2014.10 ethenea-market-commentary-ethna-aktiv-e

[email protected] www.ethenea.com

MARKET COMMENTARY

No. 10 / October 2014

This Market Commentary focuses on a slightly different topic than usual, because this time we look at the long-term situ-ation in the markets rather than the current one. We usually take a look at the economic data and compare them with our expectations and those of the market. This task is performed by the surprise indicators (Graph 1), at least for the market. While the markets are increasingly disappointed by the figures from the Eurozone, data from the US is better than expected (although to a steadily lesser degree). This largely coincides with our own assessment of the situation on both sides of the pond. Europe is struggling, probably in vain, against a renewed recession. However, since even supposedly strong economies like Germany are beginning to weaken, the likelihood of a turnaround in European growth has to be considered fairly remote.

The picture in the US, though, is very different (for now). The economic data continue to surprise positively, especially labour market data, which play an important role in the interest rate policy of the US central bank. Interpreting the US

labour market data is a science in itself, as we have frequently reported in the past. This seems to be the only reason why the Fed (Federal Reserve) is continuing its loose monetary policy. After all, it’s not as simple as a first look at the data would suggest.

All in all, the markets are performing as we predicted in past commentaries: Eurozone yields continue to fall, US yields are largely stable and are not rising significantly. The equity mar-kets seem to be disappointing, but only at first sight – when you consider that the global economic data actually point towards a weakening, which is not exactly a point in favour of corporate earnings growth. In this environment equities remain quite stable, which is undoubtedly due to the presumed lack of alternatives to equity investments.

We therefore concern ourselves less with the current market, and instead take a long view of the markets before exploring the subject of dividends in greater detail in the equities part of this Market Commentary.

The worst is yet to come. Definitely.

Many European countries are well above the 60 percent debt limit. Another negative development could lead to market instability. Will countries manage to reduce their debt in the future?


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ETHENEA | Market Commentary

Graphs 3 to 11 show a very simple projection of future public debt in relation to gross domestic product (GDP). Although we may be oversimplifying here, we think this provides signifi- cant insights.

In making these projections, we first of all assume that government budgets are balanced. A closer look at the prima-ry balances (Graph 2) nevertheless reveals that budgets are anything but balanced even before debt servicing, with the almost glorious exceptions of Germany and Italy. However, the picture changes significantly when interest payments are added. For Italy, this results in a budget deficit of 3 % of the country’s GDP.

As stated, we nevertheless try to be optimistic about the future and take the satisfying gift of balanced budgets as a given. Moreover, we look at three scenarios: The main scenario in-volves the continuation of the status quo, designated as ceteris

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10 11 12 13 14

Econ

omic

Sur

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Eurozone USA

Graph 1: Surprise indicators USA and Eurozone

Source: Bloomberg, ETHENEA, Citibank

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98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13Gov

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s %

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Germany France Greece Spain

Portugal Italy USA

Graph 2: Primary balances of selected countries

Source: OECD, ETHENEA

paribus in the graphs. In the charts, we keep the currently observed GDP growth rate and the real interest rate on debt (10-year nominal interest rate minus the annual consumer price inflation rate) constant. This scenario is seen in the charts as a red line. Another variant of the projection involves an increase in the real interest rate by 1 % (blue line). In the last scenario, we used the data of the supposed model pupil Germany for the projection, i.e. German real interest rates and GDP growth rates (green line).

The projections for Germany, the USA and Switzerland allow the viewer to look calmly to the future. Even ceteris paribus Germany will reach the 60 % Maastricht limit again in 23 years. If the European Central Bank (ECB) succeeds with its policy of increasing inflation while simultaneously maintaining low nominal interest rates, this 60 % level could even be reached earlier. The USA and Switzerland, where the situation is com-parable, also seem likely to avoid debt problems.

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t/GD

P

past ceteris paribusreal yield -0.86 real yield 1.14

Germany

Starting level 78.40Real Annual Growth 1.210yr 0.944CPI 0.8

Graph 3: Projection Germany

Source: Bloomberg, ETHENEA

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t/GD

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past ceteris paribusreal rate 1.80German status quo

