Issue 62 | May 2014

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Our core views about the investment outlook remain unchanged. We believe the global economy is likely to grow steadily throughout 2014. Meanwhile, plentiful central bank liquidity should continue to support financial markets, with equities delivering the most attractive returns.

However, we are aware that there are various risks to this outlook. First, any further escalation of the ongoing tensions between Ukraine and Russia could depress investor sentiment and cause energy prices to rise. Second, the recovery across the developed world could stall. Notably, there are concerns about deflation in Europe, and its peripheral sovereign debt markets could be approaching bubble territory. Third, any increase in US inflation, wages or household rents could encourage the Federal Reserve (the Fed) to increase interest rates too soon. Fourth, growth in the major emerging markets remains vulnerable to any increase in US interest rates.

On balance we remain positive although we continue to use hedges and diversifying assets to protect investment portfolios against these risks. The US recovery is gathering pace, and although Europe is several years behind, the region is heading in the right direction. Japan is experiencing some weakness owing to the recent VAT increase but its economic recovery seems to remain on track. Emerging markets have suffered from Fed tapering and tightening talk, uncertainty around China and weak commodity prices. But conditions appear to have stabilised and there are few signs of any contagion into developed markets.

Dirk WiedmannChief Investment OfficerRothschild Wealth Management

Issue 61 | April 2014

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Cover: Walking Past Two Chairs – detail (lithograph and screenprint) by David Hockney © 2008. David Hockney.

© 2014 Rothschild Wealth Management & TrustPublication date: May 2014Values: all data as at 7th May 2014Sources of charts and tables: Rothschild and Bloomberg unless otherwise stated.

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Rothschild Market Perspective | May 2014 | Page 1

Rothschild Market Perspective | May 2014 | Page 2

Equities

Although valuations are starting to look stretched following an extended period of strong returns, we continue to favour equities as the most attractive asset class for the following reasons:

¡ Abundant liquidity and repressed interest rates in our “muddling through” and “economic renaissance” scenarios continue to support the markets (see the latest edition of Our Big Picture Outlook for more information about our scenarios).

¡ Improved earnings prospects in our “economic renaissance” scenario should also boost equity prices despite the prospect of higher interest rates.

¡ This pattern applies particularly to the US market. It is the most overvalued region but equity prices could continue to rise if our “economic renaissance” scenario becomes increasingly likely.

Fixed income

¡ We are avoiding long-maturity nominal bonds because they would be negatively affected by a return to more normal monetary policy in the “economic renaissance” scenario.

¡ Within fixed income we continue to like shorter-maturity corporate bonds. This part of the market has two attractive features. First, there is still a decent yield advantage relative to government bonds. Second, the short maturity offers some protection against rising interest rates.

Real assets

The still sizeable probability of the “new monetary world” scenario lies behind our ongoing exposure to real assets. They can include allocations to gold, real estate and inflation-linked bonds.

¡ We are also confident that over an economic cycle equities continue to offer protection against inflation.

¡ Additionally, we are focusing on hedge funds that have the flexibility to adjust to an unexpected rise in inflation.

Hedging strategies

We believe our “depression” scenario is the least likely but its impact would be so disruptive that it must be considered within our investment strategy. Although equities remain the most attractive asset class, they are vulnerable to stretched valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero.

¡ Therefore, we include hedging strategies that can limit the potential losses from our portfolios if the equity markets suffer a material correction.

¡ We have an allocation to hedge funds that can provide significant protection in a bear market or which are not affected by adverse movements in equity markets and therefore provide true diversification.

¡ Additionally, we have direct equity hedges usually in the form of out-of-the-money put options on broad equity indices.

Our investment preferencesAlthough equities remain the most attractive asset class, valuations are starting to look stretched, particularly in the US.

Rothschild Market Perspective | May 2014 | Page 3

Interest rates are likely to remain low

At this point in the economic cycle, we would expect to see inflation begin to pick up. Yet the rate has been falling in the US, Eurozone and UK, and we believe any substantial increases are unlikely in the near term. These weak inflation figures relieve pressure on central banks to increase interest rates too soon. In addition, comments from the Fed’s head, Janet Yellen, have been particularly dovish recently. Apparently, Ms Yellen believes monetary policy should remain loose for an extended period of time as both an economic and social necessity.

