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Standard life global outlook
 

Standard life global outlook

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Standard Life Global Outlook

Standard Life Global Outlook

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    Standard life global outlook Standard life global outlook Document Transcript

    • Standard Life Investments 3rd Quarter 2010 Market views • Investors face a series of political and regulatory hurdles on top of normal fiscal and monetary decisions • Stock market cycle supported by corporate profits and healthier balance sheets • Volatile financial markets expected into 2011 Global Outlook Q3 www.standardlifeinvestments.com
    • Summary 04 Global Overview - Economics and politics interact The House View is more positive on sustained corporate profits growth as the economic upturn becomes more broadly based, geographically and across sectors. However, there are growing risks for financial markets from the degree of political and regulatory interference being seen in more countries. 06 Focus on Change - Casting an eye over consumer stocks Many investors are wary of consumer stocks as some household incomes will be under considerable pressure in coming years. However, detailed micro level analysis shows very different trends in consumer spending across different groups. 08 Global Sectors - Light at the end of the tunnel The technology sector has emerged as one of the bright lights of the global recovery with LEDs set to benefit. 09 European ex-UK Equities - Broadening horizons Congested capital markets pose a challenge for many European banks. We are finding the winning contenders, alongside firms exploiting worldwide economic growth 10 US Equities - The price is right Pricing resilience stands several transport-related companies in good stead, while life insurers are poised to profit from attractively priced prospects.
    • 11 Japanese Equities - Investing for growth 17 Currency - New world order Consolidation in Japan’s non-life insurance sector The global currency pecking order has changed allows for better pricing, while takeover activity among following the recession and the sovereign debt crisis, pharmaceutical firms should deliver greater balance and may not yet have found a new equilibrium. sheet efficiency. 18 Property - Opportunities in Europe 12 Emerging Market Equities - India enjoys The outlook for European commercial property prevailing winds remains positive despite the sovereign debt crisis. We Strong Indian growth has propelled domestically expect a steady but slow recovery in occupier markets. orientated stocks higher, whilst investors are also increasingly focused on income opportunities across Asia. 19 Global Absolute Return Strategies - Changing tack on directional trades The big move down in interest rate swap yields and 13 UK Equities - Differentials within the high valuation of US smaller companies has defensives highlighted some relative value opportunities. Several positive catalysts have prompted us to view the telecoms sector more positively than other defensive companies. Meanwhile, some favoured stocks are reaping the rewards of internal change. 14 Government Bonds - The state of European sovereigns Concerns about sovereign debt in the Euro-zone have had substantial and far-reaching effects both inside and outside the single currency area. 15 Corporate Bonds - By hook or by crook As sovereign debt levels remain elevated across the Euro-zone, we examine the repercussions for corporate bond investors and consider which companies are best placed to deliver value. 16 Treasury - Active fiscal - passive monetary The coming period of fiscal austerity will be accompanied by an extended maintenance of low interest rates. Global Outlook
    • Standard Life Investments is a dedicated investment company with global assets under management of approximately €163.5 billion (as at 31 March 2010), making us one of the world’s major investment companies. Responsible for investing funds on behalf of over five million retail and corporate customers including the Standard Life Group, we offer global coverage of investment instruments and markets. We are active fund managers, who place significant emphasis on research and teamwork. After in-depth analysis, our Global Investment Group forms a view of where to allocate assets, based Foreword on the prevailing market drivers and on forecasts of future economic indicators. The Global Investment Group is made up of senior investment managers from the Strategy and Asset Class teams and is responsible for providing the overall strategic focus to the investment process. The House View delivers a consistent macro-economic framework to our investment decisions. It generates the market and thematic opportunities for us to add value to our customers over the timescales they use to measure our success. It is formulated in such a way as to make timely investment decisions but to also allow all members of the investment teams to influence its conclusions. Keith Skeoch Chief Executive In a diverse, dynamic world we use our insight and intellect to seek out investment opportunities. Our ability to predict, react and adapt rapidly helps us to maintain our position as a leading investment house. 2 Global Outlook
    • Standard Life Investments is avowedly an active investor; global agendas start to dominate the debate and it is our Focus on Change investment philosophy has long been difficult to think of a time in the last 30 years when there built on the view that markets are inefficient and the future have been so many moving parts. For an active investor all is more uncertain than many investors are prepared to this change and uncertainty makes life difficult but it also recognise. Our investment process is driven by an brings a real opportunity to add value for clients. acceptance that in the face of uncertainty, it is important to have a strong view on the available return opportunities. So what are the key insights to be gleaned from our Focus Insights into return opportunities that deliver alpha are on Change philosophy and this latest edition of Global generated by 90% perspiration through systematic, Outlook? The first is that macro still matters. The big picture rigorous research and analysis and 10% inspiration. about where the world is heading is profoundly important especially because so much depends on striking the right Surveying the investment landscape a year into the balance between fiscal austerity and monetary support recovery in financial markets the one thing that is through devaluation and Quantitative Easing. Our view abundantly clear is the continued high level of uncertainty remains that while growth will slow we do not expect a on so many fronts, which leaves risk appetites in such a slide back into prolonged recession. The world’s corporate fragile state. The pace of economic recovery, the world sector remains in good shape and will continue to perform monetary system and its impact on currencies, the policy well even in a low growth world. The continued availability prescription for sustained growth, the regulatory of historically high risk premia reflects a good deal of the environment especially for banks and the role of corporate uncertainty surrounding the impact of all this change. engagement are all areas of active debate and sources of However, given that risk appetites remain on a macro hair possible significant change in the return environment. Add trigger, the sustainability of the yield support for these into this mix a political agenda, which during the first half premia continues to be a key theme for our asset allocation. of the year has seen national and regional rather than Global Outlook 3
    • Global Overview Chart 1 Business surveys Economics and politics interact 70 30 65 20 60 10 55 0 50 -10 The House View is more positive on sustained corporate profits growth as the economic upturn becomes more broadly based, 45 -20 geographically and across sectors. However, there are growing risks 40 -30 for financial markets from the increasing degree of political and 35 -40 regulatory interference in many countries. 30 -50 25 -60 2005 2006 2007 2008 2009 L.H. scale: US ISM Chinese PMI German IFO R.H. scale: Japanese Tankan Andrew Milligan Source: Bloomberg Head of Global Strategy countries, forced to make some extreme changes in recent months. However, the details of the packages do need to be examined carefully. While individual nations such as Greece or Portugal have implemented programmes worth 2-4% of GDP in a single year, such nations are only a small part of the Euro-zone. On balance, the fiscal tightening across the region is only about 1% of GDP, by no means unimportant but manageable in the absence of further major shocks. In reality, there is no definitive conclusion amongst economists to this key question about the impact of a major fiscal tightening. While some commentators argue that the reduction in public sector demand will Introduction inevitably push fragile economies into a further recession, historians can show successful examples across a range of The good news for investors is that the world economy is countries where the process resulted, at worst, in slow making continued progress in recovering from the after growth. effects of the major financial crisis of 2007-09. The bad news for investors is that the process is by no means over, Certain aspects require careful analysis. One is the efficacy hence we expect to see volatile financial markets for some of past public sector spending; can productivity be raised, years as investors try to price in correctly some of the long- so that services can be provided in a more cost efficient term implications. Investment processes need to include manner? A second is the time horizons of businesses and not only analysis of economic cycles but also political and households. If they believe that the fiscal tightening is regulatory developments. While valuation signals will be credible and public sector finances will be brought onto a helpful in some markets, more often behavioural signals will sustainable path, then they should be prepared to run matter. down their savings and wealth to cushion the blow. A third issue is the danger of not acting on the fiscal position, and Steady as she goes allowing debt levels to build up to unsustainable levels. This In most respects our House View economic forecasts have could provoke a damaging market reaction such as much not changed markedly in the past year. As we expected the higher borrowing costs. On balance the House View world economy has exited from its deep recession, and concludes that the most likely outcome is a slow-growth, indeed the recovery is broadening out across geographies low-inflation recovery with interest rates kept lower for and sectors. The key driver in this respect remains the longer. Plan B would include further quantitative easing by corporate sector; having re-built profits and strengthened central banks to deal with unwanted shocks. balance sheets, firms are starting to engage in some capital spending and new hiring. Consumer income growth is The only ‘double dip’ recessions in advanced economies in moderate but it is sufficient to support spending, albeit this recent history have been the US in the early 1980s, which remains below levels usually seen in a recovery as many was an intentional policy decision to drive inflation out of households are unable to access credit. While these factors the system, and Japan in the mid 1990s when a consumer mean a slow growth recovery by past standards in most tax increase accidentally coincided with the Asian debt OECD economies many of the Global Emerging Markets crisis. In this respect, it remains very important that the (GEM) are showing strong growth driven by long-term primary drivers of the world economy, namely the US and structural trends. All in all, global GDP growth looks set for the larger GEM, do not slow markedly. Recent policy 4-5% a year in 2010-11. decisions are helpful. The US is not following Europe into tighter fiscal policy. Parts of Asia are facing inflationary What could bring this uptrend to an end? One risk is the pressures, either in CPI measures or property markets. error of tightening fiscal policy too quickly. After all, However, countries such as Australia and China have taken countries equal to about 40% of global GDP are in the early action and it looks likely that they are on top of the process of cutting spending and raising taxes. The most issues, even if others such as India look to be lagging a obvious concerns are amongst many of the Euro-zone little. In this respect, the recent Chinese decision to allow 4 Global Outlook
