Paying Heed to Politics, Doom Loops and Bubbles

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1 5 Volume 7, Issue 5 Allianz Global Investors Insights May 2015 Global View Paying Heed to Politics, Doom Loops and Bubbles The ongoing rise in asset prices which was both predictable and predicted continues unabated, supported by abundant liquidity and by receding concerns over the pace, size and impact of US Federal Reserve (Fed) tightening. Yet this steady buildup in valuations is occurring against a backdrop of uncertainty over the strength of the global economy, weak earnings growth, significant political noise and rising concerns over the central banks exit strategies from quantitative easing (QE). As such, market participants should be on alert. Politics Despite a resounding victory by the Conservative party in the recent UK elections, I fear it will not hold good news for UK assets and the pound sterling: A Conservative-led government will in all likelihood lead to a referendum on the UK s European Union (EU) membership and raise the disconcerting possibility of a Brexit from the EU. Elsewhere in Europe, a Grexit appears to be an increasingly distinct possibility, though it is not yet a certainty. More importantly, an exit by Greece from the EU has not yet been priced sufficiently into the markets; if this were to happen, it could take markets by surprise, at least temporarily. Doom Loops It is starting to dawn on policymakers and markets that if today s ultra-low and in many cases negative yields on highly rated government securities were to persist, they could pose a serious threat to the financial system, notably the insurance industry, and thereby significantly reinforce the disinflationary dynamics that the European Central Bank s (ECB) QE is meant to combat. Andreas Utermann Global Chief Investment Officer While not yet Allianz Global Investors base-case scenario, we believe a rapid normalisation of monetary conditions is very much required. All eyes will be on Europe s inflation expectations and growth in the coming months. Bubbles In previous market outlooks, we had contended that for asset prices to qualify for (Cont. on page 2) 02 Perspective on the US Investment Implications of a Weaker US Dollar 03 Viewpoint Demographics, Technology and the Low-Yield Environment 04 Soundbites from Research Asian High-Yield Bonds Plough Through Headwinds 05 Grassroots SM Research Impact of Petrol Price Decrease on US Consumer Behaviour

2 Global View bubble territory, they must not only be overvalued, but leverage must be involved. Only if these two criteria were satisfied would high asset prices become systemically relevant. I am moved to modify this stance in the face of the unprecedented, QE-enabled buying of high-quality fixed-income securities, in addition to the impact these massive purchases have on lower-quality securities. This, arguably, is a form of leverage in itself. Furthermore, there are justifiable fears about the liquidity that would be available in markets in the event of a reversal; even without leverage, a freezing of fixed-income markets could have a wide-ranging and negative impact on the wider global economy. The lack of alternatives to low-yielding fixed income is also driving increasing numbers of investors to purchase dividend-paying stocks, dragging equity valuations higher; while not in bubble territory overall, the fact that earnings are not keeping up with price appreciation means valuations will become more stretched. Despite the predictable path of certain events to date, including rising asset prices, much remains unknown about the coming months. Investors should anticipate that the markets will be thoroughly tested and expect them to be volatile. Perspective on the US Investment Implications of a Weaker US Dollar At the beginning of 2015, the market consensus was for the US dollar (USD) to remain strong versus most other major currencies. This assumption was predicated on the belief that the US economy would remain the growth engine for the global economy, and that the Fed would raise rates while other monetary authorities, particularly the ECB, engaged in some form of quantitative easing. This assumption has been called into question in recent weeks with US gross domestic product much weaker than expected, running below 1 per cent in the first quarter, which pushed expectations of a Fed rate hike farther into the future. Meanwhile, green shoots have emerged in Europe, with the Citigroup Economic Surprise Index for that region in a solid upward trend. As a result, the USD has recently begun to weaken and could fall further in the coming weeks; this has significant implications for US equity positioning as well as Fed policy. Given the consensus assumption at the beginning of the year of continued USD strength, money had previously flowed into areas of the market considered to be strong dollar beneficiaries that is, areas with minimal foreign exchange exposure such as health care and consumer discretionary and retail. In some cases, these investments drove these sectors of the market to historically high valuation levels. But if the USD instead continues to weaken, money will likely flow out of these sectors and into weak dollar beneficiaries such as energy, materials and industrials. In fact, such a transition may have already begun, given that the energy sector has dramatically outperformed the S&P 500 Index so far this quarter. A weaker USD will also give the Fed a freer hand to raise interest rates this year, as a strong dollar was cited by Fed policy makers as an impediment to growth. As a result, we could begin to see interest rates rise at both the short and long ends of the yield curve, which would be favorable for US financials but negative for rate-sensitive areas such as utilities and staples. While a stronger dollar may ultimately take shape over the long term, a shorter-term drop in the greenback will likely lead to significant sector rotation and a higher prospect for the Fed raising rates sooner rather than later. Scott Migliori CIO Equity US 2

