Robeco outlook 2015 the return of volatility

Outlook 2015

FOR PROFESSIONAL INVESTORS ONLY

The return of volatility 3

Macroeconomic prospects

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Financial market prospects

Outlook 2015 The return of volatility Macroeconomic prospects Oil price decline set to boost the world economy in 2015 US: modest rate hikes at last, Fed probably first major central bank to act UK: Bank of England will follow Fed Europe: fiscal loosening up Japan: Abe’s new gamble casts doubts on multi-faceted Abenomics China: slightly slower growth target Other Brics: a mixed bag

Financial market prospects

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Fed exit from unconventional policy means bad news will be bad news after all 8 Push back on the risk curve 8 Markets will assess regional divergence on the economic – and policy fronts 9 Decoupling correlations signal the beginning of the end of easy money 10 Equities 10 Sales growth likely to drive earnings growth 10 US profit margins may very well remain sustained at historically high levels 11 Contribution of price appreciation to returns could be negative 12 Equities remain vulnerable to return of volatility 12 Government bonds – an end to the rally? 13 Bond market theme has shifted towards secular stagnation 13 Higher nominal rates likely as oil prices stabilize 13 Divergence in monetary policy will keep rate differentials significant across regions 13 US bond market likely to see combined real and nominal rate rise 14 Eurozone to see modest rise in nominal rates as secular stagnation scare remains 14 Not much action expected in Japanese yields 14 Episodes of market turbulence will keep sovereign bonds pricey 14 Real estate less promising as rates rise 14 High-yield bonds – carry on 15 Investment grade credits have less to offer 16 Emerging market government debt in for another volatile year 17 Commodities 17 Perfect storm has been brewing for oil 18 OPEC rebalancing the oil market?

18 Game of chicken 18 Few opportunities for gold to shine 18 Currencies 19

Important information

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– Divergence between US and other developed economies more pronounced – Chinese growth to slow somewhat – Abe’s new gamble casts doubts on Abenomics – | Outlook Risky2015 assets face more uncertainty, but equities remain our favorite asset class 2 – High yield bonds lose their shine as volatility returns

Macroeconomic prospects 2015: the year of increasing volatility

2014 should have been the year of gradual but convincing global economic recovery. The US would strengthen markedly; investments would take off. The Eurozone would recover too; with most positive developments in the periphery. In Asia, the Chinese economy would slow slightly, while Japan would suffer a temporary dip as a consequence of the sales tax hike.

But it turned out to be a disappointment. The US economy did well, but the Eurozone failed to impress. The impact of the Ukrainian crisis was much larger than expected and the German economy weakened substantially, contrary to expectations. ‘Abenomics’, a policy that can be characterized as overreliance on monetary policy, ran into difficulties, while the ‘dip’ was much more severe than expected. In China, skepticism prevailed about the official growth figures (Q3 2014, still an impressive 7.3% – at least on paper).

For 2015, we continue to expect growth to pick up both in developed and emerging markets, but it will probably not be overly impressive. In the meantime, uncertainties have risen. Will the Ukraine crisis stabilize into a ‘frozen conflict’, paving the way for a stronger producer confidence in Germany? Will the Russian Federation refrain from stimulating tensions on its borders (e.g. in the Baltic or Kazakhstan), beaten down by Western sanctions and the collapse in the oil price? Or will it damage both Europe and its own economy further by engaging in a gas war with Ukraine and the West? Will oil prices stabilize above the USD 80 level despite the ongoing shale revolution in the US? Will a thaw in US-Iran relations prevent a further escalation in the Middle East? Will Japanese PM Abe’s whole strategy known as ‘Abenomics’ be thrown into doubt and worries about Japan’s public debt sustainability increase markedly, now that the sales tax hike has been delayed and snap elections have been called for in December? Will the Eurozone avoid a new crisis while its larger members Decline in financial market volatility

struggle to reach deficit targets and German policy makers openly criticize measures taken by the European Central Bank? Will China continue to be the world’s growth engine as its authorities strive to meet ambitious growth targets (around 7.0%)? Will the US economy continue to buck the trend and not be held back by weak growth elsewhere? What will be the global impact of the Fed’s first rate hike, forecast for the third quarter of 2015?

Our baseline scenario is for the world economy to gain some extra momentum, but uncertainty has increased – or to put it another way – confidence is not very high. Fortunately, central banks still have additional fire power, especially the ECB which could engage in fully-fledged QE if the need arises. The Fed could also start hinting that it will delay its first rate hike.

Oil price decline set to boost the world economy in 2015 Weak demand for commodities and increasing supply from Iraq, Libya and the US (thanks to the ongoing shale revolution) have led to a drastic fall in the price of oil, with swing producer, Saudi Arabia, making no effort to support Brent at the USD 100 level. The price now seems to have stabilized at around USD 80. If this persists, it will be a clear boon for the world economy. A rule of thumb is that a fall of 20% in the oil price means a 0.4% point uptick in global economic growth. We expect OPEC to reach some kind of agreement to cut back production, though it remains Collapse in oil price

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Outlook 2015 | 3

to be seen if the cartel will be disciplined enough to implement it. In our opinion, Brent is unlikely to be pushed back above USD 90 level, while failure to reach an agreement could even drive prices below USD 80. The cartel will therefore be ‘forced’ to reach some kind of consensus. Geopolitically, the decline in the oil price is a boon too, pressing Iran and Russia to adopt a more conciliatory stance vis-à-vis the West, as their government finances are thrown into disarray.

US: modest rate hikes at last, Fed probably first major central bank to act The Fed has successfully ended its policy of quantitative easing, now that the US economy is experiencing a self-sustained recovery. The growth rate is still unexciting, but in 2014 a cruise speed of around 3.0% is likely to have been reached. With the unemployment rate dipping below 6.0%, it will only be a matter of time before we finally see convincing wage growth stimulating consumption and the housing market. Despite the economic recovery, inflation will trend lower still, thanks to the weaker oil price and the stronger US dollar. Still, the Fed will probably want to take the punch bowl away, before the party gets going – a central bank should not wait to take action until inflation is considered a problem. On the other hand, it does not want to disrupt the ongoing modest recovery, so any first interest rate hike (a modest 25 basis points, probably in the second quarter of 2015) will be accompanied by assurances that further future hikes will occur very gradually. A second 25 basis point hike is likely in the last quarter of 2015. The main risk to this outlook is weakness in the rest of the world (China, Eurozone, Japan). The Fed’s first line of defense in the event of disappointing global developments is to use verbal intervention to suggest that the first hike will be postponed. These modest rate hikes in 2015 will lead to somewhat higher bond yields, with the ten year yield rising to 3.0% in the course of 2015. Actual inflation will be lower in 2015 Strong US dollar

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than in 2014, but expectations for inflation will probably rise.

