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Certitude Global Investing Insights - May 2013

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The Certitude Global Insights is produced each quarter, and provides a summary of key global investment themes over the last quarter coupled with investment insights from our fund managers. Highlights …

The Certitude Global Insights is produced each quarter, and provides a summary of key global investment themes over the last quarter coupled with investment insights from our fund managers. Highlights this quarter include: 10 Reasons for Global Equity Income, Breaking the Bad News Cycle, Watch Capital Flows for the Central Bank’s Next Move & Easy Eurozone Trades are Running Out of Road.

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  • 1. certitudeglobal.com.au May 2014 CERTITUDE GLOBAL INSIGHTS HIGHLIGHTS THIS QUARTER: 10 Reasons for Global Equity Income Breaking the Bad News Cycle Watch Capital Flows for the Central Bank's Next Move Easy Eurozone Trades are Running Out of Road
  • 2. Letter from Certitude CEO, Craig Mowll Another financial year is fast approaching the end! 2014 has presented some volatility (both market and AUD currency) on the back of strong global equity markets last year. Whilst returns are still very good Australian investors have continued to express concerns around the Australian economy, the Middle East, Russia and Ukraine crisis, China economy and Japan….all for good reasons. That said; the global markets are still providing quality investment opportunity and we continue to witness an increase in interest in investing in various asset classes throughout the global landscape. Global equities, particularly global equity income is getting the greatest attention and no far behind is global equity long short. Both strategies support the feelings described in the first paragraph. Whilst global fixed income has taken a certain backseat in investor’s minds it certainly has not been forgotten at Certitude and we do see this strategy playing a stronger role in 2015…so watch this space! Don’t forget the Certitude Global Investing Intentions Index (CGIII) which is produced monthly and measures Australian investors’ current appetite for investing in overseas assets. The index is based on: actively engaged Australian investors (investors who have assets in addition to home and compulsory super); The relative proportion of investors intending to increase their exposure to overseas assets over the next quarter, relative to those intending to decrease overseas exposure; and figures above 100 indicate more prospective ‘buyers’ than ‘sellers’ of overseas assets. This survey data is collected monthly via an online method with ~1,000 respondents. Certitude tracks the Index and releases the findings monthly at http://cgiii.certitudeglobal.com.au/ Please enjoy this edition of Certitude Global Insights and would be happy to receive your feedback, questions or comments via email to globalinsights@certitudeglobal.com.au or by contacting our Investor Services team on 1300 30 90 92. We look forward to working with you in 2014. Yours sincerely Craig Mowll Chief Executive Officer Certitude Global Investments 1
  • 3. CERTITUDE GLOBAL INSIGHTS CONTENTS Certitude CEO’s letter Page 1 From the Desk - Stephen Thornber Page 3 About Threadneedle Investments Page 7 Threadneedle Investments - Highlights Page 8 Threadneedle Investments – Investment outlook Page 9 Threadneedle Investments – Ten Reasons for Global Equity Income Page 11 Threadneedle Investments – Investments themes Page 25 About Lighthouse Partners Page 27 Lighthouse Partners - Quarterly outlook (summary) Page 28 Lighthouse Partners – First quarter 2014 review Page 29 Lighthouse Partners – Second quarter 2014 outlook Page 30 About GaveKal Capital Limited Page 32 GaveKal - Quarterly outlook Page 33 GaveKal Research – Breaking The Bad News Cycle Page 34 GaveKal Research – Watch Capital Flows For The Central Bank's Next Move Page 36 GaveKal Research – Easy Eurozone Trades Are Running Out Of Road Page 39 Why Certitude? Page 41 Certitude's funds Page 44 Quarterly fund performance summary Page 46 Certitude contact Page 47 Threadneedle Investments – Is Europe heading for Japanese-style deflation? Page 16 2
  • 4. Stephen Thornber, Portfolio Manager, Threadneedle Global Equity Income Fund Whilst 2013 was a difficult environment for dividend strategies (mainly because of fears that the US Federal Reserve would reduce its program of quantitative easing), we continue to believe dividend strategies are a powerful strategy – primarily because they grow over time your purchasing power becomes stronger. We believe by identifying companies with really robust growth potential, they will be able to perform strongly even when the market penalises quality companies and income stocks. Looking forward on consensus estimates, the Fund’s portfolio is expected to grow earnings 8.3% and dividends 8.2% this year (2014). This doesn’t mean revenue has to go up 8%... earnings generally rise faster than revenue due to leverage. The Fund’s portfolio has a current running dividend yield of 4.5% and the Fund yield is a 79% premium to the World Index (source: Threadneedle, as at 31 March 2014). The MSCI All Country Index (MSCI AC) has a current dividend yield of around 2.5% (as at 31 March 2014). Valuations are still attractive and we expect the improved economic background to lead to useful corporate earnings growth this year, which will result in continued attractive payouts to shareholders. We continue to believe that Income strategies will outperform and that the companies within the Fund’s portfolio, which all have attractive yields and strong growth prospects and strong balance sheets will continue to maintain and grow their distributions. There are no signs of an income bubble. After several years of good stock performance, and with bond yields at historic low levels, one could be forgiven for thinking that dividend stocks must have reached expensive levels. However, when we look at the valuations of high-dividend paying companies globally, they are still trading at a discount to the broader market. Valuations of high dividend companies Source: MSCI index data as at 31 March 2014 We remain of the view that investors can expect attractive earnings growth in 2014, and that this is likely to provide a supportive backdrop for capital gain; while the high dividend-yield we expect from all of our stocks provides a high income stream. We expect global economic growth to continue to strengthen this year and this, together with an acceleration in company profitability should provide a supportive backdrop for equity markets. The continuing economic recovery in the US, Japan and Europe are likely to provide a supportive backdrop for earnings growth and capital gain; while the high dividend-yield we expect from all of our stocks provides a compounding income stream to bolster returns. We continue to focus on companies that offer rewards on both fronts, while operating with a robust financial structure. Equity markets have clearly performed extraordinarily well over the last couple of years; the S&P 500 is up by 50%, the FTSE All-Share by more than 33% and the MSCI World index by over 40% (as at 31 December 2013). Although corporate profits have grown, this growth has been nowhere near as strong as equity markets have been, and so the return from equities has been driven by a rerating fuelled by increasing confidence and ongoing central bank stimulus and liquidity provision. However, we are now beginning to see signs of corporate growth come through, and this we feel will provide an additional supportive backdrop to dividend paying stocks. 12.4 9.7 11.1 14.7 13.9 11.8 13.3 15.7 Europe inc UK Asia Pacific AC ex Japan Japan USA High dividend yield index Regular Index Forward PE ratios FROM THE DESK May 2014 3
  • 5. Currently we’re overweight Europe and the UK. We’re positive on the UK, we see the growth there accelerating and we do think it’s a good area for equity markets. We think valuations are reasonable. Europe is a little more difficult because it’s really still very much a two-speed market. We’re beginning to see some recovery from the austerity measures that Spain, Portugal, Greece and Ireland have put in, but big economies like France and Italy are still struggling. Possibly Europe as a region may well struggle because a couple of the larger economies are still struggling. But that doesn’t mean that we can’t find opportunities. We’re really focused on Germany, Switzerland and Scandinavia where we can see good valuations, good corporate profits and more robust economies. The US is around a third of the Fund but we’re actually thinking of taking money out because whilst we are confident on economic growth there we think the market is looking a little bit, not overvalued, but fully valued. We think there are better opportunities, partly in Europe where we’ve been adding to, partly in Japan where we do see ‘Abenomics’ beginning to have some positive effects. The underlying strategy has a very unique set of criteria that sets the Fund apart from competitors. What do we look for in a stock? An ideal stock for us will meet three factors;  A yield over 4% - no exceptions  Earnings and dividend growth greater than 5%.  Robust balance sheet – gearing less than 75% and dividend cover greater than 1.25x (payout ratio of less than 80%). The three factors are designed to identify ‘Quality Income’ – a high, growing and sustainable income stream. ALL companies must be able to demonstrate good growth and healthy balance sheets so that the companies do not come under pressure even in weak markets. Earnings and dividend growth are to ‘embedded’ growth in the portfolio – We want the income stream from the portfolio to grow over time. Balance sheet strength is required to ensure dividend payments are sustainable into the future; we want to make sure companies are not over-distributing their income, and may have to cut their dividend in the future. The portfolio in aggregate has these characteristics, but the Fund manager will flex the second and third factors for individual stocks if he can convince himself self that the quality and potential return of the company is good enough. Due to the “income sustainability” and “growth” elements of the Fund, we believe that the Fund’s portfolio of companies will continue to grow their dividends even when the market penalises quality companies. Please see a few examples below that help demonstrate just some of the quality companies within the Fund. There are a number of themes running throughout the portfolio. EM CONSUMER- Despite the obvious challenges that the world’s emerging economies face, we are still positive on emerging market consumers. We are looking for high-quality companies that are benefiting from rising consumption and demographic growth without being too reliant on the local economy, so we often obtain exposure to emerging markets through Western companies. We are very positive on consumer brands, and Hugo Boss is a good example of this. This German company performed extremely well for the Fund last year, even in the second-half rotation out of high-quality stocks. We own it for its exposure to Asian consumers rather than to a European recovery. The company has had long-running problems in Europe, but is restructuring its supply chain and its stores base. What excites us most about it, however, is the growth that we see coming from Asia. The company missed the first phase of Asian expansion undertaken by peers such as Gucci, Swatch, Burberry and Mulberry. Having missed that, Hugo Boss is obviously playing catch-up, but that in itself entails growth. It has also been able to learn from the mistakes made by other Western brands when they first went into Asia. The company should enjoy 12-15% earnings growth over the next few years, and its management has committed to increasing the dividend in line with this. And all this from a stock that’s already yielding around 4.5%. Las Vegas Sands, a casino operator, which is benefiting from very strong revenue growth in Macau. Although Las Vegas Sands is a US company, 80% of its revenues come from Asia, and 80% of its casinos are in Hong Kong and Macau. The Asia gambling theme is a very strong one - The growing spending power of the Asian consumer is a theme that we also play through our holding in Cambodian casino company NagaCorp, which also performed extremely well over the year. Both companies continued to outperform in the second half of the year, despite the general move away from high-quality stocks. These 2 stocks get exposure to the EM consumer which is one of the key themes in the Fund. 4
  • 6. We also like Asian telecoms companies and currently own Australian, Singapore, Malaysian and Thai operators. These offer us attractive exposure to growing economies and positive demographic trends, and also give the Fund exposure to the early stages of mobile adoption, 3G adoption and data consumption. In the US and Europe, the telecoms industry is very competitive; rates are being cut, and the sector is highly regulated. In Asia, however, we’re getting in at an early stage of the industry’s development, and so we’re getting growth – and a lot of these companies are paying very good dividends. DEFENSIVE GROWTH - Another theme in our portfolio is defensive growth. Defensive growth was not too badly beaten up last year so we see good value. We invest in tobacco and consumer staples, including food companies such as Nestlé and Unilever. We also favour large pharmaceutical firms like Roche, Merck and GlaxoSmithKline. These companies have had a difficult four or five years, as patent expiries have come through, but they all have attractive pipelines, two to three years out, which have significant potential to drive earnings and dividend increases. US ENERGY REVOLUTION - We are very positive on the US energy revolution, as we have been for the last four or five years. We see huge, long-term cost advantages in US shale gas. In the US, companies are paying $4 or $5 per million British thermal units for their natural gas; in Europe, firms are paying $10 or $12; in Asia, they’re paying $15+. That’s a huge cost advantage, particularly for chemical companies and refiners. We also own pipeline companies – the infrastructure – a long term theme. DIVERSIFIED FINANCIALS - are another portfolio theme. Blackstone was a standout performer for us last year and we feel that it has very strong potential for 2014. We own a couple of private-equity firms and a hedge-fund operator. Strong contributors to performance last year - What we’re looking for here are companies in advantageous niches. We see upside from looking at banks’ struggles as regulators pressurise them into selling their assets and reducing risk. As banks take this risk off their balance sheets, who is taking on this risk? Private-equity firms continue to perform extremely well, as they start to realise profits on the investments they made in the depths of the recession. Blackstone has taken the Hilton chain public, while Merlin has floated Madame Tussauds and is looking to do the same with the London Eye. We remain positive on global dividend-paying stocks. Global dividend stocks provide not only a compelling source of income via yield but also the opportunity for valuation expansion, driven in part by growth. In our view, there is not better combination of return drivers than the one available from global dividend equities. This document was prepared from the views of Stephen Thornber, Portfolio Manager for the Threadneedle Global Equity Income Fund the underlying fund for the Threadneedle Global Equity Income Fund (Unhedged). 6 5
