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GLOBAL

Inside

Investor Survey: Cautiously Optimistic 2

2015 Review: Macro uncertainty driving

volatility 8

Style Outlook 2016: Shifting the gears 12

Research highlights from 2015 18

17 December 2015

Global Dynamics Style Outlook 2016 Investor Survey: Cautiously optimistic

We had 129 respondents to our 2016 market outlook survey and key themes

include:

1. Positive on Equities relative to Bonds / Real Estate with expectations of

single-digit returns. Investors expect more M&A activity in 2016;

2. Investors expect higher volatility driven macro uncertainty and US 10-year

yield to end 2016 at 3%;

3. Positive on US / Europe / India but not on Australia / China / Brazil;

4. Positive on Energy, Healthcare, IT and Financials whilst being negative on

Materials, Utilities and Consumer Discretionary sectors;

5. A cautious portfolio stance with a bias towards Quality and Earnings

Momentum and away from Value;

6. Smart Beta strategies to continue to gain market share and investors see

pressure on active fees.

A recap of 2015: Macro Uncertainty Driving Volatility

The performance of equity markets has been surprisingly robust since 2009, with

the Dow Jones clocking six years of positive performances. The rally faltered in

2015 as investors digested weaker Chinese economic data and uncertainty

surrounding the Fed’s policy action to normalise monetary policy. Investors,

fearing the ‘unknown unknowns’, invested in quality at the expense of value.

Style Outlook 2016: Shifting the Gears

A common theme that is likely to drive investor sentiment across global markets

is elevated levels of volatility. Volatility is expected to remain high on the back of

divergent Central Bank policies, shortage of US$ and strong disinflationary

pressures. Periods of higher volatility, as witnessed in Q3 2015, are likely to

cause market dislocations and support the quality tilt within investors’ portfolios.

Economic activity drives asset prices and, considering the fact that the US,

Europe and Asia ex JP are on different economic trajectories, we review the

regional economic cycle to understand the drivers of style performances.

In US, as the Fed starts to gradually normalise monetary policy, the yield

curve will flatten which favours growth relative to value stocks.

Europe is following the US lead in terms of looser monetary policy which will

drive economic recovery. Historically, value has performed well in this regime

and we continue to be supportive of this trade.

In Asia, economic risk favours quality but stretched valuations are not

supportive. Reduction in emerging market risks, especially relating to China,

will improve investor sentiment and drive flows into the Asian region. These

flows will close the valuation gap relative to the developed markets and drive

the performances of value strategies.

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Macquarie Research Global Dynamics

17 December 2015 2

Investor Survey: Cautiously Optimistic Macquarie’s 2016 Market Outlook survey reveals decreasing optimism relative to prior years

as investors grapple with lower return expectations across most assets. Market participants

are positive on Equities relative to Bonds / Real Estate but equity return expectations are for

single digits. Our survey focuses on the global economy and assets classes plus the equity

market, investor style outlooks and other topical issues.

Same, Same but different: Survey summary

Equities again reign supreme as the preferred asset class in 2016, however the conviction is

lower compared to 12 months ago. 24% of respondents are expecting negative returns to

equities compared to 11% when polled last year. Government bonds are expected to have

the weakest returns as the US interest rate cycle puts these assets under pressure. We

polled investors for their expectation for US 10-year yields in December 2016 and the

consensus view is 3%. Inflation is broadly expected to be between 1% and 2%.

Market participants expect a bumpy ride in 2016 with not a single respondent in the entire

survey suggesting that volatility will subside in 2016. This flowed through to style return

forecasts from the survey. The style with the highest expectations of the best returns,

Defensive Value, also had the highest expectation of the worst returns. Earnings Quality and

Earnings Momentum are both expected to do well while Cyclical Value continues to be out of

favour with the market. The Energy sector also continues to polarise people. Investors

continue to expect an increase in the level of M&A activity however IPOs are anticipated to

soften.

From an asset management business perspective, we’re seeing a much more favourable

environment for active managers with the majority of investors at or above target tracking

error levels. Smart Beta is expected to continue gaining market share and, on a more positive

note, the pressure on fees appears to be showing signs of easing.

A big thank you to all those who participated!

Survey Respondents Backgrounds (Job Role and Region)

We show below both the regional and functional summary of survey respondents. We had

129 respondents to the survey from a broad range of backgrounds and regions. The majority

of investors were either investment analysts or portfolio managers with an even split of

regional backgrounds.

Fig 1 Could you please indicate your functional role in the organisation?

Fig 2 Please identify your domestic Economic Region / Location?

Source: Macquarie Quantitative Research, December 2015 Source: Macquarie Quantitative Research, December 2015

8%

34%

30%

5%4%

19%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Chief Investment Officer

Portfolio Manager

Investment Analyst

Strategist Economist Other (please specify)

Pe

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31%

20%19%

13%

16%

0%

5%

10%

15%

20%

25%

30%

35%

Australia/New Zealand

Asia North America UK/Europe Middle East and Africa

Pe

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f re

spo

nse

s

John Conomos

+61 2 8232 5157

Our survey focuses

on the global

economy and

assets classes plus

the equity market,

investor style

outlooks and other

topical issues.


17 December 2015 3

Stick with Equities: Asset Class and Equity Market Returns

Investors continue to expect equities to be the best-performing asset class in 2016 with Cash

the second most popular choice. For comparison, we display the estimates from 2015 in the

figure below (on left) and can see that despite the preference for equities there is lower

conviction across the board. 47% of respondents expect equities to be the best-performing

asset class compared to 61% in 2015.

Government bonds take the unwanted prize of having the lowest return expectation with US

rate hikes driving sentiment. At 23% of the vote, commodities weren’t far behind however

highlighting the volatility in views. 13% of respondents are anticipating commodities to be the

best-performing asset class.

The chart on the right shows how investors are viewing the asset classes in terms of

valuation. Commodities are the only asset class where the consensus view is ‘undervalued’

however from the first chart we saw that the majority are not ready to call a bottom for the

sector. Equities are seen as fairly valued whilst Government Bonds and Real Estate

overvalued.

