Capital International
THIRD QUARTER 2014
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INVESTMENT REVIEW INNOVATION | INTEGRITY | EXCELLENCE
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China has once again become a major focus for global investors in recent weeks... Capital International
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Investment Review Contents Global Equities Times they are a changing...
Volume: 12 | Issue: 3
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The fundamental conundrum for investors is that there are no major asset classes that are cheap and so whilst equities are not cheap in absolute terms, they continue to offer attractions when priced against bonds and commercial property. Equities will continue to offer an inflation hedge, whilst bonds offer the deflation hedge...
Sector in Focus Technology Outlook
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Product in Focus PRISM | Redefining Investment
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PRISM is a competitive alternative to other discretionary services, passive investment offerings and structured products, combining low cost with the professionalism of highly diversified active institutional asset management together with the service of personal portfolio management...
Sector in Focus Oil Services
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As technology trends evolve, potential investment opportunities have shifted. The biggest innovations in the technology space are profound: more shopping online, more companies moving to the cloud, and people spending more time on mobile phones...
Oil exploration and production is a complex process, and each step of the oil supply chain involves specialised technology. Oil reservoirs are identified through geological field work, geological modelling, seismic imaging and exploratory drilling. Oil is then extracted with production equipment and transported in tankers and pipelines...
Asset Quality Review European Central Bank
Country in Focus Russia
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European investors will soon be adjusting their analytical models to incorporate another major regulatory change to European Capital Markets as the ECB will assume control as the main supervisory entity of the European Banking Industry on 4 November 2014. The framework for the move was laid down in March this year when the European Central Bank announced its ‘comprehensive assessment’, a new programme established in the wake of the Eurozone debt crisis to identify and monitor Europe’s significant banks...
Fixed Income Third Quarter Review
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Gilt and fixed income markets held onto their strong quarterly gains after a volatile September as investors expressed caution over the future of the United Kingdom after the Scotland Independence referendum. The usual influences of central bank intervention from the ECB and the direction of future interest rate increases also contributed to a choppy quarter...
Region in Focus Europe
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Macroeconomic concerns are growing in Continental Europe. The tepid recovery in many countries appears to be evaporating and the Eurozone risks falling back into recession. GDP growth in Q2 has disappointed investors with worrying declines in Germany and Italy and stagnation in France. Indeed, Italy is now enduring its third recession since 2008. This uncertain backdrop has also been clouded by the RussiaUkraine conflict bubbling in the background. There was some brighter news, with both Spain and Portugal posting growth rates of 0.6% in Q2...
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Russia has been seldom far from the news headline in 2014, mirroring its willingness to exert growing influence across its neighbours and further afield where Russian interests are concerned. While the eyes of the world were on the spectacular Winter Olympics in Sochi in February this year protests in Kiev against the incumbent prime minister of Ukraine were starting to intensify with deadly consequences...
Economy in Focus China
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China’s economic growth rate in the last quarter has distinctly cooled as industrial production growth slowed to its lowest level since the 2008 global financial crisis. This will increase the chance that the authorities in Beijing will step up stimulus measures to bolster the world’s second-largest economy. Growth will slow further in the fourth quarter, dragged down by further property construction weakness. That will bring about more policy support. Some investors are now forecasting Chinese GDP to slow to around 6.5% in 2015...
Region in Focus Latin America
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Over the last decade, Latin America’s economic expansion was accompanied by significant progress in poverty reduction. Between 2003 and 2013 the region grew at an average annual rate of 4.0%, in spite of the contraction brought about by the international financial crisis. This growth was primarily driven by favourable international conditions, marked by the rapid growth of world trade and increasing commodity prices, resulting in positive terms of trade impacts for the region...
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There are early signs that weaker European economic data is indicating a slowdown... Capital International
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Global Equities Times they are a changing... The fundamental conundrum for investors is that there are no major asset classes that are cheap and so whilst equities are not cheap in absolute terms, they continue to offer attractions when priced against bonds and commercial property. Equities will continue to offer an inflation hedge, whilst bonds offer the deflation hedge. Whilst near term news flow remains dominated by deflation, notably in Europe, there are longer term fears that the longer Central Banks remain dovish, the more that long term inflation expectations are increasing. Certainly the Federal Reserve have become more measured in their rhetoric and with the labour market tightening, there is scope for wage pressure to the upside. Interest rates are now indicated to move in Q2 2015 in the US and possibly in a greater scale than investors had previously factored. There also remains scope for surprise in the UK, where we would prefer interest rates to start moving in the current calendar year. In recent days, Mark Carney has indicated this could be the case. Corporate earnings over the last quarter have been mostly positive, although many UK companies that have significant exports, have noted foreign exchange losses due to the strength of Sterling earlier in the year. There have also been early signs that the weaker European economic data is also leading to a slowdown. US earnings growth is still forecast to be 10% in 2015, despite all time high profit margins reported in the second quarter. On a global basis, earnings revisions have actually hit a three year high. Top line revenue growth is still not that sparkling but with global GDP forecast to accelerate to 3.3% growth in 2015, forecasts could be too conservative as capital expenditure plans are formalised. China has once again become a major focus for global investors in recent weeks, as a number of economic data points have been weak. Industrial production, for instance, only registered a 6.7% year on year increase in August, the lowest reading since the credit crisis. Fixed asset investment, the largest component of the GDP reading, grew at the slowest rates since 2001. This downgraded view of activity has led to a poor performance in many commodities and the related equities. Indeed the Bloomberg Commodity index dropped to a four year low at the end of September. We will be watching this development closely, as Asia is our preferred equity region from a valuation perspective, along with the core UK domestic market. Geopolitics has continued to be a risk factor with Russian intentions unclear for much of the period, although the tentative ceasefire seems to be holding. However with stories of seized Western assets in the country, it remains a worry for markets, particularly as we approach the winter months. Optimists highlight that Russia need the oil/gas revenue as much as Europe needs the energy. Despite the Middle East having a notably turbulent period, the crude oil price has been subdued, even with a ramp up towards the end of the quarter as the Allies undertake more extensive airstrikes against the Islamic State. Over the third quarter, the S&P 500 Index is virtually unchanged, with the Dow Jones Industrial Index also flat. On a number of valuation measures, US equities look fully valued. For instance, the price/book valuation levels have only been higher during the late 1990’s technology boom. The forward P/E ratio on the S&P 500 is currently 17x with an average dividend yield of 2%. Merger and Acquisition activity remains robust however and after a period of underperformance this year; smaller companies could be more attractively valued currently.
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Price at Rates & Commodities 30-Sep-14 30-Jun-14 30-Sep-13 GBP/USD 1.6219 1.7102 1.6183 GBP/EUR 1.2843 1.2492 1.196 GBP/JPY 177.852 173.23 158.94 SILVER 1942.670 1940.110 1672.800 GOLD 1210.00 1313.00 1335.75 EUR Crude Oil 93.17 112.09 109.22 US Fed Funds 0.25 0.25 0.25 UK Base Rate 0.50 0.50 0.50 ECB Base Rate 0.05 0.15 0.50
% Chg Quarterly -5.16% 2.81% 2.67% 0.13% -7.84% -16.88% 0.00% 0.00% -66.67%
% Chg 1 Year 0.22% 7.38% 11.90% 16.13% -9.41% -14.70% 0.00% 0.00% -90.00%
Price at 30-Sep-14 30-Jun-14 30-Sep-13 6,622.72 6,743.94 6,462.22 17,042.90 16,826.60 15,129.67 4,493.39 4,408.18 3,771.48 1,972.29 1,960.23 1,681.55 9,474.30 9,833.07 8,594.40 4,416.24 4,422.84 4,143.44 16,173.52 15,162.10 14,455.80 22,932.98 23,190.72 22,859.86 165.89 161.75 162.62
% Chg Quarterly -1.80% 1.29% 1.93% 0.62% -3.65% -0.15% 6.67% -1.11% 2.56%
% Chg 1 Year 2.48% 12.65% 19.14% 17.29% 10.24% 6.58% 11.88% 0.32% 2.01%
World Indices UK Top 100 Dow Jones NASDAQ S&P 500 DAX CAC 40 Nikkei 225 Hang Seng Gilts
Some of the biggest gainers in the last quarter have included Monster Beverage which rose over 25% after Coca Cola announced a stake in the company. Family Dollar Stores gained 18% on merger talks and Under Armour gained 14% as the company continues to gain market share. Decliners included Transocean down 28% as rig day rates collapsed; Mattel dropped 20% on poor performance of core brands such as Fisher-Price and Walgreen fell18% as Pharmacy margins were squeezed. In the UK, the FTSE 100 is down another 1.5% over the quarter, the same decline as the second quarter, despite the positive growth outlook. The current forward P/E ratio on the market is 13x with a dividend yield of 3.80%. This still represents reasonable value; with ten year Gilt yields still as low as 2.45%. The Scottish referendum and the possible Yes vote did create some volatility, most notably for the financial sector, which continues to struggle with litigation expenditure. Unemployment has now dropped below the two million mark, for the first time since November 2008. Notable gainers for the period included ITV up 17%, Shire up 17% also and Dixons Carphone rallied 13%. Fallers included Tesco down a hefty 32%, Hargreaves Lansdown 24% lower and Royal Mail was 20% down on fears of a parcel price war. European equities have been poor in the third quarter, as the region continues to struggle for positive economic traction. The ECB stands ready to inject further liquidity into the system, whilst the Ukraine situation has also overshadowed valuations. The broad Euro Stoxx Index fell 0.50%, the DAX in Germany was 3.50% lower, the CAC 40 in France lost 0.80% and in Italy the MIB Index was 3% lower. Amongst the stocks on the rise included Nokia which continued its fantastic run gaining another 22%, ASML was 15% higher and AXA was up 13%. Fallers included BASF down 14%, Volkswagen lost 13% on fears of slower domestic demand and Carrefour dropped 9% as the domestic French economy stagnated. Parts of Asia bucked the trend in global equities during the quarter, with the Nikkei Index in Japan being the star performer. It rose 7% as the Yen weakened, boosting export related companies such as Casio up 20%, Pioneer up 34% and Mitsubishi Motors up 19%. The bullish argument for the country runs deeper than just the currency with the economy on the verge of exiting deflation for the first time in nearly twenty years and strong corporate balance sheets.
