Long-Term Outlook...Long-Term Outlook Macroeconomic Scenarios and Expected Returns 2020 – 2023 By...

Long-Term Outlook Macroeconomic Scenarios and Expected Returns 2020 – 2023

By Multi Asset Group Netherlands (Aegon Asset Management)

For professional and qualified investors only

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Authors:

Fares Ben Ghachem

Jordy Hermanns

Olaf van den Heuvel

Serdar Kucukakin

Boudewijn van Loen

Robert Jan van der Mark

Boudewijn Schoon

Tim Sterk

Jacob Vijverberg

Address:

Aegonplein 6

2591 TV Den Haag

The Netherlands

[email protected]

www.aegonassetmanagement.nl

Multi Asset Group (MAG) The Multi Asset Group is responsible for the asset allocation for a range of Aegon Asset Management funds and mandates. The team blends different asset classes to construct multi asset funds that meet the investment objectives and risk profiles of our clients.

Table of Contents

Chapter 1 – Global macroeconomic developmentsSummaryUnited StatesEurozoneUnited KingdomJapanEmerging markets

Chapter 2 – Thematic articlesCreative destruction: A driving force behind investment returnsGDP differences explained: About laborious Greeks and efficient French peopleListed real estate: Wind in the sailsAlternative Risk PremiaVolatilities, correlations and tail risk: More than two moments

Chapter 3 – Expected returnsGovernment bondsCorporate bondsDutch mortgagesAsset-backed securitiesEmerging market debtEquitiesReal estateCommodities

Chapter 4 – Asset allocation

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111316

181921222425

282930313132323334

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SummaryThe global economy has shifted into a lower gear in the past few quarters. Following a period of strong and broad-based economic momentum, soft spots in the economy emerged in the second half of 2018 and continued into 2019. The world economy expanded by 3.2%, down from 3.9% one year ago. Growth decelerated across the board, with more pronounced weakness among countries and sectors where trade and manufacturing play an important role. The slower growth fits into a dynamic of high (and rising) policy and political uncertainty, which weighs on global investment and confidence. Slower growth is also caused by ongoing trade tensions as well as the intensification of capacity constraints in specific pockets of the economy.

Chapter 1Global macroeconomic developments

Growth decelerated across the board, with more pronounced weakness among

countries and sectors where trade and manufacturing play an important role.

The United States economy has maintained its momentum on the back of sizable, albeit waning, fiscal stimulus. The US economy expanded by 2.9% in 2018 and the 2019 outlook is reasonably positive with an expected growth rate of between 2% and 2.5%. That said, more signs are emerging that the economy is late-cycle, and the trade-related uncertainty poses a risk to the outlook. We foresee two – equally likely – scenarios. In the positive scenario, growth in the coming years remains at close to the current level – around 2%. This scenario is likely to materialize if the trade dispute does not worsen, and if the recent weakness in the manufacturing sector does not persist. In the absence of (external) shocks, the cycle can continue in the coming years. In our negative scenario, we account for a growth slowdown in the near future. The slowdown could be driven by various factors, of which a further escalation of the trade dispute is among the most likely and impactful.

In the Eurozone the expansion slowed in 2018 to 1.9%, down from 2.4% the year before. Germany narrowly avoided a technical recession as manufacturing faced significant headwinds, and Italy was the first EMU member to enter a recession since 2015. So far this year, the incoming data shows a similar picture as last year. There are still headwinds for the manufacturing sector, and serious risks remain for the European economy. The outlook for the Eurozone depends, in large part, on a number of events, mainly the resolution of the trade war, Brexit and growth developments in China. A benign scenario is possible if these risk don’t materialize. In that case, the strong labor market developments are likely to continue, supporting domestic demand. The investment side should, in this case, remain solid as extremely loose monetary policy and a return of business confidence should boost investments. Also, a fiscal impulse could support growth in the near term. In any case, we do think that the best years are behind us as capacity constrains have intensified in specific pockets of the economy. If all, or more, of the above mentioned risk materialize, than the Eurozone economy is especially vulnerable due to its openness, and an economic slowdown is likely.

In the United Kingdom, the economic developments and outlook are still dependent on the Brexit outcome. Obviously, a comprehensive deal or a delay far into the future would be the favorable macroeconomic outcome in the short term. Instead, outcomes that entail more uncertainty are likely to have adverse short-term effects on the economy. Our positive scenario accounts for a comprehensive deal, as this will limit the adverse effects for the UK – and to smaller extent EU –

economies. As there are already signs of capacity constraints in some pockets of the UK economy at this time, extending the cycle intensifies these capacity constraints. Our negative scenario foresees a slowdown of the UK economy, be-it via idiosyncratic Brexit factors, or via a more global slowdown.

Japan has had an extended period of above-trend economic growth. On the policy front, six years of Abenomics saw strong labor market developments, higher female labor force participation and lower fiscal deficits. However, inflation has remained stubbornly low, and challenges are set to remain as demographic headwinds intensify. In our positive scenario we foresee decent low single digits economic growth in Japan, with some temporarily adverse effects because of this year’s VAT hike. In the negative scenario, we expect a slowdown in the Japanese economy, comparable to the negative scenario for other advanced economies. As Japan is a relatively open economy, major changes in the global economy would have a significant impact on the country.

For China, we expect its economic transformation toward a more services-oriented economy will continue in a controlled manner. The economic adjustments stemming from this transformation, coupled with the tariffs on exports to the US, are likely to result in lower growth rates. Other emerging economies were also impacted by the trade tensions, lowering growth rates on average.

Global economic growth Real GDP growth (in percent)

-4%

-2%

0%

2%

4%

6%

1980 1985 1990 1995 2000 2005 2010 2015 2020

US EU

UK JP

CN Others

World World (negative scenario)

Source: Aegon Asset Management, World Bank

Note: 2020-2023 based on expectations. All data for positive scenario, except for World (negative scenario).

Early 50's

Mid 50'sLate 50's

1960's

Early 70'sMid-late 70's

Early 80's

Mid-late 80's

1990's

2000's

Current Cycle

R² = 0.7449

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5

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15

20

25

30

35

40

45

0.0 0.5 1.0 1.5 2.0 2.5

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th o

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trs)

Average Expansion Excess Speed vs. Potential % (Real GDP Growth, QoQ Saar)

40

45

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55

60

65

2013 2014 2015 2016 2017 2018 2019

ISM Manufacturing

ISM Non-Manufacturing

6 7

In the past few months, the US economy has achieved a number of milestones – some positive and some negative. On a positive note, the current cycle is the longest US expansion on record, with over 11 years of uninterrupted growth. Employment is booming, with more than 155 million people employed and unemployment rates hovering near 50-year lows. On a more negative note, the US government bond yield curve inverted this year, which is typically regarded as a strong upcoming recession indicator. These milestones – positive and negative – are also reflected in our outlook for the US economy. We argue that there is a good chance the US economy continues the cycle, with growth around trend levels. At the same time, we acknowledge that risks have shifted to the downside, centered on policy uncertainties and increasing capacity constraints. That is why we deem our negative scenario equally likely as our positive scenario. It reflects the current highly uncertain environment.

United States

Since the expansion period started in mid-2009, the US economy has expanded without interruption for 120 months straight, making it the longest expansion phase on record and among the strongest recoveries in the OECD. The US expansion has lasted more than three times as long as an average expansion (economic expansions usually last on average about 40 months). While remarkable for its length, the US expansion has happened at a slower pace compared with other cycles.

Longest US expansion on record Ten longest US expansion periods (in months)

Last year, US economic momentum strengthened further – from an already high level of economic activity – as the Trump administration’s fiscal stimulus reached its full force. More recently, however, the economy has lost momentum, particularly in the manufacturing sector. The sector is sensitive to the trade tensions that have been present in recent years and to the weakening global economic conditions. The Federal Reserve was mindful of these ongoing crosscurrents and decided to lower the policy rate, ending the normalization path that it started in 2015.

Labor marketThe US labor market is in a strong place. The US economy has added 20 million new jobs since the financial crisis and current employment levels exceed the pre-crisis level by about 11 million jobs. The strong pace of job creation has continued in 2019. Broad measures of unemployment are now at levels last seen in the 1970s, a period of very tight job market conditions. Although the total number of jobs created since the crisis has been impressive, the growth has been uneven across all sectors, with some only just returning to their pre-recession employment levels. The manufacturing sector is still smaller than before the crisis, and much smaller than at the beginning of the century. The construction and retail trades have only just recovered the jobs that were lost in the 2008 – 2010 period. In contrast, the employment growth in the education, health services and leisure and hospitality sectors has been very strong. The number of jobs lost in these sectors was relatively limited, and since 2010 many new jobs have been added, continuing the strong trend that was already emerging before the financial crisis.

Unbalanced labor market growth Employment growth by sector, SA (Index, 2008=100)

rates continued with additional rate hikes over the years and a gradual reduction of the balance sheet.

The current looser monetary policy comes at a time when fiscal support has eased. In previous years, the US economy benefited from the most sweeping overhaul of the US tax system in more than three decades. This year, with the absence of a new fiscal expansionary programme, the positive effects are fading.

Trade and electionsSo far, 2019 has been eventful in terms of global politics. The trade dispute between the US and China is one of the most pressing concerns; it might mark a turning point in a long-term trade liberalization trend. Since 1990, a large number of preferential trade agreements were established, resulting in a widespread fall of applied tariff rates among both advanced and emerging economies. The trade liberalization coincided with intensified global trade, and the internationalization of supply chains. The admission of China into the WTO was another step toward further globalization. However, most western countries view Chinese trade practices as unfair because access to the Chinese market is restricted. Foreign companies, for instance, have to form joint ventures with Chinese partners, which increases the risk of intellectual property theft.

The US is now taking the lead in addressing these issues, via the very confrontational approach of the Trump administration. Tariffs have been implemented on a range of products, both by the US and China. At the same time, the threat of implementing additional tariffs is used in the negotiation process. Clearly the fluid situation increases global economic uncertainty and disrupts international supply chains. Chinese imports of American goods tumbled 22% in August from a year earlier. The manufacturing sector, in particular, is impacted by the trade tensions.

Manufacturing sector hit by trade turmoil ISM manufacturing and non-manufacturing, SA

0 20 40 60 80 100 120

average

1949-11 - 1953-06

1861-07 - 1865-03

1933-04 - 1937-04

1975-04 - 1979-12

2001-12 - 2007-11

1938-07 - 1945-01

1982-12 - 1990-06

1961-03 - 1969-11

1991-04 - 2001-02

2009-07 - today

Expansion pace relative to potential tends to drive cycle length

60

70

80

90

100

110

120

130

140

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

ManufacturingEducation and health servicesConstructionLeisure and hospitalityRetail trade

There are still some pockets that offer room for further labor market growth, but capacity constrains have intensified. We foresee increasing difficulties for companies to attract qualified workers and believe that employment growth is likely to slow in the coming period. Overall, labor market trends are supporting domestic demand growth and increased consumer spending.

