Hans-Peter Huber, PhD Chief Investment Officer Tel. +966 11 486 5808 hanspeter.huber@riyadcapital.com
A Mild Global Recovery and Continued Monetary Expansion Favor Risky Assets - Attractive Equity Markets albeit with Regional Differences The global economy will see some mild growth acceleration in the course of 2015, primarily due to lower oil prices, still favorable monetary conditions and less fiscal constraints. This growth acceleration will primarily be driven by Advanced Economies whereas Emerging Markets continue to face faltering growth dynamics. Continued money printing through Quantitative Easing (QE) by major central banks will not only support the economies but also be a major tailwind for financial markets whereby the gravity center of monetary expansion has shifted from the US to Europe and Asia (see figure 1). Excess oil supply will culminate in the 2nd quarter of 2015 with inventories reaching unprecedented levels. The market is expected to be balanced again at the beginning of 2016 albeit at a high degree of uncertainty. Against this backdrop oil prices remain subdued in the short term. The longer-term outlook is more promising. The Saudi Arabian economy will witness solid growth albeit at a somewhat lower pace. The main growth drivers are the countercyclical fiscal policy, a robust private non-oil sector and the country s determined efforts to defend its market share on global oil markets. Global equity markets will benefit from decent growth perspectives and the continued liquidity injection by major central banks although with distinct regional differences. The short-term outlook for the Saudi equity market is mixed as the positive impact from the market opening is mitigated by valuation concerns. Table of Contents: Summary 1 Global Economy 2 Oil Outlook 6 Saudi Economy 9 Global Equity Market 11 Outlook Tadawul 13 Emerging Markets and Commodities 14 Recommended Asset Allocation 18 Figure 1: Global Money Printing to be continued... 14000 12000 00 8000 6000 4000 QE by FED, BoJ, BoE, SNB 2000 12/06 12/08 12/10 12/12 12/14 12/16 source: FED, BoJ, BoE, ECB, SNB, RC estimates QE by BoJ, ECB Consolidated balance sheet of Federal Reserve (FED), Bank of Japan (BoJ), Bank of England (BoE), European Central Bank (ECB) and Swiss National Bank (SNB), in bln USD Page 1
Some Tailwinds for the Global Economy Lower oil prices and monetary expansion supporting the global economy Mixed economic readings in the 1st quarter 2015...but we expect Advanced Economies to gain momentum in the course of 2015 The recent oil price drop is predominantly a supply-side shock The global economy is expected to gain some mild growth momentum in 2015. This is primarily driven by Advanced Economies which are supposed to benefit from sharply lower oil prices, still very accommodative monetary policies in major economies and less fiscal constraints. Emerging Market and Developing economies on the other side will overall continue to see some faltering growth dynamics, albeit with considerable regional differences. Overall we expect global growth of 3.5% in 2015 after 3.3% in 2013 and 2014 (see figure 2). Macroeconomic readings have been rather mixed in the first quarter 2015. In the US in particular the manufacturing sector has been below expectations in the first months of the year, the same applies to retail sales. This points towards rather weak first quarter GDP figures in the US. However, we consider this weakness as temporary. On the other hand, European economies overall managed to surprise on the upside in their recovery process after the recent recession. This notably applies to business climate indicators as well as to retail sales in the Euro area which have been remarkably strong in the first months of 2015. Overall, we expect advanced economies to gain momentum in the course of this year. Actually, the net positive impact of sharply lower energy costs typically has to work its way through in the real economy and will be visible with a certain time lag in the real data. The flip side of lower oil prices, on the other hand, cutbacks in capital expenditure in the energy sector, has already started to bite into economic figures, within advanced economies particularly in the US. Actually, against the backdrop of sharply lower oil prices a lively debate has been initiated on what the net effect for the global economy may be taking into consideration potential positive as well as negative consequences. In this context, it has first to be stressed that the sharp drop in oil prices we have witnessed over the last 9 months is in our view predominantly the result of a positive supply shock (supply overhang) and only to a smaller degree the consequence of weaker global demand. In essence, it constitutes a large wealth transfer from net oil producing countries to net oil consuming countries. As can be seen in figure 3 net oil exporting countries only constitute about 12% of Figure 2: Global real GDP growth (2015 forecast) 6.0 5.0 Figure 3: Global GDP by net oil exporting vs. net -oilimporting countries (2013) 12.2% 4.0 3.0 2.0 1.0 0.0 2001 2003 2005 2007 2009 2011 2013 2015 Real annual growth World source: IMF, RC estimates 87.8% Net oil importing countries Net oil exporting countries source: IMF Page 2
and constitutes a global wealth transfer equivalent to 1.5% of global GDP The oil price drop s flip side are lower capex in the oil industry but the net effect is clearly positive for the global economy global GDP whereas 88% of global GDP is generated in net oil-importing countries. On top, oil producing countries tend to have high savings rates whereas the net oil consumers, typically large industrialized countries, exhibit a high propensity to consume. As a consequence, this wealth transfer will translate into a higher velocity of money ( money turnover ) thereby stimulating the global economy. Assuming an average oil price of about 65 USD per barrel throughout 2015 (Brent oil) and based on global demand estimates for 2015 by IEA (International Energy Agency) this wealth transfer effect amounts to approximately 1.1trln USD or roughly 1.5% of global GDP for the year 2015 compared to 2014. On the other side, lower oil prices discourage oil producing companies