06 Investment Forum12 Rising leverage24 Human and Machine28 Risk Management

Update Magazine

Active is:Allianz Global Investors

Update I/2019

Contents

04 SpotlightsNews from the world of Allianz Global Investors

06 Investment ForumConclusions and themes from our Hong Kong Investment Forum

12 Rising leverageThe global debt supercycle

22 Capital Market OutlookCapital market implications 2019

36

38

Allianz GIobal Investors TodayDividends: An airbag for your portfolio

InterviewProf. Richard B. Freeman, Faculty co-Director of the Labor and Worklife Program at the Harvard Law School

28

24Risk Management10 Years After: Insights for Sustainable Risk Management

Human and MachineHow Allianz Global Investors uses artificial intelligence in active investment processes

Dr Jan Spelsiek, Head of Digital Transformation Global Strategy, Allianz Global Investors

Dear Reader, In recent years, Artificial Intelligence (AI) has become one of the most widely discussed topics in the economic press, and for good reason. Artificial Intelligence is in no way science fiction, and is in fact already an essential component of operating processes in many companies, and a vital factor in ensuring their ability to compete in the future. AI applications are already firmly established in customer service, marketing, production and logistics processes.

As these AI applications are developed further, attention is increasingly moving towards the interaction between humans and machines. In their book “Human + Machine”1, Daugherty and Wilson demonstrate the huge potential benefits offered by the collaboration of humans and AI, when their respective strengths are combined in a symbiotic relationship.

Allianz Global Investors also believes that the use of AI offers great potential for active portfolio management, and has been gradually expanding its expertise in this area for several years. In his article Thomas Zimmerer outlines how Allianz Global Investors uses AI for active investment processes.

Furthermore, an interview with Prof. Richard B. Freeman conducted by Hans-Jörg Naumer looks at the relationship between humans and machines, and demonstrates how employee equity participation is becoming increasingly important in the age of intelligent robots.

In an analysis produced by Thomas Stephan, he presents in detail the substantial added value created by long-term active risk management. Dynamic risk management solutions are capable of reducing risks significantly in poor fiscal years, while still maintaining the given yield potential over the course of a complete market cycle, which is highly relevant for institutional investors, especially given the current capital market environment, and in light of the article by Stefan Hofrichter on the “Global Debt Supercycle”.

Neil Dwane has produced five points summarising the conclusions for investors drawn from the findings of the Investment Forum held in Hong Kong at the start of the year.

I hope you find it a stimulating read.

Dr Jan Spelsiek

Human + Machine

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Digital evolution in asset managementLast November, 30 experts from technology startups in New York, London, Milan and Bangalore were invited by Allianz Global Investors to come together to brainstorm on the use of Artificial Intelligence and other technologies for asset management.

As part of a “hackathon”, they had 49 hours to tackle the following challenges: How can Artificial Intelligence and alternative data complement traditional data analysis to improve asset class forecasts? How can AI algorithms limit systematic cognitive bias in the process of selecting stocks? Which alternative data sources such as social media, search engines, job portals and online marketplaces can complement AllianzGI’s own research, and how?

Around 100 participants watched as startups presented their ideas to a panel of experts. The best solution for each of the three ‘challenges’ will be implemented as a prototype in 2019, together with the winning company.

MORE ATwww.allianzgi.com/update- magazine/hackathon

AREF II now fully investedThe Allianz Renewable Energy Fund II (AREF II) has been fully invested within 24 months, following the purchase of further photovoltaic plants in Italy and France. The issuing period for AREF II to European institutional investors began in March 2016, and closed for further investments on November 15, 2016. Just like the first Allianz Renewable Energy Fund (AREF I), the AREF II fund invested around 350 million euros in European wind and solar power plants. In total, Allianz Global Investors’ Infrastructure Equity team manages roughly 1.6 billion euros in renewable energy and energy infrastructure projects.

Spotlights

Review Digital

Investing responsiblyAlongside an active approach to investment, Allianz Global Investors is also proactive in its client relationships. It is our conviction that sustainability factors are important investment performance drivers. We are therefore committed to integrating Environmental, Social and Corporate Governance criteria (ESG) into investment decisions, throughout the investment process and across all asset classes. Allianz Global Investors currently manages approximately 116 billion euros in line with the integrated ESG approach. Around another 28 billion euros are managed using dedicated sustainable strategies.

The latest 2018 Sustainability Report provides an overview of how Allianz Global Investors approaches the theme of responsible investment, and outlines the areas it focused on during the reporting period.

MORE ATwww.allianzgi.com/ update-magazine/esg

ESG

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Spotlights

A new team member in MunichAllianz Global Investors is further expanding its European private debt offering. Adrian Grammerstorf joined the Munich team at the start of the year, strengthening its mid-market private debt expertise. Alongside Paris, Munich is AllianzGI’s second European base for its private debt platform. This marks the second significant milestone in development in this area within a very short space of time, after AllianzGI announced in November 2018 that it is launching an Asian private credit team based in Singapore.

Allianz Global Investors Dividend Report 2019As the European economy threatens to weaken, there is also uncertainty regarding tougher global trading conditions, which is likely to spill over further into European equity markets, despite the ongoing positive economic climate. In uncertain market phases like this, high-dividend stocks can help to stabilise an equity portfolio, because dividends cushion price setbacks and generate predictable income. Equities with a high dividend yield also seem to experience much less extreme volatility than shares in companies with lower dividend payments.

Find out more on pages 36–37.

MORE ATwww.allianzgi.com/update- magazine/privatcredit

Outlook Expansion

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Conclusions and themes from our Hong Kong Investment Forum

As our investment experts gathered in Asia’s financial centre, our proximity to mainland China seemed particularly fitting given the US-China trade war that has been roiling the markets. Amid rising global leverage, political uncertainty and a patchy global economy, taking an active, long-term view may be investors’ best approach.

AUTHOR: NEIL DWANE

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Investment Forum

Source: Allianz Global Investors, Bank for International Settlements, Datastream. Data as at Q1 2018

%

50

100

150

300

250

200

350

400

0

A/ DELEVERAGING? WHAT DELEVERAGING?

GLOBAL DEBT TO GDP BY REGION

1990 1994 1998 2002 2006 2010 20182014

Global Emerging Markets Emerging Markets ex ChinaDeveloped Markets

Last year was generally a challenging one for investors overall, with poor returns and renewed volatility giving global investors few places to hide, particularly as the year came to a close. The markets are wary of the growing signs of economic fatigue around the world. Late-cycle fault lines have become more visible: corporate profit growth has peaked, fiscal stimulus is waning and central banks are providing less liquidity.

Yet perhaps the biggest problem facing the global economy is leverage (see Chart A/). The world essentially solved the last debt crisis by taking on more debt. China is one of the worst offenders – with a debt-to-GDP ratio of approximately 300% in 2018 – but many other countries have levered up as well, bringing US dollar-denominated debt outside of the US to record levels. For example, Turkish companies will need to refinance USD 250 billion in US debt in the coming years – a struggle with rates set to rise.

Economists can debate what constitutes a “normal” level for interest rates, but rates generally haven’t normalised yet: they seem set to stay lower for longer. This makes the

1/ Global growth may be patchy, but active investors can navigate recession fears

hunt for income all the more pressing – particularly with even low levels of inflation able to drastically reduce purchasing power over time.

So where is there yield to be gained? We are finding attractive yield potential in Asian fixed income and in high-yield bonds, though weaker growth, higher volatility and declining credit quality bear monitoring. Income can also be found in dividend yields from equities in Asia and Europe – less so in the US – and in inflation-linked bonds.

Economic growth around the world is getting patchier, and the US is slowing down amid growing fears of a recession. Yet although the US economy has the potential to deteriorate in 2019, as signalled by a flatter yield curve and weaker housing market, a recession seems unlikely this year. Even if a recession were to happen, we think active investors will still be able to find opportunities by focusing on the fundamentals – including using proprietary research.

