ECB press conference stating that a potentially negative deposit rate was linked with unintended negative consequences, we see better odds that this rate will remain at zero regardless of changes of the main refinancing rate. Overall, the sole announcement of the OMT programme has eliminated certain tail risks, resulting, for example, in significant spread tightening between peripheral and core eurozone government bonds. As a result we expect government bond yields in the US and in core Europe to remain around current low levels, with a tendency to edge higher. Spreads, especially of peripheral European markets, have potential to find a new equilibrium at lower yield levels. Spreads in general have the potential to tighten further. 25

26 Fixed Income outlook - Europe Franck Dixmier Chief Investment Officer Fixed Income Europe The year 2012 ended with an apparent paradox: with a 10%-plus gain by the Euro Aggregate Bond Index and more than 20% on the European high-yield market, seldom have the euro bond markets achieved such a performance even as investors face a record level of uncertainty. Remember that at this time last year, the burning issue was whether the eurozone would actually survive! This level of returns will probably not be replicable in 2013, but there are still investment opportunities out there. In a world dominated by financial repression, where central banks are likely to confirm their extremely accommodating monetary policy and consolidate their control over the yield curve, we will have to get used to the fact that higher-grade issuers on deep markets in terms of liquidity such as Germany and the US will continue to be sought out despite their demanding valuations. As the universe of AAA-rated issuers is gradually shrinking, quality and liquidity come at a price. The levels reached on the German curve, which is in negative territory on all maturities in real terms, leave little upside potential. The opportunities are elsewhere and the watchword in 2013 will be the quest for yield. In such an environment, peripheral debt is an inevitable choice. The past year has seen major progress in managing the eurozone sovereign debt crisis. Political headway combined with the refinancing mechanisms offered by the European Financial Stability Facility (EFSF) and its successor, the European Stability Mechanism (ESM), as well as the decisive Outright Money Transactions plan (OMT) announcement by the European Central Bank (ECB), currently offer extremely credible support factors that are ultimately likely to promote a significant reduction in specific risk premiums. Like the volatility that we have seen on sovereign spreads, this gradual scenario of normalisation will likely not be a ride in the park and will unfold over the medium term. While some headway has already been made, uncertainties political in the case of Italy, timing-related in the case of a formal bailout request from Spain continue to justify wide spreads. The market is likely to continue to track newsflow and stick to its risk-on/risk-off tendency, and any significant pressures on peripheral spreads will be a buying opportunity to gradually add to exposures. After the massive and often lossrealising sales by institutional investors, we believe it will take a long time to reestablish a diversified and stable base of peripheral debt investors. Even so, on top of the irrevocable commitment to the single currency by European political and monetary authorities, investors must also favour countries that have made progress in implementing structural reforms. Despite a difficult recessionary environment, these reforms are beginning to bear fruit, with an improvement in external balances (Ireland, Italy, Portugal and Spain), the emergence of primary surpluses (Italy and Ireland), and increased productivity through lower unit salary costs (with the exception of Italy). These macroeconomic adjustments will take time but they are well under way. The quest for yield is likely to boost the corporate bond market as well, which, after an excellent year in 2012, continues to offer value on a selective basis. Despite a worsening in corporate and banking fundamentals, as seen in the successive waves of downgrades by ratings agencies and amid a shrinking systemic risk premium following the ECB s OMT announcement, the credit market has drawn in investors, who have raised their exposure to this asset class. Our outlook for 2013 is in line with trends seen in The primary market should be busy, with new issuers that until now had relied on bank financing. The deleveraging process that has already been at work for 18 months is likely to continue and produce more private placements and new unrated or high yield issues. In contrast, the euro Investment Grade universe is likely to shrink, due to a net negative supply of bonds from de-leveraging banks and cuts in 26

27 corporate capex (especially in cyclical sectors and/or in southern Europe). This would further exacerbate the imbalance between supply and demand. The current valuation level as measured by the credit spread is close to its 10-year average. Investment grade is trading at a 146 basis points spread, versus a 140 basis points average, and the high-yield market at a 585 basis points spread, versus a 670 basis points average. The potential for additional compression exists in particular for bonds from peripheral country issuers and on new issues. However, we are more cautious on cyclical sectors (such as automotive and steel) and on subordinated financial bonds. Regarding banking issues, senior debt on the short end of the curve continues to offer a good risk/return profile. Lower Tier 2 (subordinated debt) also offers value in some cases, but we are taking a selective approach with a generally neutral exposure. We feel that the non-call risk is rather high and not always priced in. In Tier 1 (equity-like capital), we are underweight at current levels. The theme of burden sharing and regulatory incentives to push banks to set up a cushion composed partly of Tier 1 to absorb first losses is likely to have a negative impact on this segment. The very low liquidity and occasional spikes in volatility, in our view, is not priced in at current levels. Based on a rating category-based approach, BBB and BB (as awarded by S&P or Fitch) issuers offer the best risk-return profiles. The cumulative five-year default probability on these issuers average 0.9% and 4.6% respectively, which is more than remunerated by current spreads. All in all, in an environment of very low growth, which is not unfavourable to the corporate bond asset class, the highly accommodating stance of central banks and greater credit demand than supply should once again direct investment flows into investment grade, high-yield and convertible bonds and, hence, lead to narrower spreads. 27

