The Changing Face of Globalisation - Emirates NBD · globalisation and immigration are the external causes and closing borders and imposing tariffs are the solutions, irrespective

WEALTH MANAGEMENT

The Changing Faceof GlobalisationCIO OfficeInvestment Outlook Q3 2018

ENBD CIO Outlook Q3-2018 Final_Layout 1 12/07/2018 10:16 Page 1

1

Introduction – The Changing Face of Globalisation

Emirates NBD CIO-Office Q3 2018

EMIRATES NBD WEALTH MANAGEMENT INVESTMENT OUTLOOK Q3 2018

The first half of 2018 witnessed thereturn of volatility and hasn’trewarded investors with greatreturns so far. It started well with astrong rally in January around thenarrative of a vigorous, synchronisedand non-inflationary global economy;it did not last. Fears of higherinflation and higher rates quicklyannihilated gains in Q1 and the wallof worries only grew in Q2:divergences in the macro picture, astronger dollar hurting EM assets,and escalating trade tensions.

Volatility in 2018 didn’t come as asurprise (see our previousquarterly publications “Eyes WideOpen” and “When Markets Move”).It should indeed remain elevated,not only for months, but probablyfor years: the cycle is maturing,central banks are tightening,technology keeps on disrupting,political parties are rising andfalling, and global powers are beingredistributed.

However, volatility doesn’tnecessarily mean negative returns,it simply requires discipline: agility,discernment and careful calibration.To that extent, we are happy to saythat our cautious asset allocationproved appropriate in H1 and that a

majority of our convictions did wellin relative terms.

Having said that, absoluteperformances remain unexciting.Looking forward, we are positive forthe second half of 2018 and havestarted to increase our allocation toequities. It could be another bumpyride, between the trade war rhetoricand US mid-term elections inNovember, but we believe that thepositives outweigh the negatives.

On the positive side, the globaleconomy is robust and shouldremain so. The US is DM’s brightspot, with the long awaited increasein wages starting to materialise, animportant driver for a consumption-

dominated economy. Other regionshave moderated but their trajectoryremains positive, above trend inEurope, and with strong domesticdemand in the major emergingcountries. The second key positivefor risky assets is the combinationof double digit earnings growth withthe stagnation of stock markets.Valuations have retreated and theselower multiples are not justifiedgiven the supportive medium termoutlook. Finally, investor’spositioning is much less optimistic,which means that any good newsshould trigger flows.

We are however not in an extremesituation of distressed value andoutright panic, which wouldn’t even

Jan-18 Q2-18 H1-18Q1-18

DM Equity EM Equity Global Fixed Income

EM Fixed Income

Dollar index Oil (WTI) Gold (USD) Hedge Funds (USD)

-10

-5

0

5

10

15

20

25

5.3

-1.3

1.70.4

8.3

1.4

-8.0-6.7

1.2 1.4

-2.8-1.5

-0.2-1.5 -2.4

-3.8 -3.2 -2.3

5.02.5

7.1 7.5

14.2

22.7

3.21.7

-5.5-3.9

2.4

-1

0.2

-0.8

Source: Bloomberg as of 29 June 2018

Exhibit 1: USD % returns for major asset classes – more volatility than performance in H1

MSCI ACWI (curr. PE 14.5) 10y avg (14)+1 std dev -1 std dev

100

200

300

400

500

600

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: Bloomberg as of 29 June 2018

Exhibit 2: Valuation – evolution of MSCI All Country fwd PE


Introduction – The Changing Face of Globalisation

2Emirates NBD CIO-Office Q3 2018


require a catalyst to normalise;indeed, much of the recentmovement in markets had more todo with rhetoric rather thanfundamentals. Unlocking thisfundamental upside potential willrequire some good news.

There are a number ofuncertainties. Inflation and rateswere the dominant fear in Q1, butthe US 10 year rate is now backbelow 3%. If the US curve isflattening, it has not yet inverted (anhistorically relevant early-indicatorof recession, at least beforequantitative easing was invented),and short-term real rates remainnegative within developedeconomies. Monetary policies arestill accommodative and centralbanks are proactive with theirintentions and timing to prevent anynegative surprises.

The key concern is political risk, themost prominent one being thecurrent trade tensions. Political riskis not anecdotal; the lower andmiddle classes represent themajority of voters of anydemocracy. When they areunanimously unsatisfied, politicalchange happens – Brexit, DonaldTrump, Italy, Austria, Mexico, asexamples. This dissatisfaction ofthe masses leads some politiciansto cater to the unsubstantiatedhype, thus designating an externalcause as something to be fearedand proposing a simple solution toaddress it. For example,globalisation and immigration arethe external causes and closingborders and imposing tariffs are thesolutions, irrespective of rationaleor truth.

It is a wonder why President Trumpcut corporate taxes when theeconomy is booming and when theshare of corporate profits in the

economy is as high as ever.Equally, one could also besurprised why he would attackglobalisation symbols like China orGerman car manufacturers to“bring jobs back to America” whenthe unemployment rate is one ofthe lowest in modern history. Hecould similarly move forward.

It is probable that the announcedmeasures (levies on steel andaluminium from Europe, Mexico andCanada, and tariffs on USD 50bn ofChinese imports) will beimplemented, but we believe thatmarkets have already priced themin. From now on, some degree ofconfidence that there won’t befurther escalation could be enoughto trigger a relief for global equities,EM assets, and non USDcurrencies.

It is not impossible, especially whenAmerican manufacturing icons likeGeneral Motors or Harley Davidsonare explicitly stating that tariffs couldreduce US jobs. The very peoplewho elected Mr Trump wouldarguably pay the price of a full outtrade war and its consequences tothe US economy and inflation. Itcould eventually help China replacethe US as the leading force of globaltrade. While the author of “The Artof the Deal” (1987) is building walls,the inheritors of the 2500 years old“Art of War” are deploying the newSilk Road. However, this is not ourcentral scenario and we recall thatin Davos earlier this year, PresidentTrump also stated that “America firstdoes not mean America alone”.

Finally, but importantly, our regionshows some very encouragingsigns as GCC governments wiselyuse the opportunity of higher oilprices to stimulate their respectiveeconomies. The Kingdom of SaudiArabia’s confirmation as a new

member of the leading MSCIEmerging Market index will bepositive for the country and widerregion. Globalisation is not only anegative. And the same applies tovolatility.

Our key investmentrecommendations are detailed inthe following pages. As regardsequities, we favour the US and theEnergy sector for their formidablemedium-term earnings prospects,and will accumulate on weaknessour long term-convictions EmergingAsia and the Technology sector. Onfixed income, current levels arecompelling for GCC and EM debt inboth hard and local currency, andwe see value for the long-term inUS government bonds.

Maurice GravierChief Investment Officer


Equity Strategy4Investment Idea – The US8

Investment Idea – Video Gaming12Fixed Income Strategy14Investment Idea – Focus on China20Cross Asset Views22

Contributors28

Investment Idea – Integrated Oils10

Oil Outlook26

3

Contents






Q3 Equity Strategy – A lookback at Q2 2018

˃ Trade tensions and their consequences kept performance subdued

˃ Volatility is higher, in line with our expectations

˃ Being selective has paid off, with pockets of outperformance

˃ The KSA market had a stellar first half, fuelled by regional banks

˃ Technology and Energy sectors are leading global equity market performance

We began 2018 with a moderatelypositive stance: markets wereexpensive, however a strongeconomic backdrop and earningsgrowth warrant positive returns.Markets have been more volatile in2018 than in 2017, with the CBOEVolatility “Vix” Index averaging 15.6in 1H 2018 but well below the 10year average of 20. What standsout in 2018 is the performance ofthe more cyclical sectors and thecontinued lead of growth overvalue as a factor. The MSCI WorldGrowth Index (Net Return) is up 4percent this year, a lead of 8 pointsover its Value equivalent index.Developed markets have led in thefirst half of 2018 (H1) , with theS&P 500 ending up for a thirdstraight month, and the MSCI EMIndex posting a fifth monthly loss.