Monetary and fiscal policyAs mentioned earlier, in 2019 to-date the Federal Reserve have cut rates twice in what it called a “mid-cycle adjustment”.These were the first rate cuts since 2008. Jerome Powell, the Fed chairman, said weak global growth and the trade war had been disruptive for the world economy and had an impact on growth in America, despite the US labor market remaining strong. Leaving the door open to potential interest rate cuts in future, the Fed indicated it is ready to respond with more support for the US economy should the outlook deteriorate further.

The rate cuts ended a period of monetary policy normalization in the US. In 2015, the Fed raised the policy interest rate for the first time in nearly a decade. The gradual path towards higher

Another driver of uncertainty is the 2020 presidential election. It appears that both the Republican campaign and Democratic campaign are adopting outspoken views. If Trump is re-elected for a second term, we expect a continuation of the current policy. If the Democrat candidate is elected, it could well be that some of the changes implemented by Trump will be reversed. Although a democratic victory might ease trade tensions, it might also mean a reversal of the tax cuts. Equity markets are sensitive to both, but probably more so on the latter.

More recently, however, the economy has lost momentum, particularly in

the manufacturing sector. The sector is sensitive to the trade tensions

that have been present in recent years and to the weakening global

economic conditions.

Source: Aegon Asset Management, Federal Reserve, Bank of St Louis, NBER.

Source: Aegon Asset Management, BEA, CBO, NBER.

Source: Aegon Asset Management, US Bureau of Labor Statistics.

Source: Aegon Asset Management, Institute of Supply Management.

0

0.5

1

1.5

2

2.5

Fran

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1998200320082013

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In the past year, the world economy expanded by 3.2%, down from 3.9% one year ago. Growth has weakened in most advanced economies. In 2018 Eurozone growth was 1.9%, down from 2.4% the year before. Germany narrowly avoided a technical recession as manufacturing faced significant headwinds, and Italy had the dubious honour of becoming the first EMU member to enter a recession since 2015. So far this year, the incoming data shows a similar picture as last year. There are still headwinds for the manufacturing sector, and serious risks remain for the European economy. Robust domestic demand has offset these negative effects so far, but the outlook will depend on whether that can continue.

Eurozone

Despite all the attention on the rise of populist parties, the European parliament elections actually resulted in a pro-European outcome. A large majority of the parliament favors further integration. This outcome has also resulted in a new European Commission, which wants to focus on a social and green European economy. It is interesting that recent appointments to the top jobs in the EU have a more political background instead of being more technocratic. It seems that the EU is evolving from a institution led more by technocrats to a model where politicians need to be more aware of the demands of the electorate. This should enlarge the democratic legitimacy, but also poses a risk from the rise of populist sentiments in the longer run.

The coalition in Italy between the Five Star movement and the Lega fell, after Salvini pulled his support. His intention was to force a new election, but the gamble has failed so far. The Five Star movement managed to form a new coalition with the PD, the socialist party. The new government is likely to be less confrontational with Europe, and the European Commission might allow them a bit more leeway to help counter the threat of the rise of the Lega. For the near future this has removed part of the “Eurozone” break-up risk, which is now also reflected in tighter sovereign spreads.

Brexit is another risk for Eurozone growth. The countries most integrated with the UK - like Ireland, the Netherlands and to a lesser extent Germany - are vulnerable, given that the manufacturing sector is already weak. A beneficial side effect of the Brexit drama in the UK is that many anti-European parties have dropped their demands for an exit from the EU.

What to reform?Economists often argue that several countries in Europe should reform their labor and product markets. They probably have a point; according to economic theory, the removal of rigidities will result in a better allocation of labor and capital in an economy. This seems to be substantiated by data, but at the same time real life tends to be more complicated than the textbooks suggest.

First of all, it is interesting to have a look at product market rigidities.

Labor market regulation (High = more rigid)

During the 90s and the start of this century, product markets were reformed in Europe through the introduction of single internal market regulations. These were aimed at aligning and loosening product market regulation. The effect can be seen clearly in the chart above. Product market regulation in the EU is (according to this definition) now looser than in the US.

Secondly, the chart below shows the change in labor market rigidities. In general, several economies have loosened labor market restrictions in Europe, but to a lesser extent than deregulation in the product markets.

Labor market regulation (High = more rigid)

-6%

-4%

-2%

0%

2%

4%

6%

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Personal consumption Government consumption

Private dom. fixed investment Inventories

Net exports Real GDP

Real GDP (negative scenario)

OutlookAs mentioned earlier, we have two equally likely scenarios as much will depend on difficult-to-forecast political choices. We therefore view it as prudent to take more than one scenario into account.

The positive scenario sees growth stabilise around current levels, which is only possible in the absence of any risk escalation. This implies that trade tensions do not escalate further and that the recent weakness proves to be temporary – remaining isolated within the manufacturing sector only. This positive scenario accounts for some monetary easing in the short run, but foresees moderately higher policy rates four years ahead. Although at a slower pace than in previous years, we expect a sufficient number of jobs to be created to sustain the expansion in the coming years, via both lower unemployment rates and a continuation of the increasing participation rate. On the back of these positive labor market developments, domestic demand remains the most important driver of growth in the coming years.

The negative scenario foresees a growth slowdown in the near future, which could be driven by various developments. In our opinion, a further escalation of trade tensions – or trade uncertainty for a prolonged period – is a vital factor that could cause the loss of economic momentum. The adverse effects of trade uncertainty could disturb the economy via various channels, the confidence and investment channels in particular. In this scenario, we expect to see labor market weakness, pushing the unemployment rate up from current lows. We foresee a quick reaction function from the Fed, as it has indicated its readiness to adjust policy in the case of worsening data. This will take policy yields lower towards zero.

United States GDP composition Real GDP growth (in percent)

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1

1.5

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3

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Spai

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US

1998

2003

2008

2013

Source: Aegon Asset Management, Bloomberg, Thomson Reuters Datastream

Note: 2019-2023 data based on expectations. All data for positive scenario, except for Real GDP (negative scenario).

Source: Aegon Asset Management, OECD.

Source: Aegon Asset Management, OECD

30

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2012 2013 2014 2015 2016 2017 2018 2019

World Germany

France Italy

United States Japan

10 11

What a difference a year makes. While that statement is true for many of the challenges we face, it is not an accurate reflection on Brexit, given the lack of progress we have seen. One year ago we wrote in this publication: “The way the Brexit will play out … is now in the hands of politicians” and “…the UK’s strategy to exit the EU and the impact on the UK are still rife with uncertainty.” That is still the case.

United Kingdom

There have been some changes during the year, however, that are worth highlighting. Boris Johnson replaced Theresa May as PM, for example, and a significant number of parliamentary votes took place. Still, the actual situation has not changed; the UK has not left the EU, and there are no signs to-date of the EU and the UK finding common ground that would bring Brexit closer to an acceptable conclusion.

The Brexit vote did not cause an outright slowdown of the UK economy. In fact, UK growth has been decent in the years following the 2016 vote. The uncertainty of leaving the EU has had a less negative effect than expected. However a weaker Sterling and strong growth in its main trading partners are likely behind the decent economic performance. The benign economic situation is reflected in the strong labor market. Recently, the total number of people employed in Britain reached a record high of over 32 million, and the unemployment rate dropped to a 50-year low of below 4%.

These decent growth numbers and strong labor market developments do not mean the UK economy is not affected by the Brexit vote. After all, UK growth has lagged most developed markets. The weakness is primarily in specific pockets of the economy. For example, the total economy has grown since the Brexit vote, but that expansion hides wide divergences between sectors. The construction sector in particular stands out, given it has shrunk by over 10% since the beginning of 2017. In contrast, the production sector expanded meaningfully. On an industry level, financial services is the worst performer; it has shrank by almost 12% over the past two years. At the same time, areas such as telecommunications and information technology are generating more value than ever, indicating that not all sectors are facing headwinds. Weakness in the data is also evident at a national level. The most recent GDP estimates (Q2, 2019) revealed that the UK’s economy has contracted - the worst performance since 2012.

London's economic expansion hides wide divergences betweeen sectors GDP growth per sector (index: 2017Q1 = 100)

At the time of writing, there are two likely scenarios for Brexit to play out in the short run. The first option includes the UK leaving the EU with a deal on the 31 October 2019. The second option entails another extension beyond the current deadline date. The result of the parliamentary votes in early September means that a hard Brexit is off the table and that PM Johnson is lawfully required either to get a Brexit deal or to seek to delay Britain’s departure from the EU past the current deadline date of 31 October. We have not yet reached the end-game for Brexit and it could develop along several alternative paths.

Extension beyond 31 OctoberIn the absence of a deal before the deadline, Johnson is lawfully required to request an extension. The extension could be used to renegotiate a deal, but also to hold a general election or to organize a new referendum.

Orderly Brexit An orderly Brexit is a possibility, either before the end of October or at a later date. For an orderly Brexit to happen, the UK and EU would have to agree a deal. Currently, Theresa May's deal is still on the table, but it is unlikely that a majority of MPs would back a deal that had already been dismissed. Minor changes to May's deal are also unlikely to convince a majority of MPs to back it. A more likely scenario is that a significantly revised deal is proposed. For instance, by keeping Northern Ireland in the single market, which would allow the UK to pursue its own trade policy. This option would also avoid a hard border in Ireland, which is one of the main obstacles of agreeing on a deal. This proposal is favored by the EU, but is also highly controversial in the UK.

Cancel BrexitThe European Court of Justice has ruled that it would be legal for the UK to unilaterally revoke Article 50, i.e. to cancel Brexit. This would likely require a referendum or general election, and it would not involve the agreement from the 27 EU countries. It is not clear what the cancellation process would look like, as such a situation has never occurred before. It is unlikely that Brexit will be canceled in the near future, but it remains a possibility in the longer term, especially if the public shows support for a cancellation.

Non-orderly Brexit Recently, a law was passed that stops the UK government from seeking a no-deal Brexit. Therefore, extending the negotiation phase, i.e. seeking a delay, appears to be the default option in case a deal cannot be reached. However, while the new law has reduced the risk of a hard Brexit in the short term, a disorderly Brexit remains a possibility in the future, in part due to the need for the EU 27 to consent to any extension. Leaving without a deal is probably the worst-case scenario for the UK's economic outlook and, to a lesser extent, for the EU.