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Markets no longer take geopolitical tensions in their stride. Headlines about populism – and the accompanying rise in anti-globalisation sentiment – have the power to spook equity, bond and currency investors. A rolling-back of globalisation may make it harder for firms to arbitrage away costs in pursuit of optimal supply chains and margins – and trade wars could make matters worse.

In the US, President Donald Trump faces a divided Congress and a renewed focus by the Democrats on providing checks and balances. Mr Trump will soon pivot to re-election mode, and to win re-election in 2020 we believe he will pull all the levers at his disposal – particularly in the area of trade policy. As such, we wouldn’t be surprised if Mr Trump soon looked for some way to wind down the US-China trade war and declare victory. He may also look for common ground with Democrats, compromising on areas such as infrastructure spending or targeted health care reform – although any move to reduce drug prices may hit pharmaceutical stocks.

In Europe, Britain’s exit from the European Union looks set to be a long-running theme. Whatever the ultimate Brexit “end state”, more frictions in trade with Europe seem unavoidable. This appears likely to affect EU member countries and UK sectors differently, though Brexit will be a particularly bumpy ride for UK assets.

EU Parliamentary elections, internal battles in Italy and France, Germany’s weakening economy, and important elections in India and Indonesia also loom large. Yet even as investors keep an eye on these developments, they should take care not to write off opportunities at the regional or sector level. Being more granular and selective, and seeking out strong fundamentals, could be a smart contrarian approach.

2/ Trump and Brexit aren’t the only political question marks; just the ones attracting the most media and market attention

3/ A “tech cold war” could be more significant than a trade war

News headlines about the US-China trade war may be obscuring the potential for something more serious: a potential “tech cold war” between the world’s two largest economies (see Chart B/).

The US sees China as a strategic threat, and China wants to rely less on American technology. Both fear becoming too interdependent on shared technologies and providers, particularly now that they see how a trade war could cripple current supply chains. As a result, we fear that two competing high-tech eco-systems could emerge over time – one American, one Chinese – and the rest of the world, including China’s neighbours within Asia, may be forced to choose sides. This could be damaging to business models and supply chains, particularly those of large American tech firms that invent in Silicon Valley and manufacture in Asia.

At the same time, some countries are poised to benefit from the increased competition between China and the US – particularly countries like Thailand and Vietnam, but also India and Indonesia. So while there may be losers from a tech cold war, there are still opportunities for investors to take risk to earn returns from the winners that emerge from this conflict.

Overall, we believe China and the US need each other more than they don’t, which suggests a toning-down of the trade-war rhetoric before eventual reconciliation. Until that happens, we could see continued volatility and reduced growth. Along the way, investors may want to pursue strong secular high-tech themes within the equity markets – including intelligent cities, artificial intelligence and disruption.

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Investment Forum

China can be a polarising subject for investors. Many believe that China’s growing economic power – stemming from its focus on innovation and “rebalancing” its economy towards a consumption-driven one – is the most compelling investment story of the 21st century. Others are more concerned about China’s government interference, US-China trade wars and the credit-fuelled nature of China’s economic development. The local equity market, dominated by short-term retail investors, can be volatile.

While we understand China’s challenges, we think Beijing is well placed to handle them. China’s government understands that its economy needs to reduce leverage, and that it must control the use of credit. The country’s leadership is seeking to strike a balance between reform and growth, and we believe they will do what it takes to be successful. One needs only to look at the sheer scale of the “Made in China 2025” initiative and the “one belt, one road” programme to understand China’s commitment to securing its future – incurring short-term pain to secure long-term gains.

Many of our clients have a similar long-term view about China. While the ongoing trade dispute continues to be an issue, we think it will be resolved in the medium to long term. And even in the event of a tech cold war, investors would benefit from exposure to both eco-systems.

Navigating the local equity markets requires a long-term approach and a focus on fundamentals. To that end, incorporating ESG factors is critical. Indeed, as at May 2018, 86% of China’s A-shares included in the MSCI had below-average governance ratings. That’s a prime example of why we conduct our own ESG research – to make our own assessments of this critically important area – and why we share our insights with our clients.

China is an asset class that looks attractive to many investors – particularly with China’s A-shares currently unloved by the markets, and with China’s bonds a source of attractive real return potential inside a global bond portfolio. We believe that as ESG standards improve, the case for China will only improve further.

4/ China is an asset class in its own right

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Investors can be uncertain where to move in today’s markets, but taking risk off the table altogether can be too risky an option.

Investment Forum

Source: OECD data, UNESCO institute for statistics, Allianz Global Investors. US, France, Poland and Taiwan data as at 2015; all other data as at 2016. Size of the circle reflects the relative amount of annual R&D spending by the indicated country, measured by USD purchasing power parity.

5-Year CAGR

–5.0

5.0

0.0

15.0

10.0

–10.0

B/ IN THE R&D RACE, CHINA HAS BEEN RAPIDLY GAINING ON THE US.

GLOBAL RESEARCH AND DEVELOPMENT EXPENDITURE AND GROWTH.

0.0 0.5

Poland

Greece

3.5

R&D as % of GDP

UK

China

Norway

Netherlands

Spain

Portugal

Italy

Czech

Japan

Korea

US

Finland

Taiwan

Sweden

Germany

DenmarkFrance

1.0 1.5 2.0 2.5 3.0 4.0 4.5 5.0

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Update I/2019

Neil Dwane, Global Strategist, Allianz Global Investors

Five investment conclusions

1/ Plan your future – focus on the long term Given recent market conditions and concerns about recession, it’s understandable that investors may be nervous that this long but lacklustre economic cycle is coming to an end. However, we don’t believe it’s finished just yet. So despite market corrections and volatility, investors should aim to benefit from the long-term power of compounding. Instead, look beyond the immediate news flow and political bluster to focus on balance-sheet strengths and other qualities that underpin the sustainability of investments.

2/ Actively diversify across all asset classes In addition to a mix of equities, fixed-income and cash, consider alternatives – they are less correlated to traditional asset classes, and may be able to help improve a portfolio’s risk-return profile. Also consider supplementing a diversified approach with contrarian ideas (such as UK equities) and counter-cyclical hedges (including US Treasuries). Asian and emerging-market sovereign bonds appear to be good places to hunt for income.

3/ Use volatility – be an active investor The markets showed signs of distress in late 2018, but we think they may have overreacted. While this kind of volatility seems here to stay – due to geopolitical tensions, monetary-policy normalisation and other factors – corrections in equity and credit markets may offer opportunities for active, selective investors to move back into some risk assets. Passive investing, based on backward-looking benchmarks, may fail to capture tomorrow’s opportunities while simply tracking the market’s volatility. Strong rallies could also be good times to reduce positions, but investors should resist the urge to time the market.

4/ The biggest risk is to take no risk Investors can be uncertain where to move in today’s markets, but taking risk off the table altogether can be too risky an option. This approach has the potential to harm purchasing power over time, and it ignores the good opportunities that we think still exist. Look to mitigate necessary risks by looking for quality holdings – as evidenced by good balance sheets, healthy dividends and strong governance. Draw on fundamental research to identify the stocks, sectors and trends that offer the potential for growth, and the ability to capitalise on long-term trends.

5/ Aim for an improved risk/return profile with ESG Environmental, social and governance (ESG) investing is a rapidly growing area of investor interest – and with good reason: ESG provides a vital lens for identifying quality, scope for improvement and the potential for value appreciation. Companies that focus on ESG factors may be better positioned for the long term, and can help improve the performance of portfolios. In emerging economies such as China, good governance is being increasingly encouraged. This can help companies grow in a responsible way, and should make these markets more attractive as companies evolve their practices.

