Capital International Limited Investment Review 2013 | Third Quarter

Capital International

Third Quarter 2013

Investment Review Innovation | Integrity | Excellence

There has been a recovery of virtually all the losses from the second quarter Capital International

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Global Equities Upward trajectory maintained...

After the Federal Reserve comments regarding the tapering of Quantitative Easing caused the sharp sell-off in the last quarter, there has been a recovery of virtually all those losses in the third quarter. Global equity indices have risen across the board as investors began to appreciate that liquidity conditions will only ‘normalise’ at a very slow rate.

It will still be several quarters before interest rates are increased, indeed in regions such as Europe there is scope for further reductions.

The increase in the level of bond yields has undoubtedly made the relative valuation of equities less compelling.

The fears are interconnected and have led to a steady outflow of funds from the Emerging Markets and some evidence of rotation into growth sectors at the expense of defensive stocks.

Whilst the move up in equities has been positive, we were correct in our forecast that global markets would generally trade in a relatively narrow range. Europe has now become a consensus to buy amongst investors, whereas the US and Japan have been solid, as has the UK.

Volume: 11 | Issue: 3

Rates & Commodities GBP/USD GBP/EUR GBP/JPY SILVER GOLD EUR Crude Oil US Fed Funds UK Base Rate ECB Base Rate

Price at 30-Sep-13 28-Jun-13 28-Sep-12 1.6183 1.5185 1.6153 1.1959 1.1675 1.2545 158.94 150.821 125.855 1672.800 1507.470 1431.500 1335.75 1203.25 1781.00 109.22 102.16 113.25 0.25 0.25 0.25 0.50 0.50 0.50 0.50 0.50 0.75

% Chg Quarterly 6.57% 2.43% 5.38% 10.97% 11.01% 6.91% 0.00% 0.00% 0.00%

% Chg 1 Year 0.19% -4.67% 26.29% 16.86% -25.00% -3.56% 0.00% 0.00% -33.33%

World Indices UK Top 100 Dow Jones NASDAQ S&P 500 DAX CAC 40 Nikkei 225 Hang Seng Gilts

Price at 30-Sep-13 28-Jun-13 28-Sep-12 1,125.40 1,082.43 1,000.00 15,129.67 14,909.60 13,437.13 3,771.48 3,403.25 3,116.23 1,681.55 1,606.28 1,440.67 8,594.40 7,959.22 7,216.15 4,143.44 3,738.91 3,354.82 14,455.80 13,677.32 8,870.16 22,859.86 20,803.29 20,840.38 162.62 163.76 173.75

% Chg Quarterly 3.97% 1.48% 10.82% 4.69% 7.98% 10.82% 5.69% 9.89% -0.70%

% Chg 1 Year 12.54% 12.60% 21.03% 16.72% 19.10% 23.51% 62.97% 9.69% -6.41%

The dominance of Central Banks on investor sentiment is a concern and in the short term investors have now begun to focus on the debt ceiling negotiations in the US. Emerging Market valuations have certainly become more attractive, but with the exception of China, they probably need to get a bit cheaper before investors will add to their asset allocation.

The Banking Sector has reflected this positive domestic tone with Royal Bank of Scotland gaining 34% and Lloyds Banking is up 20%, with the Government starting to wind down its stake. Other risers included Sports Direct up 27% and Glencore Xstrata was up 27%. Fallers included Carnival Corporation down 8% on weak trading and Tate & Lyle down nearly 10% on the sugar market.

On a P/E basis these markets are pretty much bang on their twenty year averages. The Syrian situation has continued to lurk in the background but the recent Russian driven developments have led to a fall in the crude oil price, which will be a positive for global GDP.

European equities have suddenly become all the rage and the region wide equity index is up over 10% in the last three months, as investors try to anticipate a cyclical recovery.

This is despite the still negative GDP growth in the current year and continued financing concerns in countries such as Greece and Italy. If recovery does come through, there is tremendous scope for replacement demand both in the private sector and amongst corporates. Nokia surprised the markets with a handset business sale to Microsoft and the shares rose 73%, whilst Societe Generale climbed 40% and Orange rose 29%. Notable fallers included Ryanair down 10% on capacity fears and Zurich Insurance fell nearly 5%.

The S&P 500 Index is up approximately 5.5% on the quarter, although there are early signs that equity leadership is beginning to shift to other geographical regions. The Index is now trading at over 16x P/E with only a 2% dividend yield, compared to the 10 year US Treasury which has recently been yielding 3%.

Arguably the improved economic picture is now fully discounted in US share prices and they are not taking into account risks such as rising mortgage rates and budget fears. Notable stocks to the upside have included Yahoo up 30%, Dow Chemical up 24% and Apple up nearly 23%. On the downside, Abercrombie & Fitch fell nearly 20%, HewlettPackard lost 14% and Monster Beverage dropped 12%.

The UK equity index has risen nearly 5% on the quarter, a realistic rise after the market was unduly impacted by the tapering comments from the US. The domestic economy has been producing a raft of positive data, with improved manufacturing orders, positive consumer confidence and rising house prices. This self-sustaining recovery looks set to continue into 2014, although we need to keep an eye on the recent strength in Sterling.

© Capital International Limited 2013

Japan had another solid quarter with the Nikkei index increasing by 8%, as optimism remained that the economy would continue to shrug off the demographic headwinds facing it. Hong Kong rallied 11% and the Shanghai Composite was up 9%. Chinese economic growth appears to be accelerating and certainly the cyclical shipping industry seems to be improving. On the quarter Mitsui Engineering & Shipbuilding was up 41% and Kawasaki Heavy Industries was up 40%. Other positives were China Merchant Bank up 20% and Cheung Kong up 15%.

Negatives included Mitsubishi Motors falling 18% and Shandong Gold dropped 32%.

Sentiment for the rest of the year should remain broadly positive even though equity markets generally have performed well, nonetheless investors will need to monitor bond markets and crucially Central Bank rhetoric for clues on future policy.

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Third Quarter Review Fixed Income Bonds continued to suffer over the quarter, as market data strengthened the consensus view that the US Federal Reserve would start contemplating the end of Quantitative Easing before the end of the year.

This prospect of an inflection point in the longer-term cycle of ultra-low interest rates spooked bond investors, leading to substantial reallocations. For the last 5 years default risk has been a headline theme however interest rate or duration risk became the focal point, resulting in a ‘flight from quality’.

Since benchmark 10 year bonds peaked in 1981, yielding 15.3%, rates have been on a long-term Total Return on Selected Bonds downward trajectory ever since, creating one of the largest From 1st May to Fed Meeting (September) bull markets in bonds in history. While credit markets suffered sharp losses at times such as in 2002 in the wake of the MCI Inflation Linked Inflation Linked Gilts -9.60% WorldCom fraud and the 2007/2008 financial crisis, long-term Gilts investors have seen unprecedented gains due to the willingness of Central Banks to slash short-term interest rates to historic Gilts Gilts -7.26% lows to ensure market stability.

10 Year Gilt Yields From Start of Bull Market to Date

AAA Eurobonds

-3.92%

AAA Eurobonds

18 18% 16 16%

-0.32%

BBB Eurobonds

BBB Eurobonds

14 14% -12% -12%

12 12%

-10% -10%

-8% -8%

-6% -6%

-4% -4%

-2% -2%

0% 0%

Fearing higher rates in the future, investors rotated out of longer-dated, high quality issues and into shorter-dated, lower-rated bonds. Arguably this was one of the implicit aims of Quantitative Easing, adjusting the transmission of credit within the market and directing cheaper funding to those borrowers who were most in need of it.