28 Fixed Income outlook - Asia-Pacific Eugen Loeffler Chief Investment Officer, AllianzGI Asia-Pacific In 2012, Asian bonds again delivered respectable total returns, both from an absolute and a relative perspective. While returns by far exceeded those in the core global bond markets of the US, Japan and Germany, they trailed global emerging market bond returns. However, one needs to consider that Asia offers stronger economic fundamentals and risk characteristics. All major Asian markets except for Indonesia and the Philippines have investment grade status, and the latter are just one notch away. Retreating inflation enabled Asian central banks to lower rates in 2012 to support economies affected by slow external demand. Asian long bond yields have continued to come down and stay at historically low levels. The same is true for the very flat yield curves. This raises the obvious concern over whether current yields are out of sync with long-term fundamentals. Certainly, Asian yields would be higher without the effects of the global low interest rate environment and the search for remaining yields, driven by abundant global liquidity. In normal circumstances, long-term bond yields should be anchored by long-term nominal GDP growth. Historically, this has been the case for the US, Germany and Japan. However, currently long bond yields in the US and Germany and arguably even in Japan are significantly below expected long-term nominal GDP growth. This is an anomaly judged by past patterns, whereas historically Asian countries showed a pronounced negative gap between high nominal GDP growth and lower long-term rates. In retrospect, this could be interpreted as a correct anticipation of a normalisation of long-term growth and inflation rates over time, which has already happened in the former tiger economies and is currently on its way in China. From this angle, current Asian long-term rates still look low, but less distorted than the rates for core global bond markets. Along with the effects of low policy rates and bond buying by major central banks, the extremely low rates in core global bond markets can be explained by the pricing effects of disaster risk. Under normal circumstances, the entry probability of economic disaster risk, defined as a severe and long-lasting negative shock to economic growth, is so low that it does not significantly affect pricing, at least for assets that are considered risk free under normal circumstances, such as government bonds of major advanced economies. However, once disaster risk rises to a level that it influences investor decision making, it can cause the seemingly paradox result that bond yields for core countries fall, despite the fact that the default risk for these countries is actually higher than in the past. Investors seek protection in the increased relative safety of haven markets (versus other bond markets and other asset classes), driving down yields, even though the default risk for the safe haven markets has risen as well. Asian yields have certainly been affected by this, even if only indirectly. However, even at current levels Asian yields still offer a significant premium for the underlying risks. Judged by the difference between five-year government bond yields and Credit Default Swap (CDS) spreads, Asian bonds offer a higher reward for the underlying sovereign risk not only compared to the US, Germany or Japan, but even compared to countries such as Spain or Italy, which certainly still face much higher economic challenges and risks. Nevertheless, Asian long bond yields will face upward risk as well, once the global economy reverts back to normal, but certainly no more so than other global bond markets. While there are signs of the global economy bottoming out, at least outside Europe, an imminent exit from the global low-yield environment seems rather unlikely. Asian central banks have only moderately lowered policy rates in 2012, as they initially waited for a confirmed downtrend of inflation and held steady as Asian economies coped quite well with weaker external demand. In many countries, especially in South East Asia, strong domestic demand stabilised growth. And, across the board, even in the more cyclical economies like Korea, unemployment rates did not move up at all. Assuming that the US economy will continue to grow moderately and that there is a 28

29 continued stabilisation of growth in China, Asian central banks might go back to a more neutral monetary policy stance during the course of However, they will likely take their time and rather tolerate some currency appreciation first before going for outright rate hikes. Early 2013 residual rate cuts could still happen in some countries (such as in India and possibly Korea). Currencies of Asian countries, especially those with current account surpluses, will likely move up further, which would be supported by a continued measured appreciation of the renminbi easing competitiveness considerations in other Asian countries. Under this scenario, Asian bond markets will continue to appeal more to global investors seeking higher yields than those available in core global bond markets, at arguably even lower risks. Figure 1: Asian local bond market returns HSBC ALBI (Asian Local Bond Index) Total Return in USD 2012 YTD HSBC ALBI (Asian Local Bond Index) Total Return in EUR 2012 YTD HSBC ALBI (Asian Local Bond Index) Total Return in local currency 2012 YTD 10 Year Government Bond Yield Current Jun 12 China 3.7% 9.8% 5.0% 2.1% 13.3% 12.6% 2.7% 5.0% 1.4% 3.6% 3.3% 3.4% India 6.9% -10.9% 9.5% 5.3% -8.1% 17.4% 10.1% 5.8% 5.2% 8.1% 8.2% 8.6% Indonesia 7.0% 20.3% 28.3% 3.6% 25.0% 37.5% 12.6% 21.5% 21.1% 5.2% 6.2% 6.0% Korea 15.1% 3.1% 11.8% 13.3% 6.7% 18.8% 6.4% 6.4% 8.3% 3.2% 3.6% 3.8% Malaysia 7.8% 1.3% 17.9% 6.1% 4.5% 26.4% 4.1% 4.8% 4.9% 3.5% 3.5% 3.7% Philippines 16.4% 12.2% 18.5% 14.6% 15.7% 27.1% 9.0% 12.8% 12.1% 4.4% 5.9% 5.4% Singapore 10.3% 5.4% 12.4% 8.6% 8.8% 20.5% 3.8% 6.5% 2.7% 1.3% 1.6% 1.6% Taiwan 7.1% 0.0% 11.4% 5.5% 3.1% 19.5% 2.7% 3.8% 1.6% 1.1% 1.2% 1.3% Thailand 6.0% 0.0% 17.0% 4.4% 3.2% 25.5% 2.7% 5.1% 5.4% 3.6% 3.5% 3.3% Total 8.7% 5.0% 12.2% 7.1% 8.3% 20.3% 3.8% 4.1% 4.1% End 2011 Source: Bloomberg, as at 17 December