The Hartz reforms in Germany in 2002 are widely credited for the relatively strong economic performance during the subsequent decade. Also, reforms in Spain after the credit crisis are credited for the country’s subsequent strong performance. In 2017, president Macron reformed labor markets in France, and since then there has been a stronger improvement in labor statistics.

Going forward, countries that are able to reform labor markets further will likely enjoy stronger growth. At this time, however, there is little reform momentum as the economic situation is too benign to put any pressure on politicians.

There are also side effects of reforms especially within a currency union, like the Eurozone. If large countries do reform (like Germany in 2002) they can compete more efficiently and therefore benefit disproportionately from their improved competiveness as their currency takes time to adjust to the regained competitiveness. Vice versa, other countries suffer higher unemployment rates.

Another side effect is the loss of bargaining power of labor versus capital. The proportion of GDP going to labor has been shrinking in the past decades.

Cyclical weaknessThe short-run cyclical backdrop has been one of prolonged weakness and uncertainty. The trade war between the US and China has especially impacted Europe as its economy is much more exposed to trade than the US. Countries like Germany are an even more extreme case; it has flirted with a recession for a year now, due to weakness in the manufacturing sector.

This can be seen clearly from the Purchasing Managers’ Index (PMI), which indicates the state of the sector. The index has fallen across the world, however the fall has been especially pronounced in Germany. Partly this has also been the result of issues in the car manufacturing sector, which is challenged by emission standards and falling demand.

Manufacturing PMIs Global weakness in the manufacturing sector

of the Eurozone economy including disappointing inflation figures, resulted in a U-turn. In the ECB’s last meeting, Draghi announced the Bank’s intention to restart the APP and to lower rates further. The APP will continue at a pace of €20bln per month for “as long as necessary to reinforce the accommodative impact of our policy rates, and to end shortly before we start raising the key ECB interest rates”.

In our view, these measures are also aimed at preventing a (significant) widening of peripheral spreads to avoid a repeat of the Eurozone sovereign crisis. At the margin the measures could support lending further. However, as bank lending rates and market-based lending rates are already very low, we expect the effect to be very limited.

The measures do imply that any normalization of policy is pushed far ahead into the future.

OutlookThe outlook for the Eurozone depends, to a large extent, on a number of events, including a resolution to the trade war, Brexit and improved growth in China.

A benign scenario is possible if these risks don’t escalate. In that case, the pace of labor reformation will likely continue, which will keep supporting domestic demand. The investment side should, in this scenario, remain solid as extremely loose monetary policy and a return of business confidence should boost investments. We do think, however, that the best years are behind us as some parts of the economy are facing labor shortages, which makes it harder to grow at high rates. Moreover, the shrinkage of the labor force due to aging will increasingly reduce trend growth rates.

Then the Eurozone economy is especially vulnerable to a more negative outcome on the trade war or on Brexit, due to its openness. If these risks materialize, we believe exports and investments are likely to fall sharply. That said, the Eurozone economy is currently internally much more balanced than it used to be. Current account imbalances have been reduced. The major concerns are large negative investment positions in Spain and Portugal and a large government debt load in Italy. Also a lack of structural reforms is likely to keep growth low in Italy. A more negative scenario will therefore result in a tightening of financial conditions and therefore a sharper contraction in these countries.

Eurozone GDP composition Real GDP growth (in percent)

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-4%

-2%

0%

2%

4%

6%

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022





Whatever it takesThe ECB stopped its asset purchase programme (APP) at the end of 2018 and it was widely expected that the Central Bank would raise rates gradually. However, the weakness 80

90

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110

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03-2017 06-2017 09-2017 12-2017 03-2018 06-2018 09-2018 12-2018

GDP

Production

Construction

ServicesSource: Aegon Asset Management, OECD.



Source: Aegon Asset Management, Office of National Statistics.

0.6%

1.1%

1.1%

1.2%

1.4%

1.5%

1.5%

0.0% 0.5% 1.0% 1.5% 2.0%

IT

CA

JP

FR

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US

DE

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2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Personal consumptionGovernment consumptionPrivate dom. fixed investmentInventoriesNet exportsReal GDPReal GDP (negative scenario)

13

The ‘lost decade’ was a period of economic stagnation in Japan following the collapse of the Japanese asset price bubble in late 1991 and early 1992. The term originally referred to the years from 1991 to 2000, but more recently a second decade - from 2001 to 2010 - is often included so that the whole period is referred to as the ‘lost score’ or the ‘lost 20 years’. Given it broadly impacted the entire Japanese economy, Japanese policymakers are still dealing with its consequences today.

Japan

Low growth - in perspectiveAs mentioned, the Japanese economy is often linked to low growth and inflation. But has the performance of the Japanese economy really been that dire? Since the late 1980s the economy grew by approximately 1.4% annually on average, making it the second slowest level of growth among the G7 countries (only Italian growth was lower). It was also much lower than the expansion in the US, Canada and the UK, which all posted above 2% growth over the same period.

These numbers look poor at a first glance. However, the slow economic growth coincided with a slowdown of population growth, unlike any other country. Since the start of this century, Japan’s population declined, whilst the other G7 countries reported sizable population growth. Correcting for these effects, on a GDP-per-capita basis, Japanese growth was roughly similar to France and Canada. Even more impressive is the Japanese economic performance when corrected for working-age population decline. After all, the working-age population has declined by over 15% since 2000 – a function of the overall population decline and a fast aging population. In contrast, the UK, US and Canada all benefited from sizable working-age population growth. Japan ranks second-only to Germany on a GDP growth per person of working-age basis. It is ahead of the US and its ‘growth economy’. These comparisons reveal that growth in Japan, while not high on an absolute level, has been much more impressive than commonly believed, especially when taking into account the strongly adverse demographic developments.

GDP growth Compounded annual average Real GDP (in %)

GDP growth per capita Compounded annual average GDP per capita growth rate ( in %)

GDP growth per person of working age Compounded average annual GDP growth per person of working age (in %)

Large demographic differences among G7 countries Population growth in G7 counties (in %)

OutlookThe UK’s strategy to exit the EU, and the potential impact it will have on the UK economy, is still rife with uncertainty. We believe a so-called soft Brexit, whereby the EU and UK reach an orderly agreement, would be in the best interests of both the EU and the UK. Our positive scenario accounts for such a situation. In our positive scenario we expect the main trad-ing partners of the UK to perform well. As there are already signs of capacity constraints in some pockets of the economy, extending the cycle intensifies these capacity constraints. In this scenario we expect the BoE to counter these conditions, by tightening policy.

Our negative scenario foresees a slowdown in the UK economy, from both the exit from the EU and via a global slowdown. In such a scenario we expect the BoE to react swiftly by easing financial conditions. Also, we foresee the unemployment rate increasing from the current historical lows.

United Kingdom GDP composition Real GDP growth (in percent)

-6%

-4%

-2%

0%

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4%

6%

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022





0.9%

1.4%

1.8%

1.8%

2.1%

2.3%

2.6%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0%

IT

JP

FR

DE

UK

CA

US

0.9%

1.2%

1.4%

1.5%

1.5%

1.6%

1.7%

0.0% 0.5% 1.0% 1.5% 2.0%

IT

CA

FR

US

UK

JP

DE

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

CA US UK FR IT DE JP

Total population

Working population

The UK’s strategy to exit the EU, and the potential

impact it will have on the UK economy, is still rife

with uncertainty.



Source: Aegon Asset Management, IMF.

Note: Measured over period 1988-2018.

Source: Aegon Asset Management, IMF.

Note: Based on constant prices (2011). Measured over period 1988-2018.

Source: Aegon Asset Management, IMF, World Bank.

Note: Working age population = 15 to 64 yaars old. Measured over period 1988-2018.

Source: Aegon Asset Management, IMF, World Bank.

Note: Working age population = 15 to 64 years old. Measured over period 1988-2018.

1514

One of the ways the Japanese economy was able to (partly) defy the negative demographic factors was via productivity gains. Across the developed world, productivity growth has been low. But Japan stands out as a positive exception. Labor productivity in Japan has remained decent, outpacing most other developed markets. Economists cannot agree on why this is the case. One plausible explanation is the tight labor market and shrinking labor force, which have made investments in labor-replacing technology more important. Japanese companies have indeed been at the cutting edge of developments in robotics and artificial intelligence. Because the Japanese labor market is likely to remain tight, we expect this process of prioritizing investments in labor-replacing technology will remain and productivity growth will continue to support economic growth.

Labor market and inflation Overall, Japan’s labor force is very likely to continue to decline due to aging. Japan has, however, implemented several policies to stem the decline. For instance, women have been encouraged to join the labor force by offering them certain incentives. That strategy seems to be working, as female participation has been growing strongly already. The government is also trying to discourage the practice of Japanese employees working excess overtime, as this overtime tends to be fairly unproductive and this custom is another limitation for people wanting to raise children. Also, it has become easier for foreigners to apply for work permits, resulting in a small but positive influx of foreign labor.

Labor market measures to defy demographics are paying off Labor force participation rates (as % of working age population)

Fiscal and monetary policy remain supportiveJapan has a very high gross public debt level of over 200% of GDP. However, Japanese government institutions also invest in government bonds and related assets. The net debt level, which currently stands at 145% of GDP, is therefore a better measure. The government tries to address the debt issue by raising taxes. For example, VAT was hiked this year in order to structurally improve the fiscal position. The VAT hike will likely result in a mild slowdown from current growth levels. The demographics effects do have important implications for the government finances. While growth might have been relatively strong, it is still low (along with inflation) on a nominal basis. Low nominal growth and inflation, in combination with a declining and aging population, are deteriorating the sustainability of the debt position. After all, the high debt level is to be divided over a smaller number of (working) people. In recent years these effects have been dampened by the low interest rates – which have reduced the debt servicing costs. The low interest rates fit into an environment where the Bank of Japan (BoJ) has eased the monetary policy to record low levels, via negative policy rates, yield curve targeting and excessive asset buying programs. The BoJ will likely need to keep policy very accommodative as inflation is still far below the target of 2% and the central bank will likely tolerate higher inflation to make sure it becomes self-sustaining.

OutlookJapan has had an extended period of above-trend economic growth. On the policy front, six years of ‘Abenomics’ saw strong labor market developments, higher female labor force participation and lower fiscal deficits. However, inflation has remained stubbornly low, and challenges are set to remain as present demographic headwinds intensify. In general, we expect monetary policy to remain supportive in the short and medium term, and the Abenomics policy to be continued. In our positive scenario we foresee decent per-capita economic growth in Japan, with some temporarily adverse effects because of this year’s VAT hike. In the negative scenario we expect a slowdown of the Japanese economy, comparable to the negative scenario for other advanced economies. As Japan is a relatively open economy, major changes in the global economy would have a significant impact on the country.