from future capital expenditure which constitutes lower investment spending and some lower future job creation. Although it may be difficult to precisely estimate the size of this effect it shouldn t be overstated. The case of US energy production, which has been considerably expanded in the last years due to the shale oil revolution, may be used as an example to put this into perspective. Total investments in the US energy sector since the beginning of last decade amount to estimated 2.0-2.5trln USD corresponding to about 150bln USD annually. The energy sector employs directly and indirectly some 9.8mln employees. And its annual GDP contribution constitutes 1.35trln USD. This, however, has to be compared to the size of the overall US economy. The energy sector generates just 7.7% of total GDP, its employment represents 7% of total US work force and the yearly capex have to be seen in the context of annual private fixed investment spending of about 3trln USD for the entire economy. Hence, the negative impact of lower oil prices on the overall economy may be quite contained and the net effect clearly positive. According to IMF estimates the net positive stimulus on the global economy may be in the range of 0.2-0.5% while the Worldbank puts the extra boost at 0.5%. Next to lower oil prices the monetary conditions in most advanced economies remain favorable for growth. At first sight this may be astonishing given that the central bank of the largest global economy, the US Federal Reserve, has already finished its asset purchasing program to expand the monetary base and is supposed to start hiking money market rates in the course of this year. Table 1: Real GDP Growth (2015 forecast) 2012 2013 2014 2015f World 3.4 3.3 3.3 3.5 Advanced Economies 1.5 1.3 1.8 2.4 USA 2.8 2.2 2.4 3.0 Euro Area -0.6-0.5 0.8 1.7 Japan 1.4 1.6 0.1 1.0 United Kingdom 0.2 1.7 2.8 2.9 Emerging Market Economies 4.9 4.7 4.4 4.3 China 7.7 7.8 7.4 6.9 India 3.2 5.0 5.8 6.3 Russia 3.4 1.3 0.6-3.0 Brazil 0.9 2.5 0.1 0.3 Saudi Arabia 5.4 2.7 3.6 3.0 Table 2: CPI Inflation rate (2015 forecast) 2012 2013 2014 2015f World 4.3 4.1 3.8 3.6 Advanced Economies 2.0 1.4 1.4 0.4 USA 2.1 1.5 1.6 0.3 Euro Area 2.5 1.3 0.5 0.0 Japan 0.0 0.4 2.6 0.9 United Kingdom 2.8 2.5 1.5 0.5 Emerging Market Economies 6.1 6.2 5.5 5.8 China 2.6 2.6 2.0 1.5 India 9.3 10.9 6.4 6.5 Russia 5.1 6.8 7.8 15.0 Brazil 5.4 6.2 6.3 7.5 Saudi Arabia 2.9 3.5 2.7 2.5 source: IMF, RC estimates source: IMF, RC estimates Page 3
Monetary conditions remain favorable for growth Quantitative Easing will even gain momentum in 2015 and beyond which is a key macro factor with strong economic and financial implications QE fuels competitive currency devaluation However, quantitative easing (QE), i.e. creating excess liquidity through massive asset purchases by the central bank, is not a US innovation. In fact, the Japanese central bank already conducted such an exercise at the beginning of last decade for a couple of years. And it was again the Bank of Japan (BoJ) which started a new massive asset-purchasing program about two years ago and later on, by end of last year, reinforced this exercise by further increasing the amount of security purchases. And it has just been in March of this year that the European Central Bank (ECB) joined in by kick starting a QE program which is supposed to last until end of next year. All together these two central banks will purchase assets by an annual amount of 1.5trln USD. This compares to the last and largest QE program by the Federal Reserve equivalent to 1.0trln USD annually. Hence, liquidity creation at a global scale will even gain some momentum into 2015 and beyond (see figure 1 on page 1). This has to be considered as a key macro factor with strong economic and financial implications. A main objective of this massive monetary expansion actually consists in avoiding outright deflation and creating favorable credit conditions in the respective currency areas. However, this monetary expansion has also two (desired) side effects. First, it puts the country s currency under massive pressure typically leading to considerable currency devaluation. This helps improving the international competitiveness of the country s export industry thereby fueling real GDP growth. In the case of Japan, its currency has devalued against the US dollar in the last two and a half years by about 35% and against a trade-weighted basket of currencies on a real basis (i.e. adjusted by inflation differentials) by about 30%. Since the announcement of monetary expansion by the European Central Bank by mid of last year the Euro has lost 25% against the US dollar and about 15% against a trade-weighted basket of major currencies on a real basis. Unfortunately, currency devaluation is a zero-sum game at a global level as a country s competitiveness is just improved at expense of its neighbors economies. They, as a consequence, are forced to pursue a similarly expansionary monetary policy in order to prevent their currency from strong appreciation. Overall, this leads to excess liquidity creation at a global scale which risks to go beyond what would be desirable for the real economy. Figure 4: ECB weakening the Euro Figure 5: and BoJ weakening the Yen 140 1.60 95 60 135 130 125 120 115 110 105 1.50 1.40 1.30 1.20 1.10 90 85 80 75 70 65 60 55 70 80 90 110 120 12/06 12/08 12/10 12/12 12/14 1.00 130 Real trade-weighted exchange rate index EUR,l.h.sc. USD / EUR exchange rate, r.h.sc. 50 12/06 12/08 12/10 12/12 12/14 Real trade-weighted exchange rate index JPY, l.h.sc. JPY / USD exchange rate, r.h.sc, inverse Page 4