    • Chart 2 Chart 3 Sovereign stresses Interest rates lower for longer bps bps % % 1,200 1,200 5.0 5.0 4.5 4.5 1,000 1,000 4.0 4.0 800 800 3.5 3.5 600 600 3.0 3.0 2.5 2.5 400 400 2.0 2.0 200 200 1.5 1.5 0 0 1.0 1.0 2009 2010 2009 2010 5-year CDS spreads for: December 2011 futures market 3-month interest rate expectations for: Greece Portugal Spain Ireland UK Germany US Euro-zone UK Source: Bloomberg Source: Bloomberg the RMB more flexibility against a basket of currencies is an recent Australian proposal to impose a tax on mining important trigger. It signals that over time the authorities companies, and whether such windfall taxes, say on the wish the economy to rebalance towards domestic utilities sector, become more popular especially in countries consumer spending, eventually a more helpful backdrop for where the fiscal position is tight and the corporate sector Western exporters. All in all, global leading indicators reflect profitable. the momentum of future growth is slowing rather than a slide back into prolonged recession (see chart 1). Sources of volatility On top of this there are various problems relating to a While financial markets are underpinned by better profits financial system which in many countries remains reliant on growth, there remain major uncertainties about the upside central bank support. Wholesale money markets are not yet and downside estimates. Some of the concerns relate to the functioning properly, while the lack of capital amongst many economic cycle, but more of them relate to political issues investment banks means that trading liquidity can seize up in in one form or another. Most evident in the minds of many markets remarkably quickly. All in all, it is understandable that investors are the pressures on the Euro-zone. The House the time horizons of many investors are understandably short View assumes that the recent ECB/IMF package has bought term in the face of such an uncertain environment. time but Greek debt will eventually see some form of restructuring. The unknown factors are the impact of this House View on the balance sheet of the commercial banks, pension The House view has not made material changes to its asset funds and other holders of debt, including the damage allocation in recent months. Our broadly cautious stance has caused to the ECB’s balance sheet, as it could make losses already proven correct in this environment. Valuations have on debt bought under its QE programme. Chart 2 shows been a useful trigger on occasion in some areas. For the CDS spreads on various European countries, one example, we decided to reduce our positions in European measure of investor concern about these issues. government bonds when yields were considered too expensive, moving into relatively more attractive high Another prime example would be future regulation, yielding corporate debt. It does appear to be the case that primarily relating to the financial services sector. A stream of equity and bond investors have become more realistic about international and domestic proposals are making their way their return expectations in recent weeks, although a major through legislative systems and technical committees: Basel change in the economic or corporate environment would still 3, Solvency 2, the Dodd legislation in the US, the banking warrant a further adjustment in prices. While most of the commission in the UK, as just some examples. We are major asset classes are relatively close to fair value on our concerned that some of the recent discussions have not measures, we consider other factors are currently more shown much evidence of politicians listening to significant drivers of investor activity. We are paying more practitioners, such as the Alternative Investment Fund attention to behavioural finance signals in our tool kit; value Managrs (AIFM) directive in Europe. On balance the on its own is rarely sufficient to spark the correct time to complexity of much of the international discussions, often renew interest in an asset class, but investor sentiment and under G20 auspices, suggests that many of those decisions positioning measures can help with timing. could well be delayed into 2011 or even beyond. This will mean an untenacity risk premium hanging over markets for The House View continues to favour sustainable yield in the some time to come. As the financial services sector makes current environment. It remains the case that central banks up a significant proportion of total stock market profits in are unlikely to tighten monetary policy in most OECD the major economies, the outcome of these regulatory economies until well into 2011 (see chart 3 showing how discussions for future profits growth is important. interest rate expectations have altered) in the face of generally weak inflationary pressures, fiscal tightening and a Other political factors could well cause volatility in coming banking sector still under pressure. Hence, a diversified months. One issue to monitor is the result of the US mid- portfolio of income seeking assets, inclined towards credit term elections, any losses by the major parties and the rise but including commercial property and dividend paying of politicians calling for smaller government or the degree equity, is making attractive returns year to date. of the backlash against big business. A second would be the Global Outlook 5
    • Chart 1 Focus on Change Added value in luxury goods Casting an eye over consumer stocks 180 180 Many investors are wary of consumer stocks as some household 160 160 incomes will be under considerable pressure in coming years. However, 140 140 detailed micro level analysis shows very different trends in consumer spending across different groups. 120 120 100 100 80 80 60 60 40 40 2009 2010 Share price performance relative to the Dow Jones global luxury goods index for (01/01/09=100): LVMH Swatch Saks Thomas Moore Magdalene Miller Source: Bloomberg,Thomson Datastream Investment Director, UK Larger Cos Investment Director, Asia/Japan Focusing on the consumer recovery What is changing? Our investment process is based on a foundation of There are a number of positive and negative factors affecting rigorous research, guided by our Focus on Change household finances in the early stages of the recovery from investment philosophy. Central to this is our Common the recession. While unemployment looks to be peaking in Investment Language, which we use to validate all our many economies, employment prospects differ considerably investment decisions. In previous editions of Global across sectors. For example, in parts of Europe the public Outlook, we examined how Focus on Change drives sector is seeing actual salary reductions, while a pay freeze specific asset allocation and corporate profits growth, as has been announced for large parts of the UK public sector well as demonstrating our sector picking decisions. In this and there are prospects of significant job losses to come. In edition, we show how detailed analysis is required when the US, the number of workers in part-time employment for picking consumer-facing stocks. There are considerable economic reasons rose from about 4 million at the end of headwinds to household incomes in many countries, for 2007 to 9 million currently. This represents a significant example from high current levels of unemployment, a change in those households, with less disposable income growing tax burden, public sector spending cuts, the available for consumption. In general terms, real after-tax adverse wealth effects from the bear market in stocks, and incomes are currently under pressure from a combination of the high levels of debt built up in the previous cycle. higher inflation and tax increases. Looking beyond these headwinds though, it is important to look at micro level drivers of individual sub-sectors and The impact can vary significantly though. For example, lower- groups within each country. Our analysis shows a number paid households usually spend a higher proportion of their of consumer-related stock opportunities where the long- income on basics such as food and energy. Turning to access term drivers are more positive. to credit, the availability of mortgages remains more difficult for first time buyers, who need to raise a larger deposit, than We examine the outlook for consumer-related stocks, for existing home owners with significant equity in their examining five questions which form our Focus on Change house. There is a marked contrast between home owners and philosophy: households who rent; the former have generally benefitted • What are the key drivers? from the sharp reductions in interest rates as central banks have eased policy, while rents have often lagged the cycle. • What is changing? UBS’ analysis suggested that UK household incomes post tax • What expectations are priced into the markets? and interest income rose almost 10% in 2009, but the effect • Why will the market change its mind? will fade significantly into 2011 even if interest rates remain • What are the triggers? low. The recovery in stock markets, led by technology spending, and also in house prices rising from their lows in What are the drivers of consumer spending? 2009 has meant a positive wealth effect for certain households. These include many of those based in London These include: and the South East in the UK, or New England and parts of • income growth – the tax burden is rising as the west coast, Marin County and Medina which are home to governments tackle large public sector deficits, while technology-related wealth, in the USA. employment growth is low on a historical basis; A stock-specific beneficiary of these trends is Saks. We have • credit growth – certain households are less able to witnessed a close relationship between stock market access credit due to their financial position or the movements and sales at high-end retailers. As financial asset weakness of the banking sector; values recover, it appears that wealthier households resume • debt servicing – certain households benefit more than their spending habits significantly faster than the average others from the significant cuts in interest rates seen in consumer (chart 1). To the extent that the current stock many countries; market weakness continues, such customers may become • wealth effects – certain households benefit more than skittish but are typically the first to increase spending in the others from the recovery in the housing and stock economic recovery phase. Similar trends have been seen markets. across Europe, where a number of luxury goods providers, such as LVMH and Swatch, have reported strong sales growth, including high-end demand from parts of Asia, in recent months. 6 Global Outlook
