Wealth and Investment Management

CompassJune 2014

A question of growth

The bond-yield conundrum

Value investing – does a rules-based approach work?

Tactical asset allocation review: why sell in May?

Contents

A question of growth 2

The bond-yield conundrum 4

Whose price is right? .............................................................................................................. 4

Nominal growth and the cost of capital .............................................................................. 4

Productivity .............................................................................................................................. 4

Trend nominal GDP ................................................................................................................ 5

Where best to shelter? ........................................................................................................... 6

GDP growth and corporate revenues .................................................................................. 7

Conclusion ............................................................................................................................... 7

Value investing – does a rules-based approach work? 8

Value and growth investment styles ................................................................................... 8

The long-term case for value investing ............................................................................... 8

A closer look at the more recent history .......................................................................... 10

Tactical asset allocation review: why sell in May? 12

US equities and bonds ........................................................................................................ 12

Non-US developed market equities .................................................................................. 13

Emerging markets equities and bonds ............................................................................. 13

Commodities ........................................................................................................................ 14

Interest rates, bond yields, and commodity and equity prices in context 16

Barclays’ key macroeconomic projections 18

Global Investment Strategy Team 19

Compass June 2014 1

A question of growth Dear clients and colleagues,

Recent economic data in the US appeared to move in the opposite direction to what was expected. GDP declined 1% in the first quarter, although a stream of other economic data points portended a much different result. Indeed, the consensus expectation for first-quarter growth was in the order of 1.6%. A brutal winter, impacting home buying and business spending, was the culprit for the disappointment. A look at the components of GDP reveals reasons for optimism. Healthy consumer spending (which was revised upward) along with the decline in inventories suggest a re-stocking is in the offing. This inventory build and the unleashing of pent-up demand will revitalise growth in the remainder of the year.

Although it was hardly the beginning of the year investors anticipated, prospects for the balance of 2014 remain good. The consumer appears to be in fine form, and business spending seems to be stirring, as evidenced by the spate of corporate acquisitions announced this year. Furthermore, corporate profitability in the US does not map to a stagnant economy. To wit, first-quarter profits of the S&P 500 Index grew 4.7% on revenue growth of 2.6% (Figure 1). Indeed, performance of the market itself foots with earnings growth advancing 4.3% this year.

Our expectations for the US market are unbowed by the rough start. We expect overall growth for the year to be in the order of 2.5% to 3%. A quarter in which growth is above 3.5% seems likely as buyers transact purchases postponed in the first quarter. As growth improves, more investor attention will shift to when the Federal Reserve will start to raise short-term interest rates and whether signs of upward price pressure in the economy are cause for unease. These are legitimate concerns for sure, but they are not imminent threats to prosperity.

Growth in the eurozone remains sluggish: first-quarter GDP advanced 0.2% (non-annualised) with inflation within the bloc running at 0.7% – less than half the European Central Bank (ECB)'s target of 2%. The bloc's struggle to sustain forward economic momentum is creating a chorus of concern over the threat of a deflationary spiral taking hold. These fears are prompting calls for a more muscular approach from Mr. Draghi and Co. to use the central bank's balance sheet to assist in generating economic growth. June may see the ECB’s move to negative deposit rates and/ or some form of targeted liquidity measures as a nudge to banks in the periphery to beef up lending to small- and medium-sized businesses. In spite of this muted economic backdrop and little to cheer on the

Hans F. Olsen, CFA CIO, Americas

Figure 1: US Q1 2014 earnings have been strong Figure 2: The euro zone is expected to return to growth

Source: Bloomberg as of May 27, 2014 Source: Bloomberg as of May 27, 2014

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Compass June 2014 2

corporate earnings front, European equities have continued to forge ahead, perhaps aided by reasonably benign outcomes from both the Ukrainian presidential and European parliamentary elections. We still see core Europe as the region with the most upside for corporate earnings, and economic growth is expected to be positive this year and next (Figure 2). Within developed markets equities, we would still urge investors to put their money in Europe and the US.

The consumer-led rebound in the UK leaves GDP close to pre-crisis peaks. In addition to ongoing retail strength, business investment rose in the first quarter, a sign that the recovery is becoming more balanced and sustainable. Of the major western economies, the UK is probably most ready for monetary normalisation, and the US is a close second. With this in mind, we suggest investors tread carefully and lightly in the bond market, and look to the equity markets in developed economies for exposure to the pickup in growth.

Hans F. Olsen, CFA Chief Investment Officer, Americas

Compass June 2014 3

The bond-yield conundrum Bonds seem to be predicting a different outcome for the world

economy to that suggested by the equity market and its continued buoyancy. Given the bond market’s reputation for sober economic analysis, is now a good time to panic?