UK: Bank of England will follow Fed In the second quarter of 2014, the UK economy seemed to be firing on all cylinders, with an unsustainable rise in housing prices especially in London, paving the way for a first rate hike in the last quarter of 2014.

Since then, however momentum has slowed and weakness in the Eurozone has dragged the UK down. We think that the Bank of England will follow the Fed and moderately hike interest rates in the second half of 2015. There is heightened political uncertainty in the UK – a ‘Scoxit’ was narrowly avoided, but the chances of a ‘Brexit’ have risen. The rise of the Eurosceptic UKIP party which has set its sights on the May 2015 election is a problem for the government. The Conservative party has promised a referendum on continuing EU membership, but is uncertain of victory, despite the economic recovery. UKIP’s rise will split the right-wing vote, but has increased the chance of a referendum. However, this does not necessarily mean a ‘Brexit’ – will the electorate vote to leave the largest internal market in the world and clearly go against its own economic interests? Uncertainty on this matter will, however, hamper long term investment in the UK.

Europe: fiscal loosening up Rumor has it that German Chancellor Angela Merkel felt betrayed by ECB President Mario Draghi’s call for a ‘Grand Bargain’ at Jackson Hole. This plan consists of a pan-European investment program, more fiscal stimulus by countries which are in a position to offer it and more monetary stimulus by the ECB. Apparently, Draghi was deeply worried about economic developments in the Eurozone and doubted the effectiveness of more monetary stimulus alone. Fortunately, he did not wait for European politicians to implement their part of the proposed deal and lowered the discount rate to minus twenty basis points, signaling that the ECB had finally reached its lower bound.

The ECB also decided to launch a program to buy covered bonds and asset-backed securities, signaling an ambitious target to increase its balance sheet by EUR 1 trillion. This swift action by the ECB, the only major European institution with majority rule, was fortunate, as the chances of the large Eurozone countries reaching consensus on a formal ‘Grand Bargain’ are nil. In our opinion, Draghi was right to stress that fiscal policy measures under present circumstances are likely to be much more effective than monetary stimulus. A tacit, informal ‘Grand Bargain’ is still likely, with European leaders agreeing on a pan-European infrastructure fund and, more importantly, giving France and Italy more leeway in reaching their budget targets. It will also help restore confidence in the

Eurozone, where fortunately most governments will no longer be a drag on growth in 2015. Fully-fledged QE remains a measure of last resort and is a highly controversial step among German politicians, who are being further pressured by the recent rise of the Eurosceptic AfD. It would take a substantial weakening of the Eurozone economy to lead to this, which we do not expect. In our view there are no legal obstacles to this instrument in principle.

In 2014, German producer confidence was hampered by the ongoing Ukrainian crisis. The conflict could well now stabilize into a ‘frozen conflict’, paving the way for an improvement in producer confidence in Germany and in a broader sense, Eastern Europe as a whole. Stabilization would be in the clear interests of Russia, as the economy there is currently slipping into recession, while sanctions are withholding crucial knowhow from the Russian energy sector. But the Russian tone remains belligerent and the country’s ultimate intentions remain unclear. Heightened tensions in winter, when a potential gas boycott has much more impact, remain a serious risk. Elsewhere, the Russian Federation could also try to destabilize the Baltic States, which have significant Russian minorities but are also NATO members, leading to a severe deterioration in relations with the West. Unfortunately, these uncertainties will not disappear overnight and a full normalization of relations remains impossible due to the clear illegality of Russia’s move to annex Crimea. Ongoing tensions with the Russian Federation will hamper investments in Europe and continue to be a drag on growth.

We expect Eurozone economic growth to strengthen to around 1.5% in 2015, with unemployment continuing to decline slowly. Inflation will probably pick up slightly, thanks to the weakening of the euro and slight growth, but remain below 2.0% on a yearly basis.

In the periphery, Spain will be rewarded for its improved competitiveness resulting from earlier reforms. Growth can strengthen towards 1.75%.

Political instability is however on the rise (Catalonia (Podemos)). Italy, which fell back into a mild recession in 2013, may start to grow again in 2015, probably reaching a growth rate of 0.5%. Italy is the real weakest link in the Eurozone. The recent ECB Asset Quality Review highlighted the relative weakness of Italian banks. Growth was disappointing in 2014. The still popular PM Matteo Renzi has been able to push through labor market reforms, a clear sign of his commitment to structural change, but his bipartisan majority in the Senate remains very slight.

In Greece, there is a material risk of early elections at the beginning of 2015, in which the radical left is expected to do well. This would lead to a

substantially increased risk of a further Greek default (which is generally considered to be inevitable at some point). In our opinion, a new crisis in Greece will not unleash a broader peripheral debt crisis, as most Greek debt is directly or indirectly held by European governments. Furthermore, the Greek economy amounts to less than 2% of EU GDP, so we would expect Eurozone leaders to handle any crisis relatively easily.

Japan: Abe’s new gamble casts doubts on multi-faceted Abenomics As expected the three percent hike in the sales tax last April led to a slowdown in the Japanese economy, and a more severe one than was generally predicted. This cast doubt on the additional 2% tax hike planned for October 2015. Probably in a bid to incentivize the Japanese government to stick to its plans and given the window of opportunity provided by the collapse in oil prices, the Japanese central bank (BoJ) took action. It voted by the smallest possible majority of five against four to substantially increase its program of quantitative easing. This unexpected step led to an immediate further weakening of the yen. The BoJ plans to buy JPY 80 trillion worth of government bonds a year (approximately 16% of GDP) for an unspecified period (in other words QE). As a consequence, its balance sheet (as % of GDP) will dwarf all others. However, this bold move means that the BoJ, a strong supporter of the additional tax hike, has lost all its leverage on the Japanese government. It will not be pleased that just two weeks after its decision, Prime Minister Shinzo Abe decided to postpone the tax hike to April 2017. He has promised to hike this time ‘without fail’, but you could be forgiven for having your doubts.

Furthermore, he called elections for 14 December 2014. As the opposition is weak, Abe is likely to succeed in maintaining the current majority of the LDP/Komeito alliance in the lower house of parliament. But these unnecessary elections, only two years into the cycle, are not without risk – Ten year yield spreads vis-à-vis Germany

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Outlook 2015 | 5

this could be viewed as an overly opportunistic step. Furthermore, this calls into question Abe’s or rather the LDP’s commitment to Abenomics (especially the third pillar: structural reform). With a government debt ratio of 240% of GDP and a deficit of at least 6% of GDP, unease about the long term fiscal sustainability of Japan will increase. We expect the yen to weaken in the course of 2015. The BoJ will keep a strong hold on bond yields, ensuring that they stay low. Economic growth will strengthen, thanks to the weak yen, but business investment will slacken, as confidence in the long term growth prospects remains low. Household income has risen a little, partly thanks to bonuses, but, in real terms, it has declined. This trend is unlikely to change. Inflation will rise gradually due to import inflation.

