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ETF Securities | The intelligent alternative | September 2016
Big picture
Thinking outside the box
Implications of the rise of political
populism. Page 2
Exploring rising global infrastructure
needs. Page 12
Multi-Asset Strategist
Bond investing in the ‘New
Normal”. Page 4
Robotics – boon rather than bane to
society. Page 14
Nitesh Shah
GBP reaches rock bottom. Page 6
In sync: gold and the USD. Page 16
Oil stuck in US$40-55/bbl range.
Page 8
America’s infrastructure frustrations.
Page 18
European equities to play catchup. Page 10
A bridge between research and the
investment world. Page 20
James Butterfill
Head of Research & Investment Strategy
Martin Arnold
Global FX & Commodity Strategist
Edith Southammakosane
Commodities Strategist
Aneeka Gupta
Equity & Commodities Strategist
Morgane Delledonne
Fixed Income Strategist
The unintended consequences of QE
The greatest experiment in monetary policy history, quantitative easing (QE),
has led to two primary benefits: liquidity and confidence. QE has also led to
distortions in the investment world, with bond yields falling into negative
territory for the first time in history. Opinions on monetary policy are deeply
polarised; with some investors rushing to safe havens signifying concern over
monetary policy effectiveness at a time when equity markets are achieving alltime-highs.
There is now growing disquiet amongst investors regarding the fate of the bond
market, and the risk of the bond bubble bursting. Many investors believe a
sharp rise in inflation is probable, presaging a bond market sell-off. Whilst we
believe inflation will continue to rise and that central banks are in the early
stages of losing their credibility, it is unlikely to rise fast enough to discredit
them at this juncture. Bonds have a different buyer now, namely central banks
who have a different reason for buying: buying bonds as a monetary policy tool
rather than as an investment, keeping rates lower for longer.
Monetary policy has also contributed to inequality and the consequent rise of
political populism as has been witnessed in party polling in the developed
world. We believe that the rise of populist parties, elected or not, is a powerful
catalyst for reform, with incumbent parties scrambling to counter the populist
wave by implementing similar policies. We expect economic stimulus to shift
solely from monetary policy to include fiscal policy with the end result being a
rise in infrastructure spend and social initiatives to combat inequality,
prompting higher inflation.
The eventual unwinding of quantitative easing and unprecedented loose
monetary policy is likely to lead to volatility in markets, as was witnessed when
the US Federal Reserve initiated its first rate hike in December 2015. The
longer loose monetary policy continues, the more volatile the unwind is likely
to be as it increases investor perception that central banks are losing confidence
in their ability to deliver on their mandate. Furthermore, raising interest rates
now is likely to cause pain for the already populist minded electorate.
We favour assets which perform well in a moderate inflationary/populist
environment, such as equities, inflation linked bonds, precious metals and
infrastructure.
2
ETF Securities Outlook – September 2016
Implications of the rise of political populism
By James Butterfill – Head of Research & Investment Strategy | [email protected]
Summary
Populist parties are leading the polls in many
developed world countries due to inequality, weak
economic growth and a disenfranchised electorate.
Populist party policies are likely to lead to inflation.
Inequality and QE appear to go hand-in-hand. Is it
cause or effect? We do not know yet.
Protect portfolios from populism by targeting assets
which perform well in an inflationary environment.
Defining populism
Something unusual is happening in modern politics that is
threatening to destabilise incumbent political parties in the
developed world. Populism is a term being used more and more
in the media although there isn’t much consensus on its
definition. An academic paper written by Ionescu and Gellner in
1964 suggested that “populism worships the people”, and
questioned if it had an underlying unity or the name covering a
multitude of unconnected tendencies. In some respects, it isn’t
an ideology but a mode of political expression that is employed
selectively and strategically, targeting issues of mass appeal.
Populist Party Polling
49
Brexit UK
Trump US
% of total polling
44
39
FPO Austria
34
5* Italy
29
Le Pen France
24
03/2016
04/2016
05/2016
06/2016
07/2016
08/2016
09/2016
Source: RealClearPolitics, Wikipedia, ETF Securities as of close 8 September 2016
The term populism in today’s context is similar, in that it
reflects a varied demographic, being an eclectic group of voters
from both the left and right. The issues are often viewed as the
ordinary man oppressed by a remote elite to issues regarding
immigration or national sovereignty. The EU Referendum in the
UK highlighted how seemingly arcane issues can rapidly
become a mainstream school of thought. This rise of populist
politics in the UK is being mirrored across the developed world
with many populist parties rising in the polls and often leading
in them.
Populism – why now?
Populist parties in the EU have grown significantly in recent
years. Typically, the agendas of these parties have focussed on a
break from the incumbent political establishment. Populist
parties tend to overpromise, developing simple policies with
mass appeal, irrespective of their ability to be delivered.
Why has this phenomenon begun now? There do seem to be
some key drivers of today’s rise in populism, primarily high
inequality, generated by stagnant economic and wage growth
alongside increasing cultural diversity. But in the UK for
instance, traditional indicators such as the GINI coefficient
suggests the income gap has shrunken, although we believe this
is potentially misleading.
Inequality and stimulus
Though inequality is notoriously difficult to measure, the
traditional metric, the GINI coefficient, has issues in the
populism context as it is insensitive to the differences between
the richest and poorest. Populism is associated with the
ordinary man being oppressed by a remote elite and therefore a
metric for inequality such as the Palma ratio is more
appropriate as it measures the ratio between the top 10% of
earners versus the bottom 40%. Gabriel Palma, who developed
the ratio, implied in his work that globalisation is creating a
distributional scenario in which what really matters is the
income–share between the rich and lower income workers with
ever more precarious jobs in ever more ‘flexible’ labour markets.
Palma ratios (2013/14) across the OECD
Chile
Mexico
United States
Turkey
Israel
United Kingdom
Spain
Portugal
Greece
Italy
Canada
France
Germany
Austria
Norway
Iceland
0
0.5
1
1.5
2
2.5
Source: Bloomberg, ETF Securities as of close 8 September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
3
3
ETF Securities Outlook – September 2016
What the Palma ratio highlights is that some of the greatest
inequalities in the OECD are places where we have witnessed
some of the most significant populist uprisings.
The impact of Uncertainty
100%
Inequality versus Quantitative Easing
80%
3200
y oy change
1.16
Average Palma ratio of Spain,
Italy, France, Germany & Austria
(LHS)
2700
1.14
2200
1.12
1700
European Central Bank
Balance sheet (lag-1yr) (RHS)
1.1
1.08
2003
1200
700
2005
2007
2009
2011
2013
Russel 1000 defensives/dynamics
50%
defensives
ouperform
2015
Source: OECD, Bloomberg, ETF Securities as of close 8 September 2016
Quantitative Easing (QE) does appear to be exacerbating
inequality. Taking the average Palma ratio of those countries in
Europe where populist parties are leading or rising significantly
in the polls, namely Austria, France, Germany, Italy and Spain,
there is a positive correlation between the two.
Inequality and QE appear to go hand-in-hand. Is it cause or
effect? We do not know yet. But what is clear is that QE has
been very beneficial for equities and bonds and that only the
relatively wealthy have access to them.
Populism – implications for investments
and the economy
One of the more immediate effects of populism has been the rise
in uncertainty prompting investors to flock to quality and
defensive equities. Historically there has been a close
correlation between rising uncertainty and an appetite for
defensive equities. Although not as strongly correlated, demand
for gold, often seen as a safe haven, rises in times of rising
uncertainty.
When populists have historically won in emerging markets,
there is often a rise in infrastructure spending which
temporarily raises growth in output, real wages and
employment, but quickly gives way to hyperinflation which
erodes the initial gains. But in the developed world populists in
opposition tend to be more successful than populists in office,
populists are often inexperienced politicians and the barriers to
reform implementation are too difficult to overcome.
40%
60%
30%
40%
20%
20%
10%
0%
0%
-20%
EUR bn
Depriv ation as a % of total population
1.18
60%
Policy Uncertainty Index (LHS)
-40%
-60%
relativ e y oy change
120%
-10%
dynamics
ouperform
-80%
1998 1999 2001 2003 2005 2006 2008 2010 2012 2013 2015
-20%
-30%
-40%
Source: Policyuncertainty.com, ETF Securities as of close 09 September 2016
Rising inflation from populism could add to already strong
inflationary pressures in the US. Supply-side destruction in
commodities could add further waves of inflationary pressure.
In an inflationary environment, index linked bonds are likely to
perform well. With inflation expectations particularly low at this
juncture it is an opportune time for long-term investors to build
positions in index-linked products.
Populist policies in the US, which are likely to include tax cuts,
prompting a widening of the budget deficit, could weaken the
US dollar in the coming years. Furthermore, protectionist
policies that could constrict international trade and investment
are likely to exacerbate global currency volatility, in turn
contributing to further investor uncertainty.
