Arbuthnot Latham & Co., Limited is wholly owned by Arbuthnot Banking Group PLC with roots extending back to 1833. We have offices in London, the South West, the North West, and Dubai, and provide four core services: Private Banking, Commercial Banking, Investment Management and Wealth Planning.

Our thoughts on

Global MarketsOctober 2016

Introduction Page 3

Market Moving Themes Page 5

Around the World Page 14

The Asset Markets Page 16

Our report discusses general developments within global markets over the third quarter of 2016, with a focus on the issues influencing portfolios. Following an economic and market summary, we expand upon a number of themes before concluding with a review of the major asset classes.

Introduction

Economic and Market SummaryA broad overview of developments in the global economy and markets over the past quarter, highlighting our thoughts from a macro perspective.

Market Moving Themes

Commercial Property Post-BrexitThe Commercial Property sector in the UK has grabbed quite a few headlines since the vote to leave the European Union on the 23rd June 2016. News of property funds suspending redemptions is enough to spook any investor, let alone the listed real estate sector share prices falling approximately by 30%. These developments prompt us to ask what is expected from the asset class going forward and how we can potentially outperform. We start by looking at how a multi-asset investor is able to gain exposure to Commercial Property.

Electric Vehicles: A New BeginningThe automotive industry is taking large strides towards a more efficient structure. From cost reduction being driven by Elon Musk’s Tesla, to battery innovation being invested in by Dyson, we look through the changes and implications for the future while taking account of the industry leaders driving this change. In this dynamic industry we find many areas of the supply chain and development cycle which form interesting investment themes within the technology, mining and industrial sectors.

Around the World

A snapshot of the more esoteric financial and economic news that UK investors may have missed over the quarter from around the globe.

The Asset Markets

A Quarterly Review of the Major Asset Classes and OutlookThis section records some of the key data for the major asset classes within portfolios, combined with our outlook for each.

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Economic and Market Summary

The third quarter of 2016 has been marked by two main themes: the better-than-expected UK activity in the aftermath of the EU referendum, and mounting concern over the future sustainability of the monetary policies that have thus far propped up the global economy.

UK economic data has caught many city commentators out and perhaps now there will be some reflection around the ‘groupthink’ that has, in my view, lead to a city-held consensus that BREXIT is hugely damaging to the UK economy as a whole, rather than simply to Financial Services. Certainly there are a lot of unknowns, not least surrounding the ability of asset managers to sell their products into Europe and the disruption and expense this will cause, though there will be benefits too for other industries. In any event, the process has not yet begun, and when it does the process of negotiation

– and thus newsflow, good and bad – will be slow and allow for gradual market adjustments. The realisation of this has released some pent up demand that was ‘holding off’ in the run up to the vote, particularly in the property market but also in terms of business mergers and acquisitions. We are now back to normal levels of activity and the ‘shock’ appears to have passed for now; we shall have to wait and see for further market reaction as Article 50 is invoked.

The far more serious issue is the uncharted territory we remain in, eight years after the Global Financial Crisis. The situation is precarious. Central Bankers have realised that prolonged Quantitative Easing (printing money) is not working. Its objective is to reduce long-term interest rates, allowing businesses to invest and consumers to spend more, thus invigorating economic activity. It has neither created discernible activity, nor the inflation required to enable interest rates to be normalised.

Furthermore, excessive monetary stimulus has brought a range of collateral effects, including debt overhangs, lower bank profitability, formation of asset bubbles, poor returns on savings for pensioners, pension funding issues, sloppy capital allocation/utilisation, and rising wealth inequality. Only owners of financial and business assets have benefitted as real adjusted wages for the masses have fallen in the US and UK.

Nevertheless, QE can’t be blamed for these issues alone. China has contributed in preventing the rise of inflation through currency depreciation and falling demand for commodities as it rebalances from an investment-led to a consumption-led economy. Demographics has played a part in supressing wages too. The greater freedom of labour movement, a surge in working age people, and the addition to the global economy of emerging markets-based workers who, with enhancements in technology, now have ease of access for their skills across borders, has dramatically increased the supply of cheap labour.

“Central Banks in the UK, Europe and Japan continue to print money and lower rates…”

Central Banks realise and are concerned about the failure of QE in its current form. Japan is to try QE with ‘yield curve control’, in order to address the problems of shortage of long dated bonds left to buy and the price volatility for these assets thus created. Nevertheless, we still don’t feel this addresses the key problems of inflation and aggregate demand. Meanwhile, Central Banks in the UK, Europe and Japan continue to print money and lower rates, so much so that Europe and Japan have moved their rates negative, with depositors now having to pay entities to hold their cash.

In essence, Central Banks have run out of monetary tools and have realised that creating money and using it to buy bonds doesn’t work as a mechanism to get money into the real economy. So other mechanisms are being reviewed, often under the banner ‘Helicopter Money’. This can materialise in the form of tax cuts, government spending or distributing cash to consumers. It eliminates the middlemen (i.e. the financial/banking system) and provides a direct money transfer to the population.

StJohn N R Gardner MBA, FCSI, FCII, DipPFS

Head of Investment Management

Introduction

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As investors, this would be an opportunity for businesses participating in the infrastructure industry as governments spend on projects (hopefully deriving efficiencies unlike the bridges to nowhere in China!).

“Economists and Governm-ents seem perplexed at the lack of productivity gains.”

Spending on efficiency-creating projects (e.g. roads, rail, fast broadband etc.) will put those economies in a more competitive position, meanwhile creating jobs whose additional salaries will be spent in the economy and help sustain a dynamic, growing and more productive economy. It will appease developed market populations that are stirring after a long period on stagnant wages, as standards of living improve by virtue of new infrastructure. And whilst this might be inflationary, frankly that is a good thing. It reduces the value of our debt burden and can be controlled by putting interest rates back up to a healthier figure.

Such action is garnering some support now. The G20 met in the past quarter, and for the first time in many years their statement made powerful and concrete commitments to more fiscal stimulus:

“monetary policy alone cannot lead to balanced growth….we are making tax policy and public expenditure more growth-friendly….commitment to promote investment with focus on infrastructure…” Last year’s G20 statement had been very different. Mario Draghi, during an ECB press conference, referred to the G20 statement, making it clear that future central bank policies will take it into account. Mark Carney, Governor of the Bank of England, has also pointed towards politicians to do more from a fiscal standpoint.