China: slightly slower growth target The Chinese economy weakened in 2014 and, at least according to official data, GDP growth will probably turn out to be slightly lower than the official target of 7.5%. Q3 2014 GDP growth amounted to 7.3%, but ‘true’ growth is probably lower as suggested by indicators preferred by Li Keqiang (in his former life as regional governor) and by the rather weak sales reported by Western multinationals active in China. The authorities have resisted the temptation to announce a massive stimulus package as they did in 2013. But they have quietly increased stimulus measures (like pumping liquidity on a massive scale into the largest banks) to ensure that growth will not weaken too much. Of course, Chinese policy makers are aware that the economy has to rebalance and that a lower structural growth rate is unavoidable. Their priority is to avoid social instability and thus foster employment growth. Although the IMF is pressuring China to set a growth target of 6% for 2015, we consider it more likely that the government will choose a growth target of 7.0%, but at the same time will further downgrade the importance of this figure. The policy of quiet Li Keqiang indicators

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Ind. prod. Electricity Source: Datastream, Robeco

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stimulation will be continued and a gradual weakening of the yuan versus the US dollar is likely for several reasons – the declining current account surplus and, indirectly, the continuing aggressiveness of the Bank of Japan, which will put downside pressure on all Southern Asian currencies. Inflation is expected to remain benign, partly thanks to the decline in the price of oil.

Other Brics: a mixed bag The Indian economy has been boosted by the election of Narendra Modi. Expectations are high, although actual progress on reform has been less than spectacular. Nevertheless, we consider a growth rate of 6.0% within reach for 2015. Inflation, which is well entrenched at a high level, will also come down, thanks to the fall in oil prices. The central bank will probably adopt an on hold stance for the foreseeable future.

In Brazil, there is considerable skepticism about the policies of the new government (led by a narrowly reelected Dilma Rousseff). Nevertheless, we expect the economy to strengthen after a dismal 2014, during which growth almost came to a standstill and the real weakened markedly. The Russian economy will shrink in 2015 and inflation will rise. The economy will suffer as a consequence of the continuing capital flight. The risk that capital controls will be introduced has risen markedly. The South African economy, which has been crippled by a wave of long term strikes, will experience a technical rebound in 2015 with growth reaching a less than impressive 2.25%.

Financial market prospects Less room for complacency as volatility returns

So far 2014 has been benign for risky assets but, as we anticipated in our previous annual outlook, has not brought the impressive returns experienced in 2013. The real surprise this year has been in the performance of the safe haven spectrum of assets, with a further leg in the sovereign bond rally pushing yields to unprecedented lows. In our outlook last year, we thought global bond yields would gradually rise to reflect accelerating real growth and an uptick in inflation, and that the Fed’s less dovish stance on timing the ending of its Treasury purchases would further support this trend. In fact, this call proved to be ‘too much, too early‘.

Global activity stabilized with the world economy growing on balance 2.4% in real terms, but in several regions economic growth advanced less powerfully than we (and the consensus) expected. The bond market picked up these negative growth surprises, helped by the Fed’s more dovish stance – it reduced its expansion of excess liquidity at a consistent, but moderate pace and maintained its message of lower rates for a ‘considerable‘ time. In response, the market’s expectations of a Fed rate hike have been significantly reduced.

Besides disappointing growth, a sharp decline in inflation forecasts has contributed to an unexpected slide in nominal interest rates. The sharp fall in the longer term inflation outlook is partly a spin-off from continuing disappointing growth, causing the market to price in a higher future probability of global deflation and subpar growth. This world of secular stagnation, a term reinvigorated by Lawrence Summers in a November 2013 speech, has caught the attention of the market and led to a rerating of future inflation expectations (and forward bond prices). Another, more immediate cause for the destabilization of the inflation outlook has been the sudden drop in oil prices (down 25% since June). The fall in commodity prices, a combination of excess supply and a decline in demand, have exercised strong disinflationary pressure. Although the Market expectations of Fed median hike 2015

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Median fed futures rate 2015 Source: Bloomberg, Robeco

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source of disinflation has been of the ‘good deflation’ type, the market has adjusted inflation expectations along with the drop in oil prices and made the task for the ECB more difficult. Driven by lower commodity prices and the strong euro, Eurozone consumer prices have continued their downward trend from last year, increasing the challenge for the ECB to keep inflation ‘close, but below 2%‘.

Lower risk free interest rates and disappointing but moderate economic growth have preserved a favorable, but potentially fragile environment for both risky and safe-haven assets. We have therefore seen a simultaneous rally in global sovereign bonds and in equities, leading to a remarkably high correlation between equity and bond prices.

The ongoing high level of market liquidity, backed by continuing accommodative monetary policy, has also kept volatility relatively subdued. Although the most recent correction in October temporarily pushed the VIX to above average levels, risky asset specific volatility still remains below its long term average.

The central bank ‘put’ for financial markets, exercised through unconventional monetary policy has played a significant role in bringing Nominal 5y5y forward inflation swap rate versus Brent

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asset volatility down to below intrinsic levels, disrupting the traditional link between financial and economic risk. Unconventional policies have partly distorted the relationship between cause and effect in terms of financial and economic risk, resulting in a phenomenon where bad macroeconomic news is interpreted by financial markets as being positive for assets. This central-bank-policy-induced complacency about the impact of economic risk has led to a divergence between fundamentals and asset prices, reflected in the currently elevated and sometimes even stretched valuations. Financial risk taking seems to have outpaced economic risk taking. Low rates have encouraged firms to take on greater levels of debt but the effect on investment and productive capacity has been muted. For instance, increased debt issuance by high yield corporates as a result of lower rates has increasingly been used for share buybacks rather than for capital investment.

Asset specific volatility has remained well below historical mean

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Push back on the risk curve Fed exit from unconventional policy means bad news will be bad news after all Looking ahead, we expect financial markets to take up the theme of divergence between financial and economic risk as the Fed is expected to tighten its policy stance in the course of 2015, most likely in early Q3.

This return to conventional policy means that as far as the markets are concerned once again bad news = bad news. The gradual normalization of the link between financial and economic risk will also cause a shift from liquidity-driven to more growth-driven markets. However, the Fed will err on the side of caution in its policy steps – not killing the recovery by scaring bond investors as in 1994 or deflating risky asset prices in a disorderly way. In its forward guidance, it will also keep a close eye on the impact of any policy shift on emerging markets as these remain susceptible to a reversal in international capital flows.