Recovery in the US remains on course

The US is one of the main engines of global growth. Monetary policy remains loose, the fiscal drag is fading and the boost provided by the shale oil and gas revolution is helping the economy grow out of a number of structural problems. Meanwhile, both the government debt and national trade deficit have been falling. Additionally, the latest measures of the supply of money and bank loans indicate capital spending and investments are picking up. Although so far they remain below their long-term averages, the trend is positive.

Tapering is not tightening

The Fed has been reducing the scale of its monthly asset purchases over the past few months. Yet its balance sheet is still expanding and recently passed an eye-watering $4 trillion. This figure reminds us that tapering is not tightening and quantitative easing (QE) in the US is an ongoing process.

Plentiful liquidity from quantitative easing

In contrast to the direction of US policy, the Bank of Japan continues to add liquidity to the financial system. At the same time, the European Central Bank (ECB) appears to be laying the foundations for some form of QE, which has approval from Germany’s Bundesbank for the first time. Again in contrast to the Fed, the ECB’s balance sheet has contracted sharply as banks have repaid their loans from its Long-Term Refinancing Operation (LTRO). This process has put upward pressure on the euro, which is now at a level the central bank considers too high.

Focusing on the private sector

In order to avoid accusations of financing the region’s governments directly, the ECB may focus on private sector assets, which could in turn boost the flow of credit to companies. Even without QE, Europe’s central bank has already achieved a key goal of driving down peripheral sovereign debt yields to new lows with positive implications for growth across those areas. For example, Spain’s 10-year government bond yields have dropped to the lowest level since September 2005.

Positive signs from France at last

While conditions in Europe’s peripheral countries have improved, within the core France has been a concern. But it now seems to be moving in the right direction. Newly elected Prime Minister Manuel Valls has outlined spending cuts for 2015 to 2017, which include welfare benefits. He has also announced tax breaks for businesses and households over the next few years. Questions remain about how the government will implement these policies but the focus on tax reductions looks encouraging. In our view, these are the first positive signals from France since the election of François Hollande as President in May 2012.

Disappointment with Japan but some encouraging signals

The Bank of Japan’s QE initiative has involved buying government bonds at an annual rate of ¥50 trillion. This initiative has helped to push up inflation to 1.6%, which is close to the 2% target. But foreign investors have been disappointed that the central bank has not extended its QE programme, and are concerned that the third arrow of Abenomics involving structural reforms is progressing slowly. As a result, they have been selling Japanese equities, and these outflows have caused the market to fall.

More recently, Prime Minister Shinzo Abe has made some progress. For example, wages have increased for the first time since 1998 (although by only 2%) and large companies have agreed to increase bonus payments. In addition, the

The global economy and financial marketsThe US remains one of the main engines of global growth. Conditions in the Eurozone are less healthy and the ECB could step in to boost the region’s recovery.

Rothschild Market Perspective | May 2014 | Page 4

The global economy and financial marketsReforms are progressing slowly in Japan but its equity market remains attractive.

government is reforming its $1.2 trillion Pension Investment Fund, which could include increasing its allocation to equities. Other pension funds are likely to follow. The introduction of new economic zones and discussions about reducing corporate tax rates are also encouraging.

In the meantime, Japanese equity market valuations remain attractive, and corporate profitability should improve further with the proposed reforms. The Bank of Japan is likely to drive the market’s performance over the short term, with policy dependent on the economic impact of the VAT increase at the start of April.

Chinese growth slows but remains strong

Meanwhile, the pace of global growth is dangerously reliant on China, which last year confounded expectations of a substantial slowdown. GDP figures for the first quarter also came in slightly above consensus forecasts. China’s economy is likely to weaken as the supply of credit tightens and property investment slows.

