Dealing with Global Disruptors - Emirates NBD · 2017. 6. 29. · emerging market debt. What happened? Emerging market debt has proven to be one of the better performing asset classes

Dealing with Global DisruptorsInvestment Outlook 2017

EMIRATES NBD WEALTH MANAGEMENT INVESTMENT OUTLOOK 2017

CONTENTS3

7 OVERVIEW OF ASSET CLASSESOur views for 2017 are balanced between looking to long-termvalue, but paying attention to the disruption created by Brexitand Donald Trump’s victory in the US Presidential election.

5 2016 REVIEWEquities have in aggregate produced modestreturns whilst bonds have generated someoutsize returns.

11 AN AGE OF DISRUPTORSOften disruptors were seen as technologicaldevelopments that challenged incumbentcompanies and processes.

13 REGIONAL GROWTHMore stable to higher oil prices andstructural change holds the prospect of better times ahead.

15 GLOBAL GROWTHMonetary policy decisions over recent months illustratethe constraints that central banks are operating under.Fiscal expansion may become the norm.


CONTENTS 4

19 EQUITY MARKETSDespite often falling profits and revenues for theconstituents of the major equity indices equitieshave managed to often generate positive returns.

29 GLOBAL REAL ESTATEAlternative real estate and real assets have moresustainable revenues and valuations in presentvolatile market conditions.

27 BONDSShifting monetary policy a driverof near term returns.

23 EQUITY SECTORSOnly those companies that are continuallyevolving and recreating their businesses willsurvive the passage of time.

33 OIL PRICESitting in the middle of the current oil price slump makesan objective interpretation of the outlook for oil pricesthat more difficult.


2016 REVIEW

REVIEW OF PASTTHEMES 2016

GCC bonds- the fallbefore the riseOur view in January 2016:We expect GCC Sovereign spreads towiden further predicated upon thebasis of high new supply, rising USDrates and a continued rout in oilprices. The latter in turn will increasebudget deficits, tighten liquidity inthe GCC banking sector and driverisk aversion. Spread tightening inthe second half of the year shouldsupport positive returns for the fullyear. Spreads should graduallytighten on the expectation of oilprices heading towards USD 50, anaccelerating pace of fiscal reformsand inflows of cheap capital from theeurozone and Japan. GCC bonds willalso retain a relative appeal in view oftheir higher credit ratings

What happened?As we expected, the GCC bondmarkets were under some pressure inthe first quarter of the year, with oilprices as low as USD 28 worryinginvestors. Spreads narrowed and GCCbonds delivered positive returns inthe second half of the year with therecovery of the crude market andinvestors resuming the search for yield.The performance is all the moreimpressive given the heavy issuanceseen through the back end of the year.

Macro headwindsstalling GCC markets,when will fair windsblow?Our view in January 2016:We would initiate or add to GCCequity positions as soon as we see aclear bottoming of the oil price andalso when geopolitical tensions in theregion recede. We maintain apreference for high-quality companieswith sustainable cash flows.

What happened? As the oil priceplummeted to its lows the GCC equitymarket fell 16% in a virtual straightline from the start of the year toJanuary 21st. The subsequent rallywas equally sharp but from Marchthe market largely traded side-wardsfor much of the year. In the finalquarter, stocks rallied in line with theimprovement in the oil price.

UAE real estate – no major surprisesOur view in January 2016:The 2016 outlook for local real estateremains cautiously optimistic withbuying opportunities coming to themarket after recent weakness.

What happened? 2016 has provento be a mixed year with residentialrents generally down but with somepockets of communities seeingincreases. The still high yields on bothcommercial and residential continueto attract foreign interest providing areasonable prop under prices.

Dollar still in theascendencyOur view in January 2016:With the US economy likely to remainthe positive standout, the dollar islikely to benefit and risk currenciesare expected to remain subduedshould geographical unrest increase.

What happened?The dollar ended 2016 somewhat inthe ascendency but not withoutsome drama through the year. Therewere large long positions in thedollar as we started 2016 hencewhen the US economic datasurprised to the downside in the firstquarter the dollar fell sharply; on atrade-weighted basis, the dollar fell6.2% from the start of the year tothe end of April. Subsequently, thedollar recovered and started on astronger trend late in the year asconviction built that the Fed wasindeed going to raise interest rates.

Finding value inglobal bond marketsOur view in January 2016:Given the uncertainty over whetherthe Fed would be in a position toraise rates through 2016, wesuggested that investors focus ontwo areas in the global bondmarkets, European high yield andemerging market debt.

What happened? Emerging marketdebt has proven to be one of thebetter performing asset classes of2016. Although the emergingmarkets started the year poorly, theimprovement in the Brazilian andRussian economies helped theemerging market credits performwell. Eurozone high yield debtperformed well but did not quitereach the lofty levels of the returnsfrom the US high yield.

Oil prices – Volatility aheadOur view in January 2016:We expected commodity markets toremain under pressure in the first halfof the year with high volatility. Weexpected Brent futures to end theyear above USD 60 and the averageof the year to be USD 55.

What happened? Oil prices startedthe year on a very weak note andindeed displayed a great deal ofvolatility bottoming at USD 27before recovering to the USD 40-55.The average of the year is closer toUSD 45 than USD 55.

5

Emerging marketdebt has proven tobe one of the betterperforming assetclasses of 2016.


2016 REVIEW 6

Global equities –Sectors not stockmarketsOur view in January 2016:We pointed to three sectors that we believed would outpace thebroad markets in 2016, the European banks, Global healthcareand Global technology.

What happened? European bankswere a poor performer beset withproblems as further capital raising,fines and concerns with the financialwellbeing of German and Italianbanks held back the sector. Thehealthcare sector had a strong run inthe middle of the year. The USPresidential election however createdvolatility that the sector is strugglingto recover from.

By contrast, technology stocksperformed solidly. We pointed to theJapanese equity market for acountry specific play, unfortunately,a series of disappointments with thepolicies maker’s commitment toachieving growth in the economyled to some negative returns for themarket in local currency althoughthe Yen’s strength made it one of

the best performing developingmarkets in dollars.

Gold to glitter againin 2016Our view in January 2016:We expect the gold price to find afloor near USD 1,000-1,025 anounce before witnessing a strongrecovery towards USD 1,250-1,325.

What happened? Gold didindeed glitter rising from USD 1,060at the start of the year to a peak ofUSD 1,366 in early July.

India – Good news,but when will theasset marketsperform?Our view in January 2016:A combination of better corporateearnings and expectations ofgovernment measures to boostgrowth would typically lead to somegood returns from Indian assets.

What happened? Indian equitiesstarted the year on a weak note asthe general risk aversion amongstinvestors led to a near 15%

correction in the market. However,from a low base of 22951 in themiddle of February, the market hasclimbed over 20% to be one of thebetter-performing equity marketsyear to date. Bonds like equitieshave benefitted from ongoing goodnews from the economy, inparticular, the strength of growthand the good behaviour of inflation.The latter factor, in particular, haslaid the ground for cuts in interestrates. Indian 10-year governmentbonds have rallied with the yieldfalling from 7.7% at the start of theyear to 6.3%.

Protecting andbuilding your wealthOur view in January 2016:The thrust of our view was thatinvestors should maintain a balancebetween asset classes with a skewtowards safer bonds.

What happened? Given the highvolatility of risk assets, a portfoliobias to safer assets would have madefor less sleepless nights for investorsand smoother returns through 2016.Equities have in aggregate producedmodest returns whilst bonds havegenerated some outsized returns.

GCC BONDSGood performance throughthe second half of the year

UAE REAL ESTATEHigh yields on bothcommercial and residential

GCC MARKETSQuality stocks haveprevailed over cyclical

GLOBAL BONDSEurozone high yield debtperformed well

USDRecovered and started on astronger trend late in Q4

OIL PRICESWeak start recovering later onin the year

GOLDRose at the start of the year,peaked in July

GLOBAL EQUITIESYen one of the best performingdeveloping markets

INDIAMarket climbed over 20% tobe one of the betterperforming equity markets


OVERVIEW OF ASSET CLASSES

POSITIVE DISRUPTION IN THENEAR-TERM MEETS LONG-TERMVALUE CONCERNS

Our views for 2017are balancedbetween looking tolong-term value, butpaying attention tothe disruptioncreated by Brexit andDonald Trump’svictory in the USPresidential election.The policies of the new President area challenge to years of globalisationand the dominance of monetarypolicy as a spur to growth.

US EquitiesTactical view – overweightAll the momentum is with the USeconomy and the US equity market.Although the dollar and higher shortterm interest rates may present someheadwinds to the equity market, USstocks should have further upside ifconsumer and business confidencecontinue to respond to the hopesgenerated by the new administration.

Medium term view – underweightUS equities in historical terms remainat very stretched valuations, bearingin mind that the potential real growthof the US economy looks set for just2% over the medium term. Also, apotential marked increase in the US10-year government bond yield couldprovide a significant headwind to theperformance of the market.

Eurozone equitiesTactical view – neutralEurozone equities will have both the

positive support of potential gainsin the US equity markets and of stillbenign growth in Europe, but withthe headwind of the pendingelections. European companies aretrading at their lowest valuationssince July 2012 relative to the S&P500 Index and should follow theUS markets.

Medium term view – neutralThe eurozone could surprise with itsown relaxation of fiscal policy. Wehave noted that EU officials aresoftening their opposition to anexpansion of fiscal policy, whichwould help to provide somesurprises to the upside on earningsgrowth. Recent weakness in theeuro also provides a useful medium-term boost to corporate profits.

Japanese equitiesTactical view – neutralThe recent marked weakness of theYen has provided an immediateboost to corporate profit forecasts.The anchoring of the JGB 10-yearbond at close to a zero yield will alsohelp the valuation argument forJapanese equities. The equity marketyields more than the bond marketand with a lift to corporate profitsdomestic accounts will be likelyavid buyers.

Medium term view – underweightThe medium term picture is cloudedby an ongoing lack of convictionamongst investors about the abilityof the policymakers to generatesustained GDP growth. The ongoingreforms have yet to bring asignificant improvement in theoutlook for corporate profits growthand hence we can only see transitorystrength in the equity market.

Asia ex JapanTactical view – neutralThe Asian ex Japan region isdominated by China. The Chinesegovernment is doing a very good jobof trying to strike a balance betweenthe need for support to the economyvia credit expansion and for clampingdown on overinvestment leading toexcess capacity. Currently, Chineseequity markets are benefitting fromthe tailwinds of previous stimulusmeasures, as well as from thesustained weakening of the currency.Other Asian markets are dependenton Chinese demand and on globaltrade, both for now picking up, thelatter on the back of an improvingglobal economy. Although valuationsare still tame, Trump protectionistpolicies remain the main setback forthe region

Strategic view – neutralIn the longer term there is plenty ofuncertainty about the ability of theChinese authorities to avoid a moremeaningful slowdown, as bad debt isbeing accumulated as a result ofcredit growing faster than GDP. Also,the secular expansion of global tradeseems to have come to a halt, due tothe rise of populism across the globeand to the protectionist, pro-Americastance of Donald Trump.