Fig 3 Please identify the best and the worst performing asset classes (expected total returns) over the next 12 months:

Fig 4 How do you view each of the following asset classes?


The overall return expectation for equities (see below) remains at ‘between 0 and 10%’.

Compared to 2015, there is a skew towards lower returns with 24% of respondents expecting

negative returns compared to 11% last year.

Fig 5 What return expectations do you have for global equities in calendar year 2016? (2015 estimate included for comparison)

Source: Macquarie Quantitative Research, December 2015

47%

6%5%

8%

13%

22%

9%

30%

19%

14%

23%

5%

61%

5%2%

9%

19%

3%

11%

24%

18%

13%

20%

15%

0%

10%

20%

30%

40%

50%

60%

70%

Equities Government Bonds Corporate Bonds Real Estate Commodities Cash

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s

2016 Best Performing Estimate 2016 Worst Performing Estimate

2015 Best Performing Estimate 2015 Worst Performing Estimate

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Equities Government Bonds Corporate Bonds Real Estate Commodities

Pe

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Over Valued Fairly Valued Under Valued Not Sure

8%

16%

63%

13%

0%2%

9%

68%

21%

1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Less than -10% -10% to 0 0 to 10% 10% to 20% Greater than 20%

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2016 Expectation 2015 Expectation (12m ago)


17 December 2015 4

US Driving Growth: Global and Regional Economic Outlook

We asked investors, for which economies do they see the most upside risk in the next 12

months? For the second year in a row, the US was the clear preference with 51% of the

responses. Europe was next in line with the supportive monetary policy providing hope for

investors. 12 months ago China was in second place (for most upside), however it is now

seen to have much more downside economic risk with only Brazil being seen to have more.

The negative view on bond returns is being reflected in sector views with Utilities expected to

have the lowest returns in 2016. The engines of growth, Health Care and Technology, are still

in favour for investors and both have more expectation of positive returns than negative.

Materials and Energy are polarising investors which is typical at periods of extreme stress.

Interestingly, the profile of expectations was very similar 12 months ago and those

anticipating strong returns were left counting their losses.

Fig 6 In which of the world’s major economies do you see the most upside and downside risk over the next 12 months?

Fig 7 In which sector do you see the most upside and downside over the next 12 months? a


Confusion reigns over Defensive Value: Investment Style outlook

There was no clear consensus when we polled investors on style return forecasts for 2016.

In fact the style with the highest expectations of the best returns, Defensive Value, also had

the highest expectation of the worst returns. We address the outlook for Value in the following

section. Earnings Quality and Earnings Momentum are both expected to do well. Cyclical

Value continues to be out of favour with the market.

Fig 8 Which investments styles do you expect to have the best (worst) return over the next 12 months?


51%

18%

7%5%

3%

11%

4%2%

7%

13%

25%

5%

1%

5%

33%

13%

0%

10%

20%

30%

40%

50%

60%

US Euro area China Japan UK India Brazil Australia

Pe

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s

Most Upside Most Downside

-25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30%

Energy

Materials

Industrials

Consumer Discretionary

Consumer Staples

Health Care

Financials

Information Technology

Telecommunication Services

Utilities

Percentage of responses

Most downside Most upside

22%

15%14%

19%

9%

21%

32%

24%

13%

7%

19%

5%

0%

5%

10%

15%

20%

25%

30%

35%

Defensive Value (eg Div Yield)

Cyclical Value (eg Price to Sales)

Forecast Growth Earnings Momentum Price Momentum Earnings Quality

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esp

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Best Performing Worst Performing


17 December 2015 5

Steady as she goes: US Interest Rates and inflation

US Monetary policy continues to dominate headlines as we head into 2016 and expectations

of any movement in policy will continue to have a significant impact on markets. The

consensus forecast of the US 10-year in December 2016 is 3%, reflecting a reasonably

steady and controlled tightening through the year.

Inflation expectations are also at the lower end with over 75% of investors anticipating

between 0 and 2%. The range of 1-2% was the most popular.

Fig 9 Please provide a forecast yield for the US 10-year bond in December 2016 (Histogram below)

Fig 10 What is your expectation for year on year US CPI inflation in December 2016?


The only way is up: Market Volatility and risk

Volatility trended higher in 2015 as we witnessed a sharp correction in Chinese equities.

Expectations of volatility over the coming year are for similar levels to 2015 but a large portion

of people also expect increased volatility. Not one single respondent in the survey

expects volatility to subside over the coming 12 months. This further highlights the

elevated level of anxiety in the market.

So what is the biggest risk to global markets? Investors are split with an even spread

between a US economic slowdown, China slowdown and geopolitical risk.

Fig 11 What are your expectations of market volatility over the next 12 months compared to the last 6 months?

Fig 12 What do you see as the major risk to global markets in 2016?


0

10

20

30

40

50

60

0.5 1 1.5 2 2.5 3 3.5 4

Nu

mb

er

of

Re

spo

nse

s

Forecast Yield (%)

1.6%

25.6%

50.4%

21.7%

0.8% Below 0%

0-1%

1-2%

2-3%

Above 3%

41%

56%

0%

3%

0%

10%

20%

30%

40%

50%

60%

Much higher volatility over the next 12 months.

Similar levels of volatility over the next 12 months

Volatility subside over the next 12 months

Not Sure

Pe

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f re

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s

28%

31%

33%

5% 3% US economic slowdown driven by high dollar and/or monetary policy

Contagion from China slowdown

Geopolitical Risk (Russia, Middle East, Asia)

Sovereign default

Other


17 December 2015 6

A slippery slope and M&A to dominate: Oil and Corporate Activity

The price of oil was another big thematic through 2015. 12m ago our survey produced a

consensus expectation of a price between $60 and $70 a barrel for 2015 and this was clearly

off the mark. The current price of oil is hovering around $37 and averaged under $50 for the

year. Looking forward investors are herded around the $40 to $50 mark and expectations are

for a rebound in prices. Are we falling into the same trap as last year?