Our call on the KSA worked well,as the expected MSCI EM Indexinclusion came to fruition. KSAbanks fared even better, and thesector is up 32% year to date,aided by rising rates and improvedliquidity as government revenuesbenefited from rising oil prices.Other EMs however, bore the bruntof trade friction, a strong Dollar andgeopolitical tension.

Asia’s consumer economies hadmixed results in 2018: Indianequities (large caps) had gains inlocal currency terms but not so inDollars. The mid and small capIndia sectors fared worse and fellover 10% in 1H. There were largeoutflows from equity markets byforeign institutions, however largedomestic inflows more than filled

the gap. China markets suffered(the domestic Shanghai Comp.Index fell 14%), as trade tariffrhetoric escalated. However, ouroverall preference to EM Asia didwell relative to broader EM.

Amongst DMs, the US with a 3percent return for the S&P 500 and9 percent for the Nasdaq Indexstands out. European markets borethe brunt of regional political turmoil.

Globally, the technology (theFANG stocks are up 29% in 1H),genomics and energy sectorshave outperformed the MSCIWorld Index which is close to flat forthe year. The cyber security sector(+17%) profited from the growingthreat of global cyber warfare.Whilst we cannot quantify returns inthe electric vehicles industry, wesee an exponential growth in the

infrastructure i.e. charging stations,electric batteries, rollout of EVmodels by the big auto makers andregulations to ensure countriesmove on a large scale to moreenvironmentally friendly transport.

2017 H1 2018

US Bank

Robotics

India

World

China Tech

US

Semis

Aero & Defense

Energy

Technology

Genomics

KSA

FANGs

-20% 0% 20% 40% 60% 80% 100%

21%-4%

44%-3%

30%-1%

25%0%

94%0%

22%3%

41%5%

39%6%

8%6%

38%9%

47%19%

6%22%

58%29%

Exhibit 3: How have our strategies fared in 2018?

Source: Bloomberg, as of 30 Jun 2018, MSCI Indices, NY FANG, ROBO US & SOXX US Index

What stands outin 2018 is theperformance of

the morecyclical sectors




Equity Strategy for 2H 2018

˃ Strong near-term earnings growth is a tailwind for US stocks and the global energy sector

˃ Global Tech sector benefits from steady long-term earnings potential

˃ Valuations are not outrageous and close to long term averages on some metrics

˃ Volatility will generate opportunities for the long term investor

˃ This might already be the case in Emerging Markets (compelling entry points for the long-run)

Strong revisions to earnings growth in 1H 2018 creates a gap with equity valuations now close to long termaverages; no longer near the mid-January highs. This provides a favourable backdrop for equity marketperformance in 2H 2018. However active management has a key role to play in volatile markets with the addedcaveat to be selective and focus on quality. We define a quality company as one with sustainable profit growthand a strong balance sheet, able to buffer any rise in interest rates and reduced liquidity as Central Bankstighten monetary policy.

Tech Energy

Tota

l Ret

urn

YTD

(%)

Forward P

/E (x)

Cons.Disc

Healthcare DM Utility World RealEstate

Material Industrial Cons.Stpl

Financials EM Telecom-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

-20

-15

-10

-5

0

5

10

15

2016.3

13.415.5 15.2 14.6 14.0 14.0

18.2

13.014.5

17.5

10.3 10.7 11.2

Total Return YTD Forward P/E

Exhibit 4: Global sector Returns and Valuations compared to the World, DM and EMs

Source: Bloomberg, MSCI Net Return Indices as of 30 June 2018

We define a quality company as one withsustainable profitgrowth and a strongbalance sheet




Equity Strategy for 2H 2018

While global growth may moderateinto 2H 2018, it is still above trend.Geopolitical anxiety and risks toglobal trade have risen, but themacro environment remainssupportive of taking risk. The growthoutlook is strong, and we see scopefor reasonable returns in the secondhalf of 2018.

The effects of trade tariffs: UScompanies drive 73% of theirrevenue domestically but source alarge amount of raw material fromoverseas, particularly autocomponents and electrical goods.Europe generates 52% of revenuefrom overseas whilst Chinesecompanies’ are domesticallyfocused with 88% revenue internallygenerated. Therefore, trade tariffsmay not hurt all EMs as much asexpected. Potential trade tariffshave led to lower guidance so faronly from the global auto industry.GDP growth is estimated to beaffected by just 0.1% for China iftariffs are limited to USD 50bnrather than the on the overall USD502bn of exports to the US. Theripple effect however, should not beunderestimated with a possibleimpact on the US itself and itstrading partners i.e. Europe, Korea,Japan, Taiwan, Canada andMexico.

Earnings growth remains the topdifferentiator for returns. We areseeing sustained upward revisionsto earnings growth led by the USand Asia. The US and Chinatogether constitute more than twothirds of the world’s market cap andIndia is estimated in the nextdecade to become the 3rd largestcountry globally by market cap.Hence, these markets remain ourfocus in 2018 and for the longer run.In the US, strong economic growthand the benefit of tax cut are helpingthe bottom line of companies, which

should continue until the end of2018.

In Asia, the young demographicsand increasing spending power ofthe middle class will ensure thegrowth of the economy and theconsumer sector. India’s per capitaGDP is estimated to rise from USD1700 to USD 4000 in the next 10years and its consumer industry togrow from USD 500bn to USD 2tn.EMs are expected to lead DMs ineconomic growth and corporateprofitability over the next few years.

The KSA’s upgrade to EmergingMarket status, its economic reformprogram, Vision 2030 and higher oilprices supporting governmentrevenue could lead to furtherupside. Historically, newly includedcountries in the MSCI EM havedelivered an average 55% return

over the year precedingimplementation (although the indexinclusion is obviously not the onlyfactor behind this number).

We like the technology andenergy sectors as leaders ofearnings growth estimated at 16%for tech and 27% for energy, thoughthe latter is coming off lows. Thetech sector has been anoutperformer over the last decadeand should continue to do so onaccount of the large spend oninnovation and penetration power.We continue to focus on selecttechnology sectors with exponentialgrowth – cloud services, dataanalytics, robotics, cyber securityand connectivity (the Internet ofThings). Energy is a near termdefensive play with a growing andsustainable dividend yield and weelaborate on this later.

LT EPS Growth

Energy

Tech

EM

Cons. Disc

World

Industrial

DM

Financials

Healthcare

Real Est

Material

Cons. Stpl

Telecom

Utility

0% 5% 10% 15% 20% 25% 30%

27%

16%

16%

15%

14%

13%

13%

12%

10%

10%

10%

9%

6%

6%

Exhibit 5: Long term earning growth estimates by sector & region

Source: Bloomberg, MSCI LT EPS CAGR (3-5 years) as of 30 June 2018




Globalisation vs Protectionism

How do we ensure consistency of returns?Quality: Companies with strong balance sheets and cash flows,lower leverage and high ROE’s. Many of these companies have highESG (Environmental, Social & Governance) scores, as they keeppace with demographic preferences.

Innovative Sectors with Strong Growth: Technology & Digital Health

Economies with Domestic led Growth: Asia

Economies Benefiting from Policy Revision: The US and the KSA

Escalating Geopolitical and Cyber Risk: The defence and cybersecurity sectors

Defensive Strategies: Oil majors have become defensive, as thecombination of reduced capex, deleveraging, and higher oil pricesare ensuring strong cash flows and growing dividends

Underweight sectors: We are underweight the telecom sector (except for companies that are leaders in 5Gnetworks) and bond proxy sectors such as utilities. We remain wary of the fallout of privacy concerns on socialmedia companies.