Emerging marketequitiesTactical view – underweightThe anti-globalisation policies ofDonald trump and the rate hikesfrom the Federal Reserve through thenext twelve months are likely toremain significant headwinds toperformance. One exception shouldbe India, where the major reforms in

7


OVERVIEW OF ASSET CLASSES 8

the economy should provide asignificant spur to growth. The recentsignificant setback in the marketprovides a buying opportunity.

Strategic view – overweightWhilst in the near term the marketsmay believe that Donald Trump willdeliver good growth to the US andrenege on previous trade deals, this isnot sustainable over the mediumterm. Over the longer term, themore dynamic economies of theemerging countries should producestrong growth and sustainedcorporate profits growth. The recentweakness of emerging marketcurrencies will eventually provide afillip to their economies.

MENA equitiesTactical view – neutralMuch will depend on the outlook forthe oil price and whether OPEC isable to bring some discipline to bearon the oil market. At the same time,reduced government expenditure islikely to continue to be feltthroughout the economy and capstock-market returns.

Strategic view - overweightAs we move through 2017, we sensethat the market will start toanticipate a stronger oil price. The good yield support for MENAequities and the relatively lowvaluations make these marketsappealing, hence we believe thatinternational investors are waiting totime their purchases.

Global EquitiesShorter term: fundamentalsand stimulus measures are themarket driversWhile US President elect Trump hasreceived the credit for the end-of-year rally in developed marketequities, it is the improvement ineconomic data and potentially risingUS rates, which are the realbackbone. Pro-growth messages bythe Trump administration –infrastructure spending & corporatetax reform have helped. Animproving earnings cycle will help

counter high valuations in the shortterm. However, the story is over forhigh-yielding stocks as bond yieldsrise and in expensive markets thesearch for value has begun.

> Small caps, financials, industrials,materials, transportation andbiotech in the US have givendouble digit returns since Nov8th, the day of the US elections.

> The stronger dollar has led to aweaker Yen and Japanese equitiesare technically on a bull run, aftera year of underperformance.

> European equities have stabilisedon improving economic data andlook poised to break out.

> Emerging markets which were up14% till Nov 8th, suffered fromthe potentially negative effects ofprotectionist policies and astronger dollar, and fell 7%subsequently.

The US rally is expected to continueas economic growth led by fiscalstimulus, tax cuts and deregulationwill lead to an improvement incorporate profitability. Stretchedvaluations will cap gains unlike1999, the last time all 4 US indiceshit record highs. However, wecontinue to focus on select themesfor outperformance.

Short-term equitythematic strategyThe Trump effect

> US financials: Possible repeal ofparts of the Dodd Franklegislation and higher rates shouldboost profit margins.

> US Industrials: Corporates are nowcertain of policy and growth andafter a long hiatus, we expectcapex to increase and thiscombined with governmentspend on roads and railways willcontinue to boost the heavymachinery, defence andaerospace sectors.

> Energy: Tighter environmentalregulations are no longer in theoffing. As capex remainslimited, supply constraints shouldlift oil prices.

> US Technology: US consumersspent USD 5.3bn (+18%) onBlack Friday, of which 62% wasonline with mobile spending at22% of the total, +33% over theprevious year. The power of theapp and AI will rule business forthe next decade.

> US small caps: Beneficiaries of thepick-up in the domestic economy.

> Global Healthcare: Buybacks anddividends to increase ascompanies bring back cash fromoverseas on a tax amnesty. Alongwith fear of price controls beingdissipated, this should provide afillip to this ailing sector.

> European exporters: The weaknessof the euro will improve thecompetitiveness of Europeancompanies in global markets.

TRUMP EFFECT8 - 25 NOVEMBER 2016

LARGE US BANKS

+15.0%RUSSEL 2000

+12.0%US INDUSTRIALS

+7.5%JAPAN (NIKKEI)

+7.0%US UTILITIES

-6.0%MSCI EM

-6.0%


OVERVIEW OF ASSET CLASSES

BondsBonds will be challenged as we enter2017. It has become blatantlyobvious to the markets that since anunprecedented proportion of globalgovernment bonds yields fell intonegative territory, government bondshave offered hardly any protectionagainst inflation. Inflationexpectations have been consistentlyrising of late, with inflationarypressures mounting particularly in theUS and in the UK.

US Government bondsTactical view – underweightIn the US the much awaited Trumpfiscal measures come against thebackdrop of an economy runningalready at full employment, hence theyare likely to have relevant spill-overeffects on the general level of prices.

Strategic view –underweight/neutralShould the 10-year governmentbond yield lift to 3%, that mightprove a good entry point as it offersa potential real yield of 1% (relative to the central bank’s 2% inflation target).

Eurozone governmentbondsTactical view – neutralIn the absence of renewed buying bythe ECB, eurozone bond yields arevulnerable to being dragged higherby US government bond yields andby geopolitical risks related to votingin French and German elections, aswell as the aftermath of the Italianreferendum. The eurozone has so farseen no sign of higher oil pricesfeeding into inflation, which shouldhappen soon due to obvious baseeffects, as well as to the sensitivity ofthe European economy to crude prices.

Strategic view – neutralIn the longer term eurozonegovernment bonds should be drivenby growing expectations of thetapering of asset purchases by theCentral Bank and by moderateeconomic growth, the latter cappedby demographic challenges and

relevant debt levels. We maintain aneutral view for the longer term,unless the European authoritiesdecide to follow the US lead on thepath to fiscal easing.

Japanese governmentbondsTactical view – underweightIn the near term the Bank of Japanis anchoring 10 year yields at zero,making the asset class veryunattractive.

Strategic view – underweightVery likely that longer term JGB yieldreturns will be negligible.

US high yieldTactical view – overweightUS high yield continues to live up toits reputation as being a low volatilityversion of equities. Despite the recentback-up of government bond yields,sub-investment-grade debt hasperformed well with only modestlosses. We expect the asset class toremain relatively well supported, withstronger US growth and corporateearnings being the backbone of ourconstructive view on US High Yield.US corporate defaults should also fallfrom current levels, as the positiveeffects of an expanding businesscycle filter through to the bottom lineof companies.

Strategic view – overweightAfter the euphoria over what DonaldTrump may do with fiscal policy weexpect investors to go back to oldthemes and revert to the chase foryield. At that stage we expect highyield to perform reasonably well.

US - Investment gradeTactical view – neutralAlthough investment grade bondsare more sensitive to interest ratesthan to economic growth, in the USthey should still benefit formmarginal spread tightening viastronger corporate earnings. Also,Fed tightening should attractdemand from overseas investorsfleeing the still QE dominatedmarkets of Europe, UK and Japan.

Strategic view – underweightIn the longer term rising yields shouldnegatively affect the performance ofthe asset class, as the Fed tightenspolicy to avert inflationary pressures.An inflationary scenario would be anoutright negative for IG bonds, withspread tightening only partiallyoffsetting capital losses.

European high yieldTactical view – neutralReturns for European high yield couldcome under pressure in the near term,as demand for more competitive USdollar assets gains momentum andtranslates into outflows. On the otherhand a relatively stable, althoughsubdued European economysupported by expansionary monetarypolicy provides a favorableenvironment for the asset class.

9

All the momentumis with the USeconomy and theUS equity market.


OVERVIEW OF ASSET CLASSES 10

Strategic view – neutralSome longer term factors should limitpotential downside on the assetclass: leverage for European high-yielding companies has beendeclining with improvingfundamentals, default rates areexpected to remain low and overallcredit quality remains higher versusthe US and the Asian counterparts.

Emerging marketdollar debtTactical view – NeutralEM credit spreads are expected towiden further in the short term asthe yield differential with DMbenchmarks shrinks and investorslook to dollar assets which have

regained appeal. Uncertainty about Trump policies is also stoking volatility in the asset class,compounded by a stronger dollarmaking debt repayments moreexpensive.

Strategic view – overweightThe EM countries have come a longway since the Asian Crisis, haveaddressed many economicimbalances and are better placed towithstand external shocks. EM creditspreads overall look sustainable forthe long term, with the outlook forthe EM economies on a more solidfooting now that commodity marketshave bottomed out. Volatility boutsprovide good entry point forinvestors to gain exposure to theyield premium of the asset class.

Emerging Marketlocal debtTactical view – underweightWith Donald Trump yet to fullyarticulate his foreign policy,particularly with regard to pushingback the advance of globalisation, itis likely that emerging marketcurrencies will remain under pressure.The challenges will particularly hitAsia, where everyone will bewatching the reaction of China tosee if they allow further depreciationof their currency. Currency- andrates-led volatility are expected tocontinue to put pressure on the assetclass. We remain constructive onIndian local debt.

Strategic view – positiveIn the medium term a sell-off ofemerging market currencies willprovide an interesting entry pointinto the asset class. Yield premiumson local debt mitigate a fair amountof the likely volatility risk of localcurrencies over the medium term.

MENA DebtTactical view – underweightCurrent valuations suggest thatMENA bonds are expensive, with theyield premium at historically lowlevels versus long-term averages. Weexpect that more supply will come tothe market, both in the short and inthe long term. The recent surge inprimary issuance marks the start of anew trend where local governmentswill need to find alternative sourcesof funding to hydrocarbon resources.Tighter liquidity will also seecorporates seek for market funding.The rise in MENA yields will bereinforced by the outlook for atighter US monetary policy.

Strategic view – neutralIn the longer term the downsidepotential for MENA bonds is limitedby the home-bias of local investors,who tend to provide support whenprice dislocations hit the broadermarkets. The culture of favoring thelong-term holding of bonds wouldput a floor under asset prices duringperiods of market stress.


AN AGE OF DISRUPTORS

AN AGE OFDISRUPTORS

2016 was the year ofthe coming of age fora broader definitionof disruptors.Often disruptors were seen astechnological developments thatchallenged incumbent companies andprocesses. Harvard School professorand disruption expert ClaytonChristensen remarks that disruptiondisplaces an existing market, industryor technology and producessomething new and more efficientand worthwhile. It is at the same timedestructive and creative, reportsForbes magazine.

Today we can add a new wave ofpolitical thought that is challengingthe old order. The electoral wins ofNarendra Modi in India, Duarte in thePhilippines, Donald Trump in theUnited States and the UK Brexit voteare all seen as challenges to the oldpolitical order. There is the prospectof more challenges to come. Europefaces a number of elections next yearwhen over 60% of the populationwill go to the polls. There is morethan a whiff of change in the air.