Corporate activity was strong again in 2015 as investor confidence continued to build.

Companies increased capital expenditure and focussed on M&A in search of growth. IPO

levels were also high. We asked investors for the view on these for 2015. Most anticipate

M&A Activity to rise with IPO levels expected to fall. Macquarie has published extensive

research on the impact of this corporate activity on share prices1.

Fig 13 What's your expectation of the average oil price over the next 12 months?

Fig 14 What do you expect for each of following in 2016 when comparing to 2015 levels?


Business Outlook Improving: Concentration, Smart Beta, Fees and Tracking Error

Asset management fees have been under significant pressure following the onset of the

global financial crisis. Technology developments and new products across the industry have

also compounded the effect. Continuing the good news from last year only 28% of those

surveyed see significant downward pressure on fees. The majority are experiencing pressure

but it seems to be easing up.

The expectation for growth of Smart Beta market share is for strong growth with 56% of

respondents anticipating Smart Beta products to gain market share. This was discussed in

great detail in our 2015 Global Quant Conference in Hong Kong.

Fig 15 What are your current experiences regarding asset management fees?

Fig 16 What best describes your outlook for Smart Beta strategies?


1 See Boosting Buybacks, Under Offer, Decoding Dividend Increases and Enhancing Equity Issuance Signals

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Above $60

Between $50-$60

Between $40-$50

Between $30-$40

Below $30

39%

19% 15%

27%

19%

25% 32%

24%

18% 32% 26% 24%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

M&A Activity Company Capital Expenditure

IPO activity Buybacks and Capital Return

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Higher in 2016 Lower in 2016 Same as 2015

28.4%

34.5%

18.1%

1.7%

17.2% Significant downward pressure

Downward pressure but seems to be easing up

Steady fee levels -No pressure

I've been able to increase fees

Not applicable

56%

20%

24%

Smart Beta products will continue to grow in size and

number

Smart Beta market share will stabilize around current

levels

Smart Beta is a fad and will disappear

http://r.macq.co/_ODIxMDAw

http://r.macq.co/_OTE0ODAw

http://r.macq.co/_ODcwMzI0

http://r.macq.co/_ODM1Mjk5


17 December 2015 7

With the outperformance of passive mandates in recent years, asset owners are exploring the

concept of concentrated portfolios in a core/satellite model. This has flown through to asset

managers with many respondents running or looking to run concentrated portfolios. There is

however still a significant portion of investors who are not looking to do so or where this is not

applicable.

Fig 17 As the core / satellite model continues to increase in popularity for asset owners, what best describes your firm's intention with regard to building concentrated portfolios?


In good news for Active managers, tracking error levels are also back to target levels with an

even distribution between those that are above and below as well. This is a marked change

from 12 months ago where the skew was clearly to those below targets.

Fig 18 What are your current tracking error levels relative to targets?


Once again thank you to all those who participated. For full results, or if you have any

feedback please contact the authors.

18%

33%

8%

41%

No interest in building concentrated

portfolios

Currently running concentrated portfolios

Looking to launch concentrated portfolios in 2016 or

beyond

Not applicable / Not sure

16%

66%

18%

40%

51%

9%

0%

10%

20%

30%

40%

50%

60%

70%

Below target Around target Above target

Perc

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2016 response 2015 response


17 December 2015 8

2015 Review: Macro uncertainty driving volatility Despite weaker economic activity the performances of equity markets has been surprisingly

robust since 2009. Figure 19 plots the performances of Dow Jones index since 1896 and

shows that the current bull market run has clocked six consecutive years of positive

performances (2009 – 2014). The technology bubble was the only prior period to record a

longer run than the current rally (i.e. 9 versus 6-years). Equally interesting is the fact that post

1985 we have seen longer-runs of positive market performances than periods prior to 1985.

Fig 19 Dow Jones Index annual performances (1896 – 2015)


The run of more positive equity market performances post 1985 is attributed by investors to a

regime of lower economic volatility or ‘great moderation’, whilst the economic cycle pre-1985

periods showed greater cyclicality. To test this hypothesis, we leverage our macro-economic

similarity idea. Basically, this approach uses macroeconomic, market performance and risk /

volatility based factors to identify the historical periods most similar or dissimilar to the current

period. We build the similarity matrix from 1955 to get a longer term perspective of the

economic cyclicality and table below lists the factors used for this analysis.

Figure below plots the macro similarity / dissimilarity index where green (red) shades reflect

prior periods most similar (dissimilar) to current period. The chart supports the hypothesis and

shows that post 1985 we observe lots of economic similarity (i.e. green shades) which was

not the case prior to this period. Interestingly, the great bond-bull-market also coincides with

the transition from economic volatility to a regime of great moderation. Thus lower economic

volatility has supported the equity markets, and continues to be the case since 2009 as

reflected in the performances of Dow Jones Index above.

10

8

6

4

2

18

97

19

01

19

05

19

09

19

13

19

17

19

21

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25

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29

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33

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37

19

41

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49

19

53

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57

19

61

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65

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69

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01

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-25

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-5

0

0

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4

6

8

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5

# Ye

ars

of

Po

siti

ve/N

egat

ive

Per

form

ance


17 December 2015 9

Fig 20 US Economic Similarity / Dissimilarity index (1955 – 2015)


2015 brought about a significant increase in macro-economic uncertainty fuelled by the US

FED on the outlook of US monetary policy and fears of economic slowdown in China. FED

hosts a survey where it asks professional forecasters of their views on the US economy

across a range of economic variables. The figure below plots the quarterly US Macro

Uncertainty Index which shows that the macro uncertainty index had increased substantially

earlier this year relative to previous years driven by investors’ fears on US and China

economic activity before subsiding to more normal levels.

Fig 21 US Macro-Economic Uncertainty Index


-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15


17 December 2015 10

Macro-Economic uncertainty feeds through to asset prices which explain the increase in risk

and weaker performances of equity markets in 2015. The figure below plots the weekly

summary of the Macquarie Financial Risk Index and highlights elevated levels of risk,

especially during the Q3 period when equity markets suffered loss of confidence. Risk levels

have increased again reflecting investors’ concerns about the impact of tightening monetary

policy in the US.

