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Quarterly Perspectives UK | Q3 2017

THIS QUARTER’S THEMES

1 Investing for income

2 America first?

3 A new normal for commodities

4 China: Hard landing or safe touchdown?

STRATEGISTS

Stephanie Flanders Managing Director Chief Market Strategist for the UK & Europe

Tilmann Galler, CFAExecutive DirectorGlobal Market Strategist

Vincent Juvyns Executive Director Global Market Strategist

Dr. David Stubbs Executive Director Global Market Strategist

Maria Paola Toschi Executive Director Global Market Strategist

Michael Bell, CFA Vice President Global Market Strategist

Nandini Ramakrishnan Associate Global Market Strategist

Jai Malhi AssociateMarket Analyst

J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.

Guide to the MarketsUK | |

MARKET INSIGHTS

Q3 2017 As of 30 June 2017

MARKET INSIGHTS

2 | QUARTERLY PERSPECTIVES | Q3 2017

1 Investing for income

Income: Hard to find, but necessary for duration protection

• With yields at the bottom end of their ranges, investors should think about diversifying across asset classes and across regions to achieve a higher income. Emerging markets (EM) debt and high-yield corporate bonds can help generate an attractive real yield, albeit at some risk to capital.

• Capital returns in the fixed income market may be significantly affected by rising rates. The bottom chart on page 61 of Guide to the Markets shows the hypothetical impact of a 1% rise in local interest rates on fixed income assets. Government bonds would likely suffer the biggest impact, while the juicier coupon payments of high yield, EM debt and convertible bonds would offer a buffer to those losses, even making the return effects positive in some scenarios. The income provided by these higher-yielding assets is crucial for duration protection and for ensuring lower drawdowns when bond prices fall.

• Within the fixed income space, it is worth considering EM debt as a source of income. The EM local currency bond index yield is far higher than its counterparts, both on an absolute basis and in terms of deviation from historic levels. But it is worth noting that the investable universe of EM debt has grown significantly in recent years, making active management key to seeking out the most attractive opportunities and avoiding those that represent the highest risk.

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GTM – UK |Fixed income interest rate risk

Current and historical yields for selected indices

Illustration of the impact a 1% rise in local interest rates may have on selected indices

% yield, fluctuations over the last 10 years*

% change, assumes a parallel shift in the yield curve and spreads are maintained

Source: (Both charts) Barclays, Bloomberg, FactSet, J.P. Morgan Asset Management.

*Historical yield range is based on the last 10 years of data, with the exception of local currency emerging markets debt, which is based on eight years, due to data availability.

Fixed income sectors shown are provided by Barclays and are represented by: Treasury UK: Barclays Sterling Aggregate Gilts; Floating rate: Barclays US Floating Rate Notes (BBB); IG credit: Barclays Global Aggregate –Corporates; High yield: Barclays Global High Yield; Convertibles: Bloomberg Barclays Credit/Rate Sensitive;EMD sovereign USD: Barclays Emerging Markets –Sovereigns; EMD corporate ($): Barclays Emerging Markets – Corporates; EMD sovereign (LC): Barclays Emerging Market Local Currency Government.For illustrative purposes only.Change in bond price is calculated using both duration and convexity, with the exception of Convertibles, which is historical change.

Guide to the Markets - UK.Data as of 30 June 2017.

How to interpret this chart

AverageCurrent

Max

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UK Gilts 1-3 years 5-7 years 10+ years

UK Gilts 1-3 years 5-7 years 10+ years

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Investment-grade credit

Highyield

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Investment-grade credit

Highyield

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EMD LC sovereign

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Convertibles

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Source: Guide to the Markets – UK, page 61

OVERVIEW

• Income and capital return are usually the two ways investors can achieve gains in their portfolio. Income investing is typically the picking of securities that generate a stream of cash, such as traditional bonds and dividend-paying stocks.

• Income investing is a commonly used strategy by investors who prefer lower volatility, or would like the frequent payments that income-generating securities or strategies offer. But many other types of investor can also benefit from adopting this approach.

