CM15007 Compendium July

Monthly market commentaryJuly 2015

ContentsEquities 2

Credit 3

Nominal Yields 4

Inflation 5

Real Yields 6

Asset Class Performance Summary 7

Editor’s Choice 8

Contacts & Disclaimer 9

Equities fall over the month as Eurozone crisis enters unchartered territory and Chinese equity correction continues

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Equity indices

• Equities fared poorly over the month with all indices suffering losses. The FTSE All-Share was the worst performer, declining by 5.7%, followed by the FTSE Emerging Market Index (-5.1%) and the EuroStoxx 50 (-3.9%). The Topix fell by 2.4% and the S&P 500 was down 1.9%. Over the month, stock markets seemed to be mostly driven by major events such as the escalation of the Greek Crisis and ongoing concerns about the Chinese slowdown.

• The heavy fall in the FTSE All-Share Index probably did not reflect much of the UK economy as economic data that came in over this month was relatively good; purchasing manager indices showed a pick-up in construction as well as the highest level of confidence in this sector in more than a decade. The UK economy is still expected to expand comfortably above 2% this year. However, given the high proportion of global mining stocks in the FTSE All-Share Index, the ongoing slowdown in China sapped confidence with this month’s sharp correction in the Chinese stock markets serving as a reminder.

• China was probably also an important factor for the poor performance in emerging markets as a slowing Chinese economy is expected to take a heavy toll on commodity-exporting countries. Furthermore, as an interest rate increase by the Federal Reserve is becoming increasingly likely, as early as September this year, even more turbulent times might be ahead for many emerging market countries who could see substantial capital outflows as a result. Those who rely on foreign capital to fund their current account deficit would be especially heavily hit.

• European equities suffered as the Eurozone crisis entered into its most critical territory since summer of 2012. The ongoing brinkmanship by Greek’s government further risked an exit from the single currency. By the end of the month, capital controls and a daily deposit withdrawal limit had to be introduced as Greece defaulted on an IMF payment, joining the ranks of Sudan, Cuba, Zimbabwe and the Democratic Republic of Congo. The no vote to the referendum on whether to accept the austerity measures imposed on Greece’s by its creditors gave Syriza the support of voters to continue negotiations with the European Union and International Monetary Fund.

• Losses in US markets were limited due to another spree of good data. Persistently strong non-farm payrolls, an upward revision of first quarter GDP growth, high levels of consumer confidence and consumption suggested that the US economy keeps expanding. Progress in negotiating a free-trade agreement with a large group of Asian countries added to the positive news.

Equity Markets IndexPercentage Change

28/02/2015 1 Week 1 Month 1 YearS&P 500 (TR) 3816 -2.8% -1.9% 7.4%FTSE All-Share (TR) 5614 -4.1% -5.7% 2.6%EuroStoxx 50 (TR) 6492 -5.6% -3.9% 8.8%Topix (TR) 2253 2.7% -2.4% 31.5%FTSE Emerging Market Index (TR)

700 -1.5% -5.1% 6.7%

S&P 500 TR

FTSE All-Share TR

EuroStoxx 50 TR

Topix TR

FTSE Emerging Market Index(TR)

Figure 1: Equity Market Returns (rebased at 100)1

Source: Bloomberg, Capita

1Total returns in local currency


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Credit

• An increase in spreads on fixed income for all ratings might reflect the increased volatility driven by global events over the month as well as uncertainty regarding the impact of first interest rate increases by the Federal Reserve and Bank of England.

Bracing your fixed income portfolio for rising interest rates

• Policy rate increases appear to be a foregone conclusion – at least in the UK and the US, where the economic recovery remains entrenched and central banks are just waiting for signs of a sustained pick-up in wages and inflation before making their first move.

• For pension schemes in particular, this should not be a big problem. Fixed income securities are normally held as liability matching assets to hedge interest rate risk and should therefore move in line with liabilities. Trustees of pension schemes might still feel tempted to take a view on interest rates and monetary policy shifts to protect their fixed income portfolio against losses arising from central bank policy rate increases. In the optimal case, rising interest rates would reduce liabilities without affecting the fixed income portfolio when hedged with derivatives, leading to an even more pronounced improvement in the funding level.