    • Chart 2 Chart 3 Percentage of total population represented by Contrasting fortunes in transport the middle classes 110 110 Malaysia 100 100 China 90 90 Thailand 80 80 Asia ex-Jpn 70 70 Indonesia 60 60 Philippines (%) 50 50 0 10 20 30 40 50 60 70 2009 2010 2014 2009 Share price performance relative to the UK Travel & Leisure sector for (01/01/09=100): Stagecoach Group First Group Source: CLSA Asia Pacific Markets Source: Thomson Datastream The consumer staples sector provides further evidence. In As more Chinese households experience higher wages and recent months, several food producers have noted salaries, this feeds through to increases in ‘life-style’ spending increased promotional activity by some of the largest fast- from which we have identified winners amongst consumer- moving consumer goods companies. Most recently, UK facing stocks. Anta Sports Products is a ‘branded’ sportswear personal care company McBride, which sells its products company catering to the aspirations of increasingly affluent mainly through private labels, has signalled weaker-than- consumers in second and third-tier cities in China. Wage expected trading due in part to such heavy discounting. growth here has outpaced that in first-tier cities in recent The economic downturn clearly made consumers more months but for these consumers global sportswear brands price sensitive. In this environment, differentiating one's such as Nike and Adidas are still just out of reach. Another product becomes more crucial than ever. One of our company with an expanding market is internet provider favoured holdings in the consumer staples sector is high- Tencent, which benefits from rising internet penetration but end food producer Cranswick, which has managed to also provides social networking opportunities. continue growing throughout the economic downturn by offering consumer-differentiated premium product at an In the UK the differing pace of recovery in consumer well- affordable price. This is an example where consumers have being is evident from recent comments by bus and rail shown themselves to be willing to trade up to the highest companies, including Stagecoach and FirstGroup, on the price points. We feel the competitive advantage generated geographical trends which they are witnessing (chart 3). by this differentiation is not properly reflected in the Whilst both companies are reporting a relatively robust valuation of the stock. recovery in commuter traffic into London, they are also reporting weaker conditions in provincial towns, especially Another beneficiary of consumers trading up comes from the those in more deprived regions of the UK. This may reflect Asia-Pacific region. CP All operates convenience store chains the different employment conditions across different in Thailand and China, similar in concept to 7-11 stores. It is regions, as well as different levels of home ownership and expanding its range and price points in response to an consequent exposure to cheap floating rate mortgages. A increasingly health-conscious and growing middle-class similar pattern has also been observed by UK bus and rail consumer base. Chart 2 shows how these trends are forecast companies with exposure to the US market, with commuter to alter in coming years in various countries. traffic in the relatively affluent New York area recovering most rapidly. Stagecoach is our favoured stock in the bus What is in the price? and rail sector, as we consider that the improving volume Given the well-known pressures on household incomes, the trends being seen across large parts of the business are not share prices of many consumer-related stocks have been fully reflected in its valuation. under pressure. Hence, the global consumer goods and services sectors currently have P/E ratios of 18.6x and When US fuel prices were very high in 2008 and early 2009, 17.4x, which are not dramatically cheap but look lower-income shoppers in rural areas curtailed their trips to favourable against 10 and 20-year average valuations. Wal-Mart to save on the cost of fuel. Following the reduction in fuel costs, Wal-Mart has not recovered the number of trips Why will the market change its mind? What are from these shoppers. It appears that price competition from the triggers? dollar stores and grocery markets has intensified to the point where the need to return to Wal-Mart is not present. This is Our detailed analysis has concluded that it is necessary for also helped by the fact that fewer retail stores are going out investors to adopt a more granular approach rather than of business, because banks are less willing to realise loan simply examining the broad macro economic factors losses and also the ability of retailers to raise funds. Therefore, affecting consumer spending, such as analysing the impact with the supply of retailers 'artificially higher than normal', the of consumer tax increases in various countries, important as retail environment is becoming a zero sum, market share these may be. We expect the market to pay up for game. Winners in this environment offer products with the companies that can generate better revenue growth by best value to the consumer, which does not always mean the focusing on attractive trends across socio-economic groups least expensive. or regions even if the general backdrop is less favourable. Global Outlook 7
    • Global Sectors Chart 1 Beneficiaries from oil industry upheaval Light at the end of the tunnel 190 190 180 180 The technology sector has emerged as one of the bright lights of the 170 170 global recovery with LEDs set to benefit. 160 160 150 150 140 140 130 130 120 120 110 110 100 100 90 90 80 80 2009 2010 Lancashire Holdings price performance relative to Global Non-Life Insurance sector (01/01/09=100) Tullow Oil share price performance relative to Global Oil & Gas Producers sector (01/01/09=100) BG Group price performance relative to Global Oil & Gas Producers sector (01/01/09=100) Lance Phillips Source: Thomson Datastream Head of Global Equities LEDs the way ahead deepwater oil rigs. Approximately 80% of oil production in The technology sector was one of the first to display signs the Gulf of Mexico comes from deepwater production and of recovery following the recent global economic the sudden disruption in demand for such rigs is likely to downturn. Although macroeconomic uncertainties continue result in an overhang of supply globally. This in turn will to linger, the sector appears capable of sustaining its impose downward pressure on deepwater rig prices, which upward momentum. Our analysis is particularly favourable generally make up nearly 50% of a well’s overall cost. Those for the LED lighting sector which is benefiting from new standing to benefit from the cost reduction are companies products and technological innovations. This has been operating in regions that are unaffected by the drilling driven in part by the success of LED backlighting for TVs, moratorium. In particular, this has positive implications for but is expected to be extended by the increasing use of oil firms BG Group and Tullow Oil, which have significant LEDs in commercial lighting. exposure to deepwater operations in Brazil and Africa respectively. The upturn in the LED lighting cycle presents a compelling opportunity for those firms that have maintained their R&D Another beneficiary of changes within the oil sector is the investments through the crisis. Among these, we would insurance industry, which is expected to gain from upward highlight Royal Philips Electronics and Aixtron as key pressure on insurance costs. Pricing in the specialised oil beneficiaries of the LED upturn. Philips is one of the few insurance segment had previously been forecast to be flat- companies with a presence across the whole value chain of to-down. However, a renewed focus on safety in the oil LED lighting. However, a recent restructuring of its lighting sector is expected to push prices higher, with some analysts business means that it is increasingly focusing on the predicting up to a 30% increase in pricing. Our research development and design stage and is likely to emerge as a indicates that UK insurer, Lancashire Holdings, is well placed leader in the lighting architecture and consulting business. to benefit from improving volumes and pricing in the This is likely to generate strong revenue opportunities offshore energy insurance market. particularly as companies shift commercial facilities to LED lighting systems. Our strategy within global sectors Macro headwinds continue to negatively impact global Swiss firm Aixtron, a company that manufactures machines equities markets despite improving corporate fundamentals. for the production of LEDs, is another set to benefit from However, there are still opportunities in high quality the LED upturn. The firm has a dominant share of the LED companies in which we look to invest. We continue to gain manufacturing machinery market and is well-protected exposure to the high-end consumer segment through from the entry of low-cost rivals. The firm is particularly auction house operator Sotheby’s. Ongoing strength in art exposed to the exponential growth in the use of LED auction pricing around the world has boosted expectations lighting in LCD TVs. Robust demand for LCD TVs has been for a faster recovery in profitability. We have also continued a key trend in the last 18 months and is likely to continue to build our holding in US technology giant Apple. The firm as consumers maintain a stay-at-home approach to their has benefited from a robust product cycle with both iPhone leisure time. and iPad product lines delivering strong revenues. Opportunities in adversity Our bottom-up approach to stock selection is leading us to The recent moratorium on drilling activity in the Gulf of companies that are likely to be market leaders and market Mexico has halted oil exploration in the region. However, share gainers in the next phase of the economic cycle. Our the impact on short-term oil supply is likely to be moderate, allocation combines pro-cyclical and defensive elements, with the region accounting for less than 3% of world with Heavy weightings in consumer discretionary, production. Even so, there are some important technology and industrial sectors coinciding with Light consequences for the oil services industry. One key aspect is exposure to financials and materials, driven by individual the change to global supply and demand dynamics for stock ideas. 8 Global Outlook
    • European ex-UK Equities Chart 1 Banking franchises with solid fundamentals Broadening horizons 240 240 220 220 Congested capital markets pose a challenge for many European 200 200 banks. We are finding the winning contenders, alongside firms exploiting worldwide economic growth. 180 180 160 160 140 140 120 120 100 100 80 80 2009 2010 Share price performance relative to the European Banking sector for (01/01/09=100): DnB NOR Credit Suisse Will James Source: Thomson Datastream Investment Director, Europe Squeezing out value in European banks Europe. We are identifying stocks that offer exposure to The sovereign debt issues that have dominated market such global growth prospects at an attractive price (72% of movements for the last few months are now triggering the sectors in Europe are on a discount to their US peers). specific problems for the European banking sector. The Alongside these relative valuation opportunities comes the issuance needs of European banks are estimated to be additional advantage of European exporters gaining directly around €700 billion per annum over the next three years. from the currently depressed euro. Given how volatile the However, as governments rush to refinance their own currency is, we do not expect European businesses to alter balance sheets, liquidity is becoming limited within the pricing in order to drive market share. Instead, we think interbank markets, ‘crowding out’ the banks which need to they will take the currency benefit to the bottom line, obtain term funding. expanding margins and profitability. We are Light in peripheral European banks; we reduced One of our holdings that exploits these global growth BBVA in April, anticipating that Spain would have to take prospects is Prysmian, a worldwide leader in underground even more stringent fiscal austerity measures that would electric cable. We foresee growth opportunities in the US, decrease loan demand and hurt credit quality. Instead, we as upgrades of the electricity grid get underway, in China, remain focused on finding regional banking franchises built as investment of electrical and telecommunications on sustainable models, where funding headwinds are less infrastructure continues, and in Brazil as the firm develops likely to have a detrimental effect. Norway’s largest bank, flexible pipes for offshore