INSIGHT
Q U A R T E R LY M A R K E T R E V I E W
Q3 2017
HIGHLIGHTED IN THIS PUBLICATION:
GLOBAL STRATEGIC
ASSET ALLOCATION
GLOBAL SECURITY
SELECTION
REGIONAL
ASSET ALLOCATION
REGIONAL PORTFOLIO
CONSTRUCTION
Inflating gently?
OVERVIEW
UK
EUROPE
SPECIAL FOCUS
Global expansion
continues
Brexit bill
Non-performing loans
and growth
Oil price weakness
OVERVIEW
With global economic growth remaining reasonably firm, concerns are mounting
over pressures on inflation. However, as wage growth remains subdued, such
pressures are likely to continue to be modest for the time being.
The trends in world trade and in key domestic indicators
present a picture of overall global economic growth
remaining reasonably firm, with a gradual improvement in
pace seen recently.
World trade picks up
World trade in goods has picked up both in terms of volume
and its overall value in recent months (see Figure 1). The
latter reflects the fact that export and import prices are
both rising by around 4% year-on-year, in marked contrast to
the falling prices that were seen throughout 2015 and 2016.
2. Unemployment rates
14
12
10
8
%
6
4
2
0
2012
1. World trade growth
US
40
2013
UK
2014
2015
Eurozone
2016
2017
Japan
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
30
(9.3% and 11.1%, respectively), the labour market is close to
the point where upward pressure on inflation could be
expected to start in the context of such a framework.
% change on year
20
10
0
-10
-20
-30
-40
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
World trade growth volume
World trade growth value
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
This picture is in sharp contrast to that which was widely
expected soon after President Trump’s election. At that
time, there was widespread concern that a more
protectionist drift in world trade would hamper global
growth. That has not proved to be the case. This easing of
concerns is especially important for economies, notably
those in Asia, where growth is highly dependent on their
close integration in global supply chains.
Unemployment rates are falling…
There are encouraging signs with respect to domestic
growth as well. One of the clearest indications is the fall in
unemployment rates in all the major economies (see Figure
2). Indeed, in the US, UK, Japan and Germany unemployment
rates are below mainstream estimates of the so-called
NAIRU (Non-Accelerating Inflation Rate of Unemployment).1
The concept of the NAIRU is that if the unemployment rate
falls below that level, then the inflation rate will start to rise;
and an unemployment rate above the NAIRU will lead to
inflation falling. Even in eurozone economies such as
France and Italy, where unemployment rates are still high
1
However, the relationship between unemployment and
inflation does not appear in recent years to have been a
particularly strong one, certainly in the US, UK and
continental Europe. 2
…but there is little upward pressure on wages.
The key link between a tighter labour market and higher
general inflation is, in normal circumstances, stronger
growth of wages. But it has not generally been the case
that wages have risen as labour markets have tightened in
recent years. There are several reasons why this might be
the case.
First, unemployment rates may understate the true extent of
slack in the labour market as they are generally based on
quite narrow definitions of unemployment. For example, the
standard measures (used by the International Labour
Organisation and most national statistical authorities)
identify the unemployed as those without work, actively
seeking work and able to start work within two weeks.
Broader measures include those who do not meet all three
criteria; those who are employed but would prefer to work
longer hours; and those who may re-join the labour market if
conditions improve. One such broader measure of labour
market slack is around 18% for the eurozone, almost twice the
unemployment rate, according to ECB estimates.
For those employed, there have also been important
changes in the nature of work. In the UK, there has been a
Produced, for example, by the OECD.
See the recent speech by Andrew Haldane, Bank of England, Work, Wages and Monetary Policy and ECB Economic Bulletin, Issue 3, ‘2017 Assessing labour market slack’.
2
2 | Insight Q3 2017
OVERVIEW
Although Japan is often portrayed as an economy struggling
to adopt more flexible working practices, 40% of workers in
that economy are also in part-time or temporary employment.4
Such workers have had some success in obtaining higher
pay, although this has varied between sectors, largely
dependent on skills shortages. The trend has been partly
driven by the government’s attempts to equalise pay rates
between such workers and permanent employees.
Economic surprises: Japan and eurozone lead
Furthermore, Japanese economic data have tended to be
better than generally expected in recent months (see
Figure 3). The same is also true of the eurozone. US and UK
data, reflecting disappointment with the implementation of
Trump’s policies and concerns over the impact of Brexit,
respectively, have generally been softer than expected.
3. Economic surprises
120
100
80
Brexit referendum Trump election
Macron election
+ Better than
expected
60
Index
40
20
0
-20
-40
– Worse than
expected
-60
-80
Jan-16
US
Jul-16
UK
Eurozone
Jan-17
Jul-17
Japan
4. Underlying inflation
5
Underlying inflation rates*
4
3
% change on year
sharp increase in the number of workers on ‘zero-hours’
contracts, as well as those in self-employment, part-time
and temporary work. Together, workers in these categories
amount to 43% of the workforce. 3
Target
2
1
0
-1
-2
2010
US
2011
2012
UK
2013
2014
Eurozone
2015
2016
2017
Japan
*The inflation measure excludes energy and fresh/seasonal food and also, for Japan, the impact of the VAT
increase from April 2014 Source: Thomson Reuters Datastream, Bank of Japan. Data as at 22 June 2017.
to be particularly marked and would certainly not expect
them to get out of control, necessitating a more aggressive
monetary policy tightening. The case for policy tightening
rests more on a desire to return to a more appropriate
equilibrium level of interest rates, as issue which is of
particular relevance in the US.