• Even though there are ways to achieve this, it might be a better idea for Trustees to focus on stabilising their funding level and following a long-term strategy that allows them to de-risk over time instead of trying to predict short-term movements in interest rates. Such tactical decisions are probably better delegated to active fund managers.

• There are certainly methods which active fund managers can employ to reduce the impact of interest rate movements on the ultimate return of their fixed interest holdings, for example through the use of derivatives.

• If Trustees are interested in seizing short-term opportunities, a multi asset fixed income manager may be the most appropriate option as they can add value to the fixed income portfolio by taking views on short-term developments with sufficient expertise and resources to efficiently manage risk and react to quickly changing market conditions.

1 Week Movements1 Month Movements

1 Year Movements

Credit: spreads widen over the month for all ratings

Figure 2: GBP Corporate Bond Spreads over Gilts by Rating (change over week/month/year)

Figure 3: GBP Corporate Bond Spreads over Gilts by Rating (Historic)

Source: Bloomberg, Bank of America Merrill Lynch, Capita

Source: Bloomberg, Bank of America Merrill Lynch, Capita

Cred

it Sp

read

s (b

ps)

AAA AA A BBB

Prem

ium

ove

r Gilt

s (+

15 Y

r Gilt

s In

dex)

%

0 10 20 30

Nominal Yields: Gilt yields increase over the month

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Nominal Gilt yields – the recent pick up might not be sustained

• Nominal gilt yields rose over the month for all maturities but the shape of the yield curve remained largely unchanged.

• A continuing flow of positive economic data from the UK makes an interest rate increase by the Bank of England more likely – especially once the oil price effect drops out of the inflation rate calculation later this year. Sustained wage pressure can already be noticed with the recent pick-up in average earnings.

• However, this pickup in gilt yields might still prove to be short-lived. Current developments in the Eurozone could lead to renewed inflows into safe havens.

• Furthermore, markets are starting to anticipate the potential outcome of next year’s EU referendum. Prime Minister David Cameron’s cautious approach so far seemed to be well received in Brussels and many European leaders are aware that the European Union would want to avoid a “Brexit”. Nevertheless, differences on core issues such as freedom of movement remain.

• Even though most recent YouGov polls show that a majority of British people might vote to stay in the EU, there is always a degree of uncertainty associated with polling. Negotiations on EU reforms remain ongoing and the outcome of these could greatly influence public opinion and perception.

• Gilt yield volatility could increase as we get closer to the referendum. Given that uncertainty tends to lead to rising demand for gilts, yields might not rise as much as they otherwise could have, at least until after the referendum (and subject to its outcome).

Figure 4: Nominal Term Structure of Gilts


Nominal Gilt RatesMaturity Points (yrs)

2 5 10 15 20 30Current % 0.56 1.51 2.02 2.42 2.65 2.721 Week Change (bps) -6 -5 -8 -10 -10 -121 Month Change (bps) 5 16 21 20 22 181 Year Change (bps) -31 -53 -65 -74 -66 -71


2 5 10 15 20 30

Rede

mpt

ion

Yiel

d %

Chan

ge (b

ps)

Maturity (years)

Maturity (years)

Gilt Change m/m

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Inflation

• The consumer price index rose by 0.1% in the year to May 2015, compared to 0.1% fall in the previous month. The largest upward contributors were transport, motor fuels and food, partly offset by recreation and culture.

• As expected, UK deflation seemed to have been short-lived as an expanding economy and rising wages are starting to put pressure on prices.

• Once the oil price effect falls out later this year (i.e. the base month of the year on year comparison will also have low oil prices), inflation is expected to pick up more rapidly from then and gradually return to normal levels of close to 2%, which is the Bank of England’s inflation target. Oil prices are expected to stay low if the imminent Iran agreement leads to a return of its exporters to the market. This would increase supply even more and could lead to lower prices.