Japan GDP composition Real GDP growth (in %)

39%

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Males (l-axis) Females (r-axis)

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As Japan is a relatively open economy, major changes in

the global economy would have a significant impact

on the country.

Source: Ministry of Internal Affairs and Communications of Japan.



16

Emerging Markets In this uncertain environment, we believe differentiating between emerging

market countries regarding their fundamentals will be critical for investors.

Faced by these uncertainties, central banks around the world are

providing a life line.

The global economic environment is becoming more challenging for emerging markets. The major industrialized economies and many major emerging economies are cooling down. At the same time, the two biggest national economies in the world - the US and China - are engaged in a trade war. Added to these concerns are several geopolitical events as well as idiosyncratic issues, which cast further clouds over emerging markets. In this uncertain environment, we believe differentiating between emerging market countries regarding their fundamentals will be critical for investors. Faced by these uncertainties, central banks around the world are providing a lifeline.

Easing economic growth while monetary policy becomes very active As mentioned in our other regional reviews, we expect economic growth in developed markets to slow in the coming period. This should dampen import demand, affecting the economic outlook for emerging markets. Countries in South-East Asia seem to be particularly exposed. First, these economies will, like other emerging market regions, be negatively affected by the ongoing global economic slowdown. More importantly, China is a regional growth engine in Asia and many economies in the region are quite integrated in the Chinese manufacturing supply-chain. Countries in Central-Eastern Europe also have challenges ahead because of their trade links with the developed countries in Europe, many of them being integrated in the German manufacturing supply-chain.

The picture is less uniform in Latin America with, for example, Mexico appearing to be the most exposed to disruption in global manufacturing. Question marks over the policy intentions of Mexico’s president Andrés Manuel López Obrador (AMLO) are also a challenge, not only to the economic outlook but also to investors. The situation in the region is also complicated by the developments in Argentina, given the upcoming presidential election on 27 October and a populist candidate leading the race. This has already led to the government extending the maturity on parts of its sovereign debt, which is effectively a default. In general terms, small and trade-dependent emerging economies will likely be disproportionately affected by a slowdown in global growth.

The monetary authorities in developed and emerging economies are actively trying to address these concerns through accommodative monetary policy. So far this year, there have been around 32 rate cuts globally and, judging by what is priced-in for the coming 12 months, we are not even half way through. The monetary easing by the world’s two biggest central banks, the ECB and the Fed (helped by the absence of inflation danger), will play a decisive role on a global level. In emerging economies such as South East Asia and Central Eastern Europe, inflation is not a problem. In other emerging economies, such as Turkey, inflation has receded after a shock, while in Russia fears of currency depreciation have receded as the threat of potential sanctions decline. All of these developments are providing the rationale in the current

environment to cut policy rates significantly. China is another case in point. The reserve ratio requirement has been cut by a cumulative 250 basis points since the start of 2018. Given the challenges the Chinese economy is facing and the statements by policy makers following the State Council Meeting at the beginning of September, more cuts in the reserve ratio requirement seem to be on the cards.

Fiscal policyNaturally, these developments within monetary policy beg the question: what will governments do in terms of fiscal policy? Starting with the obvious statement that the space to implement fiscal stimulus is not uniform across regions or even between countries within a region, we judge that governments will be a bit more cautious compared to monetary authorities (i.e. central banks). The rationale behind this view is the deterioration of emerging market credit and the fact that government finances, and in general debt accumulation, are an important pillar of risk assessment for the rating agencies. The value of hard currency bonds on a negative credit watch with one of the three major rating agencies has surged to US $87 billion lately. High yield creditors in particular (US $72.7 billion) are on a negative watch.

In China, the government is indeed stimulating the economy and has done so since last year. Though compared to previous periods of fiscal spending this time around the stimulus is visibly more measured, encompassing mainly large-scale cuts to taxes and fees but less infrastructure spending. In other words, the government seems more committed to directly targeting the income of households and corporates. In July, India’s government presented its budget for the fiscal year 2019-2020, which runs from April to April. The buzz word here seems to be cautiousness. The targeted fiscal deficit is 3.3%, down from 3.6%. The authorities seem to betting on stimulating the economy by further opening up sectors such as insurance and retail to foreign direct investment. In Brazil, a combination of an already high budget deficit and increasing levels of public debt is considered to be the Achilles heel of the economy, which does not allow much room to increase spending. In this respect, the reform of the pension system is very important as it would lead to significant savings. Despite signals from Russian policymakers that they will look to stimulate the sluggish growth in the country, the current fiscal stance remains quite orthodox.

Trade war and China“An immediate need is to reduce policy-related uncertainty by arresting the slide towards protectionism and reinforcing the global rules-based international trade system through multilateral dialogue”.

This sentence from the OECD Economic Outlook publication from November 2018 summarizes perfectly the global setting after president Trump unleashed a trade war. The trade disputes essentially started in January last year when the US imposed safeguard tariffs on washing machines and solar cell imports. While the US does not import much of these goods from China, the accompanying statement made it clear that the US was concerned about the Chinese dominance in the global supply chain. This action immediately led to a counteraction at the beginning of February by China, which started a one-year anti-subsidy investigation into sorghum imported from the US. During the rest of 2018 this ‘tit-for-tat’ policy between the US and China escalated. Even an agreed ‘ceasefire’ for 90 days at the beginning of December last year did not bring the much-desired resolution between the countries. As a result, the 'tit-for-tat' has continued this year. The latest hopes are for the trade talks to resume in October.

Needless to say, this ongoing trade war is not positive for China. At the end of last year the Chinese authorities lowered their forecast for economic growth in 2019 to somewhere between 6.0% and 6.5% (average economic growth in the first half was 6.3%). The official forecast for 2018 was a growth rate around 6.5% (it was 6.6%). On a more structural note, the Chinese economy is re-balancing away from the investment and export-led growth model to a consumption-driven growth model. This basically means that China is lowering the share of investments in its economy. And no wonder; the return on these investments is getting incrementally lower. Maintaining an investment quota which is too high will result in spare capacity and financial instability. China is lowering this investment quota through various means, including more restrictive bank lending.

18 19

Creative destruction always produces winners and losers in the

short term, which leads to discontent.

Chapter 2Thematic articles

Schumpeter, an Austrian economist, introduced the concept of ‘creative destruction’ in economics. This is the process in which new industries are created and old industries are destroyed. In theory, this should lead to higher prosperity as new industries prove more efficient in producing the same or better goods. It is sometimes argued, however, that creative destruction is no longer as powerful because productivity gains are relatively low. We believe the process is alive and well, and remains a key driver for markets.

Don’t be a LudditeThe Luddites were an organization of textile workers in 19th century England who opposed the introduction of textile machinery. They believed the new technology was a threat to their livelihood and so they proceeded to destroy textile machines in the hope of stopping the process of creative destruction. Since then, the term ‘Luddite’ has been associated with people who try to delay the pace of innovation.

Creative destruction always produces winners and losers in the short term, which leads to discontent. It helps explain the rise of populist parties today. Currently, the fear of jobs disappearing due to ‘robotization’ is deeply entrenched. But it’s worth pointing out that countries with a high level of robotization generally tend to have high levels of prosperity and low levels of unemployment. Policy should be directed, therefore, to encourage innovation and to distribute this prosperity in a fair way.

Countries with a high level of robotization have a high level of GDP and ...

Creative destruction: A driving force behind investment returns

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Being a Luddite and weaving your clothing by hand, would clearly not have resulted in the same prosperity as we enjoy today. The same applies to the investment implications – investment Luddite’s will likely experience disappointing returns.

Source: Aegon Asset Management, IFR, OECD.

Source: Aegon Asset Management, Bloomberg, IFR.

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Investment implicationInnovation is all around us, but how do we approach it in terms of potential investment implications? As Danish physicist Niels Bohr pointed out: “It is very hard to predict, especially if it’s about the future”. This is especially true for grand visions on future technological advances and the expected impact on markets. We will therefore limit ourselves to a number of technological changes which are already happening or are expected to take place in the near future.

1. Online shoppingThe chart below shows the growth in online retail sales as a percentage of total sales in the US. This has risen from 3% ten years ago to 10% now, and is expected to increase further. Amazon has been one of the beneficiaries; it is now responsible for around 50% of online retail sales in the US. Large ‘high street’ chains like Macy’s and Sears are struggling as a result. Macy’s has closed hundreds of shops and lost half of its market value in the past five years, while Sears filed for bankruptcy in October 2018.

Implications of online shopping

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Did you know that the average Greek works more hours per year than an average German? And did you know the average French worker produces in one hour more than 30% as much as their Japanese counterpart? The average Korean, meanwhile, has a particularly bad deal; they work 25% more than the average US citizen, but have a 35% lower GDP per capita, which means they are only half as productive.

GDP differences explained: About laborious Greeks and efficient French people

We all have common prejudices about the productivity of various countries. Often, these are based on economy-wide GDP growth. But sometimes these figures are not an accurate reflection of the growth or strength of an economy. Deconstructing GDP figures into their various component parts can therefore give some interesting insight.

GDP growth is reported at a ‘total economy’ level. Dividing this figure by the total population, we get the GDP per capita. This again can be further deconstructed into the GDP that is produced in one hour of work and the total hours worked per capita. The chart below shows these measures compared to the level of the US economy.

Percentage difference with the US levels (in %)

Labor utilization is especially high in Korea and Japan. In Japan this is even more impressive as the society has a high proportion of pensioners. Despite that, hours worked per capita is 10% higher than in the much younger US population. In Korea this is even 26% higher, as Korean workers work 15% more hours compared to a US worker and the participation in the labor force is higher. Unfortunately, productivity is a remarkable 50% lower, resulting in a GDP per capita which is still 35% lower despite the many hours spend at work.

Taking a closer look at the GDP per hour worked during the past two decades yields some other observations.

GDP per hour worked (in USD)

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GDP per hour worked Labour utilisation GDP per capita


The chart above highlights a number of interesting observations. For example, the GDP per hour worked in Germany, Switzerland, the Netherlands and France is only slightly less than in the US, as shown by the blue bars. The GDP per capita (dark blue bars) is, however, significantly different. In all these countries, this is mainly due to difference in the number of hours worked (blue bars).

So what does this imply? Working more will, all else being equal, result in a higher GDP per capita. The amount of hours worked in any society is partly a result of different preferences and partly a result of economic and societal incentives. For instance, European countries have more generous welfare systems. As a result, labor utilization is generally lower. A side effect of this system is that GDP per hour worked is a bit higher as lower-skilled labor is not utilized, which increases the remaining average.