Whose price is right? For an investor, the sight of a flattening curve holds a similar level of dread to that experienced by an England cricket fan watching Mitchell Johnson pawing the ground at the end of his run-up: difficult times, apparently, lie in wait. But whatever bonds are telling us now, the equity market doesn’t seem to agree. The US stock market continues to flirt with all-time highs, bolstered by rising revenue and earnings forecasts. Fixed-interest magi will waste no time in telling you that bonds tend to be right more often than equities – a near-impossible statement to corroborate – but does this mean it is time to strike a more cautious strategic and tactical pose on behalf of our clients?

Nominal growth and the cost of capital The idea that the prevailing interest rate in an economy, plus a compensation for taking risk, should broadly equal the rate of return on productive capital is intuitively sensible. Intense competition for the use of capital in an economy by governments, corporations and households should, in theory, mean that the margin between the cost of capital and the return on capital is minimal. Furthermore, if one accepts that a “neutral” interest rate might be roughly in line with trend nominal GDP growth, one can understand why the 10-year US Treasury, offering a yield of c.2.5%, has many market observers scratching their heads about the future growth trajectory of the US economy.

The talking heads have obviously leapt into the breach with a multitude of explanations, most of which are based on a continuation of trends in productivity, inflation and labour-force growth seen over the last five years. This may be the case – but the bond market’s reluctance to believe in a brighter future for much of the developed world has surely also been helped by the “richness of embarrassments” suffered by capital markets over the last several decades. While markets have lurched from crisis to crisis – from the Asian Financial Crisis all the way up to the still-smouldering euro crisis – bond yields in much of the world have continued to fall (Figure 1). So ingrained is this trend that bond investors could perhaps be forgiven for assuming that recent trends in productivity, inflation and labour-force growth are indeed the ‘new normal’. The US economy looked to be on the cusp of delivering a rebuff to the new normal in the second half of last year but then the winter got in the way and bond yields retreated. Looking at incoming business confidence and consumer spending data, the economy may be about to offer such a rebuff again.

There may be other factors at play in the short term too: alongside continuing dogged demand for bonds, the supply story could remain supportive (net Treasury supply has been following the government’s net requirement to borrow lower (Figure 2) and will likely continue in this vein). So, while we hesitate to make a more forceful call on whether Treasury yields will soon reverse their long-term slide, our very low strategic weighting should tell investors that we don’t believe the prevailing consensus on the ‘new normal’.

Productivity Productivity is notoriously difficult to measure, particularly in the service sector. In the US, statisticians focus on output by private sector non-farm businesses per hour worked, which means that changes in measured productivity often have more to do with changes in labour

William Hobbs +44 203 555 8415

william.hobbs@barclays.com

The gap between the cost of capital and the return on capital should be minimal

Changes in measured productivity often have more to do with changes in the labour market

Compass June 2014 4

demand than broader changes in efficiency. However, mankind’s ability to invent, apply and get better at using new technology is at the heart of the improvements in living standards evident over the centuries, and even millennia, of recorded history.

Trends in productivity obviously do not travel in a straight line. New technology is not always immediately assimilated into the wider economy – it often takes companies and consumers decades to adopt and work out how to best use it. Around 120 years ago, US factories started switching steam power for electric power, however, productivity gains were reportedly muted for several decades after the switch.1 It took the next generation of factory owners to redesign manufacturing processes around this more flexible power source for the gains in productivity to be more effectively reaped. The same is true now – much of today’s global workforce grew up in a world where computers were a rarity and experts were figures of fun. It seems perverse to start betting on a structural decline in innovation as the workforce shifts towards a generation that has been immersed in this general purpose technology from birth.

Trend nominal GDP Figure 3 suggests that over the very long term – with the labour force getting better at what it does, alongside new technology – around 2% per annum is added to GDP growth. Set alongside this, the US labour force could reasonably be expected to grow at an average of 0.5% per annum over the next decade. If, on top of that, inflation hits the

Figure 3: Productivity Figure 4: UK retail sales

Source: John Kendrick, Datastream, Barclays Source: Datastream, Barclays

1 Erik Brynjolfsson – The key to growth? Race with the machines TED 2013

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Source: Datastream, Barclays Source: Datastream, Barclays

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Compass June 2014 5

Federal Reserve target of 2% – which seems plausible in a recovering economy with diminishing labour market slack – nominal GDP growth in the 4-5% range should not be an outlandish expectation.

The term structure of yields is, of course, already pencilling-in a marked rise in short- and longer-term interest rates, but not sufficiently, in our view. We’d expect 30-year and eventually 10-year yields to trade within that 4-5% region in both the US and the UK at some stage in the years ahead.