USA Starting level 71.80

Real Annual Growth 2.6

10yr 2.5

CPI 1.7

Graph 4: Projection USA



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Deb

t/GD

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pastceteris paribus

German status quoreal rate 3.40

Italy

Starting level 132.60

Real Annual Growth - 0.2

10yr 2.3

CPI - 0.1

Graph 6: Projection Italy


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t/GD

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pastceteris paribus


Switzerland



10yr 0.45

CPI 0.1

Graph 5: Projection Switzerland


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Deb

t/GD

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pastceteris paribus

German status quo



10yr 2.08

CPI - 0.2

Spain

real rate 3.28

Graph 7: Projection Spain


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t/GD

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past

ceteris paribusGerman status quo

real rate 1.88

France



82.1ry01

4.0IPC

Graph 9: Projection France


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t/GD

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past t ice eris par bus

terG man sta us quo real rate 4.46

Portugal



10yr 3.06

CPI -0.4

Graph 8: Projection Portugal


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t/GD

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pastceteris paribus


Ireland



10yr 1.61

CPI 0.4

Graph 10: Projection Ireland



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The picture for the countries that triggered the euro debt crisis looks a bit different, however: Ireland is recovering and its upgraded credit rating appears to be justified. Despite its high debt level of 123 %, Ireland will be able to grow out of its debt and reach the 60 % threshold in just 13 years. The picture is less rosy for Spain, Portugal and Italy. Of these three candidates, Spain appears to be the country most likely to be in a position to save itself. Slightly more growth and slightly lower real interest rates at the current German level would put the 60 % threshold in sight in 40 years. Italy and Portugal, on the other hand, will have a debt ratio of over 200 % of GDP in fewer than 15 years if they maintain their current course. France, a formerly stable, core European country, is now weakening. Even our calculation’s assumption of a balanced budget seems extremely hypothetical given the current level of -4.3 %.

A continuation of the current rate would also lead to an increase in debt to levels that would be difficult to correct. If France could commit itself to taking on a bit more of Schröder’s Agenda 2010 in order to increase its competitiveness, France might lose some of its charm, but at least it would be in a position to reduce its debt. Future generations in France would certainly prefer that to having to pay the excessive debts of their grandparents. Finally, we should turn to Greece. Despite (partial) debt restructuring in 2012 the country has never been in a worse position. Even in the unlikely event (or under the heroic assumption) that Greece could reduce its budget deficit from -14.3 % to zero, the debt level would be at over 200 % in three years and over 300 % in nine years. Given the generally miserable debt situation, even the greatest optimists are likely to doubt the long-term stability of several European countries. Only the credibility of the ECB has thus far prevented a renewed flare-up of the euro debt crisis. We would do well not to simply accept the current situation as it is. On the contrary, these countries (see above) should do their utmost to make structural reforms on their own, because the risk of a loss of market confidence is very real. If this happened, debt restructuring would be inevitable in the form of a sover-eign default, with the consequent loss of assets by residents of the countries. At this point, PR agencies are needed to sell these undeniably necessary but unpopular measures to voters. So far these reforms have been thwarted by populist (and often rightwing) parties. There is an urgent need for education in this area.

There is not a lot of time, but there may be enough. Other-wise the worst is yet to come, in the form of unsustainable instability caused by the huge debts of the countries involved. Definitely.

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pastceteris paribus


Greece


Real Annual Growth - 0.3

10yr 6.21

CPI - 0.3

Graph 11: Projection Greece



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84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Inde

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European Equities, Price Index

European Equities, Total Return Index

Graph 12: Price index and total return index


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in %

Stoxx 600 Dividend Yield

10 Year German Government Bond Yield

Graph 13: Dividend yield in comparison with Bund yield


– the highest level in the last 15 years. With the banking system continuing to stabilise, we think that companies will reduce these liquid assets and dividends are an excellent way to do so.

• No investment opportunities: Due to weak economic growth, organic growth opportunities in Europe are limited. Investment in new machinery and buildings only makes sense if an economic upturn is expected in the next few months. But we are far from such a scenario, as the falling leading indicators of recent weeks show.

• Pressure on the part of investors: Investors are increasing the pressure on companies to return unneeded cash to shareholders instead of investing in expensive acquisitions. Unfortunately, history has shown that, by the end of a stock market cycle, expensive acquisitions only rarely make a positive contribution to the acquiring company’s value.

• Volatility at a low level: Volatility in equity markets has declined significantly in recent months, which makes dividend stocks all the more attractive compared with bonds. For example, the volatility of European stocks has fallen to 17, compared with an average of around 25 for the last five years. The volatility levels of equities and bonds continue to converge.

Dividend stocks appear even more attractive if we assume that interest rates in Europe will remain at their low level for some time to come. Does this mean we should buy any stock with a high dividend yield? At first glance, this question can be answered with a clear yes. Dividend yields of more than 6 % in telecommunications or 5.7 % in the oil sector seem attractive, as Graph 14 shows. However, we urge caution: As so often in the capital markets, the truth is slightly more complicated.

