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10 for 2015:
Generatingvalue
in a fragile market Dr. Hendrik Garz, Doug Morrow
January 2015
Thematc Research
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About SustainalyticsSustainalycs supports investors around the world with the development and
implementaon of responsible investment strategies. The rm partners with
instuonal investors, pension plans, and asset managers that integrate environmental
social and governance informaon and assessments into their investment decisions.
Headquartered in Amsterdam, Sustainalycs has oces in Boston, Bucharest,
Frankfurt, London, New York City, Paris, Singapore, Timisoara and Toronto, and
representaves in Bogotá, Brussels, Copenhagen and Washington, D.C. The rm has
200 sta members, including more than 120 analysts with varied muldisciplinary
experse and a thorough understanding of more than 40 industries. In 2012, 2013
and 2014, Sustainalytics was voted best independent responsible investment
research firm in the Extel IRRI survey.
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Foreword
Michael Jantzi
Chief Executive Officer
2015 – Staring down challenges, building on successesI’ve always believed in the motto “Success Breeds Success,” more from personal and
professional experience than from any logical or scientific explanation. Accordingly, I fullyexpect the ESG business segment to build upon its successes of last year to achieve even
more significant accomplishments in 2015. Of course, the drivers of ESG success are both
complex and multi-dimensional. While capturing them all is too big a task for this foreword,
I’m pleased to add my thoughts about what might be in store for the ESG industry in 2015,
ever wary of the investment industry mantra that “past performance is no indication of
future results.”
By all accounts 2014 was a good year for ESG globally. We saw increased ESG integration by
asset managers, some of it explicitly mandated by ESG-minded pension funds and high net
worth clients, but also a tangible increase in ESG adoption by traditional asset managers, as
evidenced by the 19% increase in PRI signatories. With the rise in the number of U.S.-based
asset owners and managers joining the PRI, including industry bellwether Vanguard with
over USD 3trn in assets under management, I expect ESG adoption to continue to gather
strength in the year ahead.
We also saw steady growth in ESG-associated assets under management in established
markets and across multiple asset classes. According to various published reports, U.S.-
domiciled assets under management using SRI strategies grew to USD 6.57trn in 2014, a
76% increase over 2012 levels. ESG integration in Europe and Australia grew by 38% and
51%, respectively. These are impressive statistics, given Europe’s and Australia’s early
adoption of ESG practices. Though U.S. institutional investors have been slower to embrace
ESG factors as an integral piece of the investment analysis process, I view these recent
milestones as ESG success indicators for the years to come.
Building on its tremendous growth in 2014, we believe the green bond market of USD
36.6bn will more than double in size in 2015. Forty-six percent of the market was driven by
corporates and municipalities last year, with a record corporate deal by GDF Suez, including
proceeds from its USD 3.4bn green bond (split into two bonds) earmarked for renewable
energy and energy efficiency projects.
Finally, I want to shine a spotlight on several important moves to strengthen regulatory
environments across several jurisdictions, which I believe will lead to more informed capital
markets and the continued push for ESG investment. Although it is difficult to see tangible
impact at this early juncture, I believe the U.K. Law Commission’s report (in Fiduciary Duties
of Investment Intermediaries, July 2014) will serve to reinforce the concept that trustees’
fiduciary duties encompass ESG. My optimism is high, in part, because a review of the
Stewardship Code, which received strong support in 2014 from the Chair of the Financial
Reporting Council, is on tap for later this year.
And, after years of discussion that seemed to span generations, Ontario (Canada) is making
changes to its Pensions Benefit Act that will require funds to reveal whether, and if so how,
ESG considerations are taken into account in investment policies. The amendment, which
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takes effect at the beginning of 2016, is already raising ESG awareness among small- and
medium-sized pension plans across the province.
Regulatory reform is evident in a variety of Asian countries as well. The Korean National
Assembly passed two RI-related pieces of legislation in late December, one focused on the
mandatory disclosure of ESG information by listed companies and the other on the National
Pension Service (the fourth-largest pension fund in the world), which now has legislative
clarity with respect to taking ESG issues into consideration. In Japan, more than 175 asset
managers, asset owners and other market participants have signed onto the Japanese
Stewardship Code, which was put in place by the Japanese Financial Services Agency (FSA)
in February 2014 to encourage institutional investors to engage with companies on their
sustainability practices.
Alas, it will not all be smooth sailing in the year ahead. Clearly, the political landscape means
sustainability issues generally, including ESG, will likely face increased scrutiny and
Congressional challenges in the U.S. There will be some tough going with a Republican
majority in Congress and James Inhofe, author of The Greatest Hoax: How the Global
Warming Conspiracy Threatens Your Future, as Chair of the Environment and Public Works
Committee.
“First they ignore you, then they ridicule you, then they fight you, and then you win.”
I also expect that our industry will face well-funded, better-organized and more ferocious
adversaries than in the past. I look to what happened in Australia at the end of last year as
the harbinger of things to come. As one might expect in a resource-focused economy, a
debate was ignited in response to several Australian institutions deciding to divest from
fossil fuels. I’ll leave it to each of you to determine whether or not Rice Warner’s report
Analysis of ‘ Socially Responsible Investment’ Options1, undertaken at the behest of the
Minerals Council of Australia, provides “insight like no other”, as Rice Warner proclaims on
the first and last pages of the presentation.
However, the response to Australian National University’s (ANU) decision to divest from
seven fossil fuel companies was unprecedented in its vitriol, as evidenced by Australian
Prime Minister Tony Abbott’s comment that it was a “stupid decision” . Moreover, ASX-
listed Sandfire Resources, one of the companies affected by ANU’s decision, f iled
proceedings in the Federal Court of Australia against CAER, an Australian-based ESG
research house. I expect that the phrase “if you can’t stand the heat, get out of the kitchen”
will apply to all of us, as some critics will not just turn up the heat but will try to burn the
kitchen down entirely. In order to stare down these and other challenges, our ability to
muster a collaborative response will become increasingly important. The Sustainalytics
team, more than 200 strong globally, looks forward to working together with others in the
ESG industry to ensure that we continue building upon our collective successes throughout
2015 and beyond.
Michael Jantzi, Chief Executive Officer
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ContentsExecutive Summary 5
Generating value in a fragile market 5
2015 – Macro View 9
Sustaining the unsustainable 9
2015 – The Asian View 27
Modest growth, high vulnerability 27
10 for 2015 33
A platform for ESG analysis 33
DuPont 35
Sowing seeds for African growth? 35
Intel 38
Progress on “conflict-free” target could pay reputational dividend in 2015 38
GlaxoSmithKline (GSK) 41
Company looks to rebound from record bribery charge 41
LafargeHolcim 44
Proposed merger offers intriguing ESG opportunities 44
Lonmin 47
Results of Marikana Commission could create business risks 47
National Commercial Bank (NCB) 49
Playing the market for Shariah-compliant financial products 49
Telenor 52
Advanced ESG performer poised to succeed in risky environment 52
Petroleos Mexicanos (Pemex) 55
Competing in Mexico’s freshly liberalised energy sector 55
The Coca-Cola Company (Coke) 59
Product diversification brings new ESG risks 59
Netflix 62
Questionable board practices at pivotal moment in company’s evolution 62
Chartbook 65
Appendix 66
Report Parameters 66
Contributions 66
Glossary of Terms 66
Endnotes 67
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Executive SummaryGenerating value in a fragile market
AnalystsDr. Hendrik Garz
Managing Director, Thematic Research
Doug Morrow
Associate Director, Thematic Research
Thomas Hassl
Analyst, Thematic Research
Key TakeawaysMacro picture – short-term stability, but at what cost?