Over the coming year, there are many elections scheduled
where populist parties are gaining traction. As inequality issues
cannot be reversed overnight, we believe uncertainty is likely to
remain elevated in the coming year, favouring safer, lower
volatility assets. Whilst rising populism doesn’t always end up
with the political incumbent losing, some populist policies are
typically implemented to assuage the disenfranchised, which
are likely to be inflationary.
Investors can protect investment portfolios by gaining exposure
to assets which perform well in an inflationary environment,
such as equities, inflation linked bonds, precious metals and
infrastructure.
Regardless of the success of populism at elections, populist
momentum can be a very powerful catalyst for reform, with
incumbent parties scrambling to counter the populist wave. The
end result is typically a rise in infrastructure spend to stimulate
economic growth and social initiatives to combat inequality.
Infrastructure spend creates additional demand whilst social
initiatives are likely to lead to an increase in consumer spending
with the end result being a likely rise in inflation.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
4
ETF Securities Outlook – September 2016
Bond investing in the “New Normal”
By Morgane Delledonne – Associate Director – Fixed Income Strategist | [email protected]
QE. Additionally, our study shows that QE performed best in
more financially integrated economies such as the US and UK.
Overall, QE programmes helped economies to recover from the
financial crisis but only at a modest pace.
Summary
The “new normal” paradigm – slow growth, low
yields and high volatility – requires lower central
bank nominal interest rates than in the past.
Global rate outlook: lower for longer
Quantitative Easing (QE) programmes provide
opportunities to collect roll-down yield at the front
end of the yield curve and nominal capital gain on
long-dated bonds.
Duration risk prevails in the “new normal”
environment, as long as the pace of the global
recovery remains modest.
QE as monetary policy response to the “New
Normal”
The “new normal” paradigm requires lower benchmark rates
than in the past. One of the most prominent examples of this is
the decline of the estimated “natural interest rate” (i.e. the
interest rate at which real GDP is growing at its trend rate and
inflation is stable) in the US in the last decade. Historically, the
tightening cycles of the Fed resulted in an average of 380 bps
increase of the effective Fed Funds rate. Now, considering the
shadow rate1 the Fed has already increased its base rate by 337
bps since the end of the QE programme in November 2014, well
before inflation started to pick up. As a result, the Fed would
reach its natural interest rate level by only increasing the Fed
Funds rate by 25 bps or 50 bps.
The 2008 financial crisis reshaped the global financial and
economic landscape, resulting in a “new normal” environment
of anaemic growth, low interest rates and a high level of
unemployment. In response, central banks and governments
have engaged a series of unconventional monetary and fiscal
policies to help restore the banking system and boost growth in
developed economies.
US tightening cycle began Nov-2014
10
Fed Shadow rate
Effective Fed Funds Rate
7
Inflation CPI (rhs, yoy%)
Fed Natural interest rate
6
8
5
6
4
3
4
2
2
QE Performance Index
250
1
0
0
Fed QE2
Nov-10
Fed QE3
Sep-12
End of QE
Oct-15
US
BoJ QE2
Oct-10
BoJ QE3
Apr-13
-1
-2
200
UK
BOE QE2
Nov-11
150
Start of
QE
100
JN
EU
Years
0
1
-3
1995
2000
2005
2010
2015
Source: Wu and Xia (201 4), Williams and Laubach (2003), Federal Reserve, ETF Securities as of close 1 2
August 2016
50
0
-4
1990
-2
2
3
4
5
6
7
8
9
10
11 12
13
14
15
Source: Bloomberg, ETF Securities as of close 1 0 August 2016
Note: The QE Performance Index is based on a series of monetary and
macroeconomic indicators related to the transmission channels. The index
displays the pace of the convergence of an economy toward the mandates of its
central bank following the first announce of QE - UK (Mar-09=100), US (Nov08=100), Eurozone (Jun-15=100), Japan (Mar-01=100).
We found that the quantitative easing programmes generally
succeeded at reviving the economy but with a considerable lag
of two to three years and the effectiveness of monetary
transmission increases with the number of successive rounds of
Overall, the current “new normal” environment requires
negative policy rates as recommended by most policy rules (e.g.
Taylor rule), that conventional policy tools alone cannot
achieve. The use of QE programmes in major advanced
economies has generally been associated with a continuing
decline in the level of the shadow rate — that is, an easier policy
stance. QE also pushes short term rates into further negative
territory, leading to the steepness at the front end of the yield
curves and opportunities to collect roll-down yield.
1
Black (1995) provided a way to calculate the value of the call option to hold
cash at the zero lower bound. The shadow nominal yield is the observed
nominal yields minus the value of the cash option.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
5
ETF Securities Outlook – September 2016
%
8
Higher volatility
Shadow Rates: QE allows more negative short
term rates
6
4
2
Fed
0
-2
BoE
-4
-6
Sep-04 Jan-06 May-07 Sep-08 Jan-10 May-11
ECB
Sep-12
Jan-14 May-15
Source: Wu and Xia (201 4), Chicago Booth, ETF Securities as of close 1 0 August 2016
The massive stimulus from central banks have also distorted the
fixed income market. By continuously pushing asset prices
higher (and yields lower), the global economy and market have
become increasingly reliant on these interventionist measures.
As a result, any changes in market expectations on the future
policy stance results in high levels of volatility – as investors
fear a sudden stop of this bull trend. A series of market events
such as the “Taper tantrum” in the US in mid-2013 and more
recently the UK Gilt rally2 and the Japanese government bonds
(JGBs) sell-off are glaring examples of how sensitive the market
is to changes in QE anticipation. This continued shift between
“risk on/risk-off” periods has increased the overall volatility in
fixed income.
Lower yields
110
The movements in global interest rates tend to be more
correlated with each other than before the QE area, reflecting
common global factors (global public and private deleveraging,
ageing populations, reshaping of the banking system). Cyclical
and structural challenges led long term real interest rates to
decline since the 1990s, mainly because of lower inflation
expectations and lower expected return to capital investment.
12
JGBs sell-off
100
90
UK Referendum
80
70
60
10-yr Government Bond Yield
14
10-yr Government Bond Yield (performances
YTD)
JN
US
UK
EU
US Treasury
50
EUR Composit
40
UK Gilt
BoE announced an
additional £60bn UK
Gilts purchase
JGB
30
20
Dec-15
10
Jan-16
Feb-16
Mar-16
Apr-16
May-16
Jun-16
Jul-16
Aug-16
Source: Bloomberg, ETF Securities as of close 9 September 2016
The environment of “new normal” – slow growth, low yields and
high volatility – favours duration risk, but limits the unsafe
“search for yield”. With the exception of the United States,
developed economies are likely to continue to provide monetary
stimulus until growth and inflation rebound, offering
opportunities for nominal capital gains in long-dated bonds.
8
6
4
2
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg, ETF Securities as of close 09 September 2016
In general, inflation expectations have been low and stable,
partly reflecting a higher level of credibility of central banks
delivering on their mandate of price stability and partly
signalling that investors are not convinced that future nominal
growth will increase. If they expected higher long term growth
(i.e. higher future inflation), investors would have sold their
long-dated bonds to central banks to secure their profits which
would have resulted in higher long term rates.
Because most expectations are derived from current economic
conditions, we expect real long term interest rates to remain low
as long as the pace of the global economic recovery remains
modest. In turn, central banks will be forced to keep long term
nominal interest rates low. QE programmes have been efficient
tools to achieve this goal through the purchase of long dated
bonds, leaving opportunities for nominal capital gains.
2
Investors repriced lower the Gilts yield curve after the BoE increased the gilt
purchases target by £60bn, while investors sold-off long-dated JGBs is a
response to rising doubts around the size and the duration of the Japanese
QQE ahead of its upcoming review in September.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
6
ETF Securities Outlook – September 2016
GBP reaches rock bottom
By Martin Arnold – Director –FX & Macro Strategist | [email protected]
Summary
The EU Referendum sent GBP plunging over 10% to
its lowest level since 1985. Imported food and fuel
will boost inflation above the Bank of England target
as a result.
GBP moves inversely to volatility
1.75
0.0
1.65
7.0
1.55
14.0
GBP/USD (lhs)
Economic decline appears inevitable as business
and housing investment is expected to slump and
the UK’s credit rating is downgraded.
Economic weakness, aggressive central bank
stimulus and potential for a fiscal blowout are
largely priced into GBP, which is at or near its
structural nadir.
‘Leave’ fallout
The EU Referendum result sent shockwaves through financial
markets as Britain voted to ‘leave’ the European Union,
resulting in an 11% plunge in the British Pound in the days
following the vote.
Since the vote however, there has been no further clarity on
when Article 50 will be invoked, which will officially initiate the
two-year deadline to exit. New British Prime Minister May has
only stated that Britain will be leaving the European Union.
Uncertainty over the path for the UK’s membership exit of the
EU will only prolong the potentially adverse effects on the
domestic economy. The timing of the enactment of Article 50 is
arguably as important as the final structure of trade
relationships of the UK with the EU.
Assessing the damage
Elevated currency volatility has been a key feature of markets in
2016, driven higher by central bank policy and one off events
like the EU Referendum.
