Kempen Insight March16

I N S I G H TKEMPEN

China evolution, no revolution Keith AmbAchtsheer ‘Daring aCtion requireD’ brexit no, thank you

TO DUTCH VERSION

http://www.kempen.nl/Default.aspx%3Fredirect%3D1%26langtype%3D1033

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Kempen Insight, March 20162

Clear choices needed /// China’s economic transition

A night at the movies/// Evert Waterlander’s selection

Currency volatility /// Impact

Brexit/// No, thank you

4

Interview Keith Ambachtsheer /// Canadian pension expert speaks out in favour of long-term investing

TablE Of CONTENTS

Kempen Insight, March 2016 3

/// COlOPHON

March 2016 ©Kempen Capital Management

Editorial addressKempen Capital Managementto: Secretariaat KCMPostbus 756661070 AR AmsterdamT + 31 20 348 [email protected]

ImagesCover: Philip JensterMario Hooglander, Johannes Abeling, Freepik

EditorsParisa VeldmanAnja Corbijn van WillenswaardDaniëlle Levendig

DesignHenrike Beukema

DisclaimerKempen Capital Management is included in the register of the Netherlands Authority for the Fi-nancial Markets (Autoriteit Financiële Markten) as manager of investment funds and as asset manager. This information may not be construed as an offer and provides insufficient basis for an investment decision.

Credits/// Companies take matters into their own hands 6

Welcome/// Reception at National Gallery london 14

Time for caution/// Which investment categories? 18

Column by Roelof Salomons/// Changing facts 21

Urgent questionsInvesting with a focus on the long term is a topic close to our hearts at Kempen Capital Management. How can asset managers, institu-tional investors and the companies in which we invest take tangible steps in this direction? We discussed this with renowned Canadian pension expert Keith ambachtsheer, the day after he was guest speaker at the ‘focusing Capital on the long Term: from talking towalking’-dinner. a topic on everyone’s minds in 2016 is the slowdown in the Chinese economy, the second largest in the world. further on in this journal you can read about why we do not expect the Chinese economy to make a hard landing. Nor do we anticipate a brexit, the departure of the United Kingdom from the EU. Yet the fact remains that uncertainty surrounding the british referendum will cause volatility over the next few months. This climate of low, occasionally even negative interest rates and low expected returns begs the question as to whether there are still sufficient prospects for investors on the financial markets. Investment strat-egist Marius bakker explains why now is the time to be cautious.

I look forward to receiving your comments and opin-ions at the address below.

Lars DijkstraChief Investment [email protected]

4 Kempen Insight, March 2016

/// by lESa SaWaHaTa photo JOHaNNES abElING

‘The horizon is long (term) let’s getmoving.’Keith ambachtsheer

Interview Keith Ambachtsheer

Long term investing has been the subject of much debate and discus-sion over the past several years – and while there’s lukewarm agreement that it may be the best and only way forward, action hasn’t always been forthcoming. How to move beyond the fear of long-termism to successful action?

It’s the morning after the event ‘focusing Capital on the

long Term: from talking to walking…’ co-hosted by

McKinsey & Company and Kempen Capital Management,

and the atmosphere in the boardroom of Kempen’s

amsterdam headquarters is one of palpable excitement.

“Did that really happen last night or was it just a dream?”,

asks Keith ambachtsheer (who presented the academic

perspective on fClT based on his paper The Case for

Long-Termism) of Paul Gerla and lars Dijkstra, respectively

CEO and CIO of Kempen Capital Management, over an

early coffee. The success of the event, attended by a large

group representing the Netherlands’ most influential asset

owners and asset managers, academics and policy-makers

could be measured by the engagement level of the partici-

pants, and an element unusual in the normally sober land-

scape of Dutch investing: expressed emotion. Elation,

excitement, resistance, hope, confusion. and just a touch

of that most motivational of emotions, fear. “You could

feel that in the room, too,” says Gerla.

Difficult decisionsIt’s no surprise – long-termism is fraught with difficult

choices. and the pressure on the industry to keep the long

horizon in view, while dealing with the short-term realities

of current pension payouts, requires a strong constitution.

“The underlying theme for some people last night is this

funding ratio,” says Dijkstra, referring to a key area of

uncertainty and therefore anxiety in the shift to long term

investing. “One of the participants talked about having to

tell pensioners that their pension was cut; no one wants to

have to do that,” he adds.