• At a time when fixed income yields are low and equity indices may see higher volatility in the coming months, it is going to be increasingly important for nearly every investor to consider ways to invest for income.

The blue bars show total return, which are positive only for the higher-yielding assets

MARKET INSIGHTS

J .P. MORGAN ASSET MANAGEMENT | 3

Equities can provide an attractive income

• While “fixed income” has “income” in the name, it pays to remember equities as a source of income too. Dividends from equity holdings can provide a stable and consistent source of income. Over the long term, dividends have accounted for more than 40% of the total return from equity investing. In fact, for the US market since the 1920s, dividends from the S&P 500 have provided positive returns in every single decade.

• Income-focused equity investing is also a way to pay attention to the quality companies in the market. Within the emerging markets universe, companies that continue to pay high and stable dividends are more likely to have governance and shareholder return as a corporate focus. An example of this is in the EM equity space, which features a greater number of high-dividend-paying companies (yield above 3%) than anywhere else.

• Investors should think about diversifying across asset classes and across regions to achieve a higher income. The level of yield on offer in various markets changes based on prices, macro and political events. Having a go-anywhere approach to income investing would help in finding the best opportunities.

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1926-1929 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010-2016 1926-2016

% yield

Equity income

S&P 500 total return index: Dividends and capital appreciation

FTSE indices: Price vs. total return*

%, average annualised returns

Index level, rebased to 100 at December 1999Sources of income

Source: (Top) Ibbotson, Standard & Poor’s, J.P. Morgan Asset Management. (Bottom left) FTSE, Thomson Reuters Datastream, J.P. Morgan Asset Management. *Returns are in local currency. High dividend yield is the FTSE 350 Higher Yield Index. (Bottom right) Barclays, BofA/Merrill Lynch, Thomson Reuters Datastream, FTSE, Tullett Prebon, J.P. Morgan Asset Management. Converts: Barclays Global Convertibles; EM equity; MSCI EM; UK corporate: BofA/Merrill Lynch Sterling Corporate Index; Global REITs: FTSE NAREIT Index; High yield: BofA/Merrill Lynch Developed Markets High Yield Constrained; EM debt: J.P. Morgan EMBI Global. Yields for the bond indices are yield to worst and dividend yields for the equity indices. Guide to the Markets - UK. Data as of 30 June 2017.

DividendsCapital appreciation

Average UK inflation: 1.4%(12 months to May 2017)

Equi

ties

High dividend yield total returnTotal returnPrice return

+179%

+94%

+6%

58


MARKET INSIGHTS

Over the long term, total return (return with income) has given investors 88% more than simple price return

INVESTMENT IMPLICATIONS

• With yields so low across the world, income is a source of returns that cannot be ignored. To gain access to income, think beyond traditional sources of income and consider multi-asset investing. This may mean taking on more risk, but a well-diversified portfolio can help reduce volatility.

• Equity dividends can be an important source of income and have historically been very stable. Think about EM and high-yield debt as part of a portfolio, as they can offer attractive yields relative to core bonds.

• There will still be fluctuations in an income-focused strategy, but generally, income has been a great way to dampen volatility over the long term.


OVERVIEW

• US equities have outperformed othermarkets since the financial crisis.While we remain positive on theoutlook for US equities, other marketsmay have more upside in the finalyears of this economic expansion.

• Earnings and margins, which arecoming off of a lower base, providegreater upside potential for non-USequities, particularly in Europe.

• However, continued healthyearnings growth with upside riskfrom potential fiscal stimulus andlate-cycle exuberance argue againstgoing underweight US equities.

Earnings estimates for 2018 haven’t increased since Trump was elected

MARKET INSIGHTS

2 America First?

US equity outlook remains positive

• US equities have delivered strong returns since the financial crisis, but these returns have been supported by solid earnings growth. There is a common perception that US equities are factoring in unrealistic earnings expectations, on hopes of a fiscal stimulus and other changes proposed by President Donald Trump. However, 2018 earnings estimates are actually lower than they were before the US election, while still 5%higher than current 12-month forward earnings estimates.