3 Viewpoint Demographics, Technology and the Low-Yield Environment Demography was one of the topics of our January 2015 Investment Forum in Hong Kong and for very good reasons. The demographic changes that are already underway do not bode well. Although the world s population is continuing to grow 1 albeit at a reduced pace as fertility rates decline it is also growing older, with an increasing share reaching retirement age. In addition, birth rates around the globe are declining and the potential working-age population is shrinking: In North America, the share of people aged 60 and over is set to rise from 30 per cent currently to around 37 per cent by In Europe, this age group is likely to increase from 32 per cent to 39 per cent. Asia expects this same cohort to move from 17 per cent to 23 per cent. Africa will probably witness the lowest share of people aged 60 and over, with only slight growth from 12 per cent to 13 per cent. According to figures published by the United Nations, the share of the working-age population started declining in the industrialized world as a whole excluding Japan 2 back in This trend is irreversible. UN population estimates assume that this population cohort will decline by between 0.2 per cent and 0.3 per cent each year between now and 2025, and the trend will probably be comparatively uneven from country to country. A decline of more than 1 per cent per year is expected in Russia and Eastern Europe, while the remainder of Europe should witness a decrease of less than 1 per cent. And while slight growth is actually assumed for North America and parts of Latin America, large parts of Africa are expected to witness growth of 2 per cent. Admittedly, these trends in the size of the working-age population do not allow any direct conclusions about the actual working population: The participation rate may change, people may retire later or the share of women in employment could grow, and thus the potential workforce as a whole may also change. However, when we calculate the demographic trend separately for the participation rates for various countries using data obtained from the International Labour Organisation s central statistics database, we can see a resulting lower participation rate due to ageing in a whole series of countries. So the demographic trend is already influencing participation in working life. It is important to realize, of course, that demographic developments are accompanied by technological trends. With ever-increasing advances in technology, radical changes will become more and more visible in the labour markets. Indeed, some of these changes are already discernible: Digitization, adaptive machinery and information platforms are simultaneously driving trends around the world. If the signs point to an increasingly smaller workforce, it may be a stroke of luck if jobs can be replaced by technology, and if hard manual labour can be performed by robots. Hans-Jörg Naumer Global Head of Capital Markets & Thematic Research For instance, why not let machines do the work for humans and then use investment income to replace or supplement wages and pensions? That would enable several problems to be tackled at once: a decreasing workforce, machines displacing humans from the remaining jobs, and declining income from state pensions. This shift could also address prolonged periods of low or negative interest rates. For example, instead of using government bonds which can yield zero, or even negative, nominal returns to save or generate retirement income, equity investments could allow people to share in company earnings. 1. Source: United Nations, Department of Economic and Social Affairs, Population Division, World Population Prospects: The 2012 Revision (2013). 2. The declining share of the working-age population in Japan is far ahead of the demographic trend and would distort the overall picture for the other industrialized nations. 3

4 Soundbites from Research Asian High-Yield Bonds Plough Through Headwinds The Asian high-yield credit market has experienced significant growth since the global financial crisis, as shown in the accompanying chart. Once a very niche market segment where investors would allocate a small portion of an overall Asian bond portfolio to opportunistically access these higher yields it has grown to the point where there are now investment vehicles that invest solely in the Asian high-yield space. Looking ahead, we believe the Asian highyield market will continue to grow and offer attractive opportunities for fundamentally driven investors. However, this growth will not be without headwinds. Recently, we have identified a number of idiosyncratic risks in China s high-yield property sector and its commodities sector. The prospect of rising US Treasury yields is another impending headwind that will translate into higher funding costs for corporates. With this backdrop, we expect episodes of idiosyncratic risk and bouts of market volatility to continue in Yet despite these headwinds, the market offers attractive opportunities amid the low-interest-rate environment, and we expect the Asian highyield default rate to remain relatively low less than 3 per cent for 2015, given that market liquidity remains supportive. Due to the greater potential risks in the highyield sector, our credit research efforts require a much higher degree of due diligence. In particular, we pay close attention to a corporation s future free cash-flow generation and its balance-sheet liquidity position. In addition, we actively seek to avoid companies that exhibit aggressive expansion plans and have higher capital expenditure needs that could lead to increasing debt leverage. Furthermore, many high-yield corporate issuers in Asia have a legacy of family holdings, so understanding a corporation s organizational structure and assessing management s values regarding corporate governance are also important. Given all these factors, the key to successful investing in Asian high-yield bonds, in our view, is using fundamental research to differentiate between the credit quality of corporate issuers in Asia. Yoke Sei Tan Head of Credit Research, Asia Pacific Asian High-Yield Opportunities Are Growing Bond issuance in Asia as a percentage of total emerging-market high-yield issuance. 50% 47% 40% 38% 30% 27% 30% 31% 34% 24% 23% 20% 10% 15% 17% 0% Sources: J.P. Morgan, Bond Radar and Bloomberg as at 31 December Data include G3 and local-currency bonds accessible to foreign investors

