April/May Market Commentary

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US and European stock markets were in general flat in April, but the UK FTSE was up 3.1%, while the Japan Toppix Index suffered a 3.4% loss in April and is down 9.9% year to date after an impressive 60% return in 2013. Some weakness in Japan can be attributed to the increase in the sales tax implemented in April as well as slower Asian growth due to a slowdown in China and fewer Chinese imports to support the region. As a proxy for growth in world trade and exports to China the benchmark Baltic Dry Index is down close to 59% in 2014, although still up approximately 10% year on year. Chinese growth slowed slightly to 7.4% per annum as China shifts from less investment to more private consumption to rebalance the economy.

Emerging market debt returned 1.9% in April as measured in local currency terms. The Bloomberg EMEA World Index is up 4.45% year to date. Alternative investments had a good start to the year with commodities up 2.4% and real estate investment trusts up 3.2% in 2014.

Europe is experiencing a gradual economic recovery now after the financial crisis in 2008/09 and subsequent EU debt crisis laid it low. The fiscal tightening post 2008/09 is fading and private deleveraging is less acute. Bond yields in the EU periphery also declined sharply as Greece returned to the bond market for the first time in almost 5-years. Spanish 10-year yields have fallen to 3% p.a. versus 4.7% a year ago as investors return to the government bond market. However, net lending by banks has not picked up as banks repair their balance sheets and set aside more regulatory capital. Loans to the private sector are down 2% and loans to non-financial companies are down 3.1% year on year. With EU inflation up just 0.7% in 2014 over 2013 the tighter credit conditions may yet force the ECB to ease monetary policy further. That should put a cap on recent euro strength.

European corporate earnings declined 2%, while earnings in the USA climbed 5.2%. In both Europe and the US 70% of public companies beat their earnings estimates. However, first quarter GDP in the USA dropped to 0.1% from an estimate of 1.1% growth, some of which can be contributed to bad weather that held back investment and consumption. On the positive side, wages are rising ( 3%) faster than inflation ( 1.4%), which is good for US private consumption that is up 3% this year. As 70% of the US economy relies on consumption this can only bode well for consumer confidence and have a positive effect on business sentiment. As inflation is well below the Fed's 2% p.a. target they are under little pressure, yet, to start raising rates. There is enough slack in the labour market from high, long-term unemployment that there is little immediate threat to wage driven price inflation.

Emerging and Frontier Markets

Politics again dominated emerging markets in April. According to the Euromoney Country Risk Survey, global risk perceptions rose in emerging markets even as perceptions of risk dropped in developed markets in 2014. However, since 2010 risk perceptions in general have declined. In the G10 risk perceptions are down 7.5%, in the Eurozone down 10.8%, in CIS countries down 5.8% and in BRICS 3.7% lower. In India, Indonesia, S. Africa and Turkey investors are worried about fiscal and/or external balances as debt investors withdraw capital and the Fed tapers its quantitative easing. Russia and the Ukraine saw their perception of risk rise the most, but it has also affected their neighbours and trade partners such as Belarus, the Baltic nations, Bulgaria and Croatia. Elsewhere, unrelated political and economic problems are plaguing Argentina and Venezuela in Latam, and a political crisis has damaged Thailand's risk profile. Other Asian countries where perception of risk has increased are Bangladesh, India, Macau, Malaysia, Mongolia, Pakistan, Sri Lanka and Taiwan.

On the other hand, S. Korea, Mexico and Uruguay saw their risk profile improve. The G10 including Canada, EU and the USA improved as did individual nations in the EU such as Italy, Ireland, Portugal and Spain that have returned to normal since their bailouts post 2008/09. Spain was given a credit upgrade, while Italy's yield on its debt fell to historic lows. It is hoped that political reform under Prime Minister Mateo Renzi will result in constitutional change, electoral reform and a clean-up of Italy's fiscal mess. Although the peripheral countries are still suffering from high levels of debt, Greece was able to return to debt markets after almost 5-years absence to borrow new money despite its debt to GDP hitting 177% in 2014. Even Cyprus, which is still perceived as risky, is in less dire shape than a year ago.

S. Korea has an improving risk profile due to a stronger economy, fiscal stimulus, a stable budget, low inflation (0.7%) and a large current account surplus. Although the market worries about high household debt, tensions with N. Korea and problematic Chaebol conglomerates they are quite happy as Korean banks are in good shape, GDP growth is forecast to rise to 3.8% in 2015 from 3.6% in 2014, external FX reserves are up and the current account surplus is 6% of GDP.

Due to domestic, political, economic and structural problems sub-Sahara countries such as Djibouti, Lesotho, Malawi and Sierra Leone are deemed as most at risk, while those considered safer are Botswana, Namibia and S. Africa. The outlook for Gabon, Ghana and Nigeria is seen as stable, whereas the outlook for Egypt, Morocco and Tunisia is improving. In N. Africa though, risk perceptions in Algeria, Bahrain, Iran, Jordan, Lebanon, Libya, Syria and Yemen all deteriorated. Qatar is considered the least risky country in MENA, although labour problems, poor working conditions and rising tensions with its Gulf partners over their support for the Muslim Brotherhood are holding Qatar back despite its enormous gas wealth.

Elections in India

In the world's largest democracy, India is in its 4th week of elections. The popular Narendo Modi, who is seen as investor friendly, is tipped to win. India needs to revitalize its economy through concerted economic and business reform. It is hoped that a decisive electoral victory will result in a rebound in capital investment and a pick-up in private consumption. Asia's 3rd largest economy is forecast to grow 4.9% in 2014 versus 4.5% in 2013 and increase to 5.9% in 2015. India is seeing rising prosperity and greater participation in the global economy, but structural and institutional road blocks still remain.