With the ECB’s EUR 1.1trn quantitative easing programme, financial and economic
imbalances are aggravated, and the risk of a new financial crisis has increased.
The economic and social costs of a new financial crisis could outstrip those of the
last one and may trigger fundamental systemic discussions.
Investors do not have many options to hedge themselves, due to already existing
or newly emerging bubble situations in many asset classes.
The “good news” is that investors can expect that the situation , which is
unsustainable over the mid- to long term, will probably be sustained over the
short term. The slump in oil prices might lead to a positive growth surprise, which, ironically,
may exacerbate systemic risk when put into the above context.
The oil price drop has further lowered the probability for achieving a multilateral
climate agreement at the COP21 conference in Paris in December.
Generating value at the asset selection level in a fundamentally unsustainable
market environment is more than challenging, but analysis through an ESG lens
may assist in this process.
Micro picture – finding value through ESG?
We present 10 forward-looking company stories where ESG factors may have
material impacts over both the short and long run.
Our analysis supports a positive view of Intel, GlaxoSmithKline, Lafarge and
Holcim, Telenor and Pemex, with value drivers ranging from innovative
remuneration models and energy efficiency programmes, to human rights policies
and health and safety improvements.
We take a generally negative stance on DuPont, Lonmin, National Commercial
Bank, Coca-Cola and, to a lesser extent, Netflix, which faces important corporate
governance challenges despite beating analyst expectations for Q4 2014.
Our analysis can be used to supplement existing security selection models,
through tilting and other measures, or inform new investment strategies.
From asset allocation to asset selectionForward-looking, scenario-based
approach
As the Danish physicist and Nobel laureate Niels Bohr once famously remarked,
“prediction is very difficult, especially if it’s about the future.” We could not agree
more. Hence, in this report we take the approach of discussing possible scenarios for
the global economy and their implications from an ESG perspective. In addition, we
provide a dedicated Asian view regarding the economic background and ESG trends in
the region.
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]
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In the spirit of a top-down approach, we finally shift from the asset allocation focused
macro view to the asset selection micro view by presenting 10 company stories to
watch in 2015, taken from our core coverage universe of roughly 4,500 corporates. In
our view, all of these stories address key ESG issues that are likely to have a material
impact on companies from a business perspective. Our portfolio of ideas contains
stories from different regions and sectors and is well balanced, providing five storieswith a positive tilt and five with a negative tilt.
Macro View – Sustaining the unsustainableIs a new financial crisis looming on the
horizon?
Financial markets seem to be torn between hope and fear these days. Apparently, the
new historic highs for equity markets are not the result of conviction and confidence
on the part of investors, but rather appear to signal the lack of investment alternatives
and the hope of prolonged expansionary monetary policy. In this chapter we take a
look at the possible consequences of the recently announced quantitative easing (QE)
programme of the European Central Bank (ECB). We conclude that this programme is
trying to sustain the unsustainable, and that investors do not have many options to
hedge themselves, due to already existing and exacerbated or newly emerging bubblesituations in many asset classes. We also reflect on the possible default of Greece and
the risk of a breakup of the Eurozone becoming more tangible in 2015. Furthermore,
we elaborate on a contrarian, thought-provoking scenario that assumes an oil-price-
induced positive growth surprise and describe how this could eventually lead to a new
financial crisis with social unrest as a possible consequence.
Pondering the consequences of a “lower
oil price world” Last but not least, we ponder the consequences of the new “lower oil price world” and
the current economic and political environment for the climate negotiations that will
culminate at the end of the year with the COP21 convention in Paris. We have doubts
that the odds are good to achieve an effective multilateral consensus. In the absence
of political leadership, we expect the focus to shift to companies and privatehouseholds, which will be moving ahead with climate-friendly technologies based on
economic self-interest.
Investment implications – Some easy wins
As ESG analysts, we have neither the mandate nor the inclination to give
comprehensive investment recommendations. This is simply not our job and is done by
others. However, the macro picture we outlined above certainly has some obvious
implications at the strategic and tactical asset allocation level.
Don’t divest f rom high-quality fixed
income instruments too early, and don’t
overweight Oil & Gas or Banks
We draw four basic conclusions: (1) Investors are probably well advised not to divest
from high-quality fixed income instruments as long as there is hope that the QEprogramme is going to work and uncertainties around Greece and the Ukraine conflict
prevail, despite the massive bond bubble they are sitting on. (2) The risk profile of
equities seems to be still attractive only if the oil price continues to show weakness and
as long as the crisis situations in Greece and the Ukraine do not completely get out of
control. (3) At the sector level it is clear that a low or even further-falling oil price and
a new financial crisis situation certainly do not invite investors to overweight Oil & Gas
and Banks in their portfolios. (4) Over the mid- to long term, the financial risks for
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investors are high and cannot be fully hedged, due to the bubble situations that have
been emerging in many asset classes and the empirical fact that asset prices tend to be
positively correlated in down-market situations. Should markets turn into crisis mode
again, cash will certainly be king, but negative overnight rates may well become the
rule, not the exception.
The Asian View – Modest growth, high vulnerabilityChina’s soft landing and another round of
“Abenomics” Overall, we do not expect Asia to become the world’s growth engine in 2015. Economic
momentum in China is likely to ease further due to continued structural reforms and
efforts to slow credit expansion. For Japan, we expect another round of “Abenomics”,
af ter the renewal of the prime minister’s mandate in December’s elections. A
continued aggressive monetary easing and fiscal stimulus will probably at least avoid
Japan drifting into the much-feared deflationary downward spiral. On the other hand,
growth in India is expected to recover further in 2015 from historically low rates in the
years before.
ESG perspective – A mixed bagWith regard to these three countries’ ESG agendas, we expect a focus on bribery and
corruption (China and India), measures against anti-competitive corporate behaviours
(China), air pollution and water risk in India, and nuclear safety and the building up of
a renewable infrastructure in Japan. We also expect China and India to uphold the
principle of “common but differentiated responsibility” in international climate
negotiations. For Japan, we foresee that the new Stewardship Code will make listed
companies more active in incorporating ESG factors into their business practices.
10 for 2015 – A platform for ESG analysisThe value-add of ESG analysis If our global and Asia-specific macro views form the basis of our conviction for asset
allocation, the 10 for 2015 move further into the investment process and provide
insight into asset selection. Covering eight countries and ten industries, the 10 for 2015
consist of ten salient mainstream business stories where ESG factors can be shown to
be driving potentially material financial impacts. Our analysis exemplifies the type of
enhanced risk and opportunity identification that is increasingly being used by
investors to either supplement existing security selection models or inform new and
innovative standalone investment strategies. In the summaries below, we outline the
key findings of our assessment.
