Quarterly Investment Letter 2nd Quarter 2014 The Environment is improving but it does not feel much like it The optimism of market participants was exposed to some stress test over the last months. Equity investors were put back on a roller coaster with a tough January followed by strong February and a murky March (see the Market Data Table in the Appendix for details). Key concerns were growing worries about the Chinese financial system, the conflict around the Crimea and very bad weather, particularly in the U.S, which depressed global growth expectations. Investors reacted by triggering sector rotation and profit taking. By the end of the first quarter most developed equity markets indices year-to-date were back in the black albeit at levels below +2%. However, the performance of the underlying holdings showed large variety. Chart 1: Eurozone – Back to “Normal” Spreads? Source: GaveKal The more critical assessment regarding China hit the emerging markets and BRIC indices particularly in January. Despite a recovery in February and March these indices ended close to -3% for the first quarter. 1 | Asset Allocation Outlook – 2nd Quarter 2014 Highlights for Investors  The macro picture continues to improve in the developed world. Inflation remains low but deflation is not yet around the corner although cause for some concern.  Investors’ optimism was tested in Q1 as equity markets faced choppy price actions. But there is no end in sight for the current “most unpopular bull market” given continuing constructive fundamentals and no shortage of liquidity.  Sovereign bonds and credit of developed markets outperformed equity markets in Q1. Credit remains attractive while we stay cautious regarding government bonds’ exposure.  China’s financial system and its economy will not collapse and investors will finally adapt to lower growth rates. So far the Ukrainian crisis has had no impact but it might be a wildcard depending how the involved parties will handle the situation. These choppy price actions were quite difficult to manage for equity long-short funds and eventdriven strategies as they got “whipsawed” or were exposed to “short volatility”. In the first quarter, hedge funds as a whole increased just above +1%. Equity L/S managers were still able to perform by +1.25% while Event Driven achieved even an increase of +2.8%. Increasing concerns on global growth led also to a reverse movement at the yield front. Yields at the long end started to decline again and thereby interrupted the Fed-led “normalization process”. This was helped by indications of the Fed to not raise rates as quickly as previously anticipated by the markets. The search for yield supported this movement as more money flowed into the longer Marcuard Heritage maturities. This came most likely from pension funds which locked in higher yields of high-grade bonds. Thus, US government bonds with maturities above 10 years returned +6.5% in Q1. In contrast, the maturities between 3 to 5 years returned zero. For sovereign EURO bonds the respective returns equaled +7% and +1.7% as the economic environment in Europe seems to constantly improve. It is remarkable how confidence has returned as we see spreads between “peripheral” Eurozone countries sliding back towards the levels of the more robust Eurozone countries (see Chart 1). China. Simultaneously, expectations of earnings’ growth in the developed markets have come down with analysts being generally more conservative. In fact, corporations which were able to improve margins through cost cutting, cheaper refinancing and productivity gains in the past, must now rely on simple top-line (sales) growth which is directly linked to GDP growth. Chart 2: The Expected Upswing of the U.S. Economy Loans have fared well, too, although gains were a little muted as a consequence of new capital requirement rules for European banks affecting momentarily the loan market. Overall, however, developed market bonds and credit outperformed equity markets over the first three months of 2014. Emerging markets’ bonds faced a remarkable recovery in the second half of the quarter. In fact, on aggregate they were able to overcompensate for the losses, i.e. -3.5% in January, as local currency aggregates indicate. By end of March the respective return equaled +1.6%. Harsh U.S. weather and a re-evaluation of gold helped to support commodity prices. For Q1 the aggregate DJUBS index was up by 7%. After a strong start gold retreated again given the prospect of low inflation, ongoing tapering in the U.S. Yearto-date it appreciated by 6.6% but the pricing seems to be range bound around USD 1300. Where do we go from here? It is comforting that left tail risks, e.g. a country default in Europe, have been reduced significantly while visibility has improved as compared to the more difficult years 2011 and 2012. 2014 continues to be a year of increased divergence, be it with respect to economic growth across regions and countries, or with respect to asset classes and their components. Hence, successful investments will require careful selection of opportunities. Undoubtedly, investors must have had second thoughts about the robustness of the economic environment and the state of the financial markets. All of a sudden, doubts about the robustness of the US economy were back – apart from concerns on 2 | Asset Allocation Outlook – 2nd Quarter 2014 Source: BCA The following chart is taken from a recent study of BCA. Chart 2 shows a collection of U.S. economic Marcuard Heritage indicators that support the argument for a cyclical upswing. Chart 3: Good News from the Eurozone banking, in an attempt to introduce “market forces”. As the economy is in transition mode towards a more consumption led economy, the infrastructural needs to provide higher urban wages will remain colossal. Nevertheless, the government is eager to achieve a GDP growth rate between 6.5% and 7.5%. Regarding