Investing Plus - J.P. Morgan Asset Management - United Kingdom

2 | Investing Plus Q3 2012 editionInflation risk as an asset allocation problemMaddi Dessner, Katherine Santiago, Joseph Simonian, Global Multi-Asset Group (GMAG).“ Just last year, media reports were sounding the alarm bells over higher inflation, promptinginvestors to add some form of inflation protection to their portfolios. But in the wake of theeurozone debt crisis and with the prospect for slower growth, inflation fears have eased. Itwould be wrong to assume though that the need to protect against inflation is also reduced, aseven low inflation causes risks to portfolio returns in bear markets.”The need for inflation protection is long termRegardless of one’s view on where inflation is heading, there is a major weaknessin the way institutions address inflation risk, which is to add inflation sensitive orreal assets only when inflation is already on the rise. Investors often see inflationrisk primarily as a rapid inflationary spike to 4% or higher, rather than a longtermchallenge that can hurt portfolios. However, the more common scenario isa low inflationary environment accompanied by a bear market – an environmentthat often results in negative real returns.Furthermore, what we do not know about inflation can be more dangerous thanwhat we do know. The drivers and effects of inflation change from one period tothe next as policy responses to inflation evolve. At the same time, we can neverentirely predict how different asset classes will react to inflation in the future, inpart, because their performance also can be significantly affected by businesscycles. This challenge is even more difficult for some favoured inflation-sensitiveassets that have no historical track records in periods of high inflation.Despite, or perhaps because of, such uncertainties, we believe the currentsituation presents a perfect opportunity to re-examine broader questionsabout inflation as it relates to portfolio design. As we cannot effectively predictinflationary environments, we believe the most pragmatic approach is to beagnostic to inflation’s causes and characteristics. In this approach the followingissues need to be considered:• What problem are we trying to solve? In other words, how significant isinflation risk in historical or empirical terms?• How do you define the problem? How should an investor define inflation riskin a specific portfolio?• How can investors assess the cost of inflation protection?• Is there an optimal strategy to managing inflation risk?The goal in asking these questions is to construct a framework to addressdiverse forms of inflation that can be used by investors regardless of theenvironment. This holistic approach is optimal for managing inflation risk acrossall of its cycles, whether it is high or low, or rising or falling.Constructing a framework for hedging inflation riskInflation tends to move in cyclesEmpirical evidence suggests that there are small, episodic periods of rising orfalling inflation marked by larger regime shifts, ranging from prolonged periodsof moderate inflation to periods of extreme and volatile inflation. Viewed fromthat perspective, inflation ‘risks’ are really short-term uncompensated risks thatcan hurt investor returns across assets and/or erode their purchasing power.Considering the cyclical nature of inflation, investors should keep three keyissues in mind to beat inflation over the long term. First, inflation spikes are,in historical terms, relatively rare as inflation typically remains contained,interrupted by short bursts of moderate inflation; second, every asset has uniqueinflation-cycle sensitivities, meaning that returns typically vary, depending onwhether inflation is high or low, or rising or falling; and, third, asset returns canbe driven by independent factors, such as asset bubbles and bear markets, thatcan occur in connection with, or independent of, the inflationary environment.Therefore, being overweight a portfolio with a single allocation to an asset thatis designed to manage risks tied to a specific inflationary scenario could createsignificant problems later as the portfolio encounters other inflationary cyclesand economic regimes.Low inflation is an often overlooked riskInflation shocks are not the biggest risk to portfolio returns. Data suggests thatthe most common inflation risk scenario is a period of low inflation combined witha bear market, resulting in negative real returns. The risk of negative real returnshappens most commonly during periods of low inflation, not high inflation.Insurance against unexpected inflationIn the long run, an asset’s expected return will have inflation expectationsembedded in it, paying the investor a premium for bearing that risk. However,inflation risk is also the risk of short-term unexpected inflation that is notcompensated by the embedded premium. Investors can anticipate and protectagainst such risks, but must understand that every insurance policy has a costduring those times when the hedge is on, but inflation is not.