Other non-monetary actions can be deployed by the bureaucrats and indeed are required – not least a turnaround in red tape and over-regulation that has burdened businesses and rendered them uncompetitive in an increasingly global marketplace. Economists and Governments seem perplexed at the lack of productivity gains.

But in my privileged position of being able to talk to you, our clients – many of you business persons and entrepreneurs – it is clear to me that we are all suffering under a deluge of seemingly pointless ‘hammer to crack a nut’ costly bureaucracy impinging on business profitability and thus productivity. When combined with restrictions to our freedoms to carry out our value-added work and differentiate ourselves from the competition, the result is also a lack of choice for the consumer as whole industries are forced to obey a set of restrictive rules. It is within the power of each government to stop this, and perhaps the UK’s separation from the EU will enable the UK to unwind the clock in that regard.

There is other hope for the working person too, as the supply of labour appears to have peaked and the demographical model is now pointing to a slowly contracting workforce ,leading to wage rises and much-needed inflation.

So in conclusion, what does this mean for investors?

Firstly, we have discussed the potential for infrastructure spending. This in turn will pull through commodity demand and thus price rises. Secondly, Central bank easing has been a boon to equity and bond investors over the past years. Bond markets are pricing a continuation of QE infinity, with yields at dangerously low or negative levels so that investors would take years – decades in some cases – to recoup any losses from a rise in rates. Less QE, ceasing negative interest rate policy and applying more fiscal stimulus, in our view will hurt those assets which have benefited from zero/negative interest rates, like utility stocks, long-dated investment grade bonds and core government debt. So careful management of the bond element of portfolios is critical. Conversely, a floor on negative rates and fiscal stimulus should benefit banks, insurers, cyclical sectors and the dollar.

Your investment team is working hard to analyse all the factors and make appropriate decisions in your portfolios, to protect capital and provide investment returns in line with those we have discussed with you.

Introduction

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Market Moving Themes

Commercial Property Post-Brexit

The Commercial Property sector in the UK has grabbed quite a few headlines since the vote to leave the European Union on the 23rd June 2016. News of property funds suspending redemptions is enough to spook any investor, let alone the listed real estate sector share prices falling approximately by 30%. These developments prompt us to examine what is expected from the asset class going forward and how we can potentially outperform. We start by looking at how a multi-asset investor is able to gain exposure to Commercial Property.

Allocating to Property

Real estate investment trusts (REIT) were created in 1960 as part of legislation signed by President Dwight D. Eisenhower. The purpose was to provide smaller investors with the opportunity to invest in ‘large-scale, diversified portfolios of income-producing real estate.’1 Investments that were historically dominated by financial institutions and wealthy individuals were made accessible to the retail investor. Traded on stock exchanges around the world, a REIT must typically invest at least 75% of its assets into real estate and pay 90% of its taxable income in the form of shareholders dividends.

A more recent development for the UK Commercial Property industry is the Property Authorised Investment Fund (PAIF), which many traditional property funds have adopted since the structure was established by the HMRC in 2008. The PAIF structure was designed to provide a tax-efficient structure to the underlying investor for direct property investment, whereby property income and interest is paid gross of tax.

Both REIT and PAIF structures aim to deliver direct property-like returns to investors. The former tends to provide more specialised property exposure at the sector level, for example office, student accommodation or industrial property, but in return an investor needs to accept equity-like volatility as a result of trading on an exchange. As the PAIF structure is not listed on an exchange the day-to-day equity trading volatility is removed.

Therefore over the short term and long term, an investor is exposed to the diversification benefits of direct commercial property against traditional equity and bond asset classes. In their relative infancy, the PAIF funds tend to be diversified across the Retail, Industrial and Office Sectors but are able to expand further afield to hotels and leisure centres. We expect that as the fund industry expands, opportunities for more targeted exposure will arise.

“The main source of return for a commercial property investor is the rent paid by tenants.”

One of the main advantages of both structures is to provide daily liquidity in what is an illiquid underlying asset. Investors should be cognisant of this. The gating of a number of funds following the EU Referendum came as a stark reminder. Many people are acutely aware of how long it takes to transact on residential property; when we factor in tenant negotiations and development or renovations into commercial property investment, the timeframe is extended even further. The main source of return for a commercial property investor is the rent paid by tenants; this is a key risk that we often challenge a fund manager’s awareness of. Lease lengths tend to be between five and fifteen years.

Global Markets

1 https://www.reit.com/investing/reit-basics/reit-industry-timeline

Sam Carleton Investment Manager

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A predictable, recurrent income stream goes some way to explaining why the asset class is inherently less volatile than other investments. Valuation of a property is often determined on location, whether the asset is deemed a prime site or secondary, the security of the rental income and the supply and demand emanating from the occupier or investment markets.

Fund Suspensions

The move to suspend daily dealing in a property fund should be viewed as protecting existing shareholder interests. In the aftermath of the vote to leave the European Union, the high level of uncertainty in the UK Commercial Property market caused investor redemptions to rise considerably. Without the cash balances to meet the level of redemptions, many funds were forced to suspend daily dealing to provide the time necessary to make orderly disposals of direct property assets at reasonable valuations. The worst case situation is being a forced seller of an illiquid asset in a distressed market so the move to stop daily dealing is a response we advocate. In addition, many applied a fair value adjustment, reducing the price of the fund to reflect the underlying conditions perceived by valuers. These reductions ranged from 5% to 17% with many subsequently revised back up once property transactions provided evidence of a stabilising market.

Hard Landing

Many people ask why property assets were hit so hard in the wake of the vote to leave the European Union. The majority of concerns centre around London. With financial institutions occupying around 30% of office space in the capital, any significant relocation to Europe has the potential to severely affect demand. We would state a caveat that any change is not likely to be overnight and much will depend on the UK’s circumstances after exiting the Union. Since the Global Financial Crisis, property assets have performed very well thanks to a recovering economic picture with a distinct lack of property supply to service demand. When we factor in an investment community’s thirst for yield, the attraction of the asset class is magnified. An uncertain economic future, regardless of whether it may be better or worse, is viewed as a threat to those predictable cash flows property is prized on, hence the negative impact. The subsequent rebound in REIT share prices tells us the negative sentiment may have been slightly overdone, but in an event that completely changes an outlook, panic can ensue.