“I noticed last night how often Canadian

examples were mentioned; why is long

term thinking so ingrained in Canada?”,

Dijkstra asks. It started, according to

ambachtsheer, with the Ontario Teachers’

Pension Plan (OTPP). beyond adapting the

(for then) forward-thinking long-term

model – which includes a clear mission,

good governance, integrated ESG

concerns, and a board representative of all

stakeholders – there is an overarching

reason for the success of the OTPP: bold-

ness as well as humility.

Daring action“Teachers in Ontario can be retired a lot

longer than they work, and they have a life

expectancy higher than that of other

professions; they needed to figure out how

to fund that, how to create wealth with

assets”, explains ambachtsheer, “so

OTPP’s management stepped outside

normal pension investments.” OTPP

bought Canada’s largest private commer-

cial real estate firm, Cadillac fairview,

which is now ‘Consistently Delivering

Predictable Income Over the long Term’

according to OTPP’s website. This type of

innovative approach is proof of concept:

the shift to long-term investment is not

just possible, not just essential - but profit-

able. However, says ambachtsheer,

making the shift requires both novel

thinking and daring action.

and then a certain iconoclasm is needed.

He offers a quote from Irish playwright

George bernard Shaw that he finds poeti-

cally applicable to the shift to long term

investing: “The reasonable man adapts

himself to the world; the unreasonable one

persists in trying to adapt the world to

himself. Therefore, all progress depends

upon the unreasonable man.”

a bit of anxiety may be unavoidable at this

crucial moment; but ambachtsheer’s pre-

sentation of the night before had elevated

the mood and enlivened the discussion of

fClT by bringing both historical context

and models of real-life success into the

room. first and foremost, the overarching

importance of long-term thinking is related

to human survival. It was only in making

the difficult, long-term decisions about

savings and investment (in the form of

seeds, implements, and shelter at the time)

that civilisation and culture could take root

and flourish. “It was this shift towards being

able to think and invest in ever longer time

frames that made possible the eventual

transformation of the subsistence societies

of long ago to today’s far wealthier, more

stable ones,” he writes in The Case for

Long-Termism.

but that’s history. Even more encouraging is

ambachtsheer’s research into the success that

innovative long-term investing practices and

models deployed by pension funds and even

governments have achieved over the past

several decades.

One example is the australian superannua-

tion (pension) schemes, which are now

beginning to enable pensioners to transi-

tion their retirement savings in annuities,

providing the assurance that if they live

particularly long lives, they will continue to

have a reasonably dependable income.

“That’s the global solution for the work-

place pension plan,” says ambachtsheer.

“We need to get used to a two-part model,

and begin to separate the pieces into the

‘sure part’ for payment assurance, and the

‘longer horizon’ part for generating the

compounding returns that make pension

affordable. If people shift their thinking in

this direction, there is a smoother transition

to fClT.”

We are proud to introduce the

social newsroom SHIfT TO long

Term Investing, which will go live

in april at www.shiftto.org.

SHIfT TO is an independent news-

room, facilitating debate on the

topic of long-term investing

through articles, columns and

research from thought leaders

from varied backgrounds and ages.

Interview Keith Ambachtsheerkeith ambachtsheer (born Rotter-

dam 1942) is Director Emeritus of

the International Centre for

Pension Management at the

Rotman School of Management,

University of Toronto (Canada)

and was Editor of the Rotman

International Journal of Pension

Management (RIJPM).

He continues to publish the

monthly ambachtsheer letter.

Recognised by CIO Magazine as

the world’s #1 Knowledge broker

in Institutional Investing (2014),

he is the author of the influential

book ‘The future of Pension

Management’ (Wiley 2016), and

a member of the Editorial board of

SHIfT TO.


We have been witnessing a quiet revolution in the

European financial system. The financial crisis has

profoundly changed the way companies fund

themselves and accelerated the trend to tap into

capital markets by issuing corporate bonds.

There are two sources companies can tap

into when they require external debt

financing. The first option is to apply for a

bank loan. This is the option European

corporations largely depend on. alternati-

vely, they can access the capital market

by issuing debt. External financing in the

US is predominantly capital market-

based.