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Sector in Focus Technology Outlook As technology trends evolve, potential investment opportunities have shifted. The biggest innovations in the technology space are profound: more shopping online, more companies moving to the cloud, and people spending more time on mobile phones. The recent news flow in the sector has been dominated by the launch of several products by the sector behemoth, Apple. They included the iPhone 6, the iPhone 6 Plus, Apple Pay and the Apple Watch. It was notable that the concept of a smart watch almost got more attention than the new iPhone model. Early devices have thus far had a limited impact due to their technological shortcomings. The iPhone will be the main contributor to profits in the coming quarters and in the first three days after the launch; the company sold a staggering ten million units. The larger, Plus model, is likely to mean that there will be zero growth in iPad sales due to cannibalisation. Apple Pay could be a way for the company to drive device sales and it is a relatively mature solution that sees the company as an enabler rather than a competitor to other payment providers. The Apple Watch will monitor health and fitness, tracking the wearer’s movement, heart rate and activity with built-in sensors, feeding the information into Apple’s Health app for the iPhone and iPad and allowing review and analysis of the data. It is charged by a wireless, inductive charging pad that magnetically connects to the back of the watch. The screen is covered by a curved sapphire glass touchscreen that can differentiate between a tap and a touch, and vibrates with alerts using a haptic feedback component and a speaker.
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Recent forecasts suggest that smartphone growth will slow from 40% in 2013 to only single digits in 2017. There are signs of market saturation in developed markets, while stronger growth has been found in developing and emerging economies. But, even in a country where the average annual income is just under £5,000, the smartphone market in China is already fairly mature and such phones account for 80% of all mobile phone sales. While Apple and Samsung will continue to dominate the premium segment, accounting for 45% of the global sales total, local players like China’s Xiaomi will eventually lay down the gauntlet to these giants with aggressive price-points and growing economies of scale. Devices costing less than £90 will be at the centre of the next big sales surge. As a sign of how technological advances render previous solutions unappealing, Samsung Electronics have confirmed recently that they will cease selling laptops in Europe, including the Chrome Book. The shares have also been downgraded as the company look to introduce a low/mid-end smartphone later than expected. There are other examples of previously dominating technology falling on hard times. Over the last couple of years, the share price of Nokia has staged a major recovery, as the revised Lumia models have won back customers. Blackberry with its newly launched product range, will also be hoping for a similar change of fortunes. The cessation of laptop production occurs a few months after Sony sold off its Vaio line, and days after HP and Dell were each rumoured to hold merger talks with EMC in an attempt to diversify after years of PC market downturn.
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PC sales have been slumping ever since the iPad’s introduction battered on all sides by the rise of mobile, the general economic downturn, a slowdown in the pace of performance improvements, and the PC’s steady transformation into an appliance. ‘Platforms and Productivity’ is the defining phrase of Microsoft’s forward strategy. By productivity, the company means not only the documents, spreadsheets and slides — think Office — associated with the term. Rather, the definition extends beyond producing something to tools that can analyse, predict, give insights and also work on people’s personal behalf. By platforms, these are not only operating systems such as Windows and back-end infrastructure such as Azure, but also the ability to span the different platforms that people use today, from Apple’s iOS to Google’s Android to Salesforce.com. Google is best known for the online services and software it offers to consumers, things like Google Search, Gmail, YouTube and the Android mobile operating system that runs so many smartphones and tablets. It has built arguably one of the most dominant internet platforms in the world. Last year, the company generated $50 billion of advertising revenue, which represented 40% of the total digital advertising spend. However, for more than ten years, the company has also offered services, software, and even hardware to the world’s businesses, including everything from online applications such as Google Docs to sweeping cloud computing services such as Google Compute Engine. This division will now be known as Google for Work and represents a major growth driver. The aim will be to target Microsoft Office and other work practices, which have changed little in recent years. The company has been making many acquisitions ranging from satellite mapping activities to artificial intelligence. Earlier this year it paid over $3 billion for Nest Labs, a maker of “smart” thermostats and smoke alarms for homes. Cloud computing has been another key theme in recent years and Intel has positioned its strategy to benefit from the associated growth in data centres and shift from the traditional PC market.The data centre servers, in a variety of locations, can be harnessed on demand to run tens of thousands of applications accessed by individual users. At any given time, there are millions of users accessing applications in the cloud. Purchasing individual software is a thing of the past. Intel has secured a staggering 98% of the server chip market and has gained customers by extensive customisation to individual needs. Mobile applications are also exploding. The market didn’t exist in 2007, but could surpass $70 billion in 2017, according to market analysts. The leading app ecosystems, Google’s Android™ and Apple’s iOS, capitalize by taking a cut of each transaction. It’s tough to remember an iPhone without third-party apps, but sure enough, the ability to download from the App Store didn’t arrive until iOS 2.0 in the summer of 2008. The recent flotation of Alibaba.com could well have signaled the US equity market top, as investors joined a frenzied rush to buy into the world’s largest online business-to-business trading platform for small businesses and China’s largest consumer-toconsumer online shopping platform. On the first day of trading, the company achieved a market capitalisation of $225 billion which was equivalent to JP Morgan! The shares achieved a first day gain of 35%, even after being priced towards the top of the IPO range.
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Asset Quality Review European Central Bank
The following chart illustrates this through the credit default swap market, a derivative which is used to ‘insure’ against default of a company. As credit risk rises, the cost of that insurance rises...
Citigroup Morgan Stanley Banco Santander
-0.61%
Banco Bilbao Vizcaya
-0.62%
UniCredit Dexia Credit Local
-0.66%
Intesa Sanpaolo
-0.77% -0.9% -0.8%
-0.7% -0.6% -0.5% -0.4%
-0.3% -0.2% -0.1%
Credit Positive
0%
0.1%
Credit Negative
Longer-term there is concern from some areas, particularly equity investors that banks will not achieve the same level of earnings growth and justify being rated along similar lines as other cash generative, heavily regulated and predictable industries such as utilities or telecoms. There is some data to support this scenario. Since 2010, Eurozone yield curves have flattened considerably with the gap or spread between Eurozone 2 Year and 10 Year bonds dropping from 2.7% in 2010 to less than 1.3% now.
Changes in Eurozone Yield Curves 6.0% March 2010 September 2014
5.0% 4.0% 3.0% 2.0% 1.0%
50 years
30 years
20 years
10 years
15 Years
9 Years
8 Years
7 Years
6 Years
5 Years
4 Years
0 3 Years
The industry has been aware of the need to shore up risk capital under the Basel III directive for more than two years now so a considerable amount of new issuance has already bolstered loss-absorbing capital while extensive support from the ECB has allowed deleveraging without imposing massive losses.
Nomura Securities
-0.11%
1 Year
As a consequence of the ECB’s new methodology and the cooperation of the banks and national regulators, investors are not expecting any significant results to arise from the AQR. Banks have had a decent window of opportunity accompanied by favourable liquidity and market support to raise further capital ahead of any new regulation.
Wells Fargo
-0.58%
2 Years
The major change in this exercise compared to earlier attempts is that sovereign bonds are being included under items held, ’ready for sale’ a much wider scope than that of bonds held purely on a bank’s trading book. Since the Eurozone crisis highlighted how economic stress can deliver very real losses to a financial institution this is a major change in emphasis.
American Express
0.02% -0.06%
6 Months
A key element of this review is the Asset Quality Review (AQR). The review began in November 2013 and covers €3.7 trillion of assets, equivalent to almost 60% of the sector’s total risk weighted assets and 128 banks deemed ‘significant’ by the ECB. This will be the first time that a formal coordinated Europe-wide review has been conducted. Earlier attempts at measuring risk received strong criticism regarding their effectiveness following the stress tests applied to the Irish banking sector in 2010 which required a bailout just months after passing the tests.
0.03%
-0.07%
3 Months
Once the ECB assumes its role as supervisor of the banking sector under the Single Supervisory Mechanism, Europe’s banks will be reporting risk statistics in an identical format across the continent allowing true comparisons to be formed between geographically disparate banks.