Fig 22 Macquarie Financial Risk Index


Figures below plot the year to-date style performances for global regions and shows that

value theme, irrespective whether we review Defensive or Cyclical, have struggled whilst

investors have rewarded low risk / quality themes. Stocks with positive earnings momentum

continue to do well, suggesting that despite the macro or political uncertainty investors

continue to reward stocks that are delivering ahead of investor expectation.

Fig 23 Regional style returns (2015) Fig 24 Regional style returns (2015)

Source: Macquarie Quantitative Research, FactSet, December 2015 Source: Macquarie Quantitative Research, FactSet, December 2015

Reviewing annual performances hides the volatility witnessed throughout the year. Figures

below plot the US and European markets quarterly style performances. Across both markets

Q3 witnessed big moves which shaped the performances for the whole calendar year.

16

Dec

14

23

Dec

14

30

Dec

14

06

Jan

15

13

Jan

15

20

Jan

15

27

Jan

15

03

Feb

15

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Feb

15

17

Feb

15

24

Feb

15

03

Mar

15

10

Mar

15

17

Mar

15

24

Mar

15

31

Mar

15

07

Ap

r 1

5

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Ap

r 1

5

21

Ap

r 1

5

28

Ap

r 1

5

05

May

15

12

May

15

19

May

15

26

May

15

02

Ju

n 1

5

09

Ju

n 1

5

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Ju

n 1

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23

Ju

n 1

5

30

Ju

n 1

5

07

Ju

l 1

5

14

Ju

l 1

5

21

Ju

l 1

5

28

Ju

l 1

5

04

Au

g 1

5

11

Au

g 1

5

18

Au

g 1

5

25

Au

g 1

5

01

Sep

15

08

Sep

15

15

Sep

15

22

Sep

15

29

Sep

15

06

Oct

15

13

Oct

15

20

Oct

15

27

Oct

15

03

No

v 1

5

10

No

v 1

5

17

No

v 1

5

24

No

v 1

5

01

Dec

15

08

Dec

15

15

Dec

15

MFRI

Equity

Sovereign Bonds

Corporate Bonds

Commodity

FX

Economics

US Equity

EU Equity

EM Equity

UK Equity

Japan Equity

Asia ex Equity

US Sovereign Bonds

EU Sovereign Bonds

UK Sovereign Bonds

EM Sovereign Bonds

Japan Sovereign Bonds

Asia Ex Sovereign Bonds

High Yield

Investment Grade

Energy

Agriculturals

Base Metals

Precious Metals

EU FX

UK FX

Asia Ex FX

Japan FX

EM FX

US FX

Green signals low risk (higher risk appetite), Red signals high risk (lower risk appetite) and Amber signals normal risk environment

FXA

sse

t C

lass

Equ

ity

Sove

reig

n B

on

ds

Co

rp

Bo

nd

Co

mm

od

ity

-2%

-15%

22%

9%

17%

10%

-5%-7%

12% 12%

10% 8%

-9% -10%

8%

0% 0%

8%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Defensive Value Cyclical Value Low Market Risk Profitability Momentum Analyst Sentiment

Regional YTD Style Performance Charts

US EU AXJP

-8%

-27%

22% 26%

31%

12%

-10%

-17%

38%

31%

10% 6%

2%

-31%

40%

33%

78%

33%

-40%

-20%

0%

20%

40%

60%

80%

100%

Defensive Value Cyclical Value Low Market Risk Profitability Momentum Analyst Sentiment

Regional YTD Style Performance Charts

AU CA SA


17 December 2015 11

Fig 25 US style returns (2015, Quarterly) Fig 26 EU style returns (2015, Quarterly)


Lack of trend has been a defining feature of style performances in 2015. Figures above show

a quarterly rotation amongst style groups, and if were to review the style performances using

monthly data we would reach the same conclusions. Moreover synchronisation of style

performances across global regions despite each of them being on a different economic

trajectory suggests a common driver of stock prices.

In order to test whether styles are being driven by common factors, we employ the Principal

Component Analysis technique. Specifically, we use daily style factor performance data for

World, US, Europe and Asia X JP regions and assess how much of the variation is being

explained by the first component. A higher proportion would suggest that a common factor is

driving the performances of the style factors. Figure 27 shows that the variance explained by

the first factor has increased last year relative to earlier years with the biggest jump witnessed

in the US and European markets. Reviewing the underlying style factors, we note that

momentum, low risk and quality were the key drivers of factor variance.

This result is in line with the idea that that low interest rates have affected style performance

through the asset allocation channel. In particular, investors have rotated out of other asset

classes into equities in search of yield. In doing so, they have selected equity securities that

are more bond-like, namely high quality and low volatility stocks, at the expense of value.

Fig 27 PCA Analysis on Daily Style Returns Fig 28 PCA Analysis on Daily Style Returns


To conclude, increasing investor nervousness on the back of tightening monetary policy by

FED led to weaker equity market performances in 2015. Rising risk aversion, especially in

Q3, led to stronger performances of quality stocks whilst continued to struggle.