For their part, central banks are likely to remain very accommodative with inflation still easy and some wiggle room over output gaps remaining. This month, the Bank of England (BoE) raised its forecasts for UK economic growth with one hand but tried to push higher interest rate expectations further into 2015 with the other. This is in the context of an economy that is just as consumer driven as the US, where retail sales are positively booming (Figure 4). The market has already proved that it is perfectly capable of making up its own mind here, and it is markets that tend to set borrowing costs for an economy at all but the very short end of the yield curve, as we’ve noted before. We would still suggest that clients should not be shocked if interest rates were to rise towards the end of 2014, rather than later in 2015 as the BoE is suggesting. Nascent cyclical risks are currently most visible in the UK, in our opinion, risks that still appear largely absent across the rest of the developed world.

Where best to shelter? Of the big sovereign markets, we think the eurozone will continue to outperform in what we still think will be a testing time for most bonds – we expect recent gains to be eventually reversed. Bonds there are not cheap either, but there is less inflation and growth, the European Central Bank (ECB) seems poised to, if anything, loosen policy further, and the peripheral euro markets trade pro-cyclically (for lower-quality bonds, growth is viewed more positively: creditworthiness matters more than inflation and interest rate risk). Bund yields have already risen more slowly than Treasuries and gilts, and Italian and Spanish yields have fallen dramatically over the last two years, even after some profit taking this month in advance of European parliamentary elections. We think these trends can continue, although the peripheral markets are certainly running out of headroom.

Credit markets can outperform too, but we favour the high yield segment over investment grade. A further reduction in spreads (Figure 5) is quite likely, and may excite institutional credit analysts, but it will not help most private investors if it reflects rising government yields. It can, however, offer a buffer against price falls. Interest rate risk (duration) is smallest – and pro-cyclicality greatest – in the speculative grade markets, and the buffer is also greatest there.

Trend GDP growth in the region of 4 – 5% would not be unreasonable

We think the eurozone will continue to outperform

We favour high yield over investment grade

Figure 5: Credit spreads

Figure 6: S&P revenues – not as glum as the caricature

Source: Datastream, Barclays Source: Datastream, IBES, Barclays

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Compass June 2014 6

GDP growth and corporate revenues The idea that the US, and therefore the world, is somehow condemned to a lower trend-growth rate as the returns from innovation dry up is not just relevant for bond investors. For much of the last few years, those who have doubted the sustainability of the equity market’s rise have highlighted allegedly stagnant top-line growth in the corporate sector with the unprecedented rebound in corporate earnings per share being almost entirely a function of management parsimony and share buybacks – both of which are finite. At the index level, the revenue picture has indeed looked becalmed in several quarters of the last few years, but this has often been due to less-concerning trends at the sector level, with revenues in the energy sector (mostly a function of the year-on-year change in oil prices) sometimes struggling to make headway for example.

In reality, corporate revenues have increased by close to a quarter since 2009 and, although top-line growth had weakened a little last year, the closing first-quarter earnings season seems to be indicating a reacceleration in corporate revenue growth in the region of 3%, in spite of the extreme cold snap in January and February. Forecast revenues for consumer discretionary, consumer staples, health care and industrials in the US are now at, or close to, all-time highs, with the latter two sectors recently seeing revenue upgrades, suggestive of a broad improvement in business prospects. Meanwhile, forecasts for index revenue growth for 2014 and 2015 at a little less than 4% sensibly chime with consensus forecasts for real global GDP.

Conclusion We continue to feel that the economic pride that usually comes before a cyclical fall is missing. The world economy still feels likely to accelerate this year; in particular, there remains a backlog of economic opportunities still to be made good in the US, as illustrated by the average age of the capital stock (Figure 7). This means that we think investors will continue to be better served by owning companies – and the growth that they should generate in this backdrop – than lending to them. Against this improving economic backdrop, we don’t see major governments defaulting on their bonds, but monetary normalisation is coming and this is not yet adequately reflected in bond prices.

Theory suggests that – other things being equal – rising bond yields should be bad for equity valuations (indeed, some suggest that the approach of monetary normalisation has driven recent turbulence in some of the growthier areas of the market) because a rising discount rate should mean a lower present value for future corporate cash flows. In reality, rising yields may well clear the air a little, in investment terms, by confirming that the economy is on the mend and the bond market believes in the ongoing economic recovery as much as the equity market seems to.

US corporate revenue trends are not as glum as they may appear

Rising yields could actually clear the investment air a little

Capital stock looks in need of updating.

Figure 7: Backlog of economic opportunities

Source: BEA

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Compass June 2014 7

Value investing – does a rules-based approach work? High-profile value investors like Warren Buffett have consistently

demonstrated that, when performed with virtuosity and luck, fundamental analysis can be a means to outperforming the market. But can such an approach be turned into rules that benefit the average investor?