  • 7. Certitude Global Investments Limited ABN 25 082 852 364, AFSL 246747 (Certitude) is the issuer of units in the Threadneedle Global Equity Income Fund (Unhedged) ARSN 161 086 497 (the Fund). Certitude is the responsible entity of the Fund and has selected the Threadneedle Global Equity Income Fund (the Threadneedle Fund) as the underlying fund. The investment management of the Threadneedle Fund is provided by Threadneedle Asset Management Limited (Threadneedle). The investment performance of the Fund may not necessarily reflect the performance of the Threadneedle Fund. Every effort has been made to verify the accuracy of the detail contained within this report. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The information contained in this document is not personal financial product advice, it does not constitute an investment offer and has been prepared without taking into account the objectives, financial situation or needs of any particular person. All investments carry risk. Before you make an investment decision you should consider, with the help of a qualified professional, whether to acquire, or retain units in the Fund. You can obtain a copy of the Product Disclosure Statement (PDS) for the Fund at www.certitudeglobal.com.au/pds or by contacting Certitude on 1300 30 90 92. Past performance and asset allocation is not indicative of future performance or asset allocation. Neither Certitude or any of its officers, employees, representatives or affiliates guarantee the repayment of capital, payment of income or the Fund’s performance. Source: Threadneedle. Name Region Contact telephone Mobile Hector Ortiz National +61 (0)7 3218 6212 +61 (0)488 585 534 Paul Burbidge New Zealand +61 (0)7 3218 6287 +61 (0)409 723 990 Michael Akele NSW and ACT +61 (0)2 8302 3326 +61 (0)401 994 973 Jennifer Savedra Victoria and WA +61 (0)3 9225 5036 +61 (0)429 038 946 Geoff Koudelka Victoria, SA and TAS +61 (0)3 9225 5035 +61 (0)417 309 844 Paul Burbidge Queensland +61 (0)7 3218 6287 +61 (0)409 723 990 6
  • 8. CERTITUDE BRINGS THE WORLD TO YOU Threadneedle Investments forms part of the Ameriprise Financial Group and is one of Europe’s most successful asset managers. Threadneedle’s ideas are shared across a single investment platform encouraging debate across all asset classes and teams to ensure a rigorous examination of economies, markets and securities. Threadneedle is the third largest UK based retail asset manager with US$126.6 billion* assets under management. Certitude has partnered with Threadneedle Investments to provide Australian and New Zealand investors with exclusive access to their investment capabilities and global reach. * Source: Threadneedle, 30 June 2013 7
  • 9. THREADNEEDLE INVESTMENTS Highlights  Mark Burgess (CIO) – Economic and market commentary  Stephen Thornber (Portfolio Manager) – Ten Reasons for Global Equity Income  Martin Harvey – Is Europe heading for Japanese-style deflation?  Threadneedle – Investment Themes Summary 8
  • 10. Investment strategy May 2014 T16531 Issued May 2014 | Valid to end August 2014 Mark Burgess Chief Investment Officer Economic and market commentary Global equity markets were largely unchanged in April, although this masked a fairly wide dispersion in returns at the sector level. In early April, for example, technology stocks came under pressure and triggered a general slide in equities due to fears that valuations were overstretched. Tensions between Russia and the West also undermined investor sentiment. However, equity markets subsequently rallied strongly on the back of encouraging US data and some easing of geopolitical tensions before some disappointing earnings releases in the US, a deterioration in the Ukraine crisis, and fresh concerns over the economic outlook in China weighed on risk assets in the final days of the month. Treasury yields fell with the 10-year benchmark yield ending April at 2.66%, compared with the 2.72% level seen at the end of March. At the end of the month, and as expected, the Federal Reserve continued to reduce its monthly bond buying by US$10bn to US$45bn. The central bank said that growth in economic activity had picked up recently, having slowed sharply during the winter. The Federal Reserve also repeated its ambition of keeping interest rates at very low levels saying it would maintain interest rates "below levels the committee views as normal in the longer run" even after the US economy has improved enough to hit target levels of unemployment and inflation. In the eurozone, Portugal returned to the bond market for the first time in three years, holding a successful auction of €750m. The auction was three times oversubscribed and 10-year government debt yields fell sharply to an eight-year low of 3.58%. Greece also returned to the bond market for the first time since 2010. It sold €3bn of five-year bonds at a yield of 4.95% and said the issue was eight times oversubscribed. At the end of the month, the yield on the Portuguese 10-year bond had fallen to 3.64%, while that of the Greek equivalent was down to 6.64%. Eurozone bonds in general gained over the month on speculation that concerns over deflation could cause the ECB to adopt new stimulus measures. The J.P.Morgan EMBI+ Index (on a total-return basis) delivered a positive return as emerging market bonds continued to recover. Russia proved an exception, however, with tensions between the West and Moscow over the Ukrainian crisis hurting investor confidence in the country’s bonds. Moreover, the credit rating agency Standard & Poor's cut Russia to BBB- with a negative outlook, placing it on the brink of junk status. Meanwhile, the MSCI Emerging Markets Equity Index (total return, local currency) was largely unchanged over the month. We made no changes to our investment strategy over the month. We remain overweight equities as valuations are largely reasonable, although less compelling than was once the case. We also remain underweight Asian equities on concerns over China, while we are overweight Japan as valuations are attractive versus developed world peers. Although we remain overweight equities, it would be fair to say we are less optimistic than we have been, although the recent pick-up in M&A activity in areas such as pharmaceuticals should prove supportive. Within fixed income, core yields are going to grind higher, and there is much less value in credit given how far spreads have tightened. Only emerging market debt appears to offer any real value, but given the risks in terms of China, geopolitics and the macroeconomy, we are wary of increasing our weighting at present. The good news is that the current environment is likely to continue to provide opportunities for stock pickers, which we should be able to exploit. 9
  • 11. Investment strategy | May 2014 T16531 Issued May 2014 | Valid to end August 2014 Important information: For use by investment professionals only (not to be passed on to any third party). Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Issued by Threadneedle Asset Management Limited (“TAML”). Registered in England and Wales, No. 573204. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Conduct Authority. TAML has a cross-border licence from the Korean Financial Services Commission for Discretionary Investment Management Business. Issued in Australia by Threadneedle International Limited (“TINTL”) (ARBN 133 982 055). To the extent that this document contains financial product advice, that advice is provided by TINTL. TINTL is exempt from the requirement to hold an Australian financial services licence under the Corporations Act in respect of the financial services it provides. TINTL is regulated by the Financial Conduct Authority under UK laws, which differ from Australian laws. Issued in Hong Kong by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司 (“TPSHKL”). Registered Office: Unit 3004, Two Exchange Square, 8 Connaught Place Hong Kong. Registered in Hong Kong under the Companies Ordinance (Chapter 32), No. 1173058. Authorised and regulated in Hong Kong by the Securities and Futures Commission. Authorisation does not imply official approval or recommendation. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document you should obtain independent professional advice. This document is distributed by Threadneedle Portfolio Services Hong Kong Limited Dubai branch, which is regulated by the Dubai Financial Services Authority (“DFSA”). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client under the DFSA Rules. Issued in Singapore by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07 Winsland House 1, Singapore 239519. License Number: CMS100182-2. This document is being issued in Singapore to and is directed only at persons who are either institutional investors or accredited investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) in Singapore. This document must not be relied or acted upon by any persons in Singapore other than an institutional or accredited investor. Issued in the US by Threadneedle International Limited (“TINTL”), a UK.-based investment management firm provides financial services to individual and institutional investors. TINTL is registered as an investment adviser with the U.S. Securities and Exchange Commission and is authorised and regulated in the conduct of its investment business in the UK by the UK Financial Conduct Authority. Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. www.threadneedle.com 10
  • 12. Viewpoint Global Equity Income – May 2014 T16405 Issued May 2014 | Valid to end August 2014 Stephen Thornber Portfolio Manager Ten reasons for Global Equity Income 1) Dividends act as a signal of a company’s investment quality Dividends are quite simply a distribution of profit by well-established businesses, which are able to generate cash in excess of capital spending and investment needs. They provide a clear sign that a company has a good business model, and that management is dedicated to shareholder returns. Moreover, dividends are a continuing commitment, and they thus highlight the management’s confidence in the future of the company. Dividend stocks are also more reliable and are likely to prove better long-term investments than growth stocks, which can deliver spectacular gains but also big disappointments. 2) Dividends lower agency costs, and improve capital allocation Regular dividends reduce corporate cash balances and thereby lessen the likelihood of management squandering shareholder funds through pet projects or ill-conceived M&A deals. They promote the efficient use of capital and the prioritisation of investment into the most attractive projects. This has the benefit of setting a steady long-term growth culture, and reducing business risk. 3) Income strategies stand up on a total return basis Income strategies have a proven record of outperforming other approaches over the long term. Moreover, analysis covering the past 20 years (figure 2), shows that not only have dividend stocks outperformed, the higher the yield the stronger the performance. Thus, the evidence suggests that the investment quality and disciplined capital allocation that characterises these stocks has translated into superior total returns. Figure 1: Dividend-paying stocks outperform over the long term Source: CLSA, FactSet Alpha Tester as at 31 December 2013. Note: Backtest based on MSCI universe with more than 3 analyst coverage. MSCI weighted US-dollar total return (monthly rebalancing). Cumulative performance since 1995 0 200 400 600 800 1000 1200 Dec 94 Dec 96 Dec 98 Dec 00 Dec 02 Dec 04 Dec 06 Dec 08 Dec 10 Dec 12 Index First quintile dividend yield Second quintile dividend yield MSCI AC World 11