-5%

-1%

5%

-1%

-5%

-1%

-7%

-3%

-1%

1%

22%

-0%

4%

-0%

13%

-0%

4%

-1%

8%

-1%

-10%

-5%

0%

5%

10%

15%

20%

25%

Q1 Q2 Q3 Q4

Defensive Value Cyclical Value Low Market Risk Price Momentum Analyst Sentiment

-1%-0%

-6%

1%

5%

0%

-12%

0%

-7%

-3%

17%

6%

0%

-4%

12%

2% 3%

-1%

7%

-0%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Q1 Q2 Q3 Q4


68

48

43

5249

40

50

71

59

42 43

48

81

58

40

76

0

10

20

30

40

50

60

70

80

90

2012 2013 2014 2015

Var% Explained by 1st PC - Buy Portfolio Relative to Market

MSCI AC World Russell 1000 MSCI APACxJP MSCI EUROPE

49%

89%

-90%

-84%

47%

34%

-91%

-94%

86%

80%

86%

83%

-65%

-95%

77%

76%

93%

93%

-84%

-90%

85%

61%

50%

50%

-110% -90% -70% -50% -30% -10% 10% 30% 50% 70% 90% 110%

DEFENSIVE_VALUE

CYCLICAL_VALUE

MKT_RISK

PROFITABILITY

MOMENTUM

ANALYST

Drivers of 1st PC, 2015 (%Corr) - Buy Portfolio Relative to Market

MSCI AC World Russell 1000 MSCI EUROPE MSCI APACxJP


17 December 2015 12

Style Outlook 2016: Shifting the gears ‘Greed’ and ‘fear’ are known to drive investor sentiment, but despite the irrational exuberance

witnessed in the shorter-term, asset prices in the longer-run are driven by economic

fundamentals. Hence we review the regional economic clock to understand which investment

themes would be successful in 2016.

Figure below plots the Style investment clock and it shows that periods of stronger economic

activity that coincide with an environment of rising interest rates favour growth over value as

investors prefer to own stocks which can grow their earnings faster than increases in discount

rates. Similarly during periods of weaker economic activity investors’ favour quality stocks as

these companies have stable cash-flows, higher dividends and greater earnings certainty.

Value, counter-cyclical in nature, performs well on the back of improving investor sentiment

as market starts to price in an economic recovery and risk aversion abates.

Fig 29 Style Investment Clock


A common theme that is likely to drive investor sentiment across global markets, which is

supported by investor feedback, is elevated levels of volatility. Our Global Strategist expects

volatility to remain high on the back of divergent Central Bank policies, shortage of US$ and

strong disinflationary pressures. Periods of higher volatility, as witnessed in Q3 2015, are

likely to cause market dislocations and support the quality tilt within investors’ portfolios.

US: Stronger economic momentum and rising rates favours Growth

Our US economist David Doyle is constructive on the US economy which remains strong and

is resilient against weakness globally as strength persists in domestic final demand. Real

consumer spending remains robust and has been growing at a 4% pace over the past six

months. Housing construction also remains strong with lending activity picking up. There is

also broad based strength in services and inflationary pressures are firmer than popularly

perceived. For equity investors, we believe there will be two important characteristics of the

upcoming tightening cycle. First, the pace of rate hikes is likely to be very gradual and occur

over a lengthy period of time. Second, rate hikes are likely to be accompanied by a flattening

yield curve as they were in 1994-5 and 2004-6 periods.

Economy doing well and investor sentiment high => Momentum (Price and Earnings) (+)

Economy slowing down and

markets pricing a slowdown =>

Momentum (-) & Quality (+)

Economy is in recession and

investors sentiment is poor

=> Quality (+)

Economy coming out of recessions

and markets pricing a recovery => Momentum (-)

& Value (+)

Economic growth robust and

interest rate start to rise => Growth

(+)


17 December 2015 13

So how should investors position for the new regime when the monetary policy starts to

normalise? We explore a simple approach whereby we measure the performances of style

factors during periods of steepening and flattening US yield curve and measure the

performance of style factors during each of these two regimes (See Figure 30).

For now, ignoring the look-ahead bias issues, figure 31 shows that value (momentum)

performs well during periods of a steepening (flattening) yield curve. The results are intuitive

as investors reward value the most during periods of economic recovery whilst it plays no part

when yield curve flattens as the interest rate cycle kicks-off. Similarly, analyst sentiment

performs well when interest rates start to rise, the rationale being that investors reward stocks

whose earnings will grow faster than increases in the discount rates. That is, investors are

paying for growth during periods of flattening yield curve. Since our economist expects the US

treasury curve to flatten, such an environment will favour growth over value.

Fig 30 US yield curve spread (10 – 2 Year) Fig 31 Style performances (1990 – 2015)

Sources: Compustat, IBES, Russell, Bloomberg, Macquarie Capital (USA), December 2015

The above analysis focuses on events post 1990, which lends itself to a criticism that we’re

basing our views solely on two events. In our prior work – Event Driven Ideas: Rate Hikes –

we focused on periods that our economists consider to be most similar periods to the current

environment since 1950 and the figure below shows that the market performs well during

these periods supported by cyclical sectors. From a style perspective, momentum

outperforms value. Again, the analysis leads to the same conclusions as we observed with

our data earlier, that is, periods of flattening yield curves lead to underperformance of value.

-1.0

-0.5

0.0

0.5

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1.5

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2.5

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10Y-2Y Regime Defintiion

9%

17%

4%

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1%

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0%

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4%

10%

5%

0%

5%

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15%

20%

Defensive Value Cyclical Value Market Risk (Low) Profitability Pr.Mom An.Mom

Steepening Curve Flattening Curve


17 December 2015 14

Fig 32 Style performance around rate hike events (1950-2015)

Source: Macquarie Capital (USA), Fama-French Library, Federal Reserve Economic Data, December 2015

Reviewing the recommendations of our US Macro-Economic Distance Model which

incorporates economic activity, we observe that the model over the past 12 months has

shown a fair degree of consistency with an overweight in momentum / growth and

underweight in value exposures. Moreover, the model has been overweight growth relative to

value since the start of 2010, a tilt which would have added to portfolio performances.

Fig 33 US Macro-Economic Distance Model active style weights

Source: Compustat, IBES, Bloomberg, Macquarie Capital (USA), December 2015

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Market Defensive Sectors Cyclical Sectors Value Small-caps Momentum

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

12/14 02/15 04/15 06/15 08/15 10/15

Value Growth Momentum Analyst Quality Profitability Capital Risk Liquidity


17 December 2015 15

Europe: Improving economic outlook favours value

Our European economist Matthew Turner expects the slow, bumpy but increasingly robust

Eurozone economic recovery to continue in 2016. After a 3Q deceleration, high-frequency

economic data in 4Q has improved, calming fears of substantive slowdown. At its December

policy meeting the European Central Bank (ECB) didn't do enough additional monetary policy

easing to positively surprise those who were expecting a positive surprise. Nevertheless, it

did ease policy, and we believe that in the medium-term what matters is the direction of

policy. Risks remain, especially to inflation expectations, and the ECB, nowadays in pro-

growth mode, will continue easing monetary policy. Into 1Q 2016, we expect this divergence

between ECB monetary policy and its US counterpart to keep pushing the EURUSD lower.