“Without the cash balances to meet the level of redemptions, many funds were forced to suspend daily dealing…”

Market Moving Themes

Figure 1: IPD UK Monthly Property Index

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Figure 1: IPD UK Monthly Property Index

Source: Factset

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Brexit Fall-out

The implications of Brexit on the UK Commercial Property market are still very grey. In the month following the vote capital values fell by 3.3%2. Industrial property was the most resilient, declining 2.2%, whilst City Offices suffered a fall of 6.1%. Much will depend on the type of deals negotiated when Article 50 is triggered to leave the European Union. Encouragingly, the rental market held firm as day-to-day business requirements outweighed initial uncertainty. However, it would not come as a surprise if tenants request shorter lease lengths to enable flexibility to any change to the economic environment. The Bank of England’s decision to lower interest rates and subsequent compression of gilt yields should also buoy the bond-like characteristics of commercial property.

Moving forward we expect the Industrial Sector to outperform all other property sectors. A dated infrastructure network restricting prime locations coupled with the emergence of logistics through e-commerce and ‘click and collect’ requirements are likely to remain a tailwind, even in the event of lacklustre retail demand. The London City Office market is likely to remain in the Brexit Spotlight. Any operational difficulties from not having passporting rights to the European Single Market could force relocation, raising vacancy rates and putting downward pressure on rents.

Take-up of Central London Office was 48% below the 10-year average in August; however, some headroom remains, with availability significantly below the 10-year average of 14.6m sq ft at 13.8m. The outlook for the Retail Sector is slightly convoluted. Over the past few years many in the industry have noted the ‘death of the high street’ as consumers flock to shopping centres that provide an experience, with restaurants and entertainment facilities. Statistics evidence far greater footfall and amount of time spent at such sites. On the other hand, the fall in the value of sterling and the expected tourism influx could make the high street a primary beneficiary.

“We expect the Industrial Sector to outperform all other property sectors.”

Our analysis and research leading up to and after the EU Referendum makes us believe that this property cycle is very different to the difficulties experienced during the Global Financial Crisis. One of the fundamental differences is the level of debt in the property market. At the end of 2015, 87.5% of outstanding debt had a loan to value (LTV) ratio of 70% of less. Whilst the make-up of lenders had also shifted, banks and building societies had made up 72% of the lending market in 2008, falling to 34% at the end of 2015.3

Market Moving Themes

2 CBRE United Kingdom Capital Markets – Monthly Index July 2016 3 De Montfort University, UK Commercial Property Lending Report, 2016

Figure 2: FTSE EPRA/NAREIT UK Index

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Figure 2: FTSE EPRA/NAREIT UK Index

Source: Factset

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“One of the key aspects to performance in the asset class will be the level of supply to the market.”

With landlords less indebted and a more diversified lending base, the market is more resilient to short-term shocks, reducing the likelihood of forced selling. One of the key aspects to performance in the asset class will be the level of supply to the market. With the risk to tenant demand skewed to the downside, any significant development could be the catalyst for further falls in capital values.

Despite the negativity surrounding the UK Commercial Property market, we remain fairly constructive on the asset class. In a world hungry for yield the characteristics of property remain attractive once short-term uncertainty subsides. Various sub- sectors within the asset class like logistics distribution sites and healthcare properties present interesting market dynamics, capitalising on demographic and spending trends.

Whilst the different ways of gaining exposure to property provide short-term liquidity, we approach an allocation with a long-term mind-set.

Market Moving Themes

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Electric Vehicles: A New Beginning

The electric vehicle (EV) has been widely coined as the future of the automobile industry, led by innovative companies such as Tesla and Nissan, who are helping to transform the way vehicles are powered. Exactly when and how these changes in technology will be fully adopted is difficult to predict, but when the shift happens it will change the way humans travel between destinations forever.

“Failure is an option here. If things are not failing, you are not innovating enough.”

– Elon Musk, Co-founder & CEO of Tesla Motors

The Issue

Perhaps more important than the ‘when and how’, is the ‘why’. The environmental impact that carbon emissions have on global warming is well understood. Approximately 65% of global greenhouse gas emissions come from fossil fuel-generated carbon dioxide4, of which transport plays a huge role. An increase in demand for greener transport, as well as the rise of emission-related legislation has led to a flurry of innovation in the transport industry.

“Research from Berkeley Earth found that 1.6 million people are dying each year from air pollution in China alone.”

In China, where the government has declared ‘war’ on pollution, the EV market is picking up steam. During Beijing’s ‘red alert’ periods when smog is particularly dangerous, the number of cars allowed on the roads is regulated; those with odd numbered licence plates can drive one day, then those with even numbers the next. Toward the end of 2015 the quantity of PM 2.5, a hazardous particulate matter, reached levels of around 40 times the World Health Organisation’s maximum guideline5. Research from Berkeley Earth found that 1.6 million people are dying each year from air pollution in China6 alone. Evidently, there is a huge problem with air quality, and part of the answer may be found in a transformation to vehicles with zero tailpipe emissions.

Market Moving Themes

4 https://www3.epa.gov/climatechange/ghgemissions/global.html 5 http://www.bbc.co.uk/news/world-asia-china-35026363 6 http://berkeleyearth.org/air-pollution-overview/

Philip Bowyer Investment Managers’ Assistant

Eren Osman Director, Investment Management

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A common misconception is that this new wave of battery and hybrid type power sources are a modern day ambition to combat global warming. In fact, Scotsman Robert Anderson invented what may be considered the first EV using a non-rechargeable, crude-electric battery in the 1830s. This invention was the first to remove the need of a horse to pull the carriage. Since the 1830s, the demand for EVs seemed to rise and fall with the cost of oil, as the financial benefits of owning one diminishes as petroleum becomes cheaper.

Cost

Until recently, the cost of an EV has been substantially higher than traditional internal combustion engine (ICE) vehicles, which has historically caused the demand to be rather low. EVs typically use lithium-ion batteries, the same type used in laptops and mobile phones, mainly due to the high energy density properties they have, whilst remaining lightweight. However, these batteries are costly and possess a fairly limited life span.