Cost of living and consumer prices
These observations on subdued wage growth and weak
inflationary pressures will come as a surprise to many. The
actual inflation rate faced by different individuals can vary
markedly, depending on their pattern of consumption, and
some will consider the inflation rate they face as much
higher than the rates that are widely published. One
popular measure, Forbes’ Cost of Living Extremely Well
Index (CLEWI)5 has risen at an average rate of 6.2% p.a. over
the last forty years, well above the average rate of US
inflation at 3.7% (see Figure 5)
5. Cost of Living Extremely Well
Source: Citigroup, Thomson Reuters Datastream. Data as at 22 June 2017.
1200
Average annual increase,
1976 to 2016
1000
Index, 1976 = 100
Underlying inflation rates
Apart from in the UK, where inflation has been pushed
higher as a result of sterling’s weakness and consequently
higher imported goods prices, underlying inflation rates
(excluding food and energy prices) remain subdued around
the world (see Figure 4). Even in many inflation-prone
emerging economies, inflation rates have recently been at
or close to historic lows. In the US, the gentle rise in the
underlying inflation rate towards 2% has recently been
partly reversed. Underlying inflation rates remain at zero in
Japan and 1% in the eurozone.
6.2% p.a.
800
600
3.7% p.a.
400
200
0
77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17
CLEWI (Cost of Living Extremely Well Index)
CPI
Source: Forbes. Data as at 22 June 2017.
Little reason for more aggressive policy tightening
On balance, as economic growth firms and the labour
market tightens there may be some upward pressures on
underlying inflation. We would not expect these pressures
So, although the actual inflation rate in many economies
may now be only on a gently rising path, many people will be
aware that their own inflation rate is much higher.
According to Haldane, see above.
Source: Japan Times, http://www.japantimes.co.jp/news/2016/06/06/national/stimulus-efforts-struggle-abe-pushes-equal-pay-lift-japans-economy/#.WV3lR4jyuUk
5
The CLEWI index includes items such as: one-year’s tuition, room and board at Harvard University, a dozen Turnbull & Asser shirts from London, dinner at Le Tour
d’Argent in Paris and a week’s spa treatment in California.
3
4
Insight Q3 2017 | 3
ASSET MARKET PERFORMANCE
Equities outperformed bonds in the first half of the year in all the major
markets. The softening of the US dollar against the major currencies was an
important feature.
Asset market performance
Over the course of the first half of 2017, the US$ weakened
against all other major world currencies. The declines were
3.7% against the yen, 5.1% against sterling and 8.1% against
the euro.
The weakening of the US$ meant that the 8.6% local currency
return from the MSCI World equity index rose to 11.0% when
expressed in US$ terms. Overall world equity market returns
exceeded world government bond market returns. The
phenomenon was seen across all the main regions and
countries (see Figure 6).
7. Bond market returns
10
8
6
% 4
2
0
-2
6. Asset market performance
US
Japan
Canada
Switz.
UK
Eurozone
New
Australia
Zealand
Local currency terms
US dollar terms
20
Source: Citigroup. Data for six months to end-June 2017.
In terms of bond sector performance, emerging markets
produced the highest returns in the first half of the year in
US$ terms (7.0%), exceeding the returns from global
government bonds (4.5%) and global high yield bonds (6.3%).5
15
% 10
5
0
US
Europe
Japan
Emerging
World
Bonds, total returns, US dollar terms
Equities, total returns, US dollar terms
Equity markets
Asian equity markets produced some of the strongest returns
in the first quarter of the year (see Figure 8). They were
helped by signs of improved export growth and a lessening of
concerns about global trade prospects.
Source: Citigroup (bonds); MSCI (equities). Data for six months to end-June 2017.
Bond markets
The rise in US government bond yields seen in late 2016 was
partially reversed in the first half of 2017: the ten-year
government bond yield on 30 June 2017 was 2.30%, lower than
the 2.45% end-2016 level. In the Eurozone, the general trend
was for yields to rise in the major government bond markets,
but decline in several peripheral markets such as Greece and
Portugal (reflecting greater optimism about the sustainability
of those economies’ public debt positions).
The rise in the major Eurozone economies’ bond yields meant
that, in euro terms, there were losses of around 1% from
Eurozone bonds in the period; but the strength of the euro
against the US$ transformed that into a gain of 7.1% in US$
terms (see Figure 7).
Returns from the UK, US and Japan were all close to 10% in
US$ terms in the period. The Russian market was one of the
weakest, in both local currency and US$ terms, mainly
because of the weaker trend in oil prices. The Greek market
which benefited from a new agreement on dealing with the
country’s debt levels, was one of the strongest.
8. Equity market returns
30
20
10
%
0
-10
The Australian and New Zealand bond markets produced the
strongest returns in both local currency and US$ terms. This
mainly reflected those markets’ increased attractiveness in a
rising US$ interest rate environment and a recovery from
what appears to have been oversold levels in both currencies.
5
All on the basis of Merrill Lynch indices in US$ terms.
4 | Insight Q3 2017
-20
Russia
Brazil
US
Japan
UK
Local currency terms
Italy
Germany
Switz.
France
US dollar terms
Source: MSCI. Data for six months to end-June 2017.
India
Hong
Spain
China
Kong
Taiwan S. Korea Greece
UNITED STATES
Two key issues relating to the US economy and financial markets may come
closer to resolution in the second half of the year: the direction of Fed policy
and the prospects for infrastructure spending.
Change at the Fed?
The terms of office of Janet Yellen (as chair) and Stanley
Fischer (as vice-chair) of the Federal Reserve board of
governors expire in January and June 2018, respectively.
There are also three current vacancies on the sevenmember board. Given that appointments are made by
President Trump, there is clearly scope for some change in
the direction of policy as a result of these changes.
3.5%, rising (on the basis of the, FOMC, median forecasts)
to 4% over the coming two years.