5 Year Credit Default Swap Performance in 2014
1 Month
European investors will soon be adjusting their analytical models to incorporate another major regulatory change to European Capital Markets as the ECB will assume control as the main supervisory entity of the European Banking Industry on 4 November 2014. The framework for the move was laid down in March this year when the European Central Bank announced its ‘comprehensive assessment’, a new programme established in the wake of the Eurozone debt crisis to identify and monitor Europe’s significant banks.
This typically occurs before a downshift in earnings as large yield gaps between short-term and long-term interest rates offer the best environment for banks which generally take shortterm deposits and make longer-term loans. The ECB will also likely come under political pressure as well as from the banks themselves and will tread carefully to avoid creating further problems in the sector. Restricting lending is economically and politically unappealing as the Eurozone’s deflationary bias would deteriorate yet further which is why the latest phase of ECB monetary policy has contained conditions, to be imposed on participating banks and to ensure that the transmission of credit into the economy becomes more efficient.
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If cutting lending is not viable then the only other feasible route to deleveraging a bank while increasing capital is to sell more shares or bonds and/or reduce pay-outs to shareholders through dividends or share buybacks. This is the approach currently being used across Europe with banks issuing substantial amounts of new hybrid debt securities called Contingent Convertible Bonds which behave like conventional bonds until Tier 1 capital thresholds are breached, after which they perform like equity or loss-absorbing capital. This has been a rapidly growing area in debt capital markets with almost ÂŁ50bn of issuance so far in 2014 from a tentative start back in 2009 when Lloyds issued the first contingent convertible bond. The effects of central bank support have been felt throughout the banking sector. In the chart which looks at total returns for selected bank equities during 2014, the highest performers have all been from peripheral Eurozone nations or French banks which had exposure to the periphery. Conversely, the weakest performers this year have been banks which were either relatively sheltered from the financial crisis (like Standard Chartered) or which raised capital earlier in the financial crisis, before the Eurozone sovereign phase took hold (in the case of Barclays and Lloyds).
38.1% 35.5%
Natixis
32.9%
Caixabank
32.1%
Credit Agricole
27.3%
Banco Santander Lloyds Bank
-3.5% -6.0%
Standard Chartered
-12.3%
Barclays
-12.8%
Deutche Bank Erste Group
-22.9% -30%
Intesa Sanpaolo
-20%
-10%
0%
10%
20%
30%
40%
50%
While the current situation looks as though the banks are approaching fair to full valuations, the sector could still deliver some positive performance given the benefits of higher transparency and lower risk to capital after the stress testing has been published. Notably, the ECB is also continuing to support markets in particular its banks, through its Targeted Long-Term Refinancing Operations and its commitments to maintain a low interest rate policy. Therefore so while some peripheral Eurozone banks are now displaying remarkable improvements in risk and posing questions about how much further they go, the central bank policy is sure to make investors think before taking any contrarian positions against this.
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Fixed Income Third Quarter Review Gilt and fixed income markets held onto their strong quarterly gains after a volatile September as investors expressed caution over the future of the United Kingdom after the Scotland Independence referendum. The usual influences of central bank intervention from the ECB and the direction of future interest rate increases also contributed to a choppy quarter. Q3 2014
YTD
World Bonds Aggregate
3.20%
8.14%
AAA Rated
2.08%
6.66%
AA Rated
2.52%
8.24%
A Rated
2.16%
6.73%
BBB Rated
2.66%
11.14%
1 to 3 Year Maturity Bonds
0.44%
1.67%
3 to 5 Year Maturity Bonds
1.17%
4.80%
5 to 7 Year Maturity Bonds
2.18%
8.77%
7 to 10 Year Maturity Bonds
3.29%
12.32%
10 to 15 Year Maturity Bonds
4.75%
16.94%
UK Treasuries
3.85%
7.47%
UK Index-Linked
5.00%
9.43%
Overall, the story was a familiar one; the US Federal Reserve reiterated its promise to keep rates low for as long as necessary while the ECB reduced its main refinancing rate to just five basis points early in September, acknowledging the very real fears of deflation. Furthermore, and perhaps more significantly the Bank took the measure of introducing a negative interest rate on deposits of -0.20%, creating a financial disincentive for banks to hoard cash on the ECB’s balance sheet. This extensive support has created a significant tailwind for riskier credit even while the macro situation in Europe remains disinflationary. This effect has seen sovereign yields on peripheral European bonds from Spain and Italy reach alltime lows during the last quarter, with Spanish 10 year yields dropping to 2% in the wake of the ECB’s latest announcement.
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4.5
Spain 10 Year Italy 10 Year UK 10 Year Germany 10 Year
4.0 3.5 3.0 2.5 2.0 1.5 1.0
September 2014
August 2014
July 2014
June 2014
May 2014
April 2014
March 2014
February 2014
0
January 2014
0.5 December 2013
The Eurozone is still working its way out of a protracted recession even with a huge amount of support from the European Central Bank...
European 10 Year Sovereign Bond Yields in 2014
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The effects can be seen strongly in the relative outperformance of BBB-rated bonds versus AAA-rated bonds since the end of the first financial crisis phase in 2009. Since then, BBB bonds have achieved twice the return of their higher-quality counterparts in a very robust performance as investors have sought yield in a low return environment.
Relative Outperformance GBP AAA vs BBB Bonds 170 BBB GBP Return AAA GBP Return
160 150
Uptake of the facility was strong and not surprising given the generous terms of the LTRO. Banks could borrow from the ECB at 1% with 3 years to repay but in reality, repayment has been progressing quickly. Of the initial €1.2 trillion loaned by the ECB, Europe’s banks have repaid over 2/3rd of the total with just over €300 billion remaining. In a development of the programme, ECB President Mario Draghi announced the initiation of a refined LTRO, the Targeted Longer term Refinancing Operation for September 2014. Take up of this initial allotment was at the low end of the estimates which has led to varying interpretations. One side argues that the relatively low demand is due to the forthcoming Stress Tests from the Asset Quality Review once the ECB becomes responsible for regulating the European banking sector and the December allotment will prove more attractive once banks have more clearly identified their funding targets.
140 130 120 110 100 September 2014
March 2014
September 2013
March 2013
September 2012
March 2012
September 2011
March 2011
September 2010
March 2010
September 2009
March 2009
90
Clearly the Eurozone is still working its way out of a protracted recession even with a huge amount of support from the ECB since the European chapter of the financial crisis unfolded in 2012. At the heart of this has been the Long Term Refinancing Operation or LTRO. The ECB initiated this programme during the Eurozone sovereign debt crisis as an extension of its regular open market operation and rapidly saw huge interest from liquidity starved banks. As a monetary policy, it differs from the Quantitative Easing schemes of the Federal Reserve and bank of England by making loans directly to banks and does not involve the buying of bonds. This has the effect of limiting the growth of the ECB’s balance sheet while the US and UK central banks have both seen theirs soar to record highs of $2.4 trillion and £500 billion respectively.
The counterargument is that this weaker demand will force the ECB to consider further stimulus measures or even a full blown QE programme. This would inevitably have the effect of ensuring demand for riskier assets, even with the earlier bull market in lower-quality bonds. Either way, each scenario underlines how support for riskier bonds is becoming more unpredictable as yields have fallen lower and lower. This also explains why the many macroeconomic and political risks this year have played a relatively small part this year as the economic fundamentals have continued to assert the most influence. Germany’s 10 Year Bunds now yield a record 1.5% less than their US Treasury counterparts, typically a bearish sign.
The Widening Gap In German Yields to the USA 4 Germany 10 Year Spread to US Treasury UK 10 Year Spread to US Treasury
3 2 1 0
Outstanding LTRO Balance (EUR Billion)
-1
1000
600 500 400 300 September 2014
July 2014
August 2014
May 2014
June 2014
April 2014
March 2014
February 2014
January 2014
December 2013
October 2013
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November 2013
August 2013
September 2013
July 2013
June 2013
May 2013
April 2013
March 2013
January 2013
February 2013
200
August 2014
August 2012
August 2010
August 2008
August 2006
August 2004
August 2002
August 2000
August 1998
August 1996
700
August 1994
August 1990
800
August 1992
-2
900
Currently, UK Gilts trade at broadly equivalent yields to the US Treasury, which is signalling a clear difference in the speed of the recovery in the three economic blocs. The US is recovering fast and the market is adjusting to reflect the likelihood of rate rises from the Fed, yet no such recovery is being seen in Germany with ultra-low yields reflecting the weak inflation expectations in the Eurozone. Investors should therefore tread carefully over the next quarter as volatility in both the bond and equity markets is likely to rise due to the lure of further ECB support offset by the wide disparity in growth seen in global capital markets.