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The global debt supercycleAUTHOR: STEFAN HOFRICHTER

In recent years, major international institutions like the International Monetary Fund, the Organisation for Economic Co-operation and Development, and the Bank for International Settlements have cautioned against rising leverage in the world economy.

Considering that we are only ten years removed from the global financial crisis – which was at its core a debt crisis – we decided to review where the world stands in the global debt supercycle. We took a close look at a range of factors – such as debt levels, US dollar debt outside the US, and which sectors are borrowing and lending – to assess their implications for growth and financial markets.

12

Rising leverage

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Source: AllianzGI, BIS, Datastream, data as at Q1 2018

Figures in percentage points

50

100

150

300

250

200

350

400

0

A/ GLOBAL LEVERAGE BY ECONOMIC SECTORS

1990 1994 1998 2002 2006 2010 20182014

Private non-financial sector Financial sector GovernmentTotal

Our research shows that global leverage for all sectors – ie, governments, private households, non-financial companies and the financial sector – has continued to rise since the financial crisis. It currently stands at 298% of world GDP, which is close to the all-time high of 303% set in 2009, but significantly higher than the 279% level set in 2006, on the eve of the financial crisis. In the developed world, this figure is 340% of GDP – lower than the peak levels observed ten years ago, but it has been rising since 2014. In emerging markets, the amount of leverage totals 228% of GDP – about two-thirds higher than it was in 2006.

If we look at leverage by economic sectors globally, it has continued to rise in the private non-financial sector (private households and companies) and in the government sector; in fact, it has recently reached all-time highs. But leverage in the financial sector has been in decline since the financial crisis (see Chart A/).

Not all of this debt has been issued in domestic currencies. Notably, the amount of US dollar-denominated debt held outside the US has doubled during the last ten years, both in advanced and developing economies; it now stands at about USD 11.5 trillion. Moreover, US dollar debt-to-GDP ratios in both developed and emerging markets are now at or close to their multi-decade highs (see Chart B/ and C/)

1/ How much debt has the world added?

– which will likely be quite a challenge for these borrowers in times of rising US interest rates and a strong dollar. Overall, the rise in US dollar debt has been quite broad-based, and can’t be blamed on select countries like Turkey or Argentina, which saw their respective currencies tank in 2018.

This brings us to another aspect worth highlighting. While banks are still the biggest lenders, some of their market share has been grabbed by many other non-bank financial institutions – such as insurance companies, pension funds, mutual funds, hedge funds, Chinese trusts, private equity funds, broker-dealers, real estate investment trusts, captive financial institutions, special purpose vehicles and others.

The question is, does this leave the financial system less stable or more stable? A decline in financial-sector leverage is in many ways a welcome development. However, some of the “new players” in the credit market are highly leveraged and less regulated – for example, hedge funds – and we know little about their interconnectedness. The reason this is an issue is that in times of financial-system stress we may see changes in market dynamics that are difficult to anticipate – changes that could be damaging.

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Rising leverage

US dollar debt-to-GDP ratios in both developed and emerging markets are now at or close to their multi-decade highs – which will likely be quite a challenge for these borrowers in times of rising US interest rates and a strong dollar.

Source: AllianzGI, BIS, IMF, IIF, data as at Q2 2018

Figures in percentage points

5

10

20

15

30

25

0

B/ US DOLLAR-DENOMINATED DEBT OUTSIDE THE US IN % OF GDP

2000 2005 2010 20202015

Developed Markets

Source: AllianzGI, IMF, IIF, data as at Q2 2018

20

15

Figures in percentage points

25

10

C/ USD DEBT IN EMERGING MARKETS IN % OF GDP

1995 20001997 201120082003 2019201620132005

Emerging market ex-ChinaEmerging market economies

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Source: AllianzGI, Datastream, data as at Q3 2018

% %

2

1

3

4

5

6

65

60

55

70

75

Interest cover (EBITDA/interest expenses) – estimateDebt/GDP

050

D/ US NON-FINANCIAL CORPORATE LEVERAGE VS INTEREST COVER

1984 1988 1992 1996 2000 2004 2008 2012 20202016

Clearly, debt levels have been rising around the world, but this only tells part of the story. A closer examination of which sectors are borrowing and lending may shed more light on the issues associated with rising global leverage.

Let’s start with the US, which is the biggest debt market in the world. Even though leverage has declined overall since the financial crisis, the non-financial corporate sector has levered up significantly, reaching 73% of GDP (see Chart D/). This matches the previous record set in 2009, and it is significantly higher than the 64% level seen at the end of 2006, just before the financial crisis. This rise in non-financial corporate-sector debt can largely be explained by debt-financed share buybacks, and this kind of leverage does not matter as much in times of strong economic growth, low interest rates and spreads. However, we are now late in the economic cycle, and spreads have widened since early 2018 on the heels of Federal Reserve rate hikes and a subsequent increase in market volatility. It remains to be seen if the recent change in Fed policy following a series of weaker cyclical data will soothe market concerns.

2/ Where did all the money go?

The rise in the amount of US corporate debt is not the only reason for concern: the quality of this debt has deteriorated as well. More than 40% of all outstanding bonds are BBB-rated. Moreover, the leveraged loan market – the market for loans to highly leveraged companies – is as buoyant as it was in 2006-2007, and it is bigger than the high-yield bond market. In addition, lenders receive less protection than they did in the past. So-called “covenant-lite loans” now account for about 80% of all bonds – a fact that former Fed Chair Janet Yellen drew attention to a few months ago.

In many economies, there can be an upside to higher leverage: a booming housing market. This has recently been the case in many countries that were not hit (or not severely hit) by the financial crisis – countries such as China, Turkey, Mexico, Malaysia, Canada, Sweden, Norway, Australia, New Zealand and Hong Kong. We think this situation was the unintended consequence of ultra-easy monetary policy in the US and Europe. Their low central-bank rates and massive liquidity injections depressed market yields globally, which lifted demand for credit and real estate in those economies where the private sector did not have to go through a painful balance-sheet adjustment a decade ago.

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Rising leverage

Source: AllianzGI, BIS, Datastream, as at Q1 2018

E/ REAL-ESTATE PRICE PERFORMANCE VS CHANGES IN PRIVATE-SECTOR LEVERAGE

Change in real corporate and household leverage during the past 5 years, in % of GDP Change in real house prices, in %

Spain –16 10

UK 6 23

Netherlands 9 14

Ireland 32 58

Germany 11 18

United States 13 28

Greece –13 –17

Japan 1 9

Italy –7 –15

Israel 22 30

South Africa 12 1

Korea 26 3

Sweden 29 37

India 26 23

Australia 21 33

France 18 –2

Switzerland 16 13

Russia 15 –33

Canada 26 34

Turkey 80 22

Hong Kong 54 45

Singapore 47 –1

Brazil –1 –14

China 108 30

Belgium 13 4

New Zealand 23 50

Portugal –15 28

Norway 8 12

Denmark –1 24

Mexico 49 11

Hungary –9 46

Poland 29 11

Malaysia 34 17

Thailand 30 19

US 2006 40 53

UK 2007 51 66

Price-to-rent ratio ≥ 50% above the long-term average

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The crucial question is, does this rise in leverage matter? And if so, under which constraints and to what extent? To answer these questions, it’s important to understand the concept of the “financial cycle”, which was developed by the Bank for International Settlements (BIS) after the financial crisis.

The financial cycle is a way to assess the medium- to long-term health of an economy; it is measured by the joint dynamics of private non-financial sector credit growth and house prices (see Chart E/). Financial cycles are significantly longer than business cycles, which capture the ups and downs in real GDP. The average financial cycle is 16 years long (6 years of contraction and 10 years of expansion), while the average length of a business cycle is 5 years (see Chart F/). Technically, financial cycles can be calculated in multiple ways, but all of them lead to very similar results. The approach we have chosen is similar, albeit not identical, to the approach used by the BIS. We calculate the average z-score of the credit gap – ie, private non-financial sector debt/GDP relative to trend – and the deviation of real house prices from trend (see Chart G/).