Gilt Breakeven Inflation

Maturity Points (yrs)2 5 10 15 20 30

Current % 2.08 3.07 2.98 3.16 3.40 3.421 Week Change (bps) -9 -4 -5 -5 -2 -41 Month Change (bps) -1 10 12 8 10 41 Year Change (bps) -41 -23 -15 -14 0 -4

Inflation: UK deflation proved to be short-lived

Figure 5: Gilt Breakeven Inflation2 Figure 6: CPI in the UK, US and Eurozone



2Gilt breakeven inflation has been calculated as the difference between nominal Gilt yields and Gilt real yields.

Maturity (years)

Brea

keve

n In

flatio

n %


Chan

ge y

/yin

%

Maturity (years)

Chan

ge (b

ps)

Break even inflation Change m/m

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Gilt Real Yields

• The real yield curve shifted up and its shape stayed pretty much in line with nominal yields.

• Real yields still remained deep in negative territory as long-term inflation expectations have hardly been affected by the recent temporary bout of deflation.

Gilt Real YieldMaturity Points (yrs)

2 5 10 15 20 30Current % -1.52 -1.56 -0.96 -0.75 -0.75 -0.711 Week Change (bps) 3 -1 -3 -5 -8 -81 Month Change (bps) 6 6 10 13 12 141 Year Change (bps) 10 -30 -50 -59 -66 -67

Real Yields rise in line with nominal yields

Figure 7: Gilt Real Yield3 Term Structure Figure 8: 10-year and 30-year Real Yields


3Gilt real yield has been calculated as the yield on index-linked Gilts



0 10 20 30

2 5 10 15 20 30

Maturity (years)

Maturity (years)

Real

Red

empt

ion

Yiel

d %

Chan

ge (b

ps)

Yiel

d

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Asset Class Performance Summary

The charts below and the table on the left show the one month and one year performance of various asset classes to the end of June 2015.

Asset Class Performance Summary

Asset Class 1 Month Return 1 Year ReturnFTSE All-Share TR -5.7% 2.6%S&P 500 TR -1.9% 7.4%Eurostoxx 50 TR -3.9% 8.8%Topix TR -2.4% 31.5%FTSE AW Emerging Market Index TR -5.1% 6.7%FTSE A Gilt +15 Yrs -3.2% 16.3%iBoxx Non-Gilt £ 10+ TR -3.9% 8.8%FTSE A ILG +5 Yrs -2.8% 15.8%FTSE UK Commercial Property Index 0.0% 14.7%1 Month LIBOR 0.0% 0.5%


1 Month Return 1 Year Return

-4% -2%-6% 0% 2%

FTSE All-Share TR

S&P 500 TR

Eurostoxx 50 TR

Topix TR

FTSE AW Emerging Market Index TR

FTSE A Gilt +15 Yrs

iBoxx Non-Gilt £ 10+ TR

FTSE A ILG +5 Yrs

FTSE UK Commercial Property Index

1 Month LIBOR

FTSE All-Share TR

S&P 500 TR

Eurostoxx 50 TR

Topix TR

FTSE AW Emerging Market Index TR

FTSE A Gilt +15 Yrs

iBoxx Non-Gilt £ 10+ TR

FTSE A ILG +5 Yrs

FTSE UK Commercial Property Index 1 Month LIBOR

45%30%15%0%

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Ireland: One way to balance the books

During the financial crisis of 2008/2009, many countries all over the world were affected to different extents. Ireland found itself being sucked towards the epicentre of these events. The people of Ireland could only stand and watch as their economy swayed, trembled and very nearly crumbled under the mighty pressure of the “Great Recession”.

The Irish banking system was the root cause of the country’s problems. Property prices had soared to heights that were never before seen. Banks fuelled this by expanding credit to both developers and households, but seemed to be unaware of the risks building up on their balance sheets. A sharp decline in property prices ensued and banks suffered massive losses on their loans. Simultaneously, inter-bank lending began to tighten. Irish banks were sinking into a big hole of debt while cheap short term funding on which they had been relying to refinance their debt was rapidly drying up. The final blow to the Irish economy was struck when the decision was made to recapitalize the banking system with Irish taxpayers suffering the losses. In November 2010, after a lengthy negotiation with the European Union, a bailout program totalling €85 billion was agreed upon.