The British Pound has been particularly susceptible to these
periods of volatility and currently is languishing near 30 year
lows against the USD. However, with some sense of relative
calm restored to markets after the Bank of England move to
support the domestic economy, volatility has moderated, while
the GBP rebound remains lacklustre.
1.45
Volatility (rhs) (inverted)
21.0
1.35
28.0
1.25
2014
35.0
2014
2015
2015
2016
2016
Source: Bloomberg, ETF Securities as of close 09 September 2016
Imported inflation
Inflation initially has surprised to the upside, posting the largest
increase since November 2014. In July, CPI rose 0.6% from a
year ago, while core inflation is sitting at 1.3%. Imported
inflation resulting from the weaker GBP is the main avenue for
inflation lifting in the year ahead, via imported food and fuel.
Food and beverages account for around 15% of the UK CPI
basket.
Imported food to boost CPI
60
18
UK CPI Food yoy% (rhs)
50
15
UK PPI imported food yoy% (lhs)
40
12
30
9
20
6
10
3
0
0
-10
-3
-20
1997
-6
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: Bloomberg, ETF Securities as of close 09 September 2016
The 10% drop in the GBP could therefore result in a 1% move
higher in CPI in the UK in the following 6-12 months after the
exchange rate movement. The Bank of England calculates in its
August 2016 inflation report that the impact from the EU
Referendum is likely to push inflation above its target by 2018.
We expect that the impact of the EU referendum on GBP, and in
turn domestic UK inflation, could potentially contribute to
inflationary expectations becoming unanchored. With fuel and
food prices set to boost CPI in coming months, a rebound in
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
7
ETF Securities Outlook – September 2016
price expectations could occur quite rapidly, putting the Bank of
England in a difficult position.
Bank of England runs the inflation gauntlet
Although inflation is expected to spike, the Bank of England has
cut rates and added QE stimulus to support the UK economy.
The central bank has indicated that there will be a 2.5%
cumulative reduction in growth by the end of its forecast period
in three years’ time compared to its May forecasts.
With added central bank purchases, rates have fallen along the
gilt curve and the plunge in GBP has mirrored the decline in
real interest rates.
GBP reacts to real rates
2.2
1.5
UK-US 10yr real rates (rhs)
GBP/USD (lhs)
2
0.7
1.8
-0.1
1.6
-0.9
1.4
-1.7
farmers scientists and universities when the UK leaves the EU.
Such a move is estimated by the Treasury to have been around
£6bn in 2014-15.
Despite the fiscal obscurity, credit ratings have been cut by
major agencies due to the negative outlook for the UK economy
and the potential UK budget blowout.
GBP overreacts to credit downgrade
1.9
0
GBP/USD (lhs)
1.8
20
UK 5yr CDS (bps, rhs, inverted)
1.7
40
1.6
60
1.5
80
1.4
100
1.3
120
1.2
2008
2009
2010
2011
2012
2013
2014
2015
140
2016
Source: Bloomberg, ETF Securities as of close 09 September 2016
1.2
2001
-2.5
2003
2005
2007
2009
2011
2013
2015
Source: Bloomberg, ETF Securities as of close 09 September 2016
While there is very little in the way of hard data to gauge the
impact of the EU Referendum, sentiment surveys suggest a
potentially precipitous decline in economic activity.
Economic activity to decline
60
Although forecasts of public sector net borrowing (PSNB) have
been generally moving in the right direction, they have also
broadly underestimated the amount the government would
need to borrow. In March 2016, the OBR estimated that the
government would be retiring debt by 2019-20, a year later than
originally predicted in the March 2015 Budget. With Britain
leaving the EU, this estimate is expected to again be pushed
back by several years when the November Statement is released.
Indeed, in July, the PSNB reduction of around 11% was less
than half the 26% cut required to meet budget forecasts.
Public Sector Net Borrowing
3
12.0
57
2
10.0
8.0
54
1
6.0
4.0
51
0
UK Industrial production (yoy%, rhs)
UK Manufacturing PMI (lhs)
48
-1
Actual (% of GDP)
F
o
r
e
c
a
s
t
March-2012
March -2013
March -2014
March -2015
March-2016
2.0
0.0
-2.0
45
-2
2014
2015
2016
Source: Bloomberg, ETF Securities as of close 09 September 2016
Business and housing investment are expected to be the worst
casualties in the domestic economy, potentially declining by
4.75% and 2%, respectively in 2017.
UK Budget to be ‘reset’
-4.0
2000- 2002- 2004- 2006- 2008- 2010- 2012- 2014- 2016- 2018- 202001
03
05
07
09
11
13
15
17
19
21
Source: OBR, ETF Securities as of close 17 August 2016
GBP has made a pre-emptive move lower as a result of the
potential for economic weakness stemming from Britain’s vote
to leave the EU. Such weakness appears to be fully priced in to
GBP. Although there is no immediate catalyst for gains, Sterling
should be near its structural floor.
The November Autumn Statement will be when new budget
targets are revealed. So far, though, little detail has been made
public with the new UK Chancellor Hammond, indicating only
that UK budget targets will need to be ‘reset’. The Chancellor
has also pledged to underwrite payments made by EU to
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
8
ETF Securities Outlook – September 2016
Oil stuck in US$40-55/bbl range
By Nitesh Shah – Director – Commodity Strategist | [email protected]
Summary
Non-OPEC cuts back
Oil and gas industry has announced US$1trn of
capex and exploration cuts, which will bite into
supply, with a lag.
Without new capex investment, OPEC will struggle
to raise production substantially.
Falling costs have brought breakevens down, but to
ensure future production, prices are unlikely to fall
sustainably below US$40/bbl.
Crude oil has had a volatile quarter. When oil prices reached
over US$52/bbl in July, US oil rigs started to switch back on
and inventory of refined products remained elevated, acting as a
drag on price. At the same time, OPEC continued to increase
production and unplanned outages reduced. Oil fell below
US$40/bbl at the beginning of August under these strains, only
to recover to US$50/bbl within three weeks. We believe this
range-trading will define oil markets over the coming quarters,
until the substantial cuts in capex bite into supply.
After two and half years of supply surplus, in Q3 2016, we
entered a supply deficit. We are likely to remain in a modest
deficit for most of the coming year. That will help eat into the
high levels of crude inventory, but a more substantial cutback in
supply will be needed to sustainably break-through US55/bbl.
Global oil balance
2.5
Non- OPEC production declining
q-o-q production growth
4%
3%
2%
1%
OPEC supply
0%
-1%
-2%
2.0
millions of barrels per day
As a result of the collapse in oil prices in November 2014, the oil
and gas industry has announced close to US$740bn of capex
cuts between 2015 and 2020, according to Wood Mackenzie’s
field analysis. When including the cuts to conventional
exploration investment, the figure increases to over US$1trn.
The US will see the quickest and deepest cuts (of US$125bn
between 2016-17 and a further US$200bn until 2020). The 80%
decline in US rig counts has driven the largest portion of the
non-OPEC production decline so far. The tight oil industry
which dominates the US is very nimble and production can
respond to price changes quicker than conventional oil.
Conventional oil supply takes time to respond to price changes.
For example, in the North Sea, where investment has been cut
by 36% since 2014 (US$27.5bn), Jan to May production in 2016
has outpaced production over the same period in 2015 and
2014. But 140 fields are expected to close in the UK over the
next 5 years (50 just in 2016 alone) and production for the
remainder of the year is expected to be below that of 2015.
Forecast
1.5
Non-OPEC
Supply
-3%
2Q 2013
4Q 2013
2Q 2014
4Q 2014
2Q 2015
4Q 2015
2Q 2016
Source: IEA, ETF Securities, August 2016
1.0
0.5
OPEC production trending lower
0.0
-0.5
-1.0
-1.5
1Q 2013
4Q 2013
3Q 2014
Source: IEA, ETF Securities, August 2016
2Q 2015
1Q 2016
4Q 2016
3Q 2017
Although the number of trackable outages has fallen in OPEC in
recent months, production in the block outside of Iran has
failed to reach the highs reached in October 2015. While Iranian
production is nearing its pre-sanction levels of 3.7mb/d very
quickly, we doubt that it can substantially raise production
further without a large injection of foreign investment. The
country is hoping to attract US$70bn of investment under a
new Iran Petroleum Contract (IPC). This plan is a modification
of the previous buy-back plan that was unpopular with foreign
investors due to its tight returns, rigidity and limited time span.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
9
ETF Securities Outlook – September 2016
While the new plan alleviates some concerns with the previous
programme, companies would be bound to the contract even if
the UN restores sanctions, and hence we believe it will be
difficult for Iran to attract sufficient funds. Interest in the new
contract has been underwhelming and hampered by the fact the
full details have not yet been disclosed.
US wellhead breakeven by play and spud year
90
2014
80
US$/Boe
Floor at US$40, cap at US$55
In this era of low prices, oil companies have been slashing their
costs to remain profitable. Breakeven oil prices have thus
tumbled. For example, US tight oil breakevens have fallen from
over US$80/bbl in 2014 to under US$40/bbl in 2016.