Our empirical work on the financial cycles in developed and emerging economies broadly confirms the BIS results for a smaller sample (see Chart H/):

3/ So what’s the problem with rising leverage?

• In times of an expanding financial cycle – that is, when house prices and private-sector leverage increases – economies tend to benefit from structural tailwinds. However, an expanding financial cycle does not preclude a recession – though compared to periods of a declining FC, recessions are less likely, less deep and less long. This makes sense intuitively: houses are typically the biggest single asset of every household and are usually debt-financed. Hence, an expanding financial cycle points to improving private household balance sheets and a generally expanding economy. The shallow recession in the US in 2001 is a good example of a recession in times of an expanding cycle.

• Conversely, when house prices are falling and banks are constraining credit growth – that is, when the financial cycle contracts – recessions tend to be deep and long. The financial crisis of 2007-2008 is the most severe version of a recession in times of a contracting financial cycle (we analysed the relation between financial cycles and recessions for developed markets only).

We also made another important finding: near the peak of a financial cycle, there is about a two-thirds probability that a country will face a financial crisis – be it a banking crisis, sovereign-debt crisis or foreign-exchange crisis. In our analysis, all but two of the 36 crises we identified happened around the peak of their respective country’s financial cycle.

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Rising leverage

Financial Cycle

Length 16 years

Contraction 6 years

Crisis probability at FC peak ca. 70%

Crisis preceded by FC peak >95%

Business Cycle (GDP)

Length 5 years

Contraction 1 year

Recession & FC contracting –3.4%; 11 q.

Recession & FC expanding –2.8%, 6 q.

F/ THE FINANCIAL CYCLE VS THE BUSINESS CYCLE – SOME STYLISED FINDINGS

FINANCIAL VS. BUSINESS CYCLE – STYLISED FACTS

Financial Cycle peaks are a warning signal for crisis, while GDP growth tends to be more stable when the FC is expanding.

Source: AllianzGI, BIS, The Economist, OECD, Datastream, IMF. Financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial-cycle calculations for 14 developed-market economies (US, UK, Germany, France, Italy, Netherlands, Spain, Portugal, Suisse, Sweden, Norway, Japan, Australia, New Zealand) and 12 (former) emerging-market economies (Brazil, Mexico, Turkey, Israel, Russia, China, Korea, Malaysia, Thailand, India, Singapore, Hong Kong) since the 1970s or later, depending on data availability. Business cycle analysis for developed-market economies only. Data on recessions during different stages of the financial cycle indicate the average peak-to-trough move in real GDP and the average number of quarters of GDP below the previous cycle peak.

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Source: AllianzGI, BIS, Datastream, data as at Q1 2018Legend: financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial cycle of country groups are GDP weighted averages of country-specific financial cycles; EUR proxied by DEU, FRA, ITA, SPA, NET, POR, IRE; Small open DM = CAN, SWE, CHE, NOR, AUS, NZL; Asian Tigers proxied by HKG, SGP, KOR, THA; other major EM = BRA, MEX, RUS, TUR, ISR, ZAF, IND

Figures in percentage points

–1

1

0

2

G/ EXPANDING FINANCIAL CYCLE IN MAJOR DEVELOPED ECONOMIES

1970

–2

20202010200019901980

Eurozone UK JapanUSA

In developed economies, the financial cycle is expanding in countries that either caused the financial crisis in the first place (the US, UK and euro zone) or that suffered severely (Japan). The financial cycle is also expanding in New Zealand.

Even though we can’t rule out a recession in the US, Europe or Japan in the coming one to two years – some of our models are indeed pointing at a rising recession risk – we believe that any recession there is likely to be moderate. The one caveat we have to mention, however, is the lack of policy ammunition left with which to counter a recession. In terms of monetary policy, nominal and real central-bank rates are still low in all major developed economies, and further inflating central-bank balance sheets would be technically and legally difficult. In terms of fiscal policy, government-debt levels are generally so high that future fiscal stimulus is likely to be constrained.

4/ Where in the financial cycle are we today?

To the contrary, the financial cycle is near peak levels – or just beyond them – in several Asian economies (including China) as well as in small, open, developed economies that escaped the financial-crisis fallout a decade ago (notably Canada , Australia, Norway and Switzerland). The financial cycle is also clearly in decline in several major emerging markets (Brazil, Russia, India and Turkey) as well as in Sweden. We therefore expect to see structural headwinds for economic growth in these economies. Moreover, these countries also face heightened risks of stress in their respective financial systems.

For investors, the high debt levels seen in the world today remain an important risk to watch, both for economic growth and for financial markets. This underscores the need for appropriate risk management and tail-risk hedging. Yet compared to the pre-financial-crisis period, the financial cycles of major developed economies are in reasonably good shape this time around – a fact in which we take some comfort.

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Rising leverage

Stefan Hofrichter, Global Head of Econo-mics and Strategy, Allianz Global Investors

Source: AllianzGI, BIS, Datastream, data as at Q1 2018Legend: financial cycle calculated as the average z-score of private non-financial debt/ GDP (credit gap) and real house prices relative to trend. Financial cycle of country groups are GDP weighted averages of country-specific financial cycles; EUR proxied by DEU, FRA, ITA, SPA, NET, POR, IRE; Small open DM = CAN, SWE, CHE, NOR, AUS, NZL; Asian Tigers proxied by HKG, SGP, KOR, THA; other major EM = BRA, MEX, RUS, TUR, ISR, ZAF, IND

Figures in percentage points

–1

1

0

2

H/ PEAKING OR CONTRACTING FINANCIAL CYCLES IN SOME DEVELOPED AND EMERGING MARKETS

1990

–2

202020102000

Small open developed markets

Other major emerging markets

ChinaAsian Tigers

Yet compared to the pre-financial-crisis period, the financial cycles of major developed economies are in reasonably good shape this time around – a fact in which we take some comfort.

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Update I/2019

Capital market implications 2019

Iran sanctionsFrance Are social protests jeopardising the reform process and fiscal sustainability?

Germany How stable is the grand coalition? Federal state elections in 2019

“America First” Trade conflict with China & RoW/ termination of the INF treaty*

Saudi Arabia How stable is the OPEC cartel? Where are reforms heading?

Syria and US withdrawal

Italy’s budget

European elections 5/2019: Performance of anti-EU parties?

World map of political risksBrexit

Our capital market implications give you a brief summary of the baseline macroeconomic scenario. In our world map of political risks, we also take a look at existing and potential hot spots.

22

Capital Market Outlook

1/ ECONOMIC TRENDLoss of economic momentum – late cycle reflation phase. Regional and sectoral differentiation. Ongoing labour market tightening will entail a further narrowing of the global output gap. Biggest risk: global trade war.

2/ LABOUR MARKETSUnemployment continues to decline around the world – unemployment decreases markedly in the euro area, down to a rate near NAIRU – wage pressures increase gradually

3/ PRICE DEVELOPMENTBase effects of the ups and downs of raw material prices are determining CPI time profile in 2019. Headline inflation subdued/lower due to the decline in energy costs. Core rates relatively stable. Price pressure on the producer level abating.

4/ MONETARY POLICYDivergence in monetary policy to continue in 2019. Fed with two upward steps this year. ECB will remain sidelined at least till fourth quarter – BoJ expansionary due to calm price climate – BoE action depending on Brexit decision – PBoC supporting national economic policy – other DM central banks more or less in normalisation mode

5/ FISCAL POLICYExpansionary effects of US fiscal policy are coming to an end. French President Macron forced to change fiscal course due to domestic wave of protests – budget deficit above 3% in 2019. Truce between Rome and Brussel about budget deficit, but no final solution.