10 10%

8%8 6%6 4%4 2%2 0%0 1979 1979

1984 1984

1989 1989

1994 1994

1999 1999

2004 2004

2009 2009

This adjustment is partially explained by the structure of bond markets where the highest quality borrowers are often able to achieve the longest average maturities due to their perceived better credit risk and control of inflation. This aspect was explored more fully in our earlier Review of the first quarter of 2013. Conversely, countries which have experienced financial challenges have relatively short maturity profiles so are compelled to offer higher yields to investors to compensate for the heightened risk while borrowing for shorter terms. The market is comfortable with credit risk this year as yields on peripheral debt sink.

2013

It follows therefore that any reversal of this extraordinary monetary policy would have potentially significant implications for all financial markets but in particular rate-sensitive bonds.

Markets have therefore been especially sensitive to key economic data.

In testimony to Congress in May, Fed Chairman Bernanke discussed the unwinding of Quantitative Easing and suggested that it would likely commence with a gradual reduction in the amount of monthly bond purchases, or ‘tapering’. The consensus view was that tapering would commence before the end of the year with the formal disclosure of it during the September FOMC meeting.

The graph below shows that if you were a global bond investor with a high degree of caution, you might have lost 4% already while passing on the opportunity to earn a further 9% in Spain.

Total Returns from Government Bonds 2013 Year to Date

8.94% Spain

Spain

Japan

Japan

1.68%

Australia

Australia

-0.03%

France

-1.49%

France Germany

Germany

-2.28%

Swiss

-3.03%

Swiss

USA

-3.05%

USA

UK

Capital International

Italy

4.02%

Italy

UK

-4.11%

-6% -6%

-4% -4%

-2% -2%

0% 0%

2% 2%

4% 4%

6% 6%

8% 8%

10% 10%

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Since the ECB stepped up its intervention in the bond markets to secure the short term future of the Euro, bond yields across the Eurozone have been on a trajectory which will see 10 year yields meet broadly in the range of 3.00% to 3.75% over the next two years assuming the reforms and fiscal cooperation continues as planned.

Spanish yields have already declined this year by around 90 basis points to levels close to their Italian peers of 4.30% while French yields have widened almost 0.5%. Bonds issued by the EFSF, the European Financial Stability Facility, now trade inside the French Treasury and represent the closest proxy to a ‘Eurobond’ where the Eurozone collectively guarantees its debt with the full faith and backing of its members.

European 10 Year Bond Yields December 2012 to September 2013 ---- Germany ---- Italy

---- France ---- EFSF

EU 10 Year Bond Yields -2013 ---- Spain

6%6 5%5 Germany

4%4

France Spain

3%3

Italy EFSF

2%2 1%1

Aug2013 2013 Aug

Jul2013 2013 Jul

Jun2013 2013 Jun

May2013 2013 May

Apr2013 2013 Apr

Mar2013 2013 Mar

Feb2013 2013 Feb

Jan2013 2013 Jan

Dec2012 2012 Dec

0%0

This convergence has led to a notable disparity in performance in the last quarter and the year to date. We would however recommend caution; while Spanish and Italian yields have further to fall, potentially giving some nice profits, it could be a very bumpy and anxious journey. Even more concerning is that returns have been strong so we would expect some sort of retracement soon.

Given the volatility of recent years and scarcity of high quality collateral, coupled with new, more rigorous regulatory capital rules it was unlikely that investors would remain significantly underweight high quality bonds for too long and the September Fed meeting delivered a surprise.

Citing insufficient data to evidence a sustained economic recovery, no tapering was announced and Bernanke emphasised that there was no predetermined schedule regarding the monthly $85 billion bond purchase programme.

News of the continued stimulus package sent risk assets sharply higher with the S&P reaching an all-time high while bonds also jumped as the Fed effectively reset the market’s interest rate expectations.

While investors have now factored in a higher probability of rate rises, the wider macro picture is still relatively unclear.

© Capital International Limited 2013

If the continuation of QE tends to provide a short term boost to risk appetite, the reasons for it merit concern. Firstly, unemployment is clearly not improving as fast or broadly as the Fed would like and the rise in yields from the start of May to mid-September has shaken mortgage markets and subsequently affected housing values.

The overall debt of the USA is also under scrutiny with a further expansion of its $16.7 trillion ceiling again needing ratification via Congress. Following the experience of 2012 when the so-called ‘fiscal cliff’ took effect, hitting GDP through spending cuts, the Fed’s expectations of sub-optimal inflation is well founded, Adding to the uncertainty, the Federal Reserve Chairman is scheduled to leave by the end of 2013 with the most likely appointee being Deputy Chair Janet Yellen following the withdrawal of the controversial Larry Summers.

Further afield but also likely to be on the Fed’s agenda of achieving stability, Japan is engaging in its own monetary experiment, doubling its monetary base to reflate its economy while the European Union still faces severe structural imbalances. Next year, EU banks and governments will need to roll over £1 trillion of debt so the Fed will no doubt have to maintain flexibility to address any problems.

The lesson from the last quarter is that in spite of improving economic data, underlying conditions remain relatively fragile and the markets are still subject to action from central banks and politicians. Maintaining discipline with regard to valuations and fundamentals is essential as fighting central bank intervention can be very costly.

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Asset Focus Currency Insight Foreign Exchange or FX is often overlooked or misunderstood in the context of managing portfolios but FX exposure can certainly create a further level of risk to be monitored and controlled.

Foreign exchange markets in the third quarter of 2013 reflected the economic environment where markets are balanced between a fragile recovery in Developed Markets and the challenge of slowing growth in Emerging Markets.

Brazilian finance minister Guido Mantega first referred to the concept of a ‘currency war’ back in 2010 in a criticism of the distorting effect of Quantitative Easing. The policy reduces interest rates in the developed countries and directs flows to higher yielding currencies thereby causing an appreciation in the emerging market currency and decreased competitiveness in export markets. Countries that engage in the active depreciation of their currency to gain a competitive advantage are therefore said to be participating in aggressive monetary policy and risk forcing their neighbours into reciprocal action.

The situation today has some obvious similarities to the crisis that flared sixteen years ago in July 1997. Then, a combination of rapid currency devaluation and disparities in economic growth contributed to the Asian Financial Crisis requiring painful fiscal adjustments and globally co-ordinated action to stem contagion.

While Asian governments enacted substantial reforms following the 1997 IMF bailout the magnitude and scope for crisis is far larger today. In perspective the entire Asian bailout package totalled $40 billion, an amount roughly equivalent to the losses recorded by just Barclays Plc during the 2008 financial crisis.

The changes wrought by the IMF eventually led to better governance and creation of sizeable foreign currency reserves to protect against attacks on emerging market currencies yet also led to the long-term cycle of reinvesting receipts from the West back into US Treasuries, driving yields down still further and lowering USD funding costs.

The third quarter highlighted the potential for forex volatility as central bankers started to contemplate the unwinding of their extraordinary stimulus measures and the reversal of the ‘carry trade’ between the USA, Japan and China. In a carry trade investors borrow in a low-yielding currency and invest it in a higher yielding currency, exploiting the structural yield gap in economic fundamentals.