The new trend One of the most important trends in corpo-

rate financing in Europe has been the shift

away from bank-based financing. This

phenomenon of disintermediation seems to

have been triggered by the financial crisis

in Europe. Increasingly, non-financial

corporations (NfCs) have turned to capital

markets for their financing needs. In the

US, disintermediation has been occurring

since the 1980s, and some say even earlier.

This was made possible by structural, long-

term factors such as the advent of direct

market financing, the development of tech-

nology, and the deregulation of banks. In

contrast, up to the financial crisis, European

capital markets were rather underdeve-

loped.

0

350,000

300,000

250,000

200,000

150,000

100,000

50,000

Dec97

Dec99

Dec01

Dec03

Dec05

Dec07

Dec09

Dec13

Dec15

Dec11

Credits: companies take matters into their own hands

High yield-markt eurozone

Source: Bank of America Merrill Lynch

The left panel shows disintermedia-tion (securities as a proportion of the sum of bank loans and securities) since 1999. The right panel shows the total amounts of bank loans and securities outstanding at the end of each month, in millions of euro.

Development of eurozone High Yield market based on market value BofA Merrill Lynch Euro High Yield index since inception in millions of euro.


brokers to make markets. This increases the

likelihood that investors will be able to

enter this market in the foreseeable future

through a well-diversified fund.

The growth has been very visible in the

Euro High Yield market comprising debt of

companies with a rating of bb and lower

(below investment grade). The total market

value has risen to more than 300 billion

euro from less than 100 billion euro in

2009. The US High Yield market also grew

strongly from less than 500 billion dollar to

over 1,100 billion dollar now while the UK

High Yield market, though smaller,

witnessed the largest relative increase, from

5 billion to 48 billion pound.

MatureThe number of issuers in the Euro High

Yield market has doubled to more than 300

since 2009. The rising share of financials is

remarkable, from 7% in 2007 to 23% now.

also bb-rated companies are now 66% of

the benchmark versus 48% in 2007.

The Euro High Yield market is more mature

due to the experienced growth in size and

number of issuers. also liquidity is reaso-

nable compared to the investment grade

market as wider bid-offers incentivize

The graph shows the development of disin-

termediation in the euro area with securities

comprising more than 20% of securities and

bank loans combined. In the US disinterme-

diation is a lot higher with a ratio of 52%.

Attractive The cyclical causes that drive disintermedia-

tion can be divided in two categories. Push

factors relate to banks’ contraction of credit

and higher margins on loans, which have

made bank loans less available. Pull factors

relate to companies’ preference for diversifi-

cation of funding sources and the decreased

cost of issuing bonds, both of which have

made capital markets more attractive.

Institutional investors in particular have an

interest in bonds of at least 100 million

euro in nominal size to have some liquidity

and impact in the portfolio. for small- and

medium-sized enterprises (SMEs) disinter-

mediation therefore is not a positive trend

as they lack access to capital markets given

the size of their debt needs. They therefore

still largely rely on banks.

0

0.05

0.1

0.15

0.2

0.25

Mar99

Aug00

Jan02

Jun03

Nov04

Apr06

Sep07

Feb09

Jul10

Dec11

May13

Oct14

0

2.000

1.000

3.000

4.000

5.000

6.000

Mar99

Jul01

Nov03

Mar06

Jul08

Mar13

Nov10

Jul15

LOANS

SECURITIES

Richard Klijnstra

Senior Portfolio Manager

[email protected]

Development of disintermediation in eurozone

Source: Statistical Warehouse ECB


evolutionratherthanrevolution


/// by RUTH VaN DE bElT visual PHIlIP JENSTER

Investors have been concerned

about the state of China’s

economy for months. Although

China faces a number of

challenges, we do not predict a

hard landing.

Investors are very worried about the state of

China’s economy. last year, it ‘only’ grew by 6.9%.

This is its lowest level of growth since 1990 and less

than half the rate seen in 2007. although we do

not predict a hard landing (the government has the

resources and the will to prevent this), growth will

decline further over the next few years. This is all

bound up with the development phase the Chinese

economy is currently in. China passed the lewis

turning point at the start of this decade. The flow

of cheap rural labourers is drying up, enabling

employees in industry to demand higher wages

without their productivity levels rising accordingly.

This causes profits to decline and/or the price of

goods for domestic consumption or export to rise.

Entrepreneurs have less money for investment and

exports are squeezed, which adversely affects

growth.