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Region in Focus Europe Macroeconomic concerns are growing in Continental Europe. The tepid recovery in many countries appears to be evaporating and the Eurozone risks falling back into recession. GDP growth in Q2 has disappointed investors with worrying declines in Germany and Italy and stagnation in France. Indeed, Italy is now enduring its third recession since 2008. This uncertain backdrop has also been clouded by the Russia-Ukraine conflict bubbling in the background. There was some brighter news, with both Spain and Portugal posting growth rates of 0.6% in Q2. GDP forecasts have been revised down from 1.1% to 0.7% in 2014 and from 1.6% to 1.1% in 2015. In response, The European Central Bank (ECB) stands ready to use additional unconventional tools if needed to spur inflation and growth in the Eurozone. ECB President Draghi also said he expects more demand from banks for its new ultra-long loan programme, known as TLTRO’s, when the funding is offered again in December. Lower than expected take-up of the initial tranche of loans has fuelled expectations the ECB may eventually take more radical stimulus measures, such as printing money to buy securities. Such quantitative easing, or QE, would face strong resistance in Germany. According to the OECD, real wages in France were rising an annual 1.5% in 2009 and 2010. By 2012, that had fallen to just 0.2% and looks to be a similar figure in the current year. In Italy according to the OECD, real wages are now falling by 2% a year. In Greece and Spain, both real and nominal wages have been falling for the past five years. In Greece, average pay is now down 22% on what it was five years ago, according to the International Labour Organization. Pay is down 7% in Spain and 5% in Portugal. That’s what happens when there are no jobs. With such fierce competition for the very few available vacancies, it is a surprise that wages are not falling even faster. Deflation, not inflation, remains the number one concern across the region. Consumer prices are falling, or barely rising, in eight of 18 Eurozone member states, and that tally may have increased in August. Regional inflation fell to just 0.3% last month, its lowest level since October 2009. And prices for goods leaving Europe’s factories have fallen all year, except for June. Very low inflation can be as damaging to an economy as excessive price increases, particularly against the backdrop of high Eurozone unemployment. Why? Because if households and businesses expect inflation to stay depressed for a long period, they may postpone spending and investment, triggering a downward spiral. It also makes it harder for countries to pay off debts.
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Currency movements have also transpired against the region in recent months. A weak Euro-Yen exchange rate long helped keep the wind in the sails of Europe’s exports to emerging markets. However, as the Yen weakened the Eurozone’s exports to emerging markets began to struggle. Take Germany as an example: while exports to China continue to make new highs (at €19 billion a quarter), quarterly exports to other BRICS markets have dropped from €18 billion to €15 billion. Meanwhile, the political outlook just keeps getting worse. In the German region of Saxony, the anti-Euro Alternative for Germany (AfD) party won it first seats in a regional assembly over the weekend. French Prime Minister Manuel Valls faces a battle to push through even the modest reforms he has proposed. Germany currently accounts for 25% of the total population and represents 27% of the region’s overall GDP. German growth in the current year has been revised down to 1.5% with weak economic sentiment and industry impacted by Russian sanctions. German manufacturing expanded at the slowest pace in 15 months in September as new orders fell and the data also showed that new orders at factories contracted for the first time since June 2013, falling to 48.8 from 51.1. Unemployment however, remains low and a new minimum wage should boost overall pay levels. France, the Eurozone’s second-largest economy, is suffering from a record high unemployment rate - over 10 percent - and has registered no economic growth in the past two quarters. The Government is struggling to cut the budget deficit below the 3% of GDP target imposed by the EU by 2017. Added to its economic woes, the country is weighed down by a political crisis that has seen President Francois Hollande plumb record lows in opinion polls and a shock cabinet reshuffle in August to purge dissenters. Demographics are relatively strong but competitiveness is still hampered by restrictive work practices. Italy accounts for 18% of the region’s overall GDP but the latest GDP release showed the tenth quarterly contraction in the last 11 quarters. The OECD recently shocked the country by forecasting only 0.1% growth for 2015. Successive Governments have failed to implement effective reforms, with the focus currently on the labour market. For instance, a reform of the public sector has been launched, and the Government has put an extra €80 a month into the pay packets of the lowest earners. Maybe the early signs are encouraging with consumer confidence rising in August and the youngest ever Prime Minister, Matteo Renzi, still enjoys an approval rating over 60%. Spain appears to be firmly on the recovery track, with a strong growth in the level of exports spurring the economy. The economy has now grown for 13 consecutive months and the current GDP forecast for 2014 is for 1.2% growth, followed by a 1.6% figure in 2015. Borrowing costs have also fallen substantially and in the last quarter, incredibly fell below equivalent Gilt yields. However, unemployment remains stubbornly high with nearly six million Spaniards out of work. At 24.5%, the country’s jobless rate is more than twice the average in the Euro-area and the second highest in the bloc after Greece. More worryingly, say the OECD, over half of young Spaniards are also out of work.
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Š Capital International Limited 2014
Innovation Integrity Excellence
12 Page
Product in Focus PRISM | Redefining Investments PRISM is a competitive alternative to other discretionary services, passive investment offerings and structured products, combining low cost with the professionalism of highly diversified active institutional asset management together with the service of personal portfolio management.
You can simply chose the precise balance of return and volatility (risk) that is right for you, ranging from very low risk to genuinely high growth investment strategies depending on your needs. If you have a mix of requirements you can allocate different amounts to different risk/return profiles. Furthermore, all the lower risk PRISM profiles enjoy an element of capital protection over their stated time horizons giving greater piece of mind to clients with less risk appetite.
In this article we look at how Prism can help clients to invest with confidence and control. We will also look at how PRISM return expectations compare with a range of comparable alternatives.
PRISM gives you full control and you can adjust your positions over time to match with precision your requirements as they change or as your confidence in markets changes. With weekly dealing, no exit fees or initial commission, no dealing charges and free switching between profiles, PRISM really does put you in control.
First a quick introduction in case you have not heard of PRISM. PRISM offers a full range of defined risk/return investment profiles, where the performance characteristics of each are clearly stated with a high degree of confidence. This means that when you select one of the PRISM profiles you know exactly how it is likely to perform over time.
And as for cost, the PRISM profiles are delivered without any client charges. Furthermore, PRISM’s underlying Master Investment Strategy has a low annual charge of only 0.25% per annum, dramatically lower than most other active investment managers. Finally, on performance, each profile is designed to deliver a risk-return balance that structurally exceeds all traditional investment strategies. Indeed, we believe PRISM truly redefines investment.
So how can you use PRISM and how does it really compare?
ISM Pr RPE R DEFIN ING
Firstly, that you should always seek advice from a Financial Adviser or Investment professional to determine the suitability of any financial service to your specific circumstances. Financial Advisers can help you plan for the future, manage your wider financial circumstances and protect against a broad range of financial risks. INVES TMENT
Table 1 - Low Risk Investor
But let’s consider two generic types of investor for illustrative purposes – the low risk investor and the high growth investor. Expected Returns over 2 years
Expected Return
Expected Volatility
Return/ Risk
Minimum*
Average
Maximum*
Expected Return (1 year) Minimum*
Maximum*
Money Market
0.75%
1.00%
0.75
-1.27%
1.51%
4.28%
-1.21%
2.71%
5yr Gilts
1.79%
3.50%
0.51
-6.09%
3.61%
13.31%
-5.07%
8.65%
10yr Gilts
2.49%
7.50%
0.33
-15.75%
5.04%
25.83%
-12.21%
17.19%
PRISM Horizon 2
3.00%
2.10%
1.43
0.27%
6.09%
11.91%
-1.12%
7.12%
Short Corporate Bonds
3.25%
6.50%
0.50
-11.41%
6.61%
24.62%
-9.49%
15.995
Traditional ‘Cautious’ Strategy
3.50%
6.00%
0.58
-9.51%
7.12%
23.75%
-8.26%
15.26%
Table 2 - High Growth Investor
Expected Returns over 10 years Expected Return
Expected Volatility
Return/ Risk
Minimum*
Average
Maximum*
Counterparty, interest rates & inflation Quantitative Easing & Inflation Quantitative Easing & Inflation Broadly diversified markets Counterparty & inflation Poor diversification & inflation
Expected Return (1 year) Minimum*
Maximum*
UK Equity Tracker
8.75%
16.00%
0.55
32.20%
131.36%
230.53%
-22.61%
40.11%
Global Equity
9.25%
17.00%
0.54
36.86%
142.22%
247.59%
-24.07%
42.57%
Traditional ‘Growth’ Strategy
8.50%
13.00%
0.65
45.52%
126.10%
206.67%
-16.98%
33.98%
PRISM Horizon 8
10.00%
12.50%
0.80
81.90%
159.37%
236.85%
-14.50%
34.50%
PRISM Horizon 10
12.00%
16.00%
0.75
111.42%
210.58%
309.75%
-19.36%
43.36%
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Other Risks
Other Risks UK economic growth Global economic growth & currency Poor diversification & global growth Broadly diversified markets Broadly diversified markets
* The figures are prepared for illustrative purposes and the range of returns is calculated to a 95% confidence level based on return and volatility expectations for different markets and strategies.
Page 13
Low Risk Investors
Low risk investors typically keep their savings in cash, but are concerned about very low interest rates and the risk of lending their money to a bank or building society. They are seeking higher returns but are not prepared to take significant amounts of investment risk and are nervous of traditional investments. The challenge is to find a solution that can deliver real returns without taking undue risk. As illustrated in Table 1 above, investments that might traditionally have been called low risk, such as Gilts, are in fact far more volatile than most investors realise and to compound the issue their expected returns are still very low indeed. Quite simply they have a poor return-torisk trade off. Even a short dated 5 year Gilt may fall in value by 5% or 6% over a year or two and a traditional ‘cautious’ investment strategy comprising a mix of predominantly Gilts and bonds, but also with some exposure to equities, may well fall by 8% or 9% over the short term. The problem with a strategy that focuses on Gilts or indeed with a traditional ‘cautious’ investment strategy is that they are poorly diversified and subject to acute concentration risks, most notably in these examples to inflation and quantitative easing. By contrast PRISM seeks to optimise diversification at all times, and then allocates exposure to each profile in accordance with the defined risk/return parameters set. In this way the PRISM Horizon 2 profile can achieve an attractive expected return but with very low level of expected volatility. Coupled with 99% capital protection, very low costs and unrestricted access, PRISM Horizon 2 offers a genuine alternative for lower risk investors.