4 | Investing Plus Q3 2012 editionOpportunities in an unloved sectorNeil Gregson, Global Equities Team.“ Despite recent weakness, the outlook for commodity producers remains as compelling as ever.The next ten years will see more of the same fundamental support for the sector, with emergingmarkets driving commodity demand growth, while ongoing supply issues support prices.”Commodity stocks appear to be unloved at the moment. Concerns over theglobal economy have resulted in a slew of broker downgrades for materials andenergy companies, and valuations have fallen to extremely low levels. Investors’main concern is China, where some fear growth will slow from 9% in 2011 to7.5% this year.However, the moderation in growth in China is a deliberate strategy by itsauthorities, reflecting efforts to move to a more sustainable economic model,with reduced reliance on exports and a greater role for domestic demand.Should a more marked slowdown materialise, the central bank has plenty ofscope to provide support. In the meantime, China continues to build a city thesize of Chicago every year, and a volume of people equivalent to the populationof America is expected to move to urban areas between now and 2030.As a result, the long-term drivers of Chinese demand for commodities remain ascompelling as ever. However, the strength of the natural resources story actuallylies on the supply side.Base metals: focusing on supplyHistorically, supply has been the key driver of commodity prices and ofprofitability for commodity producers. As chart 1 shows, over the past twodecades, demand has been consistently been twice as high for aluminium thanfor copper, reflecting the wide range of applications for aluminium. Yet theprice for copper has risen by the same amount as aluminium – a function of thecomparative tightness of copper supply.Chart 1 | Supply, not demand, is the key price driver for commodities403530Aluminium consumption (lhs)Copper consumption (lhs)Aluminium nominal priceCopper nominal price8000600025500020400015300010200051000001991 1993 1995 1997 1999 2001 2003 2005 2007 2009Source: RBS Capital Markets. For illustrative purposes only. Past performance is not anindication of future performance. Data as at May 2012.7000Spot price²The rapid industrialisation and urbanisation of China over the past decade hasdriven rising demand for a wide range of commodities. But different miningindustries have had differing degrees of success in meeting this demand.In the case of aluminium, the industry has had few problems in satisfyingChina’s thirst. There are certainly no issues of scarcity, in fact, there have beensignificant problems of oversupply, which pushes down prices and squeezes themargins of aluminium producers.In contrast, the copper industry has been overwhelmed by the increase indemand. Mine supply growth has been weak in recent years, and has consistentlyfallen short of analysts’ expectations. Declining ore grades and maturingdeposits are forcing producers to use more expensive extraction techniques,meaning they are spending more money just to keep production at the samelevel. Skilled workers are hard to come by, while in 2011 the world’s two largestcopper mines suffered strikes as employees sought higher wages. Analysts havebeen forecasting 10% growth in copper supply this year, but these optimisticestimates are beginning to be revised down.Iron ore, too, has been dogged by supply problems. In the latest in a long lineof policy measures designed to preserve supplies for domestic use, the Indiangovernment increased its tax on iron ore exports, causing traders to slash theirexport forecasts. The big three producers – Rio Tinto, BHP Billiton and Vale –have struggled to bring on new capacity, with Vale hamstrung by environmentalissues and Rio Tinto and BHP Billiton encountering significant cost overruns anddelays. All of this means that prices are being well supported by tight supplies.Importantly, this tightness in supply has not benefited all metal producersequally. For equity investors looking for base metal exposure, the key is toidentify low-cost producers of supply-constrained commodities with expandingmargins and a growing resource base.

6 | Investing Plus Q3 2012 editionThe fixed income sweet spotNick Gartside, International Fixed Income.“ Although government bond yields remain at very low levels, the broader fixed income universehas much to offer at present. Indeed, record-low interest rates and central bank liquidityinjections are creating very positive conditions for bond investing.”Liquidity support is powering risk assetsIn 2012 to date, risk assets have powered ahead, with US equities reaching levelsnot seen since before the collapse of Lehman Brothers in 2008. The reason forthis strong performance is the level of liquidity in the system. In February, theEuropean Central Bank’s second long-term refinancing operation (LTRO) saw 800banks take up a total of EUR 530 billion in three-year funding – and this followsthe injection of EUR 489 billion in the first LTRO in December.The extraordinary liquidity support is not coming only from the European CentralBank. The Bank of England announced a further GBP 50 billion of quantitative easing(QE) in February, while the Bank of Japan unexpectedly announced JPY 10 trillion ofadditional QE. In emerging markets, meanwhile, several central banks have begun tocut rates, and China has reduced the reserve requirement ratio for its banks. In sum,this global trend represents the biggest increase in liquidity since 2009.Exhibit 1 | Central banks are pumping in liquidityCentral bank total assets or liabilities as % of GDP35%32%29%26%23%20%17%14%11%8%5%European Central BankBank of EnglandFederal ReserveBank of Japan2012 2013 2014 2015 2016Source: Bloomberg, March 2012.A positive environment for fixed incomeThese liquidity injections are of course not without risk. One way to think