New currency regimeOn the other hand, Chinese consumers have more

money to spend. a transition is taking place from

an investment-driven to a consumer-driven

economy, and this poses a challenge to Chinese

policymakers. This transition will occur in fits and

starts, occasionally triggering fears of a hard

landing.


The Chinese economic transition will have

an impact on the rest of the world. China’s

demand for commodities will decrease

further and this is one of the reasons for the

lower commodity prices. There will be

growing demand for capital goods used to

manufacture high-quality products.

Demand for luxury consumer goods will

also rise thanks to the growing Chinese

middle class. a more flexible exchange rate

is important here, given that it can be used

to manage import volumes. It should there-

fore come as no surprise that, after a long

period of maintaining a more or less fixed

exchange rate, the Chinese government is

taking steps in this direction. In august

2015, the People’s bank of China, the

Chinese central bank, devalued the

renminbi by 1.8%. at the same time,

they announced that it was to leave the

exchange rate of the domestic, onshore

renminbi more to market forces. The

offshore renminbi now plays a greater role

in setting the daily reference exchange rate,

from which the currency can deviate by up

to 2%. The direction of the change is being

left more to market forces, but not the pace

of the change. This may have been a

precondition set by the IMf for awarding

the renminbi the status of reserve

currency that China so fervently desires.

Moreover, in December 2015 China

changed its exchange rate policy from a

de facto creeping coupling to the US

dollar to a system in which a larger basket

of foreign currency is taken into account.

This coupling is likely to be merely an

interim phase and the currency will ulti-

mately be fully decoupled. full exchange

rate flexibility will ultimately be positive

for Chinese economic stability and

growth, but the transition phase will

cause volatility.

Declining reservesOn balance, the renminbi has decreased in

value against the US dollar by about 5%

since mid-2015. This is a small decrease

compared to, for instance, the decline in

value of the euro over the past year. Yet

the depreciation worries investors, as the

currency weakness is accompanied by

substantial capital outflow. China is

dipping into its foreign currency reserves

at a fast rate in order to shore up the

currency. There are several underlying

reasons for the large capital outflow. for

instance, Chinese companies and banks

are reducing their debt listed in foreign

currency in order to diminish the

exchange rate risks, and renminbi carry

trades are currently being reversed. Capital

flight also plays a role. Unfortunately, it is

impossible to say exactly which factor is

dominant. The first two factors do not

pose an economic risk.

Convincing the ChineseThe risk of the renminbi weakening further

prompting Chinese households to convert

their assets listed in renminbi into foreign

currency is an economic risk, however. In

order to restrict this risk, it is essential that

Chinese policymakers succeed in convin-

cing the Chinese population that attractive

returns can also be earned in China. This

requires more than just stabilising

economic growth. Reforms also need to be

implemented in other areas, such as closing

loss-making (semi-)state-owned companies

and privatising others. China needs to

‘Policy makersmust think

of theirglobal position’


Chinese currency reserves (x billion USD)

Source: Bloomberg Source: Thomson Reuters Datastream

RMb exchange rate per USD

move away from a centrally-led market

economy towards a true market economy.

Proceed with tactChina is undergoing an economic transition

and this poses an internal challenge to

Chinese policymakers. a sharp devaluation

of the renminbi may be an attractive option

on the basis of domestic arguments, but

policymakers also have an external respon-

sibility. The Chinese economy is the world’s

second largest and, via trade and financial

channels, has a huge impact on the ups

and downs of the global economy. a sharp

devaluation could adversely affect global

financial stability and trigger further disin-

flationary pressure. China could compro-

mise its international position if it allows a

sharp devaluation, while it wishes to be

taken seriously by the West. We believe that

Chinese policymakers will continue to aim

for their domestic targets, but in doing so

they will not ignore the rest of the world.

They will allow the renminbi to depreciate

further, but temporarily suspend the

process if it causes excessive turbulence.

Ruth van de Belt

Investment Strategist

[email protected]

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

96 98 00 02 04 06 08 10 12 14 166

6.5

7

7.5

8

8.5

96 98 00 02 04 06 08 10 12 14 16

Fixed coupling to USD

Fixed coupling to USD

Creeping coupling to USDDevaluation

Creeping coupling to basket of currencies

years years


BREXITNO, THANK YOU

CaMERON SaYS HE WIll CaMPaIGN fOR EU

MEMbERSHIP WITH HIS “HEaRT aND SOUl”.