Since much foreign investment in China is in the form of fixed capital items such as factories and infrastructure, the Renminbi is shielded to a large extent from the outflow of ‘hot money’ that investments in bonds and equities tend to follow. Its lack of convertibility and continued receipt of US Dollar flows from its Treasury bond investments created a 1% gain over the third quarter. China’s rapid growth over the last decade means it is now the largest foreign holder of US treasury debt, with over $1.2 trillion Dollars of US Treasuries in its reserves.

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Amount Owned by Non-US Countries US Dollars / Billions ---- China ---- Japan ---- Caribbean (banks/offshore)

The theme of competitive devaluation has been growing over recent years

---- Brazil ---- Opec Nations

$1,400 $1,200 $1,000 $800 $600 $400

The biggest losers against the US Dollar on the quarter were the Indian Rupee and the Indonesian Rupiah which lost 2.5% and 9.75% respectively while over the last 12 months the biggest and potentially most significant fall has been that of the Japanese Yen which has been devalued by over 20% against the USD.

$200 Dec 2012

Dec 2011

Dec 2010

Dec 2009

Dec 2008

Dec 2007

Dec 2006

Dec 2005

Dec 2004

Dec 2003

Dec 2002

Dec 2001

Dec 2000

$0

The theme of competitive devaluation has been growing over recent years and the fear is that countries struggling to implement unpopular austerity policies will try to manipulate their currency to regain competitiveness, risking an inflationary response or capital flight. Since the start of the year Japan has been engaged in an ambitious open-ended bond buying programme designed to combat deflation but which has caused Yen devaluation as a side-effect.

Markets therefore are highly dependent on each other and a large part of the movement in the third quarter was driven by expectations that better growth in the USA would lead to higher rates. This would mean higher-yielding Asian and Emerging Market currencies would be relatively much less attractive, leading to a large sell-off.

%8

8%

BRIC Currencies vs US Dollars Third Quarter 2013

%6

6%

6%

8%

%4

4%

5.2%

%2 %2-

-2%

0% -2%

%4-

-4%

-2.4%

%6-

-6%

-4% -6%

%8-

-8%

-6.5%

%01-

-10%

-8%

-12.1%

%41-

Brazil Brazil

Russia Russia

India India

SouthAfrica Africa South

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anihC

© Capital International Limited 2013

aidnI

aissuR

lizarB

China China

-14%

-14%

%21-

-12%

-12%

-10%

This political factor is an added complication in gauging the moves in foreign exchange markets and could see fundamental data disconnect from the reality as central banks attempt the difficult balancing act between growth and maintaining stability.

Sterling’s performance over the last quarter has been a good example of this disparity.

3102 - DSU sv seicnerruC SCIRB

0%

1.1%

%0

BRICS Currencies vs USD - 2013

2%

2%

4%

While the G20 group of nations has recognised Japan’s programme as a legitimate method of reflating its economy, the risk of an unpopular currency war has risen. With Japanese equity markets up over 40% for the year, the tactic appears to be genuinely targeted at inflating financial asset prices but many central bankers wary of the unintended consequences of the action. As recently as mid-September, the Swiss National Bank has talked down its currency from appreciating too strongly with publication of its Yen reserves leading to speculation that it has intervened to keep the Franc within its preferred range.

To most investors the UK has been struggling economically during 2013 with recurring fears over a slide back into recession but improving CPI and unemployment data has pushed Sterling to over $1.60/£, close to its 1 year high. In spite of new Bank of England Chairman Mark Carney reiterating his forward guidance that rates will remain low until 2016, markets are pricing in a rise during 2015 as capital would flow to higheryielding UK bonds, putting pressure on the UK’s exporters and the fragile recovery. With a further gain of 5% over the Euro, investors are seeing the UK as the ‘least-worst’ option.

Since the US Federal Reserve stepped back from its earlier stance of appearing to favour reducing stimulus, markets have been volatile due to the uncertainty and increasing the risk of a policy misjudgment. Until central bankers can convince markets of their intentions and the economic data supports their views, the outlook for the US Dollar is likely to remain uncertain.

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Country in Focus Australia Recent general elections in Australia have led to a change of political direction, with the Tony Abbott led Liberal-National coalition achieving the largest lower house majority in over ten years. One of the central policy planks looks set to be the abolishment of a controversial mining tax, just one step, aimed to help the rapidly slowing sector. The ousted Labour Party, led by Kevin Rudd (for the second stint) had been suffering from infighting and the strange decline of support for Julia Gillard. Claims of a media driven, sexist bias towards her proved to be irreversible and the overall six year term of office was the shortest tenure for a party in nearly forty years.

Even small, future increases in interest rates could cause real pain and Banks may well need to increasingly tighten their lending criteria to avoid an unacceptable level of future bad debts. Interestingly the market is somewhat different to the UK with 60% of Australians resident in cities, compared to 30% in the UK. Household debt to income also remains at elevated levels with the latest reading at 140%. This will mean that any credit growth will prove to be constrained and there is unlikely to be significant volume growth in the banking sector. Interestingly in a recent survey of the world’s safest banks, there were three from Australia in the Top 10, ANZ, Commonwealth and Westpac.

Despite some of the concerns hanging over the economy, recent economic data showed that GDP in Q2 2013 grew at 0.6% or 2.6% year on year. This represents a 22nd consecutive year of growth without a recession, with most of the current expansion coming from private investment. The problem, as with the aftermath of the credit crunch, is that Australians have got used to 3.5% GDP growth being the norm and so any slowdown can feel painful.

Forecasts from the Reserve Bank of Australia are grounds for optimism with growth expected to accelerate in 2015/16 to as high as 4.25%. Coincidentally if this were to be the actual outcome, the next elections due in 2016 would more than likely see a second term for Mr Abbott. As well as the scrapping of the mining tax, there are a number of other initiatives which the Coalition will be looking to implement. There will be a comprehensive review of the A$8 billion of infrastructure projects that the Labour party had previously committed to. The Coalition is also keen on infrastructure, notably road and rail, but they may overhaul the project approval process.

Corporate taxation rates for most companies will also be reduced from 30% to 28.5%. However, for the largest three thousand companies there will be a 1.5% levy to fund a parental paid leave system. This will offer mothers a fully paid six month period off.

The Minerals Resource Rent Tax was introduced in July 2012, levied at 30% on the ‘super profits’ generated from the mining of both iron ore and coal. Approximately 320 companies have been impacted by this, although there is a minimum threshold so as not to penalise small businesses. Despite this, the tax has been highly controversial and Fortsecue Metals tried, unsuccessfully, to get the tax nullified.

On an annualised basis the tax will raise approximately A$ 600 million, although the estimates at the peak of the mining boom was an incredible A$ 4 billion. The abolishment of the tax will provide a welcome boost to the industry and could lift longer tern valuations by 5%.

One of the focus areas of the economy that has been causing major concerns has been the housing market. Similar to the UK, on a fundamental basis the Australian property market remains expensive, with an average price of 6-8x household income. Since 2000 it is estimated that the average annual capital rise in prices has been of the order of 11.5%. As interest rates are maintained at lower levels for longer and the central Government try to kick start activity with tax concessions, so the dangers rise of a ‘bubble’.

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The economy is also encumbered with structurally high wages with minimum wages currently at A$16 per hour, compared to A$8 in the US and A$2 in China. Incredibly in the mining sector, over the last ten years average wage levels have climbed by 250%. As with many Western economies, there could be the charge that the proceeds from the mining boom simply went into consumption, rather than any long term investment.

Productivity levels have also been lack lustre with Australia languishing at 21st place in the OECD published, Global Competitive Report. The weaker currency has also started to impact the economy with imports becoming more expensive.

