Emirates NBD: Monthly Insight - January 2018

Transcription

1. Monthly Insights 2018 has begun with optimism carrying over from last year . The developed world has started strongly, regional governments are embracing more expansionary policies, and financial markets are being boosted by all of the above. The main question is actually whether too much optimism is being priced in. Monthly 17 January 2018  Global macro: 2017 ended with constructive economic data which leaves the global economy going into 2018 on firm footing. With global growth remaining robust, attention will turn to central banks with expectations of tightening monetary policy.  GCC macro: Following two years of relative austerity in terms of regional budgets, governments have signalled a more expansionary fiscal stance for 2018.  MENA macro: The outlook for Egypt is increasingly positive, as the difficult economic reforms enacted in 2016 and 2017 as part of an IMF-sponsored programme begin to reap their rewards.  Sector focus: UAE’s defence sector overview.  Emerging market focus: India  Interest rates: Slowing QE by central banks and expectations of higher inflation ensuing from the synchronized global growth caused yield on government bonds to rise across the developed world.  Credit: Rising UST yields weighed on GCC corporate bonds. However, positive sentiment on the back of higher oil prices and reducing government budget deficits in the region helped to contain losses.  Currencies: Despite a rate hike in December 2017 and three forecasted hikes in 2018, the USD has remained under pressure, finishing last year on a softer note, as the markets’ focus turned to global reflation.  Equities: The momentum in global equities is expected to continue in 2018. The reason for optimism stems from the fact that economic activity remains well above the trend signaling that growth is yet to peak, monetary policy tightening is still at a very early stage and that valuation continues to remain reasonable when compared to other asset classes.  Commodities: Oil markets are off to a blistering start in 2018, extending their gains from 2017. While we expect oil prices to be higher on average in 2018 than they were last year, we are cautious that a near-term correction in prices is approaching. Optimism prevails at the start of the year 130 120 Tim Fox Head of Research & Chief Economist +971 4 230 7800 timothyf@emiratesnbd.com 110 100 90 80 www.emiratesnbdresearch.com 70 Jan-17 Apr-17 US 10 Year Yield Source: Bloomberg, Emirates NBD Research. Jul-17 S&P 500 Index Oct-17 Jan-18 Brent Crude Oil
2. Content Global Macro ......................................................................................................... Page 3 GCC Macro ............................................................................................................ Page 5 Non GCC Macro…………………………………………………………………………. Page 6 Sector Focus……………………………………………………………………………...Page 8 EM Focus - India ................................................................................................ Page 10 Interest Rates ..................................................................................................... Page 11 Credit .................................................................................................................. Page 13 Currencies.......................................................................................................... Page 15 Equities .............................................................................................................. Page 17 Commodities ...................................................................................................... Page 19 Key Data & Forecast Tables .............................................................................. Page 21 Page 2
3. Global Macro US starts 2018 on firm footing US data continued to be encouraging at the turn of the year with retail sales showing 0 .4% m/m growth in December, accompanied by upward revisions to 0.5% growth in October and 1.2% growth in November. This continued growth not only shows that Q4 2017 has seen the strongest quarterly gain in retail sales since 2003 but in addition suggests that consumption growth accelerated in the final quarter of 2017. This in combination with a tightening labor market, with 4.1% unemployment and 2.5% y/y wage growth, bodes well for consumption continuing to be a driving force for the US economy in 2018. US retail sales accelerate in Q4 2017 2.50 2.00 1.50 released a plan that will extend the deadline for a shutdown until February 16 from the current January 19 dropoff. In addition to the funding extension, the plan tacks on a series of healthcare, tax, and military funding changes. Whether or not the bill will pass is questionable. Democrats have demanded that any funding bill include a codification of the Deferred Action for Childhood Arrivals (DACA) immigration program. Outside of the House fight, the plan will also need some support from Senate Democrats in order to avoid a filibuster there. Firm Eurozone data continues Further evidence of continued economic recovery in the Eurozone was revealed by a string of stronger than expected economic data releases over the last month. Eurozone aggregate retail sales data showed an increase of 1.5% m/m in November, beating market expectations for a 1.3% gain. In addition recent survey evidence has been encouraging with, the Sentix Investor Confidence reading rising to 32.9 in January, up from 31.1 and revealing that institutional and private investors remain optimistic about the year ahead. Furthermore data released by the European Commissions showed that consumer confidence reached 0.5 in December, the highest levels since 2001 and during the same period, economic confidence rose to 116, the highest level since December 2000. 1.00 0.50 Eurozone economic confidence soars 0.00 125 -0.50 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Adjusted Retail & Food Services Sales Total % Change (MoM) 115 105 95 Source: Bloomberg, Emirates NBD Research 85 Fed expects three rate hikes in 2018 As widely expected, the Federal Reserve hiked interest rates by 25 bps at their meeting in December and signaled to the market that the FOMC expects three further rate hikes in 2018, with the markets currently pricing in only two rate hikes for the year ahead. Looking forward, there is a risk that increases in inflation lead the Fed to raise interest rates more than three times, although this is not our central view. Economic data released by the Bureau of Labor Statistics showed that headline inflation was 2.1% y/y in December while core inflation increased to 1.8% from 1.7% in November. In addition, producer prices increased 3.3% y/y indicating that pipeline price pressures are indeed starting to build. But political risks remain The main risks to the US expansion come from politics with the Trump White House continuing to detract from what should be a positive overall economic picture. While the bulk of the attention this year will fall on the mid-term elections in November, the year is already starting with considerable uncertainty over a possible government shutdown. US lawmakers failed to achieve concensus on future government spending ahead of the current agreement that expires at the end of this week. However, House Republicans have 75 65 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16 European Commission Economic Sentiment Indicator Eurozone Source: Bloomberg, Emirates NBD Research ECB interpreted as more hawkish The minutes from the ECB’s December meeting were interpreted as hawkish by the markets. While there was a consensus among officials that economic data had been stronger than expected, there were concerns over the sustainability of the inflation uptrend and how long it would take to approach the central bank’s 2.0% target. However, comments with regards to reviewing policy language in 2018 as well as some officials calling for a firm date for the ending of the asset purchase program persuaded investors that the central bank is shifting its bias towards an earlier exit from QE. According to the OIS, the markets are pricing in a 54.2% chance of a 10bps hike by December 2018, up from 25.7% the previous month. Page 3