QE also leads to asset price inflation...pushing investors towards risky assets such as equities The regional shift in monetary expansion is important for the attractiveness of financial markets Governments have regained some fiscal flexibility The second side effect of massive monetary expansion relates to financial markets. Quantitative Easing aims at reflating the economy, i.e. increasing consumer price inflation to the central bank s target level, typically around 2%. However, massive liquidity injection into the financial system tends also to lead to asset price inflation. Central banks usually purchase government bonds with different maturities thereby keeping the sovereign yield curve at artificially low levels. Some economists even call this financial repression. In extreme cases parts of this yield curve can even fall into negative territory (like in the case of German government bonds). As a consequence, investors, seeking for adequate yield, are forced to take some more risk in their portfolios shifting gradually towards investment grade corporate bonds, high yield bonds and finally to equity investments. The US experience over the last years is an illustrative example for this. From 2009 to 2014 a total of three QE programs were conducted by the FED, thereby increasing its balance sheet by 3.7trln USD. During this period the S&P500 advanced by 150% whereas corporate earnings grew by about 85%. The difference between share price increase and underlying profit growth is explained by a revaluation of US equities expanding their PE-multiple from 12.2 to 16.5. The projected money printing at a global scale is expected to translate into further asset price inflation in the foreseeable future. The geographical shift of monetary expansion towards Europe and Japan/Asia is thereby an important factor in determining the relative attractiveness of regional asset markets. The third argument favorable to growth stems from fiscal balances. As major governments had to support the economy with massive fiscal expansion during the global economic crisis in 2008 and 2009 they were forced to consolidate their balances thereafter. However, cutting back fiscal expenditure translated into negative growth contribution to overall GDP. As budgetary deficits in major economies could be considerably reduced in the recent years the pressure for fiscal consolidation has been fading and governments have regained some fiscal flexibility again with the possibility for positive GDP growth contribution. Figure 8 and 9 illustrate this for the US and the Euro area Figure 6: FED driving US equities with QE 5000 4500 4000 3500 3000 2500 2000 1500 0 2200 2000 1800 1600 1400 1200 0 800 600 Figure 7: German sovereign yield curve partly negative 2.00 1.60 1.20 0.80 0.40 0.00 500 400 04 05 06 07 08 09 10 11 12 13 14 15 Federal Reserve balance sheet (in bln USD).l.h.sc. S&P500 index, r.h.sc. source: FED St. Louis, Bloomberg -0.40 1 2 3 4 5 6 7 8 9 10 years as of 31/03/2015 as of 31/03/2014 Page 5
economies. As a result of the massive fiscal support in 2008 and 2009 the budget deficit in the US ballooned above 8% of GDP. The subsequent consolidation process culminated in the debt ceiling debate in 2011 which ultimately led to a negative governmental GDP contribution of -0.6% in that year. Meanwhile, as the US budget deficit has again fallen below 3% of GDP in 2014 there is some more room for maneuver for the federal government in 2015. The same applies albeit to a lesser extent to the Euro area as can be seen in figure 9. The Outlook for Oil in 2015 and beyond The oil supply side has been fundamentally shaken up by US shale oil Oil supply tends to be very price-inelastic in the short term The massive drop of oil prices by almost 60% within less than 9 months is the single most important macro event in the recent past with major implications on the global economy as already outlined above. In our view it is predominantly a supply-side shock and only to a smaller degree the result of somewhat weaker global demand. The accelerated strength of the US dollar in the second half of last year may have further exacerbated the fall in oil prices. The supply side has been fundamentally shaken up by the shale oil revolution in the US which can be truly considered as a game changer in the global petroleum landscape. This is illustrated in figure 10 which shows the crude oil production by the world s largest three producer countries. In fact, due to shale oil the US managed to increase its crude production by about 65% within the last 3 years. This strong incremental production finally led to a growing global supply overhang in the course of 2014 ultimately putting massive pressure on oil prices. So far, the latest supply figures show little sign of faltering growth despite the oil price decline. This may seem astonishing at first sight. However, oil supply usually tends to be very price-inelastic in the short term, primarily due to two reasons. First, many oil producers hedge the revenues of their production over the next 1 to 2 years by selling oil futures contracts. As a consequence, their production is unaffected by subsequent price changes. Second, the oil industry generally is a capital intensive business. Large-scale investments have to be Figure 8: Some more fiscal flexibility in the US Figure 9: and in the Euro area 1.0 0.6 0.8 0.5 0.6 0.4 0.4 0.2 0.0-0.2-0.4 0.3 0.2 0.1 0.0-0.1-0.2-0.6-0.3-0.8 2002 2004 2006 2008 2010 2012 2014 Government contribution to yearly real GDP growth (in %) -0.4 2002 2004 2006 2008 2010 2012 2014 Government contribution to yearly real GDP growth (in %) Page 6
undertaken for exploration purposes prior to any operational production activity. These fixed investment costs are typically already funded when production ultimately starts and are, therefore, sunk costs. Hence, as long as oil prices don t drop below cash costs, i.e. running costs to operate production, it may still be economically reasonable to maintain production activity even if prices fall below an overall break-even cost level. According to latest estimates the marginal cash costs for the oil industry are supposed to be in a range of 30-40USD (Brent price equivalent). Over time US shale oil companies are likely first movers given their short exploration lead time The oversupply leads to rising inventories.further exacerbated by contango related arbitrage The market is expected to be back in balance by beginning of 2016 unless there will be some additional supply Over time, however, a supply reaction can be expected on the sharp oil price drop with US shale oil companies being likely first movers given their short exploration lead time. The strong decline in US oil rig count statistics released in the first months of this year may be an early indicator for this (although the correlation between