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Carrying a closed umbrella

In this stage of the cycle, we remain agile and opportunistic - and braced for any market corrections.

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Editorial

Multi Asset

Carrying a closed umbrella

In this stage of the cycle, we remain agile and opportunistic - and braced for any market corrections.

Taking your umbrella is a sure path to frustration because usually that's precisely when it doesn't rain. Leaving it home, on the other hand, can be just as frustrating because then it's sure to rain. Unfortunately, long frustration can lead to stomach pains, which we'd like to avoid. We view taking our umbrella as a necessary precaution whether it's because it's actually raining or simply because, in our experience, it never rains when we have it.

To put this in a capital-market context, we are not frustrated when it turns out we hedged ourselves "for nothing." The hedge, of course, was not "for nothing" because we paid a hedge premium, much like the premium paid for an index option. Currently, we are not hedging directly with put options. Instead, we are seeking to eliminate portfolio risks on a selective basis, increasing our liquidity position and participating in the market upswing partly through index call options, reducing the risk of loss. We are counting on rising volatility, despite the fact that it hasn't been profitable to do so for a long time. For volatility continues to fall, seemingly independent of political surprises. However, we are not trying to make money with volatility, but instead seeking to diversify our portfolio.

A lot is pointing to a continued climb in markets

To avoid any misunderstanding, we would like to emphasize that we have a constructive view of the different asset classes on a 12-month perspective, with just a few exceptions. The advanced cycle continues to spoil investors with many of the ingredients commonly attributed to a Goldilocks scenario, in other words, an economy that is neither too hot nor too cold, with low inflation and market-friendly central banks. We also have rising corporate profits, positive sentiment indicators and, contrary to expectations, skeptical equity investors.

But there are also factors that make us cautious. For example, the aforementioned record-low volatility in many risk asset classes, which in turn leads to many risk-based strategies increasing the share of riskier assets. This, just like the many investors counting on a continued fall in volatility, leads to a situation where a pronounced market correction can quickly turn into a self-reinforcing downtrend. And by no means are all of the indicators positive, as can be seen by the decline in our surprise indicator. The dwindling oil price could also pose some danger, especially to the U.S. high-yield segment. Investors could also start reading something negative into the further flattening of the U.S. yield curve. Not to mention further political surprises, for example stemming from London or Washington D.C.

We're building liquidity

It's clear there's no shortage of killjoys that could, at the very least, interrupt the capital-market party. So we're keeping some dry powder as (under the current circumstances) we would want to use it in a correction to rebuild risk positions. Accordingly, we have increased our holdings in cash, short-term bonds, gold and U.S. interest-bearing securities.

Apart from this, we are trying to achieve returns in the current market environment mainly by employing relative investment strategies. For equities, we prefer Europe and the emerging markets vs. the United States. In the emerging economies we are reducing our holdings in high-yield corporate bonds in favor of hard-currency bonds. In Europe, we see a shift based on our new foreign-exchange forecast. Unlike 2014-2016, foreign-currency investments are no longer benefiting from the tailwinds provided by a weakening euro. But they are not facing any headwinds either. This is just one reason why we continue to swing our umbrella with confidence for now.

1-year volatility falls after Brexit anniversary

One year later, the impact of the Brexit vote disappears from the 1-year volatility index

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 6/27/17

Is the transatlantic interest-rate divergence ending?

Draghi's "whatever it takes" (2012) and Bernanke's "taper tantrum" (2013) started the divergence in interest rates. # Have we reached the peak?

Sources: Thomson Reuters Datastream, Deutsche Asset Management Investment GmbH; as of 6/28/17

Allocation

Keep some powder dry

Reshuffling risk assets, building liquidity

Since the environment has largely remained the same, we've made only minor adjustments to our sample portfolio. We are still positioned for rising equity markets and slightly rising interest rates, but we are now more positive on Europe than the United States. The recovery in the emerging markets is still on track. Here we like hard-currency bonds and particularly Asian equities. We are more cautious on high-yield bonds from the United States and Europe after their solid run. We continue to like investment-grade bonds but are now more selective. For reasons of hedging and diversification, and in anticipation of rising volatility, we have increased our positions in gold and some cyclical commodities.

Source: Multi Asset Group, Deutsche Asset Management Investment GmbH; as of 6/29/17

The chart shows how we would currently design a balanced, euro-denominated portfolio for a European investor taking global exposure. This allocation may not be suitable for all investors. Alternatives are not suitable for all clients.

Indicators

Partly cloudy

Investors willing to take risk despite downturn in two indicators

A few clouds have gathered over financial markets lately. This is reflected, among others, by the divergence in development of the multi-asset indicators. Whereas the risk indicator signals a positive environment with a comparatively high level of stability during the past few weeks, the macroeconomic environment in the past 3 months has softened.

In that time, the macro indicator dropped more than 30 points with a deterioration in 9 out of the 10 sub-indicators. The only sub-indicator seeing an improvement was the U.S. labor market. Despite this, the macro indicator remains in positive territory.

The surprise indicator, on the other hand, could not maintain its positive level. A look at the surprise indicators in major regions suggests that reality could not keep pace with analysts' expectations, particularly in the United States and Asia. In both of these regions, expectations were so high that they were almost impossible to beat. The United States, in particular, saw its sub-indicator drift from distinctly positive to negative territory.

Macro indicator

Condenses a wide range of economic data

Source: Deutsche Asset Management Investment GmbH; as of 6/23/17

Risk indicator

Reflects investors' current level of risk tolerance in financial markets

Source: Deutsche Asset Management Investment GmbH; as of 6/23/17

Surprise indicator

Tracks economic data relative to consensus expectations

Source: Deutsche Asset Management Investment GmbH; as of 6/23/17

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In 2012, ECB president Mario Draghi said at a press conference that the ECB would do "whatever it takes" to preserve the euro as a common currency. As a result, German government-bond yields remained at a low level and other Eurozone government-bond yields decreased significantly. In the United States, on the other hand, the then Federal Reserve chairman Ben Bernanke's announcement in 2013 that the Fed planned to gradually "taper" its bond-buying program sent yields sharply higher. Because the idea of a gradual tapering was specially intended to avoid such a sharp market reaction, markets referred to the reaction as a "tantrum."

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