Impact DuPont. We take a contrarian view and argue that the company’s business model in
the African seed market may be misaligned with the needs of smallholder farmers. We
also suggest that DuPont’s focus on a limited array of hybrid seeds could contribute to
biodiversity loss and Monsanto-type reputational risks for investors.
Negative
Impact Intel. We present a favourable review of Intel’s plan to build a “conflict-free” supply
chain by 2016. While we question whether Intel’s customers will be willing to pay more
for conflict-free electronics, we are intrigued by the possibilities for brand building.
Positive
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Impact GlaxoSmithKline. We acknowledge that groundbreaking changes to the company’s
sales representative remuneration strategy may drag on short-term profitability, but
believe that they will help the company rebuild regulator and investor trust in the wake
of a record bribery charge in China.
Positive
Impact Lafarge and Holcim. We are bullish on the proposed merger of the world’s two largest
cement manufacturers, pointing to potential ESG synergies in energy and GHG
performance, as well as improved positioning in the growing market for sustainable
building materials.
Strongly positive
Impact Lonmin. We analyse the company’s exposure to the findings of the Marikana
Commission (expected in March 2015) and take a strongly negative stance, arguing that
the repercussions could range from reputational and brand effects to short-term
pressure on the company’s share price.
Strongly negative
Impact National Commercial Bank (NCB). We review the opening of Saudi Arabia’s equity
markets to foreign investors (beginning in 2015) and NCB’s attractiveness as a vehicle
to play the market for Shariah-compliant financial products and services. We highlightrisk factors related to NCB’s governance and project finance activities.
Negative
Impact Telenor. We find that the company’s advanced ESG practices may provide a hedge
against country risk in Myanmar, and argue that the lessons learned could potentially
be leveraged in future expansion to emerging markets in Sub-Saharan Africa.
Positive
Impact Pemex. While we question the extent to which the recent slump in oil prices may
discourage foreign investment in Mexico’s newly liberalised energy sector, we argue
that interaction with the world’s oil majors may ultimately lead to improvements in
Pemex’s health and safety performance and exposure to corruption issues.
Positive
Impact Coca-Cola. We show that the company’s recent entry into the energy drinks and milk
niches creates new and potentially under-appreciated ESG risk exposure. We gauge the
company’s strategic awareness of these risks to be low, although we find some pockets
of optimism.
Negative
Impact Netflix. We paint a picture of substantial shareholder discontent, pointing to corporate
governance challenges, including a non-responsive board of directors. We argue that
investors will be faced with a difficult choice if a takeover offer emerges in 2015, as
they have been largely rewarded to date for sticking with the board’s strategy.
Negative
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2015 – Macro ViewSustaining the unsustainable
Analyst(s)
Dr. Hendrik Garz
Managing Director, Thematic Research
Doug Morrow
Associate Director, Thematic Research
Financial markets seem to be torn between hope and fear these days. Apparently,
the new historic highs for equity markets are not the result of conviction and
confidence on the part of investors, but rather appear to signal the lack of investment
alternatives and the hope of prolonged expansionary monetary policy. In this chapter
we take a look at the possible consequences of the recently announced quantitative
easing (QE) programme of the European Central Bank (ECB). We conclude that this
programme is trying to sustain the unsustainable, and that investors do not have
many options to hedge themselves, due to already existing and exacerbated or newly
emerging bubble situations in many asset classes. We also reflect on the possible
default of Greece and the risk of a breakup of the Eurozone becoming more tangible
in 2015. Furthermore, we elaborate on a contrarian, thought-provoking scenario that
assumes an oil-price-induced positive growth surprise and describe how this could
eventually lead to a new financial crisis, with social unrest as a possible consequence.
Last but not least, we ponder the consequences of the new “lower oil price world”
and the current economic and political environment for the climate negotiations that
will culminate at the end of the year with the COP21 convention in Paris. We have
doubts that the odds are good to achieve an effective multilateral consensus. In the
absence of political leadership, we expect the focus to shift to companies and private
households, which will be moving ahead with climate-friendly technologies based on
economic self-interest.
The economy, the markets and ESG integrationESG integration: From the macro to the
micro level
Our readers may ask why we, as ESG and Responsible Investment specialists, feel cal led
upon to comment and elaborate on the current situation of the economy and financial
markets. The answer is simple: it is our conviction that the integration of ESG factors
into investment decision making has to take place at all levels. It needs to start at the
macro level (the economy and the markets) to primarily inform allocation decisions at
the asset class and sector level, and trickle down to the micro level (the companies) to
provide additional insights at the asset selection level. But why talk about valuations
and interest rates? It is all about providing and understanding the context against
which the integration of ESG factors needs to be debated.
Scenario-based analysis and discussion That said, we are aware that it would be beyond the scope of this note to provide a
detailed analysis of the economy, the markets and ESG integration. Hence, what we do
is discuss the main drivers and catalysts that can decisively move the economy and
markets in one direction or the other, and analyse the implications of such
developments from a social and environmental perspective. We do this in a scenario-
based manner and spirit, with sufficient humbleness regarding our ability to make
predictions, “especially if it’s about the future.”
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We start by taking a look at the situation in Europe in light of the gigantic QE
programme of the ECB and the increased likelihood of a Greek default or haircut. We
then turn to the slump in oil prices and its implications from an economic and
environmental perspective.
Economic and Monetary Union – “The sick man” of theglobal economy
Quantitative easing – The silver bullet to save the Euro?Decision of the ECB has triggered a highly
controversial debate
The decision of the ECB (announced on 22 January) to flood the markets with liquidity
via a QE programme with a volume of more than EUR 1.1trn (EUR 60bn to be spent
every month from March 2015 to September 2016) has provoked controversial debates
among investors, economists and policy makers. Some observers consider the QE to be
the silver bullet to avoid deflation, to save the Euro and the Eurozone and to enable
Europe to positively contribute to global economic growth again. Others stress that the
programme won’t do the job and will create new risks for financial markets and long-
term economic prospects while threatening the political cohesion of the Eurozone and
the EU member states.
Why now? The programme had already been promised by Mario Draghi in August 2013. Why has
the decision to implement the programme been made now? Is it the recent drop in
Eurozone inflation below zero? Or is it because of the snap elections in Greece, and the
worries about a jump in risk premia not only for Greek debt but also for Spain and
France?
Closing the gap – Balance sheet volume of ECB and Fed (in local currency, indexed)*
* f = forecast
Source: Bloomberg
Size of the Fed’s balance sheet has
quintupled since February 2008
The chart above shows the balance sheet volume (total assets) of the U.S. Federal
Reserve (Fed) and the ECB, reflecting the widening gap caused by the Fed’s QE
programme, launched to mitigate the consequences of the last financial crisis, over the
last couple of years. While the size of the Fed’s balance sheet has more than quintupled
since February 2008, the ECB’s total assets have increased by just over 60%. With the
0
100
200
300
400
500
600
I n d e x e d ( F e b r u a r y 2 0 0 8 = 1 0 0 )
Fed ECB
ECB Sep-2016f:
EUR 3,597bn
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Bubbles: Since the additional liquidity will not flow into additional real investments
to a large extent, it will primarily further inflate existing bubbles or create new
ones. Equity markets, which soared after the announcement, and real estate are
obvious candidates for further inflation. Through the QE programme, the ECB is
paving the ground for a new financial crisis, which could potentially be enormously
destructive (from a financial, economic, political and societal perspective). Again,the problem is not solved, but just postponed to the future, which is the opposite
of sustainable and responsible central bank policy.