In Saudi Arabia, the fiscal breakeven (the price of oil for the
government to balance its spending and tax revenue), has fallen
from US$105.7/bbl in 2014 to US$66.7/bbl in 2016 according
to the IMF.
70
60
unavoidable as foreign oil service companies reduce their
activity and international oil companies face repayment issues.
2015
50
2016
40
US oil rig counts
30
1,800
20
1,600
10
1,400
0
Permian
Midland
Permian
Delaware
Niobrara
Eagle Ford
Bakken
Source: Ry stad, ETF Securities, July 2016
-80%
1,200
1,000
800
The increase in Saudi Arabian oil production in the last two
months has been to cater for its own seasonal increase in
consumption. In fact, Saudi Arabia has drawn down on stocks at
a rate of 285kb/d during January-April compared to an average
of 40kb/d during the same period in 2015, highlighting it is not
ramping up production as fast as it is selling it.
600
400
200
0
2002
2004
2006
2008
2010
2012
2014
2016
Source: Bloomberg, ETF Securities as of close 09 September 2016
OPEC ex-Iran production
thousand barrels per day
OPEC ex-Iran, Indonesia, Gabon
28,900
28,700
28,500
However, to ensure future production of oil meets global
demand, we don’t think that prices can fall that much lower
than US$40/bbl. For example, the breakeven for most new
onshore oil is $43/bbl and for new tight oil is US$65/bbl.
28,300
28,100
27,900
Global liquids cost curve
The market has been encouraged by recent discussions about
market stabilization by Russia and Saudi Arabia ahead of an
informal OPEC meeting expected in late September. However,
the lack of success with such discussions in the past lead us to
expect that OPEC supply will continue to modestly increase. We
expect a global supply deficit despite this modest increase in
OPEC supply.
Meanwhile Venezuela, which has been struggling with an
economic and political crisis, has seen its supply decline by
170kb/d as electricity shortages disrupted production.
According to the IEA a year-on-year drop of 200kb/d looks
100
80
Other
onshore
60
Shale/tight oil
Currently producing fields
40
20
0
60
65
70
75
80
85
90
95
Cumulative production in 2020, million barrels per day
Source: Rystad Energy research, March 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
Oil sands
Source: OPEC, ETF Securities,August 2016
120
offshore midwater
Sep 15 Oct 15 Nov 15 Dec 15 Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Jul 16
offshore deepwater
27,500
Brent equivalent break-even, US$/bbl
27,700
offshore shelf
29,100
As oil can be profitably produced at lower prices, we believe that
US$55/bbl represents a short-term cap as we expect production
in the nimble US market to increase. In fact, over the past 8
weeks, rig counts in the US have been rising, indicating that
tight oil produced from those rigs are likely to be profitable at
today’s price.
10
ETF Securities Outlook – September 2016
European equities to play catch-up
By Aneeka Gupta – Associate – Equity & Commodities Strategist | [email protected]
Summary
Heightened political and financial uncertainty in
Europe has caused the widest divergence on record
between US and European equity markets which we
expect to reverse as growth and earnings improve.
The confluence of declining margins and rising wage
growth is expected to hinder future US corporate
profitability while anaemic wage growth in Europe
will alleviate pressure on margins.
Domestic growth backs Europe’s recovery
The underlying trend in quarterly European economic growth
rates remains encouraging, supported by strong data from
Germany, Spain and the Netherlands. An improvement in
demand in Spain has helped narrow its output gap. We expect a
similar trend in the periphery to help eliminate spare capacity at
the aggregate level.
Output gap in Euro-area economy
1.0%
.5%
European equities offer the dual benefit of lower
valuations and higher dividend yields in comparison
to US equity markets.
.0%
-.5%
-1.0%
-1.5%
What’s driven the gap?
The US equity market has been rising rapidly, outperforming
European equities by 116% since 1987. A broader economic and
asset price recovery commenced earlier in the US than in
Europe. In the first phase, the global hunt for yield in the
current low interest rate environment drove investors into high
dividend yielding defensive US stocks. In the second phase,
cyclical stocks in the US have benefitted from rising global
investor confidence. Europe has failed to gain the confidence of
investors as rising NPLs in the Italian banking system and
Brexit have weighed on sentiment. However, a moderate second
quarter earnings reporting season, good credit growth, and
most banks passing their stress tests bodes well for European
equities. This draws us to conclude that Europe offers a strong
potential to recover as fears over Brexit dial down.
-2.0%
-2.5%
-3.0%
Germany
France
Italy
Spain
RoEA
Total
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
11 11 11 11 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15 15 16
Source: Bloomberg, ETF Securities as of close 9 September 2016
Europe is currently at the early stage of the recovery cycle
evidenced by rebounding GDP, credit growth and stimulative
policy compared to the US in the late stage of recovery.
Historically the early-cycle phase has tended to produce
strongest performance in the broader equity market relative to
the late-cycle phase.
In the latest quarter, European GDP growth in fact outpaced US
growth. The strengthening domestic growth story supports the
case for European stocks to recover as its main index
(EuroStoxx 600 Index) generates 58% of its revenue internally.
GDP Growth - US vs Europe (yoy% change)
Relative price outperformance - US vs Europe
6
120%
US
EUROZONE
4
100%
2
80%
0
60%
-2
40%
-4
20%
0%
1987 1989 1991 1993 1995 1997 2000 2002 2004 2006 2008 2010 2013 2015
-6
2001 2002 2003 2004 2006 2007 2008 2009 2011 2012 2013 2014 2016
Source: Bloomberg, ETF Securities as of close 9 September 2016
Source: Bloomberg, ETF Securities as of close 9 September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
11
ETF Securities Outlook – September 2016
Earnings insights
European corporates have struggled to grow in the second
quarter of 2016 posting a combined negative earnings growth of
-13.4% over the prior year. The EU Referendum, slowing
emerging markets economies and the slow pace of structural
reforms in Europe have been major headwinds to the recovery.
The underperformance of European earnings has been broadbased with energy and financials stocks leading the decline with
the exception of consumer goods and healthcare attempting to
improve the scorecard. In the same vein, the second quarter
results mark the first time the US has recorded the fifth
consecutive quarter of y-o-y declines since the financial crisis.
While the energy sector had a pronounced negative effect on
overall US earnings growth rate at -2.3%. Consumer
discretionary and telecom stocks reported amongst the highest
earnings growth in the S&P 500 Index. On stripping out the
negative effect of the energy sector, US earnings growth is up
+2%. However, future US corporate profitability is at significant
risk since margins are declining by 1% while wages are rising by
+13% in 2016. In comparison, European wage growth remains
an anaemic (-11% in 2016) and poses less of a risk to future
corporate profitability.
2016 Margins vs Wages
15%
CAPE valuation gap: US vs Europe
50
MSCI EUROPE EX UK CAPE
45
US CAPE
40
35
30
25
20
15
10
5
0
1986
1991
1996
2001
2006
2011
2016
Source: Bloomberg, ETF Securities as of close 9 September 2016
European companies have a history of paying out a greater
share of their earnings to shareholders in dividends in contrast
to more profitable US companies. European corporates have
maintained higher dividend payout ratios and dividend yields
over time versus their American peers raising their appeal in the
current low yielding environment. The collective benefit of
lower valuations and higher dividends provides a compelling
investment case for yield hungry investors to turn to Europe.
1 3%
US
10%
historical average of 18.7x), offering a long-term potential
opportunity for European equities.
Historical Dividend Yield - US vs Europe
Europe
6.0%
5.5%
5%
5.0%
US
Europe
4.5%
0%
-1 %
-5%
4.0%
3.8%
3.5%
-5%
3.0%
-10%
-1 1 %
2.5%
2.2%
2.0%
-15%
Margins
Wages
Source: Bloomberg, ETF Securities as of close 9 September 2016
This divergence in wage growth offers a strong recovery
potential for European equities that also stand to benefit from
low interest rates and a supportive monetary policy by the
European Central Bank (ECB). The economic recovery in
Europe is also starting to feed into corporate earnings as
earnings growth forecasts start to return to positive territory by
the next quarter. However, earnings growth forecasts for the US
are expected to return to positive territory only by Q4 2016.
Valuations favour Europe
On analysing the Cyclically Adjusted Price to Earnings (CAPE)
ratios, known to smooth the impact of profit cycles, the US is
the most expensive market globally among 52 global equity
markets. US large caps valued at 25x, are trading 56% above
their long term average of 16x. In comparison Europe excluding
UK is relatively attractively valued at 17.5x earnings (below its
1.5%
1.0%
2002 2003 2004 2005 2007 2008 2009 2010 2012 2013 2014 2015
Source: Bloomberg, ETF Securities as of close 9 September 2016
Politics collide with markets
The US and European equity markets will be exposed to
considerable volatility given the upcoming elections in US,
Germany, France and Netherlands within a year. Polls in
Europe highlight a greater risk to European stocks as they are
skewed towards populist parties. Despite the threat of politics
colliding with markets, we believe Europe provides scope for
profit recovery owing to improvement in GDP, credit growth
and lower wage pressure that we expect to feed into future
corporate profitability.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
12
ETF Securities Outlook – September 2016
Exploring rising global infrastructure needs
By Nitesh Shah – Director – Commodity Strategist | [email protected]
Infrastructure spending in China is likely to continue to
increase.