“The key to driving down the cost of the car is to bring down the cost of the battery.”Elon Musk, owner of Tesla, knows that the key to driving down the cost of the car is to bring down the cost of the battery, as well as develop it for longevity. Musk has built a £3.5 billion factory in Nevada, USA, which is intended to produce more lithium-ion batteries in a year than the entire planet did in 20137. This factory, named ‘Gigafactory 1’, will also aim to produce 500,000 cars annually by 2020; considering the Model 3 received 276,000 pre-orders in just three days upon release, this seems necessary.

Furthermore, Musk seems to have met the challenge of cost cutting. So far, the Model 3 starts at $35,000 before incentives, instantly making it a serious competitor to the petrol alternatives with a range of 215 miles per charge. With the completion of Gigafactory 1, there is hope that the final sale price can be driven down even further through the benefits of economies of scale.

Battery Innovation

Pioneering vacuum cleaner business, Dyson, has invested $15 million in Sakti38 as part of a plan to invest £1 billion into battery development over a 5-year period. Sakti3 are a start-up company who are developing a solid state version of the lithium-ion batteries, which could potentially double battery capacity. Whilst Sir James Dyson’s focus will be on the cordless vacuum market, clearly any advancement in battery design transposes into the EV industry; if vehicles such as the Tesla Model 3 could benefit from a doubling of battery capacity, it could completely change the automobile market for consumers.

“Every year, we see around an 8% improvement in batteries… by the end of this decade, we’ll have a range well above 400 kilometres.”

Market Moving Themes

7 http://www.ibtimes.co.uk/tesla-gigafactory-incredible-images-new-5bn-building-key-teslas-future-1553057 8 http://www.techweekeurope.co.uk/mobility/dyson-invests-battery-164535

Top right: Tesla Supercharger station

Source: iStock.com/Jag_cz

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“In the UK, Germany and Italy, the carbon footprint of an all-electric vehicle is currently comparable to that of petrol hybrids.”

Jürgen Schenk, Chief Engineer at Mercedes Benz, claims that, “every year, we see around an eight percent improvement [in batteries], which means that, by the end of this decade, we’ll have a range well above 400 kilometres9.”Schenk also predicts that charging times will fall to 20 – 30 minutes for a full charge, he says that once these elements are brought together ‘there will be no alternative to electric mobility’.

How Green is Green?

So, it is clear the big players in the industry are committing to EVs becoming the inevitable next step in transportation, but to what degree will this solve the environmental issue of petrol vehicles? When assessing this question, it is imperative to understand how the electricity that goes into the vehicle is produced, and how this varies significantly from country to country. Research conducted by ‘Shrink That Footprint’ showed that in countries dependent on coal for their energy supply, such as China, India, Australia and South Africa, EVs actually have a total carbon footprint in line with typical petrol vehicles.

This is due to the emissions produced when generating the electricity used to power the car. Closer to home in the UK, Germany and Italy, the carbon footprint of an all-electric vehicle is currently comparable to that of petrol hybrids. In top spot was Paraguay who, as a hydroelectric exporter, has an extremely clean grid – more or less all of the carbon emissions arise from the manufacturing of the vehicles, making this location the greenest place to own an EV.

Tesla is in the process of acquiring SolarCity, a solar energy company also owned by Elon Musk, for $2.8 billion. Despite the merger being subject to a shareholder vote, Musk hopes that upon the successful integration of these companies, Tesla could become the world’s only manufacturer of end-to-end clean energy products, thus addressing the issue of clean cars and dirty grids. If this mission is a success, it could point to a business model rethink for the car makers of the future.

The Vision

Looking forward, it appears certain that there will be real disruption to the automobile market as we know it. Tesla is paving the way to become truly dominant in the green market, and existing car manufacturers such as Mercedes Benz, BMW and Ford do not have far to leap in order to shift more of their new cars to battery power.

Market Moving Themes

9 https://www.mercedes-benz.com/en/mercedes-benz/next/e-mobility/battery-power-from-saxony

Figure 3: Electric Vehicle Sales (UK) by Year 2010–2015

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Figure 3: Electric Vehicle Sales (UK) by Year 2010–2015

Source: www.nextgreencar.com/electric-cars/statistics

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Innovative transformations are already being seen in the battery markets, with huge sums of money being poured in to start-ups like Sakti3, to name one amongst many.

Should Apple manage to fine tune the process of wireless charging, it could hold the key to the issue of charging points. Samsung, Sony and Alphabet (formerly known as Google) already use this technology in their smartphones, however the technology requires the device to be millimetres away from the source, through the use of a charging pad – arguably, this doesn’t solve the problem of restriction by cables. Apple is attempting to build wireless charging points which can work from longer distances.

“94% of accidents in the United States are through human error; driverless cars have an extremely strong argument for safety.”

We see the trend in the automobile market not just inevitably moving to electric, but also shifting to driverless, as the driving experience becomes more about convenience.

The Google project is by far the leader in this field, where they have already covered over 1.5 million miles in self-driving cars. The development of autonomous cars could return independence to the elderly or visually impaired who are unable to drive. It has the potential to reduce drink driving rates, and also enables the user to be able to carry out other activities whilst travelling, potentially increasing employee productivity. Considering 94% of accidents in the United States are through human error, driverless cars have an extremely strong argument for safety.

Tesla believe that driverless cars are a jump too early, and so are developing their autopilot-type experience, providing more autonomy, but keeping the driver in control. This stepping stone may be what is necessary for the public to welcome the driverless concept, rather than resist change. In the UK, four cities were given the green light for the use of driverless cars on public roads. Greenwich, Milton Keynes, Coventry and Bristol began trialling driverless cars in early 2015, with trials across more of the UK to start as early as 2017.10

Market Moving Themes

10 https://www.gov.uk/government/news/driverless-cars-4-cities-get-green-light-for-everyday-trials

Top: Google Self-Driving Car

Source: iStock.com/ Jason Doiy

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In the 2016 Queen’s speech, it was mentioned that autonomous driving and EVs would be focused upon for new legislation, claiming that by 2020 autonomous cars could fall under regular car insurance policies11. This is considered one of the largest barriers to the introduction of these cars, and it is encouraging to see that the government is approaching it with optimism.

“Investors who participated in Tesla’s initial public offering in June 2010 would have been provided with a total return of 789% to September 2016.”