Exhibit 6: Our positioning across sectors – themes we like

Tactical Strategic

“The gap between strongearnings growth andvaluations is increasingand this should lead toequity market gains.

However we remainselective, with a continuedbias towards growth andinnovation industries.

In 10 years, the Netflixstock is up 10,400% as thecompany spent on content,built up a sustainableconsumer base andexpanded to new markets.”

Source: Emirates NBD CIO Office. as of Jul 2018

US

EM (Asia) – India and China

European oil majors

MSCI EM inclusion GCC – KSA banks, petchems & healthcare

Geopolitical concerns Defence

Technology in industry

Healthcare Genomics, Digital, Wearables, Life Sciences

Financial services Digital Payments, Cybersecurity

Cloud Services, Robotics, AI, E-commerce,Blockchain, Semiconductors

Improving economy &EPS growthConsumer spend, e-commerce & digitisation,growing middle-class &millennialsHigher oil prices: OilE&P

Theme Region

Top Innovation Sectors




Equity Investment Idea: The US

˃ Strong gains could continue on robust earnings growth

˃ Valuations are at 5 year averages

˃ Tax cut gains not yet fully realised

˃ The renewed capex cycle should stimulate corporate profitability

˃ Concerns remain regarding the strong Dollar, impact of trade tariffs and rising rates

Take advantage of the growinggap between earnings growthand valuations: Investors arewondering if US stocks' cycle ofgains for all but one quarter since2015 still has legs, as tradetensions sap risk appetite and Fedrates rise further. There's reason tobe optimistic, even though the S&P500’s yield advantage overTreasuries is at risk with 10-yearTreasuries at c. 2.83%. In favour ofUS equity markets, is strongshareholders’ return boosted bystrong cash flows.

Better relative earnings prospectsand reasonable relative valuationsare supported by very highoperating margins in the US(15.7%). Estimates for US EPSgrowth continue to move higherand faster than for most developedpeers, while emerging-marketforecasts have recently fallen. Taxcuts have added 14% to upgradesin US earnings growth.

Buybacks are expected to reachan astonishing USD 650bn in2018 and c. USD 400bn of theUSD 2tn overseas funds havealready been repatriated. The taxcuts, easy credit conditions andimproved cash flows provide theliquidity for increase in capitalexpenditure for US companies.

Relative to DM peers, UScompanies' have higherearnings growth forecast for thenext two years. FactSet estimatesare for S&P500 EPS growth at20% for Q2 and 21% for the year(2018) vs. 14.2% for DMs. Cyclical

sectors in the US are on pace tooutperform peers on earningsgrowth in the next 12 months. Theonly sectors expected to fall shortin the US on earnings growth areconsumer staples, real estate andutilities.

US growth prospects are led bymore than just lower corporatetaxes. Sales growth is expected tosurpass developed-marketaverages for the next two years.

Considering much higher operatingmargins, strong sales and EPSgrowth, US stocks' forwardearnings PE premium to the rest ofthe world at 8 percent looksreasonable (its 5 years average is15%). US equity-market valuationsare back to the five-year forwardaverage at 16.1X earnings.

US tech and healthcare sectorslook undervalued. Based onforward P/E, US technology stockstrade at a 7 percent discount toglobal counterparts, despite medianoperating margins that are 50%

higher. Meanwhile, median UShealthcare sector forward P/E isjust 16.6x vs. 21.1x for developed-world peers, with marginexpectations that are 23% higher.

2013 2014 2015 2016 2017 2018-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

Source: Bloomberg, as of 30 June 2018

Exhibit 7: US equities see the strongest upward earning revisionsin 2018 in the last 5 years

Estimates for USEPS growth

continue to movehigher and faster

than for mostdeveloped peers




Equity Investment Idea: The US

Doubts about the tech sector arosein early 2018 after the strong gainsin 2017. Gains have continued into2018 and the FANG stocks are up29% in 1H. Amazon, Microsoft,Apple and Netflix are responsible for84% of the S&P 500 upside in 2018.Amazon alone has contributed 36%to the S&P 500’s YTD return. Thetop 10 performing stocks in the S&P500 (largely tech) have contributedto 122% of its YTD return.

The growth outlook should be thefocus for equity performance inthe US rather than rising bondyields. The strong dollar isdetrimental to exporters revenuesand remains a risk, as do escalatingtrade tariffs. Whilst Q2 earningseason is an important barometer forestimating if top line growth meetsexpectations, mid-term elections inNovember are another importantcatalyst as markets like certainty.

The US is home to the world’s topinnovative global technology andhealthcare companies. Their growthis even more certain as they expandinto new markets like India.

EPS DPS FCF Per Share

7361

8699

105 110118 117 119

131

160176

192

28 23 23 27 31 36 40 44 46 50 54 58 63

56 5976 78 79 87 91

98 104112

136

155

174

2008

2009

US

D

2010

2011

2012

2013

2014

2015

2016

2017

2018E

2019E

2020E

0

20

40

60

80

100

120

140

160

180

200

Exhibit 8: S&P 500 – Rising EPS, Dividends and Free Cash Flows

Source: FactSet, Data in USD, as of 2 Jul 2018

The US is home to theworld’s top innovativeglobal technology andhealthcare companies




Equity Investment Idea: Attractive Backdrop for Oil Equities to Perform

˃ The late stages of the cycle are historically favourable to oil stocks

˃ Energy is now a dividend-paying defensive sector at the current oil prices

˃ A positive view on oil prices is constructive for earnings

˃ Relative valuation is accessible and investors positioning is currently low

Global GDP, industrial production,PMI, trade, transportation andoverall economic growth in 2018/19indicate that demand for oilshould continue to grow. Our in-house view is constructive on oilprices in 2018 as you will read in thefollowing pages. Business modelsthat were built for USD 50/bblshould enjoy the windfall gainthrough buybacks anddeleveraging.

The performance of the oil sectorhas lagged oil prices. Free cashflow yield at 8%, lower leverage anda lower breakeven price for oil (USD50/bbl) on account of technologyand capital allocation discipline,make the large integrated oilcompanies an attractive investment.High payout and increaseddividends should appeal to incomeseeking investors.

Oil markets are balanced and thekey message from OPEC is ofcontinued cooperation andcompromise. Both OPEC and nonOPEC nations are happy to live in aUSD 70/bbl world. Higher oil pricesmatter for energy equities as theyallow for higher earnings, highercash flow, and higher returns toshareholders.

At current oil prices (with Brent atUSD 78) free cash flow growthand net debt reduction wouldaccelerate significantly for the oilmajors. Between them: Shell, BP,Chevron, Total and Exxon willgenerate FCF of USD 84bn in 2019and dividend cover would increaseto 200%. Leverage is expected tofall by 30 to 40% over the next 3

years. The additional cash wouldnot go entirely to dividend orbuybacks but to capex for new fieldsand new technology for moreefficient production.

Oil companies are nowreinvigorating their capex cyclehence oil service providers shouldbenefit. US E&Ps are projected tospend for the first time since 2005and have pledged ongoing capitaldiscipline. Greater capital disciplinesupports both oil prices and equityvaluations. Shell has a budget ofUSD 25bn annually, BP USD 16bnand Total USD 15bn.

Not only is earnings growthestimated at 27% for the energysector globally but uncertaintyaround these earnings hasdiminished with oil majors gettingthe highest upward revisions fromanalysts.

CO1 Commodity

+26%

+3%

MXWO0EN Index

40

60

80

100

120

140

Jun-15

Dec-15

Jun-16

Dec-16

Jun-17

Dec-17

Jun-18

Source: Bloomberg, Data Index to 100 as of 26 Jun 2018

Exhibit 9: Oil sector companies are lagging oil price performance

Oil markets arebalanced and the

key messagefrom OPEC is of

continuedcooperation and

compromise




Equity Investment Idea: Attractive Backdrop for Oil Equities to Perform

We see the potential for oil E&Ps torally further into the end of 2018.E&Ps will likely be positioned toreturn cash to shareholders as theygenerate higher free cash flow andbalance sheet concerns diminish.