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A more hawkish Fed than the market expects may alter risk-return tradeoffs and push both leveraged and non-leveraged investors further back on the risk curve. This will cause more financial market stress and the return of volatility. An unanticipated shift towards more hawkish Fed projections could cause unrest in global bonds and equities. Something similar occurred after Bernanke’s first hint on the end of tapering in May 2013, Fed futures curve well below offical Fed projections

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It is clear that a strong US labor market will eventually lead the Fed into action and bring about the return of conventional monetary policy in the US. Although the Fed hike path will be gradual and moderately paced in our view, it could very well exceed current market expectations given the market deviation from Fed median policy rate projections for 2015 and the unemployment rate (5.8%), which is approaching the NAIRU (Nonaccelerating inflation rate of unemployment) estimates of Fed officials (which lie between 5% - 5.5%).

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The difference in regional economic strengths has become evident – Europe, the emerging markets and to a lesser extent Japan are now clearly diverging from the path of the US and its ongoing recovery. As a result of this, the ECB made a landmark policy shift in 2014 by embarking on unconventional monetary policies to stimulate the Eurozone economy.

The Fed, on the other hand, is now heading in the opposite direction, having disembarked from its policy of QE in November 2014 after ending its additional monthly Treasury purchases. The Bank of Japan has now also decided to implement additional easing to weaken the yen.

Returns supported again by profit growth

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after which the correlation between sovereign bonds and equities became positive for a while as both asset classes declined in value.

Geopolitical risk is a constant issue for the global investor and last year there were a number of significant new events that had a worldwide impact on financial markets. The Russia-Ukrainian conflict, the surge of ISIS (which led to high oil prices earlier in 2014) and the spread of Ebola have had repercussions on investor sentiment and economic risk taking.

While it is difficult to assess how these ‘unknown knowns’ will play out next year, it is almost certain that other new geopolitical risks will emerge.

Markets will assess regional divergence on the economic – and policy fronts

In 2015, the market will likely assess the strength and determination of these central bank policies in all corners of the world and rerate regional assets accordingly. If the Fed hesitates too much in pursuing its course of tightening next year, the policy debate at other central banks will intensify and could trigger additional easing to prevent imported deflation as these countries’ currencies appreciate against the dollar. The more clarity there is on policies and economic growth trajectories, the more volatility will be contained. A resilient US economy could attract capital inflows to profit from improved interest rate differentials, exerting downward pressure on US bond yields and strengthening the dollar.

Emerging markets with current account deficits remain particularly vulnerable to capital outflows. In a world of stretched valuations and divergence on both economic and policy fronts, a rising economic tide is no plain sailing.

Another theme – the expected divergence of monetary policy in developed markets – will result in a closer re-evaluation of risk-return trade-offs in 2015.

Declines in volatility have been highly correlated across major asset classes and this is reflected in a simultaneous and widespread pattern of prices above historical norms, with commodities being the clear exception. Looking at the volatility term structure for the S&P 500,

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volatility seems to be relatively low compared to periods where the Fed embarked on a tightening cycle.

asset specific volatility, a decreasing correlation between (regional) asset returns will also emerge.

Decoupling correlations signal the beginning of the end of easy money

Equities

The market has got used to and even become dependent on easy money.

The first central bank to exit from this zero interest rate policy could unsettle markets and have a negative impact on real activity. The central banks are aware of this and so their exit strategies will remain highly conditional on further positive developments in labor markets and the economy. But as fundamentals improve, the urge to hike will eventually surpass the need to be cautious. This transition from a liquidity driven world to a more growth driven one will most likely not be completed in 2015, but will result in a gradual normalization in the equity-sovereign bond correlation. In an environment of diverging monetary policy, where volatility remains contained but also returns to levels more consistent with

In our annual outlook last year we expected the equity market to shift its focus towards corporate fundamentals, so the contribution to returns would move back from multiples expansion (which dominated 2013 returns) to earnings growth. This is indeed what has happened this year to date, although price appreciation has made even less of a contribution than we had anticipated (taking the S&P 500 Q32014 figures). This is linked to the healthy market correction of 6% in October. As we think one of next year’s investment themes will be the move from liquidityto growth-driven markets, we expect the market to keep a close eye on earnings. This is more than sufficient reason to discuss the main components of earnings, profit margins and sales growth in more detail.

Real earnings (i.e. earnings corrected for consumer price inflation), are now almost 20% above their long term trend. We do not expect mean reversion to happen next year, but the risk of a deceleration in earnings growth has increased. A closer look at historical de-trended earnings shows that earnings only revert to trend after the peak of the central bank hiking cycle. Although we expect the Fed to start a tightening cycle, this is likely to be moderate and to peak after 2015.

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Looking more closely at corporate earnings capacity, we think further earnings growth has to come from increased sales as these have been sluggish and, since 2009, have made less contribution to earnings per share than margin expansion has. The continuing global recovery will support consumer spending and stimulate sales growth, especially in

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the US where income will rise further as wage growth picks up. Nonwage income is also still improving as the low interest environment has boosted house prices. Income growth, low interest rates and private sector deleveraging have lowered the US household debt service ratios, which are now at their lowest levels since 1980. Elsewhere, consumer spending will pick up if certain growth obstacles are removed and lending to small and medium enterprises in the Eurozone increases. Although consumer sentiment in Europe has shown signs of improvement, spending activity could be further stimulated by lower energy prices into next year.

US profit margins may very well remain sustained at historically high levels

That is not to say that there are no headwinds for profit margins going into 2015, but the story differs according to sector, company, size and region. The profit margins of cyclical stocks are still lagging those of defensives, while large companies have seen a far steeper increase in pricing power compared to smaller ones. In terms of regions, profits margins in Europe and emerging markets are clearly behind those of the US, partly because the Eurozone is lagging in the economic cycle.

The outlook for improved European profit margins looks promising in the medium term, as we expect unit labor costs to decline further in the Eurozone. We also expect a modest rise in producer prices, partly as a result of the pass-through of higher import prices due to a lower euro.

Corporate profit margins in the US have increased significantly over the past years due to a climate of stringent cost-cutting, deleveraging, historically low interest rates and lower depreciation costs resulting from aging capital stock. The consensus among analysts was that this profit margin expansion would decelerate in an environment of rising labor costs and interest rates. Last year we had our doubts as the low interest rate environment provided corporates with ample opportunity to lock in low rates on debt for longer. And the drop in capital market rates this year has provided an additional windfall, rather than a headwind for margins.

Looking ahead, we expect US profit margins to remain well above historical averages. The US is most exposed to the risk of downside pressure as its underutilization of labor resources is gradually diminishing, giving more bargaining power to workers in wage negotiations. A tail risk in a year where volatility is likely to pick up is credit spread widening in the US high yield market. This market has become more vulnerable to financial stress as there have been large numbers of CCC rated issuers which could increase refinancing risks for existing issuers and raise borrowing costs for new issuers.

Furthermore, overall unemployment has fallen, but wage bargaining power still lags the pace of labor market tightening. This is partly linked to a longer term shift in the balance of power between the corporate and private sectors. We do not expect this supportive trend for corporate profits to reverse in the near term. Also, in the early part of a tightening cycle the positive impact of higher wages on sales growth clearly outweighs their negative effects on corporate costs.