30 5. Multi asset outlook Herold Rohweder Global Chief Investment Officer, Multi Asset, Allianz Global Investors Europe Liquidity drives risk assets still higher The legacy of the European Central Bank s (ECB) Outright Monetary Transactions (OMT) a conditional form of Quantitative Easing (QE) announced earlier this year, underpinned equity markets. The generally positive trajectory for risk assets was further supported by the US expanding its QE program. In early October, Chairman of the Federal Reserve, Ben Bernanke, delivered a speech in Indianapolis that hinted at replacing Operation Twist (where the Federal Reserve sold short-dated treasuries held on its balance sheet in exchange for longer-dated equivalents) with $45 billion of additional US treasury purchases. This would accompany the open-ended purchase of $40 billion of agency Mortgage-Backed Securities (MBS) that was announced at the 13th September Federal Reserve meeting. This policy was formerly announced in December and will continue so long as the labour market does not improve substantially. The December Federal Open Market Committee (FOMC) meeting was significant for an altogether different reason. The Federal Reserve implemented a series of numerical thresholds for policy rate guidance, such as retaining exceptionally low Fed funds as long as unemployment remains above 6.5%. This is the first step towards developed market central banks moving to devalue, or at least set aside, the policy of inflation targeting. Admittedly, the Federal Reserve has always had a dual mandate, but this is the first time it has stipulated a growth-related target. The US is not alone in its thinking Bank of England Governor designate, Mark Carney, recently delivered a speech on the merits of guidance and how a nominal GDP target could be more powerful than a flexible inflation-targeting regime. The eurozone entered a technical recession in Q3, reporting the second consecutive contraction in quarterly GDP. Even in Germany, the labour market cycle peaked as it reported an increase in unemployment and a fall in total employment for the first time since early Meanwhile, the Eurozone Purchasing Manager Index (PMI) remained in contractionary territory throughout the quarter, although by November Germany was beginning to show some signs of improvement in sentiment and Spain rebounded sharply from weakness earlier in the quarter. Nevertheless, Ireland remained the only eurozone country with a PMI series in expansionary territory. This fundamental weakness was also evidenced in eurozone industrial production that recorded its second consecutive decline in October, the worst since the recession. There were, however, some bright spots as Greece completed its 31 billion buy-back of sovereign debt on 11th December, thereby unlocking further aid and reducing its outstanding debt by a net 21 billion. The positive impact of the promised OMT on bond spreads and financial conditions was much greater than any refinancing or deposit rate cut that the ECB could have executed. Together with relatively cheap historic valuations in European stocks, this underpinned the uptrend in European equities this quarter, despite some disappointment on the economic fundamental side. At the time of writing, the US government has agreed upon legislation to avoid the automatic tax rises (budget sequestration) that were due to commence on 1st January However, the prospect of severe fiscal tightening in 2013 has, for now, only been delayed by 2 months, and the need to come up with a meaningful long-term fiscal plan to at least stabilise the US public Debt/GDP ratio in the 10 year budget window will, now coincide with the requirement to seek Congress approval to, once again, raise the Federal debt ceiling. A Chinese recovery was assured by monetary and financial conditions turning accommodative during the quarter and through a rebound in property prices. According to the National Bureau of Statistics (NBS), quarterly growth is cyclically improving, while industrial production expanded as the drag from destocking lessened. In investment, rising infrastructure expenditure offset slow manufacturing capex. Elsewhere, although existing property controls were maintained, property investment rebounded, led by residential housing. The Politburo s first post 30