WE bElIEVE THaT UNCERTaINTY aND MaRKET

VOlaTIlITY WIll REMaIN HIGH OVER THE

COMING MONTHS.


/// visual fREEPIK, HENRIKE bEUKEMa

who throughout his premiership had to

deal with the continuing arguments over

Europe within his own party.

Now, we are in a new round of this

ongoing battle. The british government is

dealing not only with divided opinions

within the cabinet, but also with the UK

Independence Party (UKIP), a party that

was founded in 1993 with the explicit aim

of achieving a british exit from the EU. The

labour Party is not unequivocally in favour

of EU membership. The tabloid press is

largely Eurosceptic and enjoys focusing on

negative news about the EU.

Implications?ahead of the referendum, the ‘leave’ camp

stresses the savings that a brexit will bring

while the ‘Stay’ camp predicts financial

armageddon. If a brexit does occur, this

will cause a shock to markets. However the

scale of the impact on the UK economy will

ultimately depend on agreements with the

EU and other countries after its exit. We do

not expect a particularly advantageous deal

with the EU, as this would play into the

hands of the Eurosceptic parties in conti-

nental Europe. The City is and will remain

important. a brexit would cause huge

uncertainty in the UK financial sector and

britain’s large and global financial services

industry is already a politically sensitive

point with certain EU members. This further

complicates the need to reach trade agree-

ments in this area that are inherently diffi-

cult and complex.

although a brexit may bring some financial

The UK government itself is a proponent of

EU membership, but in an adapted form

that takes account of certain recurring

complaints of the british. In february british

demands were addressed, albeit partially.

Will this be enough to avert brexit? Doubts

about UK membership of the EU are not

new. In the Thatcher era a large proportion

of the Conservatives were opposed to the

European idea because of a perceived

threat to britain’s identity and sovereignty

posed by an ‘ever-closer union’. The oppo-

sition between the UK and Europe was seen

as ‘us’ against ‘them’. During Thatcher’s

tenure as Prime Minister, she negotiated

with the EU and the popular perception is

that she won important concessions. In

1993 she was succeeded by John Major,

In 2015, British Prime

Minister David Cameron

promised the UK electorate

that he would hold a

referendum on the UK’s

membership of the

European Union (EU)

if he won the general

election. What would it

mean for the UK if Brexit

becomes reality?

Michael Wray

Kempen Fiduciairy Management

(London)

[email protected]

benefits – as there will no longer be a

contribution to the EU budget and maybe

less regulation – it is most likely that the

economic consequences will be slightly

negative on balance. Not just in the short

term but potentially also the medium and

long term.

Political consequencesThe economic impact of the UK’s departure

is likely to be small on the EU as a whole;

the consequences for individual member

states could be considerable. It could also

increase the political headwinds against the

move towards closer European integration.

However, given the challenges facing the

EU and the Eurozone, such as the persisting

problems in Greece, the refugee crisis and

growing Euroscepticism, the EU will be

keen to put this issue behind them and

move on.

OUR SCENARIO: NO BREXIT The referendum will take place on 23 June. The Cameron government has

achieved some recent victories in negotiations on its EU membership. The EU has made a number of concessions on migration, economic

policy and sovereignty. The british Prime Minister can advise his people to vote in favour of EU membership, but no level of concessions

would have been enough to please many of the british Eurosceptics. Polling evidence shows a slight preference to remain on average,

but recent polls demonstrate that there is a significant risk of a brexit. Turnout will be important and is difficult to predict. for the time

being, our central case is that the UK will remain a member of the EU. Past experience tells us that british voters have usually voted in

favour of the status quo in referenda. In our opinion a brexit poses a tail risk. However, uncertainty will remain high over the coming

months, as will market volatility.

Ruth van de Belt


[email protected]


Monty Python’s lesson

In his reflection on the 2008 financial

crisis, Dutch Professor of Risk

Management Theo Kocken explained

to Monty Python icon Terry Jones

that economics teaching glorifies our

rational desire for prosperity (boom)

and ignores the economically-disrup-

tive forces of human greed. Conse-

quently, many people believe that

crashes cannot be prevented or

avoided and that they are in fact a fixed component of the

economic cycle. The result was a joint project to spread know-

ledge of recurring economic instability. This is done using an

interesting combination of conversations with experts, light-

hearted humour, including Muppet-like animations, and

analyses by experts who include Nobel Prize winners. The film

also examines the 1929 crash and Dutch Tulip Mania.