4. UK production outperforms ….. UK production figures showed continued improvement in November as increasing energy demands created by colder weather conditions contributed to 0.4% m/m and 2.5% y/y growth for industrial production. In addition, this was accompanied by upward revisions of 0.2% m/m and 4.3% y/y growth for the previous month. Manufacturing production also showed respectable growth in November of 0.4% m/m (3.5% y/y) with upward revisions to 0.3% m/m and 4.7% y/y in October. These reports from the UK Office for National Statistics show that UK manufactures have now reported seven consecutive months of growth, the longest run of expansion in two decades. Therefore this is likely to have contributed to stronger growth in Q4 2017. With Q3 2017 GDP being firmer than expected at 1.7% y/y compared with market expectations of 1.5% y/y, such data shows that despite all the concerns about Brexit, the UK economy has remained resilent. Japanese economy grows for 7th quarter 3.00 2.00 1.00 0.00 -1.00 Dec-15 ..while UK inflation eases only slightly Meanwhile annual CPI inflation in the UK slipped to 3.0% in December from 3.1% in November, much in line with expectations. The outturn was 0.3% above the 2.7% projected in the BOE’s November Inflation report. Core inflation also fell in December, to 2.5% from 2.7% in November. The drop in CPI probably marks the beginning of a sustained downward trend over the rest of 2018 as the pound holds onto its gains. It also gives Bank of England more breathing space though next rate move is still likely to be up. UK inflation remains elevated 3.50 3.00 2.50 2.00 1.50 1.00 Jun-16 Dec-16 Jun-17 Japan Real GDP Annualized QoQ SA GDP expenditure approach % Source: Bloomberg, Emirates NBD Research …but inflation is still subdued Despite better than expected GDP growth, spending by Japanese households on goods and services remains tepid and wage gains remain muted, rising by 0.9% y/y in November and with headline CPI steady at 0.6% y/y. While inflation and wage pressures remain far from the Bank of Japan’s target level, it is likely that the central banks preference for ultra loose monetary policy is likely to continue although it is becoming apparent that the Bank of Japan is engaging in a limited form of tapering by reducing its purchases of long dated JGBs. Such tapering ‘by stealth’ is catching market attention (see FX), although it is unclear how much further the BOJ is prepared to go given that it is already having a positive and unwelcome effect on the JPY. Tim Fox +9714 230 7800 0.50 0.00 Dec-15 The Japanese economy has now expanded for seven consecutive quarters, the longest positive run since the mid-1990’s. While data already released indicates that growth in Q4 is likely to have slowed down, it is still likely to post a positive number and show expansion. Jun-16 Dec-16 Jun-17 Dec-17 Mohammed Al Tajir +9714 609 3005 UK CPI EU Harmonized YoY NSA Source: Bloomberg, Emirates NBD Research Growth remains steady in Japan …. Q3 2017 GDP showed annulized q/q growth of 2.5% in Japan, larger than market expectations for 1.5% growth and accompanied by an upward revisision of 2.9% growth in Q2. The initial reading for Q3 was 1.4% and the stronger than expected upward revision can be explained by stonger levels of business investment and inventories, with export growth diriving corportate profits and investment. Page 4
5. GCC : The end of austerity? Following two years of relative austerity in terms of regional budgets, which saw the introduction of new taxes, cuts to energy and other subsidies, and slower public sector wage growth, governments in the region have signalled a more expansionary fiscal stance for 2018. An upward revision to Saudi spending already Saudi Arabia announced a 5.6% increase in its official budget for 2018, released at the end of last year. This excluded another SAR 133bn in off-budget (mainly infrastructure) expenditure funded through the Public Investment Fund and National Development Funds. If added to the official budget, the government planned to boost spending by nearly 20% y/y this year, a significant fiscal stimulus. However, following public complaints about the cost of living after further subsidy cuts and the introduction of VAT at the start of this year, the King announced a series of additional measures including public sector wage increases, higher allowances for pensioners and students, one-off bonuses for the armed forces and other cash transfers, which officials estimated would add another SAR 50bn to government spending (another 1.8% of estimated GDP this year). Overall, we now estimate official budget spending at over SAR 1.0tn this year, and at nearly SAR 1.2tn once the off-budget spending is included. The fiscal deficit would rise to -13.7% of GDP from -9.0% in 2017, although the financing requirement is much lower at -8.8% GDP (USD 64bn) as the balance would come from funds already earmarked at PIF and NDF. The substantial fiscal stimulus in the Kingdom, together with an expected recovery in oil output, should result in 2.5% real growth this year, following a marginal contraction of -0.5% in 2017. The decline in GDP last year was entirely due to oil production cuts and is likely to be partially unwound this year. Kuwait has yet to pass a budget for the next fiscal year (starting 1 April 2018) but we expect total expenditure will rise to KWD 20bn from an estimated KWD 18.5bn this fiscal year. The break-even oil price is likely to rise slightly to USD 69pb this year based on our assumptions. Slow progress in Oman and Bahrain The larger GCC economies have used the low oil price shock of 2015-2016 to tackle structural reform of their budgets, cuttings hefty subsidies on energy and utilities and introducing measures to boost non-oil revenues. Even if the immediate financial benefit of subsidy cuts has been partially offset by offering cash compensation to some households, the reforms have put the budgets on a firmer footing. Cash compensation is better targeted to those who need it, unlike general subsidies on fuel and utilities which typically end up benefitting wealthier households disproportionately. Moving closer to market pricing for fuel and electricity should also reduce domestic consumption of energy (and oil), as households and firms are incentivized to save energy and become more energy-efficient. However Oman and Bahrain have not made as much progress on re-prioritising expenditure and reducing reliance on oil revenues. While Oman has reduced the amount it spends on defence, and cut some subsidies, overall current spending remains high. Preliminary estimates show the government spent more than planned in 2017, although the deficit did narrow to -12.2% of GDP on higher oil prices. This year, expenditure is likely to remain broadly unchanged, and the government has delayed the introduction of VAT. Nevertheless, higher oil prices this year should result in a further modest narrowing of the budget deficit (to -10.8% of GDP), with most of this financed by debt issuance. Bahrain passed the budget for 2018 in mid-2017, at the same time as it approved (late) the 2017 budget. The expenditure target for 2018 is unchanged from 2017 at BHD 3.5bn, although the IMF estimates higher spending this year. Bahrain has also delayed implementing VAT until 2019. We expect the budget deficit to remain just under 15% of GDP this year.. Infrastructure spending to rise this year In the UAE, Dubai’s government has increased funds earmarked for infrastructure investment by nearly 47% as it steps up the pace of preparation for Expo 2020. Overall, we expect an increase of around 3% y/y in consolidated government spending, even as the deficit continues to narrow on higher oil and non-oil revenues. We estimate a consolidated budget deficit of -1.5% of GDP in 2018, down from an estimated -2.7% in 2017. Based on our estimates, the UAE’s break even oilprice in 2018 will be the lowest in the region at USD 63pb, and we expect the UAE to post a balanced budget in 2019. Qatar’s 2018 budget also indicates a modest 2.4% increase in total expenditure this year, following cuts in 2016 and 2017. Nearly half the projected spending is earmarked for major projects, including World Cup related projects. Spending on public sector wages is expected to rise nearly 9% this year. Qatar has been relatively conservative with its oil price forecasts so our forecast for the budget deficit is smaller than the official one; we estimate only a marginal shortfall of -0.3% of GDP this year. Total budget expenditure (USD bn) KSA UAE Qatar Kuwait Oman Bahrain Total GCC budget spending 2015 260.8 115.9 68.4 60.4 35.6 9.4 2016 224.0 113.6 55.6 58.4 33.5 9.4 2017 246.9 115.3 54.5 61.5 33.0 9.8 2018 279.1 118.6 55.8 66.7 33.8 10.3 550.5 494.5 521.1 564.3 Source: Bloomberg, Emirates NBD Research Khatija Haque +971 4 230 7803 Page 5