9. US Fed Funds: actual and Taylor Rule estimates
Fiscal measures
The decision over when and how rapidly to tighten monetary
policy is further complicated by the degree of successes in
passing legislation associated with infrastructure spending,
tax cuts and the much-vaunted repatriation tax break. So
far, progress has been slow on all these issues. The ageing
of US infrastructure (see Figure 10) shows the clear need for
spending but the reality is that few such projects are ‘shovel
ready’ and able to be implemented quickly. Tax cuts and the
interaction with the deficit and debt levels remain highly
contentious issues in Congress.
20
The Taylor Rule used here is based on a 2%
equilibrium real interest rate, core inflation
relative to the 2% target and the unemployment
rate relative to the Non-Accelerating Inflation Rate
of Unemployment (NAIRU).
18
16
14
12
%
10
8
6
4
2
0
1980
1985
Actual rate
1990
1995
2000
Taylor Rule estimates
2005
2010
2015
2020
Taylor Rule forecast
The complexities of the Taylor Rule may not be fully
appreciated by President Trump and it is unclear just what
stance he would expect his nominations to take. He has
criticised the Fed’s low interest rate policies, but higher
rates may well undermine his plans for stronger growth.
10. Ageing US infrastructure
Source: US Congressional Budget Office (NAIRU estimates and forecasts); US Federal Reserve
(projections for inflation and unemployment) and Thomson Reuters Datastream. Data as at 22 June 2017.
25
Average age of US public sector infrastructure
23
21
19
Years
Monetary policy decisions are made by the 12-member
Federal Open Market Committee (FOMC) which consists of
the seven (currently four) board members; the president of
the Federal Reserve Bank of New York; and four of the
remaining eleven Reserve Bank presidents, who serve
one-year terms on a rotating basis.
17
15
13
11
Two potential appointees to the vacant board seats are John
Taylor, of the eponymous Taylor Rule for setting interest
rates, and Marvin Goodfriend. Both are thought to favour a
more ‘rules-based’ approach to setting interest rates; and
both are critical of the Fed’s quantitative easing policy.
Marvin Goodfriend has recently commented that “almost
all the time the Federal Reserve gets behind the curve”.6 He
argues that the Fed is slow in raising interest rates and
that it is at risk of making a similar mistake now.
He points to the Taylor Rule as indicating that interest
rates should be higher than they are currently. There are
several variants of the rule: the one shown in Figure 9
takes into account a normal level of real (after inflation)
interest rates of 2%, the gap between inflation and its
target rate and the difference between the unemployment
rate and the NAIRU. It suggests rates should currently be
6
9
1950
Federal
55
60
65
70
75
80
85
90
95
00
05
10
15
State & Local
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
If there is unexpected success on passing the fiscal
measures, these could be expected to boost US economic
growth. But precisely because of that, the case for higher
interest rates would be stronger.
On balance, a more hawkish direction
We conclude that regardless of who takes over as FOMC
chairman, and whoever may be nominated for the other
positions, success in implementing the planned fiscal
measures would be likely to lead to a more hawkish
monetary policy stance.
Bloomberg TV interview, ‘The Taylor Rule: Hope Springs Eternal’, 3 March 2017.
Insight Q3 2017 | 5
UNITED KINGDOM
Brexit will remain the focus of UK policy in the next two years but bigger issues
relating to the direction of fiscal policy need to be resolved in the longer-term.
Brexit bill
As the Brexit negotiations between the UK and the European
Commission start, one of the key issues is the size of the
‘divorce bill’. The gross payment – to cover the EU’s budget
up until 2020 and other long-term commitments – seems
likely to be between €60bn and €100bn, on the basis of
Financial Times calculations of the amounts being sought by
the EU (see Figure 11). The UK has EU assets which it will be
able to use to offset some of this payment, bringing the net
payment to the €40-€80bn region.
11. Brexit bill?
100
EUR
60-100 billion
EUR billion
EUR 60 billion
(GBP 53 billion)
60
40
Range of reported
EU demands
Gross range less
UK assets
20
0
Gross
Net
1
2
3
4
5
6
7
Equivalent to
about seven
years’
contributions*
Mid-range
*Net contributions over the last five years have averaged GBP 7.75 billion p.a.
Source: EFGAM calculations, based on figures reported by the Financial Times.
The mid-point of that range (€60bn, £53bn) is equivalent to
2.5% of the UK’s annual GDP. If a settlement of such an
amount is made, it could be in the form of a lump sum or
paid over a number of years.
If the payments are spread – maybe as part of a transition
agreement to ensure continued access to the EU single
market – they would amount to around seven years’ worth
of payments at the recent rate (£7.75bn per year).
Of course, such a situation would be very far away from the
‘savings of £350m per week’ which the Brexit campaigners
said could be made by leaving the EU, with the money
being freed up to spend on the National Health Service.
Future trilemma
Although the Brexit negotiations will be difficult, the
bigger long-term issue for the UK (indeed almost all
advanced economies) is reconciling three conflicting aims
(see Figure 12).
First, the tendency for public spending to grow faster than
real incomes over time – a phenomenon first identified by the
German economist, Adolph Wagner (1835-1917). Specifically,
6 | Insight Q3 2017
Wagner's Law
Rising spending on public
goods as income rises
Tax competitiveness
Low taxes to encourage
incentives and
inward investment
Post Brexit
option?
Austerity
Stable/declining govt. debt
(as a share of GDP)
Source: TIER Co.
spending by the state on the goods and services it provides
(healthcare, social care, education, police protection, etc.)
tends to grow more quickly than overall incomes.
Second, ‘austerity’ – the need to constrain government
budget deficits and debt levels.