The disruptive influences of each ofthese changes has broughtchallenges to economies andfinancial markets on a scale rarelyseen in modern times.

Narendra Modi abolished overnight85% of the Indian rupee currency asa direct challenge to the old order ofa black economy that accounted forprobably 25% of total GDP.

The UK Brexit vote overnight set theUK on a path to leave the EU. It wasa direct challenge to the EU order ofopen boarders and a loss ofindividual country sovereignty. UKSterling took a battering with the

USD/GBP rate moving from 1.45 to1.20 a loss of value of the pound ofsome 17%.

Donald Trump’s victory means thereis a high probability that a new USgovernment may seek to reverse atleast part of the move toglobalisation and will challenge theview that monetary policy should doall the heavy lifting of generatingbetter growth. Fiscal policy is back in

vogue. Financial markets have seenvolatile times, equities have rallied,government bond markets have soldoff aggressively and the dollar hasbeen in the ascendency against mostcurrencies.

Commentators have many theoriesof why these disruptive politicalevents are happening now.However, there is a common threadof thought that a lack of distribution

11


AN AGE OF DISRUPTORS 12

of wealth and an alienation of largeswathes of the population has led tomany wishing to register a protestvote. In the case of India the protestvote is manifesting itself in agovernment that wishes to pushahead with reform and change,which should accelerate thecountries growth and industrialdevelopment. In the case of theUnited States, there is a concern thatthe disruptive influence will lead to a

reversal of previous positives such asglobalisation and a more selfcentered economic and geopoliticalpolicy in the future.

Barclays in a seminal research notereally encapsulated the current waveof political disruption in a paperentitled “The Politics of Rage” –Marvin Barth 23 October 2016.Barth sets out the summary of thePolitics of Rage in the following way:

Prospects for thePolitics of Rage> Its roots run deeply through and

across countries; Brexit was noexception

> Technology will likely nourish theroots of Rage by inflaming someof the proximate causes

> Governments are ill equipped tofight Rage with overextendedfiscal positions and low levels ofpopular trust

Effects of the Policiesof Rage> Challenges to globalization in a

direct and indirect way> Supranational entities such as EU,

and intergovernmental accordssuch as Basel Accords and WTOare at a greater risk of dissolution

> Redistribution of Income

Financial marketimplications> Interest rate rises > G10 FX rises versus emerging

markets > Slower demand growth

suppresses commodity prices> Equities and credit underperform

due to slower global growth

One final thought on the disruptorsin the more conventional sense i.ethose that are based on technology.There is an increasing backlash fromyounger people to some of theadvancements in technologyespecially those that challenge theirfuture prospects of landing a job. Inparticular robots aren’t necessarilyseen as progress among the young.Indeed robots often take employmentaway from the lower paid repetitivejobs. It is no surprise that Adidas aniconic retro brand is one of the bestperforming stocks in 2016.

Challenges toeconomies and

financial markets ona scale rarely seenin modern times.


REGIONAL GROWTH

WHAT IS THE SUSTAINABLE LEVELOF GROWTH IN THE GCC?

Economic growth inthe GCC between theyears 2011 to 2015was robust at 4.6%y/y driven bydynamics in thehydrocarbon market.Higher oil prices through most ofthose years enabled governments toincrease budgetary spending to meetlong term development needs.However as oil prices began to falltowards the end 2014, it was the oilsector again through higher outputthat supported still healthy albeit moremoderate levels of GDP growththrough 2015. Growth in 2016throughout the region moderatedfurther, as oil production upsidereached its limits and budgetscontracted. The cycle of economicgrowth in the region throughout thoseyears encapsulates the dependence onoil as a driver of growth and thus theneed to diversify into a moresustainable and less volatile economicmodels away from that hydrocarbondependence. We estimate real GDPgrowth in the UAE to range between3% to 5% over the next 5 years, whileSaudi Arabia could see GDP growthranging between 1.5% to 3.5% overthe same period. Over the long termwe estimate a sustainable growth rateof about 3% beyond that for majorGCC economies, as diversification andrebalancing continues.

Absolute levels of economic growthshould not matter as much as thequality of economic growth. Thus asthe region continues to push through asuite of economic and fiscal reformsmedium term growth is expected to bemoderate. While oil prices have beengradually rising higher, they are beingoffset by cuts in output, and budgetsare likely to remain more conservative.

The challenge for policy makers will bein continuing to push ahead with theirlong term commitments by diversifyingtheir fiscal income streams and moreefficiently allocating revenues andprioritizing their spending needs. Thehydrocarbon sector still accounts foralmost 80% of government revenuesin the region. Policy makers have beenvery well aware of the risks, and acrossthe region long term developmentplans have been put in place to reducereliance on oil by investing in humancapital (through education) anddeveloping new sectors that cansupport the creation of high value jobs.

2016 has been a milestone forgovernments in the region, especiallyin light of fiscal reforms. Policymakersare developing a more comprehensiveand sustainable revenue streamthrough the gradual introduction of aValue Added Tax, expected to be inplace by 2018. Significant reforms tothe region’s energy subsidies havealready taken place, with the regionaccounting for some of the highestlevels of energy subsidies globally, thisshould reduce the expenditure burdenon governments and free up fiscalresources for more importantspending needs. Finally we have seena number of GCC governments issue

bonds to fund deficits, more recentlySaudi Arabia USD 17.5bn bond issue,the largest issuance from an emergingmarket this year.

13

EMIRATES NBD RESEARCH OIL PRICE FORECASTS

Source: Emirates NBD, Bloomberg

WTI (USD/b) Brent (USD/b)

0

20

40

60

80

100

120

Dec-13

Apr-14

Aug-14

Dec-14

Apr-15

Aug-15

Dec-15

Apr-16

Aug-16

Dec-16

Apr-17

Aug-17

Oct-17


REGIONAL GROWTH 14

These sovereign issuances will have apositive impact on domesticeconomies by building up a yield curvethat will support regional corporatebond issuances.

Economic reforms in the region havealso taken a step ahead this year.Saudi Arabia this year launched itsVision 2030 defining long termstrategy of diversifying its economy,improving governance and boostingquality of life. The NationalTransformation Program 2020approved on the 6th of June is one ofseveral plans designed to achieve thelonger term targets of the 2030Vision. Where the Vision 2030 outlinesthe long term strategic goals for theKingdom, the NTP identifies specificobjectives that need to be achieved inorder to meet the Vision 2030 goals.Throughout 2016 Saudi Arabia hasbeen pushing ahead with significantfiscal reforms such as cutting wagesand reducing subsidies, whileidentifying and working on economicreforms to boost the private sector.

In the UAE, the approval of abankruptcy law into legislation byearly 2017, will significantly supportthe attractiveness of the country as aregional business hub, as legislativereforms give businesses moreconfidence.

While reforms move ahead, challengesexists. Execution and follow throughhave been difficult in the past,especially during periods of reboundingoil prices. However, given thatimprovements in oil markets are likelyto be gradual, we expect structuralreforms to continue pushing ahead inthe medium run. Furthermoregovernments in the region are keen onseeing more of their nationals seekingand getting employed in the privatesector, and with that there is increasingfocus on education, productivity andskill set developments. With 90% ofnationals in the GCC employed inthe public sector, this is a challenge,however as the private sector takeslarger role in the economicgrowth, it certain that this shiftneeds to take place.

GCC DEBT ISSUANCE AT MULTI-YEAR HIGH

Source: Emirates NBD, Bloomberg

2009 2010 2011 2012 2013 2014 2015 2016 YTD

0

10

20

30

USD

Bn

40

50

13.5

3.05.5

1.5 2.0 1.25 1.5

39.1

KEY GCC GDP FORECASTS

Source: Emirates NBD

Saudi Arabia UAE Qatar0%

1%

2%

3%

4%

5%

6%

3.6%3.1%

3.8%

3.0%3.4%

1.4%

5.0%

3.5%

4.3%

2014 2015 2016f

2016 has been a milestone forgovernments in

the region,especially in lightof fiscal reforms.


GLOBAL GROWTH

WILL MONETARY POLICY ORFISCAL POLICY SUSTAINGLOBAL GROWTH?

Monetary policydecisions over recentmonths illustrate theconstraints thatcentral banks areoperating under. The Fed is still finding it difficult to raiseinterest rates, despite improvements inthe US economy, while the BOJappears reluctant to cut them furtherfor fear of hurting banks’ profitability,instead choosing to tinker with itspolicy framework by targeting yields.

The ECB appears reticent to make anyfurther steps into negative rateterritory, whilst its EUR 80bn a monthQE program is due to end in Marchnext year, with speculation circulatingthat it may begin to taper thesepurchases. The Bank of England maystill be promising lower rates to wardoff Brexit risks, but the recent datamakes the necessity of such cutsincreasingly questionable and UKpoliticians are beginning to expressdoubts about the benefits of QE. Inshort, the effectiveness of monetarypolicy as a whole is being increasinglyquestioned, moving the debate awayfrom it and towards the possiblemerits of fiscal policy expansion.

The Bank for InternationalSettlements has long been somethingof a lone voice in criticising themaintenance of unconventionalmonetary policies for so long, andrecently wrote in its Quarterly Reviewthat monetary policy is becoming‘overburdened’ and a potential threatto financial stability.

Ultra-easy policies have created excessleverage, periodic phases of illiquidity

and yield-chasing behaviour. Investorsrecognise the risks as well, especiallywith regards to the impact of negativeinterest rates, which have had theeffect of converting trillions of dollars ofbank ‘assets’ into ‘liabilities’, damagingthe profitability of financial institutions.

Prominent academics have alsoadded their weight to the debate byarguing that rather than providing a

spur to inflation, QE simply recyclesmoney between the central banksand financial institutions in a sort of‘monetary roundabout’.

The argument is that cash simplyremains in financial institutions, neveractually entering the real economy asintended to exert upward pressure oninflation. Instead, such funds remaindeposited with central banks such as

15

Ultra-easy policieshave created excessleverage, periodicphases of illiquidityand yield-chasingbehaviour.


GLOBAL GROWTH 16

the Fed that pay interest on cashdeposits, with cash effectively goingback to its point of origin and/orinflating the price of financial assets.

Furthermore, because of decliningprofits that banks can realise fromtheir loan ‘assets’, lending hasdeclined, with cross-border lendingbeing a significant casualty. This hasput further weight on global creditexpansion and has increasedsegmentation between the marketswithin countries, particularly in theeurozone, where such behaviourmeans that cash does not trickledown to its intended targets.

