How Rothschild Sees The Future

Rothschild has identified four different scenarios that, in their view, are the most likely to occur. The series of scenarios for GDP growth and inflation in the main western economies, Japan and China may guide investor thinking but their somewhat ominous conclusion is worth bearing in mind: “Further monetary ‘experiments’ are becoming less probable. However, significant imbalances and risks persist. This is the reason why we have left the size (probability) of our depression scenario unchanged.”

Notably, equities are not well supported by current valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero...exposing equities to a potentially sharp correction.”

Setting the scene

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The scenarios presented here are intended to illustrate our economic outlook over the next few years.

What this is

A series of scenarios for GDP growth and inflation in the main western economies, Japan and China.

A simplification. The global economy is complex and multi-dimensional, and can be represented in many different ways. While narrowing in on just growth and inflation involves some simplification, we believe it is still worthwhile – most other economic variables and policy actions can be covered in relation to their impact on growth and inflation.

A guide to our thinking. The scenarios flow from our investment analysis. They are intended to illustrate the thinking that shapes the way we have built our clients’ portfolios. They can also help identify some of the main investment risks and opportunities.

What this isn’t

A series of detailed forecasts. In any exercise like this, there is always a danger of giving a false sense of certainty. We have kept our comments at a fairly high level, providing a sketch of what we see as the most likely outcomes.

Something set in stone. Our analysis evolves over time: the scenarios provide a snapshot of our outlook in 2014.

Something prescriptive. The scenarios are mainly a tool for communication. While they are valuable in our investment decisionmaking, they are not something we use rigidly.

What has changed?

Since we last published this report, the global economy has continued to recover, driven by the US. Although growth remains weak, conditions in the eurozone have also improved. Meanwhile, Japan appears to be making progress with efforts to stimulate its economy and China seems to have avoided a sharp slowdown.

Improving global economic data suggests to us that the world could begin to move away from the current situation of sluggish growth and loose monetary policies. Further monetary “experiments” are becoming less probable. However, significant imbalances and risks persist. This is the reason why we have left the size (probability) of our depression scenario unchanged.

Four main scenarios

We have identified four different scenarios that, in our view, are the most likely to occur.

For each scenario, the position of the bubble shows the combination of growth and inflation that we expect to see in the next one to three years.

The size of the bubble illustrates our view on the likelihood of this scenario occurring – this is subjective, and is intended just to illustrate our thinking.

Growth is expressed in relation to the potential for each country. For example, a growth rate of 4% would be low for China but very high for Europe. Similarly, inflation relates to a country’s individual inflation target.

We have adjusted the size of the bubbles to reflect our view that conditions in the global economy should continue to improve in 2014. We believe the world could begin to move away from our core “muddling through” scenario towards “economic renaissance” and that the “new monetary world” situation has become less likely.

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Implications for returns from asset classes

The table summarises the expected returns of the major asset classes under each of our four main scenarios.

The circles in the boxes show the expected return over the next three years, relative to the long-term expected returns*. Light green means higher than long-term expected returns*, while light red means lower.

These figures are an illustration of our thinking. They are based on an informed interpretation of our fundamental valuation models.

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Our conclusions

In most scenarios equities are the most attractive asset class. But valuation support is limited, exposing equities to a potentially sharp correction.

1. Continue to favour equities

We continue to favour equities despite their demanding valuations:

  • Abundant liquidity and repressed interest rates in our “muddling through” and “new monetary world” scenarios continue to support equities.
  • Improved earnings prospects in our economic renaissance” scenario should also boost equity prices despite the prospect of higher interest rates.
  • This pattern applies particularly to the US market. It is the most overvalued region but prices could continue to rise if the “economic renaissance” scenario becomes increasingly likely.

2. Remain cautious on bonds

  • We are avoiding long-maturity nominal bonds because they would be negatively affected by a normalisation of monetary policy in our “economic renaissance” scenario.
  • Within fixed income we continue to like shorter-maturity corporate bonds. This part of the market has two attractive features. First, there is still a decent yield advantage relative to government bonds. Second, the short maturity would offer some protection against rising interest rates, especially in our “economic renaissance” scenario.