31 election meeting included a discussion to actively promote urbanisation, thus further growth in construction is likely going forward. Looking through the fiscal cliff toward a Chinese rebound The prospect of a genuine recovery in China, albeit at a slower rate than in 2008, as authorities resist repeating the mistake of flooding the economy with excess liquidity and generating significant inflation, is very real. This should help underpin commodity demand, for which our Market Cycle Indicator has been mixed over the last quarter. Our preference for emerging market bonds is related to this recovery, although we recognise that hard currency emerging market debt has enjoyed a significant appreciation this year, so are more inclined to take profits on this overweight. In contrast, we still see value in local emerging market bonds, where the full benefit of carry can be enjoyed by investors. Moreover, most emerging market economies are nearing the end of their rate-cutting cycle, which should support domestic economic fundamentals in a region where fixed income investments are pro-cyclical. Within developed market equities, we prefer an aggregate overweight position while central banks continue to expand their balance sheets. We favour investment in Europe, due to relatively cheaper valuations, and emerging market equities that are less restricted by elevated debt levels. We are least positive on Japan, despite the proposed raising of the inflation target by the newly-elected Liberal Democratic Party and the proposal to engage in unlimited QE to achieve this. As additional satellite investments within the equity asset class, we recommend selected Asian countries, such as Hong Kong or Thailand, and selected countries within Eastern Europe, such as Turkey. In our view, European small cap stocks continue to be attractive and might benefit from a January or Q1 effect. European banks remain an attractive tactical high beta satellite investment, which of course has to be watched closely because of the remaining risks in the eurozone. Positive price momentum underpins the overweight signal from our Market Cycle Indicator for many of the higher- yielding fixed income markets. However, these signals are indicating that prices have risen too fast to excessively high levels for European Investment Grade Credit, hard currency emerging market debt, German covered bonds (Pfandbriefe) and global high yield corporate bonds. For this reason we recommend reducing the overweight and taking profits in these sectors given how far they have appreciated. Attractive fixed income satellite investments are convertible bonds, which currently have relatively attractive risk return characteristics. With regard to alternatives, we currently like macroand multi-strategies and also recommend global REITs based on positive sentiment and trend indication. Compared to equities, we are not bullish on commodities because growth prospects are moderate and inflation-contained. However for diversification reasons a small position in commodities is reasonable. Since volatility is relatively low, buying cheap protection in an overall bullish portfolio may be worth considering. 31

32 6. Sustainability Research long term trends David Diamond Global Co-Head of ESG Driving transparency in extractive industries to minimise risks for investors While prices for natural resource commodities, such as oil, gas and precious metals, remain volatile, interest in extractive industries oil, gas and mining should continue over the long term, as investors pursue ever greater diversification strategies and hedges against any potential rise in inflation. Global demand for these non-renewable natural resources is likely to be supported by three trends: 1) 50% growth in world population by 2050 according to UN estimates 2) 6% rise in global energy use by 2035 according to the International Energy Agency 3) A potential doubling of the emerging economies share of global GDP within 15 years, assuming IMF growth estimates continue at current rates Nonetheless, extractive industries present numerous environmental, social and governance (ESG) challenges of interest to investors. After the BP-linked oil spill in the Gulf of Mexico, higher costs linked to pollution controls are an issue for oil companies operating deep offshore platforms. Employee health and safety is an ongoing concern for mining companies seeking to reduce workplace accidents, such as ArcelorMittal. One particularly difficult challenge is securing long term supply for resources located in areas where political, economic and social instability is often the norm. Social unrest has regularly threatened Royal Dutch Shell operations in Nigeria and during the Arab Spring for ENI in Libya. Poor governance and lack of transparency often lie at the root of the problem as local populations fail to see any socio-economic benefits from the financial wealth generated by resource exports. According to The Economist, resource nationalism has recently jumped to the top of the list of worries for global mining companies, notably in Africa, as countries seek to boost their share of resource revenues. Natural resources: the paradox of plenty Governments in resource-rich countries are tempted to favour the export of natural resources to benefit from the financial bounty that they represent: it is simply easier to generate income from extractive industries than to build a strong and diversified economy. On the face of it, this activity is very profitable at least in the medium term for the governments themselves, the oil, gas and mining companies involved and their shareholders. However, this does not necessarily translate into sustainable long term approach. In regimes that are more frequently autocratic than democratic and rife with corruption, the income derived from resource extraction seems to be more commonly distributed to the political, military and commercial elites rather than being invested in economic and social development projects. It is important to note that most countries rich in natural resources have tended to underperform economically. Over 3.5 billion people live in countries rich in oil, gas and minerals, but the vast majority see few benefits. With good governance, the exploitation of these resources could generate large revenues to foster economic growth and diversification, while reducing poverty. However, when governance is weak, corruption, poverty and conflict often follow. These effects, however, are not inevitable and encouraging greater transparency in countries rich in these resources could mitigate some of the potential negative impacts. Benefits to companies and investors focus on limiting political and reputational risks. Political instability caused by opaque governance is a clear threat to investment. In extractive industries, where investments are capital intensive and dependent on long-term stability to generate returns, reducing such instability is beneficial for business. Transparency of payments made to a government can also help to demonstrate the contribution that the company s investment makes to a country. 32