6. MENA Macro : Egypt set for a stronger 2018 While 2017 was undoubtedly a difficult year for the Egyptian economy, the outlook is far brighter as we begin 2018. There is a growing sense that the bitter medicine taken as part of its IMF-sponsored economic reform programme is starting to work, and a host of indicators point towards ameliorating economic conditions this year. We forecast that real GDP growth will strengthen to 5.0%, from 4.2% in FY 2016/17 (ended June 30). The effects of the currency float enacted in late 2016 are progressing in an almost textbook fashion to date, and while there remain significant structural challenges to growth, there is a groundswell of optimism among businesses in the country. which averaged 30.8% y/y over January to October. A series of tax hikes and subsidy removals, as the government looked to narrow its fiscal deficit, have also played a part in this. However, here too we see an improvement coming. In November, as the effects of the peg’s removal began to pass through, inflation fell to 26.0%, the lowest rate since December 2016, and ended the year at 21.9%. Equally, the bulk of the planned tax and tariff hikes have now been implemented. As a result, we expect further sharp falls in price growth over the coming months, with the headline figure likely to dip back below 20.0% y/y in Q1, potentially aided by a modest appreciation in the pound. This will alleviate pressure on squeezed households, and should encourage an uptick in consumption. Egypt inflation & exchange rate 35.0 20 18 16 14 12 10 8 6 4 2 0 30.0 This is evidenced in the Emirates NBD Purchasing Managers surveys, which have consistently shown in recent prints that the overwhelming majority of firms expect improved conditions 12 months down the line. In the December survey, 70.0% of respondents expected greater output in a year’s time, and only 8.0% expected conditions to deteriorate. Not only that, but the headline results have also been improving, coming in at 50.7 in November, indicating an expansion in the non-oil private sector for the first time since September 2015. While the headline index dipped back down below the neutral 50.0 benchmark level once again in December, to 48.3, there remains grounds for optimism. The fourth quarter was the weakest contraction in over two years, and the rise in input prices has begun to ease. Input prices were driven up by the pound’s sharp depreciation at the end of 2016, and weighed heavily on firms’ activity in 2017. Egypt Emirates NBD PMI 55.0 50.0 45.0 40.0 35.0 Apr-11 Aug-12 Dec-13 Apr-15 Aug-16 25.0 20.0 15.0 10.0 5.0 0.0 Jan-14 Nov-14 Sep-15 Inflation, % y/y (lhs) Jul-16 May-17 EGP/USD (rhs) Source: Haver Analytics, Bloomberg, Emirates NBD Research Crucially, falling inflation will also enable the Central Bank of Egypt (CBE) to begin a rate-cutting cycle, which we expect will begin in the first quarter, further boosting domestic demand. The CBE implemented a cumulative 700 basis points of hikes to its benchmark interest rates in the wake of the pound’s peg removal. There are some concerns that rate-cutting will see the portfolio investment that has flooded into Egypt over the past year begin to fall once more - foreign ownership of treasury bills stood at USD18.7bn in November, compared to just USD0.5bn 12 months earlier. However, while yields are now falling, we do not anticipate a sudden flight of ‘hot money’ posing risk to the pound and threatening a further sharp sell-off. Egyptian debt remains an attractive proposition, and much of the foreign portfolio investment that has entered the country over the year has done so via a repatriation fund, limiting any fallout risks from potential capital flight. Dec-17 Source: IHS Markit, Emirates NBD Research Falling Inflation Will Enable Rate Cuts Foreign ownership of t-bills, USDbn It is not only firms that have struggled with higher costs owing to the weaker pound; households have had to contend with CPI inflation Page 6
7. over the first three quarters of 2017 . To date, Egypt has not been able to benefit from the devalued pound as much as it might have done if not for ongoing flight bans to key Red Sea resorts from major tourism partners Russia and the UK. However, direct flights from Russia to Cairo were reinstated in late 2017, raising the prospect for the removal of the remaining restrictions and boosting the industry even further in 2018. 20 18 16 14 12 10 Daniel Richards +971 4 609 3032 8 6 4 2 0 Mar-09 Jul-10 Nov-11 Mar-13 Jul-14 Nov-15 Mar-17 Source: Haver Analytics, Emirates NBD Research Fixed Investment Will Come Increased portfolio investment is a positive for the economy, but greater fixed investment inflows will be crucial to fostering a longlasting and durable growth trajectory. FDI has picked up, but has lagged the uptick in portfolio inflows to date. Nevertheless, we expect that there will be an improvement in this regard in 2018. For starters, investor fears over another sharp depreciation of the pound will have been allayed by the fact that Egypt’s net international reserves have surged. These stood at a record USD37.0bn at the close of 2017, exceeding even the USD36.0bn recorded at the start of 2011. With increased confidence that the pound has found a bottom, international firms will be eager to benefit from the more competitive currency. Companies which have already entered the market in 2017 include Mercedes Benz, which is re-entering Egypt with the development of a new regional distribution facility, and techtaxi firm Uber. A new investment law passed in 2017, which widens the scope for projects to be granted tax breaks, will also entice greater interest. Egypt reserves, USDbn 40 35 30 25 20 15 10 Jan-10 May-11 Sep-12 Jan-14 May-15 Sep-16 Source: Bloomberg, Emirates NBD Research Finally, there are also encouraging signs from the tourism sector, which has already benefitted from a 53.4% y/y increase in numbers Page 7
8. ammunition , armored vehicles) while aiming to advance to more complex equipment such as military aircrafts, etc. Sector Focus GCC defence spending resilient in 2016 GCC military expenditure, 2016 Defence spending was resilient across the GCC for yet another year in 2016 with Saudi Arabia and the UAE reporting the largest defence budgets with USD 63.7bn and USD 22.8bn, respectively. Overall, GCC countries spent USD 105.4bn in 2016 down by roughly -20.0% y/y due to the fall in oil prices in 2015. We expect GCC military spending to have increased in 2017 as oil recovers and GCC military commitments continue. The focus of the GCC is channeled to domestic production matched by a number of policies for attracting local investment to the sector. Domestic defense design and production however will take time. Matching GCC domestic policies to support diversification in the defense sector with investors and technologies will require partnerships between the public and private sectors. 40 % GDP % Government Spending 30 29.6 27.6 20 17.5 16.7 10 12.4 10.5 10.4 6.5 5.7 4.8 1.5 4.9 0 Oman Saudi Arabia Kuwait GCC military spending and oil prices UAE Bahrain Qatar Source: SIPRI, Emirates NBD Research 120 120 100 100 80 80 60 60 40 40 20 20 0 0 Offset programs aiming to further boost economic activity USD bn 140 USD / b 140 GCC Military Expenditure (RHS) Oil Prices (annual average, LHS) Source: Bloomberg, SIPRI, Emirates NBD Research Saudi Arabia’s military spending is expected to increase further in the next few years considering the rising commitments in active military engagement in the region. UAE’s military expenditure reached a record high in 2016 with an active procurement pipeline being continued through 2017 with large orders for aircraft and weaponry. Oman’s military budget is the highest in terms of GDP and government spending making up for a considerate part of its economic capacity with USD 9.1bn, followed by Kuwait (USD 6.6bn), Qatar (USD 1.9bn), and Bahrain (USD 1.4bn), according to latest data from Stockholm International Peace and Research Institute (SIPRI). The emerging GCC defence market and the ‘USD 30bn opportunity’ in terms of domestic defence production over the next decade is mainly driven by Saudi Arabia’s economic diversification plans. According to vision 2030, Saudi Arabia plans to