rig counts and subsequent production changes is rather vague). Meanwhile, the ongoing market oversupply leads to continuously rising oil stocks. This is particularly evident in the US where commercial crude oil inventories have reached unprecedented levels (see figure 11). By end of March 2015 crude stocks were at 472mln barrels which reflects an increase of 115mln barrels (+33%) within 6 months. The recent inventory pile-up has been further exacerbated by widespread arbitrage trades of market participants who could benefit from the steep contango shape of the futures price term structure. As spot prices had dropped far beyond futures prices the positive difference between futures and spot prices at some point outpaced the costs of carry. Purchasing oil on the spot market and selling it on the futures market while storing until delivery became a profitable trade. According to most recent demand and supply estimates the global supply overhang is supposed to culminate in the 2nd quarter of 2015 (see figure 12) with about 1.5mln barrels per day in excess of demand, not at least also due to seasonality reasons. Thereafter, market conditions should gradually ease as a result of subdued supply growth and incremental demand in the second half of 2015. At the beginning of next year the market is expected to be broadly in balance again. These forecasts remain uncertain, however, as countries such as Figure 10: Game changing US shale oil (crude oil production, in 0 b/d) 10 00 9000 8000 7000 6000 5000 Figure 11: Surging US commercial inventories 500 450 400 350 300 4000 2000 2002 2004 2006 2008 2010 2012 2014 Saudi Arabia Russia 250 1982 1986 1990 1994 1998 2002 2006 2010 2014 USA US commercial inventories in mln brl source: Energy Information Administration (EIA) source: EIA Page 7
Iran, Libya or Iraq may potentially inject additional oil on the market in the course of the year, thereby lengthening the period of oversupply. Oil prices are in a protracted bottoming out process with sluggish subsequent recovery in-line with historical experience Expected average Brent oil price for 2015: 60-65 USD Against this background we expect oil prices to stay in a protracted bottoming out process in the coming months. Depending on some stabilization of the spot market we may see a gradual price recovery in the second half of this year. To put this into a historical perspective we compare the recent sharp price drop with the three major oil price corrections which occurred during the last 30 years (see figure 13). Market conditions and economic circumstances may have been different for each of these price corrections but the subsequent recovery has in all cases been sluggish and gradual leaving oil prices between 50% and 65% of the initial peak level two years after the beginning of the price drop. Based on these considerations we expect an average oil price 2015 for Brent in the range of 60-65USD and for WTI of 53-58USD. The longer-term oil market equilibrium will be determined by the fundamental evolution of supply and demand in the long run. Based on historical experience it may be quite reasonable to expect an average annual growth rate for global demand around 1% which means that aggregate crude oil demand will be around mln b/d (barrels per day) five years from now. In a competitive market environment the long-run supply curve is determined by the marginal break-even costs of production. Given a yearly decline rate of global oil fields around 5% (which has to be replaced) and considering that a number of major oil exploration projects has recently been abandoned due to subdued oil prices there may be tighter conditions on the supply side in five years time despite any further US shale oil expansion. The long-term break-even costs will rather be at 80- USD and so will be oil prices Hence, we believe that marginal break-even costs at the global demand level of mln b/d will rather be in the range of 80- USD in five years - and so will be oil prices. This implies that the current term structure of oil futures prices is particularly mispriced at its long end with 5-year futures prices being traded considerably below our forecast. Figure 12: Global oil market imbalance (EIA figures and forecasts, March 2015, mln b/d) 96 3.00 Figure 13: Oil price drop in historical perspective 95 2.00 94 1.00 93 0.00 92-1.00 91 90-2.00 89-3.00 03/13 03/14 03/15 03/16 03/17 90 80 70 60 50 40 30 20 10 0 = peak price prior to correction (legend date = peak date) weeks 0 10 20 30 40 50 60 70 80 90 Global supply, l.h.sc 11/22/1985 Imbalance, stock change, r.h.sc. Global demand, l.h.sc. 10/12/1990 source: EIA 07/11/2008 06/20/2014 Page 8
The Outlook for the Saudi Arabian Economy We expect real growth in the Kingdom to be solid albeit at a gradually slower pace Oil prices traditionally play an import role for the Saudi economy. Hence, the recent massive price drop constitutes a challenge for the economy in 2015. However, we expect real growth in the Kingdom to be solid albeit at a gradually slower pace. This is primarily due to a concise countercyclical fiscal policy, a robust private non-oil sector and Saudi Arabia s determined efforts to keep its market share in the global oil markets. Since 2005 the government has increased its yearly fiscal expenditure from 350bln SAR to 1bln SAR. This implies a compound annual growth rate of 13.5%. Overall government expenditure represents about 40% of nominal GDP based on 2014 figures. Hence, the government constitutes an important driving force for domestic growth. On top, in every single year actual expenditures have significantly exceeded budgeted figures, on average by 25%. Last year s total expenditures outpaced the budget by 29%. This year s budget has been fixed marginally above the 2014 plan, 860bln vs. 855bln SAR. However, we expect the government to exceed this figure by a similar margin in order to keep the economy on its growth path. The non-oil private sector continues to be in a robust shape The non-oil private sector - another engine for growth - continues to be in a robust shape. Evidence for this can be found in a number of economic indicators for the first months of the year. Points-of-Sale- and ATM-transactions are sharply