When we look at Ireland and Greece, we see two countries who have faced a similar battle to overcome a debt crisis but there is stark contrast in how each have approached it. Through harsh austerity measures, Ireland approached their crisis by raising taxes, cutting expenditure and downsizing its welfare state. In 2011, the nation experienced their toughest budget ever that would trim circa €6 billion from the deficit. Cut backs included deducting €400 million from public service

pay, increasing VAT from 21% to 23%, alongside many other difficult decisions such as lowering child benefits and closing police stations. Since 2008, high unemployment rates reaching 30% have seen over 200,000 young people to emigrate out of the country in search of work abroad. However, for the rest of the population that stayed, accepting the policies put in place by the EU and International Monetary Fund (IMF), the Irish collectively decided to deal with their issues that were made through harsh austerity measures.

Two years before Ireland received the bailout, the country had already begun increasing taxes and making huge spending cuts and as a consequence it passed every quarterly review by the country’s bailout monitor with ease. Greece, on the other hand, partly resisted calls for reforms and budget consolidation. Its last election earlier this year saw a large proportion of Greek voters giving their vote to anti-bailout parties. The Greek Prime Minister, Alexis Tsipras, took a bold step to test the support for continuing to push back against creditor’s demands by holding a referendum on whether to accept the bailout conditions set by its creditors. Even though the “No” vote won with 61.3%, a bailout agreement was reached in the 11th hour, but only after the country had been pushed closer to an uncoordinated exit from the Eurozone than ever before.

The Irish example highlights one way to deal with a financial crisis, being the first Eurozone country to successfully exit a bailout. In 2013, the Irish Prime Minister Enda Kenny and leader of the Fine Gael party announced that the country had saved €28 billion (£20.5 billion) and that they would exit the bailout by the end of the year. He remained true to his word and the

official exit was completed in December. This was a milestone for the people of Ireland that marked massive progress and reward for the sacrifices made. At this junction, the Greek population has signalled some austerity-fatigue and, by voting Syriza to power, a desire to roll back some of the reforms. However, any way forward must be agreed by Greece as well as by their creditors. The IMF recently raised questions about the sustainability of Greek debt levels, and even suggested that it might walk away from the recent deal unless all parties agree a solution that will lead to long-term sustainability.

Greece like Ireland before the recession, saw strong economic growth, albeit fuelled partly by cheap credit. Both countries have been hit hard by the financial crisis. While Ireland has showcased one example of how to deal with a financial crisis and has reaped the benefits of this, Greece must now work together with its creditors to find their own sustainable path to renewed economic prosperity.

Derek is an investment analyst. Whilst the article below does not reflect Capita’s view or opinions, it shows the development in thinking of one of our investment team.

Derek Phelan

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In preparing this report we have relied upon data supplied by third parties. Although reasonable care has been taken to gauge the reliability of this data, this report therefore carries no guarantee of accuracy or completeness, and Capita Employee Benefits (“Capita”) cannot be held accountable for the misrepresentation of data by third parties involved. The report is for your private information and is for discussion purposes only.

This report is based on data/information available to Capita at the date of the report and takes no account of subsequent developments after that date. It may not be modified or provided by the Recipients to any other party without Capita’s prior written permission. It may also not be disclosed by the Recipients to any other party without Capita’s prior written permission except as may be required by law. In the absence

of our express written agreement to the contrary, Capita accepts no responsibility for any consequences arising from any third party relying on this report or the opinions expressed therein.

This report is not intended by Capita to form a basis of any decision by a third party to do or omit to do anything.

Bobby Riddaway Head of Investment Consulting

t 020 7709 4532 e [email protected]

Albert Küller Chief Economist

t 020 7709 4912 e [email protected]

Capita Employee Benefits is a trading name of Capita Employee Benefits Limited and Capita Employee Benefits (Consulting) Limited. Part of Capita plc. www.capita.co.uk. Capita Employee Benefits Limited and Capita Employee Benefits (Consulting) Limited are registered in England & Wales No: 02260524 and 01860772 respectively. Registered Office: 17 Rochester Row, Westminster, London, SW1P 1QT. Separately authorised and regulated by the Financial Conduct Authority.C

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Contacts & Disclaimer

CM15007 Compendium July

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