High Growth Investors
The high growth investor faces a similar challenge at the other end of the spectrum. The growth investor who is typically investing for the long term knows that over time the cumulative impact of higher expected returns can dramatically outweigh concerns about short term fluctuations in value. Nevertheless, keeping control of volatility is still extremely important and again the growth investor will primarily be concerned with achieving a high return-to-risk ratio. Table 2 below illustrates that this can be no easy challenge. In pursuit of higher expected returns the growth investor is driven increasingly toward equities and other high risk investments. The problem is that, beyond a point, this tends to just add risk with very little increase in expected returns. Again the problem with a strategy focused on equities or other higher risk investments is a fundamental lack of diversification leading to a poor return-to-risk ratio and key risk concentrations to specific aspects of the global economy. By optimising diversification PRISM is able to deliver true growth strategies not only with significantly higher return expectations, but also with reduced expected volatility, when compared to equities and traditional ‘growth’ strategies. Furthermore, with easy switching in and out of PRISM profiles at no cost, investors can move rapidly up or down the risk spectrum if their risk appetite or view of markets changes. PRISM is designed to make investing simple, low cost and powerfully effective. Ask your Financial Adviser about how PRISM can help you. © Capital International Limited 2014
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Capital International
Page 15
Sector in Focus Oil Services Oil exploration and production is a complex process, and each step of the oil supply chain involves specialised technology. Oil reservoirs are identified through geological field work, geological modelling, seismic imaging and exploratory drilling. Oil is then extracted with production equipment and transported in tankers and pipelines. Oil refineries refine crude oil into various marketable end products including petrol, diesel fuel, jet fuel, marine fuel, petrochemical feed-stocks and other chemicals. Most oil companies, even vertically integrated giants like Chevron and Exxon Mobil, don’t build the equipment needed to complete all of these difficult and costly tasks. Instead, oil companies turn to engineering and industrial firms that build and operate the oil rigs, tankers and pipelines that are the backbone of the industry. These oil field services companies provide the infrastructure, equipment, intellectual property and services needed by the international oil and gas industry to explore for, extract and transport crude oil and natural gas from the earth to the refinery, and eventually to the consumer. Things have started to look quite positive recently, especially in the US, with the domestic land rig count touching a two year high on the back of higher oil-directed drilling. It was also reported that Schlumberger, the largest oil field service provider, could be poised to win major wireline contracting work from Brazil’s Petrobras. Schlumberger looks set to win half of the over $2 billion worth of wire-line related work being offered by Petrobras. The company’s competitors Halliburton and Baker Hughes could be positioned to win 30% and 20% of the contract work respectively. Wire-line services are used by oil and gas companies to carry equipment into wells for testing, evaluation and maintenance. Schlumberger is the market leader in wire-line services, and the product line accounts for an estimated 13% of the company’s revenues. The global wire-line services market is estimated to stand at around $20 billion. According to data from Baker Hughes, the total US land rig count (including inland waters) rose to 1869 in September. This marks a two year high for the US land rig count. Rig counts are driven by the exploration and development spending of oil and gas companies and are influenced by the outlook for hydrocarbon prices. The US land rig count has risen by over 10% over the last year, driven primarily by higher horizontal drilling activity in regions such as the Permian basin, where operators are seeking to cash in on under-tapped unconventional resources such as shale oil. Looking at the earnings reports and calls by some of the larger oil services companies the following general themes were noted for 2014. The global economy is expected to continue to improve, with higher GDP helping to spur on oil demand. North America will continue to generate oil production growth, resulting in a balanced supply and demand scenario and continued support for crude prices at around $100 per barrel. Natural gas in international markets is expected to remain stable, given demand from Asia and Europe. US natural gas will likely remain weak, given continued strong supply and competition with coal.
If natural gas prices get too high, many power producers can switch to coal if it’s a more economical option. Total exploration and production capital expenditure levels are forecast to grow in the upper single digits for the year, with North American growth somewhat lower, offset by international growth expected to be somewhat higher. Upstream capex is directly related to the revenues of oilfield service companies, as the majority of upstream investment budgets go to services such as well drilling and completions or exploration operations such as seismic data gathering, the business lines of oilfield service companies. Capex growth should be driven largely by national oil companies. Growth in exploration spending will be lower than the 10% growth seen last year, but it will still trend higher. Exploration spending should be more well related rather than seismic, using wells to test out new plays and concepts rather than gathering data through seismic surveys. Overall deep water activity is forecast to continue solid growth throughout the year, while some rigs remain uncontracted into the future, newer rigs with higher operating efficiency would likely be contracted. However, older rigs could see day rates negatively impacted. Offshore Gulf of Mexico activity is expected to remain solid. Regarding the fracking market, a significant amount of overcapacity of equipment remains in the US, and market participants such as Schlumberger don’t expect the market to reach equilibrium this year. However, drilling and fracking efficiency is expected to drive growth in US onshore activity. Weakness in Brazil was also noted. Halliburton said that the entire services industry in Brazil is looking for relief to the over capitalisation that has occurred there in anticipation of a much higher deep water rig count. However, there has been a significant reduction in drilling activity. Companies there, such as Halliburton, are looking to negotiate the ability to remove equipment from the area and reduce costs there. Overall, 2014 looks like it will be a year of growth for the oilfield services industry, particularly the larger companies, which are expected to grow at a faster rate than the overall market. Several companies noted that they should be able to generate growth by leveraging new and cutting edge technology to achieve better pricing or margins and gain market share. Companies such as Schlumberger, Halliburton and Baker Hughes expect strong free cash flow and have a track record of returning cash flow to shareholders through dividends and stock buybacks. According to the Energy Information Administration the United States produced 13.63 million barrels per day of oil and natural gas in April. This was 2 million BPD more than Saudi Arabia, the largest difference in oil production ever recorded between these two nations. Prior to 2008 Saudi Arabia was producing between 2 to 3 million BPD per month in excess of the US. Continued on Page 16 | Stock Focus
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Stock Focus Schlumberger is one of the oil field services companies with strong footholds around the globe. The company’s shares increased 20% year to date reaching a 52 week high of $118 in July. Recently the share price dipped due to a decline in oil prices. Rather than being a concern this presents a decent buying opportunity. The company’s top line has witnessed a growth of 8% during the second quarter of fiscal year 2014 and reported quarterly revenue of $12.05 billion, up from $11.18 billion in the corresponding period last year. The strong second quarter performance was driven by significantly higher activity in both offshore and key land areas. Another contributor to the solid second quarter was the contract wins in Oman and Russia. The company’s North American segment reported markedly high performance with its offshore revenue increasing 8% compared to the corresponding period last year after a rebound in drilling activity in this region. In addition to revenue growth, the company’s strength can be seen in its strong financial position. Its current debt-equity ratio is 0.3 which is lower than the industry average of 0.4. The company also has a notable return on equity. Schlumberger has a current return on equity of 17% which is higher than its peers. In general, stocks with ROE in the range of 15% to 20% are considered attractive investment opportunities. Many people believe that the recent tension between Russia and the West on the Ukraine issue will impact oilfield service providers like Schlumberger. However just as many people believe this issue will have minimal impact on the company because Russia accounts for less than 5% of the company’s total revenue. And Russia does not have the expertise or equipment required to exploit its $8.2 trillion worth of deep water resource without Western techniques like hydraulic fracking. Schlumberger and Halliburton are working to restore an aging field in Siberia and are estimated to spend $30 billion per year in Russia. These facts suggest companies like Schlumberger are crucial to Russia and sanctions shouldn’t be a concern. Schlumberger has witnessed a strong recovery in Russia after the harsh weather and expects to continue with its recently awarded contracts. The consensus price estimate among analysts reveals considerable upside potential for Schlumberger. The mean target price estimate is $132.59 presenting an upside potential of 27% at its current price. On the lower end the company is valued at $117 presenting an upside potential of 12% at its current price. The most optimistic target price, if materialised, presents an upside of 61%. The demand for oilfield services is consistently improving due to increased drilling and production activity. The longterm prospects of oilfield service companies also look great. Schlumberger is in a strong financial position and is expected to register double-digit growth in earnings. The dip in the share price could present a buying opportunity for investors.
