GLOBAL EQUITY STRATEGY

There is now a dichotomy between the economic cycles in developed markets and emerging markets. While the outlook for developed markets has brightened, the outlook for emerging markets has taken a darker shade. Overall, this makes regional and country selection calls more critical than before. In this regard, we prefer developed markets over emerging ones as the investment case is a lot stronger for the former.

The US economy is showing signs of improvement. This is especially the case for household consumption and investments. The US housing market is clearly improving,

In Japan, it is not clear if the Abe administration has the political will to push through all three “arrows” of his stimulus programme. There is also uncertainty over the effectiveness of the programme. However, we acknowledge the improvement in Japan’s economic data in recent quarters.

We are underweight in Asia ex Japan, as the region is clearly slowing down with countries such as Indonesia and India facing structural challenges in their current accounts, debt levels and withdrawal of capital. Some of these concerns will continue to weigh on equity markets and the region may fail to deliver.

overweight position in equities

equities asset allocation

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eMeRGING

Asia (ex. Japan) lAtAm

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We take a positive view on the fundamentals of the US market as the improvement in economic activity continues to broaden out. Other than supportive consumer-related activities such as credit lending, automobile sales, residential construction and consequently employment, business related indicators such as durable goods orders and ISM data have registered strong readings in the last few months. Capital spending plans, while more moderate, are up year-on-year, and we view these to be lagging indicators.

Meanwhile, we continue to believe business activity data should maintain this recent positive momentum as lending standards continue to ease. Historical evidence suggests that the “Banks Tightening C&I Loans” index has a high correlation to various economic indicators including the Non-Residential Fixed Investments (commonly known as capex), non-farm employment and the US ISM, with the lending index leading by nine months. We have already seen the non-farm employment and the US ISM closing the gap with the lending data, and expect the capex data to follow suit and firm up in 2014 (see chart).

us

Sector allocation

Bank Lending Standard vs Capex

Bank tightening C&I Loan to Large firm (%) (left) Private Nonresidential Fixed Investment (Capex) YoY

Recession

Corporate earnings, on the other hand, have had a flat and uneventful year. Both the S&P 500 revenues and earnings (excluding financials) have hovered narrowly between -3 per cent and 3 per cent in all of the last six quarters but the last, when the S&P earnings rose a firmer than expected 4.7 per cent.

Looking ahead, we expect the S&P 500 earnings per share (EPS) to reach USD107 in 2013, representing 4 per cent growth over 2012. Profit growth in 2014 looks more attractive

-20 -15 -10 -5 0 5 10 15 -40 -20 0 20 40 60 80 100

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

Capex (Y/Y)

given the earnings estimates of USD116 and growth rate of 8 per cent. These estimates reflect the fairly stable 2013 and 2014 GDP growth forecasts of between 2.5 and 3.0 per cent, continued favourable cyclical tailwinds from consumption and a firmer capital spending outlook, which are helping to offset headwinds, especially those from the weaker the emerging markets. In terms of valuation forecast for 2014, we expect the market to price in a lower equity risk premium, higher risk-free interest rates and arrive at a target of 1920.

In addition, by 2014, we expect to have a better read on the rate of US Federal Reserve (Fed) tapering and its impact on the economy. With this backdrop, we can benefit from the US market performance in various ways.

One way is to invest in companies with a singular focus on shareholder yield or shareholder return. S&P 500 companies are now sitting on about USD1.2 trillion in cash and continue to generate strong cash flows. Cash as a percentage of total assets are at an all-time high of 11.7 per cent, as measured

by FactSet. As the non-US growth environment slows and as companies find it hard to source for more attractive ways to invest, one of the key goals of these companies is to return capital to shareholders.

This can be done through two common ways: in the form of dividends and share repurchases. The proportion of S&P 500 companies that pays a dividend has risen from a low of approximately 71 per cent in 2002 and 2009 to a level in excess of 80 per cent in 2013. Companies that practise share repurchasing are also important contributors to shareholder returns. In 2011, total shareholder payments reached USD935 billion, of which dividends made up USD256 billion, while net share repurchases contributed an even larger USD352 billion. In percentage terms, dividends and buybacks would have represented closed to 90 per cent of S&P earnings.