33 Would transparency and improved governance best be achieved by voluntary initiatives or through stricter regulation? Investors increasingly believe that both may be necessary. The Extractive Industries Transparency Initiative (EITI) is a scheme where countries voluntarily commit to a public reconciliation of the financial payments made by extractive companies and the revenues received by the governments. EITI is a multi-stakeholder initiative whereby governments, companies, civil society and investors oversee the full process, locally in each country, supervised by the EITI International Board. Today, 36 countries, totalling a population of over 900 million people, implement the EITI, and it is increasingly recognised as a global transparency standard, in turn supported by the G8, G20 and institutions like the World Bank. Key stakeholders supporting the initiative include over 60 of the largest oil, gas and mining companies, 80 institutional investors and dozens of civil society organisations. Moreover, after Norway, the United States and Australia are the first OECD countries to express their intention to become EITI implementing countries. Today, financial markets are just beginning to recognise the value of the EITI label Of the 36 countries now implementing EITI, Azerbaijan was the first country to be declared EITI Compliant by the EITI Board in In May of the following year, Fitch Ratings announced that they upgraded Azerbaijan s long-term foreign and local currency Issuer Default Ratings (IDRs) to BBB- from BB+. In the press release, Fitch indicated that it draws comfort from the transparency of the SOFAZ [the State Oil Fund that leads on EITI], underlined by Azerbaijan being the first country to be fully compliant with the international Extractive Industries Transparency Initiative. Although other rating agencies such as S&P have not yet followed suit so explicitly, the S&P Sovereign Government Rating Methodology and Assumptions includes a Political Score where the transparency and accountability of institutions, data and processes including [a country s] perceived level of corruption are considered. As such, a commitment to EITI may contribute to a country s improving its sovereign credit rating over the long term. Beyond such voluntary initiatives, however, regulation is likely to play an increasing role in assuring transparency for extractive companies. In the US, Dodd Frank legislation, as per the Security and Exchange Commission (SEC), now requires all SECregistered companies from the extractive sectors to publish government payments on not only a countryby-country basis, but also project-by-project. The European Union has signalled its intention to follow suit. As a result, in October 2011 over 20 institutional investors representing over 2.5 trillion in assets, including Allianz Global Investors, wrote to Michel Barnier, European Commissioner for Internal Market and Services, in qualified support for draft transparency legislation. This would require multinationals to disclose financial information such as production shares with governments, bonuses, royalties and taxes for each country in which they operate via their annual statements. The investors stated that they support the EU s initiative for increased transparency both through voluntary (EITI) and regulatory approaches. They stressed that the two are complementary and ultimately enhance the prospects for risk adjusted investment returns by improving disclosure, which contributes to more stable and transparent bidding markets for contracts, licences and permits, and lowers the risk that governments will seek to renegotiate or rescind contracts or nationalise projects. However, they also warned the Commissioner against exposing extractive companies to conflicting legal requirements. To this end, the investors propose that regulators work towards a single global disclosure regime with a mutually recognised reporting process across jurisdictions in order to build consistent reporting standards across global markets. Whether voluntary or regulatory, the investment case for transparency is clear. It is the first step leading to better governance in resource rich countries. Ultimately, this should produce a more stable investment climate of benefit to extractive companies, their shareholders and local populations. David Diamond represents institutional investors on the EITI Board. 33

34 7. Economic forecast summary AllianzGI Consensus AllianzGI Consensus US Real GDP % chg SAAR* CPI** Short-Term (official) Rates Year Rates US Dollar Index UK Real GDP % chg SAAR* HCPI*** Short-Term (official) Rates Year Rates GBP/USD Euroland Real GDP % chg SAAR* CPI** Short-Term (official) Rates Year Rates (Germany) EUR/USD Japan Real GDP % chg SAAR* CPI** Short-Term (official) Rates Year Rates JPY/USD China Real GDP % chg SAAR* CPI** Y Lending Rate Year Rates USD/CNY Hong Kong Real GDP % chg SAAR* CPI** M Interbank Rate Year Rates USD/HKD Commodities Gold Oil *Seasonally Adjusted Annual Rate. **Consumer Price Index. ***Harmonised Consumer Price Index. Source: Allianz Global Investors, as at 11 January