Value and growth investment styles The concepts of value and growth investment styles can be traced back to the teachings of Graham and Dodd at Columbia Business School prior to the publication of their hugely influential 1934 college textbook “Security Analysis”. The growth investment style directly corresponds to the idea of identifying those “growth” stocks with earnings growth rapid enough to allow them to beat the market. Benjamin Graham’s investment philosophy on the other hand, asserts that it is difficult for investors to beat the market, and consequently just aims to mitigate the risk of underperformance due to misjudgement, i.e. overvaluing or undervaluing a stock due to the “tides of pessimism and euphoria which sweep the market”. To reduce this risk, he suggests that investors determine the “intrinsic” equity “value” that is justified by a firm’s assets, earnings, dividends and financial strength, and buy those “value” stocks that appear underpriced.

Graham never fully explained how to determine “intrinsic” value, but considered a firm’s assets a particularly important component. Other factors included earnings, dividends, financial strength and stability. Based on this, value stocks are associated with low price-to-book and price-to-earnings ratios as well as high dividend yields. Similarly there is no single definition of a growth stock, but indicators include high earnings-per-share growth rates or implied internal growth rates (return on equity multiplied by retention rate). Valuations are not taken into account at all, even if they are already relatively high and might seem to be pricing much of that growth in.

The long-term case for value investing It is now common practice for index providers to divide their investment universes into value and growth stocks, constructing corresponding style indices that, when combined, form the overall market. Financial ratios, such as trailing price to book, have long track records of

Christian Theis, CFA +44 (0)203 555 8409

christian.theis@barclays.com

Over the long term, value has clearly outperformed growth

Figure 1: MSCI World and style total return performance

Source: Datastream, Barclays

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Compass June 2014 8

identifying value stocks, while forward-looking estimates for earnings growth only became commonly used in the 1990s. So historically this started by identifying value stocks and defining growth stocks as the remainder. Methodologies have been refined over time, but still aim for a 50/50 value/growth split and have to deal with the fact that in practice stocks can exhibit both value and growth characteristics or neither. This means that the various approaches have to have room for compromise and approximation. Summing up to the overall capitalisation-weighted market further implies using market capitalisation-based weightings, not style-based weightings such as earnings or dividends. Apart from rebalancing effects, the outperformance of one style implies underperformance of the other.

Figure 1 shows the performance of the MSCI World index alongside its style indices. There are significant regional differences in the style characteristics of stocks (for example US stocks have traditionally quite low dividend yields), so these indices are first constructed on a country or regional basis and then combined to derive global indices. Since December 1974, value has outperformed growth by 2.6% annually, with lower risk. This outperformance on a risk-adjusted basis is the so-called value premium that Eugene Fama and Kenneth French first identified in 1992 and incorporated into their famous three-factor model.

While academic research has shown that value premiums have historically existed in many markets, Figures 2 and 3 demonstrate that the relative performance of value versus growth is quite divergent between countries and regions, and there is no single global ‘style’ factor influencing all regions similarly. Regarding volatility, Figure 5 shows the large span that value

Figure 2: Relative performance of MSCI style indices Figure 3: MSCI rolling annual relative style performance

Source: Datastream, Barclays Source: Datastream, Barclays

Figure 4: MSCI sector weights

Source: FactSet, Barclays

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Compass June 2014 9

versus growth volatility has displayed. One factor contributing to these differences are varying sector weights, as shown in Figure 4. Value indices currently have the largest overweights in financials, energy and utilities. Whilst the US is roughly neutral for the weights of industrials and consumer staples, these are the largest underweights in Europe. Figures 6 and 7 show that, in the past, sectors have demonstrated extremely volatile style characteristics. For example, consumer discretionary, previously a value sector, has had a higher price-to-book value than the overall market during the last few years. During the financial crisis even consumer staples exhibited higher earnings “growth” expectations than the overall market.

A closer look at the more recent history A closer look however shows that the overall success of value strategies derives mainly from the 1970s and 1980s. Figure 2 shows that in the US, value has underperformed growth for over 25 years since peaking in July 1988. Globally, value experienced a 30% setback in the late 1990s so that there are now periods with a length of nearly 13 years over which growth has outperformed. For all regions shown, growth has outperformed value since 2007. Over the last 10 years – MSCI methodology was significantly changed in 2003 – the global annual outperformance of value over growth is 10 basis points only and does not cover the higher transaction costs of maintaining style indices: over the last year the MSCI World Value index had a turnover of 19.7% compared to 2.4% for the overall market. Can different index construction methods improve upon this performance? Figure 9 demonstrates, for the S&P

Figure 5: MSCI – volatility of value relative to growth Figure 6: MSCI sector Price/Book ratios relative to market

Source: Datastream, Barclays Source: Datastream, Barclays

Figure 7: MSCI forward sector EPS growth relative to market Figure 8: S&P 500 relative style performance

Source: Datastream, Barclays Source: Datastream, Barclays

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Compass June 2014 10

500, the difference between ordinary broad style indices and narrower ‘pure’ style indices that only include stocks with clear style characteristics using style-based weighting. In comparison the broader value and growth indices are very close to the overall market index in absolute performance terms, while the narrower pure value and pure growth indices have both noticeably outperformed the market. That outperformance has, however, come with more risk. Historical volatility of the pure style indices has been 21-22% compared to 16% for the market. As a result, Sharpe ratios for the pure style indices are only marginally higher than the market’s (0.36 vs. 0.41/0.44). From a maximum drawdown perspective, the 69% drop of pure value during the financial crisis exceeded the 51% drop of the overall market.