Earlier this year the GBP/AUD exchange rate was as low as 1.44, however this has now weakened to 1.70 and many analysts believe the psychologically important 2.00 level could be achieved in the next six months. The lower levels of purchasing power could dampen consumption demand and recently petrol prices have been increased by 15% to reflect the currency movements.

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It is increasingly hard to see where the recovery will come from and it maybe that Australia has to rely on external factors to give them a much needed boost. A recent study of construction activity showed the 38th straight month of contraction, although there are differences at a State level.

Crucially for Australia the level of iron ore imports has picked up, while construction activity has also improved. Shipping rates, such as the Baltic Dry Index, offer a useful measure as leading indicators and these have picked up sharply in recent months.

For instance, both New South Wales and Western Australia have started to improve, whereas Queensland and Victoria are still struggling. In terms of external influences, China is clearly the key and optimists will take heart from a raft of more positive economic data in recent weeks. There appears to be a ‘mini’ cyclical recovery underway, although longer term worries remain regarding the credit bubble.

There remains potential for the Reserve Bank of Australia to further reduce interest rates from their current historic low of 2.5%. Forecasts suggest that there may well be two more cuts to leave a trough reading of 2%. With the new Government, there could well be an improvement in the level of business confidence in Australia. However, it will remain a fine balancing act as long as the private sector leverage remains high and the Chinese economy casts uncertainty over the vital mining sector.

Australia | Data Capital

Prime Minister

GDP (PPP) Total

Canberra

Tony Abbott

$970.764 billion

Largest City

Legislature

Per Capita

Sydney

Parliament

$42,640

National Language

Upper House

GDP (Nominal) Total

English

Senate

$1.541 trillion

Monarch

Lower House

Per Capita

Queen Elizabeth II

House of Representatives

$67,722

Governor-General

Area Total

Currency

Quentin Bryce

7,692,024 km2 / 2,969,907 sq miles

Australian Dollar (AUD)

Chief Justice

Population

Time zone

Robert French

23,193,662

UTC+8 to +10.5

Government

Density

Federal parliamentary constitutional monarchy

2.8/km2 / 7.3/sq miles

© Capital International Limited 2013

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Sector in Focus Global Smaller Companies In the last couple of years there has been a broad, medium term uptrend in global equities. We are aware of the fundamental reasons for the rally, plentiful liquidity and improving global economic conditions being the prime drivers. In that time frame the UK Blue Chip equity market has registered an impressive 26% rise and US Blue Chips have outperformed, gaining 43%. However smaller companies have significantly surpassed even these gains, with UK small caps rising over 48% and US small caps have risen 53%.

Traditionally smaller companies have been perceived to be riskier investments than larger companies, displaying a much higher degree of volatility. Due to their size, ambitious well run businesses have the potential to increase earnings at a rate far in excess of the likes of BP or Tesco. However studies have suggested that in the last fifty years they have significantly outperformed, with some micro caps outperforming by a factor of ten the more mature, larger companies. Clearly timing is almost impossible, although small caps tend to be more domestically exposed, so will do notably well in periods of sharp economic recovery.

A good example of this is the recent performance of the UK house building sector which has enjoyed tremendous gains.

The sector was very hard hit to the downside in the credit crisis, with many companies such as Barratt Developments and Taylor Wimpey on the verge of bankruptcy.

As Quantitative Easing has ensured that interest rates have been virtually zero, arguably the housing market has not ‘corrected’ in the way it should have done. Combined with positive demographic trends and a shortage of new houses being built and the recovery has been extraordinary. For instance, Barratts is up from a low of 38p to over 330p and Taylor Wimpey has risen from 10p in 2008 to over 100p now.

Furthermore, smaller companies can make attractive takeover candidates and the sector spread is also more diverse than a few big banks/oil/telecom companies. There are, however, clearly many downsides and one of the main ones is the lower levels of liquidity experienced in dealing in such stocks. Indeed, in some micro caps, even an individual’s share dealing can move the price.

There is typically a wider bid/offer spread and one of the issues with many AIM companies in the UK has been the tendency to de-list from the market, which leaves the investor in what is essentially a private company. The actual business itself may well be more reliant on only a limited product/service line or reliant on a small number of customers/suppliers. This can frequently lead to profit warnings and in some cases may well be terminal. There is also the theme of entrepreneur led businesses, who could either leave or struggle when the company grows to a certain size.

European smaller companies could well be an interesting theme, if investors believe we have reached the nadir of the region’s economic troubles. For the last two years some of the European blue chips such as Nestle and Roche have actually been very strong performers, given their exposure to global revenue growth. Indeed, so far this year of the net inflows into the region, 75% have gone into large caps.

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Since 1990, the average earnings growth for a small cap has been 20.4%, compared to a European large cap growing earnings by 17.7%. Once again, mergers and acquisitions could be a key theme in the coming months, boosting stocks further.

In the US the definition of a small cap is a company in the market capitalisation range of $400 million to $4 billion, making it a very large universe. The average size of a constituent in the Russell 2000 Index is $1.5 billion and over the last year, this widely used benchmark for small caps is up 26%.

The US economy has been in improving shape through 2013, with an accelerating housing market and improving consumer sentiment. Big industry has also been bringing some operations, previously out-sourced, back into the US, as the benefits of cheaper shale oil/gas start to flow. This has been an almost perfect backdrop for domestic focussed small caps.

Outstanding performers year to date have included Arkansas Best Corporation up 175%, Revolution Lighting up 310% and Zale Corporation up 250%.

Small companies in Asia Pacific ex-Japan have enjoyed positive returns in the last two years but nowhere near the scale of other markets. The major restraining factor has been the uncertainty over China’s transition from an export driven economy to boosting domestic demand levels. The broad index is up just over 11% over the last two years. The region has long had wider discounts in place for such stocks as opposed to Western markets, given the far greater use of cross family holdings and associate companies. External shareholders are often at the bottom of the list of priorities and have virtually no influence on the fortunes of the business.

Japan has been a different story with the Topix index gaining 54% in the last two years, boosted by ‘Abenomics’ and the vast liquidity programme underway. There is evidence that industrial production is rising and for the first time in decades land and property prices are also on the rise. Funds have seen large net inflows which have now spread from the mainstream stocks such as Toyota into the vast universe of small companies.

For years, many have languished at discounts to book value and many have inefficient capital structures, with large piles of cash sat on the balance sheet. Indeed the bottom half of the index have no analyst coverage. Japan also suffers from numerous associate companies and there are often sporadic periods where Western investors try to introduce shareholder activism.

As for the Emerging Markets small cap asset class, many investors view corporate governance as the main priority, liquidity can also be a major issue. The Latin American region has been one of the relative poor performers in the last two years with a rise of only 10%. Clearly many economies have been impacted by negative domestic factors such as high inflation and rising interest rates.

The worst performing region however, has been India where the small cap index is actually down 23% in the last couple of years. The economy has really struggled and there has been a negative flow of funds from international investors.

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Mergers and acquisitions could be a key theme in the coming months Š Capital International Limited 2013

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Long term recovery will be hindered by reduction in human capital and loss of a skill base Capital International

Page 11

Market in Focus Is European recovery in sight?

Longer term European expansion probably needs a full fiscal union, combined with a banking union. This is simply not going to happen in the short to medium term, however there are signs of ‘green shoots’, although the recovery is likely to be both subdued and fragile. Investors need to consider there are some serious challenges, even in the strong economies such as Germany, and not be too dominated by the peripheral economies.