35 Financial markets review 31-Dec-12 Qtr-to-date 30-Sep Dec-12 Yr-to-date 31-Dec Dec-12 % Change From Calendar Calendar Year High Calendar Year Low Year 2011 Equities US S&P % 16.00% -2.02% 16.00% 2.11% NASDAQ % 15.91% -5.16% 15.91% -1.80% MS Value % 14.99% -1.77% 14.99% 1.49% MS Growth % 17.30% -3.09% 17.30% 2.39% S&P 500 VIX % % % 33.98% 31.83% NASDAQ VIX % % % 49.09% 18.74% Equities Japan Nikkei % 22.94% 0.00% 25.31% % Equities Europe DJ Euro Stoxx % 8.78% -0.91% 16.45% -8.39% FTSE % 5.84% -1.14% 12.12% -5.55% Dax % 30.37% -0.79% 30.37% % Cac % 15.23% -0.90% 23.41% % Equities Asia-Pacific MSCI Asia Pacific ex-japan (USD) % 19.40% -0.41% 24.85% % Currencies EUR/USD % 1.97% -1.93% 9.14% -3.17% USD/YEN % 12.71% 0.00% 13.85% -5.19% GBP/USD % 4.59% -0.09% 6.35% -0.74% Commodities oil brent % 1.92% % 22.47% 16.67% gold (USD) % 5.58% -7.22% 7.88% 11.07% S&P Goldman Sachs Commodity Index % 0.08% -9.25% 15.68% -1.18% Short-Term Rates Fed Funds Target 0.25% 0 bps 0 bps 0 bps 0 bps 0 bps 3-Month T-Bill 0.05% -4 bps 3 bps -9 bps 4 bps -10 bps 3-Month Euro 0.19% -4 bps -117 bps -117 bps 1 bps 35 bps 3-Month Yen 0.31% -2 bps -2 bps -3 bps 0 bps -1 bps Long-Term Government Bonds 2-Year Treasuries 0.24% 0 bps 1 bps -15 bps 3 bps -36 bps 5-Year Treasuries 0.70% 7 bps -12 bps -50 bps 15 bps -118 bps 10-Year Treasuries 1.75% 13 bps -13 bps -63 bps 35 bps -143 bps 10-Year Bund 1.30% -16 bps -53 bps -74 bps 15 bps -106 bps 10-Year JGB 0.79% 2 bps -20 bps -26 bps 12 bps -13 bps US Corporate Bonds Barclays US Aggregate AAA 10+ years 2.69% -11 bps -110 bps -119 bps 5 bps -31 bps Barclays US Aggregate BAA 10+ years 4.63% -7 bps -77 bps -84 bps 12 bps -57 bps spread BAA/AAA 1.94% 4 bps 33 bps 35 bps 7 bps -26 bps Barclays High Yield 9.05% -49 bps -311 bps -311 bps 24 bps 229 bps EMU Corporate Bonds Barclays Euro Aggregate AAA 0.88% -33 bps -118 bps -132 bps 0 bps -50 bps Barclays Euro Aggregate BAA 1.21% -31 bps -250 bps -280 bps 0 bps -16 bps spread BAA/AAA 0.33% 2 bps -132 bps -148 bps 0 bps 34 bps The periodic changes for equity indices are percentage changes, whilst for bond indices the change is given in basis points. A 1% point change is equivalent to 100 basis points. The calendar high and low columns represent the deviation of the index in percentage or basis points terms accordingly, compared to the index level at the end of the period of review. Source: Datastream, as at 31 December

36 Implied EPS growth (5-year) Global sectors AllianzGI top-down 5 year earnings growth estimate (p.a.) Market implied 5 year earnings growth (p.a.) Estimated growth minus market implied growth Oil & Gas 1.5% -4.9% 6.4% Materials 1.3% 2.4% -1.1% Industrials 1.4% 3.0% -1.5% Consumer Goods 1.2% 3.0% -1.7% Consumer Services 1.5% 6.2% -4.7% Health Care 2.0% 6.7% -4.7% Telecom 0.7% 2.4% -1.8% Utilities 1.3% 1.9% -0.6% Financials 1.9% -0.9% 2.8% Banks 2.0% -2.5% 4.6% Insurance 1.5% -2.7% 4.2% Technology 1.7% 4.7% -3.0% Source: Allianz Global Investors, as at 1 January

37 Relative sector valuations Z-Score average Delta to 3 month ago Z-Score relative P/E Z-Score relative P/B Z-Score relative P/ CF Z-Score relative DY Oil & Gas Oil Producers Oil Services Basic Materials Chemicals Basic Resources Industrials Construction & Materials Industrial Goods & Services Consumer Goods Auto Food & Beverage Personal Household Goods HealthCare Consumer Services Retail Media Travel & Leisure Telecoms Utilities Financials Banks Insurance Technology Software Hardware Note: The table summarises AllianzGI s constant monitoring of relative sector valuations: We compare the current relative valuation with the average historic relative valuation by using z-scores for four widely used valuation measures, namely P/E, Price/Book, Price/Cash flow and dividend yield. The z-score average column describes the average of all four valuation measures. The dividend yield enters the average with inverse sign, as a high dividend yield indicates a low valuation. Source: Datastream, AllianzGI, as at 1 January Legend: Numbers in green indicate z-scores of below -1 (attractive relative valuation) Numbers in red indicate z-scores of above +1 (expensive relative valuation) 37