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With the off-shore drilling stocks in disarray, the September fleet status report for Transocean provided some interesting data points. The new contracts listed in the update were generally positive with higher than expected day rates. The lack of any significant contract additions for the numerous rigs heading off contract in the near term will probably grab the markets attention. The sector stocks initially jumped on the higher day rates of contracts signed for three rigs. In total, the contracts add up to a backlog of $115 million. An analyst of RBC confirmed that the contracts were either at expected rates or higher. Though logically in the weak off-shore drilling market any contract at a higher rate has to be a major surprise. The real key is that outside of the Transocean Honour deal for an extension to the existing contract that provides the high specification rig with work through April 2016, the deals aren’t meaningful. Even this deal is probably not significantly meaningful considering the ultra-deep water rigs without contracts are worth at least double the day rate. The key to the Transocean story is the idling of the GSF Jack Ryan and the lack of any new contacts to keep up to six more ultra-deep water rigs work in the future. The fleet status update alone shows three rigs with contacts ending soon. Clearly the older rigs have no reasonable expectation for claiming work in this environment. Other rigs at risk include three that were built around 2000. The bigger concern is these rigs built around 2000 that are having difficulty finding acceptable work. Noble Corp recently accepted substantially lower rates for a couple of similar rigs to the ones coming off contract at Transocean. The Noble Danny Adkins built in 1999 accepted day rates of $317,000, down from a previous contract of $498,000. The Noble Jim Thompson built in 1984 and refurbished in 1999 accepted a day rate of $300,000, down from the previous contract of $376,000. As with all of the off shore drilling stocks, Transocean provides an interesting valuation. The stock peaked at $53 back in November 2013 and reached $45 in June. The stock currently sits near $33 and trades at a very attractive price compared to the earnings power of over $4 this year. The plunging earnings estimates for 2015 make the valuation question more of a debate. Analysts on average now expect $3.09 for next year with many estimates much lower. The earnings drop is no different for most of the legacy off-shore drillers including Noble that has seen its numbers drop to $2.57. Transocean remains a stock to avoid based on a large group of rigs headed off contract. The September fleet status update provided some compelling day rate points for the industry, but it didn’t change the investment picture for Transocean. Until the market gets closer to the bottom, this off-shore driller with outdated rigs should probably be avoided. In Europe one of the biggest oil services providers is Technip SA, based in Paris, has about 40,000 employees, operates in 48 countries and is active in the subsea, offshore and onshore segments of the energy business. It currently owns a fleet of 21 vessels in operation and has 9 more under construction. As of the end of 2013, while the operating income of Technip from recurring activities stood at €844.5 million, the total revenues stood at €9.3 billion.
Page 17 11
Technip was recently awarded by The Bahrain Petroleum Company a significant contract on a reimbursable basis to develop the Front-End Engineering Design (FEED) of the refinery located in the Kingdom of Bahrain. The FEED contract covers four main work packages that include units aimed at processing the bottom of the barrel components to high value products, and all associated off sites and utilities to provide seamless integration with existing refinery facilities earmarked for retention post this major modernisation. The project aims at enhancing the refinery configuration, by increasing the output from 267,000 to 360,000 barrels per day as well as improving the product quality and profitability. Technip’s operating centre in Rome, in cooperation with Technip’s operating centre in Abu Dhabi will execute the contract, scheduled to be completed at the end of 2015. Technip has also recently released their figures for Q2. Second quarter performance saw subsea deliver revenue growth of 12.4%, with an operating margin at 15.3%, the top end of the indicated range. The business confirmed a sharp recovery after the low first quarter. Project activity was good across all regions, in line with normal seasonality. Onshore/Offshore delivered revenue growth of 5.4% and €73 million of operating profit, but had a more challenging second quarter. Whilst they have been able to close out older projects, some clients appear to have been demonstrably slower to clear changes on other projects, reducing project progress. They have booked a charge in second quarter against one of these cases. Technip has increased subsea revenue expectations for 2014 to between €4.6 and €4.9 billion, reflecting the positive performance of the segment in the first half. No change to guidance was made for an operating margin of at least 12%. There was also no change to guidance for 2015, which includes the Kaombo project, namely revenue well above €5 billion and an operating margin of 15% to 17%. There is an estimated €3.9 billion of business in their subsea backlog for execution in 2015, representing around 75% of revenue coverage, an unprecedentedly high level. There does appear to a high quality backlog which should deliver improved results and therefore return on capital over the rest of this year and 2014. Onshore/offshore revenue expectations for 2014 have been increased to between €5.55 and €5.80 billion. The base case outlook implies a 5% to 6% margin for the full year. There are three factors impacting their margin outlook. The continued impact of the mobilisation on Yamal LNG, the expected impacts of the behaviours of their customers as mentioned earlier and the risks to the business through interruptions caused by geopolitics including sanctions. If the company’s assumptions on these issues were to prove insufficiently cautious, the margin could be about 1% less this year. With regards to 2015 revenue for the onshore/offshore segment could be slightly higher than expected at around €6 billion with stable margin versus 2014.
© Capital International Limited 2014
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18 Page
Country in Focus Russia
Sanctions have been imposed for almost half a year now and there are signs that the effects are starting to be felt in Russia. While the damage has been focused on the financial sector, there are real fears that inflation is on the rise and will be difficult to erase. Notably, Magnit, Russia’s largest chain of discount supermarkets is up 8% this year, broadly equivalent to inflation expectations, while the sanctioned banks VTB and Sberbank, will likely be reliant on Central Bank support for hard currency debt.
Norilsk Nickel
38.6%
Magnit
8.2% 3.2%
Novatek
Gazprom
-0.6% -7.4%
Rosneft -16.5%
Mobile Telesystems VTB Bank
-19.6%
Sberbank -24.2% -30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Economic indicators are turning negative in a range of key areas from food prices to car sales which have turned severely negative. Food is 10% more expensive than 12 months ago while dairy produce is 20% more expensive as Polish imports have been curbed under reciprocal sanctions.
Capital International
5 0 -5 -10 -15 Car Sales Year-on-Year % Change Inflation %
-20 -25
August 2014
July 2014
June 2014
May 2014
April 2014
March 2014
February 2014
January 2014
December 2013
November 2013
October 2013
August 2013
September 2013
-30
It would be easy therefore to assume Russia under Vladimir Putin is pursuing a policy of intimidation and imperial expansion but the reality is probably more complex. Since Putin officially returned to power in Russia Western analysis has been quick to portray him as a typical autocratic figure framed within a Cold War setting. In reality, Putin’s policies reflect Russian concerns over a unipolar world where the USA is the world’s only real superpower capable of projecting its political and military might at any location in the world. Russia’s foreign policy has been designed to respond to this fear and therefore includes a combination of military, political and economic/energy strategies. It is often noted that Europe fears a 1939 or 1914 scenario while Russia fears a repeat of the 1990s where the collapse of the Soviet Union resulted in chaos, thereby creating the need for a strong State. This has resulted in Russia’s neighbours becoming increasingly nervous about its intentions, dating back from the Georgian/South Ossetian conflict in 2008. Ethnic Russians form sizeable minorities in a number of key regions, from the Baltic states where over a million Russians live to the volatile North Caucasus region.
1.6%
Lukoil
10
July 2013
What started out in 2013 as peaceful demonstrations against the Russia-leaning President Viktor Yanukovych boiled over into outright civil war as ethnic Russians sought to partition Ukraine with the aim of incorporating the eastern provinces into the Russian Federation. Tragedy followed with the downing of Malaysian Airlines flight MH17, apparently shot down by Russia-backed separatists. The strategically important Black Sea peninsula of Crimea was already annexed earlier in March and while a shaky ceasefire is holding in eastern Ukraine, Russia’s presence is likely to remain a significant influence.
Effects of Sanctions on Russia % change over last 12 months
Russia has been seldom far from the news headline in 2014, mirroring its willingness to exert growing influence across its neighbours and further afield where Russian interests are concerned. While the eyes of the world were on the spectacular Winter Olympics in Sochi in February this year protests in Kiev against the incumbent prime minister of Ukraine were starting to intensify with deadly consequences.
Russia’s influence has extended into the Syrian conflict where it has a Mediterranean base in the northern Syrian port of Tartus. Russia was instrumental in using its veto at the UN against the USA’s call for military action in May and has been a major influence in pressing for dialogue with the Assad regime. Energy politics has been a key element of Putin’s foreign policy and he has shown no qualms over restricting exports of gas or oil to countries which are not sympathetic to Russia’s goals. The issue of energy security caught the EU by surprise in 2009 when Gazprom ceased exporting gas to Ukraine at a sub-market price, with the balance repaid later. By 2014, precrisis, around two thirds of all Russia’s EU gas was still routed via Ukraine so any interruption to supply would be potentially damaging to the Eurozone’s largest economies.
Page 19
As the largest consumer of Russian gas, Germany faced a difficult choice between encouraging western Ukraine in its EU membership goals while maintaining good relations with one of its largest energy suppliers. Nor is it a simple task to circumvent Russia from the supply chain. Through the state-owned enterprises of Gazprom and Transneft, most of Russia’s energy clients are locked into long-term contracts enforceable under International Law most of which will not become renewable until 2025 at the earliest. The opening of the Nord Stream pipeline in 2011 only served to strengthen Germany’s reliance on Russia, with the pipeline running to Germany through the Baltic according to its critics. At 759 miles, it is the longest undersea pipeline in the world and was built at a cost of more than €6bn, connecting the terminals of Vyborg in the east to Greifsheim in the west. While the construction of this pipeline is a critical part of the infrastructure, it has served to smooth out imbalances caused by the fall in volumes from Ukraine to Hungary, Slovakia and Poland. While Ukraine’s gas exports to the EU have dropped 50% since the intensification of the conflict, Russia’s supply to Germany has remained stable in spite of the increasingly firm economic sanctions against it.