3. Maintain exposure to real assets

  • The still sizeable probability of our “new monetary world” scenario lies behind our ongoing exposure to real assets such as gold, real estate and possibly inflation-linked bonds.
  • We are also confident that over an economic cycle equities continue to offer protection against inflation.
  • Additionally, we are focusing on hedge funds that have the flexibility to adjust to an unexpected increase in inflation.

4. Maintain our portfolio hedges

Although we believe the “depression” scenario is the least likely, its impact would be so disruptive that it must be considered within our investment strategy. Notably, equities are not well supported by current valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero.

Therefore, we include hedging strategies that can limit the potential losses from our portfolios:

  • We have a sizeable allocation to hedge funds that can provide significant protection in a bear market or which are not affected by movements in equity markets and therefore provide true diversification.
  • Additionally, we have direct equity hedges usually in the form of out-of-the-money put options on broad equity indices.

About the author

Related

By 
Emily Glazer
The whispers among employees had been around for years. They finally heard some facts during a conference call in June led by managers in Wells Fargo WFC +3.17% & Co.’s foreign-exchange operation: Some of its business customers had been cheated, according to two employees who were on the call.
An internal review showed that out of roughly 300 fee agreements based on anything from informal handshakes to emails to signed documents, only about 35 companies were charged the actual price they had been offered for currency trades handled by Wells Fargo, the employees say.
The phone call was part of a continuing cleanup that has led Wells Fargo to fire four foreign-exchange bankers and federal prosecutors to open their own investigation of the operation, people familiar with the matter have said.
“Wells Fargo remains committed to our foreign exchange business,” the bank said in a statement Monday. “If we find a problem, we fix it.” The bank said its foreign-exchange business is “under new management.”
The business is tiny compared with foreign-exchange operations at J.P. Morgan Chase & Co. and Citigroup Inc. but could become another huge headache for the San Francisco bank, still grappling with fallout from the sales-practices scandal in its retail operations. The scandal led to last year’s abrupt retirement of Wells Fargo’s chief executive, a $185 million regulatory settlement and numerous federal and state investigations, which are continuing.
Wells Fargo retail employees had to hit lofty goals to keep their jobs or get bonuses, which led some employees to open potentially 3.5 million accounts with fictitious or unauthorized customer information from 2009 to 2015.
Foreign-exchange employees got bonuses based solely on how much revenue they brought in, say more than a dozen current or former Wells Fargo employees. No other big bank in the U.S. calculated bonuses of currency traders in such a defined and individual way. Wells Fargo said Monday that it began making changes to those compensation plans earlier this year.
The bank also charged some of the highest trading fees around, according to current and former employees. For more than a decade, customers were sometimes charged anywhere from 1% to 4% on basic transactions such as converting euros to dollars and complicated trades like hedging.
Those percentages can be at least two to eight times higher than the middle-market industry average of 0.15% to 0.5%, depending on the trade, customer and volume, according to foreign-exchange bankers throughout the industry.
Wells Fargo disputes the descriptions of its foreign-exchange fees by current and former employees. The bank said Monday its fees in 2016 had a weighted average of 0.09 percentage point across all transaction sizes. Clients served by its middle-market banking team were charged a weighted average of 0.18 percentage point, according to Wells Fargo.
Some foreign-exchange bankers at Wells Fargo relied on the fact that customers often didn’t bother to double-check how much they were charged, fee levels weren’t straightforward, and complaints could be batted away, the current and former employees say.
‘Time fluctuation’
One former Wells Fargo manager says employees would tell customers who expressed surprise at the size of a trading fee that market prices were different at the moment when the transaction was executed and blame “time fluctuation” for any difference.
The bank’s foreign-exchange customers have included telecommunications firm CenturyLinkInc., vehicle-parts supplier Federal-Mogul Holdings Corp. and nonprofit groups such as the National Bone Marrow Donor Program.
Regulators have been investigating the foreign-exchange business at Wells Fargo, including a big trade involving Restaurant Brands International Inc., the owner of Burger King, Tim Hortons and Popeyes Louisiana Kitchen, according to people familiar with the matter.
A Burger King in Tokyo. The fast-food chain’s owner got a refund from Wells Fargo after disputing a trade handled by the bank.
A Burger King in Tokyo. The fast-food chain’s owner got a refund from Wells Fargo after disputing a trade handled by the bank. PHOTO: KIM KYUNG-HOON/REUTERS
The trade resulted in a loss to Restaurant Brands, people familiar with the matter have said, which led to a dispute between the Oakville, Ontario, company and the bank. The dispute centered on how bank employees handled the trade, rather than its pricing. Wells Fargo refunded about $900,000 to Restaurant Brands, people familiar with the refund say.
The foreign-exchange business’s problems run far deeper than what is known inside Wells Fargo as “the Burger King trade” or what has been previously reported. The extent of the trouble seems to have become apparent to top Wells Fargo executives earlier this year.
Small FryForeign-exchange spot contracts as apercent of a bank's total derivativesportfolioTHE WALL STREET JOURNALSource: Office of the Comptroller of the Currency
Bank ofAmericaCitigroupJ.P. MorganWells Fargo0%102030
The business was moved in early 2017 from Wells Fargo’s international division into its investment-banking and capital-markets operation. Since then, executives have changed internal systems, added more stringent rules around pricing and required more frequent compliance checks, current and former employees say.
Issues with the Burger King trade were found following those checks and customer complaints, people familiar with the matter say. The continuing internal review of Wells Fargo’s foreign-exchange operation is separate from the review sparked by the sales scandal, some of the people said.
A compliance training session in early November detailed what Wells Fargo called “approved margins” for different volumes of foreign-exchange transactions, according to an internal document reviewed by The Wall Street Journal. Employees say fee levels remain higher than industry norms, and some compensation practices aren’t due to change until next year.