Rothschild Market Perspective | May 2014 | Page 5

Investment viewsPerformance patterns in the equity markets have been shifting. In the bond markets, peripheral European sovereign debt yields have tightened, while the “transatlantic spread” continues to widen.

An uncertain start to the year for equities

So far this year equity markets have failed to establish a clear trend with most major indices posting either a small gain or loss. The start of the first-quarter company earnings season has been positive but investors remain distracted by potential sources of risk. They include the ongoing tensions between Russia and Ukraine, uncertainty about the pace of economic growth in China, and discussions about the Fed’s tapering strategy.

Appetite for risk appears to have shifted

Since the beginning of April equity markets have experienced a significant rotation between the performance of various sectors as investors have adjusted their exposures. For example, value stocks have outperformed growth stocks; large caps have outperformed small caps; and defensive sectors, such as utilities and telecoms, have outperformed the broader markets. Although the timeframe is probably too short to draw any solid conclusions, these shifts could suggest an increasing aversion to taking risk.

M&A activity is picking up

Several large corporate transactions have been announced over the past few weeks. They include a merger between cement producers Lafarge and Holcim; a three-part deal involving GlaxoSmithKline, Novartis and Eli Lilly; Pfizer’s bid for AstraZeneca; Valeant’s hostile takeover bid for Botox maker Allergan; walking frame manufacturer Zimmer’s agreement to acquire Biomet; and GE’s acquisition of French engineering company Alstom. According to Bloomberg, M&A activity is 57% higher so far this year than the same period in 2013. Total transactions in the first quarter were worth around $836 billion, which is the highest figure since the third quarter of 2008.

US bond curve is steep but low

At the end of April 10-year US Treasury yields were around 2.7%, unchanged from the previous month. Forward markets are equally sanguine – they expect some flattening but positive returns over the next 12 months. The bond market is exposed to two risks – rising US inflation expectations; and rising Fed

rate policy expectations. Given market valuations, these risks cannot be ignored.

Transatlantic spread could widen further

Inflation in the Eurozone fell to 0.5% in March, sustaining fears of deflation (a debtor nation’s enemy). In addition, the “transatlantic spread” has widened – 10-year Bund yields have fallen closer to 1.5%, which is 1.2% lower than US Treasuries. Europe is recovering more slowly than the US. It has more slack in its economy, and the ECB has not taken decisive action to increase inflation expectations although a strong euro could force it to act. Forward markets are pricing modest yield increases of 30bp on 10-year Bunds over the next 12 months. This scenario is likely to further support demand for Eurozone credit.

European periphery funding costs fall

Sovereign debt yields in Spain and Italy have tightened further, and are now just 150bp to 160bp above German yields. A virtuous circle is possible – lower funding costs should support the periphery’s recovery. Two risks are reduced commitment to domestic reforms and low inflation in core Europe. Expectations of looser ECB monetary policy are a key support.

US high yield and emerging market bonds

The valuation mismatch between US high yield (HY) and emerging market (EM) bonds has partially corrected over the past month. Long-term investors should continue to find value (although with volatility) in selected EM issuers. Meanwhile, US HY valuations are above their 2004–07 average. While they may still overshoot, we tend to prefer European and EM crossover credit.

Rothschild Market Perspective | May 2014 | Page 6

Hedge funds continue to struggle

The HFRX Global Hedge Fund Index fell by 92bp in April after losing 23bp in March, and is now almost flat for the year so far. Global equity markets increased by 0.5% over the same period (as measured by the MSCI World Index). Equity long-short and event-driven funds struggled in April owing largely to a continuation of the sector rotation that started in March. Notably, growth sectors, such as technology, healthcare and biotech, suffered large corrections.

With equity markets at elevated levels, we believe investors will reward those companies that over-deliver on expectations and punish laggards. This environment should be good for stock pickers but it is also likely to be volatile. We prefer managers who can generate alpha regardless of the direction of financial markets, such as equity-related funds with the skills to take advantage of current conditions. We are mindful that many global macro managers have similar exposures: long Japanese equities, short yen, and long US and UK short-term rates.