Daily Gas Flows - Russia/Ukraine to EU (Gwh/Day) 2000 1800 1600 1400 1200 1000 800 600 400
September 2014
August 2014
July 2014
June 2014
May 2014
April 2014
February 2014
0
March 2014
200
Despite the lingering concerns following the Eurozone debt crisis, Russia fears continued enlargement of the EU with the largest expansion taking place in 2004. This saw a number of former Russian allies such as Latvia, Slovakia and the Czech Republic absorbed into the new European Union. With Bulgaria and Romania joining in 2007 and Croatia in 2013, Putin’s United Russia party fears a further drive east and attracting EU-supporters in its neighbour Ukraine and in the volatile Balkan region.
© Capital International Limited 2014
In addition to EU political growth Russia has been alarmed by NATO enlargement, in particular, its proposal to site an antimissile defence system in Poland and the Czech Republic. The plan was first studied at the 2002 Prague Summit and received harsh criticism from Russia but the issue was progressed further at the 2008 Bucharest Summit. After Russia gave notice of its intention to quit the Treaty on Conventional Forces in Europe, a change was duly made by President Obama, removing the equipment from Poland and the Czech Republic, with the systems to be replaced by anti-missile ships instead. This placated Russia somewhat which in turn offered up the removal of its anti-ship missiles from the exclave of Kaliningrad on the Baltic. One potential area for continued dispute is the war in Syria. The Assad regime forms the Mediterranean link for both Russia and the Shia Islamic Republic of Iran and neither country wishes to see that link severed by US or NATO activity. Furthermore, Russia was responsible for the construction of Iran’s nuclear power station at Bushehr and helped block calls for military action from Israel and more conservative voices in the US as Iran gained the capability to weaponise its nuclear fuel in 2013. Russia’s reactions to EU and US moves are potentially no more illogical than their ideological counterparts in the West if aimed to carve out a buffer zone between Russia and its competitors. The eventual outcome of current tensions is potentially no final endgame as each side trades concession off against sanction from the other in a repeat of post-Cold war diplomacy. Putin has been responding by making approaches to the Chinese government regarding cooperation on economic policy but China too is occupied with its next Five Year Plan and protests in Hong Kong so tensions are likely to remain high for the remainder of the year, providing an additional source of political volatility.
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Economy in Focus China China’s economic growth rate in the last quarter has distinctly cooled as industrial production growth slowed to its lowest level since the 2008 global financial crisis. This will increase the chance that the authorities in Beijing will step up stimulus measures to bolster the world’s second-largest economy. Growth will slow further in the fourth quarter, dragged down by further property construction weakness. That will bring about more policy support. Some investors are now forecasting Chinese GDP to slow to around 6.5% in 2015. In a recent speech, Premier Li Keqiang, told a World Economic Forum meeting in Tianjin that China would avoid printing money, continue it’s focused spending on rail, energy and public housing projects and maintain its targeted monetary-easing program for first-time home buyers and small companies. He also stated that the Government would not be distracted by short-term fluctuations, focussing more on ‘structural readjustment and other long-term problems’. There are subtle signs that the Chinese authorities are increasingly sceptical of the effectiveness of quantitative easing. Economists said the sharp deceleration in industrial output, along with weaker fixed-asset investment, retail and real estate sales data is likely to unnerve investors, who focus on the annualised 7.5% economic-growth target. Value-added industrial output grew by 6.9% in August year -over-year, down from the 9.0% level in July. It is the weakest growth seen since December 2008. The HSBC Manufacturing sector PMI has been below a 50 reading for most of the year and imports of key commodities have been soft. Fixed-asset investment in non-rural China rose 16.5% yearover-year in the January-August period, slower than the 17.0% increase recorded during January-July. Retail sales expanded 11.9% year-over-year last month, down from the 12.2% year-overyear level in July. The property sector also continued to slump despite moves by more than 30 cities to relax purchase restrictions, with housing sales declining during the first eight months of 2014 by 10.9% to 3.43 trillion Yuan (£360 Billion) as developers fought bulging inventories, reluctant lenders and fickle buyers. The housing market restrictions had been focussed on both the number of houses people could buy and whether they were local or non-local. The next couple of months are vital to the market and estate agents often refer to them as, ‘Golden September and Silver October’. However, in the last month, new home prices have fallen in 68 of the 70 major Chinese cities. For instance, in both Beijing and Shanghai, prices have been falling at around 1.3% per month. The good news is that property is getting more affordable: the average home costs about 8.8 times the annual income of the average Chinese household, down from nearly 12 times in 2010. The bad news is that the market may yet be far from bottoming out. The weak economic data—including news that August electricity output fell 2.2%—suggest that earlier government stimulus measures lack staying power.
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While Beijing remains outwardly confident that economic growth prospects are on target, more weakness in September and October—particularly in the property market—could prompt planners to shelve their targeted stimulus approach in favour of a more broad-based stance.
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Indeed, in a recent study, the ratings agency, Standard & Poor’s, questioned whether the very notion of targeting such rigid economic growth goals was actually damaging the financial stability of China. Credit creation has been the route in recent years to achieve this, on the basis that exports are not growing nor is productivity. For instance, at the end of 2013, bank credit represented a staggering 128% of GDP. The nation had gone from being relatively prudent to being seen as a macro risk to global GDP. The post credit crisis targets by the authorities were simply too optimistic and failed to fully appreciate the negative shocks imposed on the economy. Planners in China’s top-down government have more tools at their disposal—including, for instance, telling banks and stateowned companies what to do—than their counterparts in market economies. They’re also helped by weak inflation, which eased to a four-month low in August. The People’s Bank of China is also injecting 500 Billion Yuan (£52 Billion) into the country’s largest banks. The focus of monetary policy is firmly fixed on smaller businesses which are vital in transmitting the pro-jobs stimulus. If Beijing holds to its targeted stimulus approach in its bid to shrink bad loans and pare industrial overcapacity, it could ramp up spending on public housing and transport, cut income-tax rates and mortgage-interest rates for first- and second-time home buyers and reduce property stamp-tax duties, economists said. The statistics bureau can also change the way GDP figures are calculated—something reportedly under discussion—to give more weight to corporate intellectual property and spending on research and development, thereby boosting the investment component of nominal economic growth. The Communist Party’s decision to rein in credit has global ramifications. The $25 trillion edifice is already as big as the US and Japanese banking systems combined.
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The effects of China’s industrial slowdown is a key reason why iron ore prices have crashed, and global demand for oil keeps falling far short of what was expected. If planners decide these still aren’t enough, economists added, they could introduce a broad interest-rate cut or wholesale cut in the amount that financial institutions are required to keep on reserve with the central bank. The Chinese authorities are very clear that a healthy banking system is crucial to long term economic growth. Banks appear to be well provisioned against non-performing loans and global investors could have adopted a too bearish view on the sector. The concept of a “new normal” for the world’s second largest economy is now prevailing both at home and abroad, as the indomitable growth of the three decades since 1978 is no longer feasible. New normal China is less interested in growth rates and more interested in quality and efficiency of growth: pushing forward reform, adjusting structure and trying to benefit the people. Reform since the beginning of the year has been non-stop, including streamlining company registrations, speeding up shantytown renovation and making credit easier for the agricultural sector and small businesses. The measures not only showed the government’s resolve to balance reform and growth, but laid the foundation for quality growth in the long haul. China is still one of the biggest investment stories in the world. But the market is maturing. There is the threat of the obvious: a slowdown in all economic scenarios that is well below the boom years of 2006-2012 that China bulls still consider possible.
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Region in Focus Latin America Over the last decade, Latin America’s economic expansion was accompanied by significant progress in poverty reduction. Between 2003 and 2013 the region grew at an average annual rate of 4.0%, in spite of the contraction brought about by the international financial crisis. This growth was primarily driven by favourable international conditions, marked by the rapid growth of world trade and increasing commodity prices, resulting in positive terms of trade impacts for the region. Currently the international climate is looking less favourable as a result of decreasing external demand, the moderation of commodity prices which form a significant share of regional exports, and the uncertainty generated by the hardening monetary and financial conditions across the globe. Even though the deterioration in terms of trade over the last few years continues to be less significant than that of the previous decade, the region is facing mounting constraints such as a decrease in fiscal space which to stimulate internal demand, increasing social demands, and persisting structural limitations which hinder the dynamism of the region. Although the slowdown is only moderate for the moment, there are reasons to believe that it could be persistent if there is no policy action to raise the growth capacity of the region’s economies. Lower growth can have severe consequences for the countries in the region. Overall there will be fewer new jobs, smaller pay rises and less fiscal space with which to provide the more and new public services and goods that Latin American citizens are increasingly demanding from their governments. The region’s current international context is shaped by lower external demand and more uncertainty regarding the external financing conditions at a time of normalisation of US monetary policy. On average, the region has moderate external financing needs and its composition of assets and liabilities mitigates the risks of balance of payments problems. But this average hides great differences from one country to another. Some countries have solid foundations, while others have considerably more restrictions. The situation is similar with the fiscal space available for countercyclical action if there is a further deterioration in aggregate demand. Although fiscal balances have deteriorated in many countries in the region, some countries have been able to reduce their indebtedness thanks to favourable debt levels and valuation effects. The normalisation of US monetary policy could also pose challenges to Latin America’s financial systems following major credit expansions in several countries in the region. As Brazil and Mexico are the two largest economies in Latin America, they are focused on as follows...