oil extraction. However, the DnBNOR, falls into this camp. Norway has the lowest market rates the stock as if revenues will grow at a very default risk in the world and its economy is thriving, with pedestrian rate. Elsewhere, we are invested in Danish low government debt, house prices above previous peaks diabetes drug company Novo Nordisk, whose biggest and low unemployment. Increased access to capital via market is China, and aero engine maker Safran, given its securitised mortgages following recent regulatory change exposure to US customer Boeing. We also hold several enables DnBNOR to benefit from a far more favourable exporters, such as Daimler, which is set to profit from the outlook than its peers elsewhere in Europe. recovery in the US truck market and better-than-expected demand for Mercedes cars in China. Staying in Scandinavia, we also continue to prefer Sweden’s Svenska Handelsbanken, whose differentiated business Our strategy within European equities model appears underappreciated. The bank is accelerating Europe offers the opportunity to invest in companies which its organic growth drive outside of Sweden, and these have not only world-class technology, but have also growth opportunities, alongside its focus on customer maintained their R&D investments through the crisis, in profitability, should lead to a loan portfolio with lower credit contrast to many of their global peers. ASML, a world losses. Svenska has not raised capital or joined the Swedish leader in lithography equipment for the semiconductor government’s scheme, and its relative strength signals industry, is one such example. The firm’s top line is ongoing margin health. Finally, we are still invested in benefiting from a catch-up in spend following a period of Credit Suisse, which is the most over-capitalised bank in significant underinvestment by its Asian customer base, Europe. The bank is employing its capital to facilitate client which we think will continue for longer than the market activity, rather than using it to buy and hold assets for anticipates. Meanwhile, we have added Dutch-based trading gains. dredging services group Royal Boskalis Westminster to our Winners List. In our view, the market underappreciates the Masters of the universe prospects for Boskalis’ earnings recovery, which is supported We continue to believe that in times of macroeconomic by a growing project pipeline from both port operators and uncertainty the market overlooks European companies’ oil companies. Finally, we have been reducing our funds’ exposure to global growth. In fact, around 40% of weighting in Portugal Telecom; taking some profits post a European firms’ sales are derived from outside western period of strong performance. Global Outlook 9
    • US Equities Chart 1 Sector outperformance The price is right 225 225 200 200 Pricing resilience stands several transport-related companies in good stead, while life insurers are poised to profit from attractively 175 175 priced prospects. 150 150 125 125 100 100 75 75 50 50 2009 2010 Apple share price performance relative to US Technology sector (01/01/09=100) Intercontinental Exchange share price performance relative to US Financial sector (01/01/09=100) Euan Sanderson Source: Thomson Datasteam Senior Vice President, US Equities Tightening transport market on track for course to complete by late 2010. With AIG trying to raise pricing gains capital to repay its substantial government bailout, MetLife We are positioning our US equities portfolios to take was able to secure the overseas business for what appears a advantage of transport firms’ improving pricing power. In reasonable price. Alico is attractive to MetLife for several the railroad sector, where Winners List stock CSX features, reasons. Firstly, the acquisition offers MetLife direct access and the logistics sector, where we like package delivery firm to Japan, which represents the second-largest life insurance FedEx, we see signs that rising volumes, pricing gains and market in the world. MetLife’s position in Europe will also solid cost controls are generating strong operating leverage. be enhanced, while various emerging market regions will This, in turn, should lead to share price appreciation. become more accessible, offering a wealth of new distribution opportunities. We believe the market is After years of pricing pressure, railroads finally began to underestimating the future earnings potential of the establish pricing power in 2004 as demand started to combined company as a result of this deal. outstrip supply. Following several years of pricing gains, investors became concerned that pricing discipline would We also hold a position in life insurer Prudential Financial fade as the industry faced serious volume declines in 2009. (no relation to the UK insurer). Like MetLife, Prudential is However, industry players remained disciplined in the taking significant market share, benefiting from the ‘flight downturn and retained their focus on generating earnings to quality’ trend being seen across the industry. The firm from capital invested. With volumes now recovering, we has a fair amount of excess capital at its disposal, and we believe pricing gains should accelerate from here. CSX, anticipate that this will be used to make an acquisition over which operates the largest rail network in the eastern the next few years. With many financial firms likely to be United States, should be a prime beneficiary. The reviewing their non-core insurance holdings, there should company’s excellent cost control throughout the downturn be no shortage of potential opportunities available. now sets the stage for significant operating leverage as volumes continue to rise. We are also encouraged by robust Our strategy within US equities pricing for transporting metallurgical coal, while pricing in Customers’ growing preference for smaller, more portable CSX’s intermodal business should be boosted by a mobile devices is a trend that shows no sign of abating. tightening in the truckload market. Aiming to capitalise on this, we continue to hold a Heavy position in Apple. The firm has established a market-leading Our investment in FedEx, the world’s largest express position in anticipating and responding to consumer transportation provider, reflects our belief that pricing in the preferences, and is seeing initial impressive sales for its iPad small package market will also get better. We believe the tablet computer. We also own chip maker Qualcomm, market is underestimating the potential for FedEx to whose products are used in wireless devices. Qualcomm is expand its operating margins, and think these will return to making strides in the higher end of the cell phones market peak levels faster than expected on the back of volume with its Snapdragon platform. We believe the winners in a growth and better pricing. The company’s management new world of greater device portability are likely to be cites improving pricing as a key priority and its most recent companies such as Qualcomm as opposed to current PC quarterly report provided early evidence of this chip incumbents like Intel. Elsewhere, futures exchange commitment. IntercontinentalExchange (ICE) still looks attractive. The firm has witnessed record volumes in the midst of recent market Acquisitive insurance companies offer volatility. In the longer-term, it should also gain from opportunities financial reform as the government and regulators aim to A further theme emerging across our US equities portfolios increase transparency. The push towards increased over- is that of companies benefiting from M&A activity. For the-counter (OTC) clearing and ultimately some OTC example, MetLife, the largest US life insurer, was added to derivatives becoming exchange traded also bodes well for our Winners List in April of this year. The company’s the firm. purchase of AIG’s foreign insurance operation Alico is on 10 Global Outlook
    • Japanese Equities Chart 1 Efficient use of balance sheets Investing for growth 115 115 110 110 Consolidation in Japan’s non-life insurance sector allows for better pricing, while takeover activity among pharmaceutical firms should 105 105 deliver greater balance sheet efficiency. 100 100 95 95 90 90 85 85 80 80 2009 2010 Share price performance relative to the Japanese Healthcare sector for (01/01/09=100): Astellas Daiichi-Sankyo Matthew Williams Source: Thomson Datastream Investment Director, Asia Pacific Improved pricing potential for insurers acquired OSI Pharmaceuticals, which provides it with a With a large number of firms competing for limited foothold in the US as well as access to an oncology drug business, Japan’s mature non-life insurance market has portfolio. We believe this takeover is a positive move as it suffered from a slow decline in premiums and dwindling should deliver an investment yield well in excess of the margins. However, we have started to see some return Astellas was receiving on its cash hoard and should consolidation in the industry, with the forthcoming union prove earnings-accretive over time. Importantly, the between Mitsui Sumitomo, Aioi and Nissay Dowa set to prospective drug pipeline on offer should put the company create a new industry leader. Fewer industry participants back on a growth path. should result in a better pricing environment for those who remain, including our preferred holding Tokio Marine. We also hold Daiichi-Sankyo, which does not have the same patent issues but has sought acquisitions to make more Meanwhile, better regulation in the sector also creates an efficient use of its balance sheet and grow at a faster pace. opportunity for companies to differentiate their offering and It bought a majority stake in Indian drugs firm Ranbaxy, charge at a more reasonable pricing point. For example, which specialises in generic drugs, in 2008. Since then, the semi-independent industry body Non-Life Insurance Rating integration has not gone to plan, as two of Ranbaxy’s Organization (NLIRO) currently produces only two production facilities were subject to a US import ban reference rates for auto insurance premiums – one for because of irregularities in drug storage implementation. drivers under 21 and one for those over 21. Therefore, a Daiichi-Sankyo has taken action to resolve this, engaging 22-year old driver would pay the same premium as a 45- directly with the FDA and overhauling Ranbaxy’s year old with the same accident history. However, from management team. As a result, we are starting to see 2011 NILRO will produce eight rate levels covering a range evidence of a resolution to the situation, which should of ages. Although there will continue to be no hopefully be completed by the year end. This would leave differentiation between men and women, the new pricing Daiichi-Sankyo with some good products and a decent levels will at least allow Tokio Marine to charge according to drug pipeline, which we consider deserves more individual customer risk profiles and target more profitable recognition in the share price. areas. While the pace of change in the non-life insurance sector is unlikely to be rapid, these improvements represent Our strategy within Japanese equities a big shift within the industry which we believe has not yet We recently reduced our holding in LCD TV glass maker been priced in by investors. Asahi Glass. We had previously been optimistic on the pricing outlook for the industry, with an oligopolistic market Pharmas put balance sheets to better use making for better pricing cohesion. However, we now think Pharmaceutical companies are looking to offset threats to this has played out, with two new credible competitors profitability as well as increase balance sheet efficiency by entering the industry and companies starting to jostle for using surplus capital to make acquisitions and fuel growth market share. We believe the cohesive environment will not (chart 1). We own Astellas, Japan’s second-largest last, with pricing already coming off more aggressively than pharmaceutical company by market capitalisation. It has the seasonal average reductions. Elsewhere, we have added several key drug patents ending, which could lead to to Denso, a car parts maker affiliated to Toyota, across some margin erosion. This has already been discounted by of our funds. The share price has been weak following investors, along with low growth and an idle balance sheet. Toyota’s recent recall problems but we have used this However, with net cash of around US$2 billion and capacity opportunity to raise our position, taking the view that an to raise more debt finance, Astellas has the firepower extremely competitive product portfolio will enable Denso required to counter these patent cliffs. It has already to win share outside of the group in the near future. Global Outlook 11