EUR
40-80 billion
80
12. Wagner, austerity and competitiveness
Third, the desire to keep tax levels down in order to
maintain the competitiveness of the economy and be an
attractive place for inward investment.
Only two of the three can be achieved simultaneously. The
magnitude of the problem is demonstrated by the
projected large rise in public sector debt (see Figure 13),
reflecting an ageing population and increased social
spending, on the assumption that the tax-take remains
broadly unchanged as a share of GDP.
The problem becomes even worse, on the OBR’s forecasts,
if migration to the UK is reduced following Brexit
(predominantly because migrants from the rest of the EU
are net contributors to the UK public finances).
Brexit, however difficult, may be one of the more
straightforward issues facing the UK in the coming decades.
13. UK government debt: past, present, future
300
WW2
Global
financial
crisis
250
OBR
projections
200
%
150
100
50
0
1920
1940
1960
1980
2000
Public sector net debt (PSND) as a % of GDP
Source: UK Office for Budget Responsibility (OBR). Data as at 22 June 2017.
2020
2040
2060
EUROPE
In the eurozone, business confidence remains firm but price inflation has
softened in recent months. In these conditions, we doubt the ECB is yet ready
to raise interest rates.
Business confidence and inflation
Business confidence continues to remain firm across the
eurozone. For the entire region, the overall PMI (Purchasing
Managers’ Index) remains above the 50 level which signals
the borderline between economic expansion and
contraction (see Figure 14). The latest reading (for June
2017) is consistent with overall GDP growth remaining at
close to 0.5% quarter-on-quarter. It supports expectations
that growth in the full year will be close to 2%, putting
eurozone growth ahead of that in the UK and Japan and not
far behind the US.
15. Eurozone banks: a virtuous circle?
Non-performing
loans (NPLs)
Balance sheets
stronger
Economic growth
Bank lending
14. Eurozone GDP growth and PMI index
65
60
0.5
55
0.0
50
-0.5
45
-1.0
40
-1.5
35
-2.0
30
-2.5
25
-3.0
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: TIER Co. For illustrative purposes only.
Index
%
1.5
1.0
20
GDP growth, % change on quarter (lh axis)
Eurozone Purchasing Managers’ Index (PMI, rh axis)
The fact that there is a reasonable correlation between the
scale of non-performing loans and economic growth (see
Figure 16), supports the existence of such a relationship. In
some economies, however, the benign interaction between
strengthening of banks’ balance sheets and growth has
much further to go or, in extreme cases, has not yet started.
The latest estimates of bad loans in the banking systems of
Greece and Cyprus, for example, are close to 50%.
16. NPLs and growth
However, the overall eurozone consumer price inflation
rate, which rose to 2.0% in February 2017, has fallen back
since then to just 1.3% (in June). ECB staff forecasts for the
average inflation rate for the year have been revised down
to just 1.3% (in their June forecast, compared to a 1.8%
March forecast). Furthermore, measures of future expected
inflation (such as the 5-year inflation rate 5-years forward,
a rate closely watched by the ECB) have also softened.
Banks’ NPLs and economic growth
The other concern for the ECB is the scale of European
banks’ non-performing loans (NPLs). In some European
economies – Germany, France and Spain, for example –
these are now at a relatively low level. Banks in those
countries have recognised bad loans, made write-downs in
their value and combined this with capital strengthening
measures. In Spain, this general buttressing of the banking
sector recently allowed a weak bank to be quickly taken
over by a stronger rival, with minimal effect on confidence
in the banking system and economy. Banks in economies
with such a greater resilience in their banking sectors are
able to lend again, which helps to boost economic growth
and develop a virtuous circle (see Figure 15).
Average GDP growth in 5 years to 2017, % p.a.
Source: HIS Markit and Thomson Reuters Datastream. Data as at 29 June 2017.
3.5
3.0
2.5
Latvia
UK
2.0
1.5
1.0
Poland
Lithuania
Sweden
Czech Rep.
Slovakia
Estonia
Spain
Norway
Germany
Netherlands
Belgium
Denmark
Austria
France
0.5
Portugal
Finland
Italy
0.0
-0.5
Slovenia
Hungary
Cyprus
Greece
Croatia
0
5
10
15
20
25
30
35
40
45
50
Non-Performing Loans (NPLs) as a % of total loans
Source: EBA (European Banking Authority) for data on NPLs and Consensus Economics (GDP growth).
Data as at 22 June 2017.
Premature concerns about ECB tightening
While the overall picture of the eurozone remains one of
firm economic growth, with subdued inflation but some
remaining concerns about the banks, fears of an increase
in ECB interest rates and a scaling back of its asset
purchases seem premature.
Insight Q3 2017 | 7
JAPAN
There are some encouraging signs that Japan’s central bank, helped by more
favourable underlying conditions, is being successful in raising inflation and
economic growth.
BoJ increases
bond purchases
when yields are
above 0%
0.1
%
BoJ eases bond
purchases
when yields are
below 0%
-0.2
-0.3
Jan
Feb Mar
Apr May Jun
Jul
2016
Aug
Sep
Oct Nov Dec
10-year JGB (Japanese Government Bond) yield
Jan
Feb Mar
2017
1400
105
1300
100
1200
95
1100
Weaker yen,
stronger equity
market
90
85
TOPIX
1500
110
1000
900
800
2013
USD:JPY exchange rate
2014
2015
2016
2017
700
Topix index (rh axis)
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
Apr May Jun
Zero percent cap
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
Positive surprises
Consensus forecasts for overall real GDP growth in 2017
have been revised up to 1.4% as economic data have been
generally better than expected. If achieved, that would be
a rate double the average growth rate of the last 20 years.
Some of that improvement may be down to the new policy.