The future does not only seem to be removing the driving aspect from the user, but potentially the ownership aspect also. With the rise of Uber and companies alike across the globe, Chief Executive Travis Kalanick believes that by removing the driver from the experience, they can offer even lower-cost transportation. At the point which taking an Uber anywhere becomes cheaper than the cost of ownership, car ownership will naturally begin to fall. The idea of relying on a driverless Uber for your main method of transport may seem a thing of the future, but this is the direction many of the industry pioneers see the market moving.

As an investment, this theme can be played at all stages of the cycle; from the extraction of metals used in the production of batteries, the battery and auto manufacturers themselves, or businesses set to benefit most from the use of electric and autonomous vehicles. Investors who participated in Tesla’s initial public offering in June 2010 would have been provided with a total return of 789% to September 2016.

Lithium producer Albemarle Corporation has also rewarded investors with a total return of around 121% over the same period, due partly to increased demand for the metal.

We have been researching this theme as part of a wider review into the technology sector, including areas such as virtual reality and artificial intelligence. Whilst we are seeing many new developments within the sector, it is differentiating conceptual prototypes from products with commercial potential that is challenging.

“We’re offering a real alternative to a world that looks like a parking lot and moves like a traffic jam – a new mode of transportation that complements and improves the system we have today, now.”

– Travis Kalanick, CEO of Uber

Market Moving Themes

Figure 4: Forecast of Electric Vehicles as a % of Global Car Sales

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11 http://www.autoexpress.co.uk/car-news/consumer-news/90376/ queens-speech-sets-out-new-uk-driverless-car-legislation

Figure 4: Forecast of Electric Vehicles as a % of Global Car Sales

Source: BlackRock Global Funds Presentation

Around the World

Global Markets

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Russian Elections

Parliamentary elections in Russia for the lower legislative house produced an increased majority for President Vladimir Putin’s United Russia (UR) party. It gained 76% of seats in the lower house, making life easier for the Kremlin. However, voter turnout was the lowest since Putin has been in power – some observers estimate it at 47%, with only 15% of the total eligible electorate voting for UR. Furthermore, widespread irregularities were also reported relating to vote-rigging and other electoral fraud. Wide-ranging senior ministerial reshuffles took place following the vote, including the promotion of the Speaker Sergei Naryshkin to head of the Foreign Intelligence Service.

Meanwhile, Russia has been accused of possible war crimes if proved to have carried out the recent bombing of a UN aid convoy near Aleppo in Syria. 20 people died and 18 aid lorries were destroyed, with both Russia and the West blaming each other for the attack. Sanctions remain in place.

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Around the World

Phillippine President

New Philippine President Rodrigo Duterte is interested in offering trade alliances and long-term land leases with China and Russia, despite this potentially leading to a “crossing of the rubicon” with the US. Although he doesn’t plan on cutting ties with the US, he has indicated that the Philippines are willing to forge closer economic relationships with the other side of “the ideological barrier”.

This comes shortly after Duterte made inflammatory remarks about Obama, stating that he did not want to be lectured by the US leader on human rights. The insult came after the reports that he would be questioned by Obama over his action against drug use in the Philippines that has thus far lead to over 2,400 fatalities in just over 2 months. Duterte has since expressed his regret over the strong comments used.

Colombia Signs a Historic Peace Agreement

After five decades of conflict, more than a quarter of a million people killed and nearly seven million people displaced, Colombia’s president Juan Manuel Santos has signed an agreement for peace following years of secret talks.

The deal, subject to a vote of approval by the Colombian people, will see the demobilisation of the FARC and the reintegration of its members into society, with only some being held accountable for their crimes. If approved, the group will be granted ten seats in congress – a controversial step toward shifting from violence to votes.

If Colombians vote in favour of the deal, it will enable the government to begin focusing resources on the wider economy outside of the military. The tourism industry is likely to benefit in the long term, while overdue tax hikes are probable in the short term. If rejected this would mark a huge setback for President Santos, and bring into question his mandate to govern.

Mexican Unrest

Political unrest in Mexico has recently escalated, with opinion polls identifying Enrique Peña Nieto as the most unpopular President in a quarter of a century. Entrenched corruption, an increase in crime, and fears around the weakening economy have been constant concerns since he took office in 2012, and frustrations peaked after Peña Nieto’s warm invitation and subsequent welcome of Presidential candidate Donald Trump. As the race to the White House approaches its apex, the Mexican currency is increasingly volatile, and a Trump presidency, with his stance on immigration and anti-globalisation, would be a serious blow to Mexico’s economy. There are protests calling for the President’s resignation and increasing support for the populist left, as instability is stirring and tensions rising amongst a disgruntled population.

North Korea

North Korea has tested its fifth, and most powerful, nuclear device as it continues to pursue the development of its nuclear capabilities, in defiance of multiple UN Security Council resolutions. As South Korea and the United States increase the number of periodic military exercises, tensions are also heightening with North Korea’s traditional ally, China. Although Beijing has said it is resolutely opposed to the test and has communicated this to North Korea, it has made relations with the US more uneasy since it refuses to implement its own sanctions on its ever-reliant neighbour. Pyongyang blames the United States’s hostile policy for its need to be prepared to defend itself, and this most recent test, along with ballistic missile launches, is increasingly alarming as it develops its ability to put nuclear warheads on a variety of long-distance rockets.

Turkish Sovereign Debt

On 23rd September, Moody’s slashed its rating on Turkey’s sovereign debt to ‘junk’, from Baa3 to BA1 due to deteriorating credit fundamentals following political instability and lack of reform commitment. As expected, this was swiftly reflected in the Turkish market, with the lira tumbling to a seven week low at 2.999 a dollar, and stocks taking a 4% downturn the following business day. Turkey have criticised the decision made by the credit rating company, claiming that the downgrade is purely political, although the country was placed into review for the cut on 18th July after the failed coup attempt. Nonetheless, Turkey has remained resilient, and markets recovered swiftly since the announcement.

Moody’s, following in Standard & Poor’s footsteps, has left Fitch Ratings as the only credit agency to keep the country at investment grade.

16

The Asset Markets

A Quarterly Review of the Major Asset ClassesAll data sourced from Bloomberg unless stated otherwise.

Developed Market Equity

Performance: Developed equity markets saw remarkably less volatility in the third quarter of the year following the UK’s momentous vote to leave the European Union at the end of June 2016. UK markets rose relatively steadily throughout the quarter, as sterling’s depreciation improved the substantial foreign earnings of UK corporates. Other equity markets behaved in a similar fashion, though perhaps without the full strength of the UK relief rally after the initial shock of the referendum settled.