  • 13. Viewpoint – Global Equity Income T16405 Issued May 2014 | Valid to end August 2014 4) Equity income investors take a long-term perspective Dividend-paying companies are regarded as dull. Moreover, since news headlines and market participants favour ‘what is hot’, the market often ignores the positive characteristics of dividend-paying companies in favour of higher risk/reward opportunities. Income investors also tend to avoid the latest investment fads. Consequently, price anomalies can occur that dividend investors can exploit to generate superior performance. 5) Dividends are a significant component of total returns Shifts in market sentiment, which affect valuations, can have a significant upon impact short-term performance. But valuations tend to be mean reverting. Consequently, earnings growth is the most important influence over total returns over the long term, with dividends and their reinvestment proving very significant. By targeting high dividend stocks, reliance on uncertain earnings growth is reduced. Figure 2: Contribution to annualised total return since 1970 Source: Source: MSCI, Factset, CLSA Asia-Pacific Markets March 2013. MSCI total return and price return index are used. Currency effects are ignored. 6) Income strategies can deliver a high income stream and protection against inflation We have lived through one of the largest monetary policy experiments of the last 300 years – Quantitative Easing. Whilst its longer-term implications are difficult to predict, QE is a powerful inflationary force. Although economies are not currently operating near full capacity, we would expect inflation to increase should economic growth continue to improve. For investors concerned with preserving purchasing power, even modest dividend growth of 5% per year offers excellent protection – and we believe there are many attractive companies that can grow dividends by at least 5% over the next few years. Figure 3: Yield choices available to investors Source: Bloomberg as at 31 December 2013. Equity dividend yields are consensus FY14. Expected medium-term dividend growth of a representative portfolio. 3.0 3.0 1.9 0.7 4.1 4.8 5.6 4.6 4.3 3.5 3.7 4.2 3.4 4.5 5.1 5.5 5.3 5.3 5.8 4.7 6.6 4.8 4.7 0 1 2 3 4 5 6 7 8 9 10 US UK Germany Japan Mexico Brazil Indonesia Russia Vodafone GlaxoSmithKline TotalS.A. Blackstone AT&T Vodafone GlaxoSmithKline TotalS.A. Blackstone AT&T BOCHongKong DiGi.com RadiantElec. NagaCorp ValidSolucoes % Equities (FY14)Investment Grade (10yr)Government Debt (10yr) Emerging Market Debt (USD 10yr) Zero income growth 5-10% annual income growth1 -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% 14% UK USA France Germany Australia Canada Japan Multiple expansion Earnings growth Dividends (reinvested) Total return 12
  • 14. Viewpoint – Global Equity Income T16405 Issued May 2014 | Valid to end August 2014 7) There are no signs of an income bubble After several years of good stock performance, and with bond yields at historically low levels, one could be forgiven for thinking that dividend stocks must have reached expensive levels. However, when we look at the valuations of high-dividend paying companies globally, they are still trading at a discount to the broader market. Figure 4: Valuations of high dividend companies Source: MSCI index data as at 31 March 2014. 8) An active approach to divided investing has delivered superior returns While we believe that companies with high-dividend yields offer an attractive opportunity set we certainly do not think every dividend stock is a good investment. By focusing on companies with robust financial positions and good growth prospects we avoid false bargains or value traps, when an apparently high dividend may simply be a warning of trouble ahead, including the possibility of an impending cut in the dividend. Figure 5: An active approach has been rewarded while passive investment has struggled in recent years Source: Threadneedle Investments, CLSA, FactSet Alpha Tester as at 31 December 2013. Note: Backtest based on MSCI universe with more than 3 analyst coverage. MSCI weighted US-dollar total return with monthly rebalancing. 12.4 9.7 11.1 14.7 13.9 11.8 13.3 15.7 Europe inc UK Asia Pacific AC ex Japan Japan USA High dividend yield index Regular Index Forward PE ratios Cumulative performance since fund launch 20 40 60 80 100 120 140 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 Index Global Equity Income Fund First quintile dividend yield MSCI AC World MSCI High Dividend 13
  • 15. Viewpoint – Global Equity Income T16405 Issued May 2014 | Valid to end August 2014 9) Dividend payouts are sustainable because corporates are in good health In contrast to governments, corporates have done a good job of repairing their balance sheets in recent years, although the experience of the 2008 financial crisis means that many corporates remain cautious even now, and reluctant to commit to large-scale capital expenditure (we expect this to change as economic growth slowly returns). Meanwhile, companies can use their free cash in a multitude of shareholder-friendly ways, such as dividend increases, special dividends and share buybacks. We like ordinary dividend growth as long as companies aren’t ‘playing to the crowds’ (i.e. the dividend has to be comfortable to be sustainable). Special dividends act like a release valve and are preferable to mechanical share buybacks when equity valuations in general have re-rated. Perhaps the most crucial aspect of the relatively good health of the corporate sector is that dividend payout ratios are sustainable because cash generation has been so good. We do not expect to see any major challenges to this given that the majority of company managements remain relatively cautious in terms of their capex and spending plans. 10) Global dividend investors have a wider opportunity set By adopting a global approach, investors can gain exposure to underlying economies, which may be growing much faster than their domestic economy, and to a different mix of sectors and themes. In addition, selecting companies on a global basis provides a much wider set of opportunities from which to select the most attractive ideas, and enables the construction of a much more efficiently diversified portfolio. While a regional investor has a limited number of companies to invest in, a global dividend investor has a good choice of companies in all sectors. Figure 6: A wide opportunity set of high dividend stocks Source: Bloomberg as at 31 December 2013. Market cap measured in USD. World All companies, Market Cap > $1 billion and dividend yield > 4% 1224 Sector breakdown: Financials 460 Utilities 137 Industrials 133 Energy 123 Consumer discretionary 87 Telecommunications 81 Materials 78 Consumer staples 77 Technology 37 Healthcare 11 14
  • 16. Viewpoint – Global Equity Income T16405 Issued May 2014 | Valid to end August 2014 Important information: For use by investment professionals only (not to be passed on to any third party). Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Issued by Threadneedle Asset Management Limited (“TAML”). Registered in England and Wales, No. 573204. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Conduct Authority. TAML has a cross-border licence from the Korean Financial Services Commission for Discretionary Investment Management Business. Issued in Australia by Threadneedle International Limited (“TINTL”) (ARBN 133 982 055). To the extent that this document contains financial product advice, that advice is provided by TINTL. TINTL is exempt from the requirement to hold an Australian financial services licence under the Corporations Act in respect of the financial services it provides. TINTL is regulated by the Financial Conduct Authority under UK laws, which differ from Australian laws. Issued in Hong Kong by Threadneedle Portfolio Services Hong Kong Limited 天利投 資管理香港有限公司 (“TPSHKL”). Registered Office: Unit 3004, Two Exchange Square, 8 Connaught Place Hong Kong. Registered in Hong Kong under the Companies Ordinance (Chapter 32), No. 1173058. Authorised and regulated in Hong Kong by the Securities and Futures Commission. Authorisation does not imply official approval or recommendation. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document you should obtain independent professional advice. This document is distributed by Threadneedle Portfolio Services Hong Kong Limited Dubai branch, which is regulated by the Dubai Financial Services Authority (“DFSA”). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client under the DFSA Rules. Issued in Singapore by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07 Winsland House 1, Singapore 239519. License Number: CMS100182-2. This document is being issued in Singapore to and is directed only at persons who are either institutional investors or accredited investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) in Singapore. This document must not be relied or acted upon by any persons in Singapore other than an institutional or accredited investor. Issued in the US by Threadneedle International Limited (“TINTL”), a UK-based investment management firm that provides financial services to individual and institutional investors. TINTL is registered as an investment adviser with the U.S. Securities and Exchange Commission and is authorised and regulated in the conduct of its investment business in the UK by the UK Financial Conduct Authority.Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. www.threadneedle.com. 15
  • 17. Perspectives T16363 Issued April 2014| Valid to end July 2014 Is Europe heading for Japanese-style deflation? In this White Paper Martin Harvey says that the parallels between the current situation in Europe and Japan’s deflationary experience are sufficient for policymakers and indeed investors to be concerned. Martin believes that although there are many differences that should ensure that the eurozone does not follow Japan‘s fate, policymakers will need to act forcefully if downside risks intensify.  There are many parallels between the euro area today and Japan in the 1990s  The euro area appears to be on track to avert deflation in the short term  However, many euro countries are ‘one crisis away from deflation’  The European Central Bank (ECB) claims to be ahead of the game, but policy needs to be more pro-active  Longer term, demographic considerations and high debt levels will pose problems both in the euro area and elsewhere The recent decline of headline and core inflation measures across the eurozone has heightened fears of a spiral into deflation akin to that which has blighted the Japanese economy for the past 20 years. Indeed, the ‘Japanification’ question is now a regular fixture at the monthly ECB press conference, leading European Central Bank president Mario Draghi to point out the various differences between the two situations. In this note, we will assess these differences as well as the parallels in order to gauge the extent of the risk and potential implications for markets. The Japanese experience In order to find the ultimate source of the Japanese deflation spiral, one must go back to the asset bubble of the 1980s, which peaked at the end of 1989. Following a fall of more than 50% in the stock market over the next two years, stock prices remained subdued for the remainder of the decade. Land prices (figure 1) fell in value from 1992 onwards, and have been in the doldrums ever since. The real economy did not feel the most severe effects of the burst of the asset bubble immediately, despite a swift collapse in money supply growth. Indeed, nominal GDP continued to grow until 1997, unemployment did not exceed 3% until 1995, and CPI ex-food and energy remained above zero until September 1998 (figure 2), before remaining below or close to zero until 2013 when the Bank of Japan began aggressive quantitative easing (QE). Figure 1: Japanese land prices have not recovered from the collapse Source: Reuters EcoWin, December 2013. Figure 2: Inflation in Japan remained negative from 1998 to 2013 Source: Bloomberg, February 2014. There are a number of reasons why this process was something of a slow death for the Japanese economy, and many of these reasons have been highlighted as differences with the current situation in the eurozone. The key question for the ECB to answer is whether the differences are sufficient to dismiss the possibility of deflation, as the Japanese experience proves that once the process is underway, it is difficult to reverse. Progress report for Europe In contrast to Japan, Europe’s asset price crash was part of an international phenomenon. Although there were property bubbles in some euro area countries, such as Spain and Ireland, this was generally not a concern. Initially, it -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 80 83 86 89 92 95 98 01 04 07 10 13 Japan land price, %yr -4.0 -2.0 0.0 2.0 4.0 6.0 90 93 96 99 02 05 08 11 14 Japan CPI % yoy Japan CPI ex-food and energy % yoy 16
  • 18. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 was Europe’s exposure to global trade that caused a steep drop in economic activity in the wake of the Lehman collapse, while the onset of the sovereign debt crisis later played a part. The scale of the initial drop in the Eurostoxx index was similar to that seen in Japan in the early 1990s (figure 3). Even with the recent rebound stock prices are currently around 30% below the peak of 2007. It is fair to use December 2007 as the starting point for the comparison, as this marks the moment when spare capacity began to build in the euro area economy. On the surface, it appears that the Europeans are adopting correct policies as the Eurostoxx index has surged over the past year, and broken above the levels reached prior to the debt crisis. Some regional indices, such as the German DAX, have made new highs since 2008. This mirrors the divergence in economic fortunes across the eurozone, where so-called peripheral countries such as Greece remain in significant economic difficulty while Germany is in good shape. Of course, certain countries will have a higher deflation risk than others, adding another layer of complexity to the situation. The ECB will be primarily concerned with the average situation across the euro area. Figure 3: Relative experience of equity prices from the peak of the bubble Source: Bloomberg, March 2014. Note: t represents months before and after peak. Figure 4: Relative experience of nominal GDP from the peak of the cycle Source: Bloomberg, December 2013. Note t represents years before and after peak. Comparing the macroeconomic experience, Europe’s economic correction was more abrupt than Japan’s. The level of nominal GDP has moved slowly higher since 2009 (see figure 4), while the Japanese economy continued to expand at the beginning of the nineties. Furthermore, unemployment increased much more quickly in the euro area than in Japan (figure 5). Figure 5: Relative experience of unemployment from the peak of the cycle Source: Bloomberg, February 2014. Note t represents months before and after peak. Figure 6: Relative experience of core inflation from the peak of the cycle Source: Bloomberg, March 2014. Note t represents months before and after peak. The international nature of the 2008 crisis and subsequent slow global recovery goes some way to explaining the abruptness of Europe’s decline. Cultural factors also contributed to the gradual pace of Japan’s economic demise. Specifically, within the banking system, bad loans were not realised in a timely fashion in Japan and were simply rolled over, leading to the build-up of so-called ‘zombie companies’ which continued to operate unprofitably. Consequently, as banks were not realising losses in a timely fashion, the subsequent recapitalisation that should have occurred was absent. Although this meant that unemployment did not rise as quickly as it might have done if more companies were allowed to fail, it also reduced the probability of new companies being set up, new loans being granted, and new jobs being created. 20 70 120 t-50 t-25 t-0 t+23 t+48 t+73 t+98 Eurostoxx 50, 2002 - present (Dec07=100) Nikkei 225, 1985-2000 (Dec 1989=100) 60 80 100 120 140 t-10 t-8 t-6 t-4 t-2 t t+2 t+4 t+6 t+8 t+10 t+12 t+14 Eurozone annual nominal GDP (2007=100) Japan Annual Nominal GDP (1989=100) 6 7 8 9 10 11 12 13 0 1 2 3 4 5 6 t-60 t-40 t-20 t t+20 t+40 t+60 t+80 t+100 t+120 Japan unemployment rate (Dec1989=t) Eurozone unemployment rate,RHS (Dec2007=t) -1.0 0.0 1.0 2.0 3.0 4.0 t-24 t-12 t t+12 t+24 t+36 t+48 t+60 t+72 t+84 t+96 t+108t+120 Eurozone Core CPI, (t=Dec2007) Japan Core CPI (t=Dec1989) 17