30

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France Germany The Netherland

United Kingdom United States Italy


What stands out is the general upwards trend in GDP per hour, due to improvements in productivity. Most countries have had more or less the same pace of innovation. Also, the level and trend of GDP per hour worked in Germany and France is almost exactly the same since the financial of crisis of 2008. The economy of France did lag the German economy, which is a result of its inability to create as many jobs. It seems France has less of a productivity problem, but more a problem of being too rigid to create more jobs. Italy historically had a level of GDP per hour worked that was similar to other European countries, but it has lagged by a wide margin in the past two decades. Another laggard on this measure is the UK economy, which has created more jobs, but where productivity gains and growth in GDP per hour has been non-existent.

These different trends, point to different policy implications. For those lagging in productivity, the focus should be more on investment in human and physical capital. For those lagging in job creation a better fix would be to focus on removing labor market rigidities and improving entrepreneurship.

The rise of online shopping is having profoundly disruptive effects on several sectors. Landlords and REITS that own shopping malls have experienced rent reductions and tenant defaults. We expect the trend towards more online sales to keep increasing far beyond its current level. Extreme caution is therefore warranted when investing in the sectors that are being disrupted.

2. 5G

Maximum speed of cellular network technology standards

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A new generation of cellular network technology is now being launched across the world. 5G brings a large increase in speed and decreased latency. In turn, this helps new innovations to emerge like driverless cars, IoT and numerous other innovations which we are still unfamiliar with. Suppliers of 5G equipment clearly stand to benefit. Also, the demand for datacenters and equipment is likely to increase to accommodate the expected sharp rise in data usage. Phone makers will also benefit as few devices are currently enabled to support 5G.

In contrast, the losers from the move to 5G might include cable companies, given the speed of 5G can compete with the WiFi standard, removing the need for a separate cable subscription. You might expect telcos to benefit, however the large investment needed in equipment and spectrum reduces the potential upside.

3. Driverless carsThe potential economic gains from driverless cars are very large; less time spent in traffic, a more efficient use of cars and roads, and significantly lower travel costs. It is highly uncertain when mass-market driverless cars will be available, but some companies have already achieved impressive results. While information on performance is relatively scarce, the data below shows the number of miles driven on average without any human intervention. Two conclusions can be drawn from the chart. Firstly, the head start of Waymo - a division of Alphabet (Google) – and, to a lesser extent, GM Cruise is very large compared to all other companies. Secondly, the pace of innovation is also very quick; Waymo managed to increase the number of miles driven without disengagement by a factor of four times.

Average miles driven between human interventions (disengagements) for car companies in California

Those who are first to develop a near autonomous car will benefit from strong demand and higher prices, while advantages of scale will further increase the first mover advantage. Those who lose out are likely to be traditional car companies, which have to buy-in this expensive technology from IT companies or are forced to invest heavily to catch-up.

ConclusionInnovation is all around us. New companies and new technologies will keep challenging existing business models. Investors therefore always need to challenge themselves on whether their holdings are positioned to benefit or at least survive.

Source: Aegon Asset Management, Bloomberg, US sensus bureau.

Source: Aegon Asset Management, Bloomberg.

Source: Aegon Asset Management, State of California - Department of Motor Vehicles

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The global listed real estate sector has the wind in its sails. It has benefited from lower interest rates and has been relatively immune to the trade war, given its domestically-focused nature. But there are risks to this sanguine environment, such as a potential sell-off driven by credit markets.

Listed real estate: Wind in the sails

Central bank support makes this, in our view, less likely. Real estate should, therefore, remain an attractive asset class going forward.

Global listed real estate - commonly in the form of tax transparent vehicles called REITs - earned its own separate category within the MSCI and S&P indices roughly three years ago. The sector had matured and was recognized as offering differentiating exposure to stable, recurring real estate income. The sector continued to prove its worth over the last 12 months performing better than equity markets while having a lower level of volatility and lower drawdowns. The relative outperformance versus world equities is justified in our view and could well continue given the relative quality income profile of the sector and the lack of overall global credit concerns (despite the slowdown).

Being a capital intensive industry, credit is the ‘Achilles heel’ of the real estate sector. But a freeze-up of credit (as we saw in the credit crisis) seems unlikely as central banks are offering unprecedented support to both rates and credit markets. Meanwhile, the global listed real estate sector has limited its exposure to credit risk by improving debt ratios, improvements in liquidity management, diversification of financing sources and more emphasis on longer-term financing. As an additional positive, the supply of space in real estate markets overall has been much better managed.

Real Estate Outperformance Total return index for global equities and listed real estate (2005 = 100)

Taking away (or at least reducing) the risk from credit means the sector is better positioned to do well in a global economic slowdown due to its income resilience. This resilience was also evident during the economic contraction of 2009/10; the decline in operating income (EBITDA) for the global listed real estate sector (FTSE/Epra Developed) was much less than for world equity markets (MSCI World). The 2009/10 listed real estate correction was thereby mainly led by credit concerns. A (similar) strong negative feedback loop into the real estate financing market from a potential, present-day economic slowdown is not our central view.

Japan as an example of earnings resilienceJapan’s J-REITs are the most extreme example of revenue stability within global listed real estate. This stability is reflected in the sector’s significant revenue resilience versus general equity markets (see graphs below).

Global REITs: Net Debt to EBITDA ratio

Japanese institutional investors have piled into the J-REITs market to capture this earnings stability. The catalyst for this move is investors’ increasing concerns about a potential economic slowdown due to the ongoing trade war and an upcoming VAT increase. Pushed by this demand, the J-REITs sector posted double-digit returns over the past 12 months, while the Japanese general equity market (Topix) has declined over the same period. Institutional demand was strong enough for the Bank of Japan to lower its J-REITs acquisition volume substantially below its annual budget.

ValuationsThe current valuation of the global listed REITs sector is slightly elevated, which partially reflects its strength derived from the secure income profile. The EBITDA yield of global listed real estate versus global investment grade credit is modest compared to historical averages. The relative valuation versus equities looks better.

Relative valuation listed real estate EBITDA spread listed real estate -/- IG credit rate world (PPts)

Earnings resilience Change in EBITDA (12-month trailing)

Conclusion

The current environment combined with the relatively stable earnings profile of the global listed REITs sector still allows for positive performance overall in our view. Our investment strategy will continue to focus on adding value via stock selection and picking quality income, combined with a credible and decent growth profile. This strategy should yield market winners in any macro scenario in our view.

Relative valuation listed real estate EBITDA spread listed real estate -/- equities world (PPts)

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24 25

In recent years investors have focused on the search for yield in an environment of extremely low interest rates. They address this challenge by constructing, for example, riskier portfolios with more equities or higher risk bonds than core government bonds. Another popular approach is to invest more in alternative asset classes. These investments promise a higher return but at a cost; alternative assets such as private equity and infrastructure debt are typically less liquid for example.

Alternative Risk Premia

Achieving additional returns can also be generated via so-called ‘Alternative Risk Premia’ (ARP). Traditionally, a risk premium is defined as the difference in return between a risky investment, such as high yield bonds, and a risk-free investment such as core Eurozone bonds or US Treasuries. A short overview of ARP is provided below:

The potential return sources for an investment fund

ARP and other risk factorsARP is, of course, only one of a number of risk factors that can add value to a portfolio. Modern Portfolio Theory, which was developed by Nobel Prize winner Harry Markowitz, states that investors will receive extra compensation for market-wide, systematic risks taken, such as equity market risk or credit risk. These systematic risk factors traditionally are called the ‘beta’ of the market. How does it work? Imagine that your portfolio has a ‘beta of 1.5’ towards equity markets. This means that your portfolio will, in theory, go up more on average than the equity market on good days, but likewise will decline more than the market on negative days.

Another common risk factor is specific risk (also known as idiosyncratic risk). A portfolio manager can add value if they correctly identify good idiosyncratic risk opportunities. Typically, this means they will actively deviate from benchmark weightings to capture the differences between securities, sectors or regional markets. Generating additional returns in this way is commonly known as ‘alpha’.

Beta, therefore, is the generic risk within a market while alpha is the additional return an active manager generates through identifying appropriate idiosyncratic risk opportunities. In a diversified portfolio much of the risk around idiosyncratic opportunities can be offset through the benefits of diversification. Where does ARP fit into this dynamic?

An alternative risk premium provides an investor with an additional source of return through certain systematic and intrinsic market qualities that have a clear and well-understood economic rationale. These qualities include behavioral aspects of market participants or natural supply and demand forces within markets. Four of the most common and most studied factors are carry, momentum, value and volatility. The volatility premium, for example, reflects the general willingness of market participants to pay a premium in order to be protected from certain risks or market declines. The premium may involve buying ‘put options’ for example. Consequently, by being the provider of such option protection, an investor can harvest this volatility premium. Effectively, this is what the insurance industry does; taking over risks from clients against a certain premium.

Alternative risk premia can be found in numerous asset classes, such as equities, fixed income, currencies and commodities. These risk premia can relate to carry, momentum, value and volatility strategies. Investors can analyze the individual premia in isolation, but they can also analyze them together to check whether diversification benefits can be achieved.

Overall, numerous reasons exist for investors to consider Alternative Risk Premia. Top among those reasons is the tendency for ARP to have a low correlation with traditional investments. Moreover, many ARP can be harvested via liquid financial instruments, ensuring that, unlike more traditional alternative investments, the investments are liquid. Their relative affordability and transparency are seen as positives.

Total return

Risk-free rate

Traditional risk Premia (Beta)

Alternative risk premia

Alpha

Volatilities, correlations and tail risk: More than two momentsFinancial markets and risksThe behavior of financial markets tends to be dictated by a number of specific characteristics. These include, but are not limited to, expected return and risk.

These characteristics are usually linked and cannot be analyzed in isolation from one another. As an example, classical financial theory stipulates that higher risk is associated with higher return. This can be easily verified empirically. Indeed historically, long-only equity investments have outperformed bond investments on average (given that equities are riskier than bonds).

Based on this observation, it is clear that risk analysis has to take center stage in any long-term scenario-based study.

At Aegon Asset Management, we spend a lot of time examining current and future risks and how these translate to observable and tangible measures.

Quantifying risks in financial markets and the mean-variance frameworkInvestors recognize that numerous risks arise from being active in financial markets (market risk, counter-party risk, operational risk, etc.). In this article, we start by focusing on market risk, given it is one of the most important risks investors need to monitor continuously.

Market risk can be defined as the possibility that an outcome will not be as expected, specifically in reference to returns on an investment. Economic developments as well as other influences such as political uncertainty can contribute to unexpected outcomes and investors have to monitor these very closely.

Usually, volatility and correlation are considered to be the main metrics quantifying risk in financial markets. This is the case for a number of reasons including:

• Volatility and correlation estimations attempt to quantify the magnitude of movements of a given set of financial assets on a standalone basis as well as in relation to each other.