Although we find forward earnings for the MSCI World of 11 % to be on the optimistic side, especially as analysts historically tend to overestimate future earnings, earnings growth will remain healthy as the global economy improves. Earnings per share growth could be sustained by continuing share buybacks.

S&P 500 profit margins - permanently high?

Eurozone unit labor costs show overall improvement

12

150

10

140

8

130

6

120

4

110

2

100

0 ‘90

‘94

‘98

Profit margins S&P 500 Index Source: Bloomberg, Robeco

‘02

‘06

‘10

‘14

90 ‘00

‘02 Italy

‘04 Portugal

‘06 Ireland

‘08 Greece

‘10 Spain

‘12 Germany

‘14 France

Source: Datastream, Robeco

Outlook 2015 | 11

Contribution of price appreciation to returns could be negative

Second, share buybacks have contributed to price appreciation and this trend will not end as the opportunity costs for share buybacks (i.e. return on capex) are still relatively low.

We think the contribution of price appreciation to returns is likely to be negative in a year when the Fed will tighten its monetary policy.

Uncertainty surrounding the path interest rates will take, will keep investors scrutinizing the impact on equities and curb their exuberance somewhat.

However, we do not think that equity prices will drop significantly. First, on a cyclically adjusted PE basis, global equities are now 20% above their mean. This makes equities pricey but not significantly overvalued.

Moreover, valuation is not a timing factor when it comes to short-term equity returns. Leading academic researchers in this field (Dimson, Marsh and Staunton 2014) note that we learn ‘far less from valuation ratios about how to make profits in the future than about how we might have profited in the past’.

Cyclically adjusted PE MSCI World

50 40 30 20 10 One and two standard deviations from average 0 ‘80

‘85

‘90

‘95

‘00

‘05

‘10

‘14

Cyclically adjusted PE MSCI World

Third, retail investors have not yet fully returned to the equity market.

Historically, excessive optimism among retail investors has been a clear warning signal that a mature equity rally is past its peak and heading towards a correction. Retail investors usually return to the equity market at a late stage in the corporate earnings cycle, thereby inflating equity prices. However, there is as yet no sign of irrational exuberance on the horizon, as measured by the bull-bear ratio indicator, which reflects investor sentiment.

Equities remain vulnerable to return of volatility Recent monetary history has taught us that when central banks reduce surplus liquidity, stock market volatility often increases. Volatility has a strong and negative correlation with equity returns; i.e. for the S&P 500 this correlation is - 0.8. The removal of excess liquidity by the Fed will therefore be associated with downward pressure on returns because financial markets will have to learn to stand on their own two feet again.

But timing is an important factor in volatility. We expect the volatility caused by the Fed’s actions to be of limited duration and scale because its effects on the markets will partly be counterbalanced by the easy money mode of the ECB and the BoJ. It’s a question of give (ECB and BoJ) and take (Fed).

In summary: After the solid returns of the past five years, with equities returning 13% on average, we expect performance next year to be more moderate. Supported by increasing sales growth and healthy profit margins, global equity returns are likely to be in the 5%-7% range,

Source: Bloomberg, Robeco

1 Y rolling average AAII bull-bear ratio: no exuberance among retail investors

Monthly volatility of the S&P 500; historic peaks around the ending of quantitative easing 80

3,0

70

2,0

60 50

1,0

40

0,0

30 20

-1,0

10

-2,0 ‘90

‘95

‘00

‘05

1 year rolling average AAII bull-bear ratio (z-score) Source: Bloomberg, Robeco

12 | Outlook 2015

‘10

‘14

0

‘08

‘09

Announcement QE1 Source: Bloomberg, Robeco

‘10 End QE1

‘11 Start QE2

‘12 End QE2

Start QE3

‘13

in secular stagnation. The significant decline in medium term inflation expectations is indicative of a deflation scare in the market. Another worry for the market is that interest rates need to stay low as ongoing debt deleveraging requires interest rates below the nominal growth level in order to rebalance the economy.

below their long term historical average of 8%. Price appreciation will be moderate as the divergence in monetary policy worldwide will create more uncertainty for risky assets. Given our return expectations, equities are our favorite asset class for 2015.

Government bonds – an end to the rally?

Since the start of 2014, bond markets have taken a surprising turn – not performing as we (and most analysts) expected them to. Bond yields rose steadily after Bernanke’s hint on tapering US Treasury purchases in May 2013 and we expected US rates to grind higher in the light of a further pickup in the global recovery. Instead, the bond market rallied and bond yields in the US fell to 2.3%.

Several factors have driven the impressive rally in the bond market: first, the disappointing pace of global economic recovery; second, the surge in geopolitical risk (Ukraine, ISIS, Ebola) which led to safe haven flows into the sovereign bond market; and third, the market’s response to continuing disinflation and expectations for more ECB easing during the year. Other technical factors have also played a role. In addition, partly as a result of austerity measures, sovereign bond issuance in many developed markets was negative last year, which also suppressed interest rates.

Bond market theme has shifted towards secular stagnation A more structural reason for the rally was a shift in bond market themes.

It was not the first time that economic growth disappointed during what has been a very long recovery phase since the financial crisis. But this raised doubts as to whether growth will eventually return to precrisis levels. Slower growth in the labor force due to ageing and lower productivity (fall-out from the financial crisis) could cause a structural decline in potential economic growth and inflation, leaving the world

Nominal 5y5y forward inflation swap rate versus Brent

5 4 3 2 1 0 US generic govt 10Y yield

Source: Bloomberg, Robeco

We think this deflation scare will ebb somewhat next year, but will not vanish altogether. The drop in global five year forward inflation expectations has almost coincided with the drop in oil prices since June.

However, this fall seems only warranted if oil prices continue to decline over a 10-year horizon. As we think the recent oil price fall is a typical oneoff price shock, inflation expectations appear to have undershot recently.

We expect them to rebound as oil prices stabilize next year which will also lead to higher nominal interest rates in the bond market.

We expect the divergence in monetary policy to have different effects in different regions. The current yield gap between the US and Eurozone 10-year bond is at an historical high and could very well remain at

6

03’93

Higher nominal rates likely as oil prices stabilize

Divergence in monetary policy will keep rate differentials significant across regions

10 year government yields

10 9 8 7 6 5 4 3 2 1 0

We are less bearish about the resilience of the world economy relative to current market pricing as our modal view of gradual normalization is fairly optimistic (see macro section for details). This does not mean we expect a strong rebound in real interest rates next year outside the US – the rest of the global sovereign bond market will need very convincing figures demonstrating a swift normalization in order for it to shift away from the secular stagnation theme. Economic data from the Eurozone and emerging markets will probably not be impressive enough.