• Historically, the ISM manufacturing business survey has been a good lead indicator ofUS earnings and it is currently signaling continued earnings growth for US corporates.

• US equity bear markets have generally only tended to start once there is a noticeabledeterioration in the labour market. A rise in the number of initial jobless claims hasoften been a clue that trouble is ahead for the equity market. However, both thismeasure and the labour market in general currently remain healthy.

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S&P 500 index level

US equities

S&P 500 earnings and performanceIndex level, next 12 months’ earnings estimates (LHS); index level (RHS)

Initial jobless claims vs. S&P 500 performanceThousands, four-week moving average (LHS); index level (RHS)

S&P 500 earnings per share (EPS) vs. ISM manufacturingIndex level (LHS); % change year on year (RHS)

Source: (Left) Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. EPS 2018 estimates are IBES as of 31 Oct 2016 and 30 Jun 2017. (Top right) BLS, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) ISM, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 30 June 2017.

Equi

ties

S&P 500 index levelS&P 500 EPSInitial jobless claims

46

EPS ISM manufacturing

2018 EPS estimatesOct ‘16 $146.3Jun ‘17 $144.4



But upside might be greater elsewhere

• US valuations are not cheap, but nor are they particularly expensive by historicalstandards. Looking outside of the US, valuations are slightly cheaper, but notdramatically so, and are broadly in line with their long-term averages.

• Rather than relative valuations driving performance, the relative performance of futureearnings is more likely to be key for stock market performance.

• The earnings recovery in the US is well advanced, whereas the earnings recovery inEurope and the emerging markets are only really just getting under way after five yearsof contraction. So even though US earnings should continue to expand, the upside formarkets where earnings are coming off of a lower base could well be greater than it isin the US.

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Relative equity valuations

Global earnings Global valuations EPS, US dollar, rebased to 100 in January 2009 Current and 25-year historical valuations

Source: (Left) FTSE, MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Right) FactSet, MSCI, Standard & Poor’s,J.P. Morgan Asset Management. Valuations refer to NTMA P/E for Europe ex-UK, U.S., Japan and UK and P/B for emerging markets. Valuation and earnings charts use MSCI indices for all regions/countries, except for the US, which is the S&P 500. Guide to the Markets - UK. Data as of 30 June 2017.

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Japan

Europe ex-UK

US

EM

UK

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US UK EuropeEx-UK

Japan EM

75x


MARKET INSIGHTS

Earnings recovery is only just beginning outside of the US



• US equities should still deliverpositive returns over the next year,helped by continued earningsgrowth, with even greater potentialupside if there is fiscal stimulusfrom the US administration.

• However, there may be greaterupside in equity markets outsidethe US where earnings and marginsare coming off of a lower base,such as in the emerging marketsand Europe.

• These considerations will pointmany investors in the direction of abroad overweight to equity marketswith a particular bias towardsEuropean equities.

MARKET INSIGHTS

Flows into European equities could have further to go

Europe looks particularly attractive

• European earnings in particular have struggled in recent years. The underperformanceof European earnings relative to those in the US has explained the consistentunderperformance of European equities over most of the period since the financial crisis.

• As an improving European economy leads to higher nominal growth, driving highersales, European margins are starting to improve due to operational leverage. Risingmargins can amplify decent sales growth into even stronger earnings growth. Withmargins very depressed in Europe, similar economic growth to that in the US shouldtranslate into stronger earnings growth.

• After a strong start to the year, many investors are concerned that they have missedout on the rally in European equities and that it has become a consensus overweight.However, flow data suggests that political concerns led to very large outflows fromEuropean equities last year and that those flows have only recently started to return.Many investors who sold out last year are yet to return, suggesting that if earningsgrowth remains healthy and political risk remains subdued, more money could returnto European equities.