Germany is suffering from an increasingly tight labour market with bottlenecks experienced in some sectors. There is also the major challenge of meeting the Government targets on the use of renewable energy.

The transformation, known as ‘Energiewende’, will see 35% of electricity consumption from renewables by 2020 and a staggering 80% by 2050. Such ambitious targets are being heavily criticised by industry and at an individual level where bills are already at the third highest in the European Union.

Crucially for the region, credit conditions are likely to remain loose for several quarters and OECD leading indicators have also turned up. GDP growth for the entire region is forecast to be still negative in the current year, falling by 0.5%, before increasing by 0.9% in 2014 and 1.2% in 2015.

Judging from recent comments from Mario Draghi, the ECB are still contemplating further interest rates cuts and possibly further LTRO. Members still believe that the risks lie to the downside.

From an equity perspective there has also been a dramatic fall in the level of shorting the region’s stocks. In the wake of the credit crisis this rose to a high of 24% of the market was being shorted, this has dropped now to only 1.7%. This is also backed up in the allocation that institutional investors are giving to the region. In a recent report 36% of investors were now ‘overweight’, the highest reading since May 2007.

A major hurdle remains the very high levels of unemployment, with 11% of the region unemployed with the figure rising to close to 24% for people under 25 years of age. Indeed, the figure is as high as 56% in Spain, in part leading to an outflow in the last calendar year of half a million individuals.

The International Labour Organisation recently stated that Europe faced a ‘demographic time bomb’, as not only the population aged but the youth unemployment created a ‘lost generation’. Long term recovery will be hindered by the diminution in human capital and a loss of skill base.

The Banking Sector is vital to the European story and here there are also signs of an inflection point. The European Central Bank is scheduled to oversee the sector from October 2014 and whilst there are still risks that further capital needs to be raised, this is counterbalanced by more visibility and a lower risk premium for the sector.

Since the end of 2011, the European Banks index has risen by over 50%, but incredibly is still some 60% below the 2007 peak.

© Capital International Limited 2013

Recent manufacturing purchasing manager data highlighted the highest sentiment in two years in August data. There appeared to be strong order books across a range of industries, providing much needed visibility and the ability to run down any excess stock levels. Inflationary pressures remain muted, arguably the structural issues across the region are deflationary and there is a lack of commodity price rises.

Many Sovereign states are also running contractionary fiscal policies, with the notable exception of Germany. However, despite these actions; generally debt/GDP ratios are still rising.

With the private sector yet to begin de-leveraging, there is plenty of incentive for the ECB to be more proactive.

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Money Markets | Summary Global Quantitative Easing Until the financial crisis in 2008, Quantitative Easing had been an obscure financial term referring to an unconventional monetary policy used in Japan. Five years on from the Lehman bankruptcy, QE has been deployed extensively and forms a key component of the global economic recovery. The strategy is unusual for central banks as in that their actions generally aim to reduce inflation but in a departure from this goal QE aims to increase inflation by way of expanding the monetary base of an economy.

The most evident sign of its success is the performance of financial markets since its introduction. In those five years, equity markets have risen over 100% from their lows in the USA while the 10 year bond yield fell from 4% to below 1.5%, delivering large profits for both equity and bond investors.

As Quantitative Easing has swamped markets with liquidity, it has also brought significant volatility and high correlation between asset classes. This has been seen in markets trading in an almost binary fashion referred to as ‘risk on/risk off’. Over this time negative market data has been viewed almost as a positive factor as central banks have issued guidance that they will use all options to keep markets afloat. Equities and other risk assets have then been rising sharply after weak numbers in anticipation of further significant support from QE.

It also only functions once central banks have reached the lower bound of their short-term interest rates and further rate cuts are either not possible or likely to be ineffective.

Bond buying by central banks is at the heart of a Quantitative Easing programme and while this is a normal part of a central bank’s remit, they normally act in bond markets to fine tune interest rates within a broader yield curve management exercise. In QE, bonds and other securities are bought by the central bank without reference to the yield or interest rate. With a potentially unlimited buyer of bonds in the market, interest rates can be maintained at low levels and help banks to continue lending while maintaining liquidity.

One of the largest fears over QE is the effect on markets when this huge boost to the markets is finally withdrawn.

Will the patient be healthy enough to survive without life support?

Markets gave a preview of what the unwinding of QE may look like in the second quarter after Fed Chairman Ben Bernanke noted that plans for slowing the pace of QE, or ‘tapering’, was being considered.

Co-ordinated central bank responses to the crisis have been massive; the US Federal Reserve’s balance sheet alone has exploded to over $3.7 trillion, a sum greater than the entire GDP of Germany. Similar programmes in the UK, Eurozone, Switzerland and Japan have all shown substantial growth with the current size amounting to approximately 25% of GDP in the four largest economies.

In a matter of weeks, 10 year bond yields in the US had jumped by over 1.25%, equity volatility spiked to its highest level for the year with major indexes down over 4% for three days in June. 10 year yields duly stabilised at the 3% level and equities pushed on to all-time highs in the third quarter but the effect on mortgage bonds unnerved the housing market.

For such a monumental strategy, definitive evidence of its success is elusive. While it is generally accepted that QE has been positive or at least done no more harm than if it had not existed, QE has its detractors.

---- 10 Year Treasury Yields

90.0% 90%

4.0

1400

3.5

1200

3.0

1000

2.5

800

2.0

600

1.5

QE1

400

QE2

200

1.0

QE3

0.5 0

Capital International

Aug 2013

Aug 2012

Aug 2011

Aug 2010

Aug 2009

Aug 2008

0

80.0% 80% 70.0% 70% 60.0% 60% 50.0% 50%

35.6%

40.0% 40% 30.0% 30%

23.7%

23.2% 16.8%

20.0% 20% 10.0% 10% 0.0% 0%

USA

Eurozone

Japan

UK

UK

1600

84.8%

Japan

4.5

Eurozone

1800

USA

---- US Equities

Global Quantitative Easing to GDP Ratio Third Quarter 2013 Global Quantitative Easing to GDP Ratio

Switzerland

Switzerland

Amount Owned by Non-US Countries US Dollars / Billions

Page 13

With the recovery still very weak, a reversal in real estate would be highly detrimental to market confidence and with Adjustable Rate Mortgage rates of over 4%, the Federal Reserve surprised the market in its September meeting by making no changes to the QE programme. Analysis of the meeting suggests that Bernanke had been testing market reaction to some extent but intended to dispel any idea of a predetermined route out of QE. Given the reaction to even a modest slowing of Quantitative Easing, it is easy to see why many countries are wary of its longer-term effects and potentially unintended consequences of an untested strategy. Of most concern is the rise in inflation that accompanies an expansion of the monetary base. Countries with experience of the negative aspects of rising prices like Germany are particularly wary of QE while Emerging markets complain that it makes their currencies less competitive through the devaluation of the western currencies.

Quantitative Easing remains the preferred tool of central bankers Š Capital International Limited 2013

It’s also thought that QE may not be a temporary crisis response but a more permanent fixture in global markets.

The new style of central banking sees less independence of political influence and more of an active partnership between finance ministers and bankers as seen in Japan. Inflation is also less important with more political aims targeted, such as unemployment levels tied to interest rates.

There are more subtle, social and political arguments too.

As QE inflates asset prices, the largest direct beneficiaries are those with the most assets leading to complaints that it is widening the inequality in wealth.