In short, QE has weakened theprofitability of financial institutionsand has reduced the desire orcapability of banks to lend. Ratherthan the solution, QE may becontributing to the problem.

Fiscal policy is unlikely to take up theslack left by quantitative easing

There are increasing hopes in themarkets that fiscal policy may take upthe reins from monetary policy. Untilthe arrival of Donald Trump on thescene, hopes for any global lift infiscal policy seemed a remote dream.However, his grand plan forinfrastructure spending (USD 1tn)and tax cuts has raised market hopesfor more expansive fiscal policyaround the world. Whilst we remainskeptical that other governments willfollow the lead of Mr Trump withvigour, there are some grounds forhope; for example, in recent weeksthe EU staffers have toned downtheir anti-fiscal policy/anti-government deficit rhetoric. Also inthe recent UK budget speech thegovernment has removed a targetdate for a budget surplus. Japanearlier this year approved USD 45bnin extra spending for the currentfiscal policy. However this latterprogramme was not a surprise tothe market.

Before anyone gets carried away withthinking that higher governmentspending can be a panacea forstronger growth, remember thatgovernments are already strugglingunder the weight of high debt toGDP ratios (table). Indeed they willalso be mindful that if another crisiswere to hit their economies theexperience of the last crisis is thatdebt can increase by anything northof 25 percentage points of GDP.

Developed economy governmentswill also calculate that there theirexpenditures will increase in any casejust because of the burden of ageingpopulations. Citigroup estimates thatin 20 OECD countries the unfundedliability of pensions alone is aroundUSD 78 tn roughly equivalent toglobal GDP.

If there is one area of policy whereagencies such as the OECD and IMFcry out for governments to takeaction it is on economic reform. InJapan whilst reform has been wellintentioned, cultural barriers haveslowed its progress. In the eurozone,reform is glacial in the countries suchas Italy that need it desperately. Inthe United States, big governmenthas quietly undone free markets.Governments need to be bolder andmore effective to make a meaningfuldifference to the outlook for long-term global growth.

2015 2007

Japan 229% 162%

United States 104% 76%

Euro Area 91% 65%

UK 89% 44%

HIGH DEBT TO GDP RATIOS CONSTRAIN LIKELY ExPANSION OF FISCAL POLICY

Source: National accounts

As QE has becomeless the policy ofchoice for policy

makers to stimulategrowth, the marketshave been looking tofiscal policy to take

up the reins.


EXCHANGE RATES

SUSTAINABLE EXCHANGE RATES –A FOCUS ON GBP

When thinking aboutcurrencies in 2017 andwhere they will go westart by looking atexchange ratesrelative to theirinterest ratedifferentials, inparticular differentialsadjusted for inflation.In the past when inflation andinterest rates have behaved relativelynormally, and before such conceptsas QE and negative interest rates wefound that there was a reasonablecorrelation between dollar exchangerates and two-year yield differentials(Chart 1).

However, in the recent yearsdominated by unconventionalmonetary policies and historically lowlevels of inflation such correlationshave broken down to some extent,with inflation adjusted differentialsoffering a better guide to currencymovements. A good example of thisis demonstrated below by AUDUSDand EURUSD (Chart 2 & 3).

In fact most major USD pairs areshowing consistency with thisapproach but with the notableexception of GBP where there hasbeen a significant deviation fromyield differentials. This became moststriking in November 2015, when aBrexit referendum was anticipated,and which then became a substantialdiscount in the run up to and in theaftermath of the June 2016referendum. Inspection of GBPUSDprice action compared to theinflation adjusted yield spreadsbetween 2,5 and 10 year genericgovernment bond yields show that

17

1. USD/JPY 2 YR GOVERNMENT BOND YIELD

Source: Bloomberg

USDJPY Exchange Rate (RHS)

Behaviour changes

2 year Government Bond Yield Spreads (LHS)

Jun-11

Sep-11

Jan-12

Apr-12

Jul-12

Oct-12

Jan-13

May-13

Aug-13

Nov-13

Feb-14

Jun-14

Sep-14

Dec-14

Mar-15

Jul-15

Oct-15

Jan-16

Apr-16

Jul-16

Nov-16

40

60

80

100

120

140

160

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2. AUD/USD

Source: Bloomberg

AUDUSD (LHS)Inflation adjusted yield spreads (5yr)

Inflation adj yield spreads (10yr)Inflation adj yield spreads (2yr)

Oct-11

Feb-12

Jun-12

Oct-12

Feb-13

Jun-13

Oct-13

Feb-14

Jun-14

Oct-14

Feb-15

Jun-15

Oct-15

Feb-16

Jun-16

Oct-16

-4-2024681012

0.6

0.7

0.8

0.9

1.0

1.1

1.2

3. EUR/USD

Source: Bloomberg

EURUSD (LHS)Inflation adjusted yield spreads (5yr)


Oct-11

Feb-12

Jun-12

Oct-12

Feb-13

Jun-13

Oct-13

Feb-14

Jun-14

Oct-14

Feb-15

Jun-15

Oct-15

Feb-16

Jun-16

Oct-16

-6

-4

-2

0

2

4

6

1.0

1.1

1.2

1.3

1.4

1.5

1.6


EXCHANGE RATES 18

GBP trades far below the valueimplied by rate differentials,demonstrating that a Brexit discounthas become very visible, especiallywhen compared to other currencypairs which are behaving normally.

Furthermore, anticipation of whetherthe UK will experience a ‘hard’ or‘soft’ Brexit are responsible for thisdiscount variously widening andnarrowing depending on the news,with the ‘flash crash’ seen in Octoberwhen GBP reached as low as 1.1490being caused by a combination ofthin liquidity and headlines related tothe UK’s Brexit prospects. Technicallyand historically the fact that thepound reached as low as this level,which was a 30-year low, even beforeBrexit negotiations have started,suggests that the coming year couldeasily see volatility in GBP remainelevated, with such sharp swings tobe expected especially in the contextof torturous Brexit talks and given thepossibility of a snap General Election.

Just over 30 years ago the pound fellbriefly below 1.05 (Chart 5) as oilprices weakness saw its petrocurrency status undermined, althoughthe G5 Plaza accord subsequentlyhelped it and other major currenciesto recover strongly at the dollar’sexpense. Long term measures of fairvalue will become relevant for sterlingagain, although these are likely tohave fallen from estimates close to1.60-1.70 a few years ago to closer

to 1.30-1.40 today. The UK hasamounted a current account deficit of6% of GDP in recent years even asthe pound was perceived to be cheapat around 1.50, suggesting that thereal effective equilibrium rate for it isactually somewhat lower. Recentsigns of a resurgence in UK export

activity in the wake of the pound’srecent decline is supportive of this.

The pound looks like it will experienceanother difficult year in 2017, withBrexit talks weighing on it and as theFed raises US interest rates, but downthe line a reversion back towards thisnew equilibrium still appears likely.

Source: Bloomberg

4. GBP TRADES AT DISCOUNT

Source: Bloomberg

GBPUSD (LHS)Inflation adjusted yield spreads (5yr)


Nov-12

Feb-13

Jun-13

Nov-13

Feb-14

Jun-14

Nov-14

Feb-15

Jun-15

Nov-15

Feb-16

Jun-16

Nov-16

-6

-4

-2

0

2

4

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

5. GBPUSD ExCHANGE RATE

GBPUSD Spot

1.0

1.2

1.4

1.6

1.8

2.0

2.2

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

Sharp swings to beexpected especially

in the context oftorturous Brexit

talks and given thepossibility of a snap

General Election.

the storm. The history lesson fromthe long cycle of hope and failure inthe cycle of the Japanese equitymarket is instructive. Since the peakin 1989, the equity market has beenon a jagged down trend with eachnew low lower than the previous.On market hopes of a miraculous

economic recovery, the market hasoften rallied sharply from the lowshowever, only to revert to downtrendat a later stage. Hence, the lessonfrom Japan is that rallies in assetprices do not change the direction ofthe economy and the sustainabletrend can remain down.


EQUITY MARKETS

WHAT ARE THE SUSTAINABLEVALUATIONS OF EQUITIES?

2017 could be a yearof reckoning forequities. Despite oftenfalling profits andrevenues for theconstituents of themajor equity indices,equities havemanaged to generatepositive returns.Waves of liquidity have played theirpart is sustaining equities on highvaluations with the latest fad ofbuying equities, purely for their yieldbeing another chapter in the story ofwhy equities held up so well.

The medium to long term story does not bode well. This article is a reflection of mostly the outlook for US equities however, a world oflow nominal GDP growth, ageingpopulations and low levels of capital reinvestment by corporatesargues for lower not highervaluations of equities. We aresympathetic to those that believethat equities are at risk of showingpersistent low to negative returns.

Equities remain one of the leastfavoured assets by both private andinstitutional investors and yet theyhave continued to give positivereturns within lower levels of riskthan we would typically see in themarket. We are witnessing some ofthe highest valuations at a time ofsome of the lowest nominal rates ofGDP growth.

There remains a pervading feelingthat despite the good return andlimited risk that it is the calm before

19

Source: Bloomberg

1. S&P INDEx

0

5

10

15

20

25

30

35

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

2014

S&P500 P/E Ratio

We are witnessingsome of the highestvaluations at a timeof some of thelowest nominal ratesof GDP growth.


EQUITY MARKETS 20

In trying to assess what is the longterm fair value for equities, it isinstructive to go back to the firstprinciples. One simple model of equitymarket valuations, states that thevaluation of equities is a function ofthe dividend yield, long term dividendgrowth and long term bond yields.

Through the last eight years, therehave been times when the dividendyield of the S&P500 has been abovethat of the US 10 year yield. In 2008,this was just prior to dividends beingcut by over 20% so it provedtransitory, however more recentlystrong dividend growth equities havefound favour as bond proxies. Buyingequities as bond proxies receivedgreater validation as the volatility ofequities fell, not quite to the level ofbonds but sufficiently for investors to

believe that they were not takingsubstantial risk with their capital.Hence, US equities continued toperform well in spite of a backdropof revenues and earnings falling.

The positive dividend story for theequity market may just be about togo into reverse. The market faces theprospect of dividend cuts and farfewer share buybacks – another propof valuations.

One significant support for US equitymarket returns in recent years hasbeen the growth of dividends. Therecent growth of dividends has beenquite exceptional. Over the past tenyears, S&P500 companies have beenincreasing dividends at an annualcompound rate of over 4%, some ofthe highest growth rates seen inmodern times.