In the US, equity markets rallied at the beginning of the quarter, reaching all-time highs by the second week of July, but have since traded within a remarkably tight trading range. For nearly two months the S&P 500 remained between 2,150 and 2,200, with volatility levels reaching multi decade lows; by contrast, more than half of the trading days in January 2016 had a daily range of greater than 40 points. As the quarter progressed, so investors’ attention switched between expectations of a further US Federal Reserve interest rate rise – now most likely to come in December having been passed up at the Fed’s September meeting – and the US Presidential race, the outcome of which is due in early November.

Japanese equities also traded higher to the end of September. Much of the quarter was spent speculating over adjustments the Bank of Japan would make to their program of Quantitative and Qualitative Easing as they completed their comprehensive policy review.

In September they announced a refocusing of policy away from expanding the monetary base and towards targeting interest rates, specifically with the goal of steepening the yield curve, pivoting around the 10 Year at 0% – a policy which ultimately received a rather tepid reception from equity markets.

Finally, European markets also rose during the quarter, but with little material trend following substantial volatility in previous quarters. Political commentary following the UK referendum decision dominated, but with little new news, focus is increasingly moving towards a slew of important national plebiscites, including a referendum on constitutional reform in Italy, local elections in Germany and presidential elections in France.

Valuations: In the US, price to earnings (P/E) valuations have inched up marginally to 18.5 times for the S&P 500, despite the index facing its 6th straight quarter of declining earnings and margin contraction. The US remains the most expensive on this comparable but with the UK not far behind. Despite distortions surrounding the UK referendum, markets remain at similar levels to those pre-referendum. The rise in prices of many defensive, overseas earning companies has been matched by the equivalent improvement in sterling denominated earnings, leaving valuation multiples broadly unchanged, and whilst the UK market remains optically cheaper, it is distorted by a large weighting to financials, mining and oil and gas companies which remain cheap.

Similar sector divergences are increasingly seen in Japan and Europe. In Japan, the healthcare sector looks particularly expensive, trading at c. 30 times next year’s earnings, compared to Japanese financials at a ratio of just 9 times earnings.

Global Markets

Total Return % Change, Local Currency

3 month % change 6 month % change 12 month % change

MSCI United Kingdom +6.0% +11.7% +13.6%MSCI USA +3.5% +5.6% +12.6%MSCI Europe ex UK +4.6% +1.7% -0.3%MSCI Japan +6.4% -2.1% -7.0%

17

The Asset Markets

In Japan, as in Europe, a continued negative interest rate environment undermines banking profitability whilst simultaneously increasingly investor appetite for returns in risker parts of the market. Indeed, Japanese companies are increasingly looking abroad for acquisitions as expectations for domestic returns on equity stagnate. In this guise, Japan’s Softbank’s acquisition of UK technology firm ARM Holdings was as much a function of the relative strength of the Yen and meagre investment opportunities in Japan as any particular concern over future economic confidence in the United Kingdom following the vote to leave the European Union.

Outlook: The Global equity market looks set to be dominated by policy risk for some time. In the US we maintain our outlook that long-term future returns for investors will be dependent upon underlying profit growth as margin expansion from current levels becomes increasingly unlikely. In the short term however, we expect markets to remain focused on November’s Presidential elections, with close election run-in likely to see higher levels of volatility and potential weakness if Donald Trump assumes the White House.

In Europe, the effect of national and international politics is perhaps even more acutely felt. The timing and means of Britain’s exit from the European Union will have substantial ramifications on both sides of the channel if mishandled. Any further sterling weakness is likely to continue to benefit large cap UK corporates in aggregate. In Europe, government change is possible in Italy, France and Germany within the year. These, together with numerous local elections across Europe and the UK, will test the resolve of many governments in the face of growing support for populist right wing movements and anti-immigration sentiment.

In this environment equity market strength is difficult to predict, though perhaps with the exception of the UK, where the conspicuous advantage of a weakening currency can support equity market levels in times of particular political or economic stress.

With Japanese President Shinzo Abe in a relatively stronger position, Japan’s economic concerns are likely to resonate more strongly. As ever, despite their recent alteration to policy, the Bank of Japan (BoJ) remains extremely supportive of the Japanese economy, though we continue to expect this resolve to be tested if economic improvements are not seen. Longer-term structural and demographic headwinds undoubtedly remain, but with continued central bank support and relatively attractive valuations, we have not yet called time on support for Japanese equities.

Emerging Market and Asian Equities

Performance: Emerging markets (EMs) continued to perform well in the third quarter, keeping pace with the rally experienced since Brexit and again outperforming their developed market (DM) peers. What is impressive about the continued rally in EM is that it has sustained itself through a period of dollar strength, which historically has been a notable headwind for the asset class.

The Latin American (LatAm) emerging markets have outperformed their EM peers and global equity markets significantly in the quarter. The equity market has continued to be buoyed by the prospects for the economy due to political change, as the impeachment of Dilma Rouseff was finalised on the 31st August.

In the Eastern European region, most markets underperformed as a result of fears and realisation of Brexit, risks in the European banking system, and an attempted coup in Turkey, as well as a range-bound oil price capping further gains in Russia.

Following the first half of the year, where Asian markets underperformed the rally in the rest of EM, the third quarter saw Asian markets make decent gains across the board. Chinese equity markets rebounded as concerns abated regarding growth and the economy’s highly indebted corporate sector. The technology sector in Korea continued to perform well, as did domestic cyclicals in India as the long awaited Goods Services Tax Bill was passed. The rest of the EM Asia has fared relatively well.

Total Return % Change, Local Currency

3 Months % Change 6 Months % Change 1 Year % Change

MSCI Emerging Market +8.3% +8.0% +14.1%MSCI China +13.4% +11.5% +10.4%MSCI India +4.1% +9.6% +6.1%MSCI Russia +5.9% +9.4% +20.4%MSCI Brazil +10.7% +25.4% +52.8%

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Valuation: The overall EM valuation is cheaper than that of the DM. Investors typically demand higher compensation investing in the EM because it is perceived as riskier. At the end of September, the broad index was valued at 12.6 times its forward earnings, compared to 15.5 times that of the DM.