With the top 5% of wealthiest Americans owning 60% of all the individually-held financial assets, even the Federal Reserve and the Bank of England acknowledge this problem but QE remains the preferred tool of central bankers.

Adding to the complexity, the world’s central banks are all under relatively new leaders. Mario Draghi, head of the ECB, is effectively the longest-serving bank chief, having been appointed in November 2011 with the likely departure of Ben Bernanke at the end of 2013. Kuroda of Japan was appointed in March 2013 and Mark Carney joined the Bank of England officially on 1st July 2013.

So, far from seeing the end of QE, it may be more realistic to expect an evolution of tactics, with potentially even more unorthodox measures used to support markets through a delicate phase of recovery.

Innovation Integrity Excellence

14 Page

Country in Focus Italy Italy is undertaking a series of critically important reforms in response to the economic and social crisis. As with many other countries, particularly in Europe, policies to stimulate growth have been and will likely continue to be, accompanied by harsh austerity measures to achieve fiscal consolidation. These measures include reductions in healthcare expenditure, public sector employees’ wages, and pensions. As a consequence, Italy is facing a very complicated policy environment where there are high expectations of effective, decisive government action to safeguard the interests of the general public.

With this in mind, the success of any reforms will rely heavily on the capacity of the government to restore trust in its commitment and ability to guide the country towards sustainable economic growth. However, according to recent studies, less than one quarter of Italian citizens had confidence in the quality of government decision making. Concerns over public integrity and corruption stand out as key elements underlying this prevailing lack of trust. The level of perceived corruption in Italy has risen continuously since 2007, while trust in the government’s ability to control corruption has declined steadily since 2000.

Italy’s national audit office, the Corte dei Conti, estimates that the cost of corruption in Italy in 2011 was approximately €60 billion, the equivalent of the federal deficit in the same year.

Attempts have been made in the past to strengthen public integrity as part of broader measures. One such effort was the so-called “Bruneta reform” in 2009 that sought to modernise the public service and improve its efficiency and transparency.

However, no comprehensive anti-corruption package had addressed the widely acknowledged gaps in the public integrity framework until a law was passed in 2012.

Known as the Anti-Corruption Law, it goes a considerable way towards filling the gap in integrity and anti-corruption legislation.

It signals a paradigm shift from punitive to preventive in the Italian government’s approach to corruption. The law enshrines public sector integrity management principles and strengthens existing corruption prevention through the designation of a new anti-corruption authority, a detailed framework for the adoption of a national anti-corruption plan, and measures to identify and prevent conflicts of interest in the public sector.

The Anti-Corruption Law represents a unique opportunity for Italy to strengthen the viability, sustainability, and effectiveness of its on-going economic structural reforms by institutionalising a revitalised culture of integrity anchored in new, improved public management institutions, tools and processes. If properly and effectively implemented, the law could have a major long term political and economic impact on the practices, behaviour and attitudes of the government and citizens in Italy.

The Italian system of government is more and more decentralised and there are plans to further extend spending and revenue powers to the regions. Central government funds essential expenditure at the regional and local levels.

Compared with other developed countries, social security funding accounts for a high proportion of total revenues and expenditures. To ease the on-going economic crisis Italy has introduced a number of fiscal stimulus packages.

Page 15

Their aggregate size is among the smallest of all Organisation for Economic Co-operation and Development (OECD) members due to the country’s limited room for fiscal manoeuvre that results from its relatively high levels of debt, 109% of GDP in 2010.

The Euro area’s third largest economy and the world’s seventh largest, has been hit hard by the economic crisis since 2008.

Comparison of its financial health prior to the downturn with its situation today reveals a gloomy picture. The unemployment rate is on the rise. Of 60.33 million inhabitants in 2011, 10.8% were unemployed, a substantial increase over the 6.9% recorded in the second quarter of 2008. GDP growth in 2011 was 0.4%, much lower than the OECD average of 1.8%.

Central government debt increased from €1,573.8 billion in 2008 to €1,794.4 billion in 2011, a rise of 14%. The general government debt ratio is now 109% of GDP, almost twice the OECD average of 55%. In 2010, Italy had the third highest general government debt ratio of all OECD countries.

The severe economic crisis and ensuing austerity measures have eroded citizens’ trust in the ability and commitment of governments to defend public interest over that of the few.

Grassroots movements have sprung up across the globe to express discontent and demand stronger accountability from the authorities. In Italy, the level of trust in the national government is alarmingly low. In a Gallup poll from 2012, only 24% of Italian respondents said they had confidence in their government. The figure represents a drop 8% from a similar survey in November 2011.

© Capital International Limited 2013

Against that background, the success of identified reforms will rely heavily on the capacity of the Italian government to restore trust in its ability and commitment to guide the country towards sustainable economic growth. Only a new sense of trust will renew private sector faith in Italy’s future success, encourage investments and promote innovation. Today, concerns over integrity and corruption stand out as key factors in the prevailing lack of trust in Italy’s public sector.

Only recently the Italian financial markets suffered a daily drop over 2.5% due to political instability. The catalyst for this drop was when conservative leader Silvio Berlusconi pulled support for the government, plunging Italy into a fresh political crisis which left Prime Minister Enrico Letta scrambling to rescue the government from collapse. Mr Berlusconi’s gambit capped weeks of rising tensions within his fragile coalition with Mr Letta’s Democratic Party over his tax fraud conviction in August. The conservative leader then called on Italian President Giorgio Napolitano to dissolve Parliament and pursue a new vote just seven months after the previous general election.

But Mr Letta responded by saying he would seek a confidence vote, apparently hoping that some members of Mr Berlusconi’s party, which is showing signs of a split, would still give his coalition enough support to carry on. Italy’s political chaos, which inflamed the Eurozone crisis two years ago, could be the biggest test so far of Europe’s defences against a revival of the financial panic that has afflicted the region in recent years.

This time, faith in the ECB’s promise to safeguard stability is so strong that many political leaders and economists believe a full blown run on Italy’s bond market is unlikely.

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16 Page

Sector Focus Pharmaceuticals According to the World Health Organisation the global pharmaceuticals market is now worth an estimated $300 billion a year. This figure is expected to rise to $400 billion over the next three years. The top ten pharmaceutical companies control over one third of the market, several of these can boast sales of more than $10 billion a year and profit margins around 30%.

Six of these companies are based in the United States and four in Europe. And it is predicted that North and South America, Europe and Japan will continue to dominate this market and account for a full 85% of the global pharmaceuticals market well into the 21st century.

Interestingly these companies currently spend one third of all sales revenue on marketing their products, roughly twice what they spend on research and development.

As a result of this pressure to maintain sales the World Health Organisation has said that it considers this an inherent conflict of interest between the legitimate business goals of manufacturers and the social, medical and economic needs of providers and the public to select and use drugs in the most rational way. This is particularly true where drugs companies are the main source of information as to which products are most effective. Even in the United Kingdom, where the medical profession receives more independent, publicly-funded information than in many other countries, promotional spending by pharmaceuticals companies is 50 times greater than spending on public information on health.

To tackle this problem, the World Health Assembly adopted, in 1988, the WHO Ethical Criteria for Medicinal Drug Promotion, dedicated to the rational use of drugs. However, many people have voiced concerns that these guidelines have been largely disregarded, as has the voluntary Code of Pharmaceutical Practices developed by the industry’s own International Federation of Pharmaceutical Manufacturers’ Associations (PharMA).

Capital International

A similar conflict of interests exists in the area of drug research and development particularly in the area of neglected diseases.