up in February by 42% respectively 43% compared to the previous year not at least due to the two-month salary bonus and on a smoothed 3- month average by still a sound 27% respectively 21%. These figures point towards solid growth in private consumption. As a proxy indicator for the construction sector cement production resp. sales figures increase in the first two months of the year by an average of about 10% compared to last year. Overall credit volume provided to the private sector is up in February by 11.6% on a year-on-year basis, marginally higher than the 5-year average of 10.6%. Based on all this we estimate non-oil sector real growth to be 4.5% for 2015 which is only gradually lower than the 2014 figure. Figure 14: Strong growth of fiscal expenditure 1200 0 800 600 400 200 Figure 15: Robust private consumption 50% 40% 30% 20% 10% 0% 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-10% 01/08 01/09 01/10 01/11 01/12 01/13 01/14 01/15 Government expenditure actual, in mln SAR Government expenditure budget, in mln SAR source: Ministry of Finance, KSA Points of Sales transactions (yearly change, 3M average) ATM withdrawals (yearly change, 3M average) source: SAMA Page 9
Saudi Arabia is determined to defend its market share in global oil markets The oil sector on the other hand faces a challenging market environment as highlighted above. Most recent data show that Saudi Arabia is determined to defend its market share in the global oil market. Actually, oil output in the first three months of 2015 has been higher than over the same period last year and higher than last year s overall average of 9.67mln b/d. On top, Saudi Arabia managed to gradually increase prices for selected clients which is a sign of a solid market position despite a highly competitive market environment. Based on this, we expect a positive real growth rate of about 1.0% for the oil-sector in 2015. We expect the overall economy to grow by about 3% in 2015 Taking all this together we forecast the overall economy to exhibit real growth of about 3.0% in 2015. In this context a remark on statistical GDP calculation has to be made in order to put these growth figures in a proper historical perspective. Last year the CDSI (Central Department of Statistics and Information) recalculated the GDP figures of the most recent years by changing the base year for real growth calculation from 1999 to 2010. Since prices in the oil sector and the non-oil sector developed differently over this period the (more volatile) oil sector has now a massively higher weighting in GDP calculation (44% vs. 22%) at the expense of the growth engine of the KSA economy, the non-oil sector. As a consequence, GDP figures will tend to be somewhat more volatile and gradually lower going forward. Figure 16: Cement production and sales Figure 17: KSA GDP and main sectors (2015 forecast) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 20 15 10 5 0-5 0 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15-10 2003 2005 2007 2009 2011 2013 2015 - Monthly cement sales (in 0 tons) Monthly cement production (in 0 tons) source: Yamama Cement Co. Real growth oil sector Real growth overall economy source: CDSI, RC estimates Real growth non-oil sector Page 11
Outlook for the Global Equity Markets Global equities are in an advanced stage of the multiyear bull market Elevated valuation figures have to be considered in the context of unprecedented low bond yields US equities are at an inflection point after having outperformed in the last couple of years Global equity markets are overall in an advanced stage of the multi-year bull market which started in spring 2009 after the global financial crisis. Over the last six years the World equity index MSCI advanced by about 130%. As underlying profit growth was clearly lower than this the markets witnessed a strong valuation multiple expansion. PE-ratio increased from 10x to currently 17x estimated forward earnings over this period. Hence, as figure 18 illustrates global equity markets are not cheap anymore. Compared to historical valuation of the last 10 years current levels are clearly elevated. On the other hand, they are still below the excessive technology boom valuations of the year 2000. Nevertheless, from a thorough valuation perspective a certain caution and selectivity may be warranted at this juncture. Current elevated valuation figures, however, have also to be considered in the context of yields on fixed income investments. In fact, global government bond yields have experienced a secular downtrend in the last 30 years and reached unprecedentedly low levels. This long-term decline has primarily to be seen against the background of a similar decrease of inflation rates at a global scale. On top, the most recent pressure on government bond yields also stems from massive QE programs by major central banks whereby large-scale purchases of sovereign bonds have been conducted sending yields partly to artificially low levels. As outlined above we expect these massive money printing exercises to continue over the next 1 ½ years albeit with some regional shifts. In particular US financial markets may be affected by this. The monetary regime shift from excess liquidity creation by the Federal Reserve to a more moderate stance with rising interest rates in the medium term may constitute some headwinds for US bond and equity markets. On top, the valuation premium to other equity markets, corporate profit margins at a cyclical peak and the strong US dollar biting into US earnings don t promise much relief for US equities and make them start looking much less attractive in a global comparison. In fact, US equities may be at an inflection point after having outperformed their international counterparts since a couple of years (see figure 19). Figure 18: Global equity valuation and bond yields 30 12 Figure 19: US equity primacy vs. rest of the world 160 25 10 140 20 8 120 15 6 10 4 80 5 2 60 0 0 1988 1992 1996 2000 2004 2008 2012 2016 PE ratio 12M forward MSCI World, l.h.sc. Global government bond yield, r.h.sc. Datastream 40 12/06 12/08 12/10 12/12 12/14 S&P500 MSCI World ex USA Page 11