We are still underweight in European equities, but we have reduced this underweight position as we expect the US recovery to have a positive impact on European growth, based on internal analysis and studies done by the International Monetary Fund (IMF).

As of end November 2013, European stocks have posted a strong performance on re-rating in stock multiple, as Europe’s economy looks set to expand in 2014. However, the actual earnings performance has remained poor, as shown by the disappointing 2013 third quarter reporting season and current expectations of negative earnings growth for 2014.

As previously noted, investors are also expecting the European Union (EU) and the European Central Bank (ECB) to continue with their policy support for the economy. The EU’s recent actions have amounted to a continued relaxation of various austerity targets, thereby preventing further countries from entering official stability programmes. The ECB’s importance has centred on providing stimulus to the European economy and overseeing the integration of the Eurozone

banking system.

Since becoming ECB President in June 2011, Mario Draghi has cut the ECB’s main refinancing rate five times to the current 0.25 per cent level and has hinted at more unconventional measures to address the deflationary pressures that are still threatening a number of European economies. For example, recent press reports have suggested an additional Long Term Refinancing Operation (LTRO) tied to specific loan targets for participating banks. While ECB activism is a current positive, it does carry the potential risk of a clash with the German Constitutional Court.

Expectations that Europe’s economy will return to positive growth is largely hinged on Germany’s economic growth exceeding 1.5 per cent in 2014. This compares to consensus expectations of 1.0 per cent GDP growth for the Eurozone as a whole. This suggests that many of the peripheral Eurozone economies may continue to struggle. Such a scenario is supported by the current Purchasing Managers’ Index (PMI) manufacturing and services data, which shows Germany

europe

Sector allocation

continuing to outperform its Eurozone peers. We think that important structural reforms are still required in Italy and France to help boost economic activity. However, progress in legislation to support such reform remains disappointing.

While aggregate Eurozone economic indicators appear to have bottomed and have returned to positive territory, the danger is that the important Eurozone countries will continue to see disappointing GDP growth, rising national debt-to-GDP levels and high unemployment. Increased fiscal and banking integration is vital to stabilise the European economy, but may become more difficult to achieve with uneven economic growth rates across the region.

We have kept a generally defensive investment approach that is focused on value companies with high return on equity (ROE) and consistent growth, companies with a high, sustainable dividend yield and companies with a diversified revenue base. However, we have raised our exposure to cyclical sectors, particularly those companies with exposure to the UK and stronger North European economies, and companies that are expected to benefit from an improving US economy.

In terms of sector allocation, we are overweight in the consumer discretionary, consumer staples, healthcare, industrials and technology sectors relative to the benchmark. We are underweight in the basic materials, energy, financials, telecommunications and utilities sectors.

Our main overweight is the consumer discretionary sector.

Companies in this sector have benefited from sales to the US and developing markets and should benefit from the potential rebound in European domestic markets. We remain overweight in the consumer staples sector, where companies have been able to maintain operating margins and can support sustainable dividend growth. We remain overweight in the healthcare sector, particularly pharmaceutical companies with visible new product pipelines, companies that will benefit from an aging European population and these which are least affected by uncertainties related to Obama care. Within the technology sector, we expect software companies to benefit from the pick-up in US and Japanese demand. We continue to favour companies with global leadership positions within the industrials sector.

We remain underweight in the two commodity-related sectors – basic materials and energy. Geopolitical tttrisks appear to have reduced in recent months, which may see an upturn in previously affected countries such as Iran and Libya. Although commodity companies have now made sizeable reductions to capital expenditure budgets, markets still face oversupply concerns from recently completed projects that are now coming on-stream. We remain underweight in the financials sector, ahead of possible negative headlines relating to the upcoming European bank stress tests. We are underweight in telecommunications, as competitive pressures continue to squeeze operating margins, and as data revenue growth struggles to offset falling voice revenue.

The growth outlook for Asia ex Japan seems to have stabilised, thanks to a broadening out of the G2 economic recovery, which should bode well for Asian exports. However, the US Fed’s eventual tapering of its asset purchase programme could keep markets volatile in the near term. In particular, some Southeast Asian economies and India are more vulnerable to capital outflows and currency depreciation, which in turn have placed upward pressure on local interest rates.