With global needs for infrastructure spending rising,
we expect commodity demand to increase.
China’s infrastructure spending will decline as a
percentage of GDP, but in absolute terms it will rise
substantially.
Although India faces near-term headwinds in
raising infrastructure spending, the potential to
increase growth from doing so remains substantial.
A number of policies are currently being
implemented to kick-start the investment cycle.
Infrastructure spending to continue to grow
Between 2008 and 2013, China spent approximately 8.8% of
GDP on economic infrastructure. According to McKinsey Global
Institute’s analysis, China can afford to reduce the scale of its
spending to 5.5% of GDP between 2016 and 2030 as it targets a
slower level of economic growth. But that still means that the
country could spend US$950bn a year, up from US$829bn a
Infrastructure spending needs
50
11.8
35
3.4
30
5.9
6.0
25
4.4
20
5.0
2.9
15
10
0.9
5
Western Europe
United States and Canada
India
14.2
8.2
0
2000-2015
China
9
8
7
6
India
Developed Asia and Oceania
Middle East
Eastern Europe
Other emerging Asia
Africa
US & Canada
5
4
3
Western
Europe
Latin
America
2
1
0
0
15
30
45
60
75
90
% of world GDP
Source: McKinsey Global Institute, 1992-2013
Relative to income, both India and China have good quality
infrastructure, as their individual quality assessment by the
World Economic Forum, sits above the line of best fit between
per capita GDP and infrastructure quality scores in a cross
sections of countries.
Infrastructure quality vs. GDP per capita
China
6.9
Infrastructure spending
10
Other
Developed Asia
10.8
Infrastructure spending varies considerably by country. China is
the largest spender. India spends a large portion of its GDP on
infrastructure, but has a comparatively small economy and so
aggregate spending by Developed Asia or Western Europe
(represented by the area of the bar in the chart below)
outweighs India.
2016-2030
Source: ETF Securities, McKinsey Global Institute
year in 2013.
In the same analysis McKinsey Global Institute estimates that
India will need to raise spending on infrastructure from 5.2% of
GDP to 5.7% of GDP between 2016 and 2030 to meet its growth
targets. Although many people fear that China’s lower growth
rates will lead to slower commodity demand, it is more likely
that a reduction in infrastructure spending in Developed Asia
and Western Europe will be the cause for disappointment.
7
World Economic Forum infrastructure quality
US$ trn (constant 2015 prices)
45
40
China dominates spending
Annual av erage infrastructure spending (% GDP)
Summary
6
5
4
Better than expected infrastructure
Singapore
United Kingdom
United Arab Emirates
Japan
Switzerland
France Germ any
Spain
United States
Portugal
Finland
Italy
Norway
South Africa
Saudi Arabia
China
Chile
Mexico
Russian Federation
Kuwait
Indonesia
Sri Lanka
Brazil
India
3
Rwanda
2
Burundi
Worse than expected infrastructure
1
0
20000
40000
60000
80000
100000
GDP per capita (2015, $PPP)
Source: World Economic Forum, World Bank, ETF Securities, 2015
As India continues to grow, we expect the quality of the
country’s infrastructure to continuously improve, but the
country will have to be very determined if it is to meet China’s
standard of infrastructure.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
13
ETF Securities Outlook – September 2016
High quality economic infrastructure enables economic growth
and partly accounts for why China’s GDP per capita has leapfrogged India’s since 1990. Per capita GDP in China today
stands at more than double of India’s after being close to par in
1990. The IMF estimates that the public investment multiplier
in emerging markets has historically been between 1 and 1.3.
Thus spending on infrastructure is usually compensated for by
higher economic growth.
Leap forward in commodity spending
Should India find the means to expand its infrastructure base,
China offers an illustration for what it would imply for
commodity demand. In the 1990s, China used to import a
comparable amount to India, but its aggressive build-out of
infrastructure has increased demand for raw materials. Today
China imports over 36 times more industrial metals than India
(in US$ terms).
US$ Billions
Industrial metal net imports
highest in emerging markets, banks that have lent to corporates
with over-running infrastructure projects are in a vulnerable
position. 41% of gross non-performing assets in public sector
banks were associated with infrastructure, iron and steel sectors
in 2015. As banks clean their balance sheets, private sector
access to finance for infrastructure spending could suffer.
According to IMF calculations, one additional rupee in public
investment leads to an increase of about 1.1-1.25 rupees in
private investment after eight quarters. With private investment
subdued and banks encumbered with poorly performing loans,
the government could help kick-start the investment cycle by
New investment projects in India
40
35
New investment project announcements
less shelves and abandoned
Private
30
% of GDP, 4 QMA
Infrastructure is a growth enabler
25
20
15
10
5
60
Public
0
50
-5
2005
40
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: IMF, Article IV, March 2016
spending more on infrastructure.
30
20
10
China
Imports
0
Exports
India
-10
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: ETF Securities, UN Comtrade, 1 992 - 2015
India’s scope to raise spending
Adhering to deficit and debt reduction targets will make it
difficult for India to rapidly expand infrastructure spending in
the near term. Given the aforementioned public investment
multiplier, public debt as percentage of GDP often declines as a
result of economic growth outweighing the increase in debt.
With infrastructure spending on well-selected projects being
almost self-financing, India clearly has an incentive to expand
current infrastructure programs.
Infrastructure spending in India has been declining until
recently and despite the relatively good quality of current
infrastructure stock, the IMF identifies the country’s
infrastructure deficit as an area that needs addressing. A
number of infrastructure project implementation delays and
cost overruns have deteriorated bank and corporate credit
quality. With corporate leverage (debt to equity) one of the
The government has recently set up a National Investment and
Infrastructure Fund (NIIF) with an initial corpus of Rs 200
billion with 49 percent government equity contribution to solicit
equity participation from strategic domestic and foreign
partners. They will also allow foreign direct investment of up to
100% in railway infrastructure. The development of a tax-free
infrastructure bond market announced in the last budget will
also facilitate financing into this market.
Global infrastructure spending is set to increase in coming
years, led by China. Despite all the fears of its slower growth
targets hampering infrastructure spending, China’s needs are
still large. Although India faces near-term headwinds in raising
infrastructure spending, the potential to increase growth from
doing so remains substantial. A number of policies are currently
being implemented to kick-start the investment cycle. We
believe that these policies will begin to increase infrastructure
spending in the coming year, after a protracted period of muted
investment.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
14
ETF Securities Outlook – September 2016
Robotics – boon rather than bane to society
By Aneeka Gupta – Associate – Equity & Commodities Strategist | [email protected]
Summary
The strides made by automation are assisting society
in addressing growing concerns on security, aging
demographics and climate change.
The extension of robotics into the services sector has
generated a raft of misplaced fears of job losses, we
believe short term labour market displacements are
inevitable but the long term impact should result in
job creation commensurate to the job losses.
Greater efficiency and lower costs of automation
coupled with industry’s ability to collaborate with
robots will positively impact productivity in the
global economy.
leaving humans with additional time to engage in creative tasks
enabling us to accomplish more.
Robotics tackles global productivity decline
Waning productivity growth exposes one of the most pressing
problems in the world economy today. According to the
Organisation of Economic Cooperation and Development
(OECD) productivity growth has been slowing in many advanced
and emerging economies. Productivity (measured by output per
hour of labor worked) remains the most important driver of
prosperity and slower improvements in efficiency will eventually
lead to a fall in living standards.
Decline in productivity in advanced economies
3.0%
Misconceptions on the rise of robots
Annual sales of industrial robots achieved a new record of 248k
units in 2015 and this growth trajectory that started in the wake
of the financial crisis of 2009 is showing no signs of abating.