03’00

03’07

Euro generic govt 10Y yield

03’14 Japan generic govt 10Y (RH)

120

2.5

115

2.4

110

2.3

105

2.2

100

2.1

95

2.0

90

1.9

85

1.8

80

1.7

75 01’14 Brent oil

04’14

07’14

1.6 10’14

5y5y eurozone inflation swap (RH)

Source: Bloomberg, Robeco

Outlook 2015 | 13

elevated levels as the ECB actively pursues balance sheet expansion while the Fed moves towards a tightening stance next year. This significant rate differential could trigger interest rate differential led inflows into the US bond market from overseas investors and contain the upward trend in US bond yields to a certain extent.

US bond market likely to see combined real and nominal rate rise In the US, we see more perspective for rising real yields compared to the Eurozone as the US is leading the economic cycle and real growth levels there are correspondingly higher. The US is closer to a cyclical normalization of the economy and in terms of most metrics is already performing at cyclically normal levels.

We expect the US to move towards its long term non-accelerating inflation rate of unemployment, while the Fed proceeds on its moderate path of hiking. This means that the US market could push for higher nominal yields at the long end of the yield curve, in the latter half of 2015, as it sees more inflation risks on the horizon given the improved labor market and Fed maneuvering. We expect the 10-year US Treasury yield to move 75 basis points from current levels to around 3% in 2015.

Eurozone to see modest rise in nominal rates as secular stagnation scare remains In the Eurozone, real yields are in negative territory and although some pickup is likely if the recovery remains on track, positive real yield levels in 2015 will not come anywhere near levels that correspond with the real growth potential of the Eurozone.

From a valuation and macroeconomic perspective, current sovereign bond yields seem unsustainable, even if one discounts further ECB easing.

A nominal 10-year German bond yield of 0.83% and market inflation of 2.04% imply negative real yields of minus 1.60 basis points, suggesting the market is fully pricing in secular stagnation in the Eurozone. However, we expect the Eurozone to gradually normalize to pre-crisis growth levels and the very negative real interest rate to continue to work as a stimulus for growth in the medium term. In the near term, a depreciating euro and lower energy prices will help reverse the slowing macro momentum we are currently experiencing. We expect 10-year German yields to move up 50 basis points from current levels to around 1.35% in 2015. This is above the market expectations for the 10-year yield one year from now (1%).

Not much action expected in Japanese yields In Japan, it appears that Abe’s reform program is losing some steam

14 | Outlook 2015

and the battle against deflation has not been decided. The most recent inflation figures remain encouraging, but lower real wages are eroding consumer spending power. We expect the BoJ to remain proactive( as it was in November when it implemented additional monetary easing) as the short term solution to reinvigorating the second and third pillar of Abenomics seems to be to do more in terms of the first pillar, i.e. central bank quantitative easing. The BoJ will keep expanding the central balance sheet (just as the ECB has done) in an effort to steer the economy away from deflation. Although this strategy will eventually be curbed by the law of diminishing returns, we expect that Japanese policymakers and the central bank will manage to keep the nominal interest rate at around 0.6% through a combination of quantitative easing and fiscal tightening.

Episodes of market turbulence will keep sovereign bonds pricey Looking ahead, we expect the German 10-year yield to be around 1.35% at the end of 2015, while the US yield will move in the direction of 3.00%.

These numbers are more moderate than those indicated by our fair value models, but safe haven flows will not dry up as geopolitical risks remain and although the deflation scare will ebb, it will not vanish altogether.

Also, we expect more volatility in 2015 creating opportunities for the sovereign bond market as a safe haven in times of market turbulence.

In our base scenario, a gradual normalization of the global economy makes government bonds more vulnerable at their current price levels, in spite of the fact that inflation will show only a very modest increase.

Real estate less promising as rates rise Real estate has been the clear winner in the cross asset spectrum in 2014, with returns to date of 25%. There are a number of reasons for this, which will also influence the performance of real estate in the coming year. In the first place, real estate is a more interest rate-sensitive asset class than stocks and thus has profited more from the decline in bond yields. This is evident in the sector’s excess profit performance compared to stocks since the start of the year. However, the Fed’s tightening cycle due to be initiated next year will hit real estate harder than other asset classes. The impact of rising rates is likely to be counterbalanced by a pickup in real growth (especially the US) and higher rents. REIT dividend yields also remain attractive at 3.6%.

Real estate remains promising in an environment of subdued growth and elevated uncertainty but we expect the outlook for cyclical equity sectors to improve as growth returns. This means that real estate, typically a more defensive risky asset, could lose some of its shine as its upside has become

In relative terms, spread widening has also made high yield better value than investment grade.

more limited from a valuation perspective after the strong rally.

From a valuation perspective, real estate remains relatively expensive compared to stocks, especially cyclicals. Real estate is also vulnerable in an environment of rising interest rates, given its high valuations.

High-yield bonds – carry on High-yield bonds remain an attractive asset category in the current environment of below-trend growth and very moderate inflation, but we have gradually adopted a more conservative stance as the rally in high yield slows. Looking ahead, this risky asset class requires vigilance as the Fed starts its tightening cycle and liquidity risk is not fully reflected in the market.

However, the broader environment remains favorable, and the recent ECB easing measures (covered bond buying and targeted long term refinancing operations) are an additional boost for risky assets and the European high yield market in particular. In the meantime, the search for yield will continue, albeit at a more measured pace, as the global high yield market is less assured of central bank easy money. The European market is likely to be the main beneficiary in the ongoing search for yield as it has higher ratings than the US, suggesting that the search has yet to penetrate to the lowest-rated borrowers in the euro area. From this perspective, the European market is preferable to the US. This also plays into our theme of divergence in monetary policy. There is likely to be more high yield issuance from previous borrowers in the euro loan market, especially as the ECB is supporting (parts of) the fixed income market.

Although risk perception is currently strong, we think investors are still willing to pay a relatively high price for additional carry. Coupons are still relatively attractive, especially after the spread widening we have seen.

Global high-yield spread versus global financial stress metric

6.0 5.5 5.0 4.5 4.0 3.5 3.0 02’13

08’13 Global high yield spread

Source: Bloomberg, Robeco

04’14 Global financial stress index (RH)

The prospects for high-yield corporate bonds remain favorable on the basis of fundamental factors. Default rates continue to decline and the market expects this trend to continue in 2015. Recovery figures are also high at the moment. Low interest-rate policies in recent years have given businesses sufficient opportunity to issue longer-term bonds at favorable rates. In our view the default rate expectations seem rather optimistic for the US market, given that energy companies now form an increasingly large part of the high-yield bond market and energy price falls to break-even levels will pose a threat. This will be particularly apparent if the abundance of supply prevents stabilization in oil prices, lowering pricing power.