• Volatility and correlation metrics are directly observable within markets.

• They are relatively easy to estimate and the different methods to do so are well documented and widely available.

Forecasting volatilities and correlations is one of the most important steps in our long-term scenario analysis as they are significant inputs to our ‘mean-variance framework’. A traditional mean-variance framework includes estimating future returns for a given investment universe as well as risk measures (volatilities and correlations). The following figure shows the importance of estimating volatilities and correlations in a general mean-variance framework.

Mean-variance framework

Source: Aegon Asset Management.

Mean-variance optimal portfolio

Investment universe

Expected returns

Constraints

Volatilities Correlations

Risk forecasts

Financial asset returns can be specified by a ‘probability density function’. These functions can take all kinds of shapes and sizes, and typically have to be estimated using past returns. These functions tend to be complex and are therefore split into their so-called ‘moments’. Each subsequent moment specifies the probability density function in more detail. Often, mean variance uses only the first (expected returns) and second (volatilities and correlations) moments. However, while controlling the location and the width of the expected distribution of returns, these metrics fail to capture another very important source of risk. This other risk can be defined as the third (skewness) and fourth (kurtosis) elements of the distribution function.

Higher-order moments are sometimes specified as tail risks. Tail risks and second moments are two different topics and should be studied separately. Both concepts are important and neither can be overlooked. Failing to address either second moments and/or tail risks may result in undesirable investment outcomes.


26

Tail risk and the limits of diversificationLet’s first define tail risk.

Tail risk can be defined as the existence of ‘negative jumps’ in the dynamics of financial assets. These jumps have been widely discussed and documented in academic research1. A good example is the returns observed in most markets during the global financial crisis of 2008.

One important feature of negative jumps is that they contribute to the negative skewness of the distribution of returns2. Typically, a skewness significantly different from zero means that a given distribution is not symmetrical and if the measure is negative then this results in the relatively high likelihood of severe negative outcomes. Whereas (excess) kurtosis quantifies the extent to which a distribution has fat tails. While estimating volatilities and correlations, investors intentionally exclude skewness and kurtosis analysis. This is due to the relative complexity of estimating, for instance, the skewness and co-skewness of financial assets and including these metrics in an asset allocation framework.

In not quantifying other moments (skewness, kurtosis) a strong assumption is made about the distribution of returns; normality. If an investor analyses a portfolio assuming a normal return distribution, in 2008 they would have experienced a scenario that is supposed to happen once every approx. 5500 years. Normal distributions have certain characteristics - namely symmetry and “thin” tails - that do not necessarily model financial markets adequately.

Let’s see whether this theoretical consideration can be empirically observed by looking at the historical distributions of returns for a number of asset classes. Table 1 summarizes the main statistics of the asset classes that are relevant to institutional investors.

The table shows quite clearly that most asset classes have a return distribution that is skewed (negative skew) and / or with fat tails (positive kurtosis). As we highlighted previously, negative and positive skewness increases the likelihood of tail events and presumably the magnitude of investors' losses.

Table 2 compares the historical extreme losses observed on the financial assets with the same losses, had the return distribution been actually normal.

In the overview above, the “Global Treasury Bonds” asset class seems to be an exception as the time series we looked at exhibits almost no skewness, negative (excess) kurtosis and a Value at Risk (VaR) lower than that of a normal distribution. Yields globally have been dropping since the 80s and this contributed to the continuous outperformance of bonds and this have also impacted the return distribution of the asset class. Taking a longer historical time period including more rate cycles might give different results.

Looking at the other asset classes, we can conclude with

confidence that investors are at risk of underestimating extreme losses if they assume normality of returns.

As seen previously, the high VaR relative to a more traditional return model can be explained by negative jumps of numerous financial assets. Negative jumps are very difficult to diversify since investors need to find an asset that “jumps” positively at the exact same time. This observation makes diversification difficult or at least “less easy” than widely accepted. Indeed, diversification in its traditional form consists in expanding the investment universe. In doing so, one can expect the following:

• Lower volatility• Lower drawdown (in absolute value)

However, the value of the drawdown may seem high compared to its realized volatility due to the fact that finding assets that would fully offset negative jumps is virtually impossible. This can be easily verified empirically by constructing diversified portfolios and comparing the reduction of volatility with the impact on the other moments.

We conduct an analysis based on the investment universe above and we analyze the historical performance of a diversified portfolio containing 30% equities, 50% bonds, 10% hedge funds and 10% commodities.

The diversified portfolio has some interesting features. As expected, the realized volatility of the diversified portfolio is relatively low for an attractive average return compared to an equity-only portfolio. The skewness of the portfolio, however, is still significantly negative and the excess kurtosis positive. We can conclude that diversifying the portfolio through adding more asset classes reduced volatility but didn’t reduce the likelihood of severe negative outcomes.

Final note: Tail risks should be taken into accountAs a final note we may conclude that the presence of skewness and kurtosis risk (which is not always the case) makes risk analysis more important for investors as they need to take into account moments within the return distribution that are higher than just returns and (co-)variance. By monitoring the full distribution of possible outcomes and thus rejecting normality, investors reduce the risk of unpleasant scenarios. Or at least, don’t get caught off-guard.

1. Johnson, James A and Cunha Medeiros, Marcelo and Paye, Bradley S., Jumps in Stock Prices: New Insights from Old Data (May 31, 2019). Available at SSRN: https://ssrn.com/abstract=32260132. Lezmi, Edmond and Malongo, Hassan and Roncalli, Thierry and Sobotka, R, Portfolio Allocation with Skewness Risk: A Practical Guide (June 22, 2018). Available at SSRN: https://ssrn.com/abstract=3201319

Table 1Average yearly

returnAnnulaized

volatility Skewness Kurtosis 1st percentile99th

percentile

Global Equities (EUR, unhedged) 3.7% 18.5% -1.10 0.59 -45.8% 31.1%

Global Treasury Bonds (EUR, hedged) 4.6% 3.9% 0.05 -0.73 -3.3% 12.6%

Global High Yield Corporate Bonds (EUR, hedged) 7.4% 12.1% 0.11 3.69 -32.3% 44.9%

Hedge Funds (EUR, hedged) -1.6% 7.8% -1.58 3.27 -25.3% 12.9%

Commodities (EUR, unhedged) 2.1% 14.9% -0.73 1.22 -46.2% 25.3%

Table 2 Historical CVaR at 99% Theoretical "Normal" VaR at 99%

Global Equities (EUR, unhedged) -47.7% -39.4%

Global Treasury Bonds (EUR, hedged) -3.6% -4.4%

Global High Yield Corporate Bonds (EUR, hedged) -35.1% -20.7%

Hedge Funds (EUR, hedged) -25.8% -19.6%

Commodities (EUR, unhedged) -50.2% -32.5%

Table 3Average yearly

returnAnnulaized

volatility Skewness Kurtosis

30% Equities + 50% Bonds + 10% HFs + 10% Commodities 3.5% 6.6% -0.75 0.67

Data source: Aegon Asset Management, Bloomberg.

Note: Monthly datasets starting in 29/09/2000 and ending 31/12/2018. All figures are given yearly.

By monitoring the full distribution of possible

outcomes and thus rejecting normality, investors

reduce the risk of unpleasant scenarios.

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

FEDECBFED (negative scenario)ECB (negative scenario)

29

Chapter 3Expected returns

Expected returnsIn the following sections we present our returns forecasts for a range of asset classes for the period 2020 – 2023. These are the expected returns for our two scenarios – both the more positive baseline and a more negative scenarios have an assigned probability of 50% - as we judge these two scenarios to be equally likely to occur.

In general terms, we expect relatively low returns on fixed income assets as current yields are historically low – this is the case in both our positive and negative scenarios. Risk assets – such as equities – will clearly perform better in the positive scenario as these assets are more sensitive to the business cycle.

Government bondsEurope has been in an extraordinary monetary policy environment for quite some time. The ECB – similar to other central banks – lowered interest rates rapidly in 2009 to counter the adverse economic effects of the financial crisis. In 2012, the Eurozone crisis forced the ECB to state it would do “whatever it takes” to preserve the euro. Policy rates were subsequently lowered into negative territory and asset buying programmes were established in 2015. These extraordinary measures were taken in order to support economic activity, to improve inflation dynamics and to diminish the risk of a Eurozone breakup. Since those measures were implemented, the Eurozone economy has been performing fairly well. Economic growth has been around – or even above – potential growth, unemployment has decreased to below 2009 levels and measures of spare capacity have declined.

Despite this economic recovery, inflation pressures remained subdued, and the ECB has not seen an opportunity to normalize the extraordinary measures it previously implemented. More recently, the softening growth and fading inflation dynamics have resulted in increasingly dovish actions from central banks. The market now expects additional easing by the ECB in the near term, and so do we. We expect the ECB to ease policy further in 2019. Looking further ahead, our positive scenario takes very gradual normalization into account, accompanied by a moderate curve steepening. Our negative scenario foresees a more dovish ECB, reflected in lower policy rates in the coming years. Regardless of the scenario, we foresee very accommodative monetary policy in the Eurozone, as the ECB has limited room to increase rates significantly.

Monetary policy Central bank policy rates (in percent)

In general terms, we expect relatively low returns on fixed income assets

as current yields are historically low – this is the case in both our positive

and negative scenarios.

Source: Aegon Asset Management, ECB, Federal Reserve.

Note: 2019-2023 data based on expectations. 2019-2023 solid line reflect positive scenario, dashed line negative scenario.

0%

5%

10%

15%

20%

2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

Investment grade (positive scenario)Investment grade (negative scenario)High yield (positive scenario)High yield (negative scenario)

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Dutch mortgages

Investment grade bonds

German bunds

30 31

Germany Sovereign Yield Curve Nominal yields in positive scenario (in percent)

The Eurozone bond market is in a peculiar place. The extraordinary monetary policy in combination with slowing economic growth have driven yields on core Eurozone government bonds to record lows – deep into negative territory. For core Eurozone countries like Germany and the Netherlands, the full sovereign bond curve trades at negative yields - even bonds that mature over 30 years from now have a guaranteed negative return when held to maturity. Southern European bonds include a risk premium, but they still trade at very low yields. In summary, interest rates are very low, or indeed negative, for European government bonds, even in countries with higher perceived risks. This backdrop, in combination with our belief that interest rates have limited potential to rise in the short term, results in very low expected returns for European government bonds.