emerging markets, there is no homogenous analysis possible. As stated in the previous letter, countries with negative current account, such as Turkey, India and Brazil to name a few, remain in a weak position. Source: GaveKal BCA states: “The purchasing managers’ indexes and leading economic indicator are firm, retail sales are accelerating, and unemployment claims are steadily fading…”, and further: “…the Economic Surprise index is already depressed, which suggests that the market will react more strongly to a patch of good news than bad”. Thus, we do expect that tapering continues as planned and that the yield curve will shift to the North. Therefore, we will maintain our short duration exposure. There are also steadily improving news coming from Europe. Lately, the PMI for the Eurozone hit 54 which is the highest level in over 4 years. Economic growth could be as high as 1.5% in 2014 as the latest consensus predicts and maybe higher next year if this development continues. Researchers from Gavekal further point out that as the Eurozone policy has become less austere and even allows for some tax cuts, consumer confidence is on the rise although coming from a low level. See Chart 3 for an illustration of this development. According to our view, worries about a meltdown of China’s financial systems are overstated. The size of its shadow banking system is dwarfed by countries like the U.S and the Eurozone according to BIS. Apart from China’s currently deep pockets to pay its way out of a crisis, we need to realize that most of these credits are collateralized. Nevertheless the present government will let go of poor trust companies, which are associated with shadow 3 | Asset Allocation Outlook – 2nd Quarter 2014 Despite tapering there will be no shortage of global liquidity. Monetary policies will continue to play a crucial role. It is clear that continuous interventions have distorted the pricing mechanisms for risky assets. The Fed’s move towards normalization made the USD appreciate across many currencies including the yen but it remains under pressure versus the EUR and CHF, for instance. However, the EUR might not be as expensive as one might think as Chart 4 indicates when compared to its purchasing power. Thus, a correction might not be imminent although the Eurozone could benefit from another extra 1 percentage point of growth if the EUR would, in fact, depreciate. Chart 4: The EUR might not be as expensive as Some might think Source: GaveKal The Marcuard Heritage Model Portfolio Positioning We observe the current phase of sector rotation and equity profit taking carefully. As pointed out in the previous pages the assessment regarding the economic fundamentals and equity valuations have not changed. Therefore, we continue to keep equity and credit exposure as key pillars in our asset allo- Marcuard Heritage cation. But we will stay alert to instantly react to relevant changes in the markets. We remain confident that these asset prices will be supported. Although the normalization process for interest rates has somewhat slowed down it will continue and there is no imminent need to alter our strategy to favor low duration exposure and our focus on credit and loans. Equity Long/Short and Event Driven managers are still our preferred choice over straight Beta Longonly equity managers as we expect increased volatilities in the months to come. Equity returns will most likely be significantly more modest as compared to 2013. We maintain our general equity exposure with a focus on Europe’s improved stock market environment. However, we cut our remaining exposure in a Japanese Long/Short equity manager in the more aggressive portfolios. We keep our exposure to fixed-income instruments mainly in USD and in European credits and corporate loans. Excess spreads have compressed further but yields are still comparatively attractive. In addition, default rates remain still very low. We 4 | Asset Allocation Outlook – 2nd Quarter 2014 maintain our preference for short-dated portfolio duration. Equally, we maintain our tactical position in favour of emerging market debt in hard currency to profit from its recent weakness. We decided to take profit of the insurance-linked securities as 2014 might face increased weather risks due to “El Nino”. We will assess later in the year whether we will re-invest. We cut one macro fund manager as his current portfolio positioning did no longer deliver the favorable correlation characteristics versus other funds we were and still are looking for. No altered view on gold: Our fundamental view that gold is, per se, a helpful tool to diversify, has not changed; but market sentiment and the absence of inflation expectations have clearly turned against this precious metal for the time being. Hence, we keep gold exposure at a low level as a hedge against unexpected macro risks and inflation surprises. Likewise, the overall lacklustre outlook for commodities will not lead to a re-investment anytime soon in this asset class. Marcuard Heritage Appendix Market Data Table: Strong Equity Markets for BRIC and Emerging Markets Source: Bloomberg data Disclaimer This document is for information purposes only and is not an offer to buy or sell any security or other investment. It is not addressed to any specific person and may not be used by anyone for any other purpose than pure information. It expresses no views as to the suitability of the investments described herein to the individual circumstances of any recipient. Any form of duplication or reprinting of the texts and graphics contained herein, including the saving or use on an optical or an electronic data processing medium is only permissible with the prior written approval of Marcuard Heritage. The utilization of the content of this document or any parts of it by unauthorized third parties is prohibited. 5 | Asset Allocation Outlook – 2nd Quarter 2014 Marcuard Heritage