GDP per hour worked
2.5%
1993 - 2003
2004 - 2014
2.0%
1.5%
1.0%
.5%
Worldwide annual supply of industrial robots
.0%
300
Italy
2 48
250
221
'000 of units
200
1 76
1 66
1 59
150
1 20
100
99
1 11
1 14
1 21
1 13
97
78
69
81
60
50
0
2000
2002
2004
2006
2008
2010
2012
2014
Source: International Federation of Robotics (IFR), ETF Securities as of close 9 September 201 6
A host of emerging technologies that automate intellectual tasks
are expanding the global footprint of robotics into the services
sector. Ever since the services sector started yielding to
automation, a raft of concerns about the possibility of rampant
permanent job losses has gained momentum. While there is no
doubt that the growing adoption of automation will create short
term labour market displacements. Over the long term, we expect
the age of automation will deliver opportunities for the labour
market. As mundane repetitive tasks will be supplanted by robots
United
Kingdom
France
Germany
Japan
Canada
United
States
Source: Bloomberg, ETF Securities as of close 9 September 201 6
However, the increasing sophistication in the second age of
automation will enable robots to engage in work that humans
until recently could do more efficiently, resulting in more output
for every hour of human labour. This coupled with the fact that
the cost of robotics hardware has been declining for years, should
translate into lower operating costs and improved profit margins,
thereby proliferating their use in the manufacturing and services
industry. More importantly, automation helps companies bring
their production chain in-house instead of outsourcing to low
labour cost jurisdictions. The inherent improvement of
operational cost efficiencies by means of bridging communication
gaps, better time management and a more synchronised
processes will thereby add value to production and enhance
labour productivity. Faced with rapidly ageing demographics and
slowing labour force participation rates, the adoption of robots
might be the solution to plugging the productivity gap plaguing
developed economies.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
15
ETF Securities Outlook – September 2016
Boon rather than bane to society
Differentiating the winners from the losers
Robots are no more confined to the industrial sphere and its wide
reaching appeal is serving society in myriad ways.
Many of today’s jobs brought about by the evolution of the
information age such as – app developers, bloggers, social media
managers, content creators and sustainability managers, could
not have been dreamed of a decade ago. This ties in with the
theory that our innovations assign us alternative jobs.


Robots are helping to mitigate the loss of human lives in
defence and warfare by engaging in life threatening
tasks such as dismantling land mines, disposing bombs,
infiltrating hostage situations and defending front-line
combat.
Declining mining ore grades are forcing miners to dig
deeper underground raising exploration costs and risks.
However, since robots are acclimatised to operate in
extremely harsh environments, engineers are beginning
to manage the entire mining process in centralised
locations by deploying robots in underground mines.
As the global economy grapples with a rapidly
expanding population and climate change, sophisticated
automation techniques in agriculture such as climatic
sensors, drones for watering and spraying pesticide,
satellite navigation and self-driving tractors are being
used to address the looming problem.

The medical sector has been the main buyer of
professional service robots for their use in surgery,
physical therapy, bionic prosthetics, care-giving and
pharmaceutical dispensing. Robot assisted surgery has
proved beneficial over traditional surgery – as it offers
surgeons better control of instruments, a better view
and faster recovery of patients.

Robots are also benefiting the environment by sorting
and recycling waste in addition to helping clean up
pollution such as oil spills in the sea.
Co-operation rather than competition
Throughout history, periods of significant technological
advancements such as the agricultural, industrial and internet
revolution have sparked misplaced fears of rendering human
labour obsolete. On the contrary, each of these eras of change
heralded greater efficiency, higher productivity and a better
standard of living. In reality a very small portion of jobs can be
completely automatable today. However, the vast proportion of
our day to day activities can be automated, giving labour the
opportunity to make a more productive use of their time. Our
ability to co-work with robots will lead to job transformation
rather than job destruction. The adoption of automation cannot
take place overnight given the economic, legal and societal
hurdles that exist. It is in our best interests to be proactive and
embrace the changing workplace. Spreadsheets never killed
accounting jobs, neither did the Microsoft office eradicate the
need for secretaries, they simply empowered them to become
more productive and employable.
Divergent paths in employment growth
200
y oy average employment growth rebased

180
160
Computer systems analysts, Software
developers, Computer network
architects, Web developers
140
120
100
Telephone operators, typists,
secretaries, bookkeeping
80
60
40
2000
2002
2004
2006
2008
2010
2012
2014
Source: FRED, US Bureau of Labor Statistics, ETF Securities as of close 9 September 2016
While it’s hard to predict all the likely opportunities to unfold as a
consequence of automation, a few opportunities that do come to
mind are – engineers and programmers (to write the
software that robots depend on); art designers (to make robots
look more like humans); software de-buggers (to prevent and
manage cyber security threats); anti- ageing specialists (as
automation extends the human lifespan).
Winners
Losers
Genetic councellors
Industrial engineers
Computer programmers
Software de-buggers
Art designers of humanoid robots
Augmented reality authors
Anti-ageing specialists
Urban natural disaster mitigation
Tax i driv ers
Fishermen
Fast food workers
Paralegals
Telemarketers
Firefighters
Wealth Adv isors
Journalists
Source: ETF Securities
While many argue that the new job opportunities are tilted in
favour of highly skilled workers to the detriment of low skilled
workers, potentially exacerbating the inequality gap, we believe
both strata of society are exposed to short term technological
displacements. While the first prototype self-driving cars are
starting to threaten the livelihood of taxi drivers, we are also
witnessing the launch of robo-advisers threatening the existence
of financial wealth advisors. The functioning of the new eco
system where humans and robots coexist will spur a vast number
of oversight jobs to ensure a smooth operation. Above all despite
the numerous benefits gained by employing robots, a fine balance
would need to be maintained between humans and robots
depending on how easily society takes to the change.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
16
ETF Securities Outlook – September 2016
In sync: Gold and the USD
By Martin Arnold – Director – FX & Macro Strategist | [email protected]
cyclical upswing. However, gold provides more than just a way
to defend against market risk and uncertainty. It also provides a
hedge against monetary devaluation, which potentially leads to
an inflationary spiral.
Summary
Gold’s history is inextricably linked with the US
Dollar and shows a strong negative relationship.
As a monetary metal, it appears that gold is likely to be well
supported in the current environment of aggressive global
central bank stimulus. Indeed, such excess stimulus, even in the
US, could lead to inflationary problems, with the Fed losing its
inflation fighting credibility. Although the statement from the
Fed’s July meeting was more hawkish, the market reduced its
expectations of further rate hikes in 2016. The market believes
the Fed will not move despite its rhetoric.
US Dollar and gold volatility moving back in sync
highlights gold acting as a currency rather than
metal in the current environment.
Gold and the US Dollar have the potential to rally
simultaneously, as the Fed chases inflation higher
against a backdrop of global monetary stimulus.
2004 revisited?
Currency or metal?
Gold has long been viewed as a monetary metal, part asset and
part currency. Gold is traded in US Dollars (USD), and as such
has a relatively strong and persistent inverse correlation with
the US currency.
While it depends on the end investors’ perspective into which
category – currency or metal - gold is placed, its relationship to
the US Dollar can be instructive about its future direction.
Gold v US Dollar
There is a potential environment in which gold and the USD can
both move higher – a cyclical US upswing. Moreover, a cyclical
US upswing where the central bank was chasing rising inflation
higher in its tightening cycle would be beneficial for both assets.
The period of US Fed tightening from 2004-2006 coincided
with a decoupling of the inverse gold-US relationship. Indeed,
while longer-term analysis shows a significantly negative
correlation with gold, shorter term analysis suggests that the
relationship between gold has not been significant and indeed a
positive relationship can exist.
60
1,800
Gold ($/oz, LHS)
1,600
DXY (inverted, RHS)
70
1,400
Gold Spot Price vs. US TWI
Annual %
80
Annual %
10
Gold Spot Price (LHS)
US TWI ( Federal Reserve Broad Index, Inverted Scale)
60
5
80
1,200
40
1,000
0
90
800
20
600
100
400
200
110
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Bloomberg, ETF Securities as of close 1 2 September 2016
Synchronisation
The global economy is recovering at a grinding pace, but
question marks remain. Uncertainty over the sustainability of
the recovery and the path for central bank policy are the key
threats that investors appear concerned about. As a result,
volatility across asset classes is leading investors to maintain a
somewhat defensive bias in portfolios.
With gold being in demand in times of elevated market stress,
there is a belief that gold cannot perform in an environment of
-5
0
-10
-20
-40
-15
2004
2004
2005
2005
2006
Source: Bloomberg, ETF Securities as of close 09 September 2016
2006
2007
All about inflation
Inflation erodes the value of fiat currencies. Gold’s historical
tendency to rise in periods of elevated inflation comes from its
perception as a hard asset, from the time when it backed fiat
currencies during the period of the global gold standard and
later during the Bretton Woods system. Gold was therefore the
value against which fiat currencies were priced.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
17
ETF Securities Outlook – September 2016
Elevated inflation during the 1970’s was a key episode that
highlighted the credentials of gold as an inflation fighter. In
recent decades, inflation has been mostly contained, with
central banks taking over the mantle of inflation fighters.
Although most major central banks have a specific price
stability mandate, reluctance from policymakers to be proactive
in the face of evidence of rising inflation is threatening this
perception.
Fed inflation fighting credentials appear to be weakening and
we expect the ongoing reluctance from the central bank to raise
rates in an increasingly inflationary environment will further
undermine its credibility, in turn supporting the gold price.
Inflationary expectations are still relatively depressed despite a
recent move higher, when inflationary pressure is beginning to
gain momentum in the US. CPI is at 1.0%, below the 2.0% target
for the Federal Reserve. However, core inflation is at 2.2%,
suggesting that price pressure is building rapidly.