  • 19. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 In Europe, there have been repeated attempts to avoid the same situation, via stress tests and forced recapitalisations, although the efficacy of such programmes has sometimes been questionable. In the crisis countries, “bad banks” have been created to remove bad loans from bank balance sheets, and in the most part this has proved successful. Indeed, the formulation of the banking union, and the subsequent asset quality review (AQR), aim to solidify the situation further. Given that the European banking sector remains large relative to the economy, there is probably more work to do on this front. It is possible that such actions have had a detrimental effect on lending growth, as banks have been more concerned with getting their house in order. Indeed, the headline data shows that private sector lending continues to contract across the eurozone (figure 7). A recovery in this metric will play a vital role in averting a situation similar to that experienced in Japan, where credit growth was non-existent or in contraction from 1995 to 2013 (figure 8). This will be one of the key data points on the ECB’s radar, indeed it may even become a policy target. Figure 7: Japanese credit growth remained positive until the late 1990s Source: ECB, BoJ, Japanese cabinet office to 2005, December 2005. Figure 8: Euro area credit growth has been in contraction since 2012 Source: ECB, Bloomberg, February 2014. The Asian crisis of the late 1990s increased the stress in the Japanese financial system and led to corporate failures and a surge in unemployment from an already vulnerable position. This, alongside the ill-fated increase in the consumption tax rate, was the final straw that sparked the descent into 15 years of deflation. Despite the current relative economic optimism in Europe, given the euro area’s current weak position an exogenous shock could push the economy into a similar deflationary abyss. One could argue that the sovereign debt crisis has already provided that shock and the recent trend in inflation would support this theory, particularly in stressed countries such as Greece. The speed and durability of the nascent recovery should help the situation in the coming quarters, but any shocks to growth would be very damaging, especially considering the additional debt burdened upon Europe since the beginning of the crisis. The potential consequences of slowing growth in China should also be considered, as this development has the potential to exert an added disinflationary impulse. Policy response Monetary policy: When he is quizzed about the similarities between the current eurozone situation and Japan’s lost decade, Mario Draghi is quick to point out that the ECB reacted much more quickly than the Bank of Japan (BoJ) in the early 1990s. Given that inflation was running higher in Japan at that time, the policy rate was not cut to below 1% until 1995 when headline CPI was first flirting with zero. As figure 9 shows, the policy rate remained higher than CPI throughout the 1990s, leaving real rates too high during the period. Conversely, on this measure at least, real rates have remained negative in the euro area since 2009 (figure 10). It is however, now getting too close for comfort, and the ECB will be keen to avoid a situation where CPI is entrenched below the level of interest rates, the so-called liquidity trap where policy is rendered impotent. This analysis does not account for the transmission mechanism to the real economy, which is more challenging in Europe due to the lack of fiscal union. Undoubtedly, real rates in the periphery have remained too high in recent years, although the ECB is hoping that the recent improvement in financial markets and in economic sentiment should help to ease this situation. -10 -5 0 5 10 15 20 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 AnnualPercentChange(%) Japan credit to the private sector,% yoy -4 -2 0 2 4 6 8 10 12 14 05 06 07 08 09 10 11 12 13 14 Euro Area lending to the private sector, %yoy 18
  • 20. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 Figure 9: Japanese interest rates remained above the inflation rate throughout the 1990s Source: Bloomberg to 2004, December 2003. Figure 10: Euro area interest rates have been below inflation until now Source: Bloomberg, March 2014. QE was eventually introduced in Japan in 2001 and was judged in hindsight as half-hearted due to its limited impact. Given that deflation had been embedded in the system for many years, it took an extremely aggressive QE policy from the BoJ in 2013 to give the Japanese economy a chance of redemption. The ECB stands ready to ramp up policy initiatives if inflation undershoots expectations from here, and early reports suggest that it is prepared to be aggressive. However, the ECB faces many institutional impediments that could hinder the process. It is likely that any QE attempt will be aimed towards the aforementioned transmission mechanism, in order to target policy in the places where it is most required. The preferred option is private asset purchases, but the problems of ‘one-size-fits-all’ monetary policy will remain a challenge. Striking a balance where policy is accommodative enough for the periphery and not too accommodative for Germany is a very tough proposition. The ECB has some way to go if it plans to rival the aggressive policies of other nations since 2008 (figure 13). To rival the scope of the UK QE policy for example, up to €1trn will be required. Figure 13: Central banks’ balance sheets have been inflated by QE programmes Source: Reuters EcoWin, Bloomberg, February 2014. Figure 14: Relative experience of fiscal balances from the peak of the cycle Source: Bloomberg, IMF, December 2014. Note t represents years before and after peak. -2 0 2 4 6 8 90 91 92 93 94 95 96 97 98 99 00 01 02 03 CPI Policy rate -1 0 1 2 3 4 5 07 08 09 10 11 12 13 % Policy rate Headline CPI 50 100 150 200 250 300 350 400 450 500 08 09 10 11 12 13 14 ECB Fed BoE BoJ SNB Index (Jan 08 = 100) Central Bank Assets -10 -5 0 5 t-9 t-7 t-5 t-3 t-1 t+1 t+3 t+5 t+7 t+9 t+11 t+13 Japan govt balance, % GDP Euro Area govt balance, %GDP 19
  • 21. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 Fiscal policy: Although monetary policy was arguably too tight in Japan, fiscal policy was being utilised to boost demand throughout the 1990s (figure 14). Over many years of nominal GDP stagnation, this drove the government debt stock to unsustainable levels, and although some commentators claim that this was a necessary policy, the full consequences remain to be borne. This is a classic case of crowding out, whereby bank balance sheets are devoted increasingly to government debt at the expense of the real economy, and the additional government spending eventually becomes a negative influence on growth. In Europe, by contrast, a strong effort has been made to limit the build-up of government debt following the early years of the crisis. However, this determination has ebbed of late, and the sharp drop in economic activity caused by aggressive fiscal consolidation has meant that debt ratios have risen sharply in some countries. European policymakers should continue to prioritise fiscal consolidation to avoid a situation where deficits are maintained but with no discernable positive impact on the economy. Southern European banks have been investing heavily into government debt in recent years (figure 16), which is reminiscent of the Japanese experience. As yields decline, the incentive for this trade should be reduced, but this will continue to be a key trend to monitor. Comparing inflation rates to other developed markets  Given the influence of global factors such as food and energy prices, inflation rates have been subsiding across the major developed markets, including the US and UK, where economic recovery has been uninterrupted for some time.  The ECB has highlighted these similarities to justify inaction.  Core CPI in Europe has undershot the US and UK in the past couple of years as growth has diverged.  Curiously, the IMF’s estimate of the output gap is currently larger in the US than in the eurozone, although price trends suggest otherwise.  High unemployment makes deflation a more legitimate concern in the euro area Figure 11: Core CPI in the US, the UK and the Eurozone Figure 12: The output gap in the US, the UK and the eurozone Source: Bloomberg February 2014. Source: Bloomberg, IMF, December 2013 20
  • 22. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 Figure15: Bank balance sheets are shrinking in Europe Source: Reuters EcoWin, February 2014. Figure 16: Banks have increased holdings of government bonds Source: Reuters EcoWin, February 2014. Structural reform: European policymakers are right to emphasise supply-side reforms as vital to improving the long-run growth potential of the economy. Indeed, some of the disinflationary pressure already evident in countries such as Spain is a direct result of these policies bringing down cost pressures in an attempt to boost productivity. One must bear in mind however that the growth benefits of such policies are only felt in the long term and are in many cases relatively small. In an ideal world, inflation would pick up in Germany, allowing Spain to continue to gain competitiveness without outright deflation. This re-iterates the challenge of a ‘one-size-fits-all’ monetary policy. A key component that will define the success of Japan’s new push to leave deflation is structural reform, the so-called third pillar of Abenomics. Although progress on this front is much slower than monetary expansion, the determination is there to move forward. Euro area policymakers have been emphasising the importance of supply-side policies throughout the crisis and will continue to try to improve the overall growth potential of the economy. Once the added benefit of monetary stimulus ceases, this is what will matter. 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 10 15 20 25 30 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 EUR trn (LHS) % of nominal GDP (RHS) 0 2 4 6 8 10 12 00 02 04 06 08 10 12 14 Spain Italy % of bank assets Bank holdings of government bonds Impact of low inflation on government debt  Peripheral governments, particularly in Spain, are specifically targeting so-called ‘good deflation’ to improve competitiveness.  How do you separate good deflation from bad?  The scenarios below assume a swift move to fiscal surplus and solid GDP growth, alongside an average interest cost of 3%.  The figures show how difficult it becomes to stabilise debt in a deflationary scenario.  Against this backdrop in Japan, domestic banks loaded their balance sheets with government debt, a process that has already begun in Spain and Italy.  This ‘crowding out’ added to the drain of funds from the private sector. Figure 17: Italy Government debt/GDP scenarios Figure 18: Spain government debt/GDP scenarios Source: Threadneedle, IMF December 2013. Source: Threadneedle, IMF December 2013. 21
  • 23. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 The demographic consideration: The lack of population growth contributed in no small way to the demise of Japan’s growth potential and consequent stagnation. Figure 19 shows a striking correlation between the growth in the labour force and core CPI. Europe faces some of the same problems as Japan, in particular in Germany where the working age population peaked in 1998. France shows up favourably on this scale due to a high birth rate, but the rest of the euro area is more in line with Germany (figure 20). As populations subside, spare capacity naturally rises as aggregate demand is reduced, leaving a heavy deflationary influence. Projections for the growth of the labour force remain positive across the major eurozone countries in the coming years, so this is not an obvious concern, but should remain on the radar. Indeed, this is a concern for all developed nations over the coming years, as an ever-smaller percentage of the population will be expected to provide for the remainder. The challenge for governments is enacting policies that encourage more of the working age population to work, which is something that has been a struggle for Japan and which Abenomics is attempting to address. Germany has been much more successful in this area and the focus on structural reforms in the euro area should be generally positive. However, the headwind that this trend produces in the medium term should not be ignored. Figure 19: Japanese population decline contributed to deflation Source Bloomberg, OECD, December 2013. Figure 20: Japanese population declining much more quickly than in Europe Source: Barclays, UN, January 2014. What the market is saying The recent surge in equity prices suggests that investors are confident that the euro area economy, with a bit of help from the ECB, can avert deflation as the debt crisis of 2011/12 becomes a distant memory. However, with inflation at low levels, equity investors will remain sensitive to any exogenous shocks that could put further pressure on the outlook for inflation and growth. German bond yields have remained low despite aggressive sell-offs in the other major developed bond markets over the past year. Partly this is justified by the divergence in policy stance, with the US and UK moving towards rate hikes and the ECB still threatening rate cuts. However, the extreme suppression of the term premium suggests that some expectation of persistent low inflation is embedded, which again contrasts with the US and UK where recent low inflation prints are brushed off. Compared with the experience in Japan (figure 22), where yields did not fall below 2% until 1997, risk-free yields are very low in Europe, but this has been the case for much of the last few years. If low inflation persists, it is still hard to argue that bunds offer much capital appreciation potential, although they may be attractive on a relative basis versus other assets. If the ECB can convince market participants that Europe is more like the US than Japan, then yields could rise significantly, but this seems a distant prospect at present. 82 86 90 94 98 102 -20 -16 -12 -8 -4 0 4 8 12 16 20 France 2077 UK 2071 EA ex Ger&Fra 2011 Germany 1998 Japan 1995 Index= 100 at peak year (next to country name) Years from peak Working age population (14-65) 22