Towards the end of 2016, however, we believe the markets will focus on stronger Eurozone

growth and this should help the euro recover.

As discussed above, the improving economic outlook favours companies most likely to

benefit from a stronger economic cycle and a weaker currency, hence in Europe we would tilt

towards Value. We do admit that Value has had a tough time in Europe and many investors

are questioning its relevance within an investment process. However, the linkage between

economic cycle and Value performance remains intact. For example, value had performed

well in 2013 as investors became confident that the European crisis was behind them and

increased their exposure to value stocks (see Figure 34) in expectation of improving

economic growth. Value even started to outperform in 2015 on the back of strong ECB policy

action and outperformed quality in three out of four quarters in 2015, but market jitters in

Q3’15 hurt this trade (see Figure 35). Despite these setbacks, Value tilt is more appropriate

for European investors.

Fig 34 Institutional holdings of value stocks Fig 35 European style returns (2015, Quarterly)


Reassuringly as figures below show value is trading at attractive levels as compared to lower

risk stocks which have had a good run since GFC.

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Cyclical Value

Cyc Val mean p 75 p 50 p 25

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Q1 Q2 Q3 Q4



17 December 2015 16

Fig 36 Cyclical value median valuation spread Fig 37 Low risk median valuation spread


Asia ex Japan: Improving economic outlook favours Value

Asian economies have endured a tough year driven by fears of slowdown in China, weaker

commodity prices and expectations of rising US interest rates. Risk aversion increased

sharply in Q3 which led to stronger performances of low risk / quality thematic (see Figure

38). The performances are in line with our expectations, that is, during periods of risk

aversion investors tilt towards higher quality companies with stable cash-flows, higher

dividends and greater earnings visibility / certainty. Investor crowding into the quality stocks is

also reflected in their expensive valuations (see Figure 39).

Fig 38 AsiaXJP Style Returns (2015, Quarterly) Fig 39 AsiaXJP Quality Portfolio Valuations


How should investors position for 2016? As argued above, asset prices are driven by local

economic outlook and reviewing the real GDP forecasts, figure 40 shows that our economists

are constructive for Asian economies. Outside China our economists are forecasting positive

GDP growth over the coming two years. For China, the rebalance will take time, however

government reforms and central bank policy actions are supportive of a favourable outlook.

Positive economic momentum for US and European economies and trade agreements (i.e.

TPP) will also be supportive of Asian economies.

-2%

0%

2%

4%

6%

8%

10%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Europe: Cyclical Value Earnings Yield Spread

Valuation Spread Average +1 stdev -1 stdev

-15%

-10%

-5%

0%

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90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Europe: Low Risk Earnings Yield Spread


-8%

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90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Asia X JP: Profitability Earnings Yield Spread



17 December 2015 17

Fig 40 Macquarie economic team real GDP forecasts

Source: Macquarie Quantitative Research, FactSet, December 2015

Investors have a preference for quality stocks due to many ‘unknown unknowns’, but these

companies are trading at very expensive multiples. Any unexpected positive news can hurt

the crowded quality trade, hence we think that investors should gradually start positioning for

a Value rally. Investors should review their style exposures as portfolio re-positioning would

have to be gradual as currently ‘fear’ dominates ‘greed’. If you would like Macquarie to help

with assessing style exposures, then reach out to your local quant representative on

[email protected].

Stronger economic activity will also help close the valuation gap between Asian relative to US

/ European markets which as figures below show are looking stretched on both earnings and

book multiples.

Fig 41 AsiaXJP Relative to US/Europe PE NTM Fig 42 AsiaXJP Relative to US/Europe PB


To summarise, reviewing the local economic cycle we expect Growth to perform well in the

US on the back of a flattening yield curve, Value to perform well in Europe on the back of

stronger economic activity and Value to perform well in Asia ex Japan as investors start to

price in impact of policy action in China and local economies benefitting from stronger US and

European economic growth.

2014 2015 2016 2017 2018

China 7.3 7.0 6.5 6.0 6.0

S. Korea 3.3 2.6 3.4 3.5 3.5

Taiwan 3.8 2.1 2.5 2.7 3.0

Hong Kong 2.5 2.3 2.6 2.6 2.8

Indonesia 5.0 4.8 5.5 5.8 6.1

Malaysia 6.0 5.1 6.1 6.3 5.3

Singapore 2.9 2.1 2.8 3.2 3.1

Philippines 6.1 5.8 6.6 6.5 6.6

Thailand 0.9 2.7 3.3 3.6 3.5

India 7.1 7.2 7.5 7.6 7.7

Japan -0.1 0.5 1.1 0.5 0.3

Calendar Year YoY (%)

-

0.20

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Jan

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v-1

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No

v-1

2

Jan

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Mar

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May

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13

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3

Jan

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Mar

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May

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Jul-

14

Sep

-14

No

v-1

4

Jan

-15

Mar

-15

May

-15

Jul-

15

Sep

-15

No

v-1

5

AXJP/EU PE AXJP/US PE

-

0.20

0.40

0.60

0.80

1.00

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1.40

Jan

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Mar

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May

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Jul-

11

Sep

-11

No

v-1

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Jan

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Mar

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May

-12

Jul-

12

Sep

-12

No

v-1

2

Jan

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Mar

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May

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Jul-

13

Sep

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No

v-1

3

Jan

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Mar

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May

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Jul-

14

Sep

-14

No

v-1

4

Jan

-15

Mar

-15

May

-15

Jul-

15

Sep

-15

No

v-1

5

AXJP/EU PB AXJP/US PB


17 December 2015 18

Research highlights from 2015 2015 year was a productive year for the Macquarie Quant team. Below we’ve listed the detailed

Quantamental papers for the year. There were many other thematic and topical pieces along with our regular

Abstracts Monitor publications. Please contact a member of the Macquarie Quant team for more information

on any of the work.