Significant value potential fromdigitalisation is yet to emerge:Digitalisation is transforming the oilindustry as it is transforming otherindustries globally. The use ofsensors to record data and itsanalysis to improve productivity isnow commonplace in the oilindustry. The oil price downturn

increased pressure on oilcompanies to reduce costs anddrive efficiency improvements.Drilling costs are being reduced by10-20% through automatedactivities. Future projects couldhave up to 50% less capex due tounmanned platforms, remoteoperation centers and automateddata collection. Digitally enhancedpredictive maintenance hassignificant potential to reduceunplanned downtime and costs.Big data analytics can improvetargeted drilling and optimise welllocations. The resulting FCF could

sustain rising distributions andstronger balance sheets which mayherald multi-year outperformance.

Since energy equities are a longduration play on oil prices,concerns around the demise of theinternal combustion engine and onthe outlook on the longer termdemand for oil remain a concern.However, for the next decade atleast oil, as a source of energy, willremain dominant.

British Petroleum Chevron Corp Royal Dutch Shell Total SA

'15 '16 '17 '18-8

-6

-4

-2

0

2

4

6

-8

-6

-4

-2

0

2

4

6

-8

-6

-4

-2

0

2

4

6

'15 '16 '17 '18 '15 '16 '17 '18 '15 '16 '17 '18-8

-6

-4

-2

0

2

4

6USD bn USD bn USD bn EUR bn

Exhibit 10: Integrated oil companies are seeing a rise in net profits

Source: FactSet, Data in USD, as of 2 Jul 2018




Equity Investment Idea: The Video Gaming Industry

˃ A fast growing industry

˃ Digital distribution is dominating traditional distribution

˃ Driven by technological evolution and continuous investment

˃ Multiple game segments: Multiple segments, dominated by mobile

Video Gaming is a fast growingmulti-billion industry which isexpected to reach USD 128.5bn by2020 from the current USD108.9bn. It is estimated that thereare 2.2bn gamers worldwide,and could grow to 2.7bn by 2021.China generates over one-quarterof game revenues worldwide and ishome to Tencent, the world’slargest gaming company. Half ofthe entire gaming populationcomes from the Asia-Pacific region,with nearly 1 billion gamers.

Despite gaming being oftenassociated with younger agegroups, approximately 15% of thegamers worldwide are agedbetween 51 and 65. Men spendmore time playing video games thanwomen, however numbers varybased on the genres. For example,women prefer arcade, simulationand puzzle games whereas menare often into athletic, shooter,strategy and adventure games.

A notable shift in the industry hasbeen witnessed as digitaldistribution is dominatingtraditional distribution. Theindustry may be headed to almost99% digital media, eliminatingphysical media with the remaininggroup being the niche collectorsegment.

Today, billions are spent on videogame development costs, which iscomparable to the production of aHollywood movie. Companies likeFacebook, Microsoft, Softbank arepurchasing game studios alongwith large companies such asTake-Two Interactive, Nintendo and

Activision Blizzard. An example ofa high development cost gamewould be Grand Theft Auto 5,which reached USD 1bn in saleswithin the first three days of launch.Iron Man’s 3 box office debut,considered a blockbuster, broughtin only USD 372mn in its firstweekend. Amongst the mostpopular gaming developers todayare Electronic Arts, Activisionlizzard, Take-Two Interactive andNintendo.

The industry can be split intomultiple game segments: Console,PC, Mobile – Tablet andSmartphone.

The mobile segment is thelargest, with 42% of the totalindustry revenue. With theadoption of smartphones, mobilegaming has exceeded traditionalconsole gaming numbers.Technological innovation continuesto expand the possibilities in thevideo gaming industry. Today,Nvidia, AMD and Asus compete indeveloping cutting edge graphic

cards which support the upgrade ofvideo game console and PCiterations.

Bandai Namco

Nintendo

Google

EA

NetEase

Apple

Microsoft

Activision Blizzard

Sony

Tencent

0 2 4 6 8 10 12 14

1.7

1.8

3.0

3.9

4.0

4.7

4.8

4.9

6.6

12.7

Source: newzoo.com, May 2017

Exhibit 11: Top 10 companies by game sales (USD bn) – 2017

A notable shift in theindustry has been

witnessed as digital distribution

is dominatingtraditional distribution




Equity Investment Idea: The Video Gaming Industry

In 2017, mobile gaming appsaccounted for more than 80% of allapp revenue on the Apple Storeand Google Play Stores. Theavailability of smartphones is givingaccess to a whole new class ofgamers. Mobile games are splitinto multiple categories, such asad-driven (revenue realised fromadvertisements) and freemium (abusiness model in which the gameoffers free and premium services).Most profitable mobile gamestoday follow the freemium model,such as Candy Crush Saga withover USD 800mn in revenues.

eSports is continually growingsupported by the increasedavailability of online streamingplatforms such as YouTube andTwitch.tv. The eSports market oncepopular only in core Asia has nowexpanded globally.

VR technology, had existedhistorically, however, it is onlyrecently that technological advanceshave given way for its use inapplications. Today, companies areracing towards developing a betterVR headset. Companies such asOculus, Samsung, HTC are amongstthe popular VR headset providers.

According to Statista, the global VRmarket size worldwide is expected togrow to USD 21.5bn by 2020.

The video gaming industrycontinues to grow steadilydriven by technologicalevolution and continuousinvestment. Game revenues areincreasing exponentially ascompanies explore new andattractive models for consumers toenjoy video games. China isexpected to continue to be thelargest video game market in theworld. The Battle Royale mode isclearly a game-changer andcompanies such as Activision

Blizzard and Electronic Arts whoare deeply invested, have a verylarge opportunity within this gamingmode. Tencent recently announcedthe launch of the Chinese versionof Fortnite, leveraging into theBattle Royale system.

Mobile gaming continues to growwith increased spend per consumer,due to the rising adoption ofsmartphones and the success of themobile gaming monetisationmodels. Mobile gaming’sdominance of the entire globalindustry is a trend that is very wellnoted by marketers, brands andadvertisers.

25% 23% 21% 20% 19%

5% 4% 4% 3% 3%

32% 31% 30% 28% 28%

10% 10% 10%

10% 10%

29% 32% 35% 38% 40%

2016 2017 2018 2019 2020

Smartphone Tablet Console Browser PC Boxed/Download PC

Source: newzoo.com, Apr 2017

Exhibit 12: Money Spent – Segment Split




Q3 Fixed Income Strategy – A Lookback at Q2 2018

˃ Macro fundamentals have not derailed from our expectations

˃ Reiterating Alpha over Beta positioning for the fixed income asset class

˃ We maintain our positive stance on emerging markets debt, to recover in H2

˃ GCC valuations offer compelling entry points

During the first half of 2018, financial markets witnessed the return of volatility and idiosyncratic risks, supportinga rise in bond yields and negatively affecting capital flows and returns. Between fundamentals and flight to safety,the 3 percent handle proved a strong support for the benchmark 10 year US Treasury bond. Finally, PresidentTrump’s reflationary rhetoric seems to be back.