Source: Bloomberg

2. MSCI WORLD EQUITY INDEx STILL PUSHED HIGHER

MSCI World

1450

1500

1550

1600

1650

1700

1750

1800

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

May-16

Jun-16

Jul-16

Aug-16

Sep-16

Oct-16

Nov-16

Source: Bloomberg

3. VIx INDEx AT HISTORICAL LOWS

VIX Index

0

10

20

30

40

50

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

Source: Bloomberg

4. JAPANESE EQUITY MARKET ON LONG TERM DOWNTREND

Japanese market

0200400600800

10001200140016001800

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

2016


EQUITY MARKETS 21

We believe that dividends may nowbe on the cusp of being cut or at thevery least seeing little growth. Itwould be easy to get into a falsesense of security that dividends canincrease forever. However note thatsince 1970, there have beennineteen years when dividends werecut in aggregate for the S&P500.

There are signs that we could befacing a greater volume of dividendcuts in the future indeed it is alreadyunderway. S&P report that of the10,000 US traded issues thedecreases in dividends over the 12-month period ending June 2016 rose157%, to total USD 20.9bn in totaldividend cuts, from the USD 8.2bnduring the 12-month period endJune 2015. To be fair, energy issuesaccounted for 43% of the dividendcuts, however we are also seeingthat the scale of dividend increases isdiminishing and the number ofcompanies putting their dividends onhold is also on the rise.

Aside from dividends, companieshave been inflating their share pricesby buying back their shares. It usedto be the case that companiesbought back their stock when theirshares were cheap not when theyare roundly thought to be expensive.Share buybacks in the US equitymarket have been an importantfactor behind the improvement ofearnings per share even thoughgross profits were not increasing.Share buybacks reduce the numberof shares in issue and hence theearnings per share rises bringingdown the P/E valuation of the shares.But by buying back shares and notinvesting in the long term prospectsof the business share buy backs canpotentially reduce the long growthof the business just for short termgains in earnings per share. Since2009 there have been USD 3.1tnof share buy backs compared toUSD 1.5tn in the previous cycle.

When we bring the whole picturetogether, we are very muchpersuaded that equity market

returns could be very modest in thefuture. In a seminal piece of work byDeutsche Bank (Long-Term AssetReturn Study – An Ever ChangingWorld, Jim Read et al September2016) they argued should USequities be valued at an average PEmultiple based on trend earningsthe 10-year annualised return wouldbe minus 1.5%. Should the marketrevert to its average P/E multiplesince 1958, then returns would be+1.5%. As the authors point out,the big problem for equities is thatearnings/profits in the US are at avery high share of GDP and PE ratiosare very stretched by historicalstandards.

We would also note that there aregood arguments why the equitymarket will not revert to the averagePE multiple of the last 60 years,namely that with ageing populationscomes a greater desire to hold saferassets such as bonds. Hence higherrisk assets would typically trade atlower P/E multiples than has beenthe case in the past.

Source: S&P, Bloomberg

5. US GOVERNMENT BOND YIELD LESS THE S&P500 DIVIDEND YIELD

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2016

-2%

0%

2%

4%

6%

8%

10%

Source: Standard & Poor’s Corporation

6. ROLLING TEN-YEAR GROWTH OF DIVIDENDS

1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008

2014

-8%-6%-4%-2%0%2%4%6%8%

10%


EQUITY MARKETS 22


7. US SHARE BUYBACKS (USD BILLION)

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

020406080

100120140160180


8. US EQUITY MARKET VALUATION AND DEMOGRAPHICS

1952 1962 1972 1982 1992 2002 2012 20220

4540

353025201510

4%

3%

2%

1%

0%

-1%

YoY Growth of Retiree Population (RHS, Inverted)Shiller P/E (LHS) Forecast

When we bringthe whole picturetogether, we are

very muchpersuaded thatequity market

returns could bevery modest in

the future.


EQUITY SECTORS

HOW DO COMPANIES SUSTAIN THEIRCOMPETITIVE EDGE IN A RAPIDLYCHANGING WORLD

The global economy isalways evolving andchanging. Industriesand companies thathave a leading edge inone cycle can be ‘oldhat’ and a laggard inthe next.

Only those companies that arecontinually evolving and recreatingtheir businesses will survive thepassage of time. Only thoseinvestments in companies that adaptand change will prove worthy ofbeing the important building blocksof a portfolio of equities.

When Charles H. Dow first unveiled“the Dow” Index in 1884, it had 12

stocks most of them railroads. Of theoriginal 12, only General Electricremains a member. AT&T is thesecond longest survivor (1916 to2015). Technology was firstrepresented with IBM included in1932. Healthcare got a place in 1979with Merck & Co. Since its inception,the Dow (which reflects the USeconomy) has changed itscomponents 51 times.

23

Automobile

Basic Material

Industrials

Consumer Goods

Consumer Services

Financials

Health

Oil & Gas

Technology

Telecom

Transportation

Nu

mb

er O

f C

om

pan

ies

in t

he

Ind

ex

30

25

20

1884

1896

1898

1898

1901

1905

1912

1915

1920

1924

1925

1925

1928

1929

1930

1933

1935

1956

1976

1982

1987

1997

2003

2005

2008

2012

2015

15

10

5

0

30

35 35

25

20

15

10

5

0

Source: Wikipedia

THE DJIA INDEx – FROM RAILROADS TO INDUSTRIALS AND TECHNOLOGY


EQUITY SECTORS 24

Artificial Intelligence is probablythe biggest disruptor, the most visibleof which are AI assistants such as Siri(Apple iOs) and Alexa (Amazon),providing almost a human touch.Robots are being increasingly used inmanufacturing, for surgery and are acheap replacement in retail outlets.

Banks are investing in block chain toadd end to end encryption andcentralised clearing. Block chaincould substantially reduce bankingoperational costs.

Fintech has arrived (USD 19bninvested in 2015) but in the oldworld adoption has been slow.Only 1% of US consumer bankingrevenue has migrated to digitalbanking. This is expected to grow to10% by 2020 and 17% by 2023.

In China, internet giants (Alipay andTencent) were faster than the banksto offer alternatives to traditionalbank payments and have a 50%market share.

Four elements thatlead to a sustainablebusiness/ company?

INVESTMENT AND INNOVATION

ADOPTION OF DISRUPTIVE TECHNOLOGY

ENVIRONMENTALLY CONSCIOUS, ETHICAL & HIGH GOVERNANCE STANDARDS

EXPANSION INTO NEW MARKETS

Source: Bloomberg

INVESTMENT PAYS: AMAzON SHARE + 2507% IN 10 YEARS

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

5

10

15

20

25

30

0

200

400

600

800

1000

Share Price (RHS, USD)

Fixed Assets +LT Invt (LHS, USD bn)

Source: Reserve Bank of India

INDIA RISING NUMBER OF MOBILE BANKING TRANSACTIONS

Mobile Transaction Volume (LHS, Rs bn)

Mobile Transaction Value (RHS, mn)

2010 2011 2012 2013 2014 20150

1000

2000

3000

4000

5000

0

70

140

210

280

350

Investment and Innovation:During the 1980s, Sears was thelargest retailer in the US, untilWalMart took the top spot in the90’s. Today it is Walmart that cannotkeep pace with change. Amazonleads US ecommerce with a 35%market share. Technology andhealthcare are sectors that requirecompanies to continue to invest ininnovation.

Adoption of Disruptivetechnology: Apple was a massivedisruptor of the mobile phoneindustry with its touch screendisplacing the use of the traditionalkeypad. Nokia is a case study of howa company that saw the futurebecome an also-ran. Nokia in 1865had a single paper mill. In 1982, itintroduced the first fully-digitaltelephone exchange and the world’sfirst car phone. From 1998 to 2008Nokia was the world leader in cellularphones. However, Nokia did notforesee the importance of the touchscreen and had to exit the mobilephone business in 2014. Its investorslost 85% of their investment fromthe peak in 2000.

Nokia reduces size as it evolves

Apple iPhones touch screengets bigger with more apps


EQUITY SECTORS

Companies need to invest intechnology to retain market share and grow revenue.Ecommerce is the biggest disruptor inthe retail industry. Macys andAbercrombie and Fitch – attractedcustomers with appealing storedisplays. They are now shuttingstores in the thousands as customersshift to online purchases. Chinaecommerce at USD 670bn, is onethird of the world total. India with1.3bn people, has an almostnegligible share of ecommerceoffering huge potential.

Companies need to be active onsocial media (Facebook, Twitter) forvisibility. The power of the app hasled to valuations for rental appAirbnb at USD 30bn and ridehailing service Uber at USD 63bn.A report from Cisco and IMD,predicts that 4 in 10 companies willbe displaced by digital rivals by 2020.The large internet companies aredisplacing the fixed line telecomcompanies. Facebook is planning toenter the USD 500bn telecom marketwith a new open source cellularwireless network.

Environmentally conscious and ethical:GE, with a century of innovationbehind it, rebranded itself as a“digital industrial” conglomerateand focuses on being a high valueindustrials company throughadopting clean technology. GE isthe 14th most profitablecompany globally.

The renewables market share ofpower generation is expected toincrease to 28% by 2021 replacingcoal and oil. Increased use of lightemitting diodes is expected to cutpower consumption from lighting by40% from 2013 -2030.

Fossil fuel based vehicles are going tobe replaced with electric carspowered with lithium poweredbatteries leading to the demise of thetraditional gasoline vehicle. Anexpected 25 million electric vehiclesin 2025 in the US (10%) will save amillion barrels of oil per day.

Expansion into new markets:As the number of millennials growexponentially (estimated at 2.3 billionglobally) companies need to becognizant of their preferences as theyhave the spending power. Millennialswill pay for health, branded athleticwear, ethically produced goods andwill check for carbon emission levelswhen buying cars.

European and US food and consumercompanies are targeting emergingmarkets with their growingpopulations and burgeoning middleclass who have a growing preferencefor Western convenience foods andare spending more on cosmetic careand branded apparel.

25

Source: Bloomberg

TECHNOLOGY ENABLES VALUE CREATION WITH FEW EMPLOYEES AND LITTLE CAPITAL

Market cap/Employee (LHS, USD mn)

Market cap/Book Value (RHS)

1

1. Facebook

2. Alphabet

3. Apple

4. Chevron

5. Microsoft

6. J&J

7. P&G

8. Citigroup

9. GE2 3 4 5 6 7 8 9

0

5

10

15

20

0

5

10

15

20

25

30

7.5x

4.4x 5.0x

1.3x

6.6x

4.3x 4.1x

0.7x

3.2x

Source: Bloomberg

GE FOCUS ON RENEWABLES HELPS SHARE PRICE

1990-1994 1995-1999 2000-2004 2005-2009 2010-20140

5

10

15

20

25

30

35

40

GE Share Price

Source: Bloomberg

NOKIA’S LACK OF INNOVATION LED TO ITS FALL

1990-1994 1995-1999 2000-2004 2005-2009 2010-20140

5

10

15

20

25

30

35

Nokia Share Price


EQUITY SECTORS 26

Bringing it all together -Buy sustainable companies:The S&P Long-Term Value Creation(LTVC) Index comprises stocks thatrank highly in the global equitymarkets on both “long termism” andfinancial quality leading to sustainablelong term earnings growth. It is madeup of largely consumer companies(23%) and materials (15%).Financials are 9.5% compared to theS&P 500 at 26%. Inclusion evaluateslong term operational excellence,business viability, ROE, ROA andfinancial leverage, with an overlay ofgood governance.