We believe, therefore, that the US market will be range-bound for the foreseeable future with some risk for short-term setbacks should corporate earnings disappoint. The outlook for equity markets outside the US is more promising The medium-term perspectives for European equities remain attractive The case for Japanese equities is compelling, although to a lesser extent than Europe The outlook for other equity markets outside the US is actually more promising. In particular regions with expansionary monetary conditions allowing for some more asset price revaluation, where the equity market still exhibits a valuation discount in an international comparison, and where some more profit growth and profit margin expansion potential exists do look most attractive. This currently applies in particular to Europe and to a lesser extent to Japan. Within Europe the Euro area has suffered from the impact of the sovereign debt crisis in 2011 and 2012. It went through a recession until end of 2013 with a sluggish recovery thereafter. However, the strong devaluation of the Euro in the last 9 months and the improved credit conditions due to expansionary monetary policy by the ECB have considerably improved the outlook for the economy and the equity market. After a strong performance in the first quarter of 2015 Euro zone equities may consolidate in the short-term. However, the medium-term perspectives remain still promising. Corporate profits will benefit from growth acceleration and profit margins and market valuation may further expand against the backdrop of massive liquidity injection by the ECB pushing government bond yields partly even in negative zone (see figure 7, page 5). The case for Japanese equities is similar to Euro stocks albeit gradually less compelling as it is already in a more advanced stage. Since the starting point of QE in Japan two years ago the equity market has already advanced by almost 50%. However, Japanese equities have lagged their international counterparts many years before and due to strong gains in corporate profits valuation looks attractive especially when compared to US equities (see figure 21). Figure 20: Corporate profit margin US vs. Euro area 12 10 8 6 4 2 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 Corporate profit margin Euro area equities (in %) Corporate profit margin US equities (in %) Figure 21: Valuation equity market US vs Japan 50 45 40 35 30 25 20 15 10 2000 2002 2004 2006 2008 2010 2012 2014 2016 PE 12M forward MSCI Japan PE 12M forward MSCI USA Page 12
Mixed Short Term Outlook for Tadawul Tadawul has recently gone through a period of increased volatility Tadawul s correlation to oil prices is non-linear with increased sensitivity to oil prices below the fiscal breakeven point. Market perspectives remain mixed, primarily due to valuation concerns Over the last 12 months the Saudi equity market has gone through a period of increased volatility. Mid of last year, Tadawul had barely reached a multi-year high at 11 141 after a rally triggered by the market opening announcement, when the market got hit by the massive oil price drop in the second half of 2014. The subsequent strong correction lasted until December when the market reached a level of 7330. The following recovery was interrupted in March of this year by growing geopolitical concerns in the region putting again some temporary pressure on the market. Overall, the correlation of the Saudi market to the oil price is seemingly nonlinear. At high oil prices, clearly above the fiscal break-even point, the market s sensitivity to oil prices is rather low. However, this sensitivity considerably increases when oil prices sharply drop, particularly below the fiscal break-even level. The rationale behind this can be explained by the importance of government expenditures for private non-oil sector growth. High oil prices generate a comfortable fiscal budget surplus thereby allowing an expansionary fiscal policy; however, if oil prices fall clearly below the fiscal break-even level concerns on the sustainability of the growth-oriented fiscal policy start to weigh on the market against the backdrop of growing fiscal budget deficits. This also explains the strong market recovery at the beginning of this year beyond what oil prices would have warranted. The government s determined countercyclical fiscal stance communicated in December (budget announcement) and demonstrated a first time in January (two-month salary bonus) gave the market some comfort back with immediate growth concerns fading. At this juncture, the market perspectives for Tadawul are rather mixed in the short term. The planned market opening for foreign investors in June generally constitutes a positive market factor which could be further augmented if the detailed regulatory framework for foreign investors participation is even more favorable than previously announced in last year s original proposal. However, this positive market factor is mitigated by valuation concerns. Tadawul currently trades above 16x estimated 2015 earnings which is close to valuation levels of developed markets and at a considerable premium to many Emerging Figure 22: Tadawul and oil price Figure 23: PE 2015 estimate (as of 16 ) 12000 11500 10 10500 00 9500 9000 8500 8000 7500 7000 120 110 90 80 70 60 50 40 30 20 18 16 14 12 10 8 6 4 Tadawul All-share index, l.h.sc. Brent oil price, r.h.sc. Page 13