The massive dispersion across EM sectors and countries continues. In LatAm, Mexico continued to be one of the most expensive EMs as investors remain confident in the country’s structural reform, despite building weakness in the Peso as the country has struggled with growth and the prospect of a Trump-led government in the US. Brazil’s valuation has risen since the beginning of the year alongside its price level; the country has experienced a re-rating through political change and prospects for economic change under the ‘new’ government.

The European EMs had lower valuations at the end of the third quarter compared to that of the LatAm and Asia due to the reasons outlined in the performance sector, which are numerous.

In Asia, Philippines continues to be the most expensive market, at circa 20 times of its 12-month forward earnings estimate. The valuation was supported by the country’s strong private sector growth and the benign inflation conditions, yet concerns have arisen with regards to the rather outspoken and controversial President Duerte. This could indeed lead to a de-rating in the stock market as some of the political risks are factored into the market. China’s valuation, on the other hand, is among the cheapest still. Although the MSCI China Index (a proxy used by many of the overseas investors) is biased towards the drivers of the new economy, the valuation is somewhat discounted by the weakness of the country’s sunset industries. The economy’s concern over corporate debt levels is also seen to constrain their profitability prospects, therefore restraining the capital inflow into the equity markets.

Outlook: As we noted in the 2016 Q1 Global Markets Report, the key to consistently better performance in EM equities is through improving earnings per share (EPS) growth, which had been stagnating/slowing for the last 4 years. We highlighted that the markets normally turn 6 months prior to net revisions in both directions and that we were at the end of the ‘adjustment cycle’ or downturn in earnings revisions.

Although we didn’t believe that this would initially cause the EM index to re-rate, we thought a change in market sentiment around Emerging Market growth, mainly in China, would be the catalyst for EM to outperform, as well as extremely negative positioning in EM equities being reversed. Overall we expected EM to outperform. This has happened. Growth has surprised to the upside, earnings have stabilised, investor flows have reversed and there is now money coming back into the asset class.

Not surprisingly, over the past six months we have focused on the trend for corporate earnings and economic growth. We see both accelerating which should support EM equity performance over the medium term. With the Russian and Brazilian economies expected to bottom in 2016 (the two economies that have acted as the largest drag on EM EPS over the past four years) a further growth catalyst may come from a rebound in 2017. Stability in commodity markets and easing financial conditions (11 EM countries are easing this year) will act as a further tailwind to EPS and economic growth.

In the short term however, this forecast is tainted by political risk in the US which could negatively impact EM. A Trump White House is bad for EM and poses one of the main risks to the asset class. In the recent EM rally, one must remain aware that this is a ‘nervous’, highly geared asset class, subject to higher volatility than most. Most recently, we saw the ever more concerning Philippine president pass comment on casinos and gambling, which led gambling-related stocks in the Asia region to plunge by 5%. If this is the market reaction to a comment by a relatively impotent leader, we could expect much higher levels of volatility if Trump were to be elected.

Between his view on immigration, the Mexico ‘Wall’, trade protectionism (including undoing the North America Free Trade Agreement) and the general uncertainty of his policy, we believe risk aversion towards EM would increase.

There would be potential for a strong dollar also (against EM currencies), partially because he might force repatriation of overseas profits from other countries back to the US through tax legislation, partially due to higher risk premiums for ‘high beta’ currencies dependent on global trade, which would become stressed as global trade tensions could rise under a Trump presidency.

The Asset Markets

19

The Asset Markets

So, rising risk aversion and a potentially strong dollar would be a bad macro environment for EM.

More specifically, Mexico and China (having large linkages to the US) could be the two markets more vulnerable as (i) Trump has specifically mentioned them (in the sense he would impose steep tariffs on imports) and (ii) the US runs large trade deficits with both. If he is serious about adjusting those two trade flows, these countries would be on the top of his list.

Otherwise, we hold a positive outlook for the asset class.

Global Government Bonds

Performance: The start of July saw fixed income markets coming to terms with the UK’s decision to leave the EU. The ECB (European Central Bank) continued to make supportive comments in an attempt to reassure bond investors concerned about the potential contagion effect of Brexit, leading to a breakdown of the entire European project. As a consequence, we saw 10 Year German Bunds briefly move into positive territory as investor concern peaked, however the reassurance of the central banks soon assuaged such fears.

August saw Janet Yellen, Chair of the US Federal Reserve, making her annual speech at Jackson Hole in which she highlighted the underlying strength of the US economy and particularly the labour market. Market perception was that these bullish comments pointed towards a second Fed rate hike by the end of the year, and as such we saw US yields trend generally higher over the course of the month. In contrast to the US, in the UK we saw the Bank of England (BoE) move to further loosen monetary policy. Governor Mark Carney cut base rates for the first time in seven years from 0.5% to 0.25%. He also extended the Bank’s Quantitative Easing (QE) programme by £60bn to £435bn, and added a provision to purchase £10bn of corporate bonds as well.

His final measure was to introduce a £100bn “Term Funding Scheme”, a facility designed to compel banks to pass on the cheap levels of financing to consumers. All these measures served to push Gilt yields to record lows, with the 10 Year falling as low as 0.52% over the course of the month.

The final month of Q3 saw some disappointment for European Government Bond investors, as the ECB failed to deliver on market hopes that they would extend the current QE programme beyond its scheduled March 2017 end. Again we saw German 10-year Bund yields spike above 0% into positive territory. However, as August wore on, yields again fell back into negative territory. Indeed, by the end of the month almost half of total outstanding global government debt in issue had a yield less than zero, a sum of bonds worth in the region of $12 trillion. Remarkably, now the entire range of maturities of Swiss debt generate negative yields. August also saw a significant pivot in monetary policy from the Bank of Japan (BoJ) following a comprehensive review of the schemes currently in place. The decision was announced to move away from the programme of money printing currently in place, and instead to swivel towards a policy of interest rate targeting – specifically centred around anchoring the 10 Year part of the yield curve at 0%.

Arbuthnot View: Whilst the US still appears to be on the path of gradually tightening policy, they seem to be very much out on their own in terms of the trajectory of interest rates. The other major central banks, namely the ECB, BoE and BoJ, all remain extremely accommodative and if anything, look more likely to make policy looser. There is a decent chance Mark Carney could make another small cut to interest rates in the UK before year end and, should the need arise, it’s possible Mario Draghi at the ECB will extend the current QE programme out beyond spring of next year.