6/ RISK FACTORSIntensifying autocratic tendencies – trade conflict – conflicts in Ukraine, the Middle East, North Korea, Catalonia – Brexit vote – US debt ceiling/government shutdown – EU: nationalist tendencies/refugees – debt crisis

MACROECONOMIC BASE SCENARIO

Russia/Ukraine conflict Violation of the INF treaty and arms build-up?

China: How stable is the economy? The new Silk Road as a geopolitical instrument.

Source: AllianzGI Economics and Strategy. Data as of March 2019. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. We assume no obligation to update any forward-looking statement.

* The INF treaty (“Intermediate Range Nuclear Forces”) between the US and Russia serves to ensure the elimination of intermediate-range nuclear missiles.

23

Update I/2019

How Allianz Global Investors uses artificial intelligence in active investment processes

You want to outperform the market and achieve better portfolio results? The artificial intelligence and machine learning integrated into the active investment processes of Allianz Global Investors can help investment experts to develop the decisive edge in terms of information.

AUTHOR: THOMAS ZIMMERER

24

Human and Machine

1/ The digital transformation of the financial sector

In principle data, for example on macroeconomic trends, is also available to any other asset manager for use in drafting statements about medium-term developments in market trends. The Digital Transformation Working Group at Allianz Global Investors is specifically investigating how high-frequency data can be used to improve the quality of short-term forecasts, with the help of modern technologies and alternative sources of data. Because the capital markets are currently quite dynamic, investment experts are always looking for more flexible methods in order to better exploit market volatility, and to design more robust portfolios.

3/ Modern technologies improve the quality of forecasts

It is a trend that nobody can escape: the changes brought about by digital technologies. The financial industry is also deeply involved in efforts to deal with this digital transformation. For asset managers, the focus is on how artificial intelligence (AI), machine learning and alternative sources of data such as social media, Internet search engines, the news, blogs or satellite images can be used to outperform the market, and to achieve better portfolio results.

While digital transformation has only just begun in the financial sector, it is already well under way in other sectors – for example in the self-driving cars segment. Examples from other sectors generally have a positive impact on the further development of machine learning. Asset management can also benefit from that.

In order to outperform the market, investment experts will have to draw complex conclusions which they then use to develop an information advantage over the market as a whole. New technologies offer the opportunity to take advantage of data processing and interpretation, and optimise market assessments. Implementing this at Allianz Global Investors is the focus of the Digital Transformation Working Group.

2/ AI is based on the processing of huge volumes of data

Two factors will be decisive in successfully applying AI. First: modern computers open the door with their enormous computing power, enabling us to process and evaluate very large quantities of data. The keyword here is “big data”, on which self-learning algorithms rely; the more data they receive, the more powerful they become. Second, and by extension, this involves machine learning. The “equities” asset class and multi-asset strategies show how these two factors can be integrated into the active investment process at Allianz Global Investors.

In the “equities” asset class, the focus is on using AI for the fundamental data platform and for factor investing. Allianz Global Investors has already integrated machine learning into several factor investing processes, although to date “big data” have been processed and evaluated only to a limited extent. The huge potential in this area needs to be further exploited. Currently, further focal points include natural language processing (NLP) and obtaining information from

unstructured data such as news and business and research reports from sell-side analysts. Investment experts are reviewing different areas of application, and would like to expand capacity in order to support quantitative and fundamental research and investment processes.

The idea behind using AI for multi-asset strategies is to take advantage of new technologies in order to evaluate larger amounts of data, and to make it possible to design a more efficient portfolio using machine learning. In addition, Allianz Global Investors is investigating AI’s potential for improving pattern recognition so that it can more quickly detect any anomalies in large data sets. Additional milestones include optimising and automating processes in order to free up capacity to generate new ideas. Ultimately, all data should be combined at a central site where they will be available across all asset classes for direct retrieval, in order to prevent unnecessary duplication of efforts.

25

Update I/2019

Thomas Zimmerer, Global Co-Head MultiAsset, Allianz Global Investors

The “Active is” approach also offers potential for the client. Indeed, investment experts would also like to use the new technologies to give clients optimised access to the products and solutions of Allianz Global Investors – including through digital channels. At the same time, the economic advantages created by using AI in the active investment process should not result in people being replaced as part of the digital transformation. While it is

true that the scalability of new technologies makes it possible to deploy staff more efficiently, this should not boil down to a decision between people and machines, but instead to intelligent interactions between the two. Using the latest technologies should give the people working at Allianz Global Investors more time to focus on the ideas of tomorrow.

In order to gain a deeper understanding of the current level of development of AI technologies, in November 2018 Allianz Global Investors organised a competition, the first Allianz Global Investors Hackathon, in which four companies from Bangalore, Milan, London and New York competed against one another to solve the same problem. Today, most companies claim that they are working intensively on machine learning and similar technologies, and undoubtedly there are start-ups that offer such services in isolation. In this environment, the hackathon offered a unique opportunity to look over their shoulders as some of these companies implemented their technologies under real-life conditions.

The event in fact acted as a catalyst, allowing the company to think about AI now in a broader context. It also enabled Allianz Global Investors to gain a more in-depth understanding of the issue, achieving decisive progress on projects started in recent months. The hackathon was never expected to deliver turn-key solutions, but instead to provide impetus for further research and development within the company. The important thing here was to realistically evaluate the results, not least because research in new

4/ Allianz Global Investors Hackathon pits start-ups against one another

5/ Interaction between people and machine is important

areas is never straightforward. The hackathon demonstrated how the company can approach the same problem in very different ways.

Allianz Global Investors places particular significance on taking an active approach, not only at this event, but also in the broader sense. Consequently, when integrating AI into investment processes, all actions taken should lead to decisions or assessments by the investment experts that differentiate the company from the market – in line with the brand’s “Active is” philosophy. After all, AI helps Allianz Global Investors to glean additional insights from complex data with the goal of creating portfolios that are differentiated from a market portfolio. Added to this is scalability: thanks to a complex system working in the background, the learning effect increases as the amount of data increases. This reflects an industrialisation of alpha, i.e., a fund’s excess performance compared to that of its benchmark. For a modern active asset manager this is essential in order to still be competitive in the market in five to ten years.

While it is true that the scalability of new technologies makes it possible to deploy staff more efficiently, this should not boil down to a decision between people and machines, but instead to intelligent interactions between the two.

26

Human and Machine

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.

Sources: AllianzGI, Financial Times, Mckinsey, Deloitte, as of H2 2017

ARTIFICIAL INTELLIGENCE: How the Artificial Intelligence revolution is reshaping our lives

Artificial Intelligence can now outsmart the human brain – rapidly crossing frontiers that would remain out of reach for us on our own.

Outsmarting the Human BrainMAY 2017An Artificial Intelligence program which mimics human intuition, instinct and learning beat the world’s #1 player at Go – a highly complex Chinese strategy game with an incomputable number of possible moves.

HEALTHCARE Artificial Intelligence applied to Healthcare covers diagnostics, physical rehabilitation and surgery.

Robots can make more precise incisions than humans wielding scalpels. Operations are less invasive and allow for quicker recovery times and lower hospital expenses.

Current value of robotic healthcare industry

MUSICChoosing from millions of tracks, a new emotionally intelligent speaker system uses voice analysis and the musical preferences of the user to play the perfect music for your mood.

Powering SuggestionRETAILGrocery retailers are exploring facial recognition to greet store clients and anticipate orders.

Smart shopping cards could soon deliver items to customers’ cars, and communicate with drones for home delivery.

Optimisation and ScalabilityLAWAn Artificial Intelligence system has been developed which uses language processing to analyse and answer legal questions, in a fraction of the time needed by lawyers.

The system reads through the entire body of law, and monitors any changes and updates that might affect ongoing cases.

EUR€9.35

bn

TRANSPORT100 million miles of driver data collected every day by the world’s leading transportation app to help shape the development of self-driving cars and mobility services.