localize at least 50% of its defence spending by 2030 (currently at 2%) by developing a number of defence related sectors such as industrial equipment, communication, and information technology. In 2016, soon after the department of local manufacturing support was established, Saudi Arabia has launched a few support industries (spare parts, basic The impact of transferring knowledge and technology from defence expenditure is importnat in terms of industrial compensation arrangements, often referred to as offset programs. The scope of these programs is to provide the conditions that large item purchases from foreign suppliers can create additional benefits to the economy, including the creation of domestic job opportunities. As UAE was the second largest military spender in the MENA region after Saudi Arabia , accounting for 13.4% of total spending in 2016, we expect offset programs to continue having significant impact to the economy. Overall, total arms sales recorded USD 402bn in 2016 with 7 US companies being among the top 10 suppliers with a combined arms sales value of USD 152bn for the same period, as the graph below shows. Top global arms sales by company, % of total USD 402bn in 2016 Lockheed Martin 10.2% Boeing 7.3% Raytheon 5.7% Rest 49.2% Thales 2.0% Leonardo 2.1% BAE Systems UK 5.7% Northrop Grumman 5.3% General Dynamics 4.8% Airbus Group 3.1% BAE Systems 2.3% L-3 Comms 2.2% Source: SIPRI, Emirates NBD Research Page 8
9. UAE defence strategy on track UAE ’s strategy of creating jobs for its nationals and increase domestic ownership through investment vehicles, creating many opportunities within the security sector, is the driver for the country’s offset programs. Moreover, UAE’s aspiration in building defence capabilities is taking shape through Abu Dhabi’s Economic Vision 2030 and is strongly linked to investment in aerospace. The country’s diversified investments in aerospace are gaining momentum with a number of companies dedicated to maintentance, repair, and overhaul (MRO) of military planes. By expanding MRO capabilities in the aerospace industry, UAE has created the base for the production of unmanned aerial vehicles (UAVs). Abu Dhabi Autonomous Systems Investments (ADASI) and Adcom Systems are two of the leading UAV companies presently operating in the country. Moreover, UAE is planning to enhance its maintenance and repair services designed to support military and civil air force equipment and parts, defence electronics and other equipment. So far UAE has designed and manufactured light weapons, military support vehicles, and armored personnel carriers. Namely, Mahindra Emirates Vehicle Armoring based in Ras Al Khaimah and NIMR Automotive based in Abu Dhabi have established significant capacity into this segment. It should be noted that NIMR’s military vehicles, although rebranded designs from the South African firm Denel, are being currently exported to Algeria while there are talks with Turkey and Egypt to soon import NIMR armored vehicles. In general, however modest, exports of domestically produced military equipment indicate the significant improvement of the country’s defence industry. US arms deliveries to the UAE, 2016 Quantity Type 7600 JDAM bombs 5000 GBU-39 SDB bombs 2482 MaxxPro pistols 2000 Talon air missiles 500 Caiman pistols 390 GMLRS Rocket platforms 300 AGM-84H SLAM-ER air missiles 237 RIM-162 ESSM naval missiles 200 RIM-116A RAM naval missiles 124 MGM-140B ATACMS launchers 96 THAAD missiles 50 ISB4 engines 44 M-ATV vehicles Cost USD 117mn USD 250mn USD 174mn 30 Bell-407 helicopters 24 Archangel-BPA launchers 12 M-142 HIMARS launchers USD 143mn 10 RQ-1 Predator drones USD 200mn 2 THAAD launchers USD 2.5bn 2 RDR-1700 radars Source: SIPRI, Emirates NBD Research Thanos Tsetsonis +971 4 230 7629 Last but not least, the maritime sector is undoubtedly the most advanced segment of UAE’s defence industry. Acting as a major contractor and systems integrator, Abu Dhabi Ship Building (ADSB) is the driving force of ship building in the UAE. Supported by Abu Dhabi Systems Integration (ADSI) - a subsidiary of ADSB, and Italian SELEX Sistemi Integrati, ADSB is focused on electronic and weapons systems design and development. Moreover, Gulf Logistics and Naval Support (GLNS), a joint venture between ADSB and BAE’s Maritime Systems subsidiary BVT Surface Fleet also provides support services for maritime systems, including logistics and training. Page 9
10. EM Focus - India India was one of the best performing markets in the world in 2017 . Local and global factors combined perfectly to provide impetus to financial markets amid short-term disruption caused by implementation of structural reforms. 2018 is expected to be much more challenging as the economy no more enjoys the sweet spot of low inflation, easing monetary policy cycle and stability on twin deficit front. Having said that, a gradual dissipation of policy induced disruption and solid global growth backdrop could provide buffers against probable risks. 2018 – Politics likely to dominate If the intra-day trend of financial markets on the day result for state elections in mid-December 2017 were announced is any guide then it is fair to assume that politics is likely to weigh heavily on Indian markets in 2018. More so when election calendar over 2018 includes elections in eight states and union territories. The result in these states, which contribute nearly 18% seats to the National Parliament, will be treated as a precursor to national elections scheduled in H1 2019 and will also set the tone for government policy initiatives. Structural reforms - Status check Goods & Services Tax (GST) It was no surprise to see first few months since the roll-out at the start of H2 2017 marked by changes to tax filing procedures and tax rates of various goods and services. The system appears to be now stabilizing with the government pushing ahead with the roll-out of more contentious procedures i.e., e-way bill. The changes to the tax rates mainly centered on moving items from the highest tax bracket of 28% to lower brackets. This step has affected the tax collections and raised doubts over the government’s ability to meet its target. For the record, the government collected INR 808.1bn as GST in November 2017, lower than INR 833.5bn collected in October 2017 and a peak of INR 940bn collected in July 2017. Of the total 9.9mn taxpayers registered under GST, 1.7mn are under the composition scheme where returns are filed every quarter. For the month of November, 5.3mn taxpayers filed returns. With the government addressing the various issues faced by taxpayers, we expect the compliance to increase in 2018 and the tax collection to increase herewith. The introduction of the e-way bill in Q1 2018 will be an important milestone as it would serve as an important check for tax evasion. Demonetisation The process of remonetisation seems to be complete with currency notes in supply equaling c.91% of the value in supply prior to the government’s decision to demonetize high value notes. While there is no concrete study to understand the impact of the government’s decision, it is fair to say that the step did hit the informal sector hard in the short term. The benefits of the step in the medium term remains with the government able to mine the data collected to crackdown on evaders and substantial boost to digital payments. According to National Payments Corporations of India, the number of transactions on its Digital Unified Payments Interface rose to 145.46mn in December 2017 from 4.15mn in January 2017. The value of these transactions grew nearly 10-fold. Economics The December CPI rose to a 16-month high of 5.21% y/y from 4.88% in November 2018. The rise in inflation was driven by spike in food and fuel prices. A detailed reading of the numbers suggest that the headline number may have been higher than RBI’s target but the underlying momentum behind the increase seems to have weakened compared to November 2017. Inflation above RBI’s target of 4% 13.0 11.0 9.0 7.0 5.0 3.0 1.0 2012 2013 2014 2015 2016 2017 CPI (%, y/y) Source: Bloomberg Yet, we believe that the Reserve Bank of India will retain a neutral policy stance and perhaps signal an end to the current easing cycle at its next meeting. The current commodity price trajectory, normalization of monetary policy across developed markets and pressure over government finances are likely to weigh on the RBI in the near term. India’s Central Statistics Office has forecasted for growth to slow down from 7.1% in FY 2016-2017 to 6.5% in FY 2017-2018. While the number reflects effects of GST and demonetization, some green shoots of economic recovery are now visible in high frequency data. India’s industrial production rose to its highest level in 25-months, recording an increase of 8.4% y/y in November 2017. The composite PMI for December 2017 rose by 2.7 points to 53.0 on the back of increase in both manufacturing and service PMIs. The manufacturing PMI rose to its highest level in 5 years to 54.7 while the service PMI moved back to expansion territory at 50.9. Aditya Pugalia +971 4 609 3027 Page 10