Now, as promised, some brief comments concerning the equity markets.

If dividends are good, is everything really fine?

The fourth quarter is already here; the year is drawing to a close. Since it is well known that cash is king and the bond market is currently offering little in the way of interest payments, we take a look at corporate dividend payments in 2015. We assume that European companies will be paying out more than EUR 300 billion to investors next year.

Dividend payments are pushing indices up – if dividends are good, everything is fine is not only an old well-known stock market wisdom, but also hits the nail right on the head. Since 1985, reinvested dividends have been responsible for over 60 % of shareholder profits (difference between price index and total return index, Graph 12). The rest comes from earnings growth and expansion of the P/E (price-earnings ratio).

The central banks have wiped out interest. In the low interest rate environment caused by the central banks, dividends have become even more attractive and for many investors have taken the place of the interest payments made by bond markets in previous years. While the expected dividend yield on the Stoxx 600 is still 3.5 % for 2014, interest rates on 10-year German government bonds have fallen below 1 % at times (Graph 13).

For the following reasons, we are convinced that distributions to shareholders will continue to grow steadily in the coming years:

• High cash balances: Since the financial crisis, massive cash balances have been built up again and the liquidity for increased distributions is available. At the end of 2013, European companies held over 10 % of their assets in cash


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Attractive yields of over 5 % are not always covered by the expected earnings. The telecoms sector is already distributing higher dividends than it is generating in income. In addi-tion, telecoms and utilities companies have to make heavy investments, which could bring the generous dividends under pressure. Investments in the oil and gas sector have been reduced, providing a firm footing for dividends; however, a sharp drop in the price of oil could put a spanner in the works for investors. On the other hand, insurers are distributing less than 50 % of their profits, although the dividend yield is still over 5.5 %.

Also worth bearing in mind when it comes to dividend stocks: Look before you leap.

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Telecoms Oil & Gas Utilities Insurance

Payout ratio 2015e, LHS Dividend yield 2015e, RHS

Graph 14: Distribution ratios and dividend yields

Source: Barclays


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Positioning of the Ethna-AKTIV E

With no further deterioration in the geopolitical situation, we used the higher market volatility to expand our equity exposure by just under 9 % to 28.4 % at month-end. The markets should receive particular support from further easing steps by the ECB based on current macroeconomic data. At sector level we therefore focused on the banking sector, as it should be the biggest beneficiary of additional measures. We also increased positions in the telecommunications sector. Further consolida-tion and takeover rumours will have a supportive effect on prices, particularly in the USA. Weak global demand and fur-ther growth in US production put the oil price under pressure last month. Consequently, we further reduced exposure in the oil sector. The stable pharmaceutical sector remains a core investment and was further expanded. We like the sector’s combination of solid business models, relatively attractive valuations and potential for further acquisitions.

The continued increase in policy divergence between the Fed and the ECB confirms our opinion regarding a further appre-

ciation of the USD against the EUR. Therefore, we have not changed our exposure, although the corresponding gains in-creased the weighting to 25.1 % at month-end. In order not to increase the impact of currency volatility on the overall port-folio, we further reduced the AUD portfolio and realised gains on the foreign exchange and bond side.

The average rating of the fund remained unchanged between A and A+, while the bond weighting was reduced by 2.5 % month-on-month. In particular, non-investment-grade secu-rities were closed at a profit in order to keep the overall vola-tility low at a higher equity exposure. We used Treasury futures to reduce the modified duration slightly to 4.12 at month-end. However, this was only for tactical reasons – we are maintaining our macro picture and expect interest rates to remain low for an extended period both in Europe and in the USA.

30.5

0.6 4.1

10.3 12.4

2.3

29.6

0.0 9.6 0.7

AAA

AA

A

BBB

NON IG

Not rated

Equities

Tactical reserve*

Cash

Others

% of Total NAV

Ethna-AKTIV E

Source: ETHENEA

Graph 15: Breakdown of the Ethna-AKTIV E portfolio by issuer rating

Ethna-AKTIV E % of Total NAV

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0.6 4.1

10.3 12.4

2.3

29.6

0.0 9.6 0.7

AAA

AA

A

BBB

NON IG

Not rated

Equities

Tactical reserve*

Cash

Others

% of Total NAV

Ethna-AKTIV E

* for potential direct investments and derivatives in equities

69.7

0.1

1.0

25.1

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3.6

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42.1

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CHF

AUD

USD

GBP

NOK

SEK Net Gross

Source: ETHENEA

Ethna-AKTIV E% of Total NAV

Graph 16: Breakdown of the Ethna-AKTIV E portfolio by currency


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Graph 17: Development of the various market trends, compared with the previous month and the current year