5 Grassroots SM Research Impact of Petrol Price Decrease on US Consumer Behaviour Across the US, prices for both regular petrol and diesel have decreased more than one USD per gallon over the last year. According to the US Energy Information Administration, the average household is expected to spend USD 710 less for petrol in 2015 compared with last year nearly USD 60 in monthly savings because of lower retail prices. To obtain more clarity on this issue, Grassroots SM Research conducted a survey in February of 1,000 US consumers to assess how much money they believe they are saving, and what they are doing with this extra disposable income. Respondents were required to drive their own vehicle three or more times per week. Among the 88 per cent of respondents who observed a decrease in petrol prices in the past six months, 65 per cent perceive the savings to be anywhere from USD 5 to USD 49 per week (about USD 20 to nearly USD 200 per month). Looking more closely at the data, 45 per cent perceive their weekly savings to be between USD 5 and USD 24, 20 per cent perceive their weekly savings to be between USD 25 and USD 49, and 13 per cent believe they are saving USD 50 or more per week on petrol. Among respondents who cited a decrease in petrol prices, 86 per cent will likely spend at least some of the money they are saving, including 16 per cent who will likely spend all of the money. As shown in the accompanying chart, respondents ranked food and restaurants followed by paying off debt as the highest-priority uses of the extra money they saved from lower-than-normal petrol prices. Fourteen percent indicated they Kelly Reuba Global Head of Grassroots SM Research would not spend any of the money they saved. Food/Restaurants and Debt Were Top Uses for Extra Money A recent survey asked US consumers to name the top two categories where they anticipate spending savings from lower-than-normal petrol prices. Food/Restaurants 40% 18% Debt (Credit Card/Loan Payments, Etc) 26% 11% Savings/investment 9% 16% Home Improvement 9% 11% Entertainment 6% 13% Apparel/clothing 6% 9% Travel 4% 7% 1st Choice 2nd Choice Electronics/computers, Etc. 1% 5% 0% 10% 20% 30% 40% 50% 60% 70% Source: Grassroots SM Research report as at February 2015 About Allianz Global Investors Understand. Act. This two-word philosophy is at the core of what we do. To stand out as the investment partner our clients trust, we listen closely to understand their needs, then act decisively to deliver solutions. We are a diversified active investment manager with a strong parent company, a culture of risk management and EUR 412 billion in assets under management.* With 23 offices in 17 countries and over 500 investment professionals, we provide global investment and research capabilities with consultative local delivery. Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Equities have tended to be volatile, and unlike bonds do not offer a fixed rate of return. Emerging markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates. Bond prices will normally decline as interest rates rise. Below investment grade convertible and fixed-income securities involve a greater risk to principal than investment grade securities. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material 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: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors Distributors LLC, a broker-dealer registered with the SEC; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); 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]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan. Grassroots SM Research is a division of AllianzGI Research. Data used to generate Grassroots SM Research recommendations is received from reporters and field force investigators who work as independent contractors for broker-dealers. Those broker dealers supply research to AllianzGI and certain of its affiliates that is paid for by commissions generated by orders executed on behalf of AllianzGI s clients. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Allianz Global Investors is a trademark, registered in various countries throughout the world, including the United States Allianz Global Investors. All rights reserved. *Combined worldwide AUM as at 31 December 2014 Source of all data (unless otherwise stated): Allianz Global Investors as at April AGI

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