Looking back at our strategy and positioning across the fixed income asset class

China Aggregate TR Index

Glob Developed Sovereign (Loc)

US Corporate High Yield

Global High Yield

EUR Aggr Corp (Loc)

US Government

GCC Credit

USD EM Corporate

USD Corp IG

USD EM Corp

USD EM Sov

EMD Local

-7% -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4%

Overweight

Underweight

Underweight

Underweight

Underweight

Overweight

Overweight

Overweight

Overweight

Overweight

Overweight

Overweight

Exhibit 13: Fixed Income sub-asset class performance YTD

Source: Bloomberg as of 29 Jun 2018

During the first half of2018, financialmarkets witnessedthe return of volatilityand idiosyncratic risks




Fixed Income Strategy for 2H 2018

As concerns surrounding globaltrade have intensified, globalinvestors have sought refuge in USassets. As a percentage of totalassets owned through funds, theynow represent 58% – the highestlevel since 2016, prior to thepresidential election.

In the past, when the yield curvehas flattened and then inverted, ithas often been an indicator of aweakening economy and in manycases portended an impendingrecession. This time around, thissignal may not be foreshadowing anear-term recession risk, as it isbeing heavily influenced by globalcentral bank actions. Currenteconomic activity hasn't shown anyindications of slowing down. In fact,as an indication of the currenteconomic strength, the AtlantaFed's GDP Now model forecast forQ2 2018 real GDP growth has risento 4.7%, which would be a strongacceleration from the 2.3% GDPgrowth rate in Q1 and would be thestrongest quarterly growth ratesince 3Q 2014.

Following a period of heightenedvolatility and sizeable outflowsearlier this year, investors haveadded some USD 40bn to USequity funds and another USD 8bnto US bond funds since April. Dueto the strengthening in US Dollar,we witnessed a shift in capital fromDM countries to the US since April,EM has also followed a similartrend of outflow, close to USD10bn – the fastest pace of outflowssince the US presidential election.

Bond (RHS)

% of global bond/equity allocations

Equity2010 2011 2012 2013 2014 2015 2016 2018

58%

59%

60%

61%

62%

63%

64%

65%

47%

49%

51%

53%

55%

57%

59%

Source: EPFR, IIF, as of 20 Jun 2018

Exhibit 15: US stocks and bonds – fund allocations

DM SovGCC

Global HYEM

USTCorp IG

EUR CorpEM Sov

EM CorpEM Local

UAE

0 1 2 3 4 5 6 7 8 9

8.01.3

4.66.4

6.14.2

5.85.9

2.76.1

4.07.4

1.16.2

6.47.3

5.94.6

5.35.9

4.05.9

Duration Yield

Source: Bloomberg as of 5 Jul 2018

Exhibit 14: Current valuations across the fixed income asset class

Asia CEEMA LatAm

Jan-17

US

D b

n

Feb-17

Mar-17

Apr-17

May-17

Jun-17

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18

Mar-18

Apr-18

May-18

0102030405060708090

Source: Bondradar, CIO Office, as of Jun 2018

Exhibit 16: New bond issuance for emerging markets have moderated

China 45%Mexico 8%Qatar 7%Korea 7%Brazil 6%Singapore 6%Argentina 6%Saudi Arabia 5%Indonesia 5%UAE 5%

Source: Bondradar, CIO Office, as of Jun 2018

Exhibit 17: China dominates as EM’s largest bond issuer





US Financial Conditions Index

Easier

Tighter

Fed Funds Rate (LHS)

Jul-15

No

v-15

Mar-16

Jul-16

Oct-16

Feb-17

Jun

-17

Oct-17

Feb-18

Jun

-18

-1.75

-1.25

-0.75

-0.25

0.25

0.75

1.25

-0.25

0.25

0.75

1.25

1.75

Rat

es %

Ind

ex %

2.25

Source: Bloomberg, as of Jul 2018

Exhibit 18: Fed hikes have not materially tightened US financialconditions

LIBOR Euribor

2.342.50

2.76

-0.32 -0.27 -0.18

3m

Rat

es %

6M 12M-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0


Exhibit 20: Differential in short-term interest rates have impactedfinancial markets and capital flows

Monetary policy setting andnormalisationAlthough monetary policynormalisation was taken intoaccount, markets neglected theeffects of tighter liquidity conditionsand of a stronger US dollar on EMassets.

The shift to tightening from DMcentral banks is also puttingpressure on EM central banks toadjust their policy framework tocurtail capital outflows and curbcurrency volatility.

Based on FOMC’s June policystatement, the Federal Reserveofficials maintained a hawkishstance towards two additionalinterest rate hikes for 2018. Thatsaid, some consider that thedilemma on escalating trade tariffscould result in only one additionalrate hike. Due to subduedeconomic growth and concernsregarding Brexit, the Bank ofEngland will most likely be limitedto a single token hike of 25bpduring 2018.

Based on our fundamentalassessment (comfort on thecurrent global cycle, demographictrends and consumption patterns),we keep a positive conviction onEM debt.

We keep apositive convictionon EM debt

Australia (1.50%)

Brazil (6.50%)

Canada (1.25%)

China (4.35%)

Eurozone (0.00%)

India (6.25%)

Indonesia (5.25%)

Japan (0.10%)

Mexico (7.75%)

New Zealand (1.75%)

Russia (7.25%)

Saudi Arabia (2.00%)

South Africa (6.50%)

Switzerland (-0.75%)

Turkey (17.75%)

UK (0.50%)

US (2.00%)

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Projected rate change by end-2019 Projected rate change by end-2018


Exhibit 19: Policy setting expected by global central banks for2018 and 2019 – expected rate change


17




GCC bonds have also taken a hit,due to the broad EM sell-off aswell as the significant widening ofrisk premium in Bahrain. Higher oilprices should improve thefundamental landscape for theGCC region. Weighted averageregional GDP growth in the GCCregion is expected to increase from0.1 percent last year to 2.0% thisyear and then to 3.3 percent in2019. Moreover, the recent newsabout the potential index inclusionof GCC countries into the majorUSD-denominated EM sovereignbond index is another tailwind.Should it be confirmed later thisyear, Saudi Arabia, Qatar, Kuwait,UAE and Bahrain would have anestimated weight of 12.3% in theEMBI Global Diversified index,taking the Middle East’s totalrepresentation in the index toaround 18%, from 6.2% currently.The induced flows could besignificant, as passive trackershave taken an increasing part ofthe EM fixed income asset class inrecent years.

As regards Investment-Gradebonds, we see value in SovereignBonds issued by Abu Dhabi, KSAand Kuwait. Within more risky highyield Sovereigns, Bahrain remainsour preferred play. As regardscorporate credit, we have a strongpreference towards hybridinstruments issued by banks andenergy sector. Amortising bonds alsooffer value for the shrewd investor.

It is worth noting that among the US– China trade war effects on variousasset classes, the Chinese domesticbond market has outperformed allmajor bond indices, both on anabsolute and relative basis.

With US inflation graduallyincreasing, investors look at theFed’s steadfast tightening with

apprehension. The effect of higherpolicy rates will be partiallycushioned by easing lendingstandards in the US as well as inEurope and Japan. Reports onlending standards released bycentral banks in these countries

show that the percentage of loanofficers reporting easier creditconditions is steadily rising. Also,real policy rates in the US are stillnegative, and an economic slumpunder these conditions would beunprecedented.

EM Local Currency Yields Big 4 Central Bank Assets (LHS)

USD

tn

4

5

6

7

8

9

10

0

5

10

15

20

25

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018


Exhibit 21: Effects of major central banks’ balance sheetnormalisation on EM domestic bond yields.

Core CPI Fed's Inflation TargetCore PCE

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

2.2%

2.4%

2013 2014 2015 2016 2017 2018


Exhibit 22: FED target inflation has finally been reached…

1.7%

1.8%

1.9%

2.0%

2.1%

2.2%

2.3%

2.4%

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18

Mar-18

Apr-18

May-18

Jun-18

Jul-18


Exhibit 23: …but market implied inflation expectations (5Y5Ybreakeven forward) are steady





Inflation is showing some signs ofpickup in some EM economies. EMlocal government bonds shouldremain volatile in the short-term: EMcentral banks are likely to turn morerestrictive, due to a narrowing gapwith the US. Rising US inflation hashistorically spilled over into EM, andcentral banks are likely to adopt amore hawkish stance to avoid fallingbehind the curve. We remainconvinced that this pickup istransitory.