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Relative performance of European equities

Europe vs. US: Relative performance and earningsRebased to 100 in December 2002

Europe vs. US operating profits margins%, earnings per share / sales per share

European equities flowsEUR billions

Source: (Left) MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Top right) MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) GFICC quant research group, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 30 June 2017.

Equi

ties

MSCI Europe ex-UK/S&P 500 performance

MSCI Europe ex-UK/S&P 500 earnings

US index and earnings outperforming Europe

Europe index and earnings outperforming US

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Collapsing investment in commodity supply caused prices to stabilise

3 A new normal for commodities

Commodities have been a major contributor to market volatility over recent years

• The commodity crash that began in 2011 was a leading source of many of the highest-profile investment themes during that time. As prices continued to fall, they draggedinflation down to such low—and sometimes negative—levels that central banks oftenhad to expand their already extensive efforts to return inflation to target. The equityearnings of commodity firms collapsed, causing index-wide earnings to stagnate andmarkets to trend sideways from late-2014 to mid-2016.

• At the same time, corporate credit spreads widened as the collapsing prices ledinvestors to question whether issuers could repay. Furthermore, many emergingmarket economies struggled to maintain growth, and some, such as Russia and Brazil,fell into recession. These factors severely buffeted investor portfolios, but their effectsare now largely behind us. However, the supply landscape in most commodities, rivenwith excesses and altered by new technologies, will never be the same.

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Gross fixed capital formation in commodity industry

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Commodity pricesIndex level, rebased to 100 at Dec 2010

China’s imports of key commoditiesMillions of metric tonnes

Source: (Left) Bloomberg, J.P. Morgan Asset Management. (Top right) China Customs, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) Australia Bureau of Statistics, Thomson Reuters Datastream, Worldscope, J.P. Morgan Asset Management. *Global data defined as global listedintegrated oil and gas. Guide to the Markets - UK. Data as of 30 June 2017.

Bloomberg Commodity Index weightsLivestock 7% Industrial metals 18%Energy 28% Precious metals 17%Crops 30%

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Index level, rebased to 100 at Jan 1995

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MARKET INSIGHTS

OVERVIEW

• 2016 saw an end to the declines in most commodity prices, which had been ongoing since 2011.

• Steep cuts in investment, reductions in supply due to low prices and gradual increases in demand have brought most markets close to balance.

• Prices are now likely to be range-bound for years, as materiallylower prices should induce rapidsupply reductions, whiletechnological change and sparecapacity mean any price increaseswill quickly be capped.


MARKET INSIGHTS

Oil: That sinking feeling

• Nowhere have changes to the supply landscape been more visible than in the oil market. Horizontal drilling and hydraulic fracking techniques have moved from fringe experiment to technological norm in just a few short years. Despite low prices, supply levels continue to grow.

• The Energy Information Agency predicts that oil production in the US in 2018 will exceed 10 million barrels per day—above the previous peak in April 2015 and close to the level of Russia and Saudi Arabia.

• The impact of this new cheap production is still being felt. After the crash in oil prices that began in 2014 and finished in 2016, most commentators saw a channel between USD 40, below which financial stability stress would cause supply to sharply contract, and USD 60 per barrel, above which new supply would rapidly come on stream, as the new normal for oil.

• Now both ceiling and floor are being pushed downwards. Technological change is still reducing costs in the oil market. Financing is easier to come by, as shale oil exploration is less risky than traditional methods. Debt contracts which were vulnerable at low prices have now either run off or defaulted, leaving only debt which can be serviced at low levels.

• All of this means the price corridor is sliding lower, with the ultimate resting point still unknown, despite pledges from OPEC to control its own production.