11. Interest Rates Slowing QE by central banks and expectations of higher inflation ensuing from the synchronized global growth caused yields on government bonds to rise across the developed world . US Rates The US economy finished 2017 on a very healthy note. Retail sales rose by 0.4% in December and there were upward revisions for October (from +0.4% to +0.5%) and November (from +0.8% to +1.2%). Also in December, core CPI came in strong at 0.28% m/m (annualized 1.8%), the strongest monthly reading since last January. Given these results, overall real GDP annualized growth I slikely to be 3.5% -- the third straight quarter of 3%+ growth. While economic data has largely been supportive of continued normalization of interest rates for some time, inflation has remained stubbornly muted. That said, the minutes of the December meeting indicate that Fed officials expect inflation to pick up as unemployment level falls below 4% sometime during the 2018. Two to three rate hikes in the US in 2018 Consistent with its December 2016 projection, the Federal Reserve raised rates three times in 2017, thereby defying markets’ original expectations of only one rate hike in 2017. Also, in line with previous guidance, QE unwinding commenced in October last year. In other words, after years of “under-delivering,” Fed officials in 2017 followed through on their guidance for rates (and more). This feat is likely to be repeated again in 2018. The December 2017 dots projection shows that FOMC members find three rates hikes to be appropriate in 2018 (followed by at least two more increases in 2019). boost from tax reforms and financial conditions continuing to remain easy in the face of Fed action, we see limited risk to Fed having to slow the trajectory of rate normalization. Also well synchronized global growth and with the new personnel at the Fed more hawkishly disposed, there is fundamental case for three rate hikes, raising the fed funds target range to between 2.00%- 2.25% by the end of 2018. In recent weeks, markets have begun to expect more Fed action and current market implied probability is factoring a little more thgan two hikes by the end of 2018. However, only one rate hike is expected in 2019, well below the level that policymakers themselves see as appropriate. We think the market will gradually re-evaluate its stand as economic data continues to surprise positively. We were half expecting a pause in rate hikes in the first quarter this year as inflation numbers remained muted, however, the current strong CPI data plus signs of solid consumer spending make a rate hike in March reasonably certain, followed by one in June and the last one either in September or in December, depending on the economic data. UST Yield curve likely to steepen in short term The recent steepening of the UST curve is a bit of a snapback from the relentless curve flattening that pushed long yields down in 2017. Beside subdued inflation, year end demand from pension funds added to pressure on long term yields in the 4Q. Curve flattening also happened because market participants expected Fed to fail on delivering on its rate hike projections. Now that the Fed has regained some of its credibility, the market is likely to adjust rate hike expectations upwards towards Fed projections which may see curve steepening at least in the 1Q18. UST curve likely to steepen 3.50 3.00 2.50 3.2 3 2.8 2.6 2.4 2.2 2 1.8 1.6 1.4 1.2 % 2.00 % FOMS Dot Plot vs Market Expectations 1.50 1.00 0.50 15-Jan-18 15-Jan-17 0.00 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y Source: Bloomberg 2017 2018 FOMC Dots Median Futures implied - 15 Jan 18 2019 2020 Futurees implied - 15 Jan 18 Source: Bloomberg With the unemployment rate solidly below the Fed’s NAIRU estimate, and likely to fall further, GDP growth set to receive further Even though we see the UST curve as likely to be flatter by end of 2018, there is a near term risk of a steeper curve as market participants adjust their thinking to accommodate the impact of the tax reform package. Also if President Trump starts pushing for infrastructure projects, the market may worry about deficit induced infrastructure spending and its impact on the long end. Page 11
12. Global Rates The ECB ’s December meeting minutes reflected ECB officials agreeing that while economic data had been more positive than expected, underlying inflation was yet to show convincing signs of a sustained upward trend. Comments about ECB needing to review its policy language and some officials calling for a firm end-date for bond purchases left an air of hawkishness which saw a material increase in European government bond yields during the month. Although economic growth in the region is expected to pick up in 2018, loan growth is yet to show signs of a material increase. In contrast, higher oil prices have boosted deposits in the system. In this scenario, we expect EIBOR/LIBOR spreads to remain narrow in the coming quarters. Anita Yadav +9714 230 7630 10Yr Government Bond Yields Yield % 1M chg 3M chg 12M chg US 2.55 +19 +27 +15 UK 1.34 +19 -3 -3 Germany 0.57 +28 +17 +24 Japan 0.07 +4 +2 +3 Brazil 4.50 - -6 -49 Russia 3.98 +12 +3 -30 Source: Bloomberg Japanese bond market also entered bearish trend as the BoJ alluded to slowing the pace of government bond buying. Local Rates Interbank rates in the region remained anchored to LIBOR, however, the pace of rate increase was slower than that for the LIBOR as banks enjoyed ample liquidity. The spread between EIBOR/LIBOR and that between SAIBOR/LIBOR continued to shrink. 3m EIBOR/LIBOR spreads 2 % 1.8 1.6 1.4 1.2 1 0.8 Jan-17 Apr-17 Jul-17 Oct-17 EIBO3M Index Jan-18 Source: Bloomberg Page 12
13. Credit Markets Rising USD yields weighed on GCC corporate bonds . However, positive sentiment on the back of higher oil prices and reducing government budget deficits in the region helped to contain losses. Last month was largely uneventful and price movements in the secondary market were mostly in sync with macro events. Recent increases in benchmark yield on the long end of the UST curve affected the longer dated GCC sovereign bonds negatively. ADGB 47s, KSA 47s, Qatar 46s, Oman 47s etc all lost between one to two points in price during the month. Most GCC bonds fell in price with the yield on Barclays GCC bond index rising 14bps to 3.70% even though credit spreads were slightly tighter at around 130bps. Global Bonds Yields on shorter dated US treasuries that began surging following President Trump’s election victory in late 2016, kept climbing through much of 2017 and have stuck to the same trend over the first two weeks of trading in 2018. Despite benchmark yield widening, full year total return in 2017 was positive for most corporate bond portfolios as synchronized global growth and improving oil prices lifted appetite for credit risk. With expectations of corporates benefiting from tax cuts in the coming years, US bonds outperformed their global peers in 2017, particularly the US high yield bonds. While economic growth in the Eurozone has also surprised on the upside, the waning of the QE bid is keeping a lid on demand for European bonds. Total return on the Euro Aggregate bond index was only 1% compared with 2.65% on US Aggregate index and 7.11% on EM Aggregate index. Though total return in 2017 were better than expected, bond prices across the developed and emerging world generally fell last month on the back of rising benchmark yields, barring the US high yield segment where credit spreads have tightened due to strong improvement in oil prices. Global Corporate Bond OAS (bps) OAS 1M chg 3M chg 12M chg US IG Corp 90 -5 -8 -32 US HY Corp 323 -27 -19 -70 EUR IG Agg 50 -4 -10 -21 USD EM Agg 217 -14 -24 -72 Barclays GCC Credit Index: YTW and OAS 4 2 3.5 1.8 3 1.6 2.5 1.4 2 1.2 