38 Biographies 8. Global Policy Council The Global Policy Council (GPC) is a monthly meeting of the regional CIOs, Economics and Strategy team and senior investment professionals chaired by our Global CIO, Andreas Utermann. The council focuses on the direction of the global economy, regional economic outlooks, prospects for the global bond and equity markets, and periodic thematic pieces of proprietary research. Each month the GPC produces a forecast for regional equity, bond, currency markets on tactical and strategic horizons. The tactical horizon is expected to be roughly three months, while the strategic focus is expected to be longer than one year. The allocations suggested are not reflective of any single product or recommendation and may differ from other existing products. The members share seven votes between them, which determines the virtual portfolios. Andreas E F Utermann Global Chief Investment Officer, Allianz Global Investors Andreas Utermann is Global Chief Investment Officer (CIO) and co-head of Allianz Global Investors. Andreas joined Allianz Global Investors and its Global Executive Committee in 2002 as Global CIO Equities. Between his joining and the end of 2011, Andreas was also Global CIO and Co-Head of RCM. Andreas holds a number of non- Executive positions in the industry, including Board Memberships of the CFA Society of the UK, the AMIC Council of the ICMA as well as being a member of the Advisory Council of the DVFA. Prior to joining, Andreas worked for 12 years at Merrill Lynch Investment Managers (formerly Mercury Asset Management), where he was the Global Head and CIO, Equities. Before joining MLIM, Andreas worked for two years at Deutsche Bank AG. He holds a BSc in Economics from the London School of Economics and an MA in Economics from Katholieke Universiteit Leuven. Andreas is an Associate of the Institute of Investment Management and Research and is fluent in English, German, French and Dutch. Raymond Chan, CFA Chief Investment Officer, Asia-Pacific Raymond is responsible for all investment professionals in Asia ex-japan, reporting to the Global CIO in London, and is the Chairman of the Global Balanced Investment Committee and the Regional Portfolio Management Group (RPMG) in Hong Kong. Raymond has overall responsibility for the investment process and performance. He has 22 years of portfolio management experience in the region and is the lead manager for the Core Regional (Asia Pacific ex-japan equity) products. Prior to joining the Group, Raymond was Associate Director and Head of Greater China team with Barclays Global Investors in Hong Kong, where he specialized in Hong Kong, China and Taiwan stock markets and managed single country and regional portfolios. Raymond s Hong Kong Fund at Barclays was ranked no. 1 offshore fund in He is a CFA charterholder and holds an M.A. in Finance and Investment from the University of Exeter and a B.A. (Hons.) in Economics from the University of Durham, UK. 38

39 Neil Dwane Chief Investment Officer Equities Europe Neil is Chief Investment Officer Europe, based in Frankfurt, and is responsible for all portfolio management, research and trading activities in Frankfurt, Paris and London. Neil is a member of the AllianzGI European Executive Committee as well as the Global Investment Management Group and is Chairperson of the European Equity Management Group, which consists of the most senior equity investment team leaders in Europe. Neil joined the company in 2001 as Head of UK and European Equity Management from JP Morgan Investment Management where he had been an UK and European specialist portfolio manager since He began his investment career in 1988 with Kleinwort Benson Investment Management as an analyst, later as a fund manager before moving to Fleming Investment Management in Neil holds a BA in Classics from Durham University and is a member of the Institute of Chartered Accountants. Stefan Hofrichter, CFA Head of Global Economics and Strategy Group As Head of the Global Economics and Strategy Group since 2011, Stefan s research primarily covers global economics, as well as global and European equity, fixed income and multi-asset strategy. Stefan joined the firm in 1996 as an equity portfolio manager, moving to an economist and strategist role in Between 2004 and 2010, he additionally had responsibility for various retail and institutional mandates, including global and European classic balanced funds, global multi-asset absolute return and multi-manager alpha-porting funds. Stefan became a member of the Global Policy Council in 2004, and in January 2010 was appointed chair of the European Asset Allocation Committee. He holds a degree in economics from the University of Konstanz (1995) and in business administration from the University of Applied Sciences of the Deutsche Bundesbank, Hachenburg (1991). Stefan became a CFA Charterholder in Ingo Mainert Managing Director and Chief Investment Officer Balanced Europe Ingo joined from cominvest in February 2009, following Commerzbank s purchase of Dresdner Bank. Ingo is a Managing Director and CIO Balanced Europe. Ingo takes this role having headed Asset Management of cominvest since June Ingo started his professional career with Commerzbank in 1988 and first held analyst and currency specialist functions following his traineeship, before taking management responsibility in Commerzbank as Team Head Equity Strategy Germany in 1994 and Head of Fixed Income Research in 1998 before moving to the Asset Management side of the business as Head of Global Markets Research Division in 2001 at Commerz Asset Managers. Since 2002 he held a position as Head of Balanced Portfolio Management Division at cominvest, was then named Head of Asset Management Private Banking at Commerzbank in August 2004 and was finally appointed Managing Director and CIO of Cominvest. Ingo is a Certified Investment Analyst and a board member of the DVFA Society of Investment Professionals in Germany; he graduated from the Johann Wolfgang Goethe- University with a Diploma in Business Administration. Franck Dixmier Chief Investment Officer Fixed Income Europe Franck Dixmier, CIO Fixed Income Europe, joined the Allianz Group in 1995 as Fixed Income Portfolio Manager. In 1998 he became the Head of Fixed Income for AGF Asset Management (the former name of AllianzGI in France). In this role he was also responsible for the AGF insurance portfolios. In 2008, Franck became a Member of the Executive Committee, and Chief Investment Officer of Allianz Global Investors France. He was appointed Deputy CEO of AllianzGI France and CIO of AllianzGI Investments Europe in Franck Dixmier graduated with a Master s Degree in Economics and Finance from the Paris Dauphine University (Master s degree - DEA conjoncture économique et prospective). 39