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YTD change Change since 2016 lowBrent crude -15.8% 39.2%

Oil market drivers

Crude oil pricesUSD per barrel

US rig count vs. oil inventories*Thousands of barrels (LHS); rigs (RHS)

Global oil supply and demand Millions of barrels per day

Source: (Left) Thomson Reuters Datastream, J.P. Morgan Asset Management. (Top right) Baker Hughes, Bloomberg, US Department of Energy, J.P. Morgan Asset Management. *Excluding US strategic petroleum reserve. (Bottom right) Bloomberg, EIA, J.P. Morgan Asset Management. Forecast from EIA, six-month moving average. Guide to the Markets - UK. Data as of 30 June 2017.

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Rigs

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Average: $50

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Share of total oil supply

In % Q1 2012 Q1 2017

OPEC 41.6% 39.9%

US 12.0% 15.5%

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Prices are stuck at low levels thanks to elevated inventories


MARKET INSIGHTS


• Commodity prices look set to stay in a choppy range for coming years as excess supply continues to hold down prices even in the face of gradually rising demand.

• There should be greater potential for driving returns through stock selection in the current environment. Many companies continue to struggle with the ramifications of the huge price declines witnessed since 2011, while others are better positioned to thrive in this low price era. This could point investors towards specialist natural resource managers, even if they choose to not overweight the commodity sector itself.

• Gold has a unique place in investors’ minds and their portfolios. With geo-political risks clear and present, and monetary policy still aggressive, it is no surprise that some see a place for gold within their investments. However, as a zero-yielding asset, the yellow metal is vulnerable to any move higher in bond yields.

Gold prices appear to have stabilise but would be vulnerable to higher real yields

Gold: A glittering investment?

• Gold, alongside its lesser cousin silver, has a special role in investor portfolios. Considered by many as the only true unit of money, gold tends to rally when the health of the modern capitalist system, and in particular it’s banking institutions, is called into question. As those concerns grow, government bond yields tend to fall as risk perception spikes. This reduces the cost of holding gold, which of course, pays you nothing.

• Conversely, a rise in yield, particularly inflation-protected yields, makes gold look worse by comparison. This makes the investment case for gold a tricky judgement call for investors. On the one hand, holding some gold could be a sensible way to provide some extra protection should current buoyant sentiment conditions worsen.

• On the other hand, if central bank accommodation is about to be withdrawn, then rising real yields could well be a damaging feature of the landscape for gold investors in coming years.

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Gold market dynamics

Gold priceGold vs. US 10-year Treasury real yields$ per Troy ounce (LHS); % inverted (RHS)

Breakdown of world gold demand by sectorTonnes

Source: (Top left) Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom left) World Gold Council, J.P. Morgan Asset Management. (Right) Thomson Reuters, J.P. Morgan Asset Management. Inflation-adjusted gold price is the historic gold price in today’s money, converted using the US Consumer Price Index. The 2001 low is defined as April 2001, and the 2011 peak is defined as August 2011. Guide to the Markets - UK. Data as of 30 June 2017.

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Gold

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2015Q1 2017 annualised

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Change since 2001 low

Change since 2011 peak

YTD change

Gold +371.3% -31.9% +7.4%

Inflation-adjusted gold price

Gold price

30 June 2017: $1,243

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4 China: Hard landing or safe touchdown?

Housing market less vulnerable this time

• Chinese interbank lending rates (SHIBOR) have been rising this year, but there has been no change in the benchmark policy rate and reserve ratio requirement for banks.

• The Chinese are trying to slow credit growth and clamp down on shadow banking—lending outside the formal banking system—and the recent increase in wholesale funding. Historically, increases in SHIBOR have led to sharp falls in Chinese property prices, for example, in 2012 and 2014. This has not happened so far in 2017, probably because the supply side of the market looks different to the way it did then.

• Chinese property inventories across the first- and second-tier cities are much lower than in 2012 and 2014 and have stabilised at relatively low levels. This lack of significant oversupply in housing should limit the extent of the slowdown, reducing the risk of a housing crash.