In the US the situation is somewhat different. The Federal Reserve has followed a normalization path, and increased the policy rate several times in the past few years. This year, it reversed course by lowering the policy rate. This rate cut is regarded as a so-called “insurance cut” to ensure the Fed is ahead of any real economic US slowdown. If the US economy shows more signs of slowing, the Federal Reserve is likely to react swiftly by lowering rates further. Given this reaction function to economic developments, there are major differences in our monetary policy expectations for the positive and negative scenarios. In the positive scenario, we expect the Fed to lower policy rates slightly by the end of 2021. In the years thereafter, we expect the Fed to reverse its easing course, increasing policy rates to 3% by the end of 2023. In our negative scenario, the policy rate is lowered quickly as a response to adverse economic conditions. The Federal Reserve has more room to lower interest rates than other major central banks, as the US rates have been normalized – to a certain extent – in previous years.

The Bank of England (BoE) faces a dilemma of its own. Where most central banks have to deal with below-target inflation levels, inflation in the UK has exceeded the BoE’s inflation target in recent months. To a large extent, this is caused by sterling weakening due to Brexit concerns. Although the initial effects of the sharp depreciation in the currency have faded, sterling has continued to weaken and it is likely that

inflation will remain above the BoE’s target for the time being. Simultaneously, the economy is showing signs of a slowdown, which is also related to uncertainty around Brexit. We believe that the BoE’s future actions will be very much a function of the Brexit developments. In the case of a no-deal Brexit we expect the BoE to ease policy and rates in the short-run. In the case of a comprehensive exit deal, there is some room for rates to move higher.

The Bank of Japan’s situation is roughly similar to the ECB’s. Price pressure in Japan remains very weak, despite efforts of the BoJ and the Japanese government to increase inflation. Regular market interventions by the BoJ and the yield curve control policy effectively sets the 10-year government yield at approximately 0%. This policy aims to support economic growth and restore inflation, but we do not expect the BoJ to significantly change its policy in the medium term.

Corporate bondsThe yield on corporate bonds has been hovering around record low levels as both government yields and credit spreads are low. Anecdotal evidence shows that earlier this year a number of euro-denominated high yield bonds were trading at negative yields, whilst a sizable share of the euro investment grade universe traded in the sub-zero territory.

The footprint of the ECB’s asset buying program can clearly be seen in the European corporate bonds market. The most obvious effect is the yield spread compression where spreads on almost all corporate bonds decreased since the initiation of the ECB’s buying program. The ECB began the Corporate Sector Purchase Programme (CSPP) in June 2016, buying between €5-6 billion every month up to the end of the program last year. In September 2019 the ECB decided to restart its asset purchase programme. At the time of writing, the ECB holds roughly €180 billion of corporate bonds, which is significant for a market with a total value of just over €2 trillion euros. Also, the market grew in size, as lower yields made it more beneficial for companies to issue debt at lower rates. The newly issued bonds typically had longer maturities, which allowed firms to lock-in the lower rates for a longer period. Lastly, a new investor base was attracted to the corporate bond market. Government bond investors, in an attempt to avoid investing in government bonds with negative yields, moved up the credit risk spectrum to high grade corporate bonds.

Credit spreads EUR corporate bond markets (in percent)

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

- 5 10 15 20 25 30

current 2020 2021 2022 2023

Apart from the ECB’s direct impact on the financial markets, the policy also has second-order effects. Low interest rates make it easier to meet debt payments and facilitate refinancing of debt, allowing corporates in distress more time for a turnaround. Evidence shows that the default rates for high yield investments have been low since the financial crisis. The number of BB-rated bond defaults has been zero in four out of nine years, and the BB default rate has only once risen above 0.3%. In the previous 29 years there have been only three years with no BB defaults, and the annual rate was more than 0.3% in 22 of those years. Yet, as we look at the market, average spreads have been identical in both the pre and the post-2004 periods, which means investors are now better rewarded for default risk. On the other hand, market liquidity concerns have become more present in recent years. Due to structural changes in the high yield market, there are fewer dealers holding less inventory. Also the dealers are managing their own books like portfolio managers and are less prone to take the other side of the trade anymore, should the market turn.

For the next few years, we anticipate that both credit spreads and the default cycle will loom large in our economic scenarios. In our positive scenario, we expect credit spreads to remain roughly flat over this period – supported by accommodative monetary policy measures and an extended economic cycle. In our negative scenario, we anticipate credit spreads to increase somewhat in combination with a pick-up in defaults. In our positive scenario, the risk premium over governments is relatively attractive on a risk-adjusted basis. If the negative scenario materializes, we expect central banks to support the corporate bonds market, partially limiting the negative effects for corporate bond investors. That is why we argue that the balance of risk for corporate bonds is slightly skewed to the positive side. Overall, we expect corporate credit to deliver a positive excess return over the next few years.

Dutch mortgagesWithin fixed income we expect Dutch mortgages to have an attractive risk-adjusted excess return.

Dutch mortgage rates remain very attractive in the current environment and we expect this will remain the case for the foreseeable future. Lately, mortgage spreads have become more attractive as government yields continued to decline at a faster pace than mortgage rates.

Moreover, the major Dutch banks are not able to expand their mortgage books due to regulatory and capital constraints. Many pension funds, insurance companies and foreign investors are actively sourcing mortgages, but this demand hasn’t been large enough to have a major impact on spreads. Dutch mortgage spreads are still materially higher compared to other Eurozone countries.

Dutch mortgages offer a large spread pickup 5 to 10 year yields (in percent)

Defaults have always been very low, averaging just a couple of basis points. Due to the strong labor market, partial state guarantees and house price growth, we expect this to remain the case.

Asset-backed securitiesWe expect European asset-backed securities (ABS) to deliver strong excess returns over government bonds. ABS investments have diversification effects that cannot be found in other fixed income investments. A typical multi-asset portfolio consists of two types of risks: risks related to governments, i.e. via government bond investments, and risks related to companies, i.e. via corporate bond or equity investments. Most ABS investments have exposure to consumer risk, in fact the bulk of European ABS consists of exposure to mortgages, auto loans, credit card receivables and student loans. As such, investing in ABS creates the opportunity to diversify your risk factors.

In keeping with other fixed income assets, the ECB footprint is also present in the ABS market. Although the ECB stopped purchasing ABS on a net basis, it remains a large investor in the European ABS market. It is important to note that the ECB made clear that it will reinvest the principal and interest payments and aim to keep the size of each program constant for the foreseeable future. Due to relatively large redemptions


Note: 2020-2023 data based on expectations.


Note: 2019-2023 data based on expectations.

Source: Aegon Asset Management, Bloomberg, ECB.

32 33

-6%-4%-2%0%2%4%6%8%

10%

Div

iden

d Yi

eld

Buyb

ack

Yiel

d

Real

Div

iden

dgr

owth

Infla

tion

Rera

ting

FX h

edge

cos

ts

Tota

l

Tota

l (ne

gativ

esc

enar

io)

0%

2%

4%

6%

8%

10%

12%

FFO

yie

ld

Real

FFO

gro

wth

Infla

tion

Cape

x

Rera

ting

FX h

edge

cos

ts

Tota

l

Tota

l (ne

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io)

in its ABS portfolio in the near future, we expect the demand from the ECB will be largely unchanged: approximately €700 million on a monthly basis.

Emerging market debtThe general story for emerging market debt is moderately positive, however there are very strong idiosyncratic risks that drive the performance of the asset class as a whole. In general, emerging market bonds benefit from the global search for yield, as the spread on emerging market bonds is attractive to international investors. At the same time, the lower yield makes it easier for EM countries to finance themselves through the international capital markets. Also, most EM countries are less vulnerable now than they were in the 1990s. Most countries no longer have fixed exchange rates, and their foreign exchange reserves are larger today.

At the same time, there are significant idiosyncratic risks. These risks can sometimes affect the asset class as a whole. A good example is the situation in Argentina, both on an economic and political level. Earlier in 2019, President Macri was trounced by the populist opposition in a nationwide primary vote, after his IMF-backed program - based around budget austerity - failed to pull the economy out of recession. Argentina's economy contracted by over 5% in the first quarter of 2019, after shrinking 2.5% in 2018. Furthermore, the troubled economy has one of the world's highest inflation rates, running at 22% during the first half of the year. Macri’s defeat in the primary elections cued a market rout that was spectacular even by Argentina’s standards of volatility. The peso slumped to a record low, and yields on government bonds surged. The country is now in the process of restructuring its debts, which basically implies a default on prior obligations.

Other emerging market countries also have their specific issues. Brazil faces a dire fiscal situation, and the Turkish economy still struggles with high inflation rates and slow growth. Credit spreads on EM debt markets are relatively high thanks to these issues. Overall, we maintain a neutral stance, viewing the current compensation for holding this asset class as fair in our opinion, given the potential risks.

EquitiesWorld equity markets have, on average, performed pretty well the last couple of years. Economic growth was robust, and central bank policy was supportive for financial assets in general. In the past year, however, equity volatility picked up again. Investor sentiment turned negative by the end of 2018 as the perceived risks of a recession increased and the US/China trade war intensified. In the first months of 2019 investor sentiment turned more positive, but volatility remained – mainly driven by political and central bank policy uncertainty.

To forecast equity returns, we split returns into various components. We start with the expected dividend yield and buyback yields. Dividends tend to be fairly stable and are therefore easier to forecast. Historically, dividends have been an important driver of total equity returns. Over the past 30 years, half of the asset class total returns were due to dividend payments. More recently, the importance of dividends has reduced, although they still have accounted for about 25% of the total S&P return in the past 5 years. Paying dividends, which most companies do, is one method of distributing capital to shareholders and typically ranges between 2 and 3% on index level. The other method is by buying back their own shares. These buybacks are more dependent on economic conditions. In the US, buybacks are more engrained in the corporate culture and have, at times, exceeded the amount paid in dividends. In Europe, buybacks have been less popular but have also increased in frequency. We expect dividends for world equities to yield just over 2% in the coming years, and buybacks to contribute just under 2% in total return terms. In addition, in our positive scenario we expect dividends to continue to grow in the future, thereby adding an estimated additional 2% to equity returns. In the negative scenario, we account for stable dividends.

Expected returns - World equities ACWI (FX hedged to EUR), average annual returns for 2020-2023

The most important factor (and also the most difficult to forecast) is the multiple that investors are willing to pay for equities. Currently, multiples are above their historical averages, but there are large differences among regions and sectors. Generally speaking, the US indices trade at higher multiples than other developed markets. This can partly be explained by the stronger presence of (higher valued) IT stocks in US indices. In our positive scenario, we expect valuations to slowly converge towards longer-term averages. In our negative scenario, we account for lower valuation multiples.

The final components of the return on equity markets investments are inflation and FX hedging costs. We expect an average global inflation rate of roughly 2% for the next four years. The hedging costs – to mitigate currency risks – are expected to contribute -2%, as interest rates in local equity markets are often higher than our Eurozone rates.