Quantamentals

Rethinking Value: The performance of Value factors has been disappointing, with the exception of small

cap universes, for the last 20 years. In this presentation we shift our attention from absolute value to

relative value investing. Quantitative fair value models are common in credit but not in equities, where

we mostly concentrate on models to predict stock returns. Fundamental analysis, on the other hand,

does employ methodologies such as DCF to estimate the fair value of a company based on predicted

cashflows or earnings. The scarce academic literature on the topic, largely ignored by the investment

community, documents that simple quant models of a stock's fair value can be used to generate

significant alpha in the US market. An important advantage of this approach is that, unlike most of the

attempts to find 'new' alpha factors, it does not rely on (potentially overfitted) predictive models of

returns. As a result, it can be used to address the robustness issues raised by the recent criticisms

which question the validity of the analysis behind most quant factors. We apply these ideas to a large

cap non-Financials universe and assess the profitability of long short strategies based on buying

undervalued stocks and selling overvalued ones. Both fair value models we considered would have

outperformed the traditional value factors and composites for the last 20 years, consistently across

different regions.

Embracing Uncertainty In recent years, investors have paid elevated attention to macro-level

uncertainty, from the US government shutdown to Greece’s debt crisis, and recently the mounting

expectations for the Fed’s rate hike and the turbulent Chinese economy. Given the rising concerns, in

this paper we analyse the implications of uncertainty on the individual stock selection, and more

importantly how to profit and generate alpha. Measuring uncertainty is not at all unambiguous as it is

intrinsically unobservable. We quantify uncertainty from three orthogonal dimensions: Macroeconomic

Uncertainty measured by the dispersions in professional forecasters’ views about future

macroeconomic outcomes; Economic Policy Uncertainty measured by volumes of policy-related

uncertainty news discussed in public newspapers; and Financial Market Uncertainty as measured by

our proprietary Macquarie Financial Risk Index (MFRI). The stocks’ exposure with respect to

uncertainty indices has economically significant predictability for cross-sectional stock returns, even

when we control for common risk factors. Investors can use this signal as a profitable trading strategy,

as it produces annual returns of 4% - 12% across global regions. Incorporating uncertainty signal

significantly improves the performance of Macquarie Alpha Model, bumping up the information ratio to

0.80 (0.98) from 0.52 (0.73) for US large (small) cap.

Equity Carry – Let’s not get carried away A recent academic paper has extended the concept of carry

from FX and interest rates to equities. In short, the carry of an equity index future is its expected return

assuming that the level of the underlying index stays constant until the contract expires. It is easy to

show that it can be viewed as a forward-looking measure of dividend yields, i.e. it is related to the

dividends that will be paid by the constituents of the index until the expiration of the contract. We show

that an equity carry strategy based on liquid global contracts would have generated attractive risk

adjusted returns. Our work also analyses the robustness of the results to different assumptions on

transaction costs, time lags and weighting schemes. Finally, we assess how a cash equity investor, as

opposed to one who invests through futures, can use the signal.


17 December 2015 19

Earnings Quality – a composite with solid foundations In this report, we evaluate a variety of signals for

earnings quality, going beyond commonly used variables such as ROA, ROE, earnings growth and

earnings stability. Inspired by the accounting literature, our measures span two dimensions of earnings

quality: persistence (whether realized earnings are indicative for the future) and reliability (whether

current earnings reflect accurately the economic activity of a firm). Indicators include accruals, the

variability of earnings relative to cash flows, the incidence of earnings meeting thresholds such as

forecasts and prior releases, the restatements of financial variables, as well as the misuse of

discretionary items. We confirm that accrual-based measures tend to capture significant risk premia,

and provide evidence on the extent to which the signals are priced by the market. Furthermore, we

describe how these indicators interact and can be combined.

Horizon dynamics – squeezing the most from your factors Factors, like athletes, each have their own

performance domain. Some are built for endurance and will perform well over extended periods of time;

while other factors, like sprinters, deliver performance in a quick burst and then quickly run out of

steam. When constructing a composite factor model, the selection of the investment horizon for which

to optimise the model can result in very different factor weightings, stock rankings and model

performance. In this report we explore how the factor weights and performance characteristics of our

dynamic Alpha model changes as we optimise for various investment horizons across global markets.

Human Capital – this is urgent, do it now! Labour productivity is a measure often overlooked by many in

fundamental analysis. It is a measure that indicates how efficient a company is in utilising labour capital.

As an input, human capital is at the heart of every firm because more productive firms create higher

sales and earnings ultimately leading to higher future share price returns. In this report, four measures

related to labour productivity are investigated. The first involves analysing the company cross-section

Labour Productivity relative to peers. Labour Productivity here is defined as Sales over the Number of

Employees. The second is the Change in Labour Productivity over time. The third and fourth are related

to Wage, namely Wage Turnover (Sales over Wage) and Average Wage (Wage over the Number of

Employees). The empirical tests and the additivity analysis demonstrate that labour productivity

measures predict future stock price returns. It is also a viable trading strategy that can add good risk-

adjusted returns to the Macquarie quant model in all regions.

Debt Dynamics This research is an attempt to understand the impact of debt issuance on stock

performance. With the Fed indicating that it may raise interest rates this year, raising debt and debt

refinancing could be impacted. Extant literature points to negative stock performance following debt

issuances. Using DeaLogic, we create a Debt Issuance database. We examine a total of 75,136 debt

issuances from 1990 onwards. Our study is limited to the US Large Cap Universe due to better

coverage of debt issuances. We observe stock underperformance following debt issuance. By

focussing on Duration, Steepening, Effective Spread, Usage, Stock Volatility and Interest Coverage we

can further isolate debt issuances associated with severe stock underperformance. Our research shows

that stocks with a Stronger Debt Issuance Signal (most negative in terms of attributes) underperform an

equal-weighted index by 6% over a one-year period.