    • Emerging Market Equities Chart 1 Building on infrastructure India enjoys prevailing winds 200 200 180 180 Strong Indian growth has propelled domestically orientated stocks higher, whilst investors are also increasingly focused on income 160 160 opportunities across Asia. 140 140 120 120 100 100 80 80 60 60 2009 2010 Share price performance relative to the Global Emerging Markets industrial goods & services sector for (01/01/09=100): Crompton Greaves C&C Constructions Ronnie Petrie Source: Thomson Datastream Head of Asia Pacific Equities Global equity markets have been buffeted by macro corporate management teams and the rapid development headwinds for much of 2010. However, in India, prudent of some of the region’s leading businesses has resulted in a macroeconomic policymaking and buoyant infrastructure heightened focus on dividend income. In particular, we are investment have remained key drivers of the economy. This seeing increasing evidence of Asian firms that are displaying strength was evidenced recently, by impressive first-quarter the capacity to pay out more in dividends while GDP growth of 8.6% per annum. Meanwhile, in nominal maintaining strong growth trajectories. terms, GDP growth neared an all-time high of 20% a year. This is an attractive combination for investors, in a region In this environment, it is the firms that are focused that has emerged from the financial crisis with surprisingly domestically that are offering the most attractive healthy corporate balance sheets. Indeed, recent estimates opportunities (chart1). For example, Crompton Greaves, showed that the average debt to equity ratio in Asia was as which manufactures a range of infrastructure-related low as 27%. Clearly, healthy balance sheets are equipment, is well-placed to benefit from government encouraging management teams to take a closer look at spending on roads, railways and other infrastructure the best ways in which to distribute their profits. projects. Another beneficiary of this trend is C&C Constructions. The firm has exposure to a wide range of One firm that appears to be a positive example of this trend infrastructure construction services offering good growth. is Taiwanese chipmaker MediaTek. The firm has steadily increased its dividend every year since 2003. Prior to that The strength of the domestic economy is also proving date the firm had never issued a dividend. We believe that favourable to the nation’s automakers which look set to this points to a changing mindset among Asian corporate benefit from both rising incomes and government spending management teams, which have previously always been on new roads. Tata Motors has emerged as a winner in the keen to maintain a war-chest as part of a ‘just-in-case’ Indian auto sector, which is one of the few which has been mentality. Instead, firms appear increasingly able to able to sustain demand without the need for the ‘cash for distribute cash to investors, whilst still maintaining good clunkers’ style incentives common in Europe, the US and growth prospects. China. For Tata’s domestic operations, total volumes in the first quarter of 2010 have risen by 55% year-on-year to Our strategy within emerging markets 216,646 vehicles. The firm’s market share is around 60% in Chinese economic growth remains a key driver in the region. commercial vehicles, 15% in passenger cars; with the latter Market participants are currently digesting the possibility that having been helped by the launch of the low-cost Nano. Chinese growth in late 2010 into 2011 could be somewhat slower than previously anticipated following a series of In addition, the firm has successfully turned round its Jaguar tightening measures by policymakers. As China switches from Land Rover unit which announced a profit after tax of an export-oriented growth model to a more domestic £113m in the January to March quarter, ‘several times demand-led approach, helped by RMB revaluation, spending higher than analysts' forecasts. Tata has been able to make should continue to bolster corporate profitability. big savings in the UK-based unit’s cost of production and depreciation. Land Rover sales have been particularly strong Elsewhere in the region, inflationary pressures remain in China and the UK. There is optimism that new product relatively contained, and central banks are unlikely to launches, an example being the compact Range Rover, will radically alter their monetary policy. Asian equity markets help boost volume growth further. are also supported by the relatively low levels of indebtedness of both companies and individuals, while Growing attractiveness of dividend yields in many Asian countries have further scope to stimulate Asia domestic consumption, given generally strong government Investing in Asia has traditionally been premised on the balance sheets. Asian businesses are, hence, underpinned impressive growth-style opportunities available in the by resilient domestic demand and also by their low region. However, a growing sophistication among inventory levels. 12 Global Outlook
    • UK Equities Chart 1 Valuation gap Differentials within defensives 20 20 18 18 Several positive catalysts have prompted us to view the telecoms industry more positively than other defensive sectors. Meanwhile, 16 16 some favoured stocks are reaping the rewards of internal change. 14 14 12 12 10 10 8 8 6 6 2009 2010 Price-to-earnings ratio comparison of selected UK sectors: Telecoms Food & Beverages David Cumming Source: Reuters Head of UK Equities Ringing a change in telecoms International. Both stocks are on our Winners List and we Widespread scepticism over the sustainability of the have taken advantage of recent weakness to increase our economic recovery in the UK has been reflected in the exposure to them. recent underperformance of cyclical stocks. Investors currently appear to prefer the perceived safety of those After seeing volumes dry up at the height of the financial companies with more defensive earnings streams such as crisis, Inchcape successfully addressed balance sheet issues, telecoms, a sector where we have upgraded our view from undertaking a rights issue and cutting costs, increasing Neutral to Heavy. operational gearing into the recovery. Subsequently, car sales volumes have recovered faster than expected. We Telecom companies have demonstrated resilience in the believe forecasts from Inchcape’s management are too face of the economic slowdown and as growth resumes, conservative, especially on UK margins. Inchcape has a mobile spending in particular has the potential to bounce good diversified business model, with a premium focus in back stronger than expected. This is good news for the UK and good exposure to the strongly recovering Hong companies like Vodafone. The regulatory environment, Kong market. However, the wider market appears to be meanwhile, appears to have shifted from favouring focusing on concerns around the Toyota recall unbundled providers like Carphone Warehouse and BSkyB, (approximately 50% of Inchcape’s new and used car towards the incumbent fixed line operator BT, our favoured business comes from Toyota), the impact of the end of telecom company. BT previously suffered from price scrappage incentive schemes, and the company’s exposure regulation issues, as OFCOM fought to achieve the lowest to southern European economies, fears we believe are fixed-line prices in Europe. However, new regulatory overdone. proposals could see fixed-line pricing linked to RPI, as well as unregulated pricing on fibre optics aimed at encouraging Following a £300 million capital raising, DSG International, investment in this area. which includes the Dixons, Currys and PC World brands, has implemented a transformation plan, which is delivering Telecom stocks are massively cash generative and offer the tangible results. Store refits have delivered on average a highest free cashflow yields in the market. Most of the 20% uplift in sales, while a greater focus on customer major UK players have solid balance sheets. BT’s free cash- service at non-refitted stores has also supported sales. The flow yield is around 13% and we believe this could turnaround efforts by DSG’s management are credible and strengthen further over the next few years, given scope for clearly working, helped by a slightly more favourable cost cutting and flexibility around capex. Within the background for electricals. Competition in this space telecoms sector there is also potential for M&A activity. This remains fierce, especially from online retailers, but we benefits both potential bid targets and will also be believe DSG is managing this well. supportive of remaining companies in a more consolidated industry, something Vodafone has already acknowledged. Our strategy within UK equities Despite these positive drivers, telecom stocks remain While the UK government focuses on debt reduction, attractively valued. There is a significant valuation gap corporate sector balance sheets are in good shape with between telecoms and other defensives such as food & significant flexibility over how prodigious cash flows are beverage companies where opportunities for used. Many of our favoured stocks are in industrial and outperformance appear limited. consumer sectors of the market which we expect to benefit most from growth. We also selectively favour some Healthier from the inside out defensive stocks like telecoms, which may have been Successful balance sheet repair and cost cutting during overlooked by the market. However, we are less positive on distressed times have put many UK companies in a much defensives such as food & beverages, where companies are stronger position now that economic prospects are on relatively high ratings. We expect only anaemic revenue improving. Two companies where we are seeing the fruits growth for some time to come from food and drinks of positive internal change, which we consider is not yet companies, and firms are still dealing with the impact of priced in, are global motor vehicle distributor and importer, consumers de-stocking and trading down to cheaper Inchcape, and consumer electronics retailer, DSG brands. Global Outlook 13