All-in-all, in our positive scenario we expect a mid-single digit return from equities over the next four years. This implies a decent outperformance versus fixed income, but a lower return than historical averages. In our negative scenario, higher risk assets – including equities – will struggle due to slower economic growth. For emerging markets, we foresee higher upside potential than for developed markets in our positive scenario, but also more downside potential in a negative scenario.

Real estateThe performance of global listed real estate has been resilient in 2019 to-date, posting a total return of +19% for the period from January to end August. Equity markets lagged in comparison, posting +14% for the same period. The listed real estate sector benefited from the global decline in interest rates but also showed strong earnings resilience versus earnings downgrades for equities. A region where this was especially evident was Japan. The Japanese REIT sector showed strong performance, benefiting from the relatively long leases and no development exposure, while Japanese equities sold-off on a weak earnings outlooks.

Regional performance for listed real estate has, like equities, been impacted by macro themes like Brexit, unrest in Hong Kong and the US/China trade dispute. This led to a relative outperformance of the US versus Asia Pacific and Europe. The e-commerce trend has continued to impact the sector, resulting in the largest divergence in performance between retail and logistic real estate companies since 2015.

Expected returns - Global real estate FTSE EPRA /NAREIT Global (FX hedged to EUR), average annual returns for 2020-2023

Going forward we expect the sector to continue to perform well relative to equities in an overall risk-off environment. In contrast, if global risk rebounded the sector would lag equities. Financing, oversupply and investment risks remain limited although occupancy demand for real estate could weaken. Valuation for listed real estate, however, remains attractive when looking at spreads versus corporate credits, while relative performance versus equities does not seem to fully price-in recent interest rate changes.

We expect values for physical real estate assets will peak-out in global markets during 2019. We therefore anticipate mid-single digit annual returns for listed real estate, with positive direct asset returns and management value-add offset by some softness in capital values. We will continue to screen for stocks that could benefit from broader macro/sector trends, pockets of growth and management teams that are able to add value in current market conditions.


Note: All data for positive scenario, except for Total (negative scenario).


Note: All data for positive scenario, except for Total (negative scenario).

Going forward we expect the sector to continue to perform well

relative to equities in an overall risk-off environment. In contrast,

if global risk rebounded the sector would lag equities.

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

Commodities

World listed real estate

World equities

Dutch mortgages

European ABS

Emerging market government bonds

USD high yield corporate bonds

EUR high yield corporate bonds

USD investment grade corporate bonds

EUR investment grade corporate bonds

Core Eurozone government bonds

34 35

Long term scenarios - expected returnsAverage annual returns for 2020-2023

The only sector that is really benefiting from the turmoil is precious metals. Gold serves as the traditional safe haven asset.

During the recent periods of market stress the demand for this real asset has increased again.

CommoditiesIn 2018 and early 2019 commodity prices experienced direct headwinds from increased geopolitical tensions. The tensions around global trade and conflict between the United States and China have casted a shadow over the commodity market. The combination of targeted tariffs and ongoing rhetoric hit metals and agriculture prices. The geopolitical tensions also further dampened the moderate global economic growth outlook, which also lowers demand forecasts for many commodities. These developments continuously put downward pressure on energy, industrial metals and agriculture prices.

The only sector that is really benefiting from the turmoil is precious metals. Gold serves as the traditional safe haven asset. During the recent periods of market stress the demand for this real asset has increased again. On top of that, US interest rates and the subsequent drop in real yields on US Treasuries supported the case for an inflation-linked asset like gold. This has been acting as a catalyst for price increases. The only scenario in which we see the gold price continue to drift higher is one where geopolitical tensions intensify and real yields drop to sub-zero levels.

Oil, which is the most volatile and most important commodity in our view, has not been able to withstand the impact of geopolitical events. Demand expectations have drifted lower. The supply-side dynamics have also been key for the crude oil market. Two parties are predominantly shaping the supply side: (1) OPEC and its oil production strategy and (2) US shale oil and its continued expansion in the past 10 years. OPEC has committed itself to balance the global oil market and has been running with production caps for its members to achieve that aim. Recently, they have been able to keep oil price moves contained. We expect this delicate balance to persist for a few years to come.

Our economic growth expectations have a mixed impact on commodity prices. In our baseline scenario, we expect global economic growth to moderate in 2020 and stabilize thereafter. Inflation will slowly creep up over the next four years. This will support demand growth and spark positive spot price momentum. Since most of the commodity index is traded in US dollars, depreciation of the dollar makes commodity prices cheaper in local currency terms. This in turn has a positive effect on commodity prices, since investing in commodities is typically not done by trading actual hard commodities but rather by transacting with financial derivatives. Investing in this manner involves a number of technical aspects, such as the so-called ‘roll yield of futures contracts’. Combining the return components brings us to an expected return for commodities hedged to euros of about 5% on average over the next four years.


Note: Expected average annual returns for 2020-2023. Bars show the range of expected returns for the negative and positive scenarios. Presented returns are in EUR. Foreign denominated assets hedged to EUR.

37

Our annual study of long-term scenarios is an important driver

of the Dynamic Strategic Asset Allocation (DSAA).

Chapter 4Asset allocation

We periodically adjust the asset allocation for a range of Aegon Asset Management funds and mandates in order to align it with our strategic market views and return expectations. Our annual study of long-term scenarios – of which the most important features are presented in this publication – are an important driver of the Dynamic Strategic Asset Allocation (DSAA), which we implement across several mandates. This process combines our return expectations, volatilities and correlations for a large number of asset classes to determine the optimal allocation for every mandate. Within this process, we consider a range of scenarios to ensure robust portfolios are constructed that can weather various market conditions.

To illustrate the impact of the 2019 DSAA process, we present the deviations from the benchmark of a typical multi-asset portfolio that invests 65% in fixed income assets and 35% in equity investments. This is detailed in the chart below.

Within the fixed income categories, we have a significant underweight in core Eurozone bonds and an overweight in Dutch mortgages. We also have a small overweight in Asset Backed Securities and in the high yield categories. There are no deviations from the benchmark weightings for European investment grade credits and Emerging Market debt. The long-term scenario study did not reveal any significant mispricing across equity categories. As such, there are no deviations from benchmark weights for equity categories.

Asset Allocation

Asset allocation 2019Deviations from the benchmark weights (in percent)


Note: Based on model portfolio (SAF Fixed Income 65% - SAF Equity 35%).

-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

Commodities

Listed real estate

World equities

European ABS

Emerging market debt

United States high yield

European high yield

Dutch mortgages

European investment grade credits

Eurozone government bonds

38 39

AbbreviationsCentral banks and economic institutionsBIS Bank for International SettlementsBOE Bank of EnglandBOJ Bank of JapanECB European Central BankFed Federal ReserveIMF International Monetary FundNBER National Bureau of Economic ResearchOECD Organisation for Economic Co-operation and DevelopmentPBoC Peoples Bank of China

Countries and RegionsAU AustraliaBE BelgiumBR BrazilCN Peoples Republic of ChinaDE GermanyEM Emerging marketsEMU European Monetary UnionES SpainEU European UnionFI FinlandFR FranceGR GreeceHK Hong KongIE IrelandIN IndiaIT ItalyJP JapanKR South-KoreaLU LuxembourgLV LatviaMX MexicoNL NetherlandsRU RussiaTW TaiwanUK United KingdomUS United StatesZA South Africa

Eurozone countries include Austria (1999), Belgium (1999), Cyprus (2008), Estonia (2011), Finland (1999), France (1999), Germany (1999), Greece (2001), Ireland (1999), Italy (1999), Latvia (2014), Lithuania (2015), Luxembourg (1999), Malta (2008), Netherlands (1999), Portugal (1999), Slovakia (2009), Slovenia (2007), Spain (1999)

OECD countries include Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Latvia, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States

BRIC countries include Brazil, Russia, India and China

G7 countries include Canada, France, Germany, Italy, Japan, United Kingdom and United States

CurrenciesCNY Chinese renminbi (onshore)CNH Chinese renminbi (offshore)EUR EuroGBP Pound sterlingJPY Japanese yenUSD United States dollar

MiscellaneousABS Asset-Backed SecuritiesABSPP Asset-Backed Securities Purchase ProgrammeACWI All Country World IndexCSPP Corporate Sector Purchase ProgrammeEDIS European Deposit Insurance SchemeEMD Emerging Market DebtESG Environmental Social and GovernanceFTE Full-time employeesFX Foreign exchangeGDP Gross Domestic ProductJ-REITs Japanese Real Estate Investment TrustsNFP Non-Farm PayrollsNSA Non-Seasonally AdjustedOPEC Organization of the Petroleum Exporting CountriesREITs Real Estate Investment TrustsS&P Standard & Poor’s

DisclosuresAegon Investment Management B.V. is registered with the Netherlands Authority for the Financial Markets as a licensed fund management company. On the basis of its fund management license Aegon Investment Management B.V. is also authsorized to provide individual portfolio management and advisory services. This presentation is confidential and solely intended for its recipients. The content of this document is for information purposes only and should not be considered as a commercial offer, business proposal or recommendation to perform investments in securities, funds or other products. All prices, market indications or financial data are for illustration purposes only. Although this information is composed with great care and although we always strive to ensure accuracy, completeness and correctness of the information, imperfections due to human errors may occur, as a result of which presented data and calculations may differ. Therefore, no rights may be derived from the provided data and calculations.

Aegonplein 6, 2591 TV, The Hague, The Netherlands www.aegonassetmanagement.nl

Aegon Investment Management B.V. has its statutory seat in The Hague, the Netherlands. Registered at the Chamber

of Commerce at The Hague, the Netherlands, registration number: 27075825. VAT number NL0073.95.954.B.01

About Aegon Asset ManagementAegon Asset Management is a global, active investment manager. Aegon Asset Management uses its investment management expertise to help people achieve a lifetime of financial security, with a focus on excellence, trust and partnership. Institutional and private investors worldwide entrust Aegon Asset Management to manage approximately €339 billion* on their behalf.

Positioned for success in its chosen markets (Continental Europe, North America, the UK and Asia), Aegon Asset Management’s specialist teams provide high-quality investment solutions across asset classes. Its clients benefit from the extensive international research capabilities and in-depth local knowledge of Aegon Asset Management as well as Kames Capital, its UK investment team, and TKP Investments, its fiduciary management investment team in the Netherlands.

Through the Aegon Group our heritage stretches back to 1844, meaning we understand the importance of long-term relationships, robust risk management and sustainable outperformance. A long and successful history of partnership with our proprietary insurance accounts has enabled us to establish experienced investment teams, a solid asset base and proven long-term track records.

For more information, visit www.aegonassetmanagement.nl

*Source: Aegon Asset Management June 30, 2019.

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