“It doesn’t work in theory, but it works in practice”
Shouldn’t we be more optimistic after the
positive experience with similar
programmes in the U.S. and U.K.?
So what? one may ask. These are all theoretical considerations, and quantitative easing
has proven to work in the U.S. and U.K., so why not in Europe? Or to say it with Ben
Bernanke’s famous words, “It doesn’t work in theory, but it works in practice.” We have
our doubts that such an attitude would be appropriate in the European context for
several reasons. First, we are not aware of any successful examples regarding the
impact of QE when applied against the background of structural weakness (see Japan).
Second, liquidity is not in short supply in the Eurozone anyway, and it’s not the lack of
liquidity that hinders banks to lend money to the real economy. And third, the situation
in the Eurozone is completely different due to the fact that it is a single currency room,
but not a single fiscal room, with very different national interests. The construction
fault that was made and deliberately accepted when the Euro was launched for political
reasons is now firing back and may eventually confirm the concerns of those
economists who opposed the introduction of the Euro at the beginning.
ECB’s independence is called into
question
Different from the Fed, the ECB will also buy debt of lower credit quality, although it is
at least limited by minimum requirements and the rule not to buy debt from nations
under the umbrella of a financial assistance programme governed by the so-called
“troika” (the ECB, EU and International Monetary Fund (IMF)). It is certainly not a pure
coincidence that the dividing line in the ECB governing council is between those that
tend to struggle with their debt situation and a structural reform backlog and those
that have been traditionally viewed as stability anchors. The obvious influence of
national interests on the main decision-making body of the ECB, the governing council,
calls the bank’s independence, which is the single most important feature of its
credibility and power, into question.
“The European flu” – Global contagion effects to be expected
Laying the foundation for the next
financial crisis
Our conclusion is that the ECB’s move is a very risky one economically and politically.
It provides no solution to the underlying structural problems in the Eurozone, but tries
to cover them over the short term at the expense of a much higher bill presented over
the long run. It prolongs the liquidity-driven rally on equity markets and helps to sustain
the unsustainable valuation levels on fixed income markets. The combination of
excessive liquidity and the lack of investment alternatives will propel an increasing
willingness of investors to take incalculable risks and may well lay the foundation for
the next financial crisis. A new crisis would certainly not be limited to Europe, but would
entail global contagion effects with consequences beyond the ones of the last crisis,
which has not even been fully digested yet.
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Greece – “An end with pain vs. pain without end” Likelihood of a Greek haircut or default
has jumped significantly of late
The debate around the sustainability of the situation in Greece has heated up again
with the announcement of snap elections that became necessary after the failure of
the presidency vote in the Greek parliament in December. With the victory of the
“radical left” party Syriza, whose leader has already announced his intention not to pay
back the Greek debt in full, the odds of Greece leaving the Eurozone have suddenly jumped. Giving further credence to this view, German chancellor Merkel and other
European politicians publicly pondered the ramifications of Greece leaving the EU,
despite having vigorously refused this possibility at the outset of the debt crisis.
Whether this was just a trick to manipulate Greek voters, as Greek leftists suspect, has
become an academic question now, as the outcome of the elections is known.
Unforeseeable consequences of spillover
effects following a Eurozone exit of
Greece
It is clear, however, that national governments in Europe would have a hard time
explaining a haircut or default of Greece to investors, their taxpayers and voters.
Market turmoil and political unrest could certainly not be ruled out, and the pressure
on Greece to leave the Economic and Monetary Union (EMU), intended by
governments or not, would undoubtedly increase. Indeed, in itself the “Grexit”, as it isfrequently called in the press and on trading floors, would probably not be an
unmanageable challenge for the EMU and its other member states (though it certainly
could be for Greece). What makes it so risky are the unforeseeable consequences of
spillover effects that can be anticipated and that may eventually lead to a breakup of
the Eurozone and, even beyond that, have an influence on the future of the European
Union (for example, having the British referendum in 2016 in mind). Back to our
introductory thought, the QE programme of the ECB may well have been designed as
a hedge against the unfolding of such a scenario.
Oil price drop – A double-edged sword for the global
economyThe oil price is back on investors’ radar
screens No doubt, 2015 will be a challenging year for the global economy and financial markets
from both a fundamental and an ESG perspective. And there is one factor that could
play a pivotal role in the overall equation: neglected for quite some time, but back once
again on investors’ radar screens, is the oil price, probably the single most significant
factor with the potential to determine where economies and markets will be heading
in 2015 and beyond.
Quite spectacularly, the price for a barrel of crude oil (WTI) dropped from a 2014 high
of USD 101 to a low of USD 43.4 at the beginning of 2015 (-57%). Over the past 30
years, this period therefore belongs to the handful of examples (six, including the
current one, to be precise) where prices declined by 30% or more within a six-month
time frame. All of these episodes were related to major global events. The spectacular
drop in oil prices observed in 2008, for instance, overlapped with the financial crisis of
2007-2008.
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Crude oil price history (1930 –2014) – The pendulum is swinging back
Source: Bloomberg
Oil price slump supports global growth,
but to what degree?
In principle, there is a lot of agreement among economists that lower oil prices help
the global economy via cost reduction and income effects and the reduction of
inflationary and fiscal pressures in oil-importing countries. This view already takes into
account that oil exporters will suffer from adverse shifts in real income and a slowdown
in economic activity.
As always, the disagreement arises when it comes to evaluating the net impact of a
single driver like the oil price for the overall picture, including concrete growth
forecasts. And, of course, the oil price slump entails risks as well, including the
Eurozone and/or Japan being eventually pushed into a deflationary spiral, or countries
with high oil export exposures facing significant capital outflows, currency
depreciations, rising credit spreads and financial market volatility.
It’s all about expectations… Putting all of these pieces together into a single forecast is certainly a science, but it isalso an art, since the assumed transmission mechanisms are all based on assumptions
about how economic actors build expectations and accordingly adjust their behaviours.
Experience with cases in the past, like the effects of the 2007 –08 financial crisis on
corporate and private households, should make us humble and also skeptical with
regard to consensus opinions, which often suffer from a conservatism bias.
Growth forecasts for 2015 – Too conservative?
Contrarian view – Boom and bust triggered by the slump in oil pricesWhat if? Taking a contrarian view
regarding the net effect of lower oil
prices
As already said above, the slump in oil prices entails both opportunities and risks. These
have already been discussed intensively by economists (see recent World Bank and IMF
publications).4,5 We do not want to repeat these discussions here, but try to add value
for our readers by discussing a scenario that has not been covered sufficiently so far
but may constitute an enormous risk for the global economy. By doing this, we
explicitly take a view that is contrarian to the current mainstream view, in that it
assumes a significant upward surprise in GDP growth in 2015 and hypothesises that
this in turn could trigger an overreaction of monetary policy makers, eventually leading
to a burst of the apparent bubble on bond markets.