Market indices. On top, the underlying consensus earnings growth estimates for 2015 (+14%) seem to be rather lofty. As a consequence, the market s shortterm potential may be somewhat limited. The long-term outlook for Tadawul remains positive The longer-term outlook, however, remains positive for the market given its potential inclusion in major Emerging Market indices as a result of its market opening. This could result in a considerable inflow by index-linked and indexoriented Emerging Market funds. From a more fundamental perspective the market will eventually receive some major support from our longer-term oil price outlook which is clearly above current market consensus. Emerging Markets losing further Growth Momentum/ Commodities unattractive Emerging Markets have been a major growth engine for the global economy In China investment spending stood for 50% of GDP in 2011 The Chinese transformation to a more balanced economic model will be accompanied by lower growth rates Emerging Markets (EM) have been a major growth engine for the global economy for almost a decade. The joint EM business model essentially consisted of being a combined large-scale commodity producer and low-cost manufacturing hub for the world economy. Domestic growth was mainly driven by investment spending to build up further production capacity. This was particularly accentuated in the case of China where gross fixed investment expenditure finally climbed to almost 50% of GDP in 2011, a quota never seen before at the climax of any other regional growth trajectory (e.g. Japan, Korea, SE Asian tiger states). Sustained large investment spending risks ending up in massive overcapacity and strong deflationary pressure. In order to avoid this a more balanced growth model has to be pursued where gross fixed capital formation is partly replaced by increased domestic consumption. In fact, China has entered this transformation process and the Chinese government is taking reasonable measures to smoothen this transformation and to avoid a hard landing of the economy. However, this transformation process towards a more balanced economic model will inevitably be accompanied by considerably lower sustained economic growth rates. Figure 24: Growth dynamics driving EM equities Figure 25: and the USD driving EM equities 160 8 160 70 7 140 6 120 5 4 3 80 2 60 1 0 40-1 20-2 1995 2000 2005 2010 2015 Relative performance EM - DM equities (MSCI), l.h.sc. GDP growth difference EM DM (2015f), r.h.sc., IMF, RC estimate 140 75 80 120 85 90 80 95 60 105 40 110 20 115 0 120 1995 2000 2005 2010 2015 Relative performance EM - DM equities (MSCI), l.h.sc. Real trading weighted USD index, r.h.sc., inverse source: Fed St. Louis, Bloomberg Page 14
China happens to be the second largest economy in the world behind the US. Therefore, this development has major implications for the global economy as well as for EM financial markets and the entire commodity complex. EM growth dynamics have been a major driver for EM financial markets with the US dollar as another key variable for EM investments Longer term we are still in an environment of a strong US dollar Faltering growth dynamics and a strong US dollar don t favor EM investments The commodity cycle is strongly linked to EM growth EM growth dynamics have in fact been a major driver for EM financial markets. After having suffered in the second half of the 1990ies due to the Asian and later on the Russian crisis EM equities started to outperform global Developed Market (DM) equities when real growth in EM started to outpace growth of industrialized economies at the beginning of last decade (see figure 24). Measured in terms of MSCI equity indices EM equities outperformed DM equities in the period from 2001 until 2010 by an accumulated 300%. However, when growth dynamics in Emerging Markets, and particularly in China, started to falter EM equities started to underperform. Next to real growth dynamics there is another key variable sustainably driving the relative performance of EM asset prices: the US dollar. There are various reasons for this. Most importantly, a stronger US dollar typically causes international investors to withdraw their money from EM investments. To stem this outflow EM countries are forced to pursue a more restrictive policy, e.g. by raising interest rates which in turn is negative for their domestic growth perspectives curbing the longer-term attractiveness of local investments. The US dollar has significantly strengthened against major foreign currencies over the last nine months. Therefore, a short-term consolidation is warranted for the US currency. Nevertheless, from a longer-term perspective we are still in an environment of a strong US dollar (see figure 26). Hence, faltering growth dynamics in EM and a strong US dollar environment don t favor EM equity investments although as a result of their recent underperformance they exhibit a considerable valuation discount to DM equities at this juncture. What is valid for EM financial assets also applies to commodity investments. They, as well, have been largely driven by the growth dynamics of Emerging Markets, in particular China, and the evolution of the US currency (see figure Figure 26: The prevailing strong USD regime 150 140 130 120 110 90 80 70 Figure 27: Commodities suffering from strong USD 250 200 150 50 60 70 80 90 110 120 60 1980 1985 1990 1995 2000 2005 2010 2015 Real trade-weighted USD index Nominal trade-weighted USD index source: Fed St. Louis 0 130 1995 2000 2005 2010 2015 Bloomberg commodities index, l.h.sc. Real trade-weighted USD index, r.h.sc., inverse source: Fed St. Louis, Bloomberg Page 15
...and inversely related to the US dollar 27). Throughout its massive investment cycle over the last 10-15 years China has absorbed a large part of global supply for a number of raw materials. With its economic transformation and the curbed investment spending Chinese commodity demand has faltered as well. Besides, commodity prices are generally inversely related to the US currency. A stronger US dollar puts pressure on commodity prices as they are traditionally traded in USD and, hence, more expensive for non-usd-based countries when the US currency appreciates. As a consequence, with higher prices in local currency domestic demand is curbed with a negative impact on commodity prices. EM growth outlook and a USD strength don t favor commodities Against the backdrop of a sober EM growth outlook and in the current stage of a strong US currency commodity investments cannot be considered as attractive at this juncture. Page 16