However, we think that just as significant a contribution has
probably come from preparations for the 2020 Tokyo
Olympics. As is typically the case, hosting the event is likely
to cost more than initially expected. In Japan’s case, the
estimated cost is now US$12.6bn, twice the cost when it was
awarded the Olympics in September 2013. This is despite
strenuous cost-cutting since summer 2016.
Although a concern in terms of budgeting, the extra
spending will be a boost to the overall economy. We
estimate it can raise GDP growth by 0.2%-0.3% p.a. in the
run-up to the event.
Faster growth plus skills shortages
Stronger growth and skills shortages in certain areas of the
economy are putting some upward pressure on wages
(especially part-time and temporary), but the effects tend
8 | Insight Q3 2017
1600
115
to be very industry and sector-specific. The core consumer
price inflation rate (excluding fresh foods) edged upwards
to 0.3% year-on-year in April. It may still, however, be
difficult to reach the 1.4% target the Bank of Japan has set
for March 2018; and it could be some time before the
‘overshooting’ of the 2% inflation target – which the central
bank aims to see before reversing policy – is achieved.
0.0
-0.1
1700
75
2012
Policy announcement
21 September 2016
0.2
125
120
80
17. Japan: capping 10-year bond yields
0.3
18. Japan: Topix and the yen
USD:JPY
Zero-yield policy
The latest Bank of Japan policy to revive economic growth
and inflation, launched in September 2016, appears to be
gaining traction. That policy involves a cap on 10-year bond
yields at zero (see Figure 17). Bond purchases by the Bank
of Japan are scaled up when yields are above zero, adding
further stimulus to the economy. As rising bond yields are
normally a sign that economic growth is improving and
inflation is expected to rise, the policy acts as a ‘positive
feedback’ system, amplifying the initial impact.
Investor attitudes
Foreign investors still seem to remain sceptical about a
recovery in Japan’s economy and the attractiveness of the
equity market. We take a more positive view, seeing
structural and economic reforms as having a material
effect and the equity market not being particularly
expensively valued. On the basis of a range of valuation
measures (its trailing price/earnings ratio, the cyclically
adjusted price/earnings ratio and price/book ratio) it
trades in line with or cheaper than its history.
Breaking the currency-equity link?
One sign that investor perceptions may be changing is the
recent appreciation of the equity market even as the yen
has strengthened (see Figure 18). In the past, it has typically
been the case that equity market strength has been seen in
times of yen weakness and vice versa. The explanation is
that as Japanese companies are highly exposed to
conditions in world markets, a weaker yen improves
profitability; and the opposite is the case with a stronger
yen. The recent break of that link may be a reflection of a
willingness to judge the Japanese equity market not just as a
‘yen play’ but more on its own intrinsic merits. In our view,
that changed perception would be correct.
ASIA
Growth in Asian developing economies remains superior to that in other
developing economies and in the advanced economies. There is reason to
believe this will continue for some time.
Trade recovery
GDP growth in Asian developing economies (a group of 30
countries identified by the IMF, the largest of which are
China, India and Indonesia) is forecast by the IMF to be
6.4% in real terms in 2017 (see Figure 19). That is, not
unsurprisingly, more than three times higher than growth
in the advanced economies (including the US, UK,
eurozone and Japan); but, more surprisingly, it is also three
times faster than growth in other developing economies in
the world.
19. Emerging Asian growth
12
improvements around the world. Globally, McKinsey
research estimates a need for additional infrastructure
spending of US$3.3 trillion per year over the next 15 years
(US$49 trillion in total) just to sustain current projected
economic growth rates; further spending would be needed
to boost growth.7
Japan-Korea tunnel
So, even though China currently spends more on its
infrastructure (just under US$1 trillion per year) than North
America and western Europe combined, much more still
needs to be done on the basis of such estimates.
20. Japan-Korea tunnel?
10
8
6
RUSSIA
CHINA
% 4
Tsushima
2
NORTH
KOREA
0
-2
-4
1990
1995
2000
2005
2010
2015
2020
Asian developing economies
Advanced economies
Other developing and emerging economies
Honshu
Three tunnel options suggested:
SOUTH
KOREA
JAPAN
Busan
A
Karatsu - Tsushima (South)
- Geoje (209km)
B
Karatsu - Tsushima (North)
- Geoje (217km)
C
Karatsu - Tsushima (North)
- Busan (231km)
Geoje
Tsushima
Iki
Fukuoka
Karatsu
Shikoku
Source: IMF World Economic Outlook database. Data as at 22 June 2017.
Kyushu
The growth advantage of developing Asia is expected to
persist in coming years. In our asset allocation, we have
shifted to favour Asia over other developing markets
recently, not just because of this growth advantage but
because of the region’s longer-term fundamental strengths.
Fundamental strengths
Three of these are particularly noteworthy. First, a
‘demographic dividend’ – generally growing and younger
populations than in the developed world, a trend that is
most pronounced in India. Second, a move towards more
business friendly policies in many, if not all economies.
Third, the ‘demonstration effect’ provided by China in recent
years. China provides a model of economic development
which it is now sharing with other economies in the region.
Its ‘one belt one road’ scheme, a US$1 trillion infrastructure
spending plan covering as many as 65 countries, not just in
Asia, is particularly noteworthy in this respect.
Infrastructure: much maligned but the key ingredient?
Infrastructure projects, however, are often maligned as a
source of wasteful spending on ‘vanity projects’ and ‘roads
to nowhere’. Some clearly fall into such categories. But
there is, equally, a real need for infrastructure
7
Iki
Source: The Chosun Ilbo (http://english.chosun.com/site/data/html_dir/2007/05/11/2007051161010.html)
One ambitious project, discussed for several years and
which may now be more likely to proceed, is a tunnel from
Japan to South Korea (see Figure 20). The tunnel would be
around four times the length of the Channel Tunnel linking
the UK and France. Preliminary estimates put the cost at
around US$20bn (see Figure 21).