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Mainstream expectations for economic growth in 2015
Reduction of the IMF’s growth forecast
from 3.8 to 3.5%
The current market consensus can probably be best described by the IMF’s view that
the headwinds for global growth outweigh the positive impacts of lower oil prices,
which recently (19 January) led to a reduction in the Fund’s growth forecast for 2015
from 3.8 to 3.5%.6 The World Bank’s view, too, appears rather conservative (see table
below). It expects global growth to rise only moderately, to 3.0% in 2015, up from 2.6%in 2014, acknowledging an overall positive net effect of the slump in oil prices, but also
stressing the dampening effect of lower oil and commodity prices for the growth
prospects of some exporting countries.7
Global economic outlook* – Still too conservative for 2015?
* percentage change from previous year: e = estimate; f = forecast
** aggregate growth rates calculated using constant 2010 U.S. dollars GDP weights
Source: World Bank (2015)
Motivating an upward growth surprise
Global stimulus of close to USD 2trn can
be expected The starting point for our contrarian scenario is to get a handle on the overall size of
the oil price effect. For the U.S. alone, it is estimated that the oil price drop is equivalent
to a fiscal stimulus package of USD 200bn, despite the country’s resurgence as an oilproducer (see below).8 Globally, the effect is likely to be close to the estimated USD
2trn that was spent as a reaction to the global financial crisis of 2007 –2008 by the G20
countries.9 The difference is that this stimulus was spread over a much longer period
of time, and its impact accordingly unfolded in an incremental fashion. The impact of
an oil price drop, on the other hand, has more of the characteristics of a liquidity shock,
although some indirect effects will take some time to unfold as well. Private
households and corporates more or less feel the effects of an oil price drop
immediately in their pockets, and, in light of the lack of attractive investment
opportunities, the windfall surplus may well end up in additional consumption and
higher wages, leading to another positive knock-on effect on growth. As a
consequence, a possible scenario is that current global GDP estimates for 2015 aremuch too conservative.
Upward growth surprise may still be an
underestimated scenario
Hence, in our view, a still-underestimated scenario is that of an upward growth surprise
in high-income countries, which may well become more and more tangible in the
course of the year. The consequence would be that the pressure on the Fed and ECB
to cease their strategy of flooding markets with liquidity and keeping rates at record
lows could mount dramatically and much sooner than expected. For the Fed this would
2012 2013 2014e 2015f 2016f 2017f
Real GDP**
World 2.4 2.5 2.6 3.0 3.3 3.2
High income 1.4 1.4 1.8 2.2 2.4 2.2
United States 2.3 2.2 2.4 3.2 3.0 2.4
Euro Area -0.7 -0.4 0.8 1.1 1.6 1.6
BRICS 5.4 5.4 5.0 5.1 5.5 5.6
Russia 3.4 1.3 0.7 -2.9 0.1 1.1
India 4.7 5.0 5.6 6.4 7.0 7.0
China 7.7 7.7 7.4 7.1 7.0 6.9
Commodity Prices
Oil price 1.0 -0.9 -7.7 -31.9 4.9 4.7
Non-oil commodity price index -8.6 -7.2 -3.6 -1.1 0.2 0.3
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certainly be less of a problem, since the direction of its policy is pointing towards a
gradual tightening anyway. The ECB, on the other hand, would be caught on the wrong
foot, after just having launched its massive QE programme, as we have discussed
above.
Perceived comfort may turn out to be
elusive
Of course, over the short term, the drop in fuel prices gives central bankers some relief,
since inflation rates have not only dropped significantly of late (in the Eurozone even
below zero in December) but can also be expected to have an inflation-reducing effect
in 2015. The World Bank expects an oil-price-induced reduction of between 0.4 and 0.9
percentage points.10
But is the oil price drop really a blessing for those who support a continuation of loose
monetary policy regimes? In our view, the currently perceived comfort may turn out to
be elusive, as soon as the deflationary effects of the oil price drop begin to peter out
and the base effect begins to kick in. If the downward trend in oil prices does not
continue, and prices stabilise in the range of USD 40 –50, this will be felt in Q4 at the
latest. The inflationary risks of stronger-than-expected economic growth will come to
the fore, and monetary policy hawks will break cover again.
Monetary policy dilemma – Risking the burst of the bond market bubble
For us, it appears questionable whether central bankers will find a loophole out of the
dilemma they have manoeuvred themselves into over the last few years in response to
the global financial crisis. They now have to move on very thin ice. And the tricky thing
is that it is not about fundamentals; small rate hikes from the close-to-zero levels would
certainly not make real investments significantly less attractive. It is all about sudden
adjustments of expectations on financial markets and the “last straw that may break
the camel’s back”. And in our scenario, this last straw is assumed to be an unexpected
change in monetary policy stance, driven by an oil-price-induced positive growth
surprise.
“The mother of all bubbles” Driven by the surplus of liquidity and historically low rates, bond and equity markets
have rallied impressively over the past few years. While equity markets have reached
valuation levels that are still considered acceptable or at least not out of the range from
a historical perspective, bond markets have reached close to all-time-high valuation
levels after a long and historically unprecedented rally since the 1980s. Some call it the
“mother of all bubbles”, which may not be exaggerated if we take the possible
consequences of a sudden deflation of bond prices into account.
We’re not talking about “irrational
exuberance” here
When we talk about a bubble here, we’re not saying that it has been inflated by
“irrational exuberance”, to quote Alan Greenspan in his famous speech addressing the
valuation situation on equity markets at the beginning of the millennium. This time,
the story is admittedly different, since the rally is anchored in monetary policy and low
current interest rates. In that sense, valuations are certainly not irrational, but they are
nevertheless exposed to the risk of a significant change in expectations, comparable to
the one that triggered a jump in U.S. long-term rates of eight percentage points
between August 1977 and August 1981, i.e. within just four years (see overleaf chart).
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Fixed income markets – The “mother of all bubbles” (1881 –2015)
Source: Robert J. Shiller (2015)11
A massive sell-off of bonds could trigger
substantial economic and social
upheavals
The burst of a bubble is inherently unpredictable. Nevertheless, we can comfortably
say that a positive growth surprise, like the one we described above, would certainly
increase the likelihood of a price collapse, not the least due to the mounting doubts
about the sustainability of monetary policy in general and the ECB’s recent moves in
particular, as discussed above.
But what would be the consequences of a massive sell-off of bonds by institutional and
private investors? Would central banks be capable of leaning against this in their
function as “lenders of last resort”? In any case, the effort needed to prevent a systemic
breakdown would be enormous. The economic and social upheavals catalysed by the
sell-off would probably go much beyond the ones experienced as a consequence of the
last financial crisis, in which only a small segment of the market became “toxic”.