17 December 2015 20

Which seeds are good The Investment factor corresponds to the excess returns of firms with low Total Asset

Growth (TAG) compared to that of firms with high TAG. Recently, it has come back in fashion, as Fama and

French (2014) argue it can better explain portfolio returns, and there is evidence suggesting it could replace

initial factors such as Value. We confirm that this effect is present in Europe, US and Asia Pacific ex Japan,

and tends to be stronger in ‘down’ markets. Moreover, we argue that while firms with low TAG do not score

well in terms of typical Quality (ROE) and Defensive Value (Earnings Yield) measures, they exhibit a different

type of Quality: the ability to avoid unprofitable balance sheet expansions. In addition, we make the important

distinction between Capitalized Investments (CI) such as TAG, which have a limited impact on current

earnings, and Expensed Investments (EI) such as R&D, which are immediately subtracted from current

earnings. The former are likely to ‘hide’ over-payments and future write-downs, and are negative predictors

of returns. In contrast, EI are likely to underestimate future stores of value, and are positively related to future

returns. Furthermore, we examine subcomponents of TAG from the Investing (Receivables, Inventories,

PPE, Intangibles) and Financing (Debt, Equity, Retained Earnings) sides of the balance sheet, and confirm

that the effect is stronger for external financing, as well as in items of lower reliability.

I just called to say I’m bullish Recent academic research (and our own work on US data) have found that

analyst conference calls convey useful information which is not contained in earnings numbers and analyst

forecasts. The slow reaction of markets to that type of information implies that sentiment, as it is expressed

by analysts and management during the call, predicts returns. This effect is distinct from the well known post

earnings announcement drift. We collected call transcripts for global companies from Factset going back to

2002. Using text mining techniques, we measure the tone of the management discussion and Q&A session

of each call. The goal is to develop an alpha signal at low frequency, with horizons of one to three months.

The main research questions we address are: Does tone display predictive power on returns in our global

universe? Can textual analysis help us predict which companies will have stronger earnings momentum /

earnings surprise effects? We also investigate whether we can build a better signal by using different

variables (tone, complexity, readability). Finally, we consider the use of more sophisticated techniques than

the ‘word counts’ the existing literature almost universally adopted, for example a naïve Bayes approach to

identify bullish sentiment.

Don’t follow the herd A recent study shows that US managers often bet on the wrong side of common pricing

anomalies. In this report, we leverage a unique shareholding dataset for retail managers to question whether SA

managers are prone to similar biases. We find that the styles with a strong aggregate following have weaker

performances while styles with no following have stronger performances

Under the Hood

Data manipulation in R Data manipulation is central to any data analysis. R has many packages for

performing this, dplyr and tidyr are some of the best. The data modelling and visualisation workflow is

substantially faster when the data is in the Tidy Data format.

Visualisation in R Data visualisation enables insights to be gained quickly. R is a fantastic tool for

visualisation, with an incredibly rich array of functionality. Unlike most competing tools, statistical analysis

can be done as part of the visualisation processes. Mastering visualisation in R will vastly increase the speed

of your data analysis.


17 December 2015 21

Important disclosures:

Recommendation definitions

Macquarie - Australia/New Zealand Outperform – return >3% in excess of benchmark return Neutral – return within 3% of benchmark return Underperform – return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield

Macquarie – Asia/Europe Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie – South Africa Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie - Canada

Outperform – return >5% in excess of benchmark return Neutral – return within 5% of benchmark return Underperform – return >5% below benchmark return

Macquarie - USA Outperform (Buy) – return >5% in excess of Russell 3000 index return Neutral (Hold) – return within 5% of Russell 3000 index return Underperform (Sell)– return >5% below Russell 3000 index return

Volatility index definition*

This is calculated from the volatility of historical price movements. Very high–highest risk – Stock should be

expected to move up or down 60–100% in a year – investors should be aware this stock is highly speculative. High – stock should be expected to move up or down at least 40–60% in a year – investors should be aware this stock could be speculative. Medium – stock should be expected to move up or down at least 30–40% in a year. Low–medium – stock should be expected to move up or down at least 25–30% in a year. Low – stock should be expected to move up or down at least 15–25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only

Recommendations – 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations

Financial definitions

All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards).

Recommendation proportions – For quarter ending 30 September 2015

AU/NZ Asia RSA USA CA EUR Outperform 48.87% 59.96% 35.63% 42.13% 59.44% 42.11% (for US coverage by MCUSA, 3.54% of stocks followed are investment banking clients)

Neutral 33.44% 25.00% 39.08% 52.55% 37.06% 38.42% (for US coverage by MCUSA, 5.05% of stocks followed are investment banking clients)

Underperform 17.68% 15.04% 25.29% 5.32% 3.50% 19.47% (for US coverage by MCUSA, 0.51% of stocks followed are investment banking clients)

Company-specific disclosures: Important disclosure information regarding the subject companies covered in this report is available at www.macquarie.com/research/disclosures.

Analyst certification: We hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. The Analysts responsible for preparing this report receive compensation from Macquarie that is based upon various factors including Macquarie Group Ltd total revenues, a portion of which are generated by Macquarie Group’s Investment Banking activities. 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17 December 2015 22

Germany, this research is issued and/or distributed by Macquarie Capital (Europe) Limited, Niederlassung Deutschland, which is authorised and regulated by the UK Financial Conduct Authority (No. 193905). and in Germany by BaFin. France: In France, research is issued and distributed by Macquarie Capital (Europe) Ltd, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority (No. 193905). Hong Kong & Mainland China: In Hong Kong, research is issued and distributed by Macquarie Capital Securities Ltd, which is licensed and regulated by the Securities and Futures Commission. In Mainland China, Macquarie Securities (Australia) Limited Shanghai Representative Office only engages in non-business operational activities excluding issuing and distributing research. Only non-A share research is distributed into Mainland China by Macquarie Capital Securities Ltd. 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