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Foreign-exchange trading has been a problem area for many banks. In 2015, several large U.S. and European banks agreed to multibillion-dollar settlements with U.S. regulators and pleaded guilty to criminal charges filed by U.S. authorities over alleged collusion among currency traders.
Bank of New York Mellon Corp. agreed in 2015 to pay $714 million to resolve allegations it defrauded pension funds and other clients by overcharging them on currency transactions.State Street Corp. agreed in 2016 to pay $530 million to settle similar allegations.
Both banks admitted giving some clients far worse pricing on currency transactions than the banks implied the clients would get.
The Journal reported in October that the U.S. Attorney’s Office for the Northern District of California is investigating the Restaurant Brands currency trade and has subpoenaed information from Wells Fargo.
Potential issues related to that trade also are being examined by the Federal Reserve, the Journal reported. Examiners from the Office of the Comptroller of the Currency are auditing Wells Fargo’s foreign-exchange business, according to employees at the bank. A Wells Fargo executive says the audit is “normal course of business.”

Payment Plans

Some current and former Wells Fargo employees say its charges on foreign-exchange trades encouraged employees to cheat customers.

Fees for some currency trades
Industry average
Wells Fargo
Fee: 0.15 - 0.5%
Fee: 1% - 4%
For a $10 million trade
Fee:
$100,000 - $400,000
Fee:
$15,000 - $50,000
How Wells Fargo compensated bankers
If a banker had a revenue target of $5 million
and brought in $6 million ...
Revenue target: $5 million
Revenue that exceeded target: $1 million
.. the banker would earn a bonus of $100,000,
or 10% of the $1 million
Bonus
Source: People familiar with the bank
Current and former bank employees say its pricing practices were rooted in a culture and compensation system that looked to maximize revenue. Bonuses were defined as 10% of revenues exceeding revenue targets.
If a banker’s revenue target was $5 million and the person brought in $6 million, he or she would earn a $100,000 bonus, or 10% of the additional $1 million in revenue. Bankers typically received such bonuses twice a year in cash, rather than stock, as part of a signed contract, they added.
It’s rare among foreign-exchange groups in other banks to have so-called defined-bonus plans focused on individual earnings, according to people in the industry.
After Wells Fargo moved the foreign-exchange business into its investment bank earlier this year, managers began telling employees that bonuses would become “discretionary” by the end of 2017. Under this more typical arrangement, management would decide employee bonuses, and bankers wouldn’t know exactly how much they would receive. It would be based on a variety of factors, not just revenue.
Wells Fargo has 18 foreign-exchange sales and trading offices, including in New York, San Francisco, Charlotte, N.C., London and Hong Kong. A few hundred people work in the group world-wide.
Current and former employees say Wells Fargo’s foreign-exchange customers are largely midsize businesses that don’t tend to trade in large volumes. As a result, those clients don’t have the same insight into the market as larger firms that are more-active traders.
Some Wells Fargo clients have complained to the bank. In November 2016, Ecolab Inc., a water, hygiene and energy company based in St. Paul, Minn., bought and sold currency in a so-called swap arranged by the bank, according to people familiar with the deal. These people say Wells Fargo collected 1% on one part of the $100 million deal.
Ecolab contested the fee charged by Wells Fargo on a transaction arranged by the bank.
Ecolab contested the fee charged by Wells Fargo on a transaction arranged by the bank. PHOTO:ARIANA LINDQUIST/BLOOMBERG NEWS
After Ecolab compared the full trade, including fees, to overall market prices, the company contested the bank’s fee. Wells Fargo refunded hundreds of thousands of dollars to Ecolab in December 2016, according to current and former employees.