  • 24. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 Figure 21: European equity markets, regional indices rebased to 2007 Source Bloomberg, March 2014. Figure 22: Relative experience of bond yields from the peak of the cycle Source Bloomberg, March 2014 Note t represents months before and after peak. One curiosity that inspired the ECB to step up its rhetoric and mention the possibility of QE is the strength of the euro. There are a number of reasons why the euro has continued to strengthen in spite of the divergence in interest rates mentioned above, most notably the return of investment capital and the continued retrenchment of the European banking sector. There are some further parallels here with Japan, where years of currency strength undermined attempts to break away from deflation, even though exports were noticeably harmed. However, when putting the two situations in parallel, the euro’s move pales into insignificance. Indeed, the appreciation over the past 12 months is in the region of 5%, compared with 15-20% gains in the yen in 1999 (figure 23). Figure 23: Relative experience of trade-weighted exchange rates from the peak of the cycle Source Bloomberg, March 2014 Note t represents months before and after peak. Summary There are enough parallels between the current situation in Europe and Japan’s deflationary experience for policymakers and indeed investors to be concerned. It seems however, that at this point, the euro area economy’s fate is in the hands of those policymakers. Recent commentary suggests that the ECB, the only institution with enough firepower to act aggressively, is wary of these risks and ready to react to further downside as and when it emerges. Draghi has always been keen to warn investors not to question the ECB’s firepower, and until now they have not. If downside risks do emerge in the coming months and quarters, the fight against deflation could prove to be his toughest test yet. 20 40 60 80 100 120 140 03 05 07 09 11 13 Dax Cac IBEX FTSE MIB 80 100 120 140 160 180 t-36 t-12 t+12 t+36 t+60 t+84 t+108 Trade-weighted Euro, Dec 2007=100 Trade-weighted Yen, Dec1989=100 23
  • 25. Perspectives | April 2014 T16363 Issued April 2014 | Valid to end July 2014 Important information: For use by investment professionals only (not to be passed on to any third party). Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Issued by Threadneedle Asset Management Limited (“TAML”). Registered in England and Wales, No. 573204. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Conduct Authority. TAML has a cross-border licence from the Korean Financial Services Commission for Discretionary Investment Management Business. Issued in Australia by Threadneedle International Limited (“TINTL”) (ARBN 133 982 055). To the extent that this document contains financial product advice, that advice is provided by TINTL. TINTL is exempt from the requirement to hold an Australian financial services licence under the Corporations Act in respect of the financial services it provides. TINTL is regulated by the Financial Conduct Authority under UK laws, which differ from Australian laws. Issued in Hong Kong by Threadneedle Portfolio Services Hong Kong Limited 天利投 資管理香港有限公司 (“TPSHKL”). Registered Office: Unit 3004, Two Exchange Square, 8 Connaught Place Hong Kong. Registered in Hong Kong under the Companies Ordinance (Chapter 32), No. 1173058. Authorised and regulated in Hong Kong by the Securities and Futures Commission. Authorisation does not imply official approval or recommendation. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document you should obtain independent professional advice. This document is distributed by Threadneedle Portfolio Services Hong Kong Limited Dubai branch, which is regulated by the Dubai Financial Services Authority (“DFSA”). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client under the DFSA Rules. Issued in Singapore by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07 Winsland House 1, Singapore 239519. License Number: CMS100182-2. This document is being issued in Singapore to and is directed only at persons who are either institutional investors or accredited investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) in Singapore. This document must not be relied or acted upon by any persons in Singapore other than an institutional or accredited investor. Issued in the US by Threadneedle International Limited (“TINTL”), a UK-based investment management firm that provides financial services to individual and institutional investors. TINTL is registered as an investment adviser with the U.S. Securities and Exchange Commission and is authorised and regulated in the conduct of its investment business in the UK by the UK Financial Conduct Authority.Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. www.threadneedle.com 24
  • 26. Investment themes April 2014 T16198 Issued April 2014 | Valid to end July 2014 Investment themes Theme Thesis Investment conclusions Income growth  Improving economic outlook and QE tapering will increase focus on growth rather than yield per se  Growth in revenues and/or cash flow underpin income growth as well as investment in business to fuel future growth  Tapering of QE will lead to rising bond yields  Growing yields being paid by businesses with stable earnings and cash flows will remain in demand  High yield alone may be a value trap  Opportunities in dividend initiators or those giving surplus cash back to shareholders  Risks in bond proxies as yields rise M&A activity  Corporates are in good financial health and have the cash to do M&A  Equity is no longer as cheaply valued as in recent past so discrimination is vital  Opportunities to add value through M&A to supplement growth  Beneficiaries of consolidation  Improved operational and financial management  Opportunities to increase capacity without building  Low valuation of weak companies Long term growth from “compounders”  Challenging economic and market environment favours ‘strong’ businesses with robust models  The ability to re-invest cash flow at attractive rates of return is is a key driver of value creation  Favour high return on investment with strong and stable cash flow  Well-financed companies with strong management will take share and create value in the long term Structural Growth opportunities  Even in a low growth world there are growth areas  Innovation creates growth opportunities (3D printing?)  Outsourcing growth will continue  Health and well-being a growing issue  Clean technology  Opportunities in developing world  US industrial renaissance Growth from economic recovery  Global recovery is underway  Cyclical opportunities from improving activity  Huge variations in activity even within regions so focus required  Tapering will present challenges  Recovering housing market and domestic consumption  Growth opportunities in EM  Risks in current account deficit parts of EM  Financial sectors emerging from crisis Emerging inflation theme  Rising labour costs in EM reducing competitive advantage  Risks of a tightening oil market or disruption to supply  Abundant liquidity everywhere distorting behaviours and boosting asset prices  Risk in bond proxies  Pricing power is valuable, beware price takers.  Capacity tightness  Real asset owners benefit The views expressed above reflect our position as at 27 March 2014. 25
  • 27. Investment themes | April 2014 T16198 Issued April 2014 | Valid to end July 2014 Important information For Investment Professionals use only, not to be relied upon by private investors. Past performance is not a guide to the future. The value of investments and any income from them can go down as well as up. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Issued by Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Conduct Authority. Issued in Hong Kong by Threadneedle Portfolio Services Hong Kong Limited ("TPSHKL"). Registered Office: Unit 3004, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Registered in Hong Kong under the Companies Ordinance (Chapter 32), No. 173058. Authorised and regulated in Hong Kong by the Securities and Futures Commission. Please note that TPSHKL can only deal with professional investors in Hong Kong within the meaning of the Securities and Futures Ordinance. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document you should obtain independent professional advice. Issued in Singapore by Threadneedle Investments Singapore (Pte) Limited, 07-07 Winsland House 1, 3 Killiney Road, Singapore 239519. Any Fund mentioned in this document is a restricted scheme in Singapore, and is available only to residents of Singapore who are Institutional Investors under Section 304 of the SFA, relevant persons pursuant to Section 305(1), or any person pursuant to Section 305(2) in accordance with the conditions of, any other applicable provision of the SFA. Threadneedle funds are not authorised or recognised by the Monetary Authority of Singapore (the “MAS”) and Shares are not allowed to be offered to the retail public. This document is not a prospectus as defined in the SFA. Accordingly, statutory liability under the SFA in relation to the content of prospectuses would not apply. This material includes forward looking statements, including projections of future economic and financial conditions. None of Threadneedle, its directors, officers or employees make any representation, warranty, guaranty, or other assurance that any of these forward looking statements will prove to be accurate. Issued in the US by Threadneedle International Limited (“TINTL”), a UK.-based investment management firm provides financial services to individual and institutional investors. TINTL is registered as an investment adviser with the U.S. Securities and Exchange Commission and is authorised and regulated in the conduct of its investment business in the UK by the UK Financial Conduct Authority. Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. threadneedle.com 26
  • 28. Lighthouse is an innovative global absolute return manager with a strong reputation in the marketplace. At Lighthouse, they are dedicated to managing funds of hedge funds with US$7.4 billion* assets under management. The Lighthouse investment process utilises a proprietary managed account platform that provides portfolio transparency, improved liquidity and robust asset control. Certitude’s partnership with Lighthouse Partners enables it to provide Australian and New Zealand investor’s exclusive access to their capabilities and unique management of investment risk. * Source: Lighthouse, 30 September 2013 27
  • 29. LIGHTHOUSE PARTNERS Quarterly outlook  LHP believes that fundamentals have started to matter more in the current investing environment.  Macroeconomic concerns do exist which is driven by central banks that have the largest influence over monetary conditions around the globe.  LHP is excited about their emerging markets exposure.  LHP remains bullish on the long-term opportunity set in China and elsewhere in Asia, which they believe currently, lacks investor capital. 28