Collecting Data

‡1

100mn

AI

EUR 842 billion What use of mobility services like ride-sharing could cut this to.

EUR 2.8 trillion What consumers are projected to spend on parking services in 2025.

15-20% of total passenger vehicle kilometres expected to be accounted for by mobility services like car-sharing by 2030.

27

Update I/2019

28

Risk Management

10 Years After: Insights for Sustainable Risk ManagementAUTHOR: PROF DR THOMAS G. STEPHAN

When Lehman Brothers was forced to file for bankruptcy protection in the early morning of September 15, 2008, the perfect storm – unleashed by U.S. subprime mortgages – that had been gusting through the global financial markets since 2007 turned into a hurricane. Institutions such as Fannie Mae, Freddy Mac and AIG – at that time the biggest insurance company in the world – collapsed and had to be rescued by the government. In 2009, the IMF estimated that U.S. and European banks had sustained losses from toxic assets and loans exceeding USD 1 trillion between 2007 and September 2009, and predicted that this figure would more than double by 2010.

In 2009, very few professional forecasters realised that in March the MSCI World had entered its longest-ever bull market, which has now passed the 10-year mark. During this decade, there have been substantial changes, not only in central bank policies, but also in the global financial architecture. How have risk management approaches to investment progressed during this period, and what are the challenges we face over the next few years?

29

Update I/2019

After a decade of unorthodox central bank policy, defensive investments in bonds offer investors little compensation for resurgent inflation. In the vast majority of developed countries, real yields on government bonds are negative, even for long maturities (see Chart A/).

Institutional investors in continental Europe that traditionally had invested heavily in defensive fixed-income securities increasingly felt compelled to switch to corporate bonds and other spread market segments,

The hot phase of the Great Financial Crisis started on August 9, 2007 when BNP Paribas froze three of its money-market funds to bar redemptions. While this initially affected ABSs, the liquidity crisis increasingly expanded to corporate bond markets. Then, for a short time in September-October 2008, it was hard to trade even European government bonds. Investors were at least able to find adequate liquidity on the equity and bond futures exchanges, even in the fall of 2008. In this regard, investors’ risk management position was and is sustainable if they can draw on the full range of financial instruments.

The financial architecture has changed further in the 10 years since the financial crisis. The increasing percentage of trading based on electronic algorithms, the fragmentation of trading volumes on alternative electronic trading platforms and the uninterrupted success of passive investments using ETFs raise doubts as to whether sufficient mutual liquidity will actually be available in the event of a crisis. The dramatic impact that electronically orchestrated (bogus) sell orders can have was demonstrated by the flash crash of May 6, 2010, when the S&P 500 dropped by almost 6% within a few minutes, and individual shares lost more than half of their market value in the short term.

1/ Insight No. 1: The biggest long-term risk is not taking any risks

2/ Insight No. 2: Market liquidity is central, but not a constant

Even the most liquid markets in the world are vulnerable to distortions that are compounded exponentially by algorithms. That presumably applies even more strongly to the significantly less liquid corporate bond markets and other spread markets: strategic demand from institutional investors and the support provided by central bank purchases have resulted in corporate bond markets whose liquidity has hardly been tested for years. A highly respected study of global liquidity by PwC in 2015 also refers to the decreasing liquidity after 2010, in particular with regard to the corporate bond markets. For example, European corporate bond trading volumes dropped by up to 45% between 2010 and 2015. Further indicators of diminishing market liquidity are the investment banks’ smaller trading positions: as an example, trading portfolios of U.S. corporate bonds shrank by almost 60% between 2008 and 2015.

Conclusion: the financial architecture has changed significantly since 2008. Consequently, for risk management, there is an even stronger focus than before on asset classes and, in particular, derivatives, which offer high liquidity based on efficient electronic trading.

as well as alternative investments, in order to be in a sustainable position to satisfy long-term obligations. For some groups of investors, strategic investments in equity markets were also suitable vehicles enabling them to participate in risk premiums. This strategic focus will increase the risks faced by these investors in the event of another market crisis. This gives rise to a strategic need for efficient risk management in order to avoid overtaxing institutional investors’ risk-bearing capacity.

30

Risk Management

A/ REAL YIELDS ON GENERIC GOVERNMENT BONDS

3M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 30Y

Germany –2.88 –2.78 –2.82 –2.79 –2.69 –2.57 –2.48 –2.38 –2.27 –2.16 –2.03 –1.76 –1.59 –1.40

France –3.06 –2.83 –2.68 –2.53 –2.37 –2.20 –2.13 –1.97 –1.82 –1.74 –1.55 –1.12 –0.99 –0.60

Italy –1.66 –1.22 –1.16 –0.58 –0.25 0.15 0.41 0.67 0.66 –0.88 1.09 1.39 1.67 1.90

Netherlands –2.65 –2.46 –2.40 –2.26 –2.12 –1.96 –1.83 –1.71 –1.58 –1.48 –0.96

Belgium –3.70 –3.44 –3.44 –3.32 –3.19 –2.95 –2.84 –2.66 –2.48 –2.32 –2.19 –1.74 –1.44 –1.17

Austria –2.75 –2.84 –2.82 –2.63 –2.53 –2.38 –2.22 –2.05 –1.97 –1.88 –1.41 –1.03

Finland –1.96 –1.91 –1.89 –1.75 –1.60 –1.52 –1.31 –1.23 –0.92 –0.56 –0.33

Switzerland –1.92 –1.75 –1.79 –1.70 –1.63 –1.52 –1.44 –1.38 –1.32 –1.25 –0.89 –0.75 –0.63

Sweden –2.55 –2.51 –2.34 –2.17 –2.00 –1.70

Denmark –1.27 –1.29 –0.98 –0.55

UK –1.68 –1.65 –1.68 –1.69 –1.65 –1.56 –1.51 –1.47 –1.40 –1.20 –0.96 –0.71 –0.62

USA 0.23 0.40 0.30 0.27 0.30 0.36 0.46 0.79

Japan –0.95 –0.98 –0.94 –0.94 –0.94 –0.94 –0.94 –0.94 –0.92 –0.87 –0.80 –0.56 –0.31 –0.08

Source: Bloomberg, AllianzGI, taking into account country-specific consumer price inflation, HICP for Eurozone countries, figures as of 1/2/2019. Past performance is not a reliable indicator of future results.

31

Update I/2019

Source: Allianz Global Investors Global Economics & Strategy, Bloomberg (data as of 12/2018)

15

10

5

20

25

Eurozone UK SwitzerlandUS Japan China

0

B/ AGGREGATE MONETARY BASE AS % OF GLOBAL GDP

2006 2008 2010 2012 2014 2016 2018 2020

Projection

Even the most liquid markets in the world are vulnerable to distortions that are compounded exponentially by algorithms.

32

Risk Management

The global economy is in the ninth year of a widespread upturn. However, there is a noticeable decrease in growth momentum. Even the U.S. equity market, stoked by Donald Trump's tax reform, is on increasingly thin ice, as a glance at the market valuation of the S&P 500 according to the cyclically adjusted price-earnings ratio (“CAPE”) shows. With a CAPE of over 30, the valuation of the U.S. equity market in 2018 reached a level similar to that preceding the global economic crisis of the 1930s. The valuation level had significantly exceeded 30 only in 2000, which in hindsight is regarded as the high point of the tech bubble.

3/ Insight No. 3: Global economy and financial markets are at a crossroads in 2019

Another factor acting as a brake on future economic growth is the global debt level: after the 2008 financial crisis, public debt increased significantly, while the private sector largely failed to deleverage. In China, the private sector was in fact the main driver behind a historically rapid increase in the debt ratio over the past decade.

The high absolute valuation of equity markets and the expansion of global debt levels is not at all irrational, but rather is the result of the monetary policy pursued during the past decade. However, this policy of “quantitative easing”, conceived in response to the financial crisis, probably peaked in 2018, as a glance at the aggregate monetary base of the main central banks demonstrates (see Chart B/).