Duration positioningThe US yield curve has continued toflatten throughout this tighteningcycle, following historical normsduring times of rising policy rates.The spread between 5-and 30-yearyields reached the lowest level inmore than ten years. We hold theview that the US yield curve couldinvert if the Federal Reservecontinues with the plannedtightening. This phenomenon isexacerbated by the increasedsupply of short-dated Treasurynotes necessary to fund the risingUS deficit. Increasing demand byinstitutional investors for longer-maturity Treasuries, boosted by theappealing yield differential with DMpeers and the tame inflationoutlook, will keep the curve inflattening mode. The term structuredoes not compensate for durationmaking it unattractive to takeduration bets.

In our view, the short-to-belly ofthe curve offer value in thecurrent phase of the extendedeconomic cycle.

0%

1%

2%

3%

4%

2013 2014 2015 2016 2017 2018


Exhibit 24: EM-US Inflation Gap

0

20

40

60

80

100

120

Jul-17

Aug-17

Spr

ead

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18

Mar-18

Apr-18

May-18

Jun-18

Jul-18

UST 30Y minus 5Y UST 10Y minus 2YSource: Bloomberg, as of Jul 2018

Exhibit 25: The yield curve likely to invert with further rate hikeson the way

UST UK Germany Japan

-0.50.00.51.01.52.02.53.03.5

2013 2014

Yie

ld %

2015 2016 2017 2018


Exhibit 26: US yields are attractive within developed markets andoffer value as compared to long-term averages

China Japan

US

D b

n

1000

1050

1100

1150

1200

1250

1300

1350

2013 2014 2015 2016 2017 2018


Exhibit 27: China’s holdings on US securities have been consistentso far despite trade tensions


19




2.4

2.5

2.6

2.7

2.8

2.9

3.0

3.1

3.2

Jan-2018 Feb-2018 Mar-2018 Apr-2018 May-2018 Jun-2018 Jul-2018

Inflation report showed sharp price increases

The return of volatiliity – VIX spiked in a disorderly fashion

US imposes trade tariffs and the saga begins with retaliation by the Chinese

Global trade spat moves to a global phenomenon spurring demand for safe haven bonds

FED's Hawkish stance spooks markets in April

Italy's polictical crisis takes centre stage

Exhibit 28: US Treasury yield breaches the 3 percent handle briefly as flight to safety bid propelsyields lower

Source: Bloomberg as of Jul 2018

The Chinesedomestic bondmarket hasoutperformed allmajor bond indices


Fixed Income Investment Idea: Focus on China



Over the last four decades, Chinahas emerged among the worldlargest super-powers, due toambitious political reforms, whichhave seen the country masteringdifferent phases of globalisation. InOctober 2016, the IMF added theChinese Renminbi (RMB) to thebasket of currencies that make upthe Special Drawing Right. TheSDR is an international reserveasset created by the IMF in 1969to supplement its membercountries’ official reserves. TheRMB joins the SDR basket inaddition to the previously includedfour currencies — the US dollar,the euro, the Japanese yen, andthe British pound.

The Chinese Renminbi has a10.92% weight on the SDR basket.So far SDR 204.2bn (equivalent toabout USD 291bn) have beenallocated to members, includingSDR 182.6bn allocated in 2009 inthe wake of the global financialcrisis.

While we see this as an essentialmilestone in the integration of theChinese economy into the globalfinancial system and a testimony toits higher standards, the Chinesemarkets have not significantlybenefitted from this inclusion.

With global central bank’s policytransitioning and recent headwindscaused by tighter monetarypolicies, markets have recentlyadjusted for the required riskpremium on many of the countriesfaced with idiosyncratic risks andfiscal imbalances. However, Chinais well placed to deal with such

pressures and still has a hugeFX reserve base (USD 3.24tn)and a robust external position.The capital account is still verycontrolled, and policymakers havedemonstrated prudent fiscal andmonetary policies, with many toolsat their disposal to respond to anyeconomic headwinds.

The successful internationalisationof the RMB is linked to its adoptionin cross border trades for actualpayments. The common fear of apotential devaluation is certainlyone of the reasons why it hasn’tbeen widely adopted yet.

Regarding listed securities however,foreign holdings of Chinese stocksand bonds have risen exponentiallyin the last five years with equitiesaccounting for the lion’s share. TheBond connect program, and thesurge in panda bond issuance aresome of the most recent reformsthat the nation implemented tofoster and enable broaderinternational participation andcapital flows.

Foreign holdings ofChinese stocks andbonds have risen

exponentially in thelast five years

The yields on the Chinese bondshave remained well insulated andcontained under the 4 percent levelYTD, despite the various volatilityepisodes which have affectedemerging markets, linked to USdollar and rates. The benchmarkten-year bond yield is currently at3.6%, a sharp increase after therecord low of 2.7% in September2016. Our preference withinChinese bond issuers would befinancials and across theinvestment-grade corporates. Whilethe deleveraging process continues,corporate balance sheets are soundwhile valuations on a risk-adjustedbasis are compelling.

˃ China’s debt level and growth are manageable.

˃ Monetary policy setting - a robust and credible framework

˃ Non-financial leverage is a well identified issue, widely dealt with by authorities

˃ Prefer Chinese banks (The Big 4) and corporate IG issuers

China

Rea

l GD

P g

row

th a

nnua

l % c

hang

e

US MENA WorldDev. Nations (G7)

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

0

2

4

6

8

10

12

Source: IMF, as of Jul 2018

Exhibit 29: China growth differential to the rest of the majoreconomies cannot be ignored


21

Fixed Income Investment Idea: Focus on China



In a period where the US Fed hasembarked on tighter monetarypolicies, hiking rates and shrinkingbalance sheet, EM outflows haveexacerbated, especially in the lastsix to nine months. However, theChinese policymakers haveremained committed to theiragenda and implementationframework, and ensured financialstability to the Chinese economy.This factual resilience is for us aproof that Chinese authorities havea firm grip on the entire financialsystem and don’t lose control. Theconstant market intervention, activeFX control triggers, rules andflexibility on the reserverequirement ratios (RRR) to namea few tools, assure propermanagement and abundant liquidityfor economic activity. Theauthorities have also kept monetarypolicy in a neutral stance as theycontinue to clamp down on highcorporate debt levels and riskylending practices to prevent anydamage to the financial system.

Although the nation’s recent officialeconomic data remains upbeat,policymakers are starting tobalance concerns about economicconditions alongside theirlongstanding commitment towardscontaining credit and curbingexcess borrowings. So far, resultsshow that the deleveraging processis in progress without hurting theeconomy.

The overall Chinese governmentdebt position remains wellcontained and in our viewmanageable across both centraland local borrowers. The primaryconcern lingers around thecorporate sector leverage and itsmounting debt.

The reduction on the corporatedebt would inevitably have

ramifications to businessinvestments and could be a dragon China’s economic growth.China’s policymakers have beenaggressive in their drive to reducethe corporate debt mountain,intensifying their efforts to

implement measures to curbborrowing. As a result, outstandingoff-balance sheet lending has fallenby 100bn yuan in the first fourmonths of 2018, having grown by2.2tn yuan in the same period lastyear.