A good year so far for listed real estate

Global real estate investment trusts (REITs) have risen by 8% since the start of the year. The US, UK and Europe have been the strongest regions, while Asia has underperformed. Yet over the past 12 months global real estate markets have fallen by 4%, which compares unfavourably with a 16% rise in global equities. Only UK REITs have outperformed equities during this period – they have risen by 19%, while the FTSE 100 Index increased by 8%.

From a valuation perspective, developed market REITs are not compelling. Although REITs in many emerging markets look more attractive, the investment risks are much higher. Notably, the slowdown in China is a serious concern for Asia’s property markets in general.

Gold prices have fallen back

Gold prices increased steadily during the first quarter but then fell back below $1,300 an ounce in April. There are a number of reasons. Notably, investors have been selling gold ETFs as

price momentum slowed and physical demand from China fell. Meanwhile, physical demand from India has been stable. However, imports increased only moderately following the recent relaxation of controls, which could be a negative signal.

Over the short term, prices have been reacting to announcements by the Fed, with any mention of tighter monetary policy causing them to fall. Weaker physical demand from China could also continue to push prices down. Any escalation of tensions between Russia and the West over Ukraine could revitalise gold price momentum. In the meantime, prices are more likely to stay where they are or fall given lower physical demand and relatively low inflation expectation over the next few months.

Energy prices remain stable

Oil prices have been stable this year and are likely to continue to trade within a tight range. Notably, inventories across the developed world are rising now that winter has finished. Meanwhile, supply disruptions have persisted or recovered slower than expected in Iran, Iraq and Libya. Yet Saudi Arabia’s production is running at an all-time high of 10 million barrels a day, offsetting this weakness.

Slowing economic growth in China and higher rates of production from the US are the two main risks to energy prices. However, any increase of tensions in Ukraine could lead to the introduction of economic sanctions on Russia, which would have implications for global energy markets over the short term.

Investment viewsHedge funds have suffered from equity market volatility and sector rotation. Meanwhile, gold prices have fallen and oil prices are holding steady.

Rothschild Market Perspective | May 2014 | Page 7

Chart bookThe charts below provide an overview of key trends in financial markets over the past 12 months. The table provides a snapshot of key economic indicators.

Interest rates %

Government bond yields Inflation %

Unemployment %

GDP growth %2 year % 10 year %

US 0.25 0.4 2.6 1.5 6.3 2.3

Eurozone 0.25 0.2 1.5 0.7 11.8 0.5

Switzerland 0.00 0.0 0.8 0.0 3.2 1.9

UK 0.50 0.8 2.7 1.6 6.9 3.1

Japan 0.10 0.1 0.6 1.6 3.6 2.6

China 2.60 3.8 4.4 2.4 4.1 7.4

Source Bloomberg. All data as at 07/05/2014. Equity market indices are MSCI; figures are for Total Returns, net dividends, in local currency. Volatility is measured by VIX Index. GDP and inflation figures are annual and latest available. Chinese interest rates as measured by the three-month deposit rate . Eurozone bond yields shown are for Germany. Past performance shown is not a reliable indicator of future returns.

Equity market performance – 12 months to date

Volatility

10-year bond yields

Trade-weighted currencies (indexed)

US UK Eurozone Japan Switzerland

USD GBP EUR JPY CHF

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4.08.2 7.8 8.7

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Aug Sep

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Rothschild Market Perspective | May 2014 | Page 8

ContactsRothschild’s Wealth Management business advises and invests for a wide range of successful people, charities and foundations. Wealth preservation is what we do best, with an investment approach that helps us to smooth returns and dampen risk across the market cycle.

BrusselsAvenue Louise, 1661050 BrusselsBelgiumTelephone: + 32 2 627 77 30

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Tokyo20F Kamiyacho MT Bldg4-3-20, Minato-kuTokyo 105-0001JapanTelephone: + 81 3 5408 8045

ZurichZollikerstrasse 1818034 ZurichSwitzerlandTelephone: + 41 44 384 71 11

Rothschild Market Perspective | May 2014 | Page 9

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