Source: Bloomberg (rebased to 100)

Source: CIO Office

LONG TERM VALUE CREATION (LTVC) INDEx OUTPERFORMS MSCI WORLD BY 33%

S&P LTVC Global Index MSCI All Country World Index

0

2040

60

80

100120

140

160180

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

Oct-13

Oct-14

Oct-15

Oct-16

151.8

118.2

Sector Sustainability Innovates Invests Disruptive Environmentally New Driver Technology friendly markets

InnovativeHealthcare(Eli Lilly, Roche,Bristol Myers)

Continuing Investment in finding new cures. Firstmover advantage in registering patents, ensuringgrowth & adding to strong existing pharma sales

Social media(Facebook, Tencent)

Tencent is using its 700mn active internet users toexpand into messaging & online gaming in China.FB's 1.7bn user base globally will ensure dominancein growing mobile advertising

Internet search(Google)

Betting on AI for long term growth and increasingmobile ads

Autonomousdriving, Robotics (Infineon, iRobot)

Use of AI for sensors and steering systems. Chipmakers are expanding through growth drivers in theindustrial and automotive chip sectors. Robotsincreasingly used in healthcare and defence

Ecommerce(Amazon, Alibaba)

Key beneficiary of ecommerce growth, investcontinuously to maintain global position. Addingdigital payment channels and AI (drones) for delivery,eliminating the middle man

Digital banking (DBS)

Using big data to analyse customers habits andmobile banking to reach new customers.

Global payments(Visa, Mastercard)

User base of 2 bn can be expanded as 50% of globalpayments still via cash and EM 90% cash

Health (Nike, Nestle)

Adopting "wellness" as their marketing strategy andfocus on EM as the growth market.

Convenience andlifestyle (Starbucks, Inditex)

Strong branding, quickly adapting to changingconsumer preferences of millennials and addingonline selling channels

Renewables (GE)

Consumers prefer products of clean technology andregulators reward low carbon emitters

BUSINESSES, WITH A SUSTAINABLE STRATEGY


BONDS

SUSTAINABLEBOND YIELDS

In recent years theextraordinary centralbank’s stimulusglobally along withcommitment towardsasset purchases havecompressed yields torecord low levels, inmany cases deeperinto the negative-yielding category.

US government bond yields are thebenchmark for every bond in theworld. Hence having a view on thesustainable level of bond yields is animportant starting point fordetermining what returns can beexpected from the fixed incomesub asset classes.

Trying to gauge what is thesustainable level of US governmentbonds yields is a challenge when yourealise that the US 10 yeargovernment bond yields have beenfalling consistently since their peak of15.8% in 1981. Yields have notoscillated around some given level.Rather they have remained on adownward track. One of the mainreasons for the fall in yields was thecollapse in global inflation. Adjustingnominal yields for inflation to give areal yield still provides us with noconsistent pattern. Only when weadjust yields for the market’sexpected level of inflation do we seea more consistent pattern.

If instead we use projected inflation(by the market) rather than the actualrate of inflation then we get a betterpattern of recent yields that areresting between zero and 50bps.

We come to the conclusion thatsustainable US 10 year bond yield willlikely trade between 2.25% and2.50% over the medium term. Thatbeing said if the central banks of theworld continue in 2017 to supporttheir bond markets with quantitativeeasing yields will remain biased toeither the lower end of that band oreven lower. We expect to see globalgrowth to remain under 3% for yearsahead. Higher inflation cannot beruled out but there is no sense thatinflation is going to lift dramaticallygiven still benign commodity marketsand developed economies wheredemographics and poor productivityshould keep demand growth low.

For other government bond marketsspreads look far too tight but arebeing artificially held down by ongoingquantitative easing particularly inJapan where the seeming policy of the

Bank of Japan is outright manipulationof the bond market to anchor longerdated yields at zero. In time we seehigher yields with likely capital lossesfor bond holders.

The greatest risk to governmentbond yields would be helicoptermoney that would be an out and outattempt to create inflation. Such amove by central bankers still seemssome way off. The Bank of Japan isthe most likely central bank to switchon helicopter money however, thecurrent Bank of Japan GovernorHaruhiko Kuroda has repeatedlyruled out helicopter money.

Global CreditIn Global Credit markets, we continueto see strong technical support for USDollar denominated corporate debt.At current yield levels U.S Corporatecredit seems to be fairly valued relative

27

Source: Bloomberg

US 10 YEAR GOVERNMENT BOND YIELD

0%2%4%6%8%

10%12%14%16%

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

2016

Source: Bloomberg

REAL US 10 YEAR GOVERNMENT BOND YIELD USING MARKET’S ASSUMPTION OF FIVE YEAR INFLATION

-1.5-1.0-0.50.00.51.01.52.02.53.0

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

Nov-10

May-11

Nov-11

May-12

Nov-12

May-13

Nov-13

May-14

Nov-14

May-15

Nov-15

May-16

Nov-16


BONDS 28

to our long term expectations forsustainable spreads. Strong technicalsupport surrounding Euro Investmentdebt should prevail as the ECB buyingprogram continues at a strong pace ofaround EUR 7.5bn/month, amidmeaningful mandated flows andportfolio capital find their waythrough both on investment gradeand high yielding assets.

Given ongoing central bank andgovernment support for economicgrowth and the financial system weexpect spreads to continue to trade atthe lower end of the long term range.Hence through 2017 we still expectpositive returns for high yield bondsparticularly US high yield. AlthoughEuropean high yield bonds do offergood investment opportunities,capital flows and momentum towardsUS-Dollar assets should keep thecurrency (FX) component underpressure which falters total returns.

Given that we expect emergingmarket growth to remain at a

premium to global growth we expectthe EM bond markets to continue toperform well with spreads still havingsome scope to maintain theirrelatively tight spreads over USgovernment bonds. EM creditspreads are currently wider to theirlong-term averages whilst Asian andHigh yielding Sovereigns offer thebest value within EM credit in relativeterms. Furthermore, steepening ofthe UST curve would have dramaticimplications towards EM spreads

although we expect to see somestability on the US rates along withthe diminishing euphoria towards theUS-Dollar strength.

The Brazilian and Russian economiesin particular, seem to have movedout of an extended period ofrecession leading to strong capitalinflows. We expect the EM centralbanks to maintain conservativemonetary policies, and governmentsto maintain fiscal discipline.

ESTIMATES ON BOND YIELDS AND SPREADS

Option-Adjusted spread using Treasuries for risk free rate. 5-Year US Treasuries being used for the above table limiting duration to 4 to 5 years.* Germany 5-year Bunds referenced for yield/spread calculations

Source: Bloomberg

Source: Bloomberg

EMERGING MARKETS SOVEREIGN SPREAD AND EM MANUFACTURING PMI – NO SIGNS OF WIDENING

EM Manufacturing PMI (RHS)EM Sov (LHS)

2013 2014 2015 201647

48

49

50

51

52

200220240260280300320340360380

Current Short term Sustainable Medium 2017/F term valuations (3yr-5yr)

BONDS Yield Spread Yield Spread Yield / Spread

10 - Year US Government Bond 2.50% 0 2.50% to 2.75% 0 2.25% to 2.50%

Developed Markets

Global Developed Sovereign Bonds 0.92% 19 1.10% - 1.35% 40 25 bps to 50 bps

Global Investment Grade 2.58% 121 2.75% - 3.00% 125 100 bps to 150bps

High Yield

U.S High Yield 6.30% 434 6% - 6.50% 450 450 bps to 550 bps

European HY Bond* 3.33% 353 3.50% - 4.00% 350 300 bps to 350 bps

Global High Yield 5.85% 423 6.25% - 6.50% 475 400 bps to 500 bps

Emerging Markets

Sovereign Bonds 5.03% 282 4.75% - 5.25% 300 250bps to 300 bps

Corporate Bonds 5.24% 333 5.25% - 5.75% 350 350 bps to 400 bps

GCC Bonds 4.24% 210 4.40% - 4.70% 250 225 bps to 275 bps


GLOBAL REAL ESTATE

GLOBAL REAL ESTATE -SAFE AS HOUSES?

Prime real estate hasbeen a significantbeneficiary of thepersistent low interestrate environment andis expensive in almostall developed markets;

Europe is stillexperiencing tailwindsfrom loose monetarypolicy but volatilityfrom European politicsand banking sectorpresents downsiderisk;

Alternative real estateand real assets havemore sustainablerevenues andvaluations in presentvolatile marketconditions.

Real estate has experienced asustained period of robust growthacross almost all major markets andproperty sectors over the past fewyears. The search for yield andsecurity in a volatile, low rateenvironment has led to huge capitalflows and created intense competitionfor well-let, yielding assets pushingproperty values close to and, in somecases, in excess of historic highs. Thequestion many real estate investorsare asking themselves now is: is realestate overvalued?

29

The Central Londonresidential markethas already startedto experience acorrection.


GLOBAL REAL ESTATE 30

US & UKAverage commercial property yields inthe US and UK are currently 6.1%and 5.1% respectively1. By traditionalmeasures of fair value, there remainsa healthy spread over equivalent bondyields. However, this average ismisleading as commercial property inmost major cities in the US and the UKis now considered to be almostuniversally expensive with prices andrents for the best assets in excess oftheir pre-financial crisis peaks. In spiteof headwinds from the UK vote toleave the EU (“Brexit”) and questionmarks about the sustainability ofoccupational demand in a lowgrowth environment there is still toomuch money chasing too few assets,particularly in major internationalgateway cities like London and NewYork. This is likely to be sustained inthe near term by continuing investordemand and general lack of supplyalthough they look increasinglyvulnerable to downside shocks from asharp rise in interest rates, falloutfrom the US presidential elections andongoing Brexit disruptions.

The Central London residential markethas already started to experience acorrection. A succession of UK taxreforms over the past few years havespecifically targeted second homeowners / buy-to-let investors andhigher value properties of whichCentral London has the highestconcentration. In addition, there areconcerns about oversupply of luxuryapartments and sentiment has beenaffected by Brexit uncertainty.Although the next move in the high-end London residential market iscertainly downwards, the subsequentfall in GBP may stimulate overseasbuyers (c.50% of prime CentralLondon purchasers2) and stop a deepcorrection in market values like the -22% fall experienced between March2008 and May 20093.