21. Asian infrastructure projects
USD
billion
Status
Completion
date
China South-North Water Transfer Project
78
Under
consideration
2067?
Japan-Korea tunnel
20
Under
consideration
2040?
Beijing Daxing Airport
13
Under
construction
2025
Hong Kong-Zhuhai-Macau bridge/tunnel
11
Under
construction
2021
Source: http://www.visualcapitalist.com/worlds-largest-megaprojects/
The tunnel would cut transportation costs between the two
economies significantly, create an economic zone centred on
Japan and South Korea and may well stimulate efforts to
bring North Korea into the global market economy, even
though that may currently seem a distant prospect.
McKinsey Global Institute, Bridging Global Infrastructure Gaps, June 2016.
Insight Q3 2017 | 9
LATIN AMERICA
Corruption and measures to address it are once again at the forefront of the
Latin American policy debate. Tackling the issue is key to achieving sustained
economic growth.
Corruption in the spotlight
In Brazil, the acquittal of President Michel Temer (and his
predecessor Dilma Rousseff) on charges of soliciting
illegal campaign donations could have proved an
important step in demonstrating that the economy is
becoming less corrupt, had it not been swiftly followed by
new corruption allegations.
Michel Temer himself claims that his attempts to ‘clean up’
the economy led to the expansion of GDP in the first
quarter of the year after eight quarters of decline. The
claim lacks credibility mainly because the link between
corruption and economic prosperity is one which tends to
be seen over long, not short, time horizons. ‘Cleaning up’
an economy’s institutions, public offices and legal system
is not a quick win. That, indeed, is why it is often so difficult
to achieve.
Prosperity and corruption
The link between GDP per head and perceived levels of
corruption, measured by the Transparency International
Corruption Perceptions Index (CPI), is shown in Figure 22. A
CPI score of 100 would represent a perfectly clean
economy. No country achieves that: the highest-ranking are
New Zealand, Denmark and Finland with scores in the high
80s/low 90s. Libya, Sudan, Yemen and Afghanistan occupy
the other extreme.
22. Prosperity and corruption
improved its ranking in the last five years. Chile has,
indeed, slipped backwards as have Brazil and Mexico.
Argentina is one of only the few countries in the region to
have made strong gains recently, reflecting the
implementation of President Macri’s policies.
Going sideways
The potential for this to translate into an improvement in
prosperity is evident from the fact that Argentina’s GDP per
head has remained around one-third of the US level (see
Figure 23) since 1990. Indeed, that sideways trend has been
the general pattern across the entire Latin American
region. There is no economy that has emulated the rapid
rise seen in China, despite the fact that China is an
important market for Latin American exports.
23. Latin America: going sideways?
100
50
25
%
13
6
3
1990
1995
2000
2005
2010
2015
2020
2025
GDP per capita at Purchasing Power Parity (PPP) as a % of the US level in:
China
Brazil
Argentina
Venezuela
Colombia
Mexico
Chile
256,000
Source: Oxford Economics. Data as at 22 June 2017.
GDP per head at PPP (USD)
128,000
64,000
Argentina
Mexico
32,000
16,000
Ecuador
Venezuela Paraguay
8,000
Apart from corruption, the region’s commodity dependence
is a weakness. Latin America has been less successful than
rapidly-growing Asian emerging markets in making the
transition to export-based manufacturing industries, with
Mexico an obvious exception.
Panama
Brazil
Chile
Uruguay
Colombia
Peru
Bolivia
4,000
2,000
1,000
500
0
10
20
Highly corrupt
30
40
50
60
Corruption Perceptions Index
70
80
90
100
Very clean
Source: IMF World Economic Outlook database; Transparency International Corruption Perceptions Index 2017
A score below 50 indicates that the level of corruption is a
serious impediment to the efficient allocation of resources
and economic growth.
100-year debt
Improving investor attitudes to Argentina are demonstrated
by the recent strong demand for its 100-year US$denominated bonds. It has joined Mexico in issuing such
debt, but without the benefit of an investment-grade rating,
having only recently returned to international bond markets.
Given that Argentina has defaulted on its sovereign debt
eight times since 1824,8 investors are clearly giving the
economy and its policymakers the benefit of the doubt.
Only two economies in Latin America – Chile and Uruguay
– score above 50. However, neither of those economies has
8
Reinhart and Rogoff, This time is different: eight centuries of financial folly, Princeton University Press 2009.
10 | Insight Q3 2017
SPECIAL FOCUS – THE OIL MARKET
One of our key predictions for 2017 was that the oil price would be capped at
US$60-65 per barrel. Half-way through the year, it is well below that level.
24. Oil price in 2017
25. US crude oil production
10.0
9.5
Million barrels per day
Short-term price weakness
At the start of the year, we predicted that the oil price
would not move substantially higher during the year and
that the price of Brent crude oil (the European benchmark)
would be capped at US$60-65 per barrel. So far, that price
has dropped to US$46 per barrel; and the US benchmark
(for WTI, West Texas Intermediate oil) has remained around
US$3 per barrel lower (see Figure 24) .
9.0
8.5
8.0
7.5
7.0
6.5
6.0
58
5.5
2012
56
52
50
48
2015
2016
2017
44
Jan
Brent
Feb
Mar
Apr
2017
West Texas Intermediate
May
Jun
Source: Thomson Reuters Datastream. Data as at 22 June 2017.
Sub-US$50 until 2021?