The OECD sees rising bad loans in the country's state-run banks as a threat to overall economic growth. It sees a need to shift lending from corporate loans to consumer credit as necessary. After the elections India needs labour, fiscal and tax reforms to improve business sentiment and consumer confidence. Already the Prime Minister's Cabinet Committee on Investment has approved projects worth 6% of the economy. India in particular is growing quickly due to its growth in services. Knowledge intensive growth is outpacing labour or capital intensive growth. Globally, knowledge intensive growth in such sectors as aircraft, automobiles, semi-conductors, pharmaceuticals and micro-electronics are worth approximately $12 to $13 trillion annually.

India is benefiting from the spread of internet and digital technologies that reduce the cost of production and distribution. Global online traffic increased 18-times between 2005-2012, and may further increase by another 800% by 2025. The era of outsourcing low-cost production is slowly coming to an end with a rise in knowledge intensive production for India. The Bombay Stock Exchange SENSEX hit an all-time high in April 6.17% YTD and 16.88% year on year.

Global Trade

According to McKinsey & Co. the flow of goods and services across borders now exceeds $26 trillion, which is 36% of the global economy. That is up 150% since 1990 as large developing countries like China, India and others join the global economy. They predict that over the next ten years that these trade flows could increase another 300%, and could be anywhere from $54 to $85 trillion by 2025. For nations open to trade and investment this can add up to 40% to national receipts. It is estimated that trade adds $250 to $450 billion annually to global GDP. One third of all flows of goods and financial transactions are now cross-border. Germany, Hong Kong and the USA are the most connected economies followed by Singapore. However, developing economies such as Morocco, Mauritius and Saudi Arabia are also growing in connectedness.

Rising incomes in the developing world are also helping to create new consumer demand. Emerging markets now account for 38% of global flows, which is up 300% since 1990. So-called South-South trade flows between developing countries increased to $4.2 trillion from just $200 billion in 1990. These countries are also enjoying more cross-border business and leisure travel. One-half of the world's $90.6 trillion GDP (2011) came from low-middle income countries according to the World Bank, and that middle income countries are expanding their share of the world economy at a faster rate than either low or high income countries.

According to a World Bank survey, Switzerland and Norway are the world's most expensive economies followed by Bermuda, Australia and Denmark. On the purchasing power parity basis the lowest cost economies are Egypt, Pakistan, Myanmar, Ethiopia and Laos. The richest countries by GDP per person are Qatar, Macao, Luxembourg, Kuwait and Brunei, while the poorest countries include Malawi, Mozambique and Liberia.

Investment Trends

Index-based investing and investing in exchange traded funds is increasing faster than traditional fund investing due to a combination of cheaper fees and superior performance versus stock picking, value-based or arbitrage funds run by active managers. According to Deutsche Bank, ETF assets have grown 200% since 2011 to reach $2.3 trillion under management. That compares to $2.2 trillion in private equity and $2.6 trillion in hedge funds. Assets in US ETFs grew by $150 billion in 2013, while emerging market ETFs grew 300% to $300 billion over the past 6-years. Due to EM political turmoil and better growth prospects in developed markets assets in EM ETFs have suffered withdrawals in 2014 YTD.

There is some concern, perhaps misplaced, that high frequency trading is leading to excessive stock turnover and the withdrawal of conservative long-term investors. And that arbitrage activity between ETFs and the underlying stocks is driving volatility. It is feared that this could lead to non-fundamentally driven demand shocks. However, the reality is that ETFs currently only account for 10% of all mutual fund assets, and that HFT at the margins actually has very little effect on real investors who have never seen tighter bid-offer spreads ever. The share of US stocks owned by individuals and households has been steadily declining from 48% in 1980 to 20% today. Whereas almost all equity fund assets were actively managed in 1980 that number is now around 83% today. There is certainly a place for index-based and low cost ETFs alongside traditional funds for investors looking for the right balance between diversity, performance and fees.

Commodity Returns

As an alternative investment class, commodities are quite different than an equity or bond portfolio over the long run. Unfortunately though, over the past 5-years the returns and correlations of commodities have failed to meet expectations. Commodity returns have under-performed equity and bonds, while displaying a strong correlation due to the risk-on, risk-off nature of the broader market since the contraction and recovery phase of the business cycle since 2008/09. However, as Goldman Sachs argue, commodities should continue to pay equity like returns to investors over the coming exploitation phase of the commodity supply cycle. They see the 20-30 year cycle as having an investment and an exploitation phase.

During 2002-12 we were in an investment phase with rising prices, good returns, and investment in new capacity that eventually overwhelmed growth in commodity demand. Now, markets are over¬supplied and it is time to exploit existing capacity. They estimate that nearly $2 trillion was invested over that 10-year period with the increase in capital stock up $1.4 trillion in the 6-biggest producing nations, including China and the USA, alone. That rapid increase in capital spending resulted in an estimated 45% decline in capital and labour productivity. Now the market outlook is deteriorating and, as the market moves into surplus, margins are likely to compress. As producers become less profitable they will need to concentrate on reducing costs. Improving operating performance will be key to reversing the decline in productivity, and producers will have to emphasize discipline and strict risk management to deliver shareholder value.

However, for commodity-equity investors those cost reductions through improved productivity can be passed along to investors to maintain returns. And for direct commodity investors, the over-supply versus demand should create a backwardated forward curve that will yield a positive carry and pay a commodity dividend to buy and hold. This should keep commodity returns relatively constant even if prices are declining slightly, so commodity investors should be paid an equity-like return for providing risk capital to producers.

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