Asset class rotation – Will equities benefit from a bond sell-off?A double-edged sword for equity markets For the equity markets, the situation is a double-edged sword. On the one hand, it can
be expected that the equity market would initially benefit strongly from shifts out of
fixed income securities. Valuations still seem reasonable and, as said, the drop in oil
prices will not only lead to significant cost reductions, particularly in the manufacturing
sector, but could also give a boost to private consumption. On the other hand, it is
foreseeable that a burst of the bond market bubble could have consequences at the
real economy level that would quickly backfire on equity markets. The experience with
the last financial crisis showed us that in situations like these, all actors in an economy
tend to fall into a wait-and-see mode, with the effect that companies start to downsize
their capacities and downward adjust their earnings expectations. Large-scale
redundancies, in turn, lead to reduced income expectations for private households – inother words, the classical downward spiral. Based on reduced growth expectations,
equity market valuations would very quickly look much less attractive. Over the last
few years, equities have rallied anyway, and investors will probably come to the
conclusion that there does not appear to be an attractive alternative.
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A further increase in cash balances to be
expected
But where will the excessive liquidity end up, if the money flows out of fixed income
but not into equities? Real assets could be the answer. Coming back to the
sustainability angle, the “great transition of our economies”, for example, undoubtedly
has enormous financing requirements that still need to be covered. However, this is
certainly not a solution for the short term. First, despite the abundant long-term
investment needs, investors complain that direct investment opportunities with areasonable risk-return profile are scarce. Second, in the case of a bursting bubble on
the financial markets, risk aversion will jump, and investors will have a strong
preference for liquidity. Hence, it is unlikely that the proceeds from the bond market
sell-off will end up in real asset markets over the short term. It is a safer bet that
companies, institutional investors and private households would want to further
increase their cash positions, which are already much above normal levels.
Transmission mechanism of monetary
policy is not working properly anymore Corporates, for example, have already increased their cash balances dramatically since
2007, as the example in the chart below shows. This increase reflects conservative debt
policies and massive de-leveraging that took place after the last financial crisis. While
these efforts may have made corporates more resilient, they also signal the lack of
profitable real investment alternatives (including M&A), despite record-low financing
costs. This shows that the usual transmission mechanism of monetary policy is not
working properly. Furthermore, it has to be doubted whether central bank measures –
such as charging negative rates for short-term deposits of large financial or non-
financial institutions, as introduced by the ECB in 2014, for example – will break
investors’ wait-and-see attitudes.
Excessive cash positions on corporate balance sheets* – High resilience, lack of
opportunities
* total U.S. non-financial corporate cash balances
Source: Moody´s Investors Service (2014)12
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Sustaining the unsustainable – Where do we go from here?Inflation, deflation or stagflation? The not-much-liked but obvious question is whether the excess liquidity that does not
find attractive investment opportunities will finally translate into an inflation of
consumer goods prices and then to the much feared inflation-wage spiral, triggering
even more significant steps of monetary tightening by the central banks. As a result,
we could face the dreaded combination of inflation and a stagnating economy over themid-term. But how likely is a stagflation scenario going forward? We certainly do not
want to bet on its impending emergence, just as we do not want to forecast the timing
of a bursting bond market bubble. We are aware that these are only scenarios, and
none of them has to materialise in 2015. And there are also scenarios that are much
more optimistic than the ones we discussed, with the one that can be characterised as
the maintenance of the current status quo, i.e. the “sustaining of the unsustainable”
current equilibrium, being the most likely one. But although the burst of the bubble
might well be postponed beyond 2015, we see many reasons to be seriously concerned
about the further development from a risk management perspective and hence view
the valuation levels achieved on equity markets with a healthy dose of skepticism.
A new debt crisis could spark enormous societal costs
A litmus test for the resilience of the
banking sector and public budgets
A new financial crisis, triggered by a bond market crash, for example, would eventually
be a litmus test for the resilience of the banking sector and of public budgets globally.
As a consequence of the last financial crisis, national net debt levels have increased
over the last few years (in the U.S., from 50.4% of GDP in 2008 to an estimated 80.8%
in 2014; in the Eurozone, from 54.0% to 73.9%),13 albeit at a slower pace, due to the
historically low interest rates that dramatically lowered the costs of refinancing and
made debt levels appear more sustainable. This, however, may quickly prove to be
illusory, and a new round of bailouts may overstrain fiscal capacities.
But it is not only about the financial costs involved; the political and societal costs
would likely be high as well. The examples of Greece and Spain have shown that even
democratic/pluralistic societies can absorb economic shocks only to a certain extent
and only if a clear majority still believes that the consequences are fairly distributed
across societal groups. In cases like these, there could be a thin line between rescue
and complete failure, with the latter having far-reaching consequences for the idea of
a unified Europe, among other things.
Breakup of the Eurozone, and Britain’s
exit from the EU becomes a tangible
option
The economic and political tensions that the next financial crisis would instigate could
not only lead to a breakup of the Eurozone but could also exert pressure on politicians
in the U.K. to make the final step and leave the EU even before 2017, the year of the
scheduled referendum.
Oil price drop – Mixed implications with regard to the goal
of decarbonising the global economy
In the spirit of the top-down approach, we hypothesise that the dramatic fall in oil
prices is a possible catalyst for shifts in the expectations of actors in the real economy
and financial markets, which could potentially lead to a boom and bust scenario with
high social costs. Undoubtedly, the lower oil price also has a significant impact on the
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debate around the decarbonisation of the global economy and global climate goals. Its
role, however, is double edged, with positive and negative effects at different levels
and winners and losers depending on the perspective.
Stranded assets debate – Oil price shock helps to increase investors’
sensitivityU.S. oil production almost doubled over
the last five years, thanks to shale
High oil prices made investments in the exploitation of unconventional oil reserves
highly attractive over the last couple of years. In particular, the production of shale oil
in the U.S. soared and, with an overall oil production of now more than 9 million barrels
per day from just around 5 to 6 million just five years ago (see chart below), brought
the country back on the global map as a significant oil producer and even transformed
it into a net exporter.
The shale revolution – Is the party over?
Source: Bloomberg
Financing situation of companies in the
shale industry has deteriorated
dramatically
A sustainable drop in oil prices below USD 50 would mean that investments in assets
linked to reserves with high production costs either become stranded (if capex made
already) or become unattractive going forward. For example, the International Energy
Agency (IEA) estimates that the average production cost for a barrel of oil produced
from North American shale reserves is USD 65. (We are aware of the differences in
available estimates, partly driven by the fact that some take transportation costs into
account, others not.) Producers may still be hedged, but these hedges will eventually
need to be rolled over, at which point producers will start to incur significant losses
with each barrel they get out of the ground. At current prices, only those producers
able to produce most efficiently will survive. Stock prices of shale oil producers have
already collapsed, and risk premia on bond markets have soared. The ability of these
companies to refinance their debt is at stake, and some banks have already pulled the
emergency break by refusing to provide fresh capital. Also, their suppliers are badly hit,
as the example of Schoeller-Bleckmann, an Austrian producer of drilling heads and
rods, shows.