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Brazil A less favourable external environment, combined with a weak domestic business environment, is expected to constrain Brazilian growth in the coming quarters. It is also believed that President Dilma Rousseff will be unable to make the substantial reforms necessary to boost productivity and investment in a second term, underpinning many analysts subdued multi-year growth outlook. A number of domestic and external factors will continue to constrain Brazilian real GDP growth in the coming years, including a weak business environment, a less robust consumer story, and slowing Chinese demand for industrial metals. As such, it is expected that Brazil will remain mired in a period of low growth for the next few years, forecasting real GDP to expand by 1.1% in 2014 and 2.1% in 2015. These forecasts mark downgrades from previous projections of 1.8% and 2.3% real GDP growth in 2014 and 2015 respectively, as weakening high frequency data indicates that the slowdown seen since the start of the year is likely to be more severe than previously anticipated. Also, it is anticipated that President Dilma Rousseff will win a second term in October, but that the government will have insufficient political capital to make the far-reaching reforms to the labour market and tax code in the next several years necessary to boost productivity and incentivise investment. This underpins the forecast for average growth of 2.3% in the five years to 2018, below the 2.7% average expansion recorded during the previous years. Private consumption growth will remain weak in the coming years, as high interest rates and household debt levels constrain consumers’ take-up of credit, and currency depreciation erodes household purchasing power. These factors, combined with a weakening outlook for the economy, have seen consumer confidence fall to multi-year lows in recent months, underpinning the downgrade of 2014 real private consumption forecast to 1.8%, from 2.0% previously. Also, only a modest uptick in 2015 is anticipated, forecasting real growth of 2.1%, as the central bank cuts the Selic target rate by 100 basis points to 10.00%, modestly reducing household borrowing costs and the government continues to use fiscal policy to bolster consumption. We forecast private consumption to contribute 1.2 percentage points to growth in 2014 and 1.4pp in 2015.
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Government consumption is expected to remain subdued by historical standards in the next few years, forecasting real growth of 3.0% in 2014 and 2.8% in 2015, as the government opts to rely on tax breaks over increasing spending levels in order to boost economic growth. As such, we see government consumption contributing a relatively muted 0.6pp to headline growth in 2014 and 2015. Moreover, with Standard & Poor’s having already downgraded Brazil’s sovereign credit rating from BBB to BBB- in March, the government will look to temper spending following the election, in order to avoid further credit rating downgrades. However, given the forecast for only modest fiscal consolidation beginning in 2015 and still-weak real GDP growth, it cannot be ruled out. Persistent business environment challenges, including an uncompetitive labour market and significant red tape, will continue to temper gross fixed capital formation in the coming years. Slow growth domestically and in Argentina, a major market for manufactured goods exports, continues to weigh on Brazil’s manufacturing sector. This, combined with uncertainty over the outcome of the presidential election, and the knock-on effects from a spike in electricity prices in the first quarter of 2014, has prompted a revision down of 2014 real fixed investment growth forecast to 0.0%, from 1.8% previously. With some of these factors set to dissipate in the next few quarters, particularly electoral uncertainty and very weak growth in Argentina, a moderate rebound in real fixed investment growth to 3.3% in 2015 is forecasted, contributing 0.7pp to headline real GDP growth. This is also underpinned by the view that an ongoing transport concessions programme and the completion of a number of projects related to the government’s PAC II growth acceleration programme will help to bolster investment in the next several quarters. Net exports are expected to be a modestly positive contributor to headline growth in 2014 at 0.2pp, before weighing on the headline figure once again in 2015. This year, weak import growth, in line with a significant slowdown in the manufacturing sector, will see net exports contribute positively to growth, despite continued headwinds for exports from slowing Chinese demand for industrial metals. © Capital International Limited 2014
Next year though, a moderate rebound in imports and continued weakness in exports will see net exports drag on headline growth once again, in line with the trend in recent years. President Dilma Rousseff will not be able to make the significant reforms to Brazil’s labour market and tax code necessary to substantially improve labour productivity and incentivise investment during her second term. This, combined with a less favourable external environment as Chinese demand for industrial metals slows, underpins the forecast for Brazilian real GDP growth to average just 2.3% between 2014 and 2018. Indeed, upside pressure on labour costs in recent years, from minimum wage increases and relatively strong real wage growth, have eroded economic competitiveness and tempered productivity gains. Also, a high total tax rate and a significant amount of time to pay taxes remains a major disincentive for foreign firms to invest, particularly in light of relatively weak real GDP growth. While President Rousseff has indicated that piecemeal efforts to improve these issues will continue in the coming years, we do not believe that she has the political sway to push difficult reforms through the legislature, underpinning the subdued growth outlook. Should President Dilma Rousseff fail to make any changes to economic policy following her re-election in October, sparking concerns that inflation could head higher while growth remains low; we could see a further decline in consumer and business confidence levels in the next several quarters. This would likely see private consumption and fixed investment growth stall, posing downside risks to the 2014 and 2015 real GDP growth forecasts of 1.1% and 2.1% respectively. In addition, should Rousseff lose the October presidential election to Marina Silva of the Partido Socialista Brasileiro (PSB) or Aecio Neves of the Partido da Social Democracia Brasileira (PSDB), we could see growth head lower in the coming quarters. Both candidates have expressed a move towards more orthodox economic policies, which would likely entail removing support from the economy in the short term. However, we would see a much brighter medium-term outlook for the economy, given an increased likelihood of structural reforms.
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Mexico The Mexican economy is expected to accelerate in 2014 and 2015, driven by a recovery in public investment, as well as by acceleration in export and private consumption growth. The construction sector to return to growth in 2014 after contracting last year, and manufacturing to be a top performing sector in the coming years, bolstered by stronger US demand. Economic growth in Mexico should accelerate through the rest of 2014 and into 2015, following weak economic activity in 2013 and the first quarter of this year. Ongoing delays in public investment, combined with sluggish external demand and the impact of new taxes on household spending, saw real GDP growth slow from 4.0% in 2012 to 1.1% in 2013, and then come in at 1.8% year-on-year in Q1 2014. However, public investment and manufacturing exports are picking up, two dynamics which will be main drivers of faster headline growth in the coming months. It looks as though real private consumption growth bottomed in the first quarter, and expect stronger household spending in the coming quarters as labour market dynamics improve. As a result, real GDP growth is expected to accelerate to 3.1% in 2014 and 3.7% in 2015. Several factors indicate that the consumer sector is past its worst and that household spending growth will accelerate in the coming months. First, sustained upticks in consumer confidence in March, April, May and June are strong evidence that households are rapidly adapting their spending patterns to the new taxes. Second, the Banco de México’s 50-basis-point rate cut to bring the policy rate to 3.00% on June 6 will stimulate consumer credit demand in the coming months. Third, stronger manufacturing activity, a key generator of employment, will also support greater private consumption growth in the coming quarters. It is forecast that real private consumption growth will accelerate to 2.9% in 2014 and 3.7% in 2015, up from 2.5% in 2013. It is anticipated that government consumption growth to improve in the next couple of years, following spending delays in 2013 associated with a transition in government. Indeed, President Enrique Peña Nieto has increased expenditure allowances and implemented a spending acceleration programme this year. Government consumption already began to pick up in Q114, expanding by 2.9% year-on-year, up from 1.2% in 2013. Real government consumption growth is forecast at 3.0% in 2014 and 2.5% in 2015. Gross fixed capital investment is expected to recover this year after contracting in 2013, and then to accelerate in 2015. President Enrique Peña Nieto’s $594.0 billion 2014-2018 National Infrastructure Plan will be a main driver of a stronger fixed investment in the coming years. This amount represents a significant increase from the $394.0 billion previously allocated to the programme when it was first announced in July 2013, and is a strong signal that the government is addressing the delays seen in public investment last year. Stronger fixed investment into infrastructure will drive the construction sector back to positive growth this year, after contracting by 4.5% last year. It is expected that net exports will have a small, yet positive contribution to real GDP growth in 2014 and 2015, after subtracting from headline growth in 2013, driven by a faster expansion in manufactured goods exports. Manufactured goods account for nearly 85.0% of total goods exports, and about 80.0% of Mexico’s goods exports go to the US.
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However, import growth will also pick up, though at a slower pace than export growth, due to an improving consumer and a gradual appreciation of the peso. Analysts have forecast imports of goods and services growth of 5.4% in 2014 and 5.1% in 2015, compared to exports growth of 5.5% and 5.3% respectively. Risks to the growth outlook lie mostly to the downside. First, recent tax changes could continue to weigh on private consumption for a longer period than currently reflected in many analysts forecasts. Second, the manufacturing sector is highly exposed to the trajectory of the US consumer, and further deterioration in the US economy could weigh on demand for Mexican manufactured goods. Third, the construction sector continues to contract and additional delays in public investment could impede the return to growth we expect in the sector this year.
Articles have been written by Chris Bell, Stephen Kelly and Paul Martinez
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CIL - Investment Review Q3 - 2014 - V1.01-10.14
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