China aggregate bond index (CNY, LHS)

Yie

ld %

Rates %

FED Funds rate

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jul-16

Aug-16

Sep-16

Oct-16

Nov-16

Dec-16

Jan-17 Feb-17

Mar-17

Apr-17

May-17

Jun-17

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18 Feb-18

Mar-18

Apr-18

May-18


Exhibit 30: Higher US policy rates have not been a major concernfor Chinese bonds

Household Debt Non-Financial CorporatesGovernment Financial Corporates

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

0%

50%

100%

150%

200%

250%

300%


Exhibit 31: The non-financial corporate is the major concern.Reforms on deleveraging is critical.

The Chinesepolicymakers haveremained committedto their agenda and

implementationframework


Cross asset views: Opportunities in Volatile Markets



˃ Synchronised growth gives way to narrow US-led expansion

˃ Market volatility rises with US dollar ascendancy and higher US policy rates

˃ Non-US growth expected to pick up in H2 2018 amidst rising geopolitical risks

˃ Outlook for EM assets should improve alongside fundamentals

This year’s disappointing marketperformance across asset classesprovides payback for 2017’sGoldilocks backdrop, when riskassets delivered elevated returnsamidst record-low volatility forglobal equities and bonds. Returnsfor equities, government bonds,credit and hedge funds areunderwhelming for the year, withmoney managers on averagetracking the flattish-to-negativeperformance of most benchmarks.Investors are increasinglyconcerned about trade conflictsand geopolitical tensions, inspite of a relatively supportivemacroeconomic environment andhealthy corporate earnings growth.This marks a sharp departure fromthe Olympian calm marketssported only some months ago,and reflects peaking liquidity andgrowth globally.

The degree of synchronisation inworld growth has been questionedby markets in Q2. Last yeargrowth was accelerating both inthe developed and the emergingnations, and most of the globalmarkets were up. Currently, theworld is still expanding at a robustpace but acceleration can reallybe found only in the US. As Exhibit32 shows, this has led to anarrower leadership within globalequities so far.

Some pockets of the US equitymarket shone in Q2, in particularUS Small Caps and US Technology,the former very sensitive todomestic growth, the latter on asecular up-trend expected to drive anew wave of technological progress

across the economy. The Fedsignalled on multiple occasions thatpolicy rates would continue to rise inkeeping with the expandingbusiness cycle, bringing the USdollar (+5 percent in Q2) on theascendancy. The improved USoutlook has at least partially been

priced in for the short-term,especially in the currency, ashighlighted by the overbought levelsin our US Dollar Risk AppetiteIndex, and to some extent in therelative performance of US stocksversus rest-of-world equities(Exhibit 33).

MSCI All-Country World Index % Markets in Bullish Trend (RHS)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

2005 2007 2009 2011 2013 2015 2017 0

100

200

300

400

500

600

Source: Bloomberg, CIO Office as of Jun 2018

Exhibit 32: MSCI AC World Index and proportion of equitymarkets above their 200-day moving average

US Equities vs Rest-of-World US Dollar Risk Appetite Index

-2

-1

0

1

2

3

4

2010 2011 2012 2013 2014 2015 2016 2017

US Dollar Risk Appetite Index: aggregate of momentum, positioning, volatility, skew and economic growth differentialsSource: Bloomberg, CIO Office as of Jun 2018

Exhibit 33: US Dollar Risk Appetite Index and US equities versusrest-of-world


23




The outperformance of US assetsis accounted for by the country’soutstanding economic growth rate.The US Purchasing ManagerIndex, a comprehensive measureof business confidence, is in theupper-end of its historical range,while similar gauges in othercountries are trailing visibly behind(Exhibit 34).

We hold the view that USoutperformance will ultimatelybe followed by a broadening ofthe growth cycle to othercountries, which would see theresumption of the equity rally andin general positive returns acrossrisk assets. This could happenthrough two channels: either spill-over effects from the buoyant USconsumer will lead a recovery inglobal retail sales and eventually inmanufacturing, or the positivefeedback to manufacturing willcome from the full-employmentlevels in the DM countries (Exhibit35). Either way, tight labourmarkets should be the propellingforce behind a manufacturingrevival outside of the US.

The loosening of monetarypolicy in China should also helpstabilise Chinese markets andeventually EM assets. Chineseauthorities are lowering theReserve Requirement Ratio (RRR)for deposits to stabilise theeconomy, following the curbing ofexcessive credit creation and theadverse impact of trade tariffs. Inthe past a lower RRR was followedby an expansion in money supply(Exhibit 36), which in turn ended upboosting domestic equities.

US Man. PMI EM Man. PMIDM x US Man. PMI

48

50

52

54

56

58

Jul-16

Sep-16

Nov-16

Jan-17

Mar-17

May-17

Jul-17

Sep-17

Nov-17

Jan-18

Mar-18

May-18

Jul-18


Exhibit 34: US manufacturing PMI, versus DM ex US and EM PMI

Money Supply (M1, YoY%)Reserve Requirement Ratio, Major Banks (Inverted, RHS)

15

16

17

18

19

20

21

22 0 5

10 15 20 25 30 35 40 45

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018


Exhibit 36: China’s lowering of Reserve Ratio should be followedby expansion in money supply

Global Manufacturing PMI (LHS)

Consensus Unemployment Forecasts OECD Unemployment Rate (6M Change, Inverted)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0 30

35

40

45

50

55

60

65

2002 2004 2006 2008 2010 2012 2014 2016 2018


Exhibit 35: Tight labour markets should boost globalmanufacturing activity





US Japan EMEurope

-5%

0%

5%

10%

15%

20%

25%

30%

Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18


Exhibit 37: Expected 12M forward MSCI EPS growth rate

300

320

340

360

380

400

420

-4

-3

-2

-1

0

1

2

3

2011 2012 2013 2014 2015 2016 2017 2018

EM FX Risk Appetite Index (LHS) JPM EM Currency Index

EM FX Risk Appetite Index: aggregate of momentum, volatility and economic growth differentialSource: Bloomberg, CIO Office as of Jun 2018

Exhibit 38: Oversold levels of EM FX model highlight excessivepessimism on EM

Investors should keep some powderdry on the side to take advantage ofvolatility spikes in the second half ofthis year. If the economic scenarioplays out according to our script,adding to risk on weaknessshould prove to be rewarding.Wehold the view that a barbellapproach would work best, byholding risk assets in the US, wheregrowth is expected to remainresilient, and increasing EMpositioning in bonds and equitieson oversold levels.

The expected 12-month-forwardgrowth in earnings is highest forUS equities (Exhibit 36), supportedby a favourable macroeconomicbackdrop and monetary policy stillfar from being restrictive. For bondinvestors US Treasuries lookparticularly appealing as well,offering the highest yield amongstDM issuers. This is unusual, sinceUS government debt is regarded asthe risk-free asset of choice.

EM FX seems to be alreadyoffering value, as shown by ourEM FX Risk Appetite Index,currently at levels which in the pastoften coincided with buyingopportunities (Exhibit 37). Thisholds true for EM sovereign hard-currency bonds as well, whosespread is wider than US high-yieldcorporate spread for the first timesince 2000.

Adding to riskon weaknessshould prove tobe rewarding


25




MSCI EM (Standard Deviations from 12M Average, LHS)Sentix Sentiment EM Equities Headline Index

-40

-30

-20

-10

0

10

20

30

40

-3.0

-1.5

0.0

1.5

3.0

2007 2009 2011 2013 2015 2017 2018


Exhibit 39: Sentiment on EM equities not yet at deeply oversoldlevels

MSCI EM Equities YoY%Morgan Stanley Global Trade Leading Indicator

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2005 2007 2009 2011 2013 2015 2017


Exhibit 40: EM equities have a high beta to global trade activity

Although EM equities alreadydiscount quite some investor anxietyabout shrinking global growth due toexisting trade conflicts, andincorporate as well a risk premiumdue to the rising dollar and US policyrates, sentiment could still deterioratefurther (Exhibit 39). EM equities arehistorically sensitive to global growth(Exhibit 40) and it is another factor forvolatility. However, we recall that thedynamics of the major EM regionsare increasingly domestic andconsumer-led, in a word, moreautonomous. We advise investors toadd opportunistically to EM equitieswhen volatility spikes, to enhancetheir long-term expected returns.