UK Gilt yields have generally trended lower over the third quarter, and despite touching record lows in mid-August, we could well see further drops from here – a real possibility when we look to the example set by equivalent bonds in Japan and Europe.

Bond Yields % (10 year) 30th September 2016 30th June 2016 31st March 2016United Kingdom 0.75% 0.87% 1.42%Germany -0.12% -0.13% 0.15%France 0.18% 0.18% 0.49%Europe -0.12% -0.13% 0.15%Japan -0.09% -0.22% -0.04%US 1.59% 1.47% 1.77%

20

Much will depend on the actions of the BoE in guiding the UK through its exit from the EU. Outside of the UK, the future direction of Government bonds, at least in the immediate future, will be shaped by the outcome of the US election. Should we see Hilary Clinton prevail, it’s likely the Federal Reserve will press on in raising rates in an attempt to return to some kind of normalcy with regards to monetary policy. However, should Donald Trump emerge victorious, the shock this will send through markets could well derail the Fed’s hawkish intentions, and unwind some of the upward momentum we’ve seen in US yields over the quarter.

Global Corporate Bonds

Performance: IG corporate bonds posted positive returns and outperformed government bonds across major regions. Credit spreads tightened across the US, UK and European bond markets over the month. At the regional level, UK IG corporate bonds outperformed their European and US counterparts, benefitting from both spread tightening and strong returns on UK Gilts. In the US, sentiment remained buoyant in credit as demand for yield continued unabated, while the ECB Corporate Sector Purchase Programme provides ongoing technical support to European corporate bonds.

Arbuthnot View: The hunt for yield continues as investors look for assets that pay an income, combined with other investors trying to weather the storm that was created around the referendum. This continues to cause yield spreads to tighten which is only being exacerbated by the bond buying programmes of both the Bank of England and European Central Bank. Opportunities arise through volatility, and we will continue cautiously to seek out those opportunities as and when they arise.

Property

Performance: According to CBRE’s Monthly Index, in total, UK Commercial Property declined 2.4% to the end of August.

The biggest fall was seen in London City Offices, measuring 5.7%, whilst Industrial Units outside London and the South East proved to be the most resilient, falling 0.4%. Despite the falls in capital values, rental growth continued in strong fashion, appreciating 0.2% over the last three months as the market returned to ‘business as usual’ following the vote to leave the European Union.

Valuation: The uncertainty following the 23rd June has made valuing properties extremely difficult. Heading into the vote, valuations were touching 10-year yield lows across sub-sectors, with many believing rental growth would be the main source of return following years of strong capital appreciation. Transactional activity in the past few months has been weak; early indications point to falls in capital values of 3-7% dependent on sector. Activity is encouraging considering the listed market pricing in approximately 20% discounts to net asset value in the most London-centric names.

Outlook: The fall in the value of sterling, potentially attracting foreign investors, and yield the asset class provides over government bonds will be supportive over the short term. The longer-term outlook for Commercial Property hinges on the UK Economy outside of the European Union; we will have further clarity when Article 50 is triggered. Logistic Industrial Units and Prime Retail sites are expected to outperform thanks to strong trends in consumer buying habits.

Hedge Funds

Despite the negative headlines, Q3 2016 was a strong quarter for Hedge Funds performance, with the HFRX Global Hedge Fund Index delivering 2.2%. Equity Long Short funds managed to capture part of the market upside in July while it outperformed equities in August and September, as indices went sideways. Event-driven funds posted even stronger numbers; despite that, they faced the largest amount of redemptions with billions of US dollars of outflows coming from most prominent names in the industry.

The Asset Markets

Corporate Bond Yields % 30th September 2016 30th June 2016 31st March 2016Global Investment Grade 2.29% 2.41% 2.68%US Investment Grade 2.87% 2.92% 3.22%US High Yield 6.59% 7.55% 8.58%Europe Investment Grade 0.62% 0.85% 1.02%Europe High Yield 2.84% 3.24% 3.46%UK Investment Grade 2.23% 2.84% 3.25%

21

The Asset Markets

Performance had been disappointing in the previous quarters and investors fear we are at the end of the M&A cycle, as deal breaks kept reaching new records. Under a challenging business environment, with investors fleeing and inconsistent performance, Perry Capital was the last name to throw in the towel and shut down their business after over 20 years of track record and more than $4bn in assets. On another extreme, Systematic/trend-following strategies received most of the inflows in 2016, while posting negative numbers in Q3. A number of trends reversed in during the last quarter, negatively impacting such strategies.

Commodities

Following two strong quarters of returns, the Bloomberg Commodity Index closed down 4.8% in Q3. Despite this, the index has returned circa 8.6% year to date and commodities remain one of the best performing asset classes of 2016. Whilst commodity inflows slowed in Q3 compared to the first two quarters, the January to August inflows stand at $54bn; an all-time high for the first eight months of any year.

The oil market looks range-bound as it continues to trade in a $40-$50 range since rebounding from February lows, with prices briefly breaking above the $50 resistance level at times. Whilst demand remains healthy, the energy market continues to be characterised by supply disruptions in Iraq, Libya and Nigeria, although there is some evidence that relations are thawing, and reductions in unplanned outages remain a big threat to the global rebalancing.

As at the end of the quarter, Crude Oil is trading at $48.05 with prices throughout the quarter mainly driven by the weakening dollar and rhetoric surrounding a potential OPEC output freeze. At an OPEC meeting in Algeria, the world’s largest oil producers agreed to cut production to 32.5M – 33M bpd from 33.2M bpd in August. The first OPEC production cut in eight years came largely as a surprise, with the consensus being that a deal would be difficult to reach given tensions between Saudi Arabia and Iran; the deal sent crude oil prices up 6% and sparked big gains for energy stocks. However, concerns remain surrounding the credibility of the preliminary agreement as individual country quotas, measurement and compliance still need to be determined and some analysts doubt the actual impact on market rebalancing.

Gold closed the quarter flat at $1,315, after trading at a two year high of $1,372. Gold has been the most popular investment this year, accounting for half of the total investment flow into commodities. The fundamentals for gold remain supportive, with uncertainty about the financial sector, global growth and the US Elections, as well as a lower real interest rate environment.

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October 2016

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