Figure 8 and 10 show the relative performance and rolling annual relative returns for the style and pure style indices. The charts demonstrate that relative performance has been significantly more volatile for the pure style indices as well; with peaks around 80%, the relative annual performance has been nearly double the amount of the ordinary style indices. Regarding absolute volatility, Figure 11 shows that also for pure style indices there have been both times where value was more volatile than growth and the other way round. A clear outlier is the volatility of pure value during the financial crisis, which peaked at 50% and reflects the large drawdown of this pure style index.

In the last 10 years, relative performance between value and growth indices has been rather muted, offering little attraction to rules-based investors. Pure style indices, which are less investable, come with higher absolute performance, but at the price of higher risk.

Narrower pure style indices have outperformed the broad market

Figure 9: S&P 500 and style total return performance

Source: Datastream, Barclays

Figure 10: S&P 500 rolling annual relative style performance

Figure 11: S&P 500 styles – volatility

Source: Datastream, Barclays Source: Datastream, Barclays

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Compass June 2014 11

Tactical asset allocation review: why sell in May? Equity and bond markets continued to disagree in May. Economic

data and earnings were largely positive, but bond yields continued to suggest a lower-for-longer trend growth environment. Meanwhile, global equities continued to march higher.

US equities and bonds May saw equity and fixed income markets witnessing the same events but seemingly coming to divergent conclusions on what they might mean for future US, and therefore global, growth.

Data released last month signalled a pickup in economic activity. Housing starts and building permits surged, and leading indicators pointed to a second-quarter bounce. First-quarter earnings results echoed the same refrain, exceeding expectations in both the large and small- and mid-cap sectors. The unemployment rate dropped to the lowest level since the start of the recession, and inflation hit the Federal Reserve’s elusive 2% target. Consumer and business confidence ticked upward as a result.

In response, US equities moved to new all-time highs, while 10-year Treasury yields remained largely unmoved at around 2.5%. With yields flat to falling in May, US fixed income performance continued to confound consensus expectations. We explore some of the possible reasons for this capital markets scuffle in a separate essay – The bond-yield conundrum. We hesitate to make a tactical call on exactly when the government bond market will cease to defy valuation gravity, however, our very small suggested strategic weight should tell investors that we do not believe this will be the case for long and investors should lower their fixed income portfolio durations (Figure 1).

Laura Kane, CFA +1 212 526 2589

laura.kane@barclays.com

William Hobbs +44 203 555 8415

william.hobbs@barclays.com

Same data, different stories

Figure 1: Longer duration, more price risk

Source: Barclays Investment Bank, as of May 13,2014. Past performance does not guarantee future results. An investment cannot be made directly in a market index. Index durations are represented by the following: 1-3 Yr by Barclays 1–3 Year US Treasury; 5-7 Yr by Barclays 5–7 Year US Treasury; TIPS by Barclays US TIPS; 7-10 Yr by Barclays 7–10 Year US Treasury; 25+ Yr by Barclays 25+ Year US Treasury; High Yield Bonds by Barclays US High Yield; MBS by Barclays MBS; Emerging Markets Debt (EMD) by Barclays EM Hard Currency Aggregate; Broad Market by Barclays US Aggregate; Corporate by Barclays US Aggregate Corporate; Munis by Barclays Municipal Bond

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Compass June 2014 12

For the moment, we still see some relative merit in US high yield bonds, where the combination of higher coupons and low default risk make the asset class more attractive than its peers. Within this space, we prefer actively managed credit-related vehicles based on deteriorating credit quality in the loan market.

Non-US developed market equities Equity markets in both the UK and continental Europe put in an impressively resilient performance in May – helped in part by voters. In the end (in spite of some fairly hysterical media commentary), European parliamentary elections played out much as we expected. There was a rise in support for the more extreme ends of the political spectrum, aided by very low voter turnout. However, this surge in support for the more populist parties was insufficient to meaningfully change the political equilibrium within the European Parliament. We also had potentially pivotal presidential elections in Ukraine and again the result was broadly benign for markets. Billionaire businessman Petro Poroshenko managed to grab more than half of the vote in what has been declared a legitimate election. Russia has cautiously acknowledged this legitimacy and, although the violence in the east of the country continues, this feels a step forward from earlier in the month. We would continue to caution against trying to call the likely twists and turns in the crisis, but we still expect tensions to relax over time, given both sides’ strong incentive to do so.