  • 30. Past performance is not necessarily indicative of future results April 15, 2014 FIRST QUARTER, 2014 REVIEW EXECUTIVE SUMMARY In just the first three months of 2014, it feels as though we have already had more volatility-inducing global events than we had in all of 2013. While concern about slowing growth in China was nothing new, the combination of this worry with Russian-Ukrainian tensions, new leadership at the U.S. Federal Reserve and renewed emerging market concerns all conspired to send global equities as measured by the MSCI World down 4.0% in January. Of course, some of that weakness may have just been profit-taking after a strong 2013, but it is clear volatility increased. Equity markets staged a mild recovery to finish positive for the quarter with the MSCI World +1.2% and the S&P 500 +1.8%. As we commented in our last letter, fundamentals have started to matter more in the current investing environment – which is a positive for us. Yet, the first quarter was a reminder that macroeconomic concerns exist, as demonstrated by the global tensions described above and the fact that central banks remain the biggest drivers of monetary conditions around the globe. As evidence of our view that fundamentals are driving a larger share of returns, the Lighthouse funds produced quarterly results that were highly uncorrelated with broader markets. January was a particularly strong month for Lighthouse, with all funds and strategies positive despite the market sell-off. Contributions in January were led by equities, with healthcare a notable winner, as well as event-driven strategies and fixed income. Most market indices rebounded in February, and we were again able to generate positive performance across all strategies. March saw significant market rotation and volatility that challenged equity managers, leading to the give-back of some year-to-date gains. While March was negative overall for the Lighthouse funds, our credit and fixed income strategies were both positive – as they were each month of the quarter. Some of the key drivers of Lighthouse fund performance over the quarter by strategy:  Equity strategies were the largest contributor. In a reversal of the fourth quarter of 2013, when Asia and Europe led the way, the best performance for the quarter came from U.S. focused investments. Alpha generation in the U.S. was strong across most sectors with healthcare, consumer and industrials among the standouts. Despite some volatility in March, most equity managers finished the quarter in positive territory. The few negative performers were predominantly focused on China and Japan, two markets that experienced meaningful losses in the quarter.  Credit was a steady performer each month with gains largely driven by liquidations and event-driven distressed situations. Despite the perceived risk in distressed investing, we have actually seen many of our credit investments hold up better in the recent down markets as these positions tend to trade on their own merits and less on broader perceptions of global growth or lack thereof.  Relative value strategies were strongest in February, and most of our relative value managers were positive each month of the quarter. Further, we saw broad participation across sub-strategies. While event-driven led the way, we also saw positive attribution from capital structure arbitrage, convertible bond arbitrage and options, as these strategies were able to monetize market volatility in a hedged manner.  Fixed income had its best performance since the third quarter of 2012. Agency mortgage strategies were the largest contributors, and we continue to increase our exposure to this sub-strategy. Gains were also recorded by non-agency mortgage, CMBS and municipal strategies – although each of those sub-strategies is likely to remain underweight. This underweight reflects the fact that, while we are finding some niche trading opportunities, our forward-looking expectations for those asset classes are below average in the near-term.  Global trading was positive – a notable accomplishment given that most managed futures indices and large CTAs have suffered losses so far in 2014. Our focus in CTA and macro strategies is to create a portfolio that is not overly dependent on strong trends in equities or bonds to generate returns. This has led us to overweight short-term managers relative to long-term trend followers. This move has been a significant contributor to our outperformance year-to-date relative to CTA indices. 29
  • 31. Past performance is not necessarily indicative of future results April 15, 2014 SECOND QUARTER, 2014 OUTLOOK Below are some of the investment themes we will be pursuing in the coming months:  Global equity markets underperformed the S&P 500 in the first quarter, in what has become a common occurrence. In fact, since January 1, 2010, global markets (as measured by the MSCI World) have managed barely half the return of the S&P 500 (7.9% versus 15.4% annualized), and emerging markets have fared even worse (2.7% annualized for the MSCI EM index). While there are many legitimate concerns about investing in emerging markets, correlations among these markets are near an eight-year low, which we believe allows for prudent long/short investing. We remain pleased with our emerging markets exposure and expect to selectively add on further signs of weakness.  The largest emerging market of all – China (to the extent that the world’s second largest economy can still be considered “emerging”) – was again in the spotlight as a crop of weak data frightened investors in March. China’s stock market has been notoriously fickle since 2009 and, yet, it has been a strong source of alpha generation for our funds. Recently, we have observed that valuations are a bit stretched in the few sectors that have performed well, including internet, gaming and certain consumer sub-sectors. Our net exposure has already been reduced in some of these names, and we are likely to make further reductions in areas where the upside has become more limited. Despite this near-term move, we remain bullish on the long-term opportunity set in China and elsewhere in Asia, and we continue to benefit from a lack of investor capital in the region.  With respect to U.S. equities, part of the regime shift we experienced in March was a momentum reversal as equity investors took profits in companies and sectors – largely growth-oriented – that had performed well over the past year. With cautious optimism about 2014 GDP growth, we believe investors no longer feel compelled to overpay for growth companies since they can ride the wave of a broader cyclical rebound. While March was not easy, we continue to observe that sector specialists in the U.S. seem better-equipped to manage these transitions than generalists – not only because we believe they know their companies better but also because they typically are running smaller assets and can reposition their portfolios more adeptly.  We admit that we were a bit surprised that interest rates declined as much as they did to start 2014, with the benchmark 10-year U.S. Treasury note yield falling from 3.01% to 2.72% for the quarter. While we still expect rates to rise over time, this only reinforces our long-standing view that making macroeconomic calls on the direction of rates should not be our objective. We have long sought to manage our duration-sensitive strategies of credit, fixed income and relative value to have an expected interest rate beta near zero. Even investments that we like in part because they will do well as long-term rates rise must have other factors working in their favor. As an example, our agency mortgage-related investments performed quite strongly in the first quarter, despite lower rates, as refinancing activity declined and prepayments remained below recent trends.  We are often asked about “activists.” While we typically do not allocate to these funds, this decision is more a function of our desire to avoid large, directional generalist managers than any rejection of the merits of activism. In fact, we would categorize a large number of our investments across many strategies as catalyst-driven, and sometimes these catalysts need to be helped along by an outside party. Our style of investing very much favors managers who can identify favorable conditions and then create opportunities, and likewise we believe we have created a structure in our funds that allows us to overweight the most compelling of these opportunities. As we write this letter, April is again testing the mettle of investors. JP Morgan Asset Management recently published a research piece discussing how the highly volatile financial crisis and recovery (2008 to 2011) gave way to a period of easy money, with above-average equity returns and below-average volatility (2012-2013). JP Morgan forecasts a return to more modest equity performance and higher volatility going forward – something we have seen so far in 2014. Whether this holds true or not, we do know that we continue to see strong alpha opportunities and will continue to seek to position the portfolios to take advantage of the conditions we face. As always, we welcome your comments and inquiries. Best regards, LIGHTHOUSE PARTNERS 30
  • 32. Past performance is not necessarily indicative of future results April 15, 2014 IMPORTANT NOTICE & DISCLAIMER: Lighthouse Investment Partners, LLC (“Lighthouse”) manages investment vehicles, considered funds of hedge funds (the "Lighthouse Funds“), that invest directly in other hedge fund investment vehicles or through accounts owned by Lighthouse Funds, which are managed by third- party managers (collectively, “Alternative Investments”). Alternative Investments can be highly illiquid and may engage in leveraging and other speculative investment practices, which may involve volatility of returns and significant risk of loss, including the potential for loss of the principal invested. No assurances can be given that the investment objectives of the Lighthouse Funds will be achieved, and investment results may vary substantially over time. Investors should be aware that there is no secondary market currently available for interests in the Lighthouse Funds, and that there are restrictions on transferring interests in the Lighthouse Funds. Additional information can be found in a confidential private placement memorandum. Alternative Investments are not suitable for all investors. Investing in Alternative Investments is intended for experienced and sophisticated investors only who are willing to bear the high economic risks of the investment. Investors should carefully review and consider potential risks before investing. These risks may include: losses due to leveraging, short-selling, and other speculative practices, lack of liquidity, absence of information regarding valuations and pricing, counterparty default, complex tax structures and delays in tax reporting and less regulation. Diversification from traditional market investments does not guarantee a profit or protect against a loss. Lighthouse Funds that allocate capital to accounts owned by such funds and managed by third-party managers are referred to herein as Managed Account Funds, for which the risks above continue to apply. The Managed Account Funds’ investments in such accounts generally will be made indirectly through investment companies managed by Lighthouse or its affiliates. These investment companies are generally comprised of various segregated portfolios (each, a “Portfolio” and, collectively, the “Portfolios”). Generally, each Portfolio represents a separate managed account. The investment companies invest primarily in separate prime brokerage accounts and sub-accounts held in the name of each Portfolio, over which a third-party manager will have discretionary trading authority. In certain circumstances a single Portfolio may be further sub-divided into separate accounts, each of which represents a managed account. In such a case, each separate account may be advised by a separate third-party manager. The assets and liabilities of the separate accounts of a Portfolio will not be considered segregated from one another. Rather, the assets and liabilities of all separate accounts of any Portfolio will be considered on an aggregate basis. As a result, liabilities of one separate account of a Portfolio may be enforced against another separate account of the same Portfolio. Increased transparency into trading activity in the Portfolios may not mitigate or prevent losses or fraud by third-party managers. Although Lighthouse may monitor trading activity in these accounts, Lighthouse does not expect to direct any trading decisions or have access to live recommendations from third-party managers. Due to the volume of trading activity in a Portfolio, there is no guarantee that Lighthouse can monitor all such activity. As noted, the Investment Advisory Agreement which governs the managed account relationship with the manager generally allows Lighthouse (but not in all instances) very broad authority to revoke a manager’s trading authority over an account at any time. However, Lighthouse’s ability to revoke a manager’s trading authority may cause a Portfolio to incur termination penalties or ongoing management or performance fees beyond the revocation of a manager’s trading authority. If a manager’s authority is revoked, Lighthouse may not be able to liquidate investments held in Portfolios in a timely manner or may only do so at prices which Lighthouse believes do not reflect the true value of such investments, resulting in an adverse effect on the return to investors. Certain Lighthouse Funds described herein as “100%” Managed Account Funds may have some nominal direct fund investments for the purpose of structuring seeding transactions, which include funding commitments by a Lighthouse Fund that be may be characterized as a limited redemption restriction. In limited circumstances, Lighthouse may utilize third-party intermediaries to access underlying managers via managed account investments. In such instances, Lighthouse will not enjoy the full benefits of asset ownership; however, transparency and liquidity terms are equivalent to that of direct managed account investments. Liquidity in a Managed Account Fund may vary widely based on the managers’ trading strategies. The enhanced liquidity provided by a Managed Account Fund does not mean that an end investor in a Lighthouse Fund will receive the benefit of such liquidity with respect to his or her investment in a Lighthouse Fund. Although underlying managers of Managed Account Funds may not impose lock-ups, gates or other similar restrictions, Lighthouse retains the right to impose such restrictions upon all investors at the Lighthouse fund level. Performance data, if any, presented herein includes reinvestment of all dividends and other earnings and is net of all management fees and performance fees. Certain results noted herein may be unaudited and subject to adjustment following an audit of the Lighthouse Funds. Past performance is not necessarily indicative of future results. The information contained herein is neither an offer to sell nor a solicitation of an offer to purchase any securities. Such an offer will only be made to Qualified Purchasers by means of a private placement memorandum and related subscription documents. This presentation has been prepared to provide general information about certain types of investment products to a limited number of sophisticated prospective investors, in order to assist them in determining whether they may have an interest in the types of products described herein. When considering whether to purchase any financial instrument, no reliance should be placed on the information in this presentation. Such information is preliminary and subject to change without notice and does not constitute all the information necessary to evaluate the consequences of purchasing any financial instrument referenced herein. In addition, this presentation includes information obtained from sources believed to be reliable, but Lighthouse does not warrant its completeness or accuracy. Accordingly, any decision to purchase any financial instrument referenced herein should be based solely on the final documentation related to such financial instrument, which will contain the definitive terms and conditions thereof. Nothing in this presentation should be construed as tax, regulatory or accounting advice. Any prospective investor must make an independent assessment of such matters in consultation with his or her own professional advisors. This presentation is not intended for distribution to, or use by, any person in any jurisdiction where such distribution or use is prohibited by law or regulation. This presentation may contain confidential or proprietary information and its distribution, or the divulgence of its contents to any person, other than the person to whom the presentation was originally delivered, is prohibited. Additional information for investors meeting suitability requirements is available upon request. ©2014 31