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China monetary conditions and housing

Chinese house prices vs. Shanghai Interbank Offered Rate% (LHS); % change year on year (RHS)

Chinese property inventoriesMonths of inventory

Policy rate and reserve ratio requirement (RRR)**% policy rate on one-year renminbi deposits (LHS); % RRR (RHS)

Source: (Left) BIS, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Top right) CREIS, J.P. Morgan Securities Research, J.P. Morgan Asset Management. *Tier system used in China to rank cities based on GDP, politics and population. (Bottom right) FactSet, People’s Bank of China (PBoC), J.P. Morgan Asset Management. **Average RRR for large and small banks. Guide to the Markets - UK. Data as of 30 June 2017.

China house price growth

SHIBOR

Low 2nd tier averageTop 2nd tier average

1st tier* average

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OVERVIEW

• With the recent increase in interbank lending rates, the authorities are aiming at a slowdown in credit growth and house prices, which have been growing at double-digit rates. However, the risk of an outright house price crash should be lower than in the past, due to a lower level of property inventories. While Chinese growth will probably slow in the second half of this year, a hard landing remains unlikely.

• China’s economic and financial linkages to the rest of the world have undoubtedly been growing, but they are probably still not large enough for financial problems in China to cause a major downturn in the global economy.

• Psychology matters for markets and levels of global confidence could well be affected by events in China. But on paper, at least, neither foreign banks’ exposure to Chinese debt, nor China’s share of global trade, are at levels that would be likely to derail the global economic recovery in the event of a serious slowdown in Chinese growth.

Oversupply of housing is now less of a problem

MARKET INSIGHTS


Global exposure to China is smaller than sometimes perceived

• Global investors are not currently focused on the global impact of a slowdown in China. That could well get more attention in the second half of 2017, but the direct impact of slower growth in China on the rest of the world could be smaller than many predict.

• While China’s share of global trade in goods and services has grown, it has only increased by less than four percentage points over the last decade and remains at 10%. In addition, Chinese demand makes up a relatively small share of other countries’ exports, with the US and euro area markedly less exposed than other countries in Asia.

• Foreign ownership of Chinese onshore debt has actually been falling, with only 1.3% held externally. In addition, foreign banks’ exposure to Chinese debt, though higher than before, is just 2% as a portion of their total assets. There are likely to be some financial linkages that are not fully captured by the official data, including offshore borrowing by Chinese companies. But on most reasonable estimates, direct foreign financial exposure to China is not yet at the level where it would directly cause significant trouble for the global economy.

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China economic and financial linkages

Foreign bank lending to China by sector% of world total by sector

China’s share of world GDP and trade% of world total

China’s share of merchandise imports% of total imports of selected economies

Source: (Top left) OECD, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom left) OECD, Thomson Reuters Datastream, J.P. Morgan Asset Management. *Chinese Taipei, Hong Kong, Malaysia, the Philippines, Singapore, Thailand and Vietnam. **BRIIS is Brazil, India, Indonesia, Russia and South Africa.(Right) OECD, BIS, Bloomberg, J.P. Morgan Asset Management. ***Chinese bonds are onshore Chinese bonds only. All lending is lending by BIS reporting foreign banks and excludes lending in domestic markets. All sectors is lending to all sectors in China as a proportion of lending to all sectors in all countries. Chinese non-financial corps is lending to Chinese non-financial corps as a proportion of lending to all countries non-financial corps. Chinese banks is foreign bank lending to Chinese banks as a proportion of lending to all countries banks. Guide to the Markets - UK. Data as of 30 June 2017.

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• A slowdown in China could be a source of some market volatility in the second half of the year and could affect broader global confidence if Chinese policymakers appeared not to be in control of the situation.

• Markets in those emerging market economies most exposed to China could also face headwinds, as and when the Chinese economy slows.

• However, the rest of the world’s direct economic and financial exposure to a potential Chinese slowdown appears manageable. This suggests that any China-related market volatility could provide attractive buying opportunities for global equities against a backdrop of broadly positive global economic momentum.

MARKET INSIGHTS

Chinese demand represents a small portion of developed economies’ exports

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LV–JPM50361 | 07/17

MARKET INSIGHTS

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