Central bank policy has a lagged impact on the underlying
economy. A central bank therefore needs to be pre-emptive with
its policy setting behaviour – something that the Fed does not
have a history of doing. The Fed has, at best, been reactive with
its policy actions in recent decades
Wages are at the intersection of the Fed’s dual mandate: price
stability and full employment. With indicators showing that the
US economy is close to its full employment level, accelerating
wages could be the key feedback loop into inflation. As a result,
prices could begin to overshoot the central bank’s inflation
target if wages continue to move higher at the current pace.
Strong correlation
Annualised volatility
45
18
40
16
35
14
30
12
25
10
20
8
15
6
10
5
4
Gold Price Volatility (LHS)
2
USD Index Volatility (RHS)
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
0
Source: Bloomberg, ETF Securities as of close 09 September 2016
Negative real rates
A result of central bank’s low and negative rates policy,
accompanied by the threat of rising prices, is that real interest
rates are for the most part below zero. With gold being a nonyielding asset, one of the headwinds is alleviated that
historically holds gold back in a cyclical upswing.
Although real rates have been rising of late, they remain
negative and haven’t been rising as fast as nominal rates
showing that inflationary expectations are beginning to rise,
albeit from low levels. Until the Fed begins to tackle the
potential inflationary build-up, the USD is likely to range trade
and not be a significant influence on the gold price.
2,000
Real rates matter
-4
Volatility
We believe that competitive devaluations resulting from central
bank policy activities has driven currency volatility higher,
which has in turn flowed into other asset markets. USD
volatility has a strong historical relationship with gold volatility.
The strength of the correlation of gold and USD volatility
highlights the ‘currency’ characteristics of gold. The divergence
during 2015 highlights the varied role that gold plays within
investment portfolios. At a time of rising USD volatility as the
market was concerned about rate hikes and Chinese market
contagion, gold volatility moderated and prices softened over
the ensuing six months.
-2
1,500
0
1,000
2
500
4
Gold ($/oz, LHS)
Real interest rate (%, RHS, Inverted)*
0
2006 2007 2008 2009 2010
6
2011
2012
2013
2014
2015
2016
Source: Bloomberg, ETF Securities as of close 09 September 2016
As we expect currency volatility to remain elevated, gold prices
are likely to be well supported in the current monetary stimulus
environment. However, downside risks remain if the Fed begins
to adopt a more pre-emptive approach against inflation.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
18
ETF Securities Outlook – September 2016
America’s infrastructure frustrations
By Maxwell Gold – Director – Investment Strategy | [email protected]
fairly steady at 2-3% of annual GDP since 1956 it has also seen a
slowing trend since the post-war period.
Summary
Market and political factors are currently favourable
to support additional US infrastructure investment.
Due to continued budget deficits, private capital will
most likely need to supplement public infrastructure
spending.
Recently, there have been signs of changing attitude in US fiscal
spending towards its deteriorating infrastructure. In December
2015, the Fixing America’s Surface Transportation (FAST) Act
was passed and allocated $305 billion over the next five years
for highway and transportation4. This, however, is only a small
step in the right direction as the projected funding gap is
estimated at over $1.6 trillion across all segments (see table).
Investment gap in American Infrastructure
Renewed investment in US infrastructure should
help drive US growth, labour and commodity
demand.
America is showing its age
US infrastructure is in dire need of an upgrade as its quality
currently lags levels seen in other developed economies3. Many
of the US’s aging assets (roads, bridges, airports, waterways,
and mass transit) continue to deteriorate due to the lack of new
investment. In 2013, the American Society of Civil Engineers
(ASCE) conducted their Report Card for America’s
Infrastructure and assigned a grade of D+ (defined as poor) to
the US national infrastructure. They also estimated an
additional $200 billion in annual spending over the next eight
years was needed to bring the nation’s infrastructure up to par.
US Infrastructure spending has trended lower
4.0
Share of GDP (%)
3.0
200
Share of GDP (lhs)
2.5
150
2.0
100
1.5
1.0
Billions ($US)
3.5
250
Total Capital Spending (rhs)
50
0.5
0.0
0
1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011
Source: Congressional Budget Office, ETF Securities as of close 23 August 2016. Ex hibit
data from 1 /1 /1956 to 1 2/31/14
This is partly a result of three decades of underinvestment with
a 23% drop since 2003 in real capital spending across the two
largest infrastructure categories: transportation and water.
While overall federal infrastructure spending has remained
Billions (USD)
Total
Needs
Estimated
Funding
Funding
Gap
Roads/Bridges/Transit
$1,723
$877
$846
Energy (Electricity)
$736
$629
$107
Airports
$134
$95
$39
Dams/Waterways /Ports
$131
$28
$103
Rail
$100
$89
$11
Other
$811
$306
$505
Total
$3,635
$2,024
$1,611
$454
$253
$201
Annual Investment
Source: American Society of Civil Engineers 2013 Report Card for American Infrastructure.
Other = public parks & recreation, schools, water & wastewater, hazardous & solid waste, ETF
Securities as of 23 August 2016.
Pricing and populism bode well for US
public works spending
The present economic and political climate is primed for
increased US fiscal spending on infrastructure. The current
interest rate environment remains near record lows highlighting
that borrowing and financing costs are currently cheap,
therefore an opportune moment for the next political
administration to invest in infrastructure. Additionally, since
rates are expected to remain lower for longer, this may extend
the window of opportunity for policymakers to enact on more
infrastructure projects.
Commodity prices remain well below their average prices in
2003 (the start of a commodity bull market) which saw the
beginning of a marked decline in US real capital spending. The
reduced costs across key building and construction materials
and fuel for machinery and vehicles presents an attractive
opportunity for the US to enter into projects to rebuild its
infrastructure.
The growing rise of populism in global politics is also increasing
public support for economic growth through infrastructure
3
World Economic Forum. See “Commodity demand to increase with rising global
infrastructure needs”
4
U.S. Department of Transportation Federal Highway Administration
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
19
ETF Securities Outlook – September 2016
investment. In this year’s US Presidential election, the only
topic both party candidates seem to agree on is the need to
increase fiscal spending on America’s deteriorating
infrastructure. Hillary Clinton, the Democratic Party candidate,
has outlined a plan to increase federal infrastructure funding by
US$275 billion over a five-year period of which US$250 billion
would be used in direct public investment. The remaining
US$25 billion would be levered to fund up to US$225 billion in
direct loans, for a total spending increase of US$500 billion.
Donald Trump, the Republican Party candidate and real estate
entrepreneur, has expressed similar intentions to drastically
increase the federal spending on infrastructure.
Utilising the growing populist sentiment, politicians appear very
keen to increase employment, US competitiveness, and
economic growth in manufacturing and construction related
sectors. With mass public support and growing populist
sentiment, the current climate may help expedite fresh
investment into US infrastructure which has hit political
hurdles in the past.
Funding the future
There appears to be a greater commitment from federal
spending to offset the multi-decade decline, but historically
state and local governments have carried the majority of
financing for public projects. As of 2014, state and local
governments accounted for over 75% of total public
infrastructure spending5. This burden, however, may be difficult
to sustain in the years ahead as budget deficits (-11% as of 2015)
continue to plague state and local governments in the US. Given
the continued weak economic recovery, raising tax revenue to
combat these shortfalls is a politically unpalatable option.
Dry powder may serve as growing source of
infrastructure fianncing
$1,600
Global Private Capital Dry Powder (lhs)
$1,400
-5%
-10%
-15%
$2004
2006 2008
2010
2012
2014
Source: Preqin, NIPA, US Bureau of Economic Analysis, ETF Securities as of close 23 August 2016.
In order to avoid spending cuts on future infrastructure
investments, local governments may find supplemental funding
in the form of public-private partnerships and direct private
investment funds, which as of June 2015 hold over US$1.2trn in
dry powder. Against the landscape of stretched equity
valuations, record low interest rates, and negative real yields on
5
Congressional Budget Office
67%
2
66%
1
65%
0
-1
64%
-2
63%
-3
62%
US Economic Output Gap (lhs)
61%
60%
1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
Source: OECD, US Bureau of Labor Statistics, ETF Securities as of close 23 August 2016
-25%
2000 2002
68%
US Labor Force Participation (rhs)
3
-6
-20%
$200
Infrastructure could improve US output gap
and labor participation
4
5%
$800
$400
Public infrastructure spending is vital to boosting the US
economy, particularly when the impact of monetary stimulus
appears to have diminishing returns. Increased public projects
would see a rise in US import and demand for copper, steel,
cement, aluminium, petroleum and other cyclical commodities.
This would also provide a boon to the US manufacturing,
materials, and construction sectors which have slowed of late.
1985
0%
$600
Infrastructure can reignite US economy
-5
10%
US State & Local Gov't Budget (rhs)
$1,000
Nearly half of the projected funding gap in US infrastructure is
tied to bridges, roads, and transit all of which operate on tolls
and income. This potential cash flow would be an attractive
option for many yield hungry investors. This is particularly
attractive to institutional investors like endowments and
pensions, which have long time horizons matching the tenor of
infrastructure investments. Further private investment is
expected to rise in the near term since 66% of US-based
infrastructure investors are currently below their target
allocation to the asset class6.