A spokeswoman for Ecolab confirmed the details of the trade and said it was the only fee issue Ecolab had with Wells Fargo.
Fee issues arose for some Wells Fargo clients even when they had a pricing agreement. The bank agreed within the past 18 months to a specified rate with data-management firm Veritas Technologies LLC, according to bank employees. After making one trade on behalf of Veritas, Wells Fargo bankers told Veritas that the bank’s fee was 0.05 percentage point higher than the agreed rate, the employees say.
Unusually high fees
The result: The bank made an extra $50,000 on a $100 million trade, the employees say. Wells Fargo later made a refund to Veritas, according to people familiar with the matter. A Veritas spokeswoman declined to comment.
Wells Fargo’s foreign-exchange business also charged unusually high fees for trades with different currency conversions, known as “Bswift” transactions, current and former employees say.
“And if anybody did complain, it was an easy tap dance,” one former employee says. He says employees would say the pricing had been done automatically by the bank’s computer system so “there’s no accountability for the spread.”
Wells Fargo sent an internal email Nov. 2 detailing new guidelines for Bswift transactions, according to a copy of the email reviewed by the Journal. The guidelines include specific handling and pricing procedures for those trades.
The operation also charged high fees to other parts of Wells Fargo. Wells Fargo Rail, which leases locomotives and railcars, and the bank’s corporate-trust division are often charged 1% to 1.5% on currency transactions, according to current and former employees.
The bank’s foreign-exchange management often celebrated big trades and the money they made for the bank, the current and former employees say. Sara Wardell-Smith, who led the foreign-exchange group, emailed the group to hail big trades, naming clients and spelling out revenue generated. The employees say managers used to encourage employees to ring a brass bell in the San Francisco office when the bank made a lot of money on a trade.
In mid-October, the bank announced that Ms. Wardell-Smith would lead its financial institutions group in the Americas region, according to a memo reviewed by the Journal and confirmed by a bank spokeswoman.
Current employees say the move was viewed within Wells Fargo as a demotion, coming just months after Ms. Wardell-Smith had been promoted to co-lead the bank’s division focusing on trading of rates, currencies and commodities. She didn’t respond to requests for comment.
The other co-leader, Ben Bonner, now leads that group on his own and is overseeing foreign-exchange trading, a bank spokeswoman confirms.
Mr. Bonner has been working with other executives to fix the problems in the currency business, according to several current employees.
Last month, the bank sent a memo to foreign-exchange employees that instructs them not to create informal or oral pricing agreements. The memo, reviewed by the Journal, also said employees are “responsible for ensuring customers are not misled regarding” pricing.
Current and former employees say some Wells Fargo employees expressed concerns about pricing practices to top executives before the bank’s internal cleanup efforts began earlier this year. Some employees say they were reluctant to press for sweeping changes, citing what they saw happen to one manager in the foreign-exchange operation about a decade ago.
During a meeting of foreign-exchange managers in the mid-2000s, Cathy Witt said it wasn’t right to celebrate high fees by ringing a bell, people familiar with the situation say. Ms. Witt, an employee in the bank’s Chicago foreign-exchange group, warned that Wells Fargo could become known as a “bucket shop,” a derisive term for a disreputable finance firm, some of the people say.
A few weeks later, Ms. Witt was summoned to a meeting in St. Louis, told that her comments had been offensive and demoted on the spot, according to people familiar with the matter. She also was told to apologize to other managers for her unprofessional behavior, the people say. She later left the bank.
—Aruna Viswanatha contributed to this article.

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