The euro crisis will no doubt continue to smoulder while the political and fiscal architecture for the euro remains only partially built. However, we see the weight of history and the lack of credible alternatives forcing the project unevenly forward from here. European parliamentary elections have done nothing to change this view. In this context, we still see European equities, alongside those in the US, as a good place for investors to take selected risk. Earnings headroom remains greatest in Europe, even if the latest earnings season provided little evidence of it.

A weaker currency may help the corporate sector at the margin given its globally well-diversified revenue footprint relative to the US equity market. To this end, June may see the European Central Bank actually start to follow through on its promise to do “whatever it takes” – a change in language in its most recent statement, suggesting that it is no longer happy with medium-term inflation expectations, may indicate that a negative deposit rate and/or some form of targeted liquidity operation are coming our way. This is all in the context of a still fairly sluggish economic recovery, albeit not far from trend, as evidenced by May’s business confidence data.

So far this year, Japanese equities have provided a fairly brutal reminder, in both constant and local currency terms, of why we prefer to sit on the fence. To date, Japanese authorities have deployed headline-grabbing monetary and fiscal measures in their attempts to shake the country out of its economic torpor. There were some signs of life in the first-quarter’s GDP data, however, the bottom-up reform and liberalisation that we would need to see before comfortably taking an active position on the market, remains largely absent.

Emerging markets equities and bonds Emerging markets equities were the strongest performer in May, returning 4.5%. Russian and Indian stocks were the stand-out markets, with the former benefiting from a more moderate posture from the Kremlin in the wake of the successful Ukrainian elections (Figure 2). Meanwhile Indian equities had been rallying for several months in anticipation of a victory for Narendra Modi’s Bharatiya Janata Party and the election itself didn’t disappoint. Indian voters haven’t spoken with such a unified voice since 1984, when Rajiv Gandhi led the Indian National Congress Party to a landslide victory following the assassination of his mother, Indira Gandhi.

Eurozone equities are outperforming

Election results spur rally in Indian equities

Compass June 2014 13

.

Figure 2: Russian and Indian stocks performed well in May

Source: Bloomberg As of May 27, 2014 Past performance does not guarantee future results. An investment cannot be made directly in a market index.

Even with the strength of his party’s mandate, it is too early to say how much progress Mr. Modi will manage in an economy famed for its constrictive bureaucracy. Expectations are clearly high. We are not encouraging direct exposure ourselves, but a reinvigorated India would certainly be good for the region’s economy and equity markets.

For our part, our optimism on emerging stocks is more strategic (five years) than tactical (three to six months). We remain wary of emerging market bonds, in spite of a 2.2% (unhedged local currency) return for May, particularly those denominated in local currency.

Commodities After rallying at the start of the year, commodity returns flattened out in May, ending the month down 220 basis points. Agricultural commodities slumped from early-year highs. Coffee, for example, fell from April peaks, as Brazilian growers and dealers exported stockpiled beans to capitalise on higher prices.

Industrial metals posted modest returns. Nickel prices surged in May due to supply concerns stemming from an export ban by Indonesia, and the potential for more sanctions by the US and Europe against Russia, which is home to the biggest producer of the refined metal.

Despite the recent strength in commodities, we remain underweight the asset class. This year’s tailwinds, particularly in the agricultural sector, are likely temporary. Further, an increase in US interest rates may lessen the attractiveness of commodities as a portfolio diversifier.

-30%

-20%

-10%

0%

10%

20%

30%

Jan-14 Feb-14 Mar-14 Apr-14 May-14

MSCI Russia MSCI India

Year-to-date Return

The upbeat trend for emerging markets bonds continues

Commodity returns are flattening

Compass June 2014 14

Figure 3: Tactical Asset Allocation tilts and Strategic Asset Allocation Benchmark (moderate risk profile)

Expected 5Yr

Returns SAA

Profile 3 Strong

Underweight Underweight Neutral Overweight Strong

Overweight

Cash & Short Maturity Bonds 1.5% 7%

Reduced 7th February: counterpart to increased weighting in developed equities

Developed Government Bonds 1.4% 4%

CB buying and falling supply offset by high valuations and likely recovery in risk appetite

Investment Grade Bonds 2.3% 7%

Very expensive: little spread compression left to go for, prefer lower tier 2 banks and insurers

High Yield & Emerging Markets Bonds

5.0% 11%

Expensive, and vulnerable to reversal of inflows as slow process of monetary normalisation begins

Developed Markets Equities 7.9% 38%

Up from neutral 7th February to take advantage of recent setback: cycle and relative valuations still favour stocks