40 Eugen Loeffler Chief Investment Officer, AllianzGI Asia-Pacific Dr. Eugen Loeffler is Chief Investment Officer Fixed Income Asia Pacific for Allianz Global Investors and is based in Korea. Dr. Loeffler has been with the Allianz group for more than 20 years, having worked in various roles within the group. His main focus has been on capital market research and investment management. Before relocating to Asia in early 2010, Dr. Loeffler was Chief Investment Officer of Allianz Suisse in Zurich, responsible for the investments of Allianz Life and Non-Life insurance companies in Switzerland. Dr. Loeffler has a doctoral degree in Business administration and studied Business administration as well as German literature and History at Johann Wolfgang Goethe University in Frankfurt. Klaus Teloeken Chief Investment Officer Systematic Equity Dr. Klaus Teloeken is the Co-CIO of the Systematic Equity team. He joined Allianz Global Investors in 1996 as a quantitative analyst, and in 2001 he assumed the role as Head of Systematic Equity. He oversees more than EUR 9 billion of assets under management, and is responsible for the development and the management of systematic investment strategies for equities. In this role, Klaus has developed the team s Best Styles and High Dividend product line. He is also responsible for the management of the Best Styles Global and High Dividend Global product. Klaus studied mathematics and computer science in Dortmund, Germany. Contributors non GPC members David Diamond Global Co-Head of ESG David joined Allianz Global Investors in 2008 in charge of all ESG related commitments for AllianzGI France, including Head of ESG Research. In October 2012 he was promoted Global Co-head of ESG. In that capacity he is responsible for all governance related activities, including engagement and proxy voting. He currently represents investors, including Allianz Global Investors, on the boards of the Extractive Industries Transparency Initiative (EITI) and the French Social Investment Forum (FIR). He has also participated in several Global Reporting Initiative (GRI) working groups. Prior to AllianzGI, David had joined Crédit Lyonnais Asset Management as an SRI analyst in 2001 after several postings at Paribas Asset Management (Marketing Dept) and then BNP Paribas Asset Management (European equities financial analyst and advisor to the UN Pension Fund) from 1996 through He was Senior Sustainability Analyst and Head of Shareholder Engagement at Amundi from He graduated with a B.A. in Art History from Williams College (Massachusetts, USA) in David also has a Master s degree in Management from ESCP-Europe (Paris-Oxford-Berlin) in Dr. Herold Rohweder Global Chief Investment Officer Multi Asset, Allianz Global Investors Europe Herold Rohweder is a Managing Director and Global Chief Investment Officer Multi Asset at Allianz Global Investors. He is also member of the European Executive Committee of Allianz Global Investors and a member of the Global Investment Management Group. Herold joined Allianz in 1989 as a portfolio manager for global balanced, European equities and European fixed income. In 1998 Herold initiated the Systematic Asset Management effort for equity and multi asset investments. Since 2011 Herold has been Global CIO Multi Asset at Allianz Global Investors. Herold has graduated from Wayne State University, Detroit with a Master-of-Arts degree in Economics and has received a Ph.D. from the Ecomomics department of the University of Kiel, Germany. 40

41 Robert Parenteau, CFA Economist and Investment Strategist, External Advisor As the sole proprietor of MacroStrategy Edge, Rob employs macroeconomic insights to contribute to asset allocation and equity sector selection decisions. Rob received his BA (Hons.) in political economy from Williams College in January 1983 and earned his CFA in Rob also serves as a research associate of the Levy Economics Institute. Stefan Scheurer Global Capital Markets & Thematic Research Stefan Scheurer joined Allianz Global Investors in 2008 and is Vice President, Global Capital Markets & Thematic Research. The focus of his work is on analysis relating to strategic and tactical allocations, specific investment opportunities and the identification of long-term investment trends. Stefan is a regular interview partner for radio, TV and print journalists. He has also been writing columns and contributions for leading newspapers and investment magazines for years. Stefan has comprehensive experience in delivering speeches and presentations; his audience consists of high-net worth individuals, asset managers, investment advisors and institutional investors. Stefan Scheurer passed a degree in business administration at the University of Augsburg and started his career as an equity analyst with the broker firm Cheuvreux S.A. in He quickly gained an excellent reputation as an analyst for information technology, software and renewable energy stock recommendations. 41

42 Disclaimer Investments involve risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the principal invested. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. High-yield or junk bonds have lower credit ratings and involve a greater risk to principal. Convertible securities involve the added risk that securities must be converted before it is optimal. Past performance is not indicative of future performance. No offer or solicitation to buy or sell securities, nor investment advice/strategy or recommendation is made herein. In making investment decisions, investors should not rely solely on this material but should seek independent professional advice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts are inherently limited and should not be relied upon as an indicator of future results. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or willful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This is a marketing communication. This material has not been reviewed by any regulatory authorities, and is published for information only, and where used in mainland China, only as supporting materials to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: RCM Capital Management LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors Europe GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); RCM (UK) Ltd., which is authorized and regulated by the Financial Services Authority in the UK; Allianz Global Investors Hong Kong Ltd. and RCM Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No Z]; RCM Capital Management Pty Limited, licensed by the Australian Securities and Investments Commission; and Allianz Global Investors Japan Co. Ltd., registered in Japan as a Financial Instruments Business Operator. Unless stated otherwise, all data is as of 30 September Copyright 2013 Allianz Global Investors 42

43

44 Allianz Global Investors Europe GmbH Mainzer Landstraße Frankfurt am Main Germany Phone Fax January 2013