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Schoeller-Bleckmann – Stock market performance (2012 –2015)
Source: Bloomberg
A good “learning opportunity” for
investors
We don’t want to speculate here whether the oil price drop has been caused by a
strategy of OPEC countries to price unconventional oil reserves out of the market, or
whether the low-price environment is ultimately sustainable. But the situation, in any
case, shows what a burst of the often-cited carbon bubble could mean for investors.
Cynically, one could say that the current situation is a good learning opportunity for
them.
Oil production costs – Global liquid supply cost curve (USD/bbl)
Source: Rystad Energy research and analysis14
The beginning of the end? And for the shale industry itself? If the oil price remains at the current level sufficiently
long (6 months? 12 months?), it seems unavoidable that companies in the sector,
which are mostly heavily indebted, will start to default on their debt obligations, and
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this may well mean the demise of the industry for the foreseeable future.15 The
appetite of investors to finance a comeback when oil prices swing back again to more
“normal” levels would certainly be limited, in light of the credible threat of OPEC to
repeat their “punitive exercise” once again. Surely, this scenario must sound like music
to the ears of environmental protagonists, who have long fought against fracking. On
the investors’ side, it will definitely strengthen the understanding of carbon bubblerisks, independent of the question of whether the outlined scenario will finally
materialise or not.
Removing adverse incentives – Oil price drop provides an opportunity
to remove fossil fuel subsidies at low political costFuel subsidies are estimated to make up
more than 2% of global GDP Another positive-side aspect of the oil price drop is that it gives governments (mainly
in emerging, oil-exporting countries) more room to reduce fuel subsidies, killing two
birds with one stone: reducing the bias towards energy-intensive economic activity and
improving fiscal sustainability in times of sluggish growth and a tightening of monetary
policies. According to an IMF estimate, subsidies for petroleum products, electricity,
natural gas and coal reached USD 480bn in 2011 (0.7% of global GDP or 2% of totalgovernment revenues) on a pre-tax basis.16 The total effect, taking the negative
externalities created into account, is even much higher (USD 1.9trn, amounting to 2.5%
of global GDP or 8% of total government revenues). A number of developing countries
provide large fuel subsidies, in some cases exceeding 5% of GDP.17
Several countries have already started
slashing subsidies significantly
The drop in oil prices now allows governments to reduce subsidies with little perceived
impact on consumer prices, lowering the political and social costs of such actions.
Several countries have already started slashing subsidies significantly in Q4 2014, like
Indonesia and India, for example. And there is much hope that others will follow in
2015. The resources released by lower fuel subsidies could either help to further
restore the fiscal resilience of these countries or be channeled to more sustainableuses, like the improvement of critical infrastructure or investments in education.
Shrinking economic incentives to replace fossil fuels and the
(unavoidable?) failure of climate negotiationsThe role of falling oil prices With regard to the climate perspective in general, and the feasibility of global warming
caps in particular, the dramatic drop in oil prices also entails some negative effects.
First, it lowers the economic incentives to switch from fossil fuel based energy to
renewable energies, making it even more necessary that policy makers create a
regulated environment in which private actors are incentivised to move away from
climate-damaging energy sources. In itself, this is already a challenging situation, due
to the strongly diverging vested interests of the different parties involved, includingdeveloped vs. emerging markets, and net energy producers vs. net energy consumers.
But with the economic and market scenario described above, the probability of a
meaningful and effective multilateral political agreement (with climate negotiations
culminating in the COP21 convention in Paris in December) is moving even closer to
zero.
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The end of climate policy endeavours at
the multilateral level
A failure of the Paris conference would probably also imply the end of climate policy
endeavours at the global level and would lead to a recalibration of expectations and
actions. Acceptance of the non-feasibility of the two-degree goal will probably cause a
significant shift in focus from: (1) mitigation to adaptation (companies and private
households preparing for an inevitable temperature increase); (2) a multilateral to a
national or regional perspective; and (3) a macro to a micro perspective. This does notmean that the big transformation that climate change mitigation protagonists call for
will come to a complete halt. The energy transition in countries like Germany will
continue; we’ve no doubt about this. However, change will probably take much longer
than hoped for, at least as long as no game-changing technological breakthroughs
emerge unexpectedly.
Inconvenient implications for investors The implications for investors are challenging and also inconvenient. For example, they
have to ask themselves even more intensely than before what a divestment from fossil
fuel sources means for their portfolios from a strategic perspective, i.e. beyond the
short-term advantage of being underweighted in Oil & Gas during periods of dropping
oil prices. Is there a critical level of oil prices that makes the tradeoff between risk and
return sufficiently attractive again to re-invest? Or at the geopolitical level, how
interested can the Western world be in a further decline in oil prices in light of the
challenging economic and political situation Russia has manoeuvred itself into? What
kind of reactions do we have to fear if economic pressures continue to increase in a
situation where Russian leaders feel cornered anyway? How will the West take this into
consideration while at the same time trying to credibly push for decarbonisation of the
global economy in Paris?
Decreasing carbon prices (EU ETS): Technical market failure or lack of conviction?
Source: Bloomberg
Climate action – The recalibration of roles and expectationsThe diminishing role of policy makers and
regulators A failure in Paris would certainly not put an end to climate action, but investors need
to be prepared that change will be less driven by political consensus and regulatory
activity than previously thought. Rather, the responsibility for making climate-relevant
decisions will shift from the macro to the micro level, i.e. to companies and private
households. We expect this to have mainly two consequences. First, with the lack of
perceived government support, private economic actors will increasingly take the
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physical consequences of a changing climate into account when making fundamental
decisions about where they want to live or produce, i.e. the adaptation side of climate
change will gain in importance relative to the mitigation side. And second, the focus
will continue to be on technological solutions to curb emissions, but tests regarding
their cost competitiveness will become more critical than in the past.
More than ever, solutions have to be not
only cleaner but also cheaper
So the good news is that efforts to find cleaner but also cheaper alternatives to fossil
fuels will persist and continue to offer tremendous opportunities for investors.
However, we do not expect new national or regional windfall-type profit situations (e.g.
feed-in tariffs) to re-emerge. In the new political environment described above, the
time of non-market-induced gains would be over. New technologies will offer a
financial return to investors only if they are both cleaner and cheaper than fossil fuel
based solutions. In many sectors of the economy, alternative technologies are already
disrupting conventional patterns of energy use and consumption in the absence of any
meaningful multilateral climate agreement.
Can the failure of multilateral negotiations be compensated for with
national or regional carbon pricing initiatives?Sixty carbon pricing systems in place or in
development globally In a joint study by the World Bank and Ecofys published in 2013, 60 carbon pricing
systems were found to be in place or in development globally. This number is quite
impressive, and the progress made has raised hopes that carbon markets may have a
future, despite the EU Emissions Trading System (ETS) struggling in recent years with
prices at historic lows, and despite the prospect of a possible failure of multilateral
climate negotiations. The report highlights cap and trade systems in the EU, California,
Kazakhstan, New Zealand, Quebec, Japan and the U.S. (through the Regional
Greenhouse Gas Initiative), as well as South Korea, which launched the world’s second-
largest carbon market earlier this month. In addition, carbon taxes are cited in
Australia, British Columbia, Denmark, Finland, Ireland, Norway, South Africa, Sweden,Switzerland and the U.K.