Yield 1.5 Jan-17 OAS 1 Apr-17 Jul-17 Oct-17 Jan-18 Source: Bloomberg Directly or indirectly, ‘sovereigns’ accounts for circa two thirds of the outstanding debt in the GCC bond universe. Several sovereigns announced their annual budget at the end of December / early January including Dubai, Saudi Arabia, and Oman. Saudi Arabia’s actual 2017 deficit came in lower than its original budget while Oman’s came in higher than its original 2017 budget. However the impact on sovereign bonds was minimal as much of this was already factored in the ratings. GCC Sovereign CDS 5yr CDS 1M chg 3M chg 12M chg Abu Dhabi 53 -9 -8 -40 Saudi Arabia 82 -9 Qatar 92 -8 12 -1 Bahrain 279 42 -23 -87 Dubai 112 -17 -38 -122 Source: Bloomberg The monetary tightening bias of central banks and current stretched valuation warrants a cautious view on corporate bonds in the coming year, particularly as new supply is expected to remain high. GCC Bonds – Secondary market GCC bond market has almost doubled in size over the last three years and liquidity premium has narrowed substantially. That said, it has underperformed its wider EM peers in the recent past mainly as a result of higher percentage of high grade rated issuers, which are more sensitive to interest rate hikes, in GCC than in the EM universe. In 2017 total return on Barclays GCC bond index was 3.65% compared with over 7% return on the wider EM universe. Source: Bloomberg Away from sovereigns, the best performing securities in the secondary market during the month was the 2019 maturing bonds of Kuwait Energy. Rumours surfaced about Kuwait Energy’s (rated CCC) plans to merge with Soco International Pls. After failure of its Page 13
14. planned $150 million IPO last year, Kuwait Energy needs access to additional funding to avert defaulting on existing obligation. Merger with a stronger party may offer this option. KUWAIE 19s rose circa ten points in price during the month to close with yield at 12.04% (704bps). January marked the introduction of VAT in the region. Bonds from the banking sector were largely unaffected by the expectations of slower growth in fee and commission based income which will be impacted by VAT as majority of the core lending remains VAT exempt. The dispute relating to the legality of the Dana Gas sukuk is no closer to resolution as the court hearing scheduled for 25 th December 2017 was adjourned. On the side, Dana Gas plans to bid for new energy development rights in Iraq. The company’s improved cash-flow position and a reasonable possibility of favorable outcome of the legal dispute is supporting a bid for the Dana Gas sukuk even after the company defaulted on coupon and principal payments that were due in October last year. Yield on DANAGS 9% 2017s sukuk tightened another 90bps during the month to 9.94%. Earning announcements commenced this week and so far results have been better than expectations. DP world expects to report about 10% growth in gross volumes for 2017 on the back of stronger than expected recovery in global trade in 2017. DP World’s diversified asset base, solid cash-flow and manageable capex has comforted investors through 2017. 5yr CDS on DP World has reduced circa 30bps over the year to 105bps now. Yield on DPWDU 37s has also reduced from 5.95% in January 2017 to 4.88% now. S&P released a report on Gulf banks citing three key risks – a) low loan growth, b) higher cost of risk, and c) lower profitability. However their outlook on the industry still remains stable, barring in Qatar where the evolution of the current boycott by its neighbors may impact the creditworthiness of banks negatively. Looking at the projected budget deficits, we expect all GCC sovereigns to tap capital markets this years. With circa $31 billion of fixed and floating rate USD bonds maturing this year, we expect total new issuance in 2018 to be in line with recent years. Expected Budget Deficits in 2018 USD'bn Revenue Expenditure Deficit Qatar 48 56 -8 KSA 209 261 -52 UAE 113 119 -6 Bahrain 6 9 -3 Kuwait 56 67 -10 Oman 25 33 -8 Total GCC 457 544 -87 Source: Emirates NBD Anita Yadav +9714 230 7630 S&P also affirmed Abu Dhabi’s rating during the month at AA/Stable, citing the emirate’s large net asset position and expectation of economic growth to recover to 3% by 2020-21. Zspread on ADGB 27 has reduced from 105bps in November last year to 92bps now although yield has increased from 3.38% in Nov 17 to 3.45% now as a result of increase in the underlying UST benchmark yields. GCC Bonds - Primary Market In the primary market, Oman rated BB/Baa2/BBB- by S&P, Moody’s and Fitch respectively raised $6.5 billion during the month via three tranches with 5yr pricing at T+190bps ($1.25 billion), 10 yr at T+310bps ($2.5 billion) and 30yr at T+395bps ($2.75 billion). The final pricing was tighter than the initial guidance, but it still offered a premium over the existing bonds and has tightened further in the secondary market. Yield on newly issued OMAN 28s closed nearly 15bps tighter at 5.49% in the first week of trading. In another news, Kuwait sovereign obtained approval from its parliament to issue debt of as much as 25 billion dinars with maturity of upto 30 years. Page 14
15. Currencies The USD continues to find itself under pressure and is currently on target to depreciate for a third month in succession . This is despite the Federal Reserve raising interest rates in December and forecasting three further rate hikes in 2018. USD remains vulnerable Over the last month, the Dollar Index has fallen 2.68% to trade at 90.686, putting the index in a position which looks technically vulnerable. Analysis of the weekly candle chart shows that the downtrend that has been in effect since 30 December 2016 remains intact with a series of lower highs and lower lows being formed. Another sign of vulnerability is that the index has now closed below the 200 week moving average for a fifth week as well as broken below the supporting baseline. A weekly close below this level may lead to further declines towards the 38.2% five year Fibonacci retracement of 88.423, an area last seen in December 2014. consumer prices in coming months, especially around the middle of the year when negative base effects fall away. With headline CPI at 2.1% y/y in December and core CPI increasing to 1.8% y/y, the risks of inflation picking up faster than expected remain realistic in our view. Euro outperforms following constructive data The Euro has continued to be supported as data out of the Eurozone continues to demonstrate robust growth and as political risks recede. Following a series of constructive surveys, production and trade data out of the Eurozone, market expectations for action from the ECB have increased with the market currently pricing in a 54% chance of a hike by December 2018, up from 31% last month. As a result, EURUSD is currently trading near a three year high of 1.2212, levels last seen in December 2014 and analysis of the daily candle chart shows that the daily uptrend that has been in effect since December 2016 remains intact, following a false reversal in October 2017. Euro remains in daily uptrend Dollar Index breaks below baseline Source: Bloomberg Source: Emirates NBD Research, Bloomberg Looking forward in 2018 the main driver behind appetite for the USD is more likely to be the relative performance of other economies, with global reflation becoming a key theme. With this in mind, dollar softness is more likely catalyzed by other developed economies catching up with the US, rather than by weakness in the US economy which we see continuing to perform well. The one key upside risk to dollar strength is that inflation accelerates faster than expected which could result in the Federal Reserve tightening monetary policy more quickly than the markets currently expect (see Global Macro). Recent increases in wages and producer prices are likely to translate into further increases in While EURUSD continues to trade above the 50% five year Fibonacci retracement of 1.2167, short term risks remain to the upside. However, we believe the market is overly optimistic on Euro and see it trading in the 1.20-1.25 range for the majority of the next year, in spite of other’s higher estimates, with the risk being that the market is expecting normalization from the ECB too soon. …and steadier politics Admitedly, political developments have also been favourable for the Euro in recent days, with a ‘Grand Coalition’ government on the verge of being formed in Germany and with Spain stepping away from a constitutional crisis in late 2017. However, risks have not completely gone away, with the sustainability of any CDU/CSU/SPD Page 15