  • 33. CERTITUDE BRINGS THE WORLD TO YOU GaveKal Capital Limited offers investment products which combine their knowledge of the Asia-Pacific region alongside innovative portfolio construction and disciplined risk processes. Certitude partners with GaveKal to provide Australian and New Zealand investors exclusive access to their capabilities, access to the greater investment opportunities of Asia and their successful management of the inherent risks. * 32
  • 34. GAVEKAL Quarterly outlook GaveKal believes there are a few key trends for the second quarter of 2014 around which portfolios can be oriented: 1. The first and foremost is that with the Fed starting to taper we can expect to see fixed income strategies outperforming. GaveKal has now started to see bonds no longer underperforming – which makes sense as back to back years of losses on bonds are very rare. 2. Asia now trades at a discount almost similar to that which prevailed at the time of SARS. 3. The US is not exporting enough US$ to fuel global trade needs which has led to central bank reserves shrinking – and whenever central bank reserves shrink, someone (either highly levered or running large negative cash flows) goes bust. Fortunately, Asia is not really in the line of fire and is actually in a pretty good shape when looking at Asia’s fiscal and current account positions. 4. GaveKal also believes that Japan should be a source of capital for Asian financial markets in 2014. Japan is fundamentally a mercantilist country. GaveKal therefore believes that Japan will print and devalue aggressively until the trade balance closes down. This puts pressure on the Yen weakening which leads to the Japanese moving their savings from cash into other assets. Where will Japanese savings go could be the big driver of 2014 performance. Highlights for 2014  Louis Gave - Breaking the Bad News Cycle  Chen Long – Watch Capital Flows For The Central Banks Next Move  Charles Gave – Easy Eurozone Trades Are Running Out Of Road 33
  • 35. www.gavekal.com GavekalDragonomics The Daily Tuesday, April 15, 2014 Page 1 Global Research © Gavekal Ltd. Redistribution prohibited without prior consent. This report has been prepared by Gavekal mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Alarm bells have been ringing over China for a while, and there have been plenty of Quasimodos to sound them. With a poorly-understood “shadow financing” system that accounts for 20% of total credit, an overbuilt real estate market, deficit-ridden local governments and under-capitalized banks, China’s financial system has been looking shaky. Financial stress, along with the relative tightness of central bank policy since last May, helps explain why most Chinese banks now trade below book value, and why Shanghai is the only stock market still close to its 2008 lows. Is it time for the bell-ringers to take a rest? Arguably yes, thanks to the past weekend’s well-telegraphed announcement that four Chinese banks are set to boost their capital by issuing 290bn renminbi (US$47bn) in preferred shares, with more lenders expected to follow. This move reinforced a huge reversal in global equity markets. Until recently, no piece of bad news could stop the US equity markets from making new highs, while no good news could get in the way of the Chinese bear market (see It’s All Good In America And All Bad In China). That changed three weeks ago when the Chinese government announced it would let big Shanghai-listed firms issue preferred shares, a policy obviously aimed at the banks (see Due Like Yesterday’s Bills). Since then, the situation has been turned on its head and Chinese equities have not looked back. More generally, emerging-market stocks have outperformed (Brazil and Turkey even more dramatically than China). So investors should ask themselves whether they have just witnessed an important turning point. As we discussed in our recent London and Paris seminars (see presentation here), capital-raising by Chinese banks should be reflationary for emerging markets, since many remain dependent on Chinese demand. Plans for Chinese banks to raise fresh capital... ...reinforces a big turnaround in global equity markets Louis Gave lgave@gavekal.com Arthur Kroeber akroeber@gavekal.com Global Research Breaking The Bad News Cycle Checking The Boxes Fact Consensus belief Our reaction US retail sales rose 1.1% MoM in Mar, from 0.7% in Feb; ex auto & gas rose 1.0% Both better than expected 0.9% & 0.4% respectively US consumption is likely to remain strong as pent-up demand unleashes US business inventories rose 0.4% MoM in Feb, from 0.4% in Jan Lower than expected 0.5% As weather improves, inventories should get worked off in the coming months Eurozone IP rose 1.7% YoY in Feb; figure for Jan revised lower to 1.6% from 2.1% Better than expected 1.5%; recovery continuing to firm up Positive IP trend offset by disinflationary trends; pressure on ECB to act still strong China new bank loan and aggregate financing totaled CNY 1.1tn and 2.1tn in March Both were slightly above consensus; while M2 missed The growth of aggregate financing slowed to 16.3% due to high base in 1Q13 Our short take on the latest news 34
  • 36. GavekalDragonomics The Daily Tuesday, April 15, 2014 Page 2 www.gavekal.com There are of course reasons to be skeptical. One could argue that the amount of new capital is far too small to restore the banks to health. The 80bn renminbi to be raised by ICBC, China’s largest bank, represents just 0.4% of total assets—scarcely enough to placate pessimists who think Chinese banks’ true non-performing loan ratios are 5-10% rather than the currently reported 1-2%. Or one could worry that boosting bank capital does little to address the risks in the rapidly growing “shadow” financial system, much of which does not even show up on bank balance sheets. But these concerns may miss the point. Chinese stocks were priced for general catastrophe, with the nature of the supposed calamity changing more often than rationales for the invasion of Iraq (property prices will collapse; the banks will collapse; the shadow lenders will collapse; the economy will slow to 3%, China will move to a trade deficit). Stocks could easily re-rate as investors conclude a) none of these catastrophes will occur any time soon, and b) Chinese regulators want to ensure the system is well-capitalized as they push ahead with potentially destabilizing reforms. If the market has indeed made this psychological move, Chinese stocks might even be able to withstand the bad news flow that is likely in the coming months (more corporate defaults, slower GDP growth, etc.). The point is that a marginal improvement after a long downturn can be powerful enough to trigger large rallies in undervalued stocks. The question non-China minded investors should ask themselves is whether this will be enough to support a continued rally in over-sold and under- owned deep cyclicals not just in China, but all over the world. Reasons to be skeptical... ...may be missing the point 3435
  • 37. Ideas www.gavekal.com Wednesday, April 23, 2014 Page 1 GavekalDragonomicsChina Research © Gavekal Ltd. Redistribution prohibited without prior consent. This report has been prepared by Gavekal mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. How will China’s central bank respond to the country’s slowing growth? Speculation about the next move from the People’s Bank of China has been rising as economic indicators continue to be tepid, credit growth continues to slow and the currency remains weak. Similarly, in early 2012 GDP growth was also weak, credit was cooling and the RMB was depreciating— and shortly afterward the central bank cut banks’ reserve requirements and credit growth rebounded. But we do not think the policy response in 2014 will be a repeat of that in 2012. A cut in reserve requirements is certainly not imminent, and if one comes it would be a signal less of a major change in policy than of a shift in the balance of capital flows. First of all, the central bank has been quite active in damping expectations of further monetary easing. On Tuesday it announced a policy change that takes longer to describe than its importance really warrants: a cut in the reserve-requirement ratio (RRR) for rural commercial banks at the county level and for rural credit cooperatives. The announced intent was to free up more funds for banks to support agriculture and rural development. But as a similar cut in rural banks’ RRR in April 2012 was shortly followed by a cut in reserve requirements for the entire banking system in May 2012, this move could be interpreted as preparation for broader easing of monetary policy. The People’s Bank however made clear it does not want markets to expect this; in a statement afterward, it said the cut is “a structural adjustment policy to increase funding for agriculture, and does not mean While capital inflows remain strong, there is little reason for the central bank to cut reserve requirements The central bank has been actively discouraging markets from expecting more monetary easing Watch Capital Flows For The Central Bank’s Next Move Chen Long lchen@gavekal.com 36
  • 38. Ideas www.gavekal.com Wednesday, April 23, 2014 Page 2 GavekalDragonomics that the direction of monetary policy has changed...it will not affect overall liquidity in the banking system.” Such a direct statement by PBOC is quite unusual, and it echoes numerous recent comments from central government officials that economic policy will only be fine-tuned and that massive stimulus is not an option. Second, one of the reasons that the central bank is talking down additional easing is that monetary policy has already loosened—perhaps more than some observers appreciate. Credit growth is indeed slowing: total credit, including bank loans, corporate bonds and shadow financing, grew about 16% YoY in March, down from 18% in December. But much of this slowdown in YoY terms reflects a high base from the rapid credit growth in 1Q13, and in fact sequential credit growth has been picking up. Interbank liquidity is already much looser than it was during the credit crunches of mid- and end-2013, and money market rates are pretty low. Even if the central bank did want to further boost lending, a cut in the RRR may not help much. Formal bank lending is increasingly constrained by the regulatory cap on banks’ loan-to-deposit ratio (see The Rocky Road To Market Rates). So an RRR cut would do more to encourage bond issuance shadow financing—when in fact PBOC has been working to contain the scale of shadow financing. And compared to 2012, the central banks has more tools with which it can adjust interbank liquidity: it has introduced the standing liquidity facility (SLF) and short-term liquidity operations (SLO). These were in fact the tools deployed during the episode of capital outflows in mid-2013, which means the RRR cut will probably be the policy of last resort even if the PBOC really does decide to inject more liquidity. Finally, and most importantly, the behavior of capital flows is now very different from 2012. China had sustained capital outflows from 4Q11 to 3Q12, which was mainly triggered by the end of quantitative easing in the Though headline credit growth has been slowing, new credit has been stronger than market expectations The central bank has already eased by allowing short-term interbank to come down to relatively low levels An RRR cut might work against the central bank’s desire to contain growth in shadow financing 37
  • 39. Ideas www.gavekal.com Wednesday, April 23, 2014 Page 3 GavekalDragonomics US, and that led to the depreciation of the RMB in early 2012. The outflow of capital took liquidity out of the domestic banking system, which required the central bank to compensate by injecting more liquidity— hence the cuts in reserve requirements. By contrast, the RMB depreciation in early 2014 has been a move completely driven by PBOC policy, and the market has not yet followed it (see RMB Limbo: How Low Can It Go?). Capital flows have remained robust: China’s foreign exchange reserves grew by US$130 bn in the first quarter of 2014, while they fell by US$13 bn from February to May 2012. And significantly, monthly capital inflows, as proxied by banks’ purchases of foreign exchange, stayed strong in March even after February’s sharp change in currency policy. This suggests that the private sector was neither causing the RMB depreciation nor fully convinced that the recent depreciation means a big change in the RMB’s longer-term appreciation, since they continue to buy RMB and sell foreign currencies. Simply put, capital inflows into China remain very strong, and in its recent history the central bank has only cut the RRR when there are capital outflows. Even as the central bank pushes the currency down, the private sector still seems quite happy to buy RMB 38