Some market commentators have turned notably more
bearish on the oil price in the short-term. That is based on
a recent build-up in inventories and, the underlying cause
of that, continued strong production levels in the context
of a modest demand increase. Strong production, in turn,
reflects three main developments: within OPEC, cuts in
Saudi Arabian production have been more than offset by
increased production from other OPEC members; a pick-up
in US output (see Figure 25); and a rise in the amount
produced by other non-OPEC countries (such as Russia).9
Too bearish?
Our models suggest that while there may be some further
short-term weakness in the oil price, futures market pricing
(that the WTI price will not rise above US$50 per barrel
until 2021) is broadly supported by expected supply and
demand trends.
Longer-term trends
Oil is an industry in which the alignment of supply and
demand is, however, notoriously difficult.
Looking back, it has often been the case that high oil
prices have resulted, with a lag, in additional supply, which
typically becomes available as demand softens in response
to previously high prices. For example, after the first and
second ‘oil shocks’ of the mid and late 1970s (see Figure 26)
the real oil price drifted lower, with a sharp lurch
downwards in the mid-1980s (reflecting excess production).
It was not until the mid-2000s that the oil price (in today’s
real terms) exceeded US$40 again.
26. Oil prices: shock and bore
160
140
120
100
USD
USD per barrel
2014
Source: Citigroup, Thomson Reuters Datastream. Data as at 22 June 2017.
46
9
2013
US crude oil production
54
42
2012
80
60
40
20
0
1960
1965
1970
1975
Oil price, USD per barrel*
1980
1985
1990
1995
2000 2005
2010
2015
Real terms (deflated by US CPI)
*Brent oil price since 1970; Arabian Light posted at Ras Tanura from 1960-1970.
Source: Citigroup, Thomson Reuters Datastream. Data as at 22 June 2017.
Looking ahead, two new dynamics are important. First, on
the supply side, new techniques (fracking and horizontal
drilling) allow for much more flexible production: this can
be increased more quickly in response to rising demand
and prices, thereby dampening price spikes. Second, we
may well be seeing the start of a long-term decline in oil
usage, driven by the rise of alternative energy sources,
greater use of electric cars and improved battery storage.
Balancing supply and demand will be no easier in the
future than it has been in the past.
See EFG’s InFocus ‘Five questions on OPEC and oil prices’, July 2017.
Insight Q3 2017 | 11
Important Information
This document does not constitute and shall not be construed as a prospectus,
advertisement, public offering or placement of, nor a recommendation to buy,
sell, hold or solicit, any investment, security, other financial instrument or other
product or service. It is not intended to be a final representation of the terms
and conditions of any investment, security, other financial instrument or other
product or service. This document is for general information only and is not
intended as investment advice or any other specific recommendation as to any
particular course of action or inaction. The information in this document does
not take into account the specific investment objectives, financial situation or
particular needs of the recipient. You should seek your own professional advice
suitable to your particular circumstances prior to making any investment or if
you are in doubt as to the information in this document.
Although information in this document has been obtained from sources believed
to be reliable, no member of the EFG group represents or warrants its accuracy,
and such information may be incomplete or condensed. Any opinions in this
document are subject to change without notice. This document may contain
personal opinions which do not necessarily reflect the position of any member
of the EFG group. To the fullest extent permissible by law, no member of the
EFG group shall be responsible for the consequences of any errors or omissions
herein, or reliance upon any opinion or statement contained herein, and each
member of the EFG group expressly disclaims any liability, including (without
limitation) liability for incidental or consequential damages, arising from the
same or resulting from any action or inaction on the part of the recipient in
reliance on this document.
The value of investments and the income derived from them can fall as well as
rise, and past performance is no indicator of future performance. Investment
products may be subject to investment risks involving, but not limited to,
possible loss of all or part of the principal invested.
The availability of this document in any jurisdiction or country may be contrary
to local law or regulation and persons who come into possession of this
document should inform themselves of and observe any restrictions. This
document may not be reproduced, disclosed or distributed (in whole or in
part) to any other person without prior written permission from an authorised
member of the EFG group.
This document has been produced by EFG Asset Management (UK) Limited for
use by the EFG group and the worldwide subsidiaries and affiliates within the
EFG group. EFG Asset Management (UK) Limited is authorised and regulated by
the UK Financial Conduct Authority, registered no. 7389746. Registered address:
EFG Asset Management (UK) Limited, Leconfield House, Curzon Street, London
W1J 5JB, United Kingdom, telephone +44 (0)20 7491 9111.
If you have received this document from any affiliate or branch referred to below,
please note the following:
Bahamas: EFG Bank & Trust (Bahamas) Ltd. is licensed by the Securities
Commission of The Bahamas pursuant to the Securities Industry Act, 2011 and
Securities Industry Regulations, 2012 and is authorized to conduct securities
business in and from The Bahamas including dealing in securities, arranging
deals in securities, managing securities and advising on securities. EFG Bank
& Trust (Bahamas) Ltd. is also licensed by the Central Bank of The Bahamas
pursuant to the Banks and Trust Companies Regulation Act, 2000 as a Bank and
Trust company.
Bermuda: EFG Wealth Management (Bermuda) Ltd. is an exempted company
incorporated in Bermuda with limited liability. Registered address: Thistle House,
2nd Floor, 4 Burnaby Street, Hamilton HM 11, Bermuda.
Cayman Islands: EFG Bank is licensed by the Cayman Islands Monetary Authority
for the conduct of banking business pursuant to the Banks and Trust Companies
Law of the Cayman Islands. EFG Wealth Management (Cayman) Ltd. is licensed
by the Cayman Islands Monetary Authority for the conduct of trust business
pursuant to the Banks and Trust Companies Law of the Cayman Islands, and
for the conduct of securities investment business pursuant to the Securities
Investment Business Law of the Cayman Islands.