16. collation still open to doubt , and with Italian elections posing the main risks to politics as usual in 2018. GBPUSD recovers to pre-Brexit levels GBPUSD performed in line with our expectations last month, hitting our Q4 2017 forecast of 1.34 and continuing to build on those gains since. Currently trading at 1.3760, GBPUSD is trading back at levels last seen on 24 June 2016, the date of the Brexit referendum and looks poised to add further gains. We expect the cross to approach 1.39 over the first half of 2018, not far from the 38.2% five year Fibonacci retracement of 1.3885 with the prevailing risk that the market is too complacent over the timing of the next rate hike from the Bank of England. With OIS implying that traders have priced in a 47.7% chance of a rate hike by June 2018, the risk is that the BOE moves faster in 2018 with the labour market continuing to tighten, GDP growth firmer than expected and inflation currently sitting at 3.0% y/y, above the BOE’s 2% target. From a technical point of view, USDJPY sits at a critical level. Analysis of the weekly candle chart shows that the cross find itself capped by a resistance trendline that has held since December 2016. In addition, currently sitting at 110.60, it is likely to test of the supporting baseline that has held since September 2016. A break of this level is will quickly lead to a test of the psychological 110 level and the 100 week moving average of 109.95. A close below these levels is likely to lead to larger declines towards 108. USDJPY tests important support levels GBPUSD retakes referendum levels Source: Bloomberg INR finishes 2017 on firmer footing Source: Bloomberg JPY benefits from shift in BOJ stance Over the last week, the JPY has appreciated under relatively unusual circumstances. Rather than benefitting from safe haven bids and a lack of market risk appetite, it was changes in the Bank of Japan’s bond purchasing that triggered speculation over when the central bank intends to begin tightening its ultra loose monetary policy. At the weekly bond purchases on Tuesday 9th January, the BOJ reduced its puchases of debt maturing in 10-25 and over 25 years triggering speculation that tapering may come sooner than anticipated, and may even have actually started. For the first time in seven years, the INR made annual gains. The USDINR rallied +6.0% y/y in 2017 to end at 63.87. The move was in line with our expectations and driven by broad based weakness in the USD and the underlying strength of the Indian economy. Looking ahead into 2018, we expect the INR to have a weakening bias primarily on account of a weaker macro environment and renewed pressure on government’s finances. Much of those concerns are driven by sustained increase in commodity prices, longer than expected delay in stabilization of the Goods & Services Tax regime and politics heavy 18 month calendar. Having said that, firm signs of recovery in domestic growth and probability of the USD remaining under pressure should provide some buffer to the INR. We have revised our Q1 2018 forecast to 65.0 and end of 2018 forecast to 66.0. In terms of major currencies we have also revised our near-term forecasts to reflect a softer USD profile in Q1 (see page 29) Mohammed Al Tajir +9714 609 3005 Page 16
17. Equities With equities having a phenomenal year in 2017 , there are a number of reasons to doubt a repeat in 2018. Most of these are on account of significant rerating of earnings multiple, political risks and a changing cycle of monetary policy. We, however, don’t subscribe to such doubts and believe that the momentum from 2017 may continue at least into early part of 2018. The reason for optimism stems from the fact that economic activity remains well above the trend signaling that growth is yet to peak, monetary policy tightening is still at a very early stage and that valuation continues to remain reasonable when compared to other asset classes. All major equity markets have had a positive start to the year helped by the passage of the tax bill in the US in the last week of 2017. The positive momentum continues to receive a boost from strong macroeconomic data across economies, strength in commodity prices and a positive start to the earnings season. The MSCI World index has rallied +3.9% ytd on the back of gains across its subindices. The MSCI EM index, the MSCI G7 index and the MSCI Arabian Markets index have added +4.3% ytd, +4.1% ytd and +3.1% ytd respectively. Volatility continues to remain low with the VIX index and the V2X index dropping -8.0% ytd and -19.3% ytd respectively. likely to be included in the MSCI EM index in June 2018. Needless to say, the step would be a positive catalyst for the market. According to market estimates, Saudi Arabia is likely to have a weightage of anywhere between 2.0 to 3.0% and that could translate into passive inflows of as much as USD 4bn. With 3.0% weightage Saudi Arabia would be the eight-largest constituent in the MSCI EM index. KSA could potentially be 8th largest constituent in the MSCI EM index 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% China S Taiwan India Korea Brazil S Russia S Mexico Africa Arabia Source: MSCI, Emirates NBD Research The biggest wildcard in 2018 is likely to be politics. From mid-term elections in the US to the Italian elections in Europe, the Brexit talks in the UK or state elections in India, all of these events have the potential to disrupt positive momentum. More so when most equity indices are trading at all-time highs. Having said that, the experience of 2017 shows that the impact could be short-lived unless the same is accompanied by a macroeconomic shock which appears highly unlikely at the moment. Another key risk in 2018 could be the return of inflation. Most market participants are pricing in a benign inflation trajectory and hence any negative surprise on that front could lead to volatility and repricingof risk assets.f Markets to watch Saudi Arabia – High conviction The Tadawul ended 2017 with gains of +3.5% as several political developments and lack of upgrade to the MSCI EM index overshadowed the progress made by the country on the structural and regulatory reform front. We believe that 2018 could mark a significant turnaround for Saudi Arabian equities as greater progress is made to achieve completion on issues which have been hanging on the horizon for a while. These include sustained gains in oil prices, completion of the Saudi Aramco IPO and inclusion in the MSCI EM index. On the MSCI front, the changes made recently by the CMA has been acknowledged. The MSCI, in a statement, said that it expects consultation process on inclusion in the MSCI EM index to conclude in June 2018. The index provider also added that based on its discussion with international investors, the new market operating model implemented in April 2017 has had no issues and the T+2 settlement issues was considered effective. Based on this statement by the MSCI, it is likely that Saudi Arabian equities are It is worth noting here that the period prior to inclusion is generally positive for equity markets given flows from active investors. For the record, Qatar and the UAE received inflows of USD 2.7bn in the year leading up to their inclusion. The Saudi Aramco IPO is likely to be a key milestone given all the talk that has preceded it so far. However, signs are now emerging that the IPO could happen as early as Q4 2018. The company has arranged loans with various banks, a process which generally precedes an impending IPO. Additionally, reports have also emerged about shortlisting of investment banks for the IPO. The IPO is expected to be a key catalyst in attracting foreign investor flow into the region broadly and Saudi Arabia in particular. The IPO will also result in increasing the weightage of Saudi Arabia in the MSCI EM index. In terms of valuation, the Tadawul is currently trading at 13.2x 12m forward earnings compared to the MSCI Arabian Markets index which is trading at 12.2x and the MSCI EM index which is trading at forward earnings and 12.9x 12m forward earnings. Europe – More room to go At a time when there are growing concerns over stretched valuations in developed markets, European equities do provide a buffer should there be a mean reversion in global equity markets. From a fundamental viewpoint as well, European equities look attractive with tailwinds of accommodative monetary policy from the European Central Bank, positive momentum in economic indicators and reduced political risk premium. It is worth noting here that the Eurozone manufacturing PMI is well above the 60.0 levels and the differential with the US is at its widest since 2012. Page 17