We therefore also see limited refinancing risks in 2015. The cash flows of companies which issue high-yield bonds remain on target, thanks to an expected pick up in cyclical growth in developed markets, enabling them to continue to finance interest charges relatively easily.

Still, we note that this asset class is losing some of its glamor. The compensation for credit risk has dropped to 438 basis points and therefore lies below the 10-year average of 610 basis points.

There are a number of factors that will inhibit further index spread compression from current levels. In the first place, financial stress is closely related to high yield spread widening and we expect a return to more normal asset specific volatility next year.

Secondly, the expected default rates appear very rosy compared to comparable economic cycles in the past, but there is now a risk of higher Speculative default rates, 1920-2014

0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 10’14

18 16 14 12 10 8 6 4 2 0 1920 1927 1934 1942 1949 1956 1963 1971 1978 1985 1992 2000 2007 2014 Moody’s median speculative default rate

Median during NBER expansions

Source: Moody’s, Robeco

Outlook 2015 | 15

defaults in some pockets of the market, despite the continuing economic recovery. Thirdly, if higher value segments of the market are affected by contagion from defaults, low market liquidity could exacerbate problems.

Trading activity is much more volatile for high yield ETFs during stress periods than it is for investment grade bonds. This volatility will also increase liquidity risks. Fourth, the issuance of covenant lite bonds has surged, as a result of the search for yield which keeps bargaining power on the supply side. But covenant lite issuance does not equal bad credit quality. Instead, sometimes issuers with stronger fundamentals are able to push for fewer covenants.

We think the investment grade rally is past its peak given the stretched valuations. We are not positive on spread compensation on investment grade credits in 2015. Credit spreads are almost priced for perfection and when European high yield spreads widened recently, investment grade spreads compressed even further. In many instances, investment grade credit spreads are even lower than those on the corresponding government bond in the same country, while the company’s official credit rating is lower than that of the government. Also, in northern Europe, credit risk premiums have approached levels that show discrepancies as regards the underlying risks.

Taking into consideration the somewhat more favorable valuation of equities compared to high-yield bonds, we prefer equities in 2015.

Within fixed income, we prefer high-yield bonds to government bonds in developed and emerging markets because of the additional return on credit risk.

With low interest rates and credit spreads that have narrowed as the search for yield intensified, the credit market is likely to be more driven by changes in the risk-free rate than by underlying credit developments.

Any reacceleration in macroeconomic momentum or a pickup in inflation in the Eurozone could lead to higher sovereign bond rates, which will correspondingly lead to lower price returns on investment grade bonds.

The recovery in the periphery looks promising, but it still has a long way to go, and won’t be without a glitch, as the recession in Italy has shown.

Investment grade credits have less to offer Investment grade yields have shown a consistent performance and, in the euro area, yields have now compressed to 117 basis points, just 14 basis points above the current 10-year Dutch sovereign bond yield. Our view of investment grade credits remains largely focused on country risk. The correlation with government bonds has declined, partly due to the unsurprising results of the ECB’s asset quality review of major Eurozone banks. But despite the uncelebrated success of the stress tests, correlations remain high (0.80) and the vicious circle between governments and banks has not been entirely broken, particularly in the Eurozone periphery. The premium for credit risk offered by investment grade credits in these countries is mainly a reward for the implicit country risk embedded in local companies.

Returns on high-quality corporate bonds are closely linked to government bonds – Adjusting for country risk, spreads are at 2007 lows

The bottoming out of disinflation in the Eurozone, stimulated by a lower euro and more stable energy prices, could push nominal capital market rates higher, eating into the remaining spread buffer on investment grade bonds. This reflation process will also lower the beneficial effects of ECB balance sheet expansion (covered bond buying) on the corporate credit market as the market is less confident in the ECB as a structural bond buyer.

In brief, despite the fundamental improvements that are evident in the European banking sector and improved corporate balance sheets, the High yield and investment grade credit spread versus mean

4.0

18

3.5

16

3.0

14 12

2.5

10

2.0

8

1.5

6

1.0

4

0.5

2

0 2007

2008

2009

Corrected credit spread Source: Bloomberg, Robeco

16 | Outlook 2015

2010

2011

Credit spread

2012

2013

2014

0 ‘02

‘03

‘04

‘05

Global IG spread Source: Bloomberg, Robeco

‘06

‘07

mean spread

‘08

‘09

‘10

‘11

Global HY spread

‘12

‘13

mean spread

‘14

low return on credit risk makes us more cautious about this investment category in 2015. On a risk-corrected basis we prefer high-yield bonds over investment grade credits for 2015 as the former has a decent spread buffer left to mitigate rising capital market rates.

Emerging market government debt in for another volatile year While emerging market debt in hard currency has had a good year, local currency denominated debt has lagged behind considerably.

Local currency emerging market bonds typically display a high negative correlation (a coefficient of 80%) with US dollar currency movements. It has been a rough ride for emerging market currencies, after a promising start in 2014. Declining volatility in the US Treasury market coincided with a further decline in emerging currency volatility, generating positive returns. But sentiment soured as issues surfaced such as unrest in Ukraine, declining oil prices and a slowdown in emerging markets (especially the EMD issuers) compared to developed markets.

We do not think the downward pressure on emerging market currencies will vanish in 2015. They will face headwinds from a tightening Fed and an uneven recovery. The IMF’s future projections of current account balances for the top 10 issuers do not forecast an improvement in external balances, which does not bode well for the performance of the corresponding emerging market currencies.

A current account deficit implies a national saving deficit which has to be financed by external flows. The emerging market top 10 local currency issuers are also still slightly overvalued on a purchasing power parity basis.

In addition to global influences, internal economic forces will determine returns, albeit to a lesser degree. Recently credit spreads have somewhat PMI EMD local currency issuing countries versus global PMI

lagged emerging market risk, leaving downside potential for returns should credit spreads widen.

Average inflation in the countries of the top 10 emerging issuers has consistently remained in the 4-5 percent bracket in recent years, somewhat on the upper band of inflation targets. Therefore, we continue to expect further monetary tightening in emerging markets in order to stabilize inflation expectations and limit currency depreciation. This will have negative effects on cyclical growth in these markets in 2015.

The current yield is 640 basis points. Although this is almost 180 basis points higher than the yield on European high-yield corporate bonds with a similar maturities, we do not expect the additional return for the credit risk to compensate for the significant currency risk during volatility spikes in 2015. Only over the past year EM FX currency returns were a negative 817 basis points and, as stated above, there are compelling arguments for this depreciation pressure to continue. However, current yields are significant compared to those currently available in developed markets.

We are therefore neutral on local currency emerging market debt compared to high-yield bonds.

Commodities Returns on commodity markets since the financial crisis appear to have been mainly driven by macroeconomic factors and the wave of excess liquidity provided by central banks. In our outlook last year, we expected another dynamic to enter the market, whereby ‘commodities appear to be less subject to external factors but appear again to obey fundamental supply and demand conditions’. One of the indications for this is lower correlations within the commodity spectrum, a trend which has since continued.