ofthe LTRO is as a drug. The drug has done a good job of healing the patients –indebted European sovereigns and the ailing European banking sector – in theshort term, but the long-term impact might be that of many drugs: addiction.Investors will need to keep a watchful eye on the ability of weak banks andsovereigns to wean themselves from central bank dependence.However, the high levels of liquidity in the system create an extremely favourableenvironment for fixed income. Interest rates are expected to remain lower for longer:the Federal Reserve has indicated that it still believes rates will be at extremely lowlevels until the end of 2014, while the Bank of England has maintained the currentrecord-low rates for three years now and is also not expected to move until 2014.In a low rate environment, investors go in search of yield – if they own cash,they move into government bonds; if they own government bonds, they moveinto investment grade corporates; if they own investment grade corporates theymove into high yield. This is positive news for fixed income investors.The deleveraging cycle has further to runIn the coming years, the positive environment for fixed income looks set topersist. The deleveraging cycle that began back in 2008 remains in its earlystages, and has a long way to run. Debt levels in developed countries are stilltoo high, and we expect them to continue to come down. As a result, Gilt yieldsand US Treasury yields may be expected to remain range-bound. Based on theseassumptions, we expect to see yield compression in certain sectors of the fixedincome market as investors are forced to move up the risk spectrum (Exhibit 2).Exhibit 2 | Looking towards the future2006* 2012** 2014***Economic backdrop Leveraging Early stages ofdeleveragingECB main refi rate 2.78% 1.00% 1.00%Fed funds rate 4.96% 0.25% 0.25%UK base rate 4.64% 0.5% 0.5%Ten-year Bund yield 3.78% 1.84% 1 – 3%Ten-year US Treasury yield 4.79% 2.18% 1 – 3%ContinueddeleveragingTen-year UK Gilt yield 4.51% 2.09% 1 – 3%Investment grade corporateoption-adjusted spread (USD) 79 191 150 – 250High yield option-adjustedspread (USD) 325 593 350 – 550EMBIG spread 206 339 105 – 300Liquidity ample declining ImpairedRegulatory environment lax tightening strictSource: Bloomberg, March 2012. *Average over the year 2006, ** As at 12 March 2012***2014 figures are an hypothetical assumption

7 | Investing Plus Q3 2012 editionAttractive opportunities in high yield and emerging market debtThe key to bond investing in this environment will be dynamic and active sectorallocation. Given the positive market conditions, the decision for investors willnot be whether or not to be in fixed income, but where best to allocate to takeadvantage of the opportunities.European high yieldParts of the debt market that currently appear attractive include high yield, whichcontinues to benefit from strong fundamentals. Companies are in excellent health,and remain very cautious about taking on leverage. Default rates are low byhistorical standards, and we do not expect them to rise markedly this year. Technicalfactors are also favourable, with companies finding it easy to roll over their debtgiven the high number of investors entering the asset class. Finally, valuations areattractive, with investors being well-paid to take on the additional risk of investingin high yield versus investment grade credit and government bonds.In the euro market in particular, there are real opportunities, with solid high yieldcompanies in the core eurozone appearing to offer good value. Euro-denominatedhigh yield bonds suffered last year from the general aversion to European assetsthat resulted from the debt crisis. However, euro high yield issuers benefit frombetter average credit quality than their US peers, with a lower average durationand a higher average yield. The liquidity injections from the ECB have served toweaken the euro, which is also good news for euro high yield companies, sincemany of them are exporters and therefore benefit from euro weakness.Emerging market debtEmerging market debt also looks appealing in the current environment. Bond investorsare essentially moneylenders, and, like moneylenders, should be focused on the abilityand the willingness of the borrower to pay. Assessing the global markets on this basis,emerging markets are simply better equipped to pay, given their lower debts and lowerdeficits compared with their developed market peers (Exhibit 3).This is borne out in the recent activity of rating agencies: while developedeconomies have been seeing downgrades to their credit ratings, emergingmarket economies are being upgraded. The average credit rating on theemerging market index is now investment grade.Exhibit 3 | Emerging market debt: better equipped to repay debt-12 USD billion2011 Fiscal deficit (% of GDP)-10-8-6-4-2-2Developed marketsDeveloping marketsIndiaSpainPolandVenezuelaSouth AfricaMexicoIndonesiaBrazilArgentinaChinaRussiaKoreaUnited StatesUnited KingdomHungaryFranceGermany4- 20 40 60 80 100 120 140Public debt 2011 (% of GDP)Source: J.P. Morgan Asset Management, IMF, September 2011.So emerging markets are able to pay. They are also willing, given their desire fortheir economies to play a bigger role on the global stage. And, like high yield,emerging market debt currently compensates investors well for the risk theytake on.A flexible, strategic bond approach is keyBond investors can capitalise on these and other opportunities in the current fixedincome sweet spot by replacing rigid bond benchmarks with cash and taking astrategic view across global bond markets and sectors. Such a flexible, internationalapproach can help improve diversification and boost risk-adjusted returns.By allocating dynamically across global bond markets and sectors, investorscan access a huge global opportunity set and position themselves wherever thegreatest opportunities lie.Italy