Investors might wonder whethergold has lost its luster for good,considering that it has deliverednegative returns year-to-date inspite of rising geopolitical tensions.Real US rates, global growth andmarket positioning play in our view astronger role in gold’s trends thantrade conflicts or the scrapping ofthe Iran deal (Exhibit 41). Accordingto our sentiment model gold is notyet at long-term oversold levels,although a rebound seems to beoverdue as US real rates ease backand the US dollar consolidatesrecent gains. As US monetary policybecomes outright restrictive in 2019gold should derate further and offera long-term buy opportunity.

Gold Risk Appetite Index (LHS) Gold Spot

1000

1200

1400

1600

1800

2000

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2011 2012 2013 2014 2015 2016 2017 2018

Gold Risk Appetite Index: aggregate of momentum, positioning, volatility, skew and economic growth momentumSource: Bloomberg, CIO Office as of Jun 2018

Exhibit 41: Gold not yet offering a buy opportunity in spite ofnegative YTD returns

We adviseinvestors to addopportunistically toEM equities whenvolatility spikes


Oil Outlook



˃ Oil markets have moved from feast to famine as OPEC’s production cuts have moved the markets intodeficit faster than had been expected

˃ Unplanned outages in major producers like Venezuela and Iran pose a substantial risk to supply forthe rest of 2018 and into next year

˃ Production increases now will help to balance markets but will leave supplies at very tight levels goinginto 2019, providing a floor to prices in the medium term

Oil markets enter the second halfof 2018 with great uncertaintyover whether there will beenough crude to meet demand, acomplete reversal of the past fewyears when rapid supply growthcontributed to massive increases ininventories. OPEC’s production cutshelped to move markets back tobalance faster than the producers’bloc had likely expected and OPECis now signaling it will raise outputover the coming months. However,declining production capacity inseveral members means that anynear term increase in output setsthe scene for persistently tightmarkets to the end of the year andinto 2019.

OPEC managed to come to anagreement at its latest meetingwhich was a more constructiveoutcome than had been widelyexpected. The statement given bythe producers’ bloc stressed thatmembers will “strive to adhere” totheir target of 100% compliance withthe production cut agreement thathas been in place since January2017, rather than the over-compliance that has helped oilmarkets tighten quickly. However,the official statement appears tohave been left intentionally vaguewith no specific country allocationsnor is there a timeline for howquickly production will be raised.This has left the market guessing asto how much output will end upcoming back online and how quickly.

For OPEC to achieve 100%collective compliance with its

production cut, it has space to raiseoutput by around 700k b/d from itsproduction levels in May (accordingto IEA estimates). Part of OPEC’sover-compliance is down tointentional cuts beyond targetedlevels by Saudi Arabia and a fewothers but most of the ‘extra’decline this year is due tounplanned outages fromVenezuela, Angola and, mostrecently, Libya. Saudi Arabia hasalready increased production

significantly with market estimatesfor June output ranging from 10.5mb/d to 10.7m b/d, near record highs.

Meanwhile for OPEC’s partners inthe deal, hitting 100% compliancewould imply a decrease in output ofaround 230k b/d from May levelsas compliance between the 10countries has only averagedaround 70% during the tenure ofthe deal. Sharp declines inproduction from Mexico have been

Market balance (mn b/d, LHS) OECD commercial stocks (mn bbl, RHS)

Jan-15

Apr-15

Jul-15

Oct-15

Jan-16

Apr-16

Jul-16

Oct-16

Jan-17

Apr-17

Jul-17

Oct-17

Jan-18

Apr-18

Jul-18

Oct-18

Jan-19

Apr-19

Jul-19

Oct-19

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2650

2700

2750

2800

28502900

2950

3000

3050

3100

Source: IEA, Emirates NBD Research.

Exhibit 42: Market balance v stocks

OPEC cut relative to baseline Over/(under)

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Jan-17

Feb-17

Mar-17

Apr-17

May-17

Jun-17

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18

Mar-18

Apr-18

May-18

(mn

b/d)


Exhibit 43: OPEC’s over-compliance leaves room to increase output


27

Oil Outlook



more than offset by increasingoutput from Kazakhstan andmiddling compliance by Russia inrecent months. Between the 24countries that are part of the deal,an additional 500k b/d would meanaggregate compliance of 100%.

In practice though the terms of theproduction cut deal are now likelyto fall by the wayside in favour offinding a production level thatkeeps prices in a band betweenUSD 70/b – USD 80/b. Theagreement in June to raise outputwas likely only made on theunderstanding that production fromVenezuela and Iran will fallsignificantly by the end of the year.We expect that production fromVenezuela and Iran will be around650k b/d lower in 2018 comparedwith 2017. However, thedeterioration in Venezuela’sproduction is accelerating and ourforecast of a 470k b/d decline maybe too conservative.

For Iran the expected decline inoutput is more uncertain as itdepends on how strictly importingnations adhere to US sanctionsagainst taking Iranian barrels. Sofar signs are that main importers ofIranian crude – eg; South Korea,EU nations, India – are alreadymoving away from Iran andexports, and production, will fall asa result. The US is taking a harderline with respect to sanctions thanthey did in 2012 with the StateDepartment targeting a completeend to Iranian crude exports oncesanctions come into effect. Iranexports roughly 2.2mn b/d, anenormous amount for otherproducers to have to offset directly.

OPEC did not revise specificcountry quotas at its meeting toavoid officially sanctioning atransfer of market share between

members. But there are fewcountries with the capacity to raiseproduction and any increase inproduction would be borne mostsignificantly by Saudi Arabia, theUAE and Kuwait. Between themthese three countries have around2.75mn b/d of spare capacity,accounting for around 85% ofOPEC’s total, according to IEAestimates. An increase in outputnow would further erode OPEC’sspare capacity—which has alreadybeen in decline since 2015—andhelp to set a longer-term floorunder prices. Perhaps one of themost bullish statements thatemerged out of last week’s meetingwas Saudi minister al Falih’swarning that Saudi Arabia’s long-term strategy of maintaining sparecapacity of 2mn b/d was “very high”and “very expensive.”

In just 18 months the oil market hasmoved from feast to famine andprices have moved upward as aresult. We expect that prices are

likely to hold in a range betweenUSD 70/b-USD 80/b, althoughtemporary upward spikes anddownward crashes are to beexpected on short-term, idiosyncraticfactors. As we move into 2019 thefull impact of higher tariffs will beginto drag on broader economic growthand mean oil prices stay closer tothe bottom end of the range.

Spare capacity (mn b/d)

Saudi Arabia

Iran

Iraq

UAE

Kuwait

Qatar

Angola

Nigeria

Libya

Algeria

Eq Guinea

Ecuador

Venezuela

Gabon

Total

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00

2.02

0.03

0.33

0.33

0.22

0.02

0.05

0.27

0.05

0.04

0.01

0.01

0.00

0.04

3.42


Exhibit 44: OPEC spare capacity held in the GCC


Contributors



Maurice Gravier – Chief Investment Officer

Tel: +971 (0)4 609 3739 Email: [email protected]

Anita Gupta – Head of Equity Strategy


Syed Yahya Sultan – Head of Fixed Income Strategy


Giorgio Borelli – Head of Asset Allocation and Quantitative Strategies


Sunny Naqi, CPA – Fixed Income Analyst, CIO Office


Muna Alawadhi – Analyst


Nawaf Fahad Ali Mousa AlNaqbi – Equity Analyst


Budour Al Fahim – Analyst, CIO Office


Edward Bell – Director Commodity Research



29

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