18. highest level at 53 .0 since 2015. Similarly, the IMF forecast emerging market and developing economies GDP to grow at 4.9% in 2018, a 2.9% growth premium compared to developed economies. Earnings revision ratio 0.4 0.2 EM – Improving fundamentals 0.0 70 -0.2 60 -0.4 50 40 -0.6 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 30 Oct-17 20 Citigroup earnings revisions index Europe ex. U.K. 10 0 Source: Bloomberg -10 Encouragingly, the Citigroup index tracking earnings revision in Europe excluding the UK is at its highest level since last May. This coupled with the valuation differential between the US and European stocks makes the latter more attractive. The S&P 500 index is currently trading at 18x 12m forward earnings compared to the Euro Stoxx 600 index which is trading at 15x 212m forward earnings. Interestingly, the Stoxx 600 index P/E ratio still remains below the peak seen in 2015. European equities are expected to deliver nearly double the dividend yield than that of its US peers. According to Bloomberg, the expected dividend yield for Euro Stoxx 600 index is 3.43% compared to 1.93% for the S&P 500 index. P/E ratio differential 30 25 Return on Equity (%) Free Cash Flow per share (USD) 2015 2016 Dividend Growth (%) 2017 Source: MSCI, Bloomberg Based on the MSCI EM index Emerging markets are also likely to draw investor interest owing to strong earnings growth and valuation differential with developed markets. According to market estimates, earnings are expected to grow at a high double digit 13% y/y but lower than 2017’s earnings growth of 24%. While on a standalone basis, emerging markets are trading one standard deviation higher than their 15-year average, it is still cheaper than developed market peers. The MSCI EM index is currently trading at 12.9x 12m forward earnings compared to the MSCI World index which is trading at 17.3x and the MSCI G7 index which is trading at 17.4x 12m forward earnings. The 35% discount to developed market peers stand out when the growth differential is expected to widen in 2018 and 2019. Aditya Pugalia +9714 609 3027 20 15 10 2013 2014 2015 STOXX Europe 600 Index 2016 2017 2018 S&P 500 Index Source: Bloomberg Emerging Markets – Positive but idiosyncratic Emerging market equities were the best performing equities in 2017 with the MSCI EM index rallying +37.1%. While most factors are in place for the current momentum to continue in 2018, the varied dynamics of emerging markets are likely to result in idiosyncratic moves. This would be a continuation of a trend seen in 2017 as well. For example, the MSCI China outperformed MSCI by 20%, Russia underperformed by 30%. It would not be a stretch to say that fundamentals are at their best in the recent past with low inflation, benign political risk, steady economic growth and continued expansion in earnings. As per Bloomberg, the Markit Emerging Market Composite PMI is at its Page 18
19. Commodities Oil markets are off to a blistering start in 2018 , extending their gains from 2017. Brent futures have traded above USD 70/b for the first time since 2014 and WTI is nearing on to USD 65/b. The rally in oil prices will be welcome for GCC oil exporters but the pace of gains since October 2017 looks to us to have moved past fundamental support. While we expect oil prices to be higher on average in 2018 than they were last year, we are cautious that a near-term correction in prices is approaching. Fundamentals in play OPEC has been the principal author of the fundamental factors currently supporting higher oil prices. The production cuts that the bloc initiated last year pushed the overall market balance into deficit in Q1 2017 and OPEC’s plan to keep the cuts in place for all of 2018 should help keep markets on a tighter footing than they have been since 2014. But there have been few plans from the major producers, or their partners like Russia, to suggest that the cuts will be taken further or deeper. Rather, the market narrative is shifting to whether the deal can expire early, particularly as oil prices have hit multi-year highs. We doubt that there will be an official endorsement of an early end to the plan but that compliance to the terms, which had been high, will ebb at perhaps a faster pace than we had expected. Beyond OPEC, the major supply side risk to end the current rally will come from changes in expectations for US oil production. The US government’s EIA expects production there to breach 10m b/d as early as February and to average 10.3m b/d in 2018 as a whole, a nearly 1m b/d increase y/y. The broad shift higher in oil futures makes for a particularly attractive hedging opportunity for nimble shale-focused producers, with WTI above USD 55/b all the way along the curve out to the end of 2019. Already exploration and production companies are showing activity as the drilling rig count snaps out of its downward trend (including adding 10 rigs in a single week in mid-January). Rig count looks to be bottoming out Refinery margins shrinking 80 18 75 16 70 14 65 12 60 10 55 8 50 6 Singapore gasoline 92 Singapore gasoline Brent crack (USD/b) Source: EIKON, Emirates NBD Research. External risks loom large Even if oil market fundamentals point to a still strongly supplied market in 2018 we expect that a correction in oil prices is more likely to come via external forces. Investor positioning in oil futures is at extraordinarily high net long levels and in currency terms is at new record levels. The positive carry that investors receive thanks to a backwardated curve explains part of the surge in investment in oil futures but a general reorientation of funds to risk assets (equities and commodities more generally) has also helped push prices higher. However, the concentration of investors in longs appears stretched—indeed Brent net length as a share of total open interest is at extreme levels—and could see a rapid unwinding if fundamentals look shaky. Net length at extreme levels 35 30 25 20 15 10 5 0 -5 -10 25 20 (%) 450 400 350 300 250 200 150 100 50 0 On the other side of the fundamentals equation, high oil prices run the risk of sowing their own destruction by weakening marginal demand. Refinery margins—crack spreads—have compressed sharply over the last few months as refiners still face large stockpiles of refined products and high oil prices. Weak margins may lead to refiners, particularly in Asia, crimping their crude purchases particularly if demand growth slows as expected by the IEA this year. 15 10 5 0 2013 Rig count: annual change (lhs) Rig count: weekly change (rhs) Source: EIKON, Emirates NBD Research. 2014 2015 2016 2017 WTI: net length/open interest Brent: net length/open interest Source: EIKON, Emirates NBD Research. Note: managed money only. Page 19
20. Further afield from oil and commodity markets , the deterioration in the USD is also having a lubricating effect on the current oil rally. The greenback has lost more than 12% against trading peers since the start of 2017 but the impact on oil only looks to be in place from around October last year. The weakness in the dollar is all the more striking considering the Fed did raise rates in December and appears on track to do so several more times this year. In the nearterm, a reversal in the USD stemming from a rate hike possibly as early as March should take some of the fizz out of the oil rally. A less tangible negative risk could come from an end to the “rally in everything.” Equities, commodities, gold, forex and cryptocurrencies are all headed in the same direction. Underlying economic performance in major economies is good and is helping corporate results beat expectations but most asset classes look overbought in current conditions. Considering geopolitical and US domestic political risks remain high a temporary correction seems inevitable and would take oil down with it. While it’s hard to identify what could be the catalyst for the correction we would expect to see a rapid shift of capital out of oil positions that could accelerate downward. Edward Bell +9714 230 7701 Page 20