Performance equity markets Valuation equity markets 2012 2013 2014 Q1/15 World (MSCI World AC) 13.4 20.3 2.1 1.8 Adv. Economies (MSCI World) 13.2 24.1 2.9 1.8 USA (S&P500) 13.4 29.6 11.4 0.4 Euro Area (EuroStoxx) 15.5 20.5 1.7 18.2 Japan (Topix) 18.0 51.5 8.1 9.6 United Kingdom (FTSE) 5.8 14.4-2.7 3.2 Emerging Markets (MSCI EM) 15.2-5.0-4.6 3.6 China (CSI300) 7.6-7.7 51.7 1.1 India (Sensex) 25.7 9.0 29.9 6.8 Russia (Micex) 5.2 2.0-7.2 26.0 Brazil (Ibovespa) 7.4-15.5-2.9 0.3 Saudi Arabia (Tadawul) 6.0 25.5-2.4 5.4 MSCI indices in USD, all other indices in local currency, price changes net of dividends PE 15 PE 16 PB 15 RoE 15 World (MSCI World AC) 16.8 14.9 2.1 12.3 Adv. Economies (MSCI World) 17.5 15.5 2.2 12.5 USA (S&P500) 17.5 15.5 2.6 15.0 Euro Area (EuroStoxx) 16.7 14.7 1.7 10.1 Japan (Topix) 16.8 14.8 1.4 8.4 United Kingdom (FTSE) 15.9 13.9 1.8 11.2 Emerging Markets (MSCI EM) 12.3 10.9 1.4 11.4 China (CSI300) 14.7 12.7 2.1 14.6 India (Sensex) 18.4 15.6 2.8 15.3 Russia (Micex) 6.0 5.1 0.5 8.0 Brazil (Ibovespa) 12.2 9.9 1.2 9.8 Saudi Arabia (Tadawul) 15.4 13.4 2.0 12.7 As of 31 March 2015 PE price/earnings ratio, PB price/book ratio, RoE return on equity all figures based on analysts' consensus estimates, Bloomberg Central bank rates 2012 2013 2014 2015f Advanced Economies USA 0.25 0.25 0.25 0.50 Euro Area 0.75 0.25 0.05 0.05 Japan 0.10 0.10 0.10 0.10 United Kingdom 0.50 0.50 0.50 0.65 Emerging Market Economies China 6.00 6.00 5.60 5.00 India 8.00 7.75 8.00 7.25 Russia n.a. 5.50 17.00 11.50 Brazil 7.25 10.00 11.75 13.00 Saudi Arabia 2.00 2.00 2.00 2.25 End of period, 2015 forecast 10-year Government bond yields 2012 2013 2014 2015f Advanced Economies USA 1.76 3.03 2.17 2.50 Euro Area 1.32 1.93 0.54 0.30 Japan 0.79 0.74 0.33 0.45 United Kingdom 1.83 3.02 1.75 2.00 Em. Market Economies China 3.60 4.60 3.65 3.50 India 8.24 9.23 8.00 7.50 Russia 6.81 7.83 10.39 12.00 Brazil 9.17 10.88 12.36 12.75 Saudi Arabia n.a. n.a. n.a. n.a. End of period, 2015 forecast Central bank rates (as of 31 March 2015) Government bond yields (as of 31 March 2015) 16.00 12.00 14.00 12.75 16.00 12.00 13.04 12.37 8.00 7.50 8.00 7.82 5.35 4.00 2.00 4.00 3.63 1.92 1.58 0.00 0.50 0.25 0.10 0.05 0.00 0.41 0.18 n.a. Source: Bloomberg, RC estimates Page 17
Recommended Asset Allocation for Balanced Investor The following recommended asset allocation is tailored to an investor with a Balanced investment profile. This profile is reflected in the Strategic Asset Allocation which is an optimized portfolio structure based on the long-term risk/return-characteristics (i.e. more than 5 years horizon) of all asset classes considered. The Tactical Asset Allocation for the Balanced profile incorporates the short-to medium term investment view expressed in this document and translates into under- and overweights for each asset class compared to its strategic quota. Hence, these under- and overweightings reflect the relative attractiveness of different asset classes from a tactical perspective. Asset Class Tactical Allocation Strategic Allocation Over- / Underweight Equities 55 50 +5 Saudi Arabia 25 25 0 GCC other 5 5 0 USA 9 10-1 Europe 9 4 +5 Asia/Japan 7 3 +4 Emerging Markets 0 3-3 Fixed Income 15 25-10 High grade bonds 5 15-10 High yield bonds 5 5 0 Emerg. Market bonds 5 5 0 Alternative Investments 10 15-5 Hedge Funds/Private Equity 5 5 0 Real Estate 5 5 0 Commodities/Precious Metals 0 5-5 Money Market 20 10 +10 Cash SAR 20 10 +10 Total 0 Tactical Asset Allocation (as of ) Underweights / Overweights (Tactical vs. Strategic Asset Allocation) Money Market, 20% Equities +5 Fixed Income -10 Equities, 55% Alternative Investments, 10% Alt. Investments -5 Fixed Income, 15% Money Market +10-15 -10-5 0 5 10 15 Page 18
Disclaimer The information in this report was compiled in good faith from various public sources believed to be reliable. Whilst all reasonable care has been taken to ensure that the facts stated in this report are accurate and that the forecasts, opinions and expectations contained herein are fair and reasonable, Riyad Capital makes no representations or warranties whatsoever as to the accuracy of the data and information provided and, in particular, Riyad Capital does not represent that the information in this report is complete or free from any error. This report is not, and is not to be construed as, an offer to sell or solicitation of an offer to buy any financial securities. Accordingly, no reliance should be placed on the accuracy, fairness or completeness of the information contained in this report. Riyad Capital accepts no liability whatsoever for any loss arising from any use of this report or its contents, and neither Riyad Capital nor any of its respective directors, officers or employees, shall be in any way responsible for the contents hereof. Riyad Capital or its employees or any of its affiliates may have a financial interest in securities or other assets referred to in this report. Opinions, forecasts or projections contained in this report represent Riyad Capital's current opinions or judgment as at the date of this report only and are therefore subject to change without notice. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or projections which represent only one possible outcome. Further such opinions, forecasts or projections are subject to certain risks, uncertainties and assumptions that have not been verified and future actual results or events could differ materially. The value of, or income from, any investments referred to in this report may fluctuate and/or be affected by changes. Past performance is not necessarily an indicative of future performance. Accordingly, investors may receive back less than originally invested amount. This report provide information of a general nature and do not address the circumstances, objectives, and risk tolerance of any particular investor. Therefore, it is not intended to provide personal investment advice and does not take into account the reader s financial situation or any specific investment objectives or particular needs which the reader s may have. Before making an investment decision the reader should seek advice from an independent financial, legal, tax and/or other required advisers. This research report might not be reproduced, nor distributed in whole or in part, and all information; opinions, forecasts and projections contained in it are protected by the copyright rules and regulations. Riyad Capital is a Saudi limited liability company, with commercial registration number (1010239234), licensed and organized by the Capital Market Authority under License No. (07070-37), and having its registered office at Al Takhassusi Street, Prestige Building, Riyadh, Kingdom of Saudi Arabia ( KSA ). Website: www.riyadcapital.com Page 19