TiTLE: Boom Bust BoomDiRECToR: Terry JonesSCREENPLAY: Terry Jones and Theo KockenCAST includes John Cusack, Dirk Bezemer, Zvi Bodie and Willem Buiter

When the bubble bursts

This film takes viewers through the rise

and fall of the US housing bubble,

which burst in 2008. Who were the

men who succeeded in making money

out of all that misery and how did they

do it? The inflating of the US housing

market and the financial markets as the

place where parties prefer to parrot

rather than correct each other is

portrayed using caricature. The big

Short tells its tale at a cracking pace and contains humour and

interludes in which global stars explain Wall Street behaviour.

The film ultimately sets its audience thinking. Where are the

brakes in the financial system and is earning money in the short

term really more important than averting a foreseeable problem

with long-term consequences?

TiTLE: The Big ShortDiRECToR: Adam McKaySCREENPLAY based on the book The Big Short by Michael LewisCAST: Christian Bale, Steve Carrell, Ryan Gosling and Brad Pitt

On 2 December 2015, we hosted

our first Kempen cocktail reception

at the National Gallery in london.

The evening consisted of great

food and wine, and provided the

backdrop for introducing our new

colleagues to our clients and key

contacts in the UK. To make the

evening memorable for all who

attended, we invited Ilka van Steen,

the curator of the art collection

owned by our parent company Van

lanschot, along with the amazing

replica of one of Van Gogh’s

‘Sunflowers’ paintings. She walked

us through the history of the

painting and gave us an insight

into the artist himself.

Paul Gerla gave an inspiring speech

on our heritage; how we should

share knowledge and learn from

each other and how we intend to

build a successful fiduciary

Management business in the UK.

15Kempen Insight, March 2016

a NIGHT aT THE MOVIESfOR INVESTORS

15

Evert Waterlander isDirector Client Solutions at Kempen Capital [email protected]

the man who brought down Barings

This docudrama shows how leeson

strayed from the straight and narrow

by linking unauthorised transactions

to a fictitious client account. In the

meantime, as he becomes an incre-

asingly important ‘profit machine’,

no obstacles are put in his way.

leeson finds himself celebrated at

barings and takes a huge gamble in

order to recoup his covert, loss-ma-

king positions. These positions collapse after the Japanese

market plummets in the wake of the Kobe earthquake. leeson

goes on the run and discovers that his actions have brought

barings to its knees. We all know how this ends: barings went

bankrupt in 1995 and leeson went to prison.

TiTLE: Rogue Trader DiRECToR: James DeardenCAST: Ewan McGregor and Anna Friel

WElCOME


Currency fluctuations are having an increasing impact on economic and investment results. Standard budgetary and monetary policy is being pushed to the limit.

The use of currency as a tool is growing in

popularity among policymakers. Exchange

rates are primarily affected by the balance of

trade, budgetary and monetary policy,

economic growth and inflation. The interac-

tion between these factors constantly alters

the demand for and supply of a currency,

which makes the direction of that currency

unpredictable in the short term.

Real effective exchange rates The exchange rate is the price of two curren-

cies compared to one another. a euro-US

dollar rate of 1.20 therefore simply means

that for 1 euro you can buy 1.20 in US dollars.

You cannot conclude from this that the euro

is worth more than the US dollar, however. a

real exchange rate is required to determine

what a currency is ‘worth’, which means that

you have to correct for local price levels. for

instance, you can compare currencies objec-

tively, as the law of one price applies in the

long term (the big Mac index). If, for instance,

a product is 20% cheaper in US dollars than

in euros, it is simply a matter of time before

traders take advantage of this (arbitrage).

Traders buy the product in US dollars, sell it

in euros and pocket a ‘risk-free’ profit. The

behaviour of arbitrageurs accidentally guar-

antees that real exchange rates tend towards

equilibrium.

as countries always trade with several other

countries, we need to combine the different

real exchange rates to reach one price. This

price is the real effective exchange rate (REER)

and reflects the fundamental value of the

currency. a REER of below 1 points to under-

valuation against the rest of the world and,

vice versa, over 1 points to overvaluation.