-4
Percent Surplus/Deficit
Billions, USD
$1,200
cash, private investment may find attractive opportunities in
infrastructure deals.
Additionally, the US labour market could benefit by not only
improving the labour participation rate - which has been in
structural decline for several decades - but also by creating new
low-skill jobs, which have become scarce due to automation and
globalisation. With more infrastructure activity and higher
labour participation translating into GDP growth, this could
further help close the US’s current negative output gap.
After years of reduced investment, the current economic and
political backdrop has reached a confluence that is supportive of
a boost in US infrastructure spending. This should prove a boon
for US growth which has remained sluggish in recent quarters
and remains below its long term potential growth. Additionally,
US labour markets and materials sectors should benefit from an
expected increase in public spending.
6
Preqin Special Report: US Infrastructure. May 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
20
ETF Securities Outlook – September 2016
A bridge between research and the investment world
By Edith Southammakosane – Director – Multi-Asset Strategist | [email protected]
equities (28) and bonds (7). The initial weights are based on the
weighting methodology of:
Summary
As opposed to traditional benchmark, our strategic
portfolio includes commodities as we believe that
commodities can help enhance returns whilst
reducing volatility.
Compared to the strategic benchmark, our tactical
portfolio follows a rule-based model that has
returned 5.2% per year and has enhanced the
Sharpe ratio by 30% since 2005.
For August, the tactical portfolio increased its
weight in US sovereign debt, reducing its allocation
in emerging market sovereign debt and US equities.
This is the first edition of a report that we plan to release on a
quarterly basis. This publication aims to implement, in a
systematic way, the team’s analysis of the global economy and
its potential impact on equities, bonds and commodities into an
asset allocation model where the weighting would reflect our
views in each asset class that we cover.
To fulfil that purpose, we have derived two portfolios from the
model: the strategic and tactical portfolios. Both portfolios
rebalance on a monthly basis and represent a balanced portfolio
of equities, bonds and commodities as illustrated below.
Portfolio initial weights (in %)
Equity
US
Japan
Europe
Other DM
EM
Bond
US Sovereign
Europe Sovereign
EM Sovereign
Investment grade
High yield
Commodity
Energy
Industrial Metals
Precious Metals
Grains
Softs
Livestock

The Bloomberg Commodity Index for commodities

The MSCI AC World Index for equities

The Barclays bond indices for bonds
The strategic portfolio represents a balanced portfolio with 55%,
35% and 10% allocated in equities, bonds and commodities
respectively. Every month, the strategic portfolio rebalances
into the weights set by the above benchmarks.
Compared to a more traditional portfolio of 60% equity and
40% bond, the strategic portfolio slightly underperforms the
60/40 benchmark by 0.4% per year since January 2005. This is
explained by the poor performance of commodities between
2010 and 2015. However, we believe that commodities can help
enhance the portfolio returns whilst reducing volatility when
held over a longer investment horizon (see Commodities
enhance and diversify portfolio returns).
Our tactical portfolio
Our tactical portfolio aims to outperform its strategic
benchmark by applying a weighting methodology that would
reflect the team’s expertise in each asset class and our views of
the global economy.
The tactical portfolio is based on three models and rebalances
every month back to a new set of weights derived from three
different rules.
Firstly, while the weight of commodities is fixed at 10%, the
weight of equities and bonds varies based on the equity bond
relative trade model which we discussed in the Triannual
Outlook 2016 – April update. The model uses the volatility of
the S&P 500 (VIX) as a trading signal, increasing the weight in
equity when the volatility index is low and vice versa.
Secondly, the weight of each investment within the asset class
also varies based on the following models:
0%
10%
20%
30%
40%
50%
Source: Bloomberg, ETF Securities as of Jan 2005
Our strategic benchmark
60%

the ETFS CAPE model for equities

a CDS model for bonds

the ETFS contrarian model for commodities
The CAPE (cyclically adjusted price to earnings) model uses the
CAPE ratio relative to its historical average as a trade signal,
underweighting the 5 most overvalued investments and
overweighting the 5 most undervalued one while keeping the
weight unchanged for the remaining 17 investments.
Our benchmark model is a long-only strategy with 60
investments across three asset classes: commodities (25),
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
21
ETF Securities Outlook – September 2016
The CDS (credit default swap) model is a long-short bond model
that uses regional CDSs as a trade signal, taking a short
exposure to the regions with a high CDS and vice versa.
The ETFS contrarian model uses inventories, positioning, roll
yield and price momentum, as trade signals. When all these
indicators had a positive impact on price, the model is taking a
short exposure to that commodity and vice versa.
Third and last rule, the resulted weights from all the above is
then adjusted to reflect the team’s latest market analysis. For
this first edition, this third rule has not been implemented and
will start from the next quarterly report and onwards.
Model performance
Whilst underperforming the 60/40 benchmark, the tactical
portfolio is outperforming its strategic benchmark by 0.4% per
year since January 2005.
August 2016 positioning
The below chart shows our positioning in the tactical portfolio
compared to the strategic benchmark, based on the output of
the aforementioned model recommendations as of July 2016.
Our current positioning (in bps)
Equity
US
Japan
Europe
Other DM
EM
Bond
US Sovereign
Europe Sovereign
EM Sovereign
Investment grade
High yield
Commodity
Energy
Industrial Metals
Precious Metals
Grains
Softs
Livestock
-1,500
60/40
benchmark
Strategic
portfolio
Tactical
portfolio
Volatility
11.3%
11.4%
8.8%
Annual returns
5.7%
4.8%
5.2%
Max drawdown (peak-trough)
-38.5%
-39.1%
-25.5%
Max recovery (to previous peak)
3.25
3.25
2.42
Beta
1.00
1.01
0.09
Correlation to benchmark
1.00
0.99
0.12
Tracking error
0.0%
1.4%
13.4%
Sharpe
0.37
0.29
0.42
Information ratio
-0.60
-0.03
*Based on monthly data in USD from Jan 2005 to Jul 2016. Volatility and returns
are annualised. Max drawdown defines as the maximum loss from a peak to a
trough based on a portfolio past performance. Max recovery is the length of time
in number of years to recover from the trough to previous peak. Risk free rate
equals to 1.5% (a simulated combination of the IMF UK Deposit Rate and the
Libor 1Yr cash yield). Source: ETF Securities, Bloomberg
The tactical portfolio has the lowest volatility compared to the
benchmarks, improving the Sharpe ratio by 30% on average.
This has been persistent over the period (see chart below). The
tactical portfolio also provides higher protection from the
downside risk and recovers faster to its previous peak.
Portfolios relative volatility
1.5
1.4
1.3
1.2
60/40 benchmark less volatile
1.1
1.0
0.9
0.8
0.7
-1,000
-500
0
500
1,000
1,500
Source: Bloomberg, ETF Securities as of August 2016
The equity bond relative trade model reduced the allocation in
equities from 55% in the strategic benchmark to 45% in the
tactical portfolio for August and increased the allocation in
bonds from 35% to 45%. We are taking the view that if the
volatility index remains stable compared to its historical
median, the portfolio should keep a 50/50 split between equity
and bond. This has been the case since June 2014.
The portfolio allocation in commodities as an asset class is fixed
at 10% as mentioned previously. Within the asset class, the
weight of individual commodities is the same as in the strategic
benchmark as none of the commodities have all four indicators
during July aligned in one direction or the other to justify a
change in commodity positioning for August.
The ETFS CAPE model is underweighting the US, France, the
Netherlands, Italy and Denmark for the third consecutive
month as the CAPE ratios stand above their respective 10-years
median by 56% on average. On the other hand, the model is
overweighting Canada, Spain, Brazil, India and Russia for the
fourth consecutive month. The CAPE ratio of these countries is
30% below their respective 10-years median on average.
For bonds, the CDS model is increasing the portfolio allocation
in US sovereign debt as the CDS of US sovereign debt fell below
its lower band as of last month. On the other hand, the model is
reducing the portfolio allocation in emerging market sovereign
debt as the region CDS crossed upwards its upper band in July.
ETFS RAAM tactical less volatile
0.6
0.5
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Bloomberg, ETF Securities as of close 22 August 2016
A closer look to Q2 performance shows that the tactical
portoflio outperformed both benchmarks by 0.7% per year on
average. Interestingly, the three asset classes when taken
individually have lower return than when combined in the
tactical portfolio, highlighting the benefit of diversification.
As opposed to actively managed investment solutions that tend
to persistently underperform their benchmark, our tactical
portfolio outperforms its strategic benchmark by 0.4% per year
since 2005 and has enhanced the Sharpe ratio. We expect the
team’s input in the portfolio weighting methodology to further
improve the portfolio risk/return profile.
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
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The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This
communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go
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