Emerging markets current account as percentage of GDP versus EMD local currency FX basket

57

10

56

5

55

0

54

-5

53

-10

52

-15

51

-20

50

-25

49

-30

48 02‘12

06’12

02’13

JP Morgan global composite PMI Source: Bloomberg, Robeco

06’13

Average PMI EMD countries

02’14

10’14

HSBC EM composite

-35 ‘95

3 2 1 0 -1 -2 ‘00

‘05

Average nominal exchange rate

‘10

‘15

-3 ‘19

GDP weighted CA deficit (RH)

Source: BIS,IMF, Robeco

Outlook 2015 | 17

This change to more bottom-up driven commodity pricing is especially evident in the oil market. To date, Brent oil prices have dropped 20% since the start of the year as a result of supply- and demand-side related developments. On the other side of the commodity spectrum, coffee prices have gone up by 60% year to date on a global supply deficit due to bad weather in Brazil.

The commodity index year to date now shows a negative return of 13%, illustrating the volatility of this asset class. Although from a macroeconomic perspective the outlook is still mediocre given the pace of the global recovery, roll returns for the asset class as a whole have improved and become slightly positive. More commodity curves are now in backwardation, indicating the market is expecting future prices to decline over time.

Perfect storm has been brewing for oil The oil market has experienced a perfect storm from supply- and demandside developments over the last few months. On the one hand, the oil market is currently experiencing a supply glut. We expected to see a further shift in production from OPEC suppliers to non-OPEC countries but the strong production volumes generated by the continuing shale gas and oil revolution in the US have surprised us and the oil market. At the same time the macroeconomic growth momentum of the global economy has slowed, leading to less demand for oil.

The main question now is – whether the oil market is going to rebalance next year and if so, how this rebalancing process will take shape.

OPEC rebalancing the oil market?

A rebalancing in the oil market is likely as many key producers within US oil imports/production

12000 10000 8000 6000 4000 2000 0 08’06

08’08 US oil production

Source: Bloomberg, Robeco

18 | Outlook 2015

08’10 US oil imports

08’12

08’14

OPEC (and Russia as well) are now experiencing producer prices around or below fiscal breakeven levels, making current production levels unsustainable from a budgetary perspective. However, uncertainty surrounding OPEC rebalancing has increased since Saudi Aramco lowered its prices, without Saudi Arabia hinting that it would cut production in the wake of the sharp decline in oil prices. This could suggest a strategy to gain market share in preference to retaining pricing power. The underlying reason for this strategy change could be to challenge the firming nonOPEC competition, especially the US tar sand oil producers. Saudi Arabia’s reluctance to cut production could also be aimed at bringing OPEC producers more into alignment to implement more meaningful production cuts later on.

Game of chicken A risk to the above scenario is that OPEC remains reluctant to cut production, because it sees higher demand in the future and because of the lack of consensus within OPEC on how to fight the current bearish market forces. A more determined stance to push the US into the role of global swing producer could also be a factor. In this scenario, oil prices could even drop further from current levels, as the market acts as the rebalancing mechanism. But this is a tail risk in our view, because Saudi Arabia knows the longer oil prices remain below fiscal breakeven levels, the more stressed the fiscal situation in oil producing countries will become, risking civil unrest and geopolitical repercussions. This would be too high a price to pay for triggering a setback in US oil production.

Although it is very difficult to see how this potential game of chicken between OPEC and the US oil producers will play out, higher oil demand could come to the rescue later in 2015. Although the US is clearly advancing towards energy self-sufficiency, it still remains dependent on OPEC. The marginal barrel of oil – the barrel that is barely profitable in the economic process – will still be imported from OPEC countries.

Academic research shows that a decline in oil prices of 20% generates 0.4% of additional real growth for the global economy and this increased economic activity will boost demand for oil still further. Developments in China are also important. Although there will be increasing growth challenges in 2015, so far these have not translated into a structural break in China’s oil imports and are not likely to do so in the near term.

From the macroeconomic perspective, a stronger dollar, which we expect for 2015, will generate headwinds for the oil market too because this pushes up the oil bill for importers outside the US. Therefore, our modal view is that oil prices are going to stabilize but a significant rebound back to the USD 100-USD 115 per barrel bracket will

Currencies

not happen next year. Prices will likely drift higher, but remain below USD 90.

Few opportunities for gold to shine The fear that loose central bank monetary policy would stoke up inflation gave gold an extra shine in the years after the financial crisis. Now that deflation, rather than inflation is the major threat to financial markets, gold is struggling. Prices have declined 11.7% over the past year. We expect gold to trend downwards in an environment of increasing economic growth and very moderate inflation. This scenario will also translate into further increases in real interest rates, raising the opportunity costs for holding gold (which has a negative cost of carry).

Although we expect a return to higher levels of volatility in 2015, we doubt whether this will boost gold as a safe haven asset as this volatility will most likely stem from Fed tightening and themes that are bearish for gold such as real economic growth and containment of inflation.

We take a positive view on the US dollar, due to the varying growth rates of the US and the Eurozone, the differences in monetary policy between the two, and the reduction in the so-called ‘twin deficits’ in the US. The yen is likely to weaken further to reflect the consequences of Japan’s reliance on the first pillar of Abenomics, i.e. BoJ balance sheet expansion.

Text closing date: 25 November 2014.

Although there seem to be few opportunities for gold to post strong returns next year, that does not mean that gold will have no chance to shine at all. If, as we expect, medium term inflation expectations are higher than expected by the market, this could also give gold a boost.

Our tail risk ‘behind the curve’ scenario, as discussed in our bond outlook, could also make us bullish on gold towards the end of next year.

We expect to see increasing diversification opportunities in an allocation to commodities given the decline in their correlation with other asset classes and equities in particular. However, given that commodities are a real asset and we only expect moderate reflation in the developed markets, equities offer better opportunities to profit from reflation and improving real economic activity.

Nominal and real gold price

2000 1800 1600 1400 1200 1000 800 600 400 200 0 ‘68

12 10 8 6 4 2 0 ‘78

‘88

Gold Bullion LBM US$/Troy Ounce

‘98

‘08

‘14

Real gold price (RH)

Source: Datastream, Robeco

Outlook 2015 | 19

Important Information This information has been carefully compiled by Robeco Institutional Asset Management B.V. (Robeco). It is intended to provide professional investors with information about Robeco’s specific skills, but is not a recommendation to buy or sell financial instruments. A decision to invest in Robeco products can and must only be based on the information in a definitive prospectus and a summary prospectus (if and insofar as required) and also other information such as (half)yearly results for the Robeco product in question. Such information can be obtained free of charge via www.robeco.nl.

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Outlook 2015

1171-11’14