Currency

TW € € $ € CHF € £ € JPY € AUD € NOK € CAD € TRY € CNH

Last 92.81 1.2676 1.20807 0.78503 137.2 1.44081 8.1671 1.4131 2.8801 7.807

-1m -1.3 % -3.6 % 0.2 % -1.0 % 0.3 % 2.4 % 0.3 % -1.0 % 1.5 % -3.4 %

ytd -5.0 % -8.1 % -1.4 % -5.7 % -5.5 % -6.7 % -2.3 % -3.6 % -2.9 % -6.5 %

German Gvmt ITRAXX 5y

2y 5y 10y 10/2y Europe Xover SenFin SubFin

Last -0.072 0.145 0.902 97 65 263 64 93

-1m -4 -3 1 5 5 22 3 10

ytd -29 -78 -103 -74 -5 -23 -23 -35

Equities

DAX Dow EuroStx CAC40 FTSE Nikkei Shanghai

Last 9,195.68 16,801.05 3,106.42 4,242.67 6,446.39 15,661.99 2,363.87

-1m -2.9 % -1.7 % -2.1 % -3.2 % -5.5 % 1.5 % 6.6 %

ytd -3.7 % 1.4 % -0.1 % -1.2 % -4.5 % -3.9 % 11.7 %

DAX P/E Dow P/E EuroStx P/E CAC40 P/E FTSE P/E Nikkei P/E Shanghai P/E

Last 12.8 14.7 14.1 14.6 13.3 17.5 9.4

-1m -4.5 % -2.7 % -2.1 % -3.5 % -5.9 % 1.0 % 6.7 %

ytd -9.2 % -5.5 % -3.3 % -6.6 % -5.3 % -17.0 % 1.4 %

Graph 18: Figures of the Ethna-AKTIV E at the end of the month

Date Fund Yield p. a. Rating is between

Mod. Duration

Current yield p. a.

Mod. Duration- bonds only-

30/09/2014 Ethna-AKTIV E 3.09 % A A+ 4.12 3.36 % 4.84

Yield pick-up to German 10y Gvmt

USA UK Japan France Austria Holland Italy Spain Portugal Greece Ireland

Last 152 142 -38 35 21 14 142 121 217 557 73

-1m 145 148 -39 36 24 17 155 134 233 493 89

ytd 110 109 -119 63 34 31 220 222 420 649 158


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34.3

20.7

6.0 5.5 4.83.6 2.9 2.1 2.1 1.8

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Graph 19: Breakdown of the Ethna-AKTIV E portfolio by origin

Source: ETHENEA

Ethna-AKTIV E % of Total NAV * Including 12 other countries

EquitiesBonds

26.7

6.8 6.4 6.04.9 4.8 4.2 3.5 3.2 3.0 2.6 2.3 1.7 1.5 1.1 1.1 1.0 1.0 0.9 0.9 0.8 0.8 0.6 0.6 0.5

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Graph 20: Breakdown of the Ethna-AKTIV E portfolio by issuer sector

Source: ETHENEA

Ethna-AKTIV E % of Total NAV * Including 12 other sectors

EquitiesBonds

[email protected] www.ethenea.com

NB:An investment in investment funds, as with all securities and comparable financial assets, carries the risk of capital or currency losses. Consequently,the unit price and the yield are variable and cannot be guaranteed. The costs of a fund investment have an effect on the actual profit. No guarantee canbe given that the investment objectives will be achieved. The statutory sales documents form the sole legal basis for a purchase of units. All informationpublished here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision ofadvice or information or a solicitation of an offer to buy or sell securities. Contents have been carefully researched, compiled and checked. No guaranteecan be given for correctness, completeness or accuracy. Munsbach, 30/09/2014.

Portfolio Management:

Guido Barthels (author)Luca PesariniArnoldo Valsangiacomo

Please do not hesitate to contact us if you have any questions or suggestions.

ETHENEA Independent Investors S.A.9a, Rue Gabriel Lippmann · 5365 Munsbach · LuxembourgPhone +352 276 921 10 · Fax +352 276 921 [email protected] · www.ethenea.com

Economy & Finance

2014.10 ethenea-market-commentary-ethna-aktiv-e