Guernsey: EFG Private Bank (Channel Islands) Limited is licensed by the Guernsey
Financial Services Commission.
Hong Kong: EFG Bank AG is authorized as a licensed bank by the Hong Kong
Monetary Authority pursuant to the Banking Ordinance (Cap. 155, Laws of Hong
Kong) and is authorized to carry out Type 1 (dealing in securities) and Type 9
(asset management) regulated activity in Hong Kong.
Jersey: EFG Wealth Solutions (Jersey) Limited is regulated by the Jersey Financial
Services Commission in the conduct of investment business under the Financial
Services (Jersey) Law 1998.
Liechtenstein: EFG Bank von Ernst AG is regulated by the Financial Market
Authority Liechtenstein, Landstrasse 109, P.O. Box 279, 9490 Vaduz, Liechtenstein.
12 | Insight Q3 2017
Luxembourg: EFG Bank (Luxembourg) S.A. is listed on the official list of banks
established in Luxembourg in accordance with the Luxembourg law of 5 April
1993 on the financial sector (as amended) (the “Law of 1993”), held by the
Luxembourg supervisory authority (Commission de surveillance du secteur
financier), as a public limited company under Luxembourg law (société anonyme)
authorised to carry on its activities pursuant to Article 2 of the Law of 1993.
Luxembourg residents should exclusively contact EFG Bank (Luxembourg) S.A.,
56 Grand Rue, Luxembourg 2013 Luxembourg, telephone +352 264541, for any
information regarding the services of EFG Bank (Luxembourg) S.A.
Monaco: EFG Bank (Monaco) SAM is a Monegasque Public Limited Company with
a company registration no. 90 S 02647 (Registre du Commerce et de l’Industrie
de la Principauté de Monaco). EFG Bank (Monaco) SAM is a bank with financial
activities authorized and regulated by the French Prudential Supervision and
Resolution Authority and by the Monegasque Commission for the Control
of Financial Activities. Registered address: EFG Bank (Monaco) SAM, Villa les
Aigles, 15, avenue d’Ostende – BP 37 – 98001 Monaco (Principauté de Monaco),
telephone: +377 93 15 11 11. The recipient of this document is perfectly fluent in
English and waives the possibility to obtain a French version of this publication.
People’s Republic of China (“PRC”): EFG Bank AG Shanghai Representative
Office is approved by China Banking Regulatory Commission and registered
with the Shanghai Administration for Industry and Commerce in accordance
with the Regulations of the People’s Republic of China for the Administration
of Foreign-invested Banks and the related implementing rules. Registration No:
310000500424509. Registered address: Room 65T10, 65 F, Shanghai World Financial
Center, No. 100, Century Avenue, Pudong New Area, Shanghai. The business scope
of EFG Bank AG Shanghai Representative Office is limited to non¬profit making
activities only including liaison, market research and consultancy.
Singapore: The Singapore branch of EFG Bank AG (UEN No. T03FC6371J) is licensed
by the Monetary Authority of Singapore as a wholesale bank to conduct banking
business and additionally carries on the regulated activities of dealing in
securities, fund management and securities financing.
Switzerland: EFG Bank AG, Zurich, including its Geneva branch, is authorized
and regulated by the Swiss Financial Market Supervisory Authority (FINMA).
Registered address: EFG Bank AG, Bleicherweg 8, 8022 Zurich, Switzerland and EFG
Bank SA, 24 quai du Seujet, 1211 Geneva 2, Switzerland.
Taiwan: EFG Securities Investment Consulting Co. Ltd, Suite A-1, 14th Floor, Hung
Tai Center, No. 168 Tun Hwa North Road Taipei, +886 2 8175 0066, SICE License
No. BO286.
United Kingdom: EFG Private Bank Limited is authorised by the Prudential
Regulation Authority and regulated by the Financial Conduct Authority and the
Prudential Regulation Authority, registered no. 144036. EFG Private Bank Limited
is a member of the London Stock Exchange. Registered company no. 2321802.
Registered address: EFG Private Bank Limited, Leconfield House, Curzon Street,
London W1J 5JB, United Kingdom, telephone +44 (0)20 7491 9111. In relation
to EFG Asset Management (UK) Limited please note the status disclosure
appearing above.
United States: EFG Asset Management (UK) Limited is an affiliate of EFG Capital,
a U.S. Securities and Exchange Commission (“SEC”) registered broker-dealer
and member of the Financial Industry Regulatory Authority (“FINRA”) and the
Securities Investor Protection Corporation (“SIPC”). None of the SEC, FINRA or
SIPC, have endorsed this document or the services and products provided by
EFG Capital or its U.S. based affiliates, EFGAM Americas and EFG Capital Advisors
(EFGCA). Both EFGAM Americas and EFGCA are registered with the SEC as
investment advisers. Securities products and brokerage services are provided by
EFG Capital, and asset management services are provided by EFGAM Americas
and EFGCA. EFG Capital, EFGAM Americas and EFGCA are affiliated by common
ownership and may maintain mutually associated personnel. This document
is not intended for distribution in the United States or for the account of U.S.
persons (as defined in Regulation S under the United States Securities Act of
1933, as amended (the “Securities Act”)) except to persons who are “qualified
purchasers” (as defined in the United States Investment Company Act of 1940,
as amended (the “Investment Company Act”)) and “accredited investors” (as
defined in Rule 501(a) under the Securities Act). Any securities referred to in this
document will not be registered under the Securities Act or qualified under any
applicable state securities statutes. Any funds referred to in this document will
not be registered as investment companies under the Investment Company Act.
Source information
The source for data used in this publication is Thomson Reuters Datastream, as
at 22 June 2017, unless otherwise stated.