The private sector dominates research and development, spending millions of Dollars each year developing new drugs for the mass market. The profit imperative ensures that the drugs chosen for development are those most likely to provide a high return on the company’s investment. As a result, drugs for use in the industrialised world are prioritised over ones for use in less developed countries, where many patients would be unable to pay for them.

Some large pharmaceutical companies support health development through public/private partnerships. In quite a few cases, international corporations and foundations have contributed drugs or products free of charge to help in disease eradication. SmithKline Beecham has made a $500 million commitment to the World Health Organisation of its drug ‘Albendazole’, used to treat elephantiasis. American Home Products has provided a non-toxic larvicide and the DuPont Company have contributed free cloth water filters for the eradication of guinea-worm disease.

The Japanese Nippon Foundation has enabled the World Health Organisation to supply blister packs containing the drugs needed for multi-drug therapy of tuberculosis in sufficient quantities to treat about 800 000 patients a year in some 35 countries. The patients receive the treatments free of charge.

The performance of the Pharmaceutical sector has been supported by relatively high dividend yields, 3% compared to 2% for the S&P 500. Investors seeking yield have driven up Pharma valuations as bond yields have fallen and, conversely, sold off Pharmaceuticals when bond yields rise. For example, 10 year Treasury yields hit a 2013 low point around 1.7% in late April while Pharmaceutical performance spiked at about 12% YTD better than the S&P 500. Pharmaceuticals as a group were up 22.3% year to date, while the S&P 500 was 10.7%.

Consequently, Pharmaceutical year to date performance is negatively correlated with bond yields.

While Pharma and Biotech has always faced a somewhat dubious distinction, these two sectors are becoming increasingly similar because of cross sector acquisitions and refocused Pharma pipelines driven primarily by market forces that apply to both sectors. For example, the lack of true generic competition for biologics has long driven Pharma companies to bolster their biological portfolios. Furthermore, the maturation of primary care medicine as major products go off patent and payers refuse to reimburse new drugs unless they are proven clinically superior to low cost standards of care, has resulted in proliferation of innovative new product launches in speciality medicine which frequently happen to biologics and tend to be considered one of the traditional domains of Biotech. Most analyst estimates believe biologic revenue will likely increase from around 20% of total Pharma revenue in 2010 to over 40% in 2020 due to the factors mentioned. Meanwhile, biologic revenue will estimated to decrease from over 60% of total Biotech revenue in 2010 to about 50% in 2020.

Year to date performance across the Pharma sector has been solid overall, +18% YTD, versus +17% for S&P 500. However, Pharma performance is mixed with certain names performing better than others driven largely by new product catalysts. For example, Bristol-Myers Squibb Co is up +39% on the strength of PD-1 (Nivolumab) data, while Allergan was -3% YTD due to pipeline setbacks and generic threats.

Page 17

AstraZeneca Plc

Pfizer Inc

AstraZeneca is a British-Swedish multinational pharmaceutical and biologics company headquartered in London. Like Pfizer it is one of the world’s largest pharmaceutical companies and has operations in over 100 countries.

Pfizer Inc is an American multinational pharmaceutical corporation headquartered in New York, with its research headquarters in Goton, Connecticut and is one of the world’s largest pharmaceutical companies.

The company was founded in 1999 through the merger of Sweden based Astra AB and the UK based Zeneca Group, currently with a market cap of just over £40 billion. The company recently reported its second quarter results for 2013, with 2013 revenue guidance maintained but guidance for 2013 operating costs was increased.

With regards to the company’s recent performance, Q2 sales were very much in-line. Consensus wanted $13,003 million and got just short of that with $12,973 million. The only area of concern was that consumer was at the bottom of the range of forecasts. It was expected to be +8% and delivered +4% and with +7% expected for the fiscal year, this is shy of the trajectory.

Astra continues to expect core earnings per share to decline significantly faster than revenues. This guidance update could lead to consensus 2013 core earnings per share being trimmed by about 2%, with likely similar cuts beyond, as consensus currently has operating costs down only by 1% in 2013, then about flat for the next few years. Whereas the recent guidance suggests increased costs for 2013, and it is expected that this higher level of spending will be maintained for the next few years. With numbers in line with expectations, a trim to 2013 guidance and no material pipeline updates, it is easy to see that the stock may under-perform in the near term.

© Capital International Limited 2013

Pharma sales delivered -8%, which was in line analysts’ expectations, that’s a 10% decline for the first half of the year, and with just a -6.5% decline expected for the year, there will have to be some improvement in the second half. However, the firm confirmed that it expects the second half of the year to be better than the first.

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18 Page

Country Update Japan | Olympics Boost Being a successful investor often requires being one step ahead of the herd and following the recent Olympic vote, which saw Tokyo chosen as the host city for the 2020 Olympics, there is the opportunity to do just that. The decision has already provided an uplift for construction stocks on anticipation of lucrative contracts being awarded. But looking further ahead, the 2020 games should benefit Japan’s tourism and travel industries.

So should we invest now for anticipated growth? A couple of points come to mind here. Firstly, do the Olympics actually help investors? Secondly, Japan has been in a slump for quite a while, so does an Olympics in seven years’ time mean you should think differently about investing in the nation?

With regards to the Olympic investment question, previous research and analysis of the investment performance of recent Olympics paint a pretty dismal picture. Only Greece and the US reported a small gain, but in China, Australia and Spain, the market fell over the period one month before the games until their end. The Barcelona Olympics actually saw an almost 15% drop in Spanish stock markets. But realistically, you would expect markets to have factored in any boost from the Olympics well ahead of the beginning of the games, so it makes sense that there could be a slump around the time of the event. However, a lot would also depend on what else is happening and influencing markets at the time.

It’s been more than a year since the London Olympic Games and sentiment is significantly more positive now than in the immediate aftermath. Trade and investment minister Lord Green recently said that the Olympics had resulted in a large pipeline of future business contracts going forward. However, investors are likely to have seen the largest gains in the years following the awarding of the games to London in 2005, rather than before, during or after the Olympics. Will it be a similar story for Japan? Being awarded the 2020 Olympics will be good sentiment and should have some real economic effects in due course. As mentioned already, the most notable beneficiaries of the announcement were construction stocks, although the impact would be expected to be spread over the next seven years. This boost from the Olympics reinforces the evidence of economic recovery with annualised GDP growth close to 4% representing a major turnaround for a country that has been in the deflationary quagmire for the best part of 20 years. One of the clearest negatives about being awarded the games is that hosting the Olympics usually requires significant amounts of government investment. As Japan is widely regarded as being quite indebted this may cause some concern. However the government does have substantial assets and there has been talk of selling them down in the next two or three years, which should assist with the deficit. But the construction and retail benefits of the games should provide a further boost to Abenomics and his aim to reflate the economy.

Abenomics is the term given to the economic policies advocated by Shinzo Abe, the current prime minister of Japan. Abe aims to expand the economy of Japan, still facing challenges related to the global economic recession, by a combination of measures such as aggressive quantitative easing from the Bank of Japan, a surge in public infrastructure spending and the devaluation of the yen.

Capital International

The policies can be compared and contrasted to other government measures across the world to stimulate economic growth. Keynesian theories of demand side macroeconomic changes are cited as partial inspiration for Abenomics. In terms of results, the yen has become about 25% lower against the US Dollar in the second quarter of 2013 compared to the same period in 2012, with highly loose monetary policy being followed. In addition, the unemployment rate of Japan has lowered from 4% in the final quarter of 2012 to 3.7% in the first quarter of 2013, continuing a past trend.