33

Update I/2019

Source: IDS/Allianz Global Investors, as of 12/31/2018. Performance gross of fees in EUR.

Rolling 12-month return

C/ MAXIMUM AND MINIMUM RETURNS OF THE COMPOSITE “DMAP ASYMMETRIC TOTAL RETURN”: A COMPARISON

SAA Composite

–5%

–10%

–15%

–20%

5%

10%

20%

15%

30%

25%

0%

24.7% 24.1%

–6.4%

4.7%6.2%

Max

Average

Min

Clients view risk management as sustainably attractive if there is a reliable increase in stability in times of crisis, and opportunity costs remain manageable even in long bull markets. Risk management solutions based on the proprietary DMAP© (Dynamic Multi Asset Plus) investment approach of Allianz Global Investors focus on maintaining upside potential over a complete market cycle, while significantly reducing risks in poor fiscal years. This is made possible by applying the principle of “dynamic asset allocation”, which is efficiently implemented with futures and other derivatives.²

Chart C/ and Chart D/ show the aggregate performance results for our mandates in the DMAP Asymmetric Total Return Composite. The chart on the left shows the dispersion in returns for rolling 12-month returns, illustrated by the average return and the respective maximum and minimum. Although under strategic asset allocation (SAA) the dispersion implies an almost symmetrical distribution around the mean value, for the DMAP Composite the realised dispersion in returns is asymmetric: the downside behaviour is significantly more attractive, which translates into a higher average return. At the same time, risk reduction in sharply negative market

4/ Sustainable risk management for the next 10 years

phases is not necessarily accompanied by a lower average return in positive market phases, as reflected by the chart on the right, where the rolling 12-month returns have been sorted into five quintiles in ascending order, and the average SAA and Composite quintile returns compared in phase. This clearly shows that the DMAP© strategy was able, on average, to generate added value both in the negative (Quintile 1) and positive market phases (Quintiles 2-5), whereas loss avoidance in bad times was significantly more pronounced than the generation of additional income in good times.

Risk management needs to consider two perspectives: first, a historical perspective in order to learn the lessons from past crises. Second, looking forward, crisis scenarios that have not yet occurred but are conceivable must also be taken into account. Algorithmic trading, which now has a dominant market share, and the reduction in trading positions by traditional market makers, are increasing the risk of discontinuities such as overnight risks. The dynamic hedging principle can be supplemented with option-based hedging features in order to reliably address such scenarios as well.

34

Risk Management

Prof Dr Thomas G. Stephan, Director of RMO Research, risklab GmbH

–5.0%

2.8%

3.5%

6.7%

9.0%

14.1%

–2.1%

5.3% 7.6% 13.0%

Average 12-month return

D/ RETURNS OF THE COMPOSITE “DMAP ASYMMETRIC TOTAL RETURN” DURING BULL AND BEAR MARKETS

Source: IDS/Allianz Global Investors, as of 12/31/2018. Performance gross of fees in EUR.

Quintile 1 Very low

Quintile 2 Low

SAA return

Quintile 3 Average

Quintile 4 High

Quintile 5 Very high

–5%

–10%

5%

10%

15%

20%

0%

CompositeSAA

Scope recently gave Allianz Global Investors its highest rating, AAA, in recognition of its excellent quality and expertise as a provider of risk management overlay services. As the market leader with many years of experience in risk management overlays and in tail-risk management3, Allianz Global Investors and our risk management experts at Risklab are exceedingly well positioned to provide efficient and innovative solutions for the next decade that meet the differing needs of institutional clients.

35

Update I/2019

2

4

6

8

10

12

Performance contribution from dividends (p.a.)Performance contribution from share price gains (p.a.)

0

A / SHAREHOLDER-FRIENDLY DIVIDEND POLICIES, ESPECIALLY IN EUROPE.

GLOBAL COMPARISON OF HOW DIVIDENDS AND SHARE PRICE GAINS CONTRIBUTED TO

PERFORMANCE BETWEEN 1973 AND THE END OF 2018 (ANNUALISED).

MSCI Europe MSCI North America MSCI Pacific

40.6%

32.2%

34.4%

Past performance is not an indication of future results.Sources: Datastream, AllianzGI Global Capital Markets & Thematic Research. Data as of 31 December 2018.

%

3.28%

2.05%

6.79%

3.22%

5.62%

3.84%

Dividends: An airbag for your portfolioIt’s now 2019, and financial repression is continuing. Parts of the yield curve are still in negative territory, and not just for German government bonds. Although the end of the European Central Bank’s quantitative easing is a first step towards improvement, there is little sign that the long-overdue base rate increases will be implemented any time soon. The ECB is likely to begin raising interest rates painfully slowly, if at all.

36

Allianz GIobal Investors Today

A look ahead to the coming dividend season offers a more positive perspective. My colleagues in fund management expect MSCI Europe companies to pay out EUR 350 billion in dividends this season, EUR 16 billion more than last year. The average dividend yield is now 4% for European stocks (as at the beginning of February 2019). If you’re bracing yourself for increased volatility, it may be helpful to remember that dividends can act like an airbag for your portfolio over the medium to long term.

Dividends have helped to stabilise overall performance in years in which price trends were negative. Since 1973 there have been three five-year periods in which stock prices fell. Dividends cushioned some of these losses, or even overcompensated for them. Over the entire period from 1973 to the end of 2018, dividends actually accounted for 41% of the annualised total return on investment in MSCI Europe stocks. Dividends were also responsible for about one-third of overall performance in other regions such as North America (based on the MSCI North America) and Asia-Pacific (MSCI Pacific), although absolute dividend yields were lower here (see Chart A/).

Equities with a high dividend yield also seem to experience less extreme volatility than shares in companies with lower dividend payments. At any rate, a look back at trends in the US, where the longest time series are available, shows that the volatility (based on the 36-month rolling standard deviation as a measurement of share price fluctuations) of shares in US companies that paid a dividend has since 1975 been lower than that of corporations that did not distribute any profits. A similar trend has been discernible in European equities since the 1990s.

As our calculations show, dividends can perform much more reliably than corporate profits, and thus have a stabilising effect on income from shareholdings. This development appears to be due to companies’ chief financial officers, who tend to adopt a highly conservative dividend policy. A 2005 study4 shows that chief financial officers (CFOs) aim for a long-term dividend payout ratio while seeking to avoid dividend cuts, as reported by 94% of respondents in the survey on which the study was based. In two-thirds of cases, decisions on investments and on dividends are considered to be equally important. Share buyback programs, on the other hand, are regarded as an instrument that can be used much more flexibly than dividends.

Managers from 394 US corporations were questioned in the survey, in which the sample was dominated by companies that paid dividends. The results were also in line with our findings that dividends – at least in the past – have developed very steadily.

A 2011 study by Skinner and Soltes is also interesting in this context.5 This study looked at annual dividend payments and profits for companies that were listed on the NYSE, AMEX or NASDAQ during the period from 1974 to 2005, excluding utilities and financial service providers. The authors conclude in their analysis that companies that pay dividends are more consistent when it comes to earnings performance than companies that do not pay dividends. This is not even dependent on the amount of the dividends, the authors say, but simply on whether or not dividends are paid.

Dividends can act as an airbag for portfolios, which is reassuring during volatile periods in particular.

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Update I/2019

Capital ownership in the age of robots Interview with labour economics specialist Prof. Richard B. Freeman6

Interview with Prof. Richard B. Freeman, Faculty co-Director of the Labor and Worklife Program at the Harvard Law School, on “robots”, the law of comparative advantages, human labour, the Universal Basic Income and how to bridge the capital/labour divide via capital ownership.

38

Interview

Warnings that advanced “robots”7 and automation threaten employment fill the media. How seriously do we need to take these headlines?