In China, we see signs of growth stability and this is another bright spot for the region. During the Third Plenary session in November 2013, China’s senior leadership announced its aim to achieve wide ranging economic and social reforms by 2020. The key focus includes fiscal reform, factor price and market reforms, as well as social safety net and government administration reforms. Although these proposed reforms will take time to play out fundamentally and the implementation progress will be gradual, a positive reform momentum should

boost market confidence and sentiment. The challenges presented by a rebalancing of China’s economy remain. However, the market looks to have largely discounted this and there is room for the valuation gap to narrow on the prospect of reforms and improving economic efficiency.

AsiA ex-JAPAn

Sector allocation

The long-term growth opportunities in Asia remain underpinned by favourable demographic trends and rising incomes. Our strategy is to remain focused on these structural opportunities by investing in companies that have sound business models, are positioned in segments offering attractive growth and have demonstrated operational and financial discipline.

We see investment opportunities in selected beneficiaries of China’s reform. These include companies in the areas of clean energy and urbanisation, but we remain cautious on deep cyclical sectors with excess capacity. We continue to favour consumer companies that benefit from the rise of the middle income population. In particular, we expect e-commerce to see explosive growth in coming years as the penetration rate of the Internet and smartphones rises in Asia, especially in China. China’s dairy industry is another high growth sector as the currently low per capita milk consumption in China and the demand-supply gap will likely keep milk prices buoyant over the

next few years. The recovery in the global developed markets present opportunities for selective US dollar earners such as certain pharmaceutical companies and Asian exporters including technology companies that form part of the supply chain of global brand names. While the impending tapering of quantitative easing by the Fed poses near term headwinds to domestic demand in Southeast Asia, the long term structural fundamentals for these economies remain robust.

Although the Japan market has posted a strong rally in 2013, we expect further gains in 2014, albeit at a more muted pace.

Firstly, the global macro backdrop now appears more favourable given the signs of a globally synchronised acceleration in economic growth. As Japan is historically highly leveraged to the global cycle, we see it as a beneficiary of this trend.

On the domestic front, consumption in Japan will inevitably slow down with the implementation of the consumption tax increase. However, we think the risk of Japan entering into a recession appears to be small, as the Abe government intends to soften the blow to the economy by implementing a supplementary budget (funded by tax overshoots and reserves), as well as corporate tax breaks or tax cuts.

However, we believe that the Bank of Japan will likely embark on additional monetary easing around the time of the tax increase to weaken the Japanese yen and support asset prices in order to avert the downside risks. Easing measures

may take the form of purchases of Japan government bonds (JGB) which are of longer duration and exchange traded funds (ETF). Coupled with increased expectations of the US Federal Reserve (Fed) tapering quantitative easing (QE), interest rate differentials may widen, resulting in a weaker JPY/USD rate. A weaker yen is positive for Japan equities given the boost to corporate earnings.

JAPAn

Sector allocation

The measures to increase equity ownership in Japan are another potential positive catalyst for the market. Starting from 2014, Japan will roll out a tax exempt individual savings account NISA (Nippon Individual Savings Account). Japan’s government pension investment fund has also announced plans to rebalance its portfolio, increasing allocation to domestic equities and other risky assets while reducing allocation to domestic bonds.

The implementation of structural reforms by the Abe government will be closely scrutinised. While progress may be slow and results evident only in the longer term, we expect positive developments in the near future in several areas, including the Transpacific Partnership (TPP), energy and agricultural reforms, corporate tax cuts and tax breaks for capital expenditure and corporate governance.

The risks to our optimistic scenario include a weaker-than-expected macro backdrop in 2014, currency volatility and poor execution of structural reforms by the Abe government. Japan’s fiscal and demographic challenges will need to be addressed too.

Valuations of Japanese equities remain undemanding despite the market’s strong performance in 2013. The price-to-book (P/B) ratio of 1.27x is lower than the 5-year historical average of 1.35x. Prospective price-to-earnings (P/E) of 15.3x for financial year 2013 are also lower than the historical average of 16.2x.

We are currently overweight consumer discretionary, consumer staples and financials, neutral industrials, telecommunications and technology and underweight materials, utilities, real estate and energy. Our preference includes beneficiaries of a weak yen, domestic infrastructure/ capital expenditure related companies, and high ROE stocks.