Source: Real Capital Analytics / Moodys, 2016

NY, US CBD AND CENTRAL LONDON PRIME OFFICE PRICE INDICES

US Office CBD (LHS) Central London Office (LHS)NYC Manhattan Office (RHS)

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Jun-13

Jun-14

Jun-15

Jun-16

50100150200250300350400450500

50

100

150

200

Pric

e In

dex

, Dec

-02

= 1

00

Price Ind

ex, Dec-00 =

100250

300

Source: Cushman & Wakefield, ENBD, 2016

UK PRIME COMMERCIAL PROPERTY YIELDS OCT-16 VS 10-YR RANGESHOPS 1. Prime Central London 2. Prime Retail Centres 3. Small Market Towns Retail 4. Secondary RetailSHOPPING CENTRES 5. Regional Dominant 6. Major Urban Centres 7. Small Urban CentresOFFICES 8. London West End 9. London City10. CBD - Major Cities11. CBD - Secondary Cities12. Regional Out of TownINDUSTRIAL13. South East Industrial14. Regional Industrial

10-Yr RangeOct-2016 Yield

1 2 3 4 5 6 7 8 9 10 11 12 13 140

5

10

15

20

25

30


GLOBAL REAL ESTATE

AsiaAsian property has also experiencedremarkable price growth, particularlyin Japanese commercial assets wherethere has been a persistent ‘carry’ ofproperty yields over funding costs andin the residential space in generalwhere capital value growth seems tocontinue unabated. The mostprominent market in the region is theChinese residential market. Despitescare stories about oversupplied‘ghost towns’, runaway credit growthand the implementation ofgovernment cooling measures, theperceived bubble has yet to burst. Infact, developers’ inventories continueto fall and average house prices haverisen 7.5% year-on-year with over30% price growth in cities like Beijingand Shanghai4. This enormous levelof growth is viewed by many marketcommentators as fundamentallyunsustainable. Real estate isinevitably cyclical and there are fearsthat this is a carbon copy of theJapanese real estate market boomand bust of the 1990s.

EuropeIn Europe the recovery from thefinancial crisis was delayed comparedto other regions due to persistenteconomic turbulence but theproperty market is now also fullyvalued driven by robust investordemand and recoveringfundamentals with the addedsupport of the ECB’s QE programmeand negative interest rates. TheEuropean property market willcontinue to benefit from monetarypolicy tailwinds. Unlike othermarkets, it was given further impetusin Q3 2016 by the Brexit vote as UKbased businesses and their staffconsider relocating to the Continent.However, the European financialsector remains under scrutiny andboth this and the upcoming Italianreferendum could disrupt investorsentiment. Property markets do notexist in a vacuum so Europeanproperty will inevitably be affected ifmarkets elsewhere in the developedworld begin to correct as was thecase in previous cycles.

31

Source: JLL (Real Estate Intelligence Service), 2016

ASIA PACIFIC RESIDENTIAL CAPITAL VALUE INDEx

100

120

140

160

180

1Q06

= 1

00 200

240

260

2Q-06

4Q-06

2Q-07

4Q-07

2Q-08

4Q-08

2Q-09

4Q-09

2Q-10

4Q-10

2Q-11

4Q-11

2Q-12

4Q-12

2Q-13

4Q-13

2Q-14

4Q-14

2Q-15

4Q-15

2Q-16

4Q-16

Source: C+W, ENBD, 2016

EUROPE COMMERCIAL PROPERTY YIELDS OCT-16 VS 10-YR RANGE

10-Yr Yield Range

Current Yield Level

Off Ret Ind Off Ret Ind Off Ret Ind Off Ret Ind Off Ret Ind Off Ret

ALL WEST EAST CEE EU EMU

Ind3%

5%

7%

9%

11%

13%

Source: Bloomberg, 2016

5-YEAR SELECT CHINESE HOUSE PRICE GROWTH VS. GLOBAL PEERS

New YorkTokyo

ChicagoBoston

Hong KongBeijing

Los AngelesLondon

San FranciscoShanghaiShenzhen

0% 50% 100% 150% 200%

9%10%

15%22%

29%41%

48%58%

68%94%

205%


GLOBAL REAL ESTATE 32

> UK ground rents: regular,nominal payments by leaseholdersto the underlying landlord. This isa highly defensive income streamas leases are often for 100 yearsor more and default or expirywould effectively allow thelandlord to reclaim the propertyfor virtually nil value;

> Student accommodation:Purpose built studentaccommodation either let to auniversity or directly to studentsthrough a specialist managementcompany. Student numbers havelittle correlation to widereconomic or financial marketconditions5. Also, rental paymentsare often underwritten by aparental guarantee;

> Infrastructure: Extremelydefensive inflation-linkedrevenues generated from long-term contracts to governmententities or regulated utilitycompanies;

> Debt opportunities: the currentrestrictive credit environment inthe UK and Europe presents anopportunity for new lenders toenter the market and gainattractive risk adjusted returns inthe absence of traditional sourcesof finance.

Sustainable StrategiesThe fallout from the US elections, arise in US interest rates, the prospectof a ‘Hard Brexit’ and concerns aboutthe European banking sector are allpotential triggers that could disruptglobal financial markets with aresultant impact on real estatesentiment and investment. This risk isparticularly acute given currentprices. In this uncertain environment,where the sustainability of marketperformance is based on theoutcome of one or two significantevents, investors should seek toinvest in tangible assets whoserevenues and valuations are relativelyunaffected by such events or indeedwould benefit from them. These‘alternative’ sectors include:

1. As at 01 October 2016. Source: CBRE, MSCI, 20162. Source: BPF, 2014, Savills, 20153. Source: Knight Frank, 20164. 12-mths to 31 August 2016. Source: Soufun, CBRE GI, 20165. UK university applications and UK GDP have a -0.3 correlation.

Source: UCAS, ONS, Emirates NBD, 2016

The European propertymarket will continue tobenefit from monetarypolicy tailwinds.


OIL PRICE

WHAT IS THE SUSTAINABLELEVEL OF THE OIL PRICE?

The price slump oilthat has endured since 2014 has sentreverberations aroundthe oil industry.The current phase of low prices hasravaged oil companies andeconomies reliant on exports ofcrude and created anxiety about thefuture direction of prices. Sitting inthe middle of the current oil priceslump makes an objectiveinterpretation of the outlook for oilprices that more difficult. But wewould argue that oil markets are in astructural break from the past andthat a more sustainable medium-term oil price of close to USD 65/bwould reflect the substantialtechnological changes to the industryand impending shifts in demand.

If markets had taken a long-termview of changes to supply anddemand in the lead up to 2014, signsof a pending price slump should havebeen clear. Long-term growth in supplyhad been outpacing demand since2011, and the excess had widened tonearly 4mn b/d in 2014. Currentprojections see the surplus narrowingwith oil supply sliding while demandgrowth should remain steady.

An eventual return to deficit will besupportive for oil prices. A priceresponse to market surpluses ordeficits should only be natural. But,on the structural change side of theargument, this time really isdifferent. This is the first era of oilprices in which the technology thatallowed the growth of the shaleindustry - with its quick responsetimes and huge initial bursts ofoutput - has played a role. Horizontal drilling and hydraulicfracturing (fracking) can't be un-invented, and their use is only likely

to spread globally from their currentbase in North America and seeefficiency improvements and costsmove down.

At the same time, the trajectory fordemand tilts more to a structuralshift in oil markets. Demandconditions in the traditional coremarkets - Europe, Japan and the US -all point to flat demand at best.Long-term demand projections pointto an increasing pace of demanddeclines by the end of the decade asefficiency gains, environmentalregulations and economic languortake their toll.

The burden for growth will be on theemerging markets where the demandoutlook appears much stronger. InIndia and China, the two countrieswith the strongest socio-economicprofiles to radically alter oil demandprojections, current levels of oilconsumption per capita are far belowdeveloped country levels. In the US,annual per capita oil demand isaround 20 barrels per year while inChina it is barely above 3 barrels andin India, it is just over 1 barrel per year.If both countries converged on USdemand levels, they would collectivelyconsume nearly 150mn b/d,compared with the current globalsupply of around 96mn b/d. Whilethis kind of scenario is highlyimprobable, and for the sake of therest of the world hopefully notachieved, the 'oil-demand gap' forthese emerging markets comparedwith developed economies representsan enormous challenge for companiesto meet future energy requirements.

If emerging market oil demandgrows as expected, then significantnew and big sources of oil supply willneed to be developed. As oil wellsdeplete, new investment is neededjust for current levels of productionto stand still. The significant cuts to

capital expenditure from majorinternational oil companies in 2014-16 mean that companies have yet tosanction projects which in theoryshould start producing by the end ofthe decade. Shale oil from the US canprovide a near-term release valve toprevent prices from an upward shockin the near term but is unlikely toscale up to the degree needed tomeet huge volumes of demand overthe long-term. The required level ofproduction growth is far beyond thepotential of shale, hence the need todevelop conventional projects furtherup the cost curve in deep water, theArctic or other high-cost assets.

Looking along the oil futures curveout to the end of the decade, onecould be forgiven for thinking thattoday will last forever. Brent futuresfor 2021 have had a high of just USD62/b so far this year, not significantly

33

An eventual returnto deficit will besupportive for oilprices


OIL PRICE 34

above spot prices considering thetime frame. Imperfect as they maybe, futures markets provide us withthe most immediate assessment ofanticipated oil market conditions andprice levels stuck around USD 60/bfive years down the line don't makefor particularly positive reading.

Oil could be set up for another pricespike toward the end of the decade.The risk to the upside will be drivenby the significant cuts to supplygrowth that has taken place acrossthe industry, particularly in theconventional oil and gas sector, thepotential for enormous increases indemand from emerging market andtheir rush to secure supply. Oil pricesare characterised more by theirvolatility than their stability, and wewould expect price shocks to theupside as an inevitability the longerprices stay at their current levels.

Source: Bloomberg

LONG-TERM SUPPLY TRENDS SUPPORT A REBALANCING MARKET

DifferenceDemand: five year change (m b/d)Supply: five year change (m b/d)

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020-4

-2

0

2

4(m

b/d

)6

8

10

Source: Bloomberg

NO OIL DISCOVERIES TODAY SETS UP A SQUEEzE TOMORROW

Dated Brent (USD/b)Five year change in global reserves (000 m bbl)

000

m b

bl

USD

/b

1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 20140

50

100

150

200

250

300

0

20

40

60

80

100

120

Source: Bloomberg

EMERGING MARKET DEMAND HAS ENORMOUS CATCH-UP POTENTIAL

United States China India0

5

10

15

bb

l/cap

ita

20

25

19.21

2.791.04


PORTFOLIO MANAGEMENT

HOW TO CREATE A PORTFOLIO THATPROVIDES SUSTAINED RETURNS?