  • 40. www.gavekal.com GavekalDragonomics The Daily Tuesday, April 22, 2014 Page 1 Global Research © Gavekal Ltd. Redistribution prohibited without prior consent. This report has been prepared by Gavekal mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Investor enthusiasm for government debt from the eurozone’s southern periphery persists unabated. Last week the yield on Spanish 10-year bonds dropped to its lowest level since September 2005. Before too long, however, I believe investors will find themselves bumping up against some hard truths imposed by simple accounting identities. In this I find myself taking a somewhat different view to the one recently expressed by François (see Believe In The ECB). As some of our readers will know I have never been a great fan of the national accounting equation: gross domestic product equals consumption plus investment plus government spending plus the net external balance—GDP = C + I + G + (X-M). I never understood why having a bigger government should make me feel richer. Nor could I ever figure out why taking the goods and services I labor to produce and exchanging them with a bunch of foreigners in return for their promise to pay me at some point in the future should contribute to my wellbeing. The only people who believe that a current account surplus is the sign of a well managed economy are called “mercantilists”. They confuse the current account with a profit and loss statement and always end up broke. To my simple mind the only thing that matters is the consumption plus investment element of the equation. That’s because consuming today makes me feel good today, while investing facilitates more consumption for my nine grand children. In this spirit, let’s have a look at consumption plus investment in Spain, always remembering that the results would be much the same for Italy. Since its peak in 2007, consumption in Spain has declined by -12.5% relative to GDP and by -18% in absolute terms (see the chart overleaf). In a depression, the current account always improves since returns on invested capital collapse. Capital flees and because the balance of All that really matters is consumption plus investment The current account always improves in a depression Charles Gave cgave@gavekal.com Global Research Easy Eurozone Trades Are Running Out Of Road Checking The Boxes Our short take on the latest news Fact Consensus belief Our reaction US leading index rose 0.8% MoM in Mar, from 0.5% in Feb Better than expected 0.7% Encapsulates evidence that the US economy is bouncing back from a cold winter decently well Japan trade deficit rose to JPY -1.4tn in Mar, from –JPY0.8tn; exports rose only 1.8% YoY Deficit bigger than expected -1tn as imports jumped & exports disappointed (expected +6.5%) Deficit to shrink as imports fall after tax hike; but weak exports = weak growth; expect more QE Italian industrial orders rose 2.8% YoY in Feb, from 2.6% in Jan N/A; 3m moving average losing momentum, but recently announced tax cuts may help Tax cuts should boost consumer spending & lift growth; but significant reform still needed 39
  • 41. GavekalDragonomics The Daily Tuesday, April 22, 2014 Page 2 www.gavekal.com payments must balance out at zero, a deficit in the capital account has to be offset by a surplus in the current account. As a result, the Spanish current account has moved from a deficit equal to 10% of GDP to a surplus today of 2.5% of GDP, with unemployment going through the roof to more than 25% and government debt soaring from 30% of GDP in 2007 to close to 100% today. Someone has to pay all the unemployment benefit for the 25%. Ultimately it will be children who are not yet born. Meanwhile, today the average Spaniard has a standard of living roughly -20% below the level ten years ago. Bravo for the euro! Now everybody tells me that Spain has “turned the corner” and that there is “light at the end of the tunnel” (as US general William Westmoreland said about the Vietnam war, just weeks before the Viet Cong’s surprise Tet Offensive). I hope there really is some light, given the beating Spain’s poor citizenry has taken, but I am not confident. Interest rates remain well above the nominal growth rate of the private sector (my consumption plus investment), which is around zero. Unemployment remains incredibly high. The budget deficit is still at 6.5% of GDP. Bank lending continues to collapse and the bad debts in the banking sector are constantly being revalued. I am told that young Spanish citizens are leaving “en masse”, that the Spanish population is falling because of a fertility rate which collapsed ages ago, and that Catalonia is restive and could do a Crimea. In recent years, eurozone investing has been simple. You had to invest in convergence trades when panic reigned, and in divergence trades when the International Monetary Fund told you everything was under control. Over the last three years, we have played the eurozone’s markets either by riding Portuguese debt or by being long Italy and short France. I am not sure there is much mileage left in these two low risk strategies. It may be time to abandon them in favor of Asia. The easy eurozone trades are running out of road 40
  • 42. Certitude Global Investments Limited offices Certitude’s Global Investment Partner offices CERTITUDE BRINGS THE WORLD TO YOU Why Certitude? Certitude aims to be Australia’s first choice for global investments. We provide Australian and New Zealand investors with single-point access to active Global Fund Managers, who offer unique investment opportunities that span the major industry sectors and geographic regions of the world. Investors choose Certitude because we: • Select Global Partners with Local Knowledge • Aim to Deliver Strong Returns with Managed Risk • Offer Diverse and Evolving Investment Opportunities. 41
  • 43. CERTITUDE BRINGS THE WORLD TO YOU Certitude carefully selects Global Fund Managers that complement each other, and forms exclusive partnerships with them to offer you access to a broad and flexible choice of global investment opportunities. Each of our partners are proven experts in their region and asset class. We continually scan the market to seek new partnerships to bring to Australian and New Zealand investors some of the best investment opportunities from around the world. SELECTING GLOBAL PARTNERS WITH LOCAL KNOWLEDGE 42
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  • 45. CERTITUDE’S FUNDS OVERVIEW Key fund features • Equity-like returns with lower volatility than traditional equity investments • Exposure to long/short international equity strategies across multiple geographical regions and sectors • Expertise of approximately 20–30 Underlying Managers. LHP GLOBAL LONG/SHORT FUND The LHP Global Long/Short Fund aims to achieve equity-like returns with lower volatility than traditional global equity investments. The LHP Global Long/Short Fund’s strategy is to access a portfolio of equity long/short investment managers with a low correlation to traditional equity markets. The LHP Global Long/Short Fund’s investment exposure is through its investment in the Lighthouse Global Long/Short Fund Limited (‘the Lighthouse Fund’), managed by Lighthouse. Each Underlying Manager of the Lighthouse Fund is selected with the intention of creating a pool of investments which blend together to create a diversified portfolio designed to achieve the Lighthouse Fund’s investment objective. The LHP Diversified Investments Fund aims to achieve consistent returns with a low probability of loss over a long term investment horizon. The LHP Diversified Investment Fund’s strategy is to access, via investment in the Lighthouse Diversified Fund Limited, a portfolio of underlying investment managers with low correlation and beta to traditional markets, investing in both commingled hedge funds and managed accounts. Key fund features • Lower levels of volatility when compared to traditional equity investments • Exposure to a broad range of investment strategies across multiple geographic regions and sectors • A low correlation to traditional equity markets • Exposure to between 30–60 core underlying managers. LHP DIVERSIFIED INVESTMENTS FUND 44
  • 46. CERTITUDE’S FUNDS (cont) For more information on Certitude’s funds visit www.certitudeglobal.com.au/products 1Source: Threadneedle, as at 30 September 2012 OVERVIEW The Threadneedle Global Equity Income Fund (Unhedged) aims to deliver regular income distributions with capital growth through its investment in worldwide companies that produce strong and consistent distributions. Key features • Exclusive access to Threadneedle Asset Management Limited (‘Threadneedle’), one of Europe’s leading managers1 • The Fund invests in the Threadneedle Global Equity Income Fund which has delivered attractive distributions since inception1 • Typically provides investors with exposure to 75–951of the world’s ‘quality income’ producers, as selected by Threadneedle. • Aims to provide Australian and New Zealand investors with income, growth and global diversification which may complement their local portfolio. • The Fund relies on Threadneedle’s rigorous global investment process, with the investment team visiting over 30001 company meetings per annum. • Short communication lines and a focus on actionable investment ideas and rapid implementation. The Threadneedle Global Equity Fund aims to achieve above average capital growth through investment in equities issued by companies worldwide. Key fund features • A disciplined, pragmatic investment process designed to identify value-creating businesses globally at attractive prices • Ability to pursue the best opportunities globally, irrespective of local regional benchmarks or constraints • Consistent performance – the Threadneedle Global Equity Fund has a historical record of consistent alpha generation driven by stock selection1 • An experienced multi-disciplined investment team – members of the Global Equities team are each responsible for specific geographical coverage as well as having dedicated sector research responsibilities. • Deep-rooted culture of collaboration: Threadneedle’s global investment approach is characterised by robust debate, with the specialist Global Equities team leveraging experienced regional resources. The GaveKal Asian Opportunities Fund is designed to capture the long term returns of Asian equity markets while constraining volatility through tactical asset allocation in Asian bonds, equities and cash. Key features • Exposure to Asia-Pacific equity and bond markets with the potential to achieve returns with a lower volatility profile than traditional equity • Portfolio diversification by adding an exposure to the potential benefits associated with economic and corporate expansion in the Asia-Pacific region • The Fund invests into the GaveKal Asian Opportunities (UCITS) Fund, which has delivered attractive returns since inception. THREADNEEDLE GLOBAL EQUITY INCOME FUND (UNHEDGED) THREADNEEDLE GLOBAL EQUITY FUND GAVEKAL ASIAN OPPORTUNITIES FUND 45
  • 47. LHP Diversified Investments Fund As of Date: 31/03/2014 Month Quarter 1 Year 3 Years (p.a.) 5 Years (p.a.) 7 Years (p.a.) 10 Years (p.a.) Since Inception (p.a.) (31/03/2001) FYTD LHP Diversified Investments W HFRX Global Index 100% Hedged to AUD -0.34 -0.04 3.77 1.67 7.33 14.15 3.63 7.03 8.75 1.81 10.40 3.23 3.30 4.93 5.20 6.58 5.61 12.97 LHP Global Long/Short Fund As of Date: 31/03/2014 Month Quarter 1 Year 3 Years (p.a.) 5 Years (p.a.) 7 Years (p.a.) 10 Years (p.a.) Since Inception (p.a.) (31/03/2001) FYTD LHP Global Long/Short W MSCI ACWI NR 100% Hedged to AUD -1.45 0.53 1.16 1.25 14.71 18.95 12.41 9.55 19.02 9.27 4.70 6.92 8.36 6.28 8.12 17.22 6.95 10.50 GaveKal Asian Opportunities Fund As of Date: 31/03/2014 Month Quarter 1 Year 3 Years (p.a.) 5 Years (p.a.) 7 Years (p.a.) 10 Years (p.a.) Since Inception (p.a.) (12/10/2010) FYTD GaveKal Asian Opportunities Fund MSCI AC Asia Pacific GR AUD -3.83 -2.87 -7.00 -5.06 7.06 17.64 7.77 7.26 7.88 0.00 4.13 6.63 6.67 -1.62 6.46 Threadneedle Global Equity Fund As of Date: 31/03/2014 Month Quarter 1 Year 3 Years (p.a.) 5 Years (p.a.) 7 Years (p.a.) 10 Years (p.a.) Since Inception (p.a.) (05/09/2011) FYTD Threadneedle Global Equity MSCI ACWI GR AUD -5.00 -2.97 -4.45 -2.31 31.35 31.79 13.20 11.80 2.08 5.47 21.70 22.89 14.29 15.98 Threadneedle Global Equity Income Fund (Unhedged) As of Date: 31/03/2014 Month Quarter 1 Year 3 Years (p.a.) 5 Years (p.a.) 7 Years (p.a.) 10 Years (p.a.) Since Inception (30/11/2012) FYTD Threadneedle Global Equity Income Unhdgd MSCI ACWI GR AUD -3.09 -2.97 -3.43 -2.31 26.00 31.79 13.20 11.80 2.08 5.47 42.79 43.88 11.46 15.98 46
  • 48. Certitude Contact New South Wales Geoff Koudelka State Manager Global Solutions VIC & NSW & TAS Jennifer Savedra Manager Global Solutions VIC & WA P +61 429 038 946 E jsavedra@certitudeglobal.com.au Queensland & Northern Territory Paul Burbidge State Manager Global Solutions QLD P +61 409 723 990 E pburbidge@certitudeglobal.com.au Michael Akele State Manager Global Solutions NSW P +61 401 994 973 E makele@certitudeglobal.com.au Western Australia Jennifer Savedra Manager Global Solutions VIC & WA South Australia Tasmania Geoff Koudelka Manager Global Solutions VIC & NSW & TAS P +61 417 309 844 E gkoudelka@certitudeglobal.com.au National Hector Ortiz Head of Global Solutions Family Offices and Institutions P +61 488 585 534 E hortiz@certitudeglobal.com.au New Zealand Paul Burbidge Manager Global Solutions New Zealand P +61 409 723 990 E pburbidge@certitudeglobal.com.au CERTITUDE BRINGS THE WORLD TO YOU This document has been prepared by Certitude Global Investments Limited ABN 25 082 852 364 (Australian Financial Services Licence No. 246747 (‘Certitude’)). Although every effort has been made to verify the accuracy of the information contained in this document, Certitude, its directors, officers, representatives, employees, associates and agents disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by any person directly or indirectly through relying on this information. The information in this document is not personal financial product advice and has been prepared without taking into account the objectives, financial situation or needs of any particular person. Before making an investment decision to invest or continue to hold units in any Certitude fund, you should obtain and read a copy of the relevant Product Disclosure Statement (PDS) from www.certitudeglobal.com.au/pds and consider, with the assistance of a financial or other adviser, whether the investment is appropriate having regard to those matters. Past performance is not indicative of future performance. This report has been prepared for use by Australian Financial Services Licensees and their representatives only. Not for onward distribution to, or to be relied upon by, retail clients. Geoff Koudelka Manager Global Solutions VIC & NSW & TAS P +61 417 309 844 E gkoudelka@certitudeglobal.com.au Victoria P +61 417 309 844 E gkoudelka@certitudeglobal.com.au P +61 429 038 946 E jsavedra@certitudeglobal.com.au
  • 49. www.certitudeglobal.com.au

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