    • Government Bonds Chart 1 Government bond spread to German Bunds The state of European sovereigns bps bps 450 450 400 400 Concerns about sovereign debt in the Euro-zone have had 350 350 substantial and far-reaching effects both inside and outside the 300 300 single currency area. 250 250 200 200 150 150 100 100 50 50 2010 0 0 Jan Feb Mar Apr May Jun Basis point spread over German 10 year bonds for: Italian 10-year gov bond spread Spanish 10-year gov bond spread Portuguese 10-year gov bond spread Jack Kelly Source: UBSDelta Investment Director, Fixed Interest The sovereign debt crisis continues to dominate bond continue to see the transfer of risk from weaker market movements in Europe. Fears over the debt organisations: that is from funds and banks limited by sustainability of Greece spread throughout peripheral ratings regulations to the central banks. Europe, leading to a blow-out in yields. At the same time, investors have been switching into core Euro-zone bond The circuit breaker for the ongoing confidence crisis in markets, seeing them as safe havens with more modest sovereign debt is ultimately that countries not only show debt levels. The result has been a widening of the spread the political will to adopt austerity packages but also between core and peripheral bond yields. demonstrate an ability to accept them over time. The problem is that the real tests for political stability and The fall-out from the crisis, however, has not been confined growth will become apparent some years ahead and not at to Europe. With heightened concerns about the possible hit the point of sign-up. to global growth, many central banks round the world have softened their monetary stance, with some, such as the The markets continue to dictate the pace of fiscal reform in Reserve Bank of Australia, specifically citing the European the Euro-zone. This is a delicate exercise because the debt crisis as the motive force for a pause in their balance between growth and reform has to be right. tightening cycle. Currently the market is much more concerned with the reform element. What the ECB buying programme does is The problem intensified at the end of April when Standard buy time to allow governments to prove their ability to & Poor’s cut Greek bonds to junk status. Quickly, other better align revenue and spending. The likelihood is that highly indebted economies of the periphery came under the buying will be extended to Spain and Italy, given the critical scrutiny. The initial responses of the authorities, both requirement for even-handedness. This will have the the ECB and the IMF, were less than convincing; with immediate impact of a short-term artificial boost to those uncertainty about what could and should be done. While spreads, but will also raise further questions about the the authorities prevaricated, bond yields in the periphery longevity of the programme itself. continued to climb. Our strategy within government bonds The developing tension eventually prompted a more Overall, we remain constructive on government bonds and comprehensive package. This involved the creation of a think that short-dated bonds should remain largely European Stabilisation Mechanism, which would provide up anchored by low policy rates. However, we continue to to €500 billion of financial help to member states, backed differentiate within the Euro-zone, holding Heavy positions up with additional IMF support of up to €220 billion. in those countries with strong fiscal balances such as However, the key to the stabilisation was the Finland. Beyond that, we have switched out of Euro-zone announcement of an ECB bond buying programme into a Heavy position in Norway and the UK. Within the (another form of quantitative easing). It soon became peripherals which make up 41% of our EU indices, Italy apparent that the central banks had immediately begun stands out as the most positive. With its stable, albeit high, buying Greek, Portuguese and Irish debt, and yields on debt/GDP ratio and a primary surplus, Italy has shown fiscal peripheral paper fell dramatically. So far, there has been restraint in recent years. It abstained from the stimulus little evidence of a concomitant recovery in confidence with packages seen elsewhere in Europe. Similarly, we the broad investor base continuing to either sell or abstain differentiate within the AAA-rated Euro-zone countries, from buying peripheral sovereign debt. underweighting France for example, as it has a higher fiscal deficit than its AAA-rated neighbours. A major threat at the moment is the risk of a split within the ECB causing the purchase programme to end prematurely, More broadly we take the view that, while German debt although the most likely outcome is that the buying will continue to get a boost from investors switching from programme continues. This will artificially underpin prices peripheral debt to core, ultimately this exercise will and preserve liquidity in the peripheral markets. We dissipate. At that point, both the US and the UK bond markets will look relatively attractive in comparison to the Euro-zone. 14 Global Outlook
    • Corporate Bonds Chart 1 Discrimination in credit By hook or by crook Spain downgraded, Greece loses bps investment grade bps Greece downgraded status 700 700 600 600 As sovereign debt levels remain elevated across the Euro-zone, we examine the repercussions for corporate bond investors and 500 500 consider which companies are best placed to deliver value. 400 400 300 300 200 200 100 100 0 0 2009 2010 5-year CDS spreads for: Santander Caja Madrid Spain Roger Sadewsky Source: Bloomberg Investment Director, Corporate Bonds Contained for now, risks remain Spain and Portugal only account for about 34% of net The legacy of the financial crisis was transference of debt income. The bank’s other key markets are the US, UK and from the private to the public sector. Banks’ liabilities had to Latin America, giving it a truly diversified client base. It has be guaranteed, government debt to GDP ratios rose sharply also demonstrated one of the strongest operating in many countries and government bond yields soared in performances in the global banking industry in the last those countries. That, in turn, impacted holders of those three years. In contrast, we do not generally hold debt from bonds, including banks throughout the region and beyond. any of the Spanish domestic savings banks, known as cajas, Fear of the consequences of a further deterioration in which are almost exclusively exposed to the Spanish conditions persuaded the ECB and IMF to organise a economy. substantial financial support facility, should it be required. The epicentre of the current troubles is in the peripheral Elsewhere, we do have some positions in Irish banks on our European states, principally Greece, Spain, Portugal and view that the country’s government has taken a more Ireland, with the ‘core’ more northerly states less affected. forceful approach to debt management and on fiscal sustainability, and is therefore further along in the process At present, the situation has been contained, but going of restructuring. Furthermore, our Irish bank exposure is forward several risks to corporate bond markets remain. Of concentrated in the strongest part of the capital structure, these, an outright sovereign default in any particular state principally in senior debt. We also hold the debt of certain seems to be the least likely eventuality. Within the market, Norwegian banks including DnbNor, given Norway’s low those sectors that are most reliant on government support, government debt and low unemployment, as well as the banks, and selective utilities and telecoms, remain the most bank’s healthy balance sheet. Finally, we have no exposure vulnerable to a further deterioration in government to either Greek or Portuguese banks, as both countries have finances. We see the main threat as the possible economic deep-rooted structural issues in addition to their sizeable impact of the various austerity measures which are being budget deficits. assembled to get debt levels under control. Tax rises and expenditure cuts are being planned, even for the ‘core’ Our strategy within corporate bonds economies where the problem is less intense, and these The recent spread widening has again created a value measures are likely to slow the pace of growth even if they proposition for credit investors. However, stock selection do not tilt any economy back into recession. remains crucial, as sovereign worries persist and investors become more discerning. The argument for sustainable While outright default is unlikely there could be significant yield remains valid, as governments are unlikely to raise sovereign downgrades which are likely to be followed by a interest rates while sovereign risk dominates sentiment. downgrade of corporate debt within those countries – as evidenced by Greece, where downgrades to banks followed Overall, we continue to favour selective high-yield debt on the heels of the country’s government debt downgrade. over investment-grade bonds as the flight to quality in As a result, we recommend a cautious approach to portfolio government bonds makes the relative value even more construction, firstly in terms of country exposure, then at compelling in high yield, while the short duration aspect is the stock selection level. also attractive. However, we would only favour the debt of those high-yield companies with robust balance sheets and Natural selection good access to funding. Within our portfolios, we have opted for a variety of carefully diversified sovereign exposures including the US Within high yield, we hold Heavy positions in relatively and Scandinavia, but also some selective exposures to Spain defensive sectors such as telecoms and media, and have a and Ireland. preference for ‘BB’ rated bonds over riskier debt. We remain constructive on the high-yield market generally; while In Spain, our main exposure is to specific bank debt: performing well in a high-growth environment, it is not Santander and BBVA. In particular, Santander’s assets in dependant on it, unlike equities as a whole. Global Outlook 15
    • Treasury Chart 1 Rates on hold Active fiscal - passive monetary % % 5.0 5.0 4.0 The coming period of fiscal austerity will be accompanied by an 4.0 extended maintenance of low interest rates. 3.0 3.0 2.0 2.0 1.0 1.0 0.0 0.0 -1.0 -1.0 2007 2008 2009 2010 December 2011 interest rate expectations less benchmark policy interest rates for: US Europe UK Gordon Lowson Source: Bloomberg, Thomson Datastream Head of Money Markets US government’s fiscal austerity package. The Governor of the US interest rates have remained close to zero for the past Bank of England certainly sees monetary policy as playing a eighteen months, and the authorities have maintained the holding role whilst fiscal policy addresses the debt problem. judgment that rates are likely to be held there for an Interest rates are unlikely to move until well into 2011 at ‘extended’ period. However, there is at least one dissenting the earliest. voice on the Federal Reserve warning of the dangers of keeping rates at such a low level, leading possibly to a Europe misallocation of resources, or even a reawakening of The intensification of the sovereign debt problems has put inflationary pressures. There are also those who are pressure on the ECB to be even more flexible in its convinced that the economic recovery is now well- approach to monetary policy. In the interests of saving the established, and that the authorities should be moving rates single currency, and with it European integration, the ECB back towards more ‘normal’ levels. will have to keep interest rates on hold, as individual authorities get their fiscal houses in order. Another For now, however, rates are on hold. It would be highly consequence of the sovereign debt crisis has been a seizure unusual, and ill-advised, for the authorities to tighten policy in the wholesale lending market within the peripheral with unemployment levels close to 10%, and with inflation markets. Consequently, the ECB will have to be careful not pressures continuing to dissipate. Indeed, some observers to add to the tension. The fact that inflation in the region is have been so impressed by the potency of the present below the target level provides ample excuse for keeping disinflationary forces that they have pushed out their rates on hold for some time yet. estimate for the first tightening move to the fourth quarter of 2011. But it is not just the absence of inflationary Japan pressures, and the weakness of the labour market that Interest rate expectations for Japan presage no movement makes an early rate hike unlikely – bank lending continues at all over the next twelve months. Although the to be insipid, as much a function of weak demand as a deflationary forces appear to be abating, it is still far too reluctance to expand loan books. In particular, the housing early for the authorities to be considering raising interest market remains moribund. Interest rates are on hold. rates. The economy as a whole has recovered, but only a narrow base is prospering, centred around exports and UK manufacturing industry. And, finally, the new prime minister The interest rate judgement in the UK is less clear-cut seems committed to getting to grips with the problem of than in the US, given that inflation has exceeded the the budget deficit, which is the largest in the developed target range again during 2010. So far, however, the world, as a percentage of GDP. Even to contain the deficit Bank of England remains confident that this is merely a will require substantive spending cuts/tax increases, which blip, associated with past sterling weakness and the suggests that present interest rate expectations will not be effects of the reinstatement of VAT at the 17.5% rate. The far off the mark. man in the street seemed to accept this – at least until May, when a Bank of England survey revealed that Regulatory changes inflation expectations, one year out, had surged to 3.3% It was inevitable that there would be a regulatory backlash compared to just 2.5% in February. as a direct consequence of the financial market is near meltdown over the past two years. Whilst there have been That should not be a problem as long as inflation falls back some attempts to impose a world-wide banking standard as expected, and as long as expectations do not fuel a drive (Basel 3), most of the changes towards tighter requirements for higher wages. The latter appears improbable given that regarding capital sufficiency and liquidity levels have been labour markets remain challenging with a continuing enforced at the individual country/region level. Generally, reduction in full-time jobs. this has resulted in money market funds having to hold a greater percentage in short-term cash, with greatly reduced These considerations are important, but are overshadowed funds available for longer time periods. by the need to take into account the impact of the 16 Global Outlook