Not perfect, but usableThe insight that the REER provides into the

fundamental value of a currency and in turn

into a country’s competitive position has led

to many international organisations, such as

the OECD and the ECb, using it in their

economic forecasts.

Caution is due in translating REERs directly

into investment decisions: trade flows and

price growth are important components in

calculating the REER, but are not always easy

to gauge. for example, the price index

selected as an indication of the growth of the

competitive position is subjective in itself and

it is difficult to obtain a complete overview of

trade data.

for this reason, we believe it is sensible not

to draw very firm conclusions in the case of

REER values close to 1: they could point to

either a change in the REER valuation or to

white noise, i.e. measurement difficulties. In

order to ensure that we are not reacting to

white noise, we apply a margin of at least

10% of the fundamental value before we

decide whether a currency is overvalued or

undervalued. a currency that is overvalued

or undervalued may be a reason to adjust the

percentage of the currency hedge during the

annual portfolio review. The most important

currencies when taking this decision are the

euro, the UK pound and the US dollar.

Currency impact The inclusion of expected currency fluctua-

tions in investment decisions means moni-

toring the expected difference in the return

expressed in local currency and in euros. Yet

currency fluctuations are not equally relevant

to all asset classes. a few asset classes are by

their very nature highly volatile, leading to

currency fluctuations having little effect on

the total return. In the short term this chiefly

applies to equities, in the long term also to

other real assets such as real estate and infra-

structure. However, currency fluctuations do

have a significant impact on nominal assets

such as liquid assets and bonds. Currency

volatility is high compared to the nominal

return on these assets, causing currency fluc-

tuations to affect the expected return greatly.

Within the risk-avoiding character of bonds,

we therefore prefer to hedge currencies.

Exchange rates affect investment results

Florian Broekhuizen


[email protected]

à a detail from ‘De Geldwisselaar’ (The Money Changer) by follower of Marinus van Reymerswaele


Are there still sufficient prospects in the financial markets

for long-term investors? Investment Strategist Marius Bakker looks

at the facts.

We are currently seeing valuations

becoming less attractive for almost all asset

classes as a result of years of upward

markets. Expected returns are low across

practically the whole market, and they

often yield too little reward for the risk

taken. Market volatility has also increased

sharply over the past few months. In this

climate, capital retention is nearly as

important as the return on capital. Govern-

ment bonds are safe investments but

currently yield very little due to the effect

of the central banks’ expansionary mone-

tary policies. Yet risk-bearing investments

such as equities also offer insufficient

reward, especially given the current market

climate.

Frameworkas investors we want to be sufficiently

rewarded for the risks involved in our

investments. Our framework for deter-

mining the return we require is based on

the assumption that each asset class adds

a specific risk. for instance, government

bonds need to reward us for their long

duration and the risk of inflation eroding

the principal. In the case of credits, the

additional component is credit risk. Share-

holders have a claim on the profits that are

shared, but they are at the bottom of the

capital structure and therefore need to be

given a higher reward. In most cases, the

historical reward is a good guide. We

demand a lower return for safe investments

such as bonds than we do for equities, and

we want a greater reward for emerging

markets than for developed countries. We

use this framework to decide whether an

investment is attractively valued or not. If

the expected return on an asset class is

roughly the same as the return we require,

then it is neutrally valued in our eyes.

above this level investments are increas-

ingly attractive, but below this level the

opposite is true.

Neutral risk attitudeThe quantitative easing policies pursued by

central banks mean that interest rates

around the world are still close to their

historical lows, and in some countries they

are even negative. This also has an impact

on government bonds, which are currently

offering investors low yields. Consequently,

investors seeking return have driven up the

price of riskier investments, leading to

many asset classes becoming highly

Time forcaution


overvalued. We expect valuations to

normalise over the next few months. This

was also the reason behind our decision to

reduce risk at the end of 2015. It is always

tricky to predict the pace at which valua-

tions revert to trend. We were (and still

are) of the opinion that the period in

which risk is substantially rewarded is

slowly coming to a close. Caution is

essential in order to restrict capital loss.

The normalisation of valuations will be

accompanied by prices decreases and

volatility. The good news is that this will

make investments more attractive in the

longer term.

Relative assessmentalthough many asset classes are not

particularly attractive in an absolute sense,

investors can still exchange a number of

risks. bonds are the most obvious choice

when we seek a lower level of risk, although

they currently offer a very unattractive

yield. This is chiefly because bond yields in

most developed regions are close to their

historical lows. However, credits do offer

sufficient additional return to compensate

for credit risk. We always find the high yield

section of the bond market attractive.