Emerging Markets Equities 10.6% 10%

Structurally attractive but tactically still vulnerable to local concerns and Fed tapering

Commodities 4.8% 5%

Cut 11th July: monetary normalisation, more US-focused cycle & rising supply threaten gold and other metals

Real Estate 8.0% 4%

Mixed: US and Europe offer best value; investable Asian markets look expensive

Alternative Trading Strategies 3.5% 14%

Regulation, and lower leverage, leave this diversifying asset class without tactical appeal

As of July 2013, we use qualitative descriptions of our Tactical positions relative to their Strategic benchmarks, ranging from ‘strongly underweight’ to ‘strongly overweight’. This is a shift away from the percentage-based reporting method we used in the past. Our Strategic Asset Allocation (SAA) models offer a mix of assets that over a five-year period will in our view provide the most desirable mix of return and risk at a given level of Risk Tolerance. They are updated annually to reflect new information and our evolving outlook. Our Tactical Asset Allocation (TAA) tilts these five-year SAA views to reflect our shorter-term cyclical views. For more detail, please see our Asset Allocation at Barclays white paper and the February 2013 edition of Compass. Source: Barclays

Figure 4: Total returns across key global asset classes

Note: Past performance is not an indication of future performance. Index Total Returns are represented by the following: Cash and Short-maturity Bonds by Barclays US Treasury Bills; Developed Government Bonds by Barclays Global Treasury; Investment Grade Bonds by Barclays Global Aggregate – Corporates; High-Yield and Emerging Markets Bonds by Barclays Global High Yield, Barclays EM Hard Currency Aggregate & Barclays EM Local Currency Government; Developed Markets Equities by MSCI World Index; Emerging Markets Equities by MSCI EM; Commodities by DJ UBS Commodity TR Index; Real Estate by FTSE EPRA/NAREIT Developed; Alternative Trading Strategies by HFRX Global Hedge Fund. The benchmark indices are used for comparison purposes only and this comparison should not be understood to mean that there will necessarily be a correlation between actual returns and these benchmarks. It is not possible to invest in these indices and the indices are not subject to any fees or expenses. It should not be assumed that investment will be made in any specific securities that comprise the indices. The volatility of the indices may be materially different than that of the hypothetical portfolio.

0.4%

10.1%

7.2%

3.9%

3.8%

5.2%

4.6%

3.2%

0.0%

6.7%

3.7%

-9.5%

-2.6%

26.7%

0.1%

0.1%

0.1%

0.1%

Alternative Trading Strategies

Real Estate

Commodities

Emerging Markets Equities

Developed Markets Equities

High Yield and Emerging Markets Bonds

Investment Grade Bonds

Developed Government Bonds

Cash and Short-maturity Bonds

2013 2014 (through 27 May 2014)

Compass June 2014 15

Interest rates, bond yields, and commodity and equity prices in context* Figure 1: Short-term interest rates (global)

Figure 2: Government bond yields (global)

Source: FactSet, Barclays Source: FactSet, Barclays

Figure 3: Inflation-linked real bond yields (global)

Figure 4: Inflation-adjusted spot commodity prices

Source: Bank of America Merrill Lynch, Datastream, FactSet, Barclays Source: Datastream, Barclays

Figure 5: Government bond yields: selected markets

Figure 6: Global credit and emerging market yields

Source: FactSet, Barclays *Monthly data with final data point as of COB 27 May 2014.

Source: FactSet, Barclays

0

1

2

3

4

5

6

7

8

9

Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

Global Government10-year moving average± one standard deviation

Nominal Yield Level 3 Months (%)

1

2

3

4

5

6

7

8

9

10

Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12

Barclays Global Treasury10-year moving average± one standard deviation

Nominal Yield Level (%)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11

Inflation Linked10-year moving average± one standard deviation

Real Yield Level (%)

70

100

130

160

190

220

250

280

310

340

Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11

Dow Jones UBS Commodity

10-year moving average

± one standard deviation

Real Prices (USD, 1991=100)

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Global US UK Germany Japan

± one standard deviationCurrent10-year average

Nominal Yield Level (%)

2

4

6

8

10

12

Investment Grade

High Yield Hard Currency EM

Local Currency EM

± one standard deviation

Current

10-year average

Nominal Yield Level (%)

Compass June 2014 16

Figure 7: Developed stock market, forward PE ratio

Figure 8: Emerging stock market, forward PE ratio

Figure 9: Developed world dividend and credit yields

Figure 10: Regional quoted-sector profitability

Figure 11: Global stock markets: forward PE ratios

Figure 12: Global stock markets: price/book value ratios

All sources on this page: MSCI, IBES, FactSet, Datastream, Barclays

8

10

12

14

16

18

20

22

24

26

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11

MSCI The World Index

10-year moving average

± one standard deviation

PE (x)