    • Currency Chart 1 Repositioning in uncertain world New World Order 180 180 The global currency pecking order has changed following the 160 160 recession and the sovereign debt crisis, and may not yet have found a 140 140 new equilibrium. 120 120 100 100 80 80 60 60 2007 2008 2009 2010 Bank of England trade-weighted currency performance for: Euro Yen USD GBP Ken Dickson Source: Thomson Datastream Investment Director, Currency US Dollar depreciation against other currencies against which the Euro remains overvalued. European politicians and The dollar continued its recovery in Q2 2010, with the authorities are beginning to see the advantage in allowing a trade-weighted index up 5.5%. During this period general period of an undervalued currency. This trend will improve market sentiment turned in the dollar’s favour, as the US European growth prospects, at the least in Germany and economy turned in a more consistently firm performance those other economies that are internationally competitive. than the rest of the developed economies. However, the The headwinds to growth are that developed market European sovereign debt fears added to the dollar’s appeal economic growth prospects remain modest, core as the euro was no longer seen as the automatic beneficiary inflationary pressures are weak and a difficult transition to a of reserve manager flows. Moreover, the market still seems more sustainable fiscal position is underway. Moreover, the to consider that the US will be the first of the developed sovereign debt concerns within the European periphery will economies to start to tighten monetary policy, as elsewhere continue to reduce the euro’s support among the main fiscal retrenchment and disappointing rates of growth will marginal buyers of the past few years – the reserve hold back monetary tightening. However, the dollar’s managers. Given that the rate of reserve growth is also recovery means that it can no longer be viewed as slowing to a standstill, the daily support for the euro generally undervalued, and the US has similar long-term disappeared in Q2. We expect the weaker euro trend to structural issues as the rest of the developed economies. On continue. balance, though, we expect the dollar to rally further as global economy activity picks up. Yen Sterling Trading in the yen so far this year has been volatile, with no defining trend. Nevertheless, the currency is up slightly over The election uncertainty is now out of the way and the new the year to date, but much of the currency’s gains seen in the government has delivered what is accepted to have been a first quarter of the year were effectively lost in the second. sufficiently credible first budget. That should lay the The drivers for the Japanese currency remain as mixed as grounds for a marked recovery in sterling exchange rates. they have been for some time. Poor domestic economic So, having been generally undervalued, under-owned and prospects in a world growth environment that prohibits having spent the past two years suffering from poor powerful export led growth should mean a weaker yen. sentiment, sterling now falls into the cheap and bad-news- However, the continued battle against domestic deflationary already-discounted camp. Interestingly, on a trade weighted pressures keeps the real yield in Japan relatively attractive. basis, this improvement had already begun last year. From Moreover, a world with low certainty over growth, lower for its nadir in Q1 2009, sterling is now trading 10% higher, longer interest rates almost everywhere, and high currency when measured against its major trading partners, although volatility is not a natural positive carry environment. It had the price action has been volatile. We expect this price been hoped that changes in the political landscape might performance to gather momentum in the following lead to a more expansionary monetary policy that could quarters as the market starts to correct the valuation trigger a weaker yen, but the new government seems to be misalignment, noting that the pound has already reached more intent upon tackling its debt mountain. With an aging 30-40 year lows when measured against a number of population, the savings of which are predominantly held in commodity currencies. bank accounts and government bonds, it is hard to see how the government will manage to rein in the debt whilst Euro fostering a robust pick-up in economic activity. Nevertheless, The big change in the foreign exchange market in 2010 given our positive dollar outlook, we think that the dollar/yen has been the decline in the euro from acknowledged currency pair will trade in a range on the summer months, overvalued levels. Against the US dollar, the euro has fallen but that there may be a more positive yen trade-weighted back towards fair value, but there is still scope for further move over that timeframe. Global Outlook 17
    • Property Chart 1 EU Prime Offices - Net Additions Opportunities in Europe % of stock 5,000 5.0 4,500 4.5 The outlook for European commercial property remains positive 4,000 4.0 despite the sovereign debt crisis. We expect a steady but slow 3,500 3.5 recovery in occupier markets. 3,000 3.0 2,500 2.5 2,000 2.0 1,500 1.5 1,000 1.0 500 0.5 - 0.0 1982-85 1986-90 1991-95 1996-00 2001-05 2006-10 2011-14 L.H. scale: Total net additions R.H. scale: Net additions as % of stock Source: PMA, SLI Alex Watt Managing Director, Property Investment Divergent trends in Europe In addition to London, Paris and Warsaw offices, our The sovereign debt crisis highlighted the disparities in Property House View also favours the higher yielding government financial balances across continental Europe. logistics markets. Robust demand for exports, helped by a The implications for individual property markets need to be weaker euro and the revival of global trade, is driving the examined. There is a distinct difference, for example, recovery of the European economy. Germany, the largest between the property markets of those countries with Euro-zone economy, along with such countries as France moderate debt levels and balanced building construction and Poland, has benefited from the considerable recovery during the last cycle and those countries with high debt in foreign orders. We expect the logistics sector in these levels and unsustainable construction booms. Certain markets to gain directly from this trend. property markets are expected to endure some contagion from the sovereign debt crisis. Given currency weakness, we expect continental Europe to become increasingly attractive to sovereign wealth funds Our most favoured office market in continental Europe is and international investors. Indeed, it is likely to overtake Paris, one of the top five financial centres as measured by the UK in terms of investor flows and interest. Recently, a the Global Financial Centre Index. Property drivers are large Korean pension fund acquired an office in Berlin for favourable; for example take-up is buoyant, rents are €570 million, a Korean consortium is in the process of increasing modestly and vacancy levels remain in single acquiring a mixed use development near Milan for €405m digits. The diversity in terms of occupiers, spanning sectors and an Australian developer is set to invest €400m in and companies, is a key success factor for Paris. logistics developments in Europe. These transactions are Government measures to address the fiscal imbalances are significant when compared with the recent average expected to have a modest effect on the occupier markets, European deal size of circa €16m. In addition, sale and given the global nature of many occupiers. Hence we leaseback transactions by banks and corporates to free up expect the Paris property market to remain on a steady capital, as well as government property disposals to help recovery path. address fiscal deficits, are providing the stock necessary to maintain momentum in investment markets. The southern European and Irish property markets, on the other hand, are in a very different part of the cycle. They Our strategy within property face oversupply and fiscal challenges which are expected to We believe European commercial property markets are dampen the recovery in the occupier markets. Rents are still moving further into the recovery, behind the UK but ahead falling and vacancies rising, albeit yields have stabilised. The of other regions such as the US. We continue to favour the recovery of these office markets is expected to be very slow Paris office market, high-yielding European logistics markets and drawn out as austerity measures take effect. The and the Polish retail market. The lower level of the euro is likelihood of weaker occupier markets in peripheral helpful in terms of making property investment in European property markets is already reflected in our continental Europe more attractive to overseas investors. In Property House View. the UK, the central London markets continue to be most attractive. Globally, we favour core prime locations and we On the positive side, there is a shortage of new supply see most resilience in better quality assets. Across North steadily building up across the region due to the lack of America we see value in under developed industrial development finance during the financial crisis. This locations in Canada while we favour the cyclical office undersupply is expected to peak in 2012 and to drive rents markets in the US. In Asian markets, we hold a preference to new highs. London, Paris and Warsaw are especially for office markets with the tightest supply pipelines, such as attractive in this instance. While we expect the pace of Sydney, and certain emerging markets benefitting from economic recovery to remain slow and bumpy, we believe trade and consumer trends, such as Chinese logistic shrinking supply will counteract this. Occupiers faced with warehouses. shrinking supply will bring forward relocation decisions. 18 Global Outlook March 2007 Global Outlook