The economic climate in the medium term

is crucial to deciding where and when to

adjust portfolios. like credits, equity

markets have already undergone a substan-

tial correction in 2016. In spite of the

decrease in prices on global equity markets

over the past few months, price/earnings

(P/E) ratios remain above the historical

average.

Outlook for growthEquities are expected to weaken further as

soon as the economic cycle picks up. The

expansionary monetary policies that have

boosted the markets over the past few

years are now less stimulatory. at the end of

2015, the US fed raised interest rates for

the first time in over nine years. The US

economy is the first to do so and we antici-

pate a slowdown later this year. We there-

fore anticipate fewer interest rate increases

and are cautious about US equities. Europe

still has room for growth and the ECb is

also poised to stimulate the economy via

monetary policy. as a result, thanks to

historically-low interest rates in the Euro-

zone, risk premiums on European equities

still offer sufficient reward. Yet Europe is not

an island. Given the current economic cycle

in which commodity prices are being

squeezed and the Chinese economy is

slowing down, we are more cautious about

the global outlook for growth. European

equities are more attractive than their US

counterparts, but this is a relative assess-

ment.

Balancedas only limited yields can be earned based

on valuations and the economic cycle is

also slowly heading towards the final phase,

we believe it is now time to operate more

cautiously. after years in which price gains

were the determining factor, the economic

risks are now increasing. It is no longer ‘buy

weakness’, but time for a more balanced

approach in which capital retention is

leading and ‘selling into strength’ is also

essential.

Marius Bakker


[email protected]

%

10

8

6

4

2

021 3 4 5 6 7 8 9 10 11 %

Exp

ecte

d re

turn

Required return

EMU BOND

EUR CREDITSUS GOVERNMENT BONDS

US EQUITYHIGH YIELD

EU EQUITYEM GOVERNMENT BONDS ($)

EM EQUITY

Expected vs required return

Source: Kempen Capital Management

The solid line shows where the required return is equal to the expected return. The dotted line shows that the slope of theline connecting expected equity and bond returns (the risk premium) is still the same, but that expected returns are lower.



/// visual PHIlIP JENSTER

Changingfacts

financial markets move between hope

and fear, euphoria and panic and bull

and bear. In our investment process we

incorporate this into the third building

block: sentiment. While valuations are

crucial in the long term and the

economic cycle determines the

medium term, sentiment affects the

short term. as long ago as 1966 Nobel

Prize winner Paul Samuelson said in

‘Wall Street indexes predicted nine of the

last five recessions’ that the equity market

was often not the best forecaster. This is

still much better than the average econ-

omist. When was the last time you heard

an economist predict a recession? In

about half the cases, the panic is nothing

more than a ripple on the surface. In the

other half, however, there is good

reason to be worried.

let us look at the facts. There was panic

on the financial markets in the summer

of 2015. Investors thought en masse that

China was heading for a hard landing

and at the same time that the US fed was

about to raise interest rates. In retrospect,

the panic proved to have no basis in

fundamentals. It was simply the expec-

tation that these were about to change

that caused the panic and investors

subsequently overreacted. There was a

short-term opportunity to increase risk.

We are now in 2016 and this year kicked

off with another panic phase. Yet we

believe that there is more reason for

concern this time. as you can read else-

where in this edition, there are doubts

about Chinese growth, concerns about

credits and high valuations – and there-

fore low expected returns – in many asset

classes. In a climate in which economic

growth is levelling off and inflation is

declining because oil reserves just won’t

diminish, these issues are a matter for

concern.

We are of the opinion that markets got

out of control and overreacted last

year. Prices are again reacting severely

now, but as the economic situation is

fundamentally different from that in

2015 it is our belief that the markets are

in the right this time. We are currently

seeing not just a change in forecasts

but also a change in facts. It is time to

operate more cautiously. after all, lean

years always follow on from good

years. after years of capital growth the

mantra for the next few years is capital

retention. Exactly what you would

expect of an asset manager.

Roelof Salomons is Chief Strategist

at Kempen Capital Management

and Professor of Investment Theory

& Asset Management at the

University of Groningen.

[email protected]

The End

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Kempen Insight March16