It is estimated that hosting the 2020 Summer Olympics in Tokyo is likely to increase Japan’s GDP by 0.5% in that year, with positive economic impact of around 432 trillion yen, as a result of the expected growing demand for new construction and a boost to tourism.

However in our view, Olympics exposure alone does not provide a reason to invest in companies perceived to be direct beneficiaries of the games. But there are a host of positive drivers supporting the case for making medium to long term investments in specific Japanese companies with domestic construction and infrastructure exposure. One such company is Mitsui Fudosan. Mitsui Fudosan is one of the country’s largest developers and real estate service providers and recently reported strong sales and increased demand for rented office space in and around Tokyo in the wake of the 2011 earthquake.

This year the company has been boosted by the more buoyant economic conditions triggered by the far ranging stimulus initiatives being implemented by the current government. This more enthusiastic, economic backdrop has resulted in an increase in residential and commercial property transactions and consequently, a stronger pricing environment for real estate players. Abe has promised a compact games, with construction to be concentrated in a relatively confined space. Mitsui Fudosan’s considerable construction project management expertise, as well as its access to Tokyo’s limited land bank, suggests that it is well positioned to benefit from games related construction.

The Japanese public still appear to be careful about what they spend on day to day essentials, but they do seem to be more comfortable about spending more on some discretionary items, like clothes. Higher summer bonus payments also appear to be encouraging Japanese consumers to shop. These bonuses are usually equivalent to several months’ salary, however are contingent upon company performance. The stronger earnings being reported by many Japanese companies fed through into higher bonuses during the summer. In addition, a new inheritance tax seems to be encouraging older people in particular to spend more, rather than seeing the tax eat into the legacies they have accumulated for their descendants.

All these factors in combination seem to bode well for a wide range of Japanese businesses whether or not they will be direct beneficiaries of games related spending. On this basis, Japan’s stock markets have plenty of room to make further gains following their impressive rally since Abe came to power late last year. The key to identifying those stocks with the most upside potential is to focus on companies whose improving underlying fundamentals are not yet fully reflected in their shares prices.

Articles have been written by Chris Bell, Stephen Kelly and Paul Martinez

Page 19

Innovation Integrity Excellence

20 Page

Group Updates Corporate Social Responsibility In the second quarter of 2013 we mentioned that we were holding a Cyclothon in aid of Breathe Easy Isle of Man, a support group for people affected by lung conditions including their friends, family and carers, part of the British Lung Foundation. The Cyclothon was held in July at the Strand Shopping Centre, where participants successfully completed a stage of the Tour de France. Julie-Anne Osland worked particularly hard in getting this event organised for a cause that is very special to her and her family. A big thank you also to everyone who sponsored the Cyclothon, we raised £650 for Breathe Easy Isle of Man. In addition, we were delighted to see all the hard work had paid off for Pete Miller and Paul Corris who both managed to complete the Parish Walk and raise £1000 for the Hospice.

Customer Exam Survey 2013 Success As a Group, we continue to support staff training and development through Continuous Professional Development.

We remain fully aligned with our Training & Competency framework, which defines the core competencies necessary for staff to fulfil their duties at all levels.

Customer Survey 2013 | focusing on our customers

We would like to express our congratulations to both Mark Wilkinson and Chris Boyde on passing their second modules of the Investment Advice Diploma. Both are presently working on the third and final module of this rigorous Level 4 qualification.

Thank you to all of our customers who completed our 2013 survey, we have had a fantastic response. At the moment we are compiling all of the results and we anticipate providing a few highlights to you in the January edition of our quarterly Investment Review.

Pictured: Pete Miller A great tribute after completing the Parish Walk They weren’t the only walkers in the Group, and we would like to congratulate Gill Porter and Helen Long who raised £350 for Cancer Research UK, through the completion of the Relay for Life and also cooking breakfast baps for the entire office.

We have been and continue to be heavily involved in Manx rugby, starting with the sponsoring of a new scrummage machine for King William’s College, as well as their training and playing kit. We also participated in four memorable rounds of this summer’s corporate touch rugby competition, with thanks going to Julie-Anne for organising this, Vaughan Paddock for captaining the side and Chris Bell Jr for his star performances. And, finally, our finance team will be working closely with the Southern Nomads over the next twelve months to help improve the club’s financial management.

If you would to take part in any of our events or would like to know more then please get in touch with our committee at: SocialandCharity@capital-iom.com Or alternatively follow us on Twitter @CIG_iom or via LinkedIn, or even visit our website at: www.capital-iom.com

You will remember that this year we offered a prize to those people who entered the survey and importantly, left their contact details. We are delighted to announce that ‘Mr Roy Harding of Walpay Limited’ was selected at random and is our 2013 prize winner.

Mr Harding is a customer of Capital Treasury Services Limited and will be receiving vouchers to the value of £100 very shortly.

Thank you again for your participation in our survey, it is an excellent opportunity for us to collect your comments both positive and negative and importantly, take some direct action. We take your responses very seriously and our dedication to focusing on our customers’ needs, continues to be a key strategic objective for the Group.

Our survey is not the only opportunity for you to let us know what you think about our products and services, as well as the day to day service you receive. Please get in touch with your Account Executive at any time or if you wish, you can contact us via e-mail at info@capital-iom.com.

Thank you for your time and participation this year. We look forward to updating you in 2014 in the January publication of our Investment Review.

CPD | maintaining and developing our staff’s knowledge and skills Mark Wilkinson | Dealing Director has recently sat and passed the second module of the Investment Advice Diploma Chris Boyde | Trading Manager has recently sat and passed the second module of the Investment Advice Diploma Jacques De Villiers | Dealing Administrator has recently sat and passed the first module of the Investment Advice Diploma Tina Corteen | Business Development & Marketing Senior Executive was presented her Diploma in Offshore Finance and Administration at the annual ICSA dinner Tara Lampitt | New Business Administrator has passed her third CISI module of the Investment Operations Certificate in Principles of Financial Regulation Paul Corris | Asset Services Administrator has recently passed the CISI Principles of UK Financial Regulation module, his third and final module for the Investment Operations Certificate David Long | Chief Investment Officer has embarked upon an intensive course to complete CISI Level 6 Diploma in Private Client Investment Advice & Management

Further Information For more information go on-line to our web portal at www.capital-iom.com or alternatively contact us at the details below: E-mail: info@capital-iom.com Website: www.capital-iom.com Telephone: +44 (0) 1624 654200 In writing: Capital International Group

Capital House, Circular Road, Douglas, Isle of Man, IM1 1AG

This document does not constitute an offer or an invitation, by or on behalf of any company within the Capital International Group of companies or any associated company, to buy or sell any security.

The information contained herein is believed to be correct, but its accuracy cannot be guaranteed.

Any reference to past performance is not necessarily a guide to the future.

Opinions constitute our judgement as of this date and are subject to change.

The company, its clients and officers may have a position in, or engage in transactions in any of the securities mentioned.

The price of a security may go down as well as up and its value may be adversely affected by currency fluctuations.

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Capital International

www.capital-iom.com T : +44 (0) 1624 654200 F: +44 (0) 1624 654201 E: info@capital-iom.com Capital International Limited is a member of the London Stock Exchange Capital International Limited is a member of the Capital International Group Capital International Limited is licensed by the Isle of Man Financial Supervision Commission Registered Address: Capital House, Circular Road, Douglas, Isle of Man, IM1 1AG

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