    • Global Absolute Return Strategies Chart 1 Relative value in spreads Changing tack on directional trades % % 10 10 9 9 The big move down in interest rate swap yields and the high valuation 8 8 of US smaller companies has highlighted some relative value 7 7 opportunities. 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 Spread Australian 2 year interest rate German 2 year interest rates Guy Stern, Source: Bloomberg Head of Multi-Asset Management Absolute return strategies Large cap vs small cap relative value At Standard Life Investments, our Global Absolute Return Since the lows in 2003, US small-cap stocks have re-rated Strategies (GARS) approach operates in a multi-asset relative to US large caps and now price in an unsustainably framework, aiming to deliver returns above UK 6-month large valuation gap. We anticipate that there will be some LIBOR cash measured on a rolling 3-year time horizon. Our unwinding of the excess performance of small cap relative absolute return process combines a broad mix of ideas to large caps as leading indicators of economic growth start across all the major asset classes through positions in to soften, credit conditions remain more constrained for market returns, or traditional beta, relative value and small caps, unlike large caps which can access the credit opportunistic ideas. Two new strategies are classified as markets, and the lagged effect of the decline in the US relative value, meaning one of the assets offers measurable dollar benefits large caps, which are more export-exposed value relative to the other. The first is a pairing for our than small caps. When large-cap stocks meet the modest continued preference for Australian 2-year interest rate expectations, while mid-cap stocks struggle to deliver swaps with German 2-year interest rates, which we pay- against their higher hurdle, this idea will perform well. This away as they appear to have fallen to extremely low levels. is not a high-risk position; it will probably work best in a The second idea is to pair the US S&P 500 large-cap equity declining equity market but we are convinced it can still market with the more expensive smaller capitalisation add value in a rising market, which is our central Russell 2000 Index. expectation. Potential risks to the trade arise from sector exposure – the S&P 500 Index has a large technology Receive Australian and pay-away German component relative to the small cap Russell 2000 Index. interest rates Also, small companies may be able to exploit niche Interest rate curves have been steep (i.e. longer-dated bond positions to outpace their large-cap rivals in the on going yields higher than shorter-dated ones) for some time across economic upswing. most OECD bond markets. The trigger to initiate a flattening idea, while yields along the curve continue to fall, Strategy within absolute return strategies has always been the extent to which the shorter-dated part The multi-year macro economic view that drives our asset of the interest rate curve was unable to rally further. In preferences suggests that the economic recovery will be Germany’s case, the 2-year government bond has benefited muted and uncertain in many parts of the world, interest from investors’ concerns about the outlook for the euro and rates will remain lower for longer and elevated volatility in Euro-zone economies. It has behaved as the ultimate risk- riskier assets will require a high risk premium as free rate and, following a strong rally, is now yielding just compensation. Consequently, we still have a preference for 60 basis points (bp). In Australia, the 2-year swap rate government duration, expressed through receiving the priced two years forwards still reflects the fact that the performance from various longer-dated bonds and the market believes that Asia is likely to be immune from the short end of the Australian, UK and Swedish interest rate effects of a patchy recovery and global disinflationary curves. Our second most important exposure is to the forces. However, with China an important source of performance of a range of equity markets. The third and demand for Australian exports (especially commodities) and fourth positions are in corporate bonds including financial the euro down 17% against the RMB in recent months credit, and receiving the volatility on cyclical relative to (Europe is China’s biggest export destination), the impact of defensive equity markets. In foreign exchange, we favour the euro sovereign crisis will have a negative knock-on high interest rate carrying emerging markets, the US dollar effect on Asian economies and rates. The spread between and sterling. The risk associated with stock picking Australian and German interest rates, at over 500bp, is close contributes to the rest of the risk budget. to a record (chart 1), and should narrow either in the most likely central scenario - steady state slow growth and low inflation globally - or if one of a number of quite extreme scenarios comes about. Global Outlook 19
    • Global Outlook team The production of Global Outlook draws on the ideas and insights of many of our investment professionals around the world within the framework of our Focus on Change investment philosophy. Below are the contributors to the publication, in addition to those mentioned within the document. Contributors Editor Frances Hudson Sub-Editors Richard Batty Andrew Milligan Douglas Roberts Jason Hepner Chart Editor Neal Caldwell Additional Contributors Thomas Moore (UK Equities) Stan Pearson (Focus on Change) Ken Murphy (Focus on Change) Simon Kinnie (Property) Copywriters Govinda Finn Lorna Malone Kathryn Robertson Julie Sheridan David Turner 20 Global Outlook
    • Contact Details For further information on Standard Life Investments visit www.standardlifeinvestments.com or contact us at one of the following offices: Europe North America Asia Standard Life Investments Standard Life Investments Inc. Standard Life Investments (Asia) Ltd 1 George Street 1001 de Maisonneuve 40/F, Tower 1, Times Square Edinburgh Boulevard West 1 Matheson Street United Kingdom Suite 1000 Causeway Bay EH2 2LL Montréal Hong Kong Telephone: +44 (0)131 225 2345 Québec Telephone: +852 3402 6000 Canada Fax: + 852 2169 3885 Standard Life Investments H3A 3C8 90 St. Stephen’s Green Telephone: +1 514 499 6844 Standard Life Investments Limited Dublin Beijing Representative Office Ireland Standard Life Investments (USA) Ltd Room A902-A903, 9th Floor, Telephone: +353(0) 1 639 7000 One Beacon Street New Poly Plaza 34th Floor No.1 Chaoyangmen Beidajie Standard Life Investments Boston Dongcheng District, 34th Floor MA 02108-3106 Beijing 100010 30 St Mary Axe Telephone: +1 617 720 7900 People’s Republic of China London Fax: + 86 10 8419 3399 EC3A 8EP. Telephone: +44 (0)207 868 5700 Standard Life Investments (Asia) Ltd Level 31, RBS Tower 88 Philip Street Sydney NSW 2000 Australia Telephone: +61 2 8211 2758 Fax: +61 2 8211 2752 Standard Life Investments (Asia) Ltd Korea Representative Office 21/F Seoul Finance Center 84 Taepyungro 1-ka, Chung-ku Seoul, 100-101 Korea Fax: +82 2 3782 4763
    • Jul 10 House View The following portfolio is based upon a global investor with access to all the major asset classes. For regional versions of the House View, please contact your Standard Life Investments representative. The Global Investment Group has concluded that portfolios will take on moderate levels of risk, Risk focusing on assets with high, yet sustainable yield, looking for relative value opportunities, in view of continued economic and market volatility. Government Bonds Still well-supported by an environment of moderate economic growth and restrained inflation, but safe European Bonds NEUTRAL haven flows about European debt servicing problems have pushed some markets to expensive levels. Yields are supported by a backdrop of muted inflation pressures, which will limit any interest rate MOVED TO US Treasuries increases into 2011, but valuations and fiscal pressures are becoming more of a concern. NEUTRAL Low Japanese government bond yields mean this asset class is increasingly being used as a funding Japanese Bonds NEUTRAL source for other investments including other government bond markets. Concerns about the economy’s fiscal position and sizeable gilt supply in the years ahead make us UK Gilts NEUTRAL cautious, but interest rate increases remain unlikely for some time. UK Inflation- There are inflation risks in the medium term from central bank quantitative easing, but valuations of NEUTRAL Linked Debt inflation-proofed debt need to be examined carefully. Corporate Bonds Spreads over government bonds are still historically wide, although not as attractive as last year. Investment Grade VERY HEAVY Improving corporate cashflow supports a peak in bond default rates. Benefiting from an attractive carry, improving corporate cashflow and a peak in the default cycle as the MOVED TO High-Yield Debt global economy recovers. Investors still need to be aware of selective default risk and periodic risk aversion. VERY HEAVY Equities Profitability is restrained by less cost-cutting than seen in the US and UK, plus the impact of tight fiscal policy European Equities LIGHT on economic growth, albeit some sectors are supported by their exposure to emerging market economies. Supported by improving corporate cashflows into 2010 on the back of strict cost control, however, the US Equities NEUTRAL upside is limited by the consumer debt and housing market overhangs restraining domestic demand. Helpful exposure to the Asian and US economies offset by weak domestic dynamics and tighter fiscal Japanese Equities LIGHT policy; government action unsuccessful so far in stimulating consumer spending or ending deflation. Developed Asian Cautiously selective on Asian economies, benefiting from strong Chinese growth but wary of inflation NEUTRAL Equities pressures building in some countries unless central banks take firm action to dampen liquidity. Emerging Market Some are benefiting from the upturn in commodity demand and upgrades to sovereign debt ratings, NEUTRAL Equities others still facing external financing problems awaiting a strong recovery in export growth. The market can make headway supported by valuations and the benefits of sterling’s depreciation UK Equities NEUTRAL on overseas earnings, but it faces headwinds from weak real income growth and fiscal tightening. Property UK Selectively Heavy with a particular focus on supply-constrained office markets, e.g. London & Paris, HEAVY European and higher-yielding Central European logistical property. Significant property debt maturities present risks for US commercial property, but Canada's lower North America NEUTRAL leveraged property markets should fare better. Excessive supply in certain markets in Asia, e.g. China & Singapore, will hold back growth but Asia Pacific LIGHT higher-yielding Australian markets look more attractively priced. Other Assets Interest rate differentials, divergent growth prospects, political and regulatory drivers are becoming Heavy $ and £ vs Foreign Exchange important differentiators for global capital flows. Light € and ¥ Global Strong demand for industrial commodities will be led by infrastructure projects in emerging NEUTRAL Commodities economies, but oil and soft commodities will eventually see new supply come on stream. Cash Central banks in the major economies will keep monetary policy very loose into 2011 as inflation VERY LIGHT pressures remain weak due to excess capacity and high levels of unemployment. Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC123321) Registered Office 1 George Street Edinburgh EH2 2LL. The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited. Standard Life Investments may record and monitor telephone calls to help improve customer service. All companies are authorised and regulated by the Financial Services Authority. ©2010 Standard Life Investments www.standardlifeinvestments.com Standard Life Investments Limited, a company registered in Ireland (904256) and Scotland (SC123321). Ireland: 90 St Stephen’s Green Dublin 2. Tel: (01) 639 7000 UK: 1 George Street Edinburgh EH2 2LL. Tel: +44 131 225 2345. Standard Life Investments Limited acts as investment manager for Standard Life Assurance Limited and its subsidiaries. All above companies are authorised and regulated in the UK by the Financial Services Authority. Standard Life Investments may record and monitor telephone calls to help improve customer service. INVGEN5_EU 0710 X.xxM