Richard B. Freeman: The key question in the “fourth industrial revolution” is thus whether robots will shift comparative advantage from humans to machines in the high-paying cognitive activities that have been the hallmark of human advancement. Are you going to work for the robot, or is the robot going to work for you? Past automation technologies gave comparative advantage to machines in physically difficult or dangerous work, or provided workers with tools that enhanced human ability to do that work. Because the machines/tools were specialised

Having my own kids in mind: What do they need to understand about the future of work and the competition with robots?

and could not think, humans had comparative advantage in tasks that required cognition and flexibility in switching from activity to activity or from issue to issue. When technology displaced workers from agriculture to industry, and from industry to service sector jobs, workers gained better jobs with higher pay than before automation struck their workplaces. Robotics and software automation at the outset of the 21st century extended machine comparative advantage from physical labour to routine human work.

Richard B. Freeman: The economic principle of comparative advantage suggests that the impact of robot technologies will be on the work tasks that people do and the income they earn from that work, rather than in joblessness per se. Comparative advantage holds that even

if robots outdo humans in every job, firms will hire human workers. They will hire humans to do jobs or parts of jobs that humans do at lower cost than machines, while hiring machines to do the work at which humans are more expensive.

Got it. My kids need to go to university. But will a better education help in struggling for a better comparative advantage?

Richard B. Freeman: Think of Google’s AlphaZero algorithm, which learned by itself to master several games in nearly real time. If AlphaZero needed just 24 hours to learn from scratch to dominate strategic games, imagine what its Nth prototype will be able to do twenty years from now when today's children enter the job market. Who you

gonna hire in 2040 – new college/high school graduate John or Martha or AlphaN, who will almost surely be connected to some Cloud computing site? In a world of digital work, comparative advantage in cognitive tasks seems destined to belong to the machines.

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Update I/2019

Richard B. Freeman: There are two ways to distribute income so that the vast majority of humans benefit from the “intolerable abundance” that AI robot technologies can bring to us. The first is to spread ownership of capital more broadly than it is today by expanding employee ownership of the firms where people work, and ownership of business capital in the rest of the economy. Ownership guarantees that a share of the improved productivity from ever smarter machines goes to people as owners of the

So, let’s talk about capital ownership!

capital, rather than as workers competing with the machines. The second is to undertake a tax/spending policy that taxes the owners of capital per Bill Gates' proposed robot tax or Thomas Piketty's global capital tax, and use the moneys to deliver goods and services to citizens, as in the Universal Basic Income that has attracted some attention. Following the “who owns the robots rules the world” apothegm, I focus on the ownership solution.

In a world of digital work, comparative advantage in cognitive tasks seems destined to belong to the machines.

Richard B. Freeman: You put your finger on the point. The effect of AI robot technologies on income depends on who owns the technologies. In a world where machines do much of the work and receive much of the earnings, the economic winners are the owners of the machines, while

That reminds me of a dialogue between Henry Ford II and the leader of the automobile workers union, Walter Reuther. Henry Ford II: “Walter, how are you going to get those robots to pay your union dues?” Walter Reuther: “Henry, how are you going to get them to buy your cars?”

the losers are workers who compete with the machines. If you own the robot that does your job/the jobs of others, you benefit from the new technology. But if I own the robot that does your job, tough luck suckah!

40

Interview

Hans-Jörg Naumer, Global Head of Capital Markets & Thematic Research, Allianz Global Investors

Richard B. Freeman: The starting place to increase workers' ownership of capital is at their workplace, and the natural way to do this is to increase incentives for firms to introduce new or to expand existing compensation systems that link worker pay or wealth to the performance of

Richard B. Freeman: Indeed. Workers will need a substantial stake in business capital outside their firm, as well as in their employer. If you accept the claim that the expansion of robot technology will shift comparative advantage in high value added cognitive activities to machines, and that ownership of capital is the best way to avoid the dystopia of an economy dominated by a small minority of owners of the AI robots, the road ahead is clear. Employers, employees, labour

Ownership and capital income vs. concentration of capital and redistribution. How to strengthen capital ownership?

Aren’t there limits to that kind of ownership? My grandma always told me: “Never put all your eggs in one basket.”

the firm or work group; and to give incentives to workers to participate in such programs. A great virtue of employee ownership is that it bridges the capital/labour divide by incentivising worker-owners to raise firm performance, which can benefit non-employee owners as well as workers.

organisations, and governments should implement policies to increase employees' ownership in their firm, and to make more citizens owners of capital in the broader economy. Pension funds and their allocation into equities, for instance, could become a very important vehicle necessary to assure that the vast majority benefit from a technological future in which AI robots do more of the work and earn more of the income from work.

The interview was conducted by Hans-Jörg Naumer, Global Head of Capital Markets & Thematic Research

at Allianz Global Investors. It is based on Professor Freeman’s contribution to the book “CSR und Mitarbeiterbeteiligung: Die Kapital-

beteiligung im 21. Jahrhundert – Gerechte Teilhabe statt Umverteilung” (October 2018).

Richard B. Freeman holds the Herbert Ascherman Chair in Economics at Harvard University. He is currently serving as Faculty co-Director of the Labor and Worklife Program at the Harvard Law School, and is Senior Research Fellow in Labour Markets at the London School of Economics' Centre for Economic Performance. He directs the National Bureau of Economic Research/Science Engineering Workforce Projects, and is Co-Director of the Harvard Center for Green Buildings and Cities.

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Update I/2019

Editorial1 Page 3: https://www.amazon.de/Human-Machine-Reimagining-Work-Age/dp/1633693864/ref=sr_1_1?ie=UTF8&-

qid=1549876055&sr=8-1&keywords=human+machine+daugherty

Interview6 Page 38: The interview was conducted by Hans-Jörg Naumer, Global Head of Capital Markets & Thematic Research at

Allianz Global Investors. It is based on Professor Freeman’s contribution to the book “CSR und Mitarbeiterbeteiligung: Die Kapitalbeteiligung im 21. Jahrhundert – Gerechte Teilhabe statt Umverteilung” (October 2018).

7 Page 39: “Robots” are taken as a synonym for any kind of disruptive technologies.

Risk management2 Page 34: There is no guarantee that the strategy will succeed, and losses cannot be ruled out.3 Page 35: AAA (AMR) Asset Manager Rating by Scope, released on 9 August 2018. The analysis covered the aspects

“Investment Professionals”, “Investment Process and Research”, “Market Position and Performance” and “Other internal and external Resources”. A ranking, a rating or an award gives no indication of future developments, and will change over time.

Allianz GIobal Investors Today4 Page 37: Cf. Brav, Alon; Graham, John R.; Harvey, Campbell R.; Michaely, Roni; “Payout Policy in the 21st century”;

Journal of Financial Economics; Vol. 77; 2005; pp. 483 – 527.5 Page 37: Skinner, Douglas J.; Soltes, Eugene; “What do dividends tell us about earnings quality?”; Revue of

Accounting Studies; Vol. 16; pp. 1 – 28; 2011

All sources and background information

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Footnotes

Masthead

Update I/2019 Client Magazine for Institutional Investors

Publisher: Allianz Global Investors GmbH Bockenheimer Landstr. 42–44 60323 Frankfurt/M. www.allianzglobalinvestors.com

Editor in Chief: Kerstin Keller

Project Manager: Maria Rita Raffaele

Editorial Team: Peter Berg, Kerstin Keller, Hans-Joachim Kollmannsperger, Hans-Jörg Naumer, Klaus Papenbrock, Maria Rita Raffaele, Oliver Schütz, Caroline Tschesche

Contact the Editorial Team: update-redaktion@allianzgi.com

Design: Rotwild GmbH, Cologne

Layout: Werbemanufaktur Albert, Frankfurt/M

Printing: Schleunungdruck GmbH, Marktheidenfeld

Photographs: Allianz Global Investors, Getty Images, iStock

As of March 2019

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