6

8

10

12

14

16

18

20

22

24

26

28

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11

MSCI Emerging Markets

10-year moving average

± one standard deviation

PE (x)

0

1

2

3

4

5

6

7

8

Jan-01 Jan-04 Jan-07 Jan-10 Jan-13

Global Investment Grade Corporates Yield

Developed Markets Equity Dividend Yield

Yield (%)

3

5

7

9

11

13

15

17

19

World USA UK Eu x UK Japan Pac x JP EM

± one standard deviation

Current

10-year average

Return on Equity (%)

9

11

13

15

17

19

21

23

World USA UK Eu x UK Japan Pac x JP EM

± one standard deviation

Current

10-year average

PE (x)

0.8

1.2

1.6

2.0

2.4

2.8

World USA UK Eu x UK Japan Pac x JP EM

± one standard deviationCurrent10-year average

PB (x)

Compass June 2014 17

Barclays’ key macroeconomic projections

Figure 1: Real GDP and consumer prices (% y-o-y)

Real GDP Consumer prices

2013E

2014F

2015F

2013E

2014F

2015F

Global 3.0

3.3

3.8

2.6

2.9

2.9

Advanced 1.2

1.9

2.2

1.3

1.6

1.8

Emerging 4.8

4.7

5.4

4.8

5.1

4.9

United States 1.9

2.2

2.6

1.5

1.9

2.1

Euro area -0.4

1.2

1.5

1.4

0.7

1.0

Japan 1.6

1.6

1.3

0.4

2.7

2.3

United Kingdom 1.7

3.0 ↑ 2.7 ↑ 2.6

1.7

1.9

China 7.7

7.2

7.2

2.6

2.4

3.0

Brazil 2.3

1.9

2.4

6.2

6.4

5.8

India 4.6

5.2

6.4

6.3

5.4

5.6

Russia 1.3

0.1

1.3

6.8

6.7

5.7

Source: Barclays Research, Global Economics Weekly, 23 May 2014 Note: Arrows appear next to numbers if current forecasts differ from previous week by 0.2pp or more. Weights used for real GDP are based on IMF PPP-based GDP (5yr centred moving averages). Weights used for consumer prices are based on IMF nominal GDP (5yr centred moving averages). There can be no guarantees that these projections will be achieved.

Figure 2: Central bank policy rates (%)

Official rate % per annum (unless stated)

Forecasts as at end of

Current Q2 14 Q3 14 Q4 14 Q1 15

Fed funds rate 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

ECB main refinancing rate 0.25 0.10 0.10 0.10 0.10

BoJ overnight rate 0.10 0-0.10 0-0.10 0-0.10 0-0.10

BOE bank rate 0.50 0.50 0.50 0.50 0.50

China: 1y bench. lending rate 6.00 6.00 6.00 6.00 6.00

Brazil: SELIC rate 11.00 11.00 11.00 11.00 12.00

India: Repo rate 8.00 8.00 7.75 7.50 7.50

Russia: One-week repo rate 7.50 7.50 7.50 7.50 6.50

Source: Barclays Research, Global Economics Weekly, 23 May 2014 Note: Rates as of COB 22 May 2014.There can be no guarantees that these projections will be achieved.

Compass June 2014 18

Global Investment Strategy Team

EUROPE

Kevin Gardiner Chief Investment Officer, Europe kevin.gardiner@barclays.com +44 (0)20 3555 8412

Peter Brooks, PhD Behavioural Finance specialist peter.brooks@barclaysasia.com +44 (0)20 3555 1261

Greg B Davies, PhD Head of Behavioural and Quantitative Finance greg.davies2@barclays.com +44 (0)20 3555 8395

Emily Haisley, PhD Behavioural Finance emily.haisley@barclays.com +44 (0)20 3555 8057

Antonia Lim Global Head of Quantitative Research antonia.lim@barclays.com +44 (0)20 3555 3296

Christian Theis, CFA Macro christian.theis@barclays.com +44 (0)20 3555 8409

AMERICAS

Hans Olsen, CFA Chief Investment Officer, Americas hans.olsen@barclays.com +1 212 526 4695

Laura Kane, CFA Investment Strategy laura.kane@barclays.com +1 212 526 2589

David Motsonelidze Investment Strategy david.motsonelidze@barclays.com +1 212 412 3805

Kristen Scarpa Investment Strategy kristen.scarpa@barclays.com +1 212 526 4317

ASIA

Benjamin Yeo, CFA Chief Investment Officer, Asia and Middle East benjamin.yeo@barclaysasia.com +65 6308 3599

Eddy Loh, CFA Equity Strategy eddy.loh@barclaysasia.com +65 6308 3178

Compass June 2014 19

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