Strategic assetallocation is the artand science of buildingan optimal mix offinancial assets for thelong term and, carriedout properly, this iswhat makes portfolioreturns eventuallysustainable.An optimal portfolio can be definedas one that meets the investor'srequired rate of return whileexperiencing limited downside duringchallenging times.

Today the overvaluation of traditionalasset classes (Chart 1), in particulardeveloped market equities andgovernment bonds, poses newchallenges to building portfolioswhich can deliver sustainable returns.These high valuations suggest thatinvestors would hardly reap anybenefit by getting exposure to them,due to little in-built risk premium.Government bond yields are close totheir all-time lows due to centralbank unconventional intervention.Equities have continued to rally dueto a wall of money irrespective of thelittle or no corporate earningsgrowth, indeed little or no revenuegrowth at the companies in many ofthe major indices.

Recent history of asset allocationBefore the internationalisation offinancial markets portfolios werebuilt mainly out of domestic assets.Up to the 80's the average portfoliowould come down to domesticequities and government bonds andmaybe domestic high-gradecorporate bonds if local marketswere developed enough to allow fora liquid corporate bond market, as it

was already the case for instance inthe US. The conventional wisdom ofthose times called for a 60% equitiesand 40% bonds allocation.

The last twenty years of the lastcentury saw a dramatic increase inthe degree of internationalisation ofportfolios. Investing in equities acrossborders became more accessible and inbond markets new asset classes suchas inflation-linked bonds, mortgage-backed securities and high-yieldsecurities were created. Emergingmarket assets came to the fore, asdemand for higher-yielding and higher-growth securities rose and in the 90’smore illiquid assets, like hedge fundsand private equity, were introduced inthe average portfolio. At the end ofthe millennium the endowment viewgained consensus, whereby a well-diversified portfolio across the availableasset classes would hold a significantproportion of illiquid assets to enjoythe benefits of the illiquidity premium.

Some basic principles for buildingportfolios that should providerobust and sustainable portfolios.International equitydiversification still worksGCC equities and internationalequities. Although correlations

amongst equity markets haveincreased due to their integration,diversification is compelling forGCC investors. Data at hand showsthat volatility and drawdowns areless extreme in an internationalequity portfolio. Also, GCCinvestors going international benefitfrom sector diversification andreduced exposure to commodity-related risks.

Emerging market equities acheaper asset.A further degree of diversification inequities can be attained by increasingexposure to emerging markets wellbeyond what is justified by market-cap considerations. The industrialcycle in the emerging economies isnot synchronized with the developedmarkets and it seems to have recentlybottomed out. Also, valuations ofemerging equities are cheap inabsolute and relative terms after fouryears of de-rating. Returns of EMequities can reasonably be expectedto be in the low double digits,although investors will have toendure their higher volatility.

Small caps alongside large caps.Investors should avoid excessiveexposure to large-cap developed

35

COMBINED OVERVALUATION OF GLOBAL EQUITIES AND GOVERNMENT BONDS (VS THEIR 10-YEAR AVERAGE)

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2004 2006 2008 2010

OVERVALUED

UNDERVALUED

2012 2014 2016

Source: World Bank, PO CIO-Office


PORTFOLIO MANAGEMENT 36

market equities and increase thedegree of diversification of theirholdings by affording capital tosmaller-capitalisation companies. Thereturns of small caps are driven to agreater extent by company-specificfactors and are less affected bymarket risk or non-diversifiable risk,hence they should outperform largercaps in a post-crisis scenario,delivering most likely high single-digitreturns across a business cycle.

There is scope for diversificationwithin fixed income.Inflation risk: government bondsversus inflation-linked bonds. Globalgovernment bonds do not offer anyprotection against rising inflation, giventheir meagre yield bordering on zero, ifnot downright negative in some cases.Barring a recessionary environment,where the asset class would cushionportfolio volatility and offer capitalgains, we don't see much value ingovernment securities. Investors shoulddiversify their exposure partiallysubstituting inflation-protectedsecurities for government bonds.

Search for yield: EM bonds andDM corporate credit. Emergingmarket bonds and DM corporatecredit are the only sub-assetclasses still offering significant yieldpick-ups versus treasuries withinfixed income. EM bonds in localcurrency have a potential for higherreturns, which comes with acurrency risk mitigated by emergingmarket economies being betterpositioned for shocks than in thepast. High-yielding corporate bonds,although carrying some equity risk,provide a cushion to the volatility ofa bond portfolio in case of risinginflation.

Duration changes to adjust to therate cycle. Changes in bond durationare the main tool to dynamicallychange a bond portfolio in keepingwith the change in the outlook forreal economic growth and inflation.

Don’t forget commodities,in particular gold.Investors can attain a further degreeof diversification through gold,

historically performing well duringperiods of higher inflation andlower real growth. Gold hasdelivered on average annualizedreturns of 4.5% according to pastrecords, hence under more favorablescenarios high single-digit returnscannot be ruled out. Gold at thesame time would offer tail-riskprotection to the whole portfolio,an appealing feature consideringthe degree of uncertainty related tothe outlook for global growth.

Cash balance should be greaterthan you think.Keeping some powder dry topurchase assets during periods ofheightened volatility makes adifference to portfolio returns,especially in a low-return and high-valuation environment.

Where do the above remarks leaveus in terms of building a sustainableportfolio?

Here is our view of a model portfoliofor sustainable returns.

Source: PO CIO-Office

STRATEGIC ASSET ALLOCATION FOR A GLOBAL INVESTOR ACROSS THREE DIFFERENT RISK PROFILES

Cash USD Cash 15.0% 9.0% 8.0%

Bonds 60.0% 53.0% 45.0%

Developed Market Gvt hedged 39.7% 20.8% 5.0%

Inflation Linked 3.1% 6.4% 8.2%

Global Corporate IG hedged 9.1% 14.9% 14.6%

Global Corporate HY hedged 4.0% 4.2% 5.5%

Emerging Market USD 2.1% 3.6% 9.7%

Emerging Market (loc) 2.0% 3.1% 2.0%

Equity 15.0% 30.0% 40.0%

Developed Market 9.1% 19.5% 23.3%

Emerging Market 3.0% 5.3% 10.2%

Small Cap 2.9% 5.2% 6.5%

Alternatives 10.0% 8.0% 7.0%

Gold 4.5% 3.5% 3.0%

Hedge Funds 5.5% 4.5% 4.0%

Expected Return 3.1% 4.6% 5.8%

Expected Volatility 4.5% 7.5% 9.9%

Asset Class Sub Asset Class Cautious Moderate Aggressive

Higher growth &return potential

Tail riskhedge

Recession riskhedge

Inflation riskhedge

Search foryield


CONTRIBUTORS

CONTRIBUTORS

37

Tim Fox – Head of Research & Chief Economist

E: [email protected] T: +971 (0)4 230 7800

Mohammed Al Tajir – Manager of FX Analytics and Product Development

E: [email protected] T: +971 (0)4 609 3005.

Edward Bell – Commodity Analyst


Giorgio Borelli – Senior Manager Asset Allocation


Nigel Burton – Director Real Estate


Anita Gupta – Head of Equity Strategy


Shady Shaher Elborno – Head Macro Strategy


Yahya Sultan – Fixed Income Strategist



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All present and future rights in and to trade secrets, patents, copyrights, trademarks, service marks,know-how, and other proprietary rights of any type under the laws of any governmental authority,domestic or foreign, shall, as between the investor and Emirates NBD, at all times be and remainthe sole and exclusive property of Emirates NBD and/or other lawful parties. Except as specificallypermitted in writing, the investor may not copy or make any use of the content of this publicationor any portion thereof. Except as specifically permitted in writing, the investor shall not use theintellectual property rights connected with this publication, or the names of any individualparticipant in, or contributor to, the content of this publication, or any variations or derivativesthereof, for any purpose.

This publication is intended solely for non-commercial use and benefit, and not for resale or othertransfer or disposition to, or use by or for the benefit of, any other person or entity. By acceptingthis publication, the investor agrees not to use, transfer, distribute, copy, reproduce, publish, display,modify, create, or dispose of any information contained in this publication in any manner that couldcompete with the business interests of Emirates NBD. Furthermore, the investor may not use anyof the trademarks, trade names, service marks, copyrights, or logos of Emirates NBD or itssubsidiaries in any manner which creates the impression that such items belong to or are associatedwith the investor or, except as otherwise provided with Emirates NBD, prior written consent. Theinvestor has no ownership rights in and to any of such items.

Emirates NBD is licensed and regulated by the UAE Central Bank.

United KingdomThis publication was prepared by Emirates NBD Bank PJSC in the United Arab Emirates. It has beenissued and approved for distribution to clients by the London branch of Emirates NBD Bank PJSCwhich is authorized by the Prudential Regulation Authority and regulated by the Financial ConductAuthority (FCA) and the Prudential Regulation Authority in the UK. Some investments and servicesare not available to clients of the London Branch. Any services provided by Emirates NBD Bank PJSCoutside the UK will not be regulated by the FCA and you will not receive all the protections affordedto retail customers under the FCA regime, such as the Financial Ombudsman Service and theFinancial Services Compensation Scheme. Changes in foreign exchange rates may affect any of thereturns or income set out within this publication.

SingaporeThis publication was prepared by Emirates NBD Bank PJSC in the United Arab Emirates. It has beenissued and approved for distribution to clients by the Singapore branch of Emirates NBD Bank PJSCwhich is licensed by the Monetary Authority of Singapore (MAS) and subject to applicable laws(including the Financial Advisers Act (FAA) and the Securities and Futures Act (SFA). Any servicesprovided by Emirates NBD Bank PJSC outside Singapore will not be regulated by the MAS or subjectto the provisions of the FAA and/or SFA, and you will not receive all the protections afforded toretail customers under the FAA and/or SFA. Changes in foreign exchange rates may affect any ofthe returns or income set out within this publication.

Please contact your Relationship Manager for further details or for clarification of the contents,where appropriate.

For contact information, please visit www.emiratesnbd.com

EMIRATES NBD WEALTH MANAGEMENT

ABU DHABI – DUBAI – LONDON – RIYADH – SINGAPORE

www.emiratesnbd.com

Documents

Dealing with Global Disruptors - Emirates NBD · 2017. 6. 29. · emerging market debt. What happened? Emerging market debt has proven to be one of the better performing asset classes