We remain underweight on Canada, as earnings growth has slipped below historical average, and the market is not expected to outperform the US stock market. Part of the reason behind the disappointment is that Canada is losing its US export market share to Mexico even though it will still benefit from some positive spill-over effects from the US recovery. This, we believe, will be an on-going concern.

Although the 2014 financial year GDP forecast for the Canadian economy is expected to be slightly above 2 per cent, this is still below the consensus GDP forecast for the US economy. Furthermore, the US is expected to post lower inflation numbers and a faster decline in unemployment rate. This can be seen from the current positive trend in general US housing-related activities such as housing sales and construction. Meanwhile, housing starts have been at a run rate below the historical 200,000 monthly average, based on year-to-date data (as of December 2013). In contrast, Canadian housing prices are at all-time highs, as represented by Canada’s New Housing Price Index, and may well roll over.

Canadian resource companies can eventually be expected to benefit from stronger growth in both the US and Chinese

economies. However, while global monetary conditions remain supportive, it is still uncertain if QE has produced sustainable growth in the world’s two largest economies. Commodity prices remain range-bound, with investors watching for signals of economic strength.

Overall, our key overweight calls are in the consumer discretionary and staples sectors and key underweights are the energy and materials sectors. We are slightly overweight in the industrials and healthcare sectors. Within the commodities sector, we expect the gold mining stocks prices to be range-bound even though they are an important part of the Canadian materials sector. The call stems from the upward pressure on global interest rates and volatile commodity prices.

cAnAdA

Sector allocation

In Australia, we expect the economic growth to be sluggish in 2014. Although there are areas of sustained activity, especially related to housing turnover and starts, this is offset by decelerating retail sales and tepid hiring and credit growth. In addition, investments have turned negative as growth over the past year shifted away from mining investment and engineering construction.

Given the likely contraction in fiscal policy, a continued accommodative monetary policy will be needed to support economic growth over 2014. The Reserve Bank of Australia is now staying pat on its cash rates of 2.5 per cent, after lowering it eight times over the past two years, while waiting

Australia equity market benefits from liquidity support as the index comprises mainly high-return and high-yielding large corporates in a high-interest rate currency. Valuations for the Australian market are reasonable, with forward P/E trading slightly below the historical average of about 16x.

Overall, our key overweight is the consumer sector and key underweight is the materials sector. We are slightly overweight the consumer staples, telecommunications, industrials and healthcare sectors, with the latter two sectors being more geographically diversified.

AustRAliA

Sector allocation

Due to the near macroeconomic headwinds, we are underweight the Latin America (Latam) markets even though we still subscribe to a long term secular growth story in the region. Therefore, our strategy is to adopt a defensive positioning within domestic plays.

On the issue of macroeconomic outlook, consensus estimates for GDP growth in 2014 are about 3.2 per cent, driven largely by the peripheral countries such as Mexico, Chile and Peru. Inflationary pressures are moderating across most of the Latam markets. Employment continues to be very strong with low unemployment rates and the increasing working population giving rise to strong real wage and income growth in the region. This bodes well for the domestic consumption story.

The fiscal balance of Latam remains strong and the central bank interest rates for most countries are now back to neutral rate. This provides the central banks with monetary policies to use as tools to stimulate the economy in the event of a global slowdown.

Latam equities are currently fairly valued in our view, with the market trading at 12.6x consensus forward P/E, a 21 per cent

premium against the historical average of 10.4x. While earnings have declined in recent months, we continue to see downside risks to the earnings and hence our underweight call on the region. Macro conditions remain critical to the overall growth expectations.

The key risks are capital outflows, current account deficits, inflation and political/ fiscal stability. Recent data have shown inflationary pressures easing in Brazil due to the recent rate hikes, but inflation in the services sector remains sticky. We think that further rate hikes by the central bank could stifle growth in country but will help to anchor inflation expectations. We believe the rate hike in Brazil which started in the early part of 2013 is coming to an end with a final hike in the first quarter of 2014.

We view that the long term structural growth story of the Latam economies remains intact, underpinned by the strong domestic demand and underleveraged population. Our strategy is to add to our positions on market declines with a preference for domestic cyclical sectors. We are overweight the financials, industrials and consumer sectors and underweight the telecommunications, energy and materials sectors.

lAtin AmeRicA

Sector allocation