How effectively can these mechanisms be
coordinated?
Altogether, the carbon pricing mechanisms identified could cover up to 20% of global
emissions, which is certainly a material share. The core question now is how effectively
these mechanisms can be coordinated in order to sufficiently cap global emissions
before these reach important tipping points. The discussed linkages between the EU
and Australia and California and Quebec, and potentially the EU and China, certainly
have the potential to increase overall impact. However, as long as sufficient regulatory
arbitrage opportunities exist globally, the scope of these coordination efforts remains
limited in terms of impact. And hence, the main risk is that the progress made with
these incremental steps is probably much too slow when having a two-degree or even
a three-degree goal in mind.
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Map of existing, emerging and potential emissions trading schemes
Source: World Bank/Ecofys (2013)
Reducing irrational fears The biggest merit of the diverse “bottom-up” initiatives from our point of view is that
they generate experience and knowledge about the function of carbon pricing
mechanisms. By doing this, they potentially help to reduce irrational fears about the
consequences of their introduction and thereby the resistance against more
comprehensive (ideally global) solutions.
Rounding out the picture
Catalysts for a more positive scenarioToo much gloom and doom? What could
a more positive scenario look like?
Taking a step back and looking at the scenarios we described above, we must ask the
question whether these are too negatively biased, too much doom and gloom? Our
intention was to discuss the (downside) risks that recent events engender against the
background of longer-term developments that seem to drive our economies more and
more away from a sustainable equilibrium. But ultimately, these are scenarios only,
and they describe only one possible logic of how the pieces of the puzzle might fit
together. We are humble-minded enough to understand that even a small number of
unanticipated events can dramatically change the overall picture or at least the
trajectory of the unfolding scenario. So, what could a more positive scenario look like?The core of such a scenario would have to be a combination of: (1) a revival of global
economic growth; and (2) a slow deflating of the fixed income market bubble governed
by masterful and coordinated monetary policies.
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Prerequisites for a more positive
scenario: (1) steps towards a solution to
the Ukraine conflict; (2) no new
escalation of the Greek debt crisis
In this optimistic scenario, global economic growth would be triggered by the fall in oil
price, but would probably help to stabilise oil prices going forward, improving the
outlook for oil-exporting countries as well. On the political front, a stabilised oil price
could help to find solutions with regard to the Ukraine conflict, by taking away domestic
political pressure from Russian leaders. This brings us to two further components of a
positive scenario that we would not consider necessary, but sufficient for a positivemarket development. The first one is that a further manifestation of a cold war scenario
can be avoided and steps towards a normalisation of the relationship between the
West and Russia undertaken (e.g. including a drop of sanctions against Russia). And,
the second one is that the risk of a new escalation of the sovereign debt crisis triggered
by political changes in Greece does not materialise.
Investment implications – Some easy wins Increased likelihood of a new financial
crisis
As ESG analysts, we have neither the mandate nor the inclination to give
comprehensive investment recommendations. This is simply not our job and is done by
others. However, the macro picture we outlined above certainly has some obvious
implications at the strategic and tactical asset allocation level. To briefly repeat themain points from our scenario analysis here: First, the QE programme of the ECB is
trying to sustain the unsustainable, increasing the likelihood of a new financial crisis,
with possibly far-reaching consequences. Second, we identified “two straws that may
break the camel’s back”, a default of Greece and/or an oil-price-fueled positive growth
surprise triggering an overreaction of monetary policy.
Don’t divest from high-quality fixed
income instruments too early, and don’t
overweight Oil & Gas and Banks
We draw four basic conclusions from this: (1) Investors are probably well advised not
to divest from high-quality fixed income instruments as long as there are hopes that
the QE programme is going to work and the uncertainties around Greece and the
Ukraine conflict prevail, despite the massive bond bubble they are sitting on. (2) The
risk profile of equities seems to be still attractive only if the oil price continues to show
weakness and as long as the crisis situations in Greece and the Ukraine do not
completely get out of control. (3) At the sector level it is clear that a low or even further-
falling oil price and a new financial crisis situation certainly do not invite investors to
overweight Oil & Gas and Banks in their portfolios. (4) Over the mid- to long term, the
financial risks for investors are high and cannot be fully hedged, due to the bubble
situations that have been emerging in many asset classes and the empirical fact that
asset prices tend to be positively correlated in down-market situations. Should markets
turn into crisis mode again, cash will certainly be king, but negative overnight rates will
then be the rule, not the exception.
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2015 – The Asian ViewModest growth, high vulnerability
Analyst(s)*
Loic Dujardin
Director, Research Products
Dr. Hendrik Garz
Managing Director, Thematic Research
* With contributions from our Asian Research
team: Sun Xi (Senior Analyst, Research
Products), Hardik Sanjay Shah (Manager,
Research Products), Yumi Fujita (Manager
Research Products)
Overall, we do not expect Asia to become the world’s growth engine in 2015.
Economic momentum in China is likely to ease further due to continued structural
reforms and efforts to slow credit expansion. For Japan, we expect another round of
“Abenomics”, after the renewal of the prime minister’s mandate in December’s
elections. A continued aggressive monetary easing and fiscal stimulus will probably
at least avoid Japan drifting into the much-feared deflationary downward spiral. On
the other hand, growth in India is expected to recover further in 2015 from
historically low rates in the years before. With regard to these th ree countries’ ESG
agendas, we expect a focus on bribery and corruption (China and India), measures
against anti-competitive corporate behaviours (China), air pollution and water risk in
India, and nuclear safety and the building up of a renewable infrastructure in Japan.
We also expect China and India to uphold the principle of “common but
differentiated responsibility” in international climate negotiations. For Japan, we
foresee that the new Stewardship Code will make listed companies more active in
incorporating ESG factors into their business practices.
Oil price drop helps Japan and IndiaEconomic activity is expected to remain
sluggish
Economic activity is expected to remain sluggish in Asia in 2015, according to World
Bank estimates (see table below), driven by a further easing of growth in China and a
Japanese economy that is still struggling to recover from the shock of the sales tax
increase in 2014 and continued fears of getting caught in a deflationary downward
spiral. India, on the other hand, is expected to lead a modest recovery in South Asia,
after growth in the region reached a ten-year low in 2014.
Economic Outlook (real GDP)* – Asian growth will remain sluggish in 2015
* percentage change yoy; e=estimate; f=forecast
Source: World Bank, 2015
Financial market volatility is one of the
most significant risks to the region
The drop in oil prices and overall soft commodity prices is a double-edged sword for
the region, with net exporters suffering and net importers benefitting. The oil price
situation will certainly help reduce energy bills for Japan, whose energy costs have
strongly increased after the shutdown of its nuclear power plants, and India, which may
additionally benefit from further reductions in fuel subsidies (see p. 22). Some of the
most significant risks for the region are contagion effects, originating from a new
2012 2013 2014e 2015f 2016f 2017f
World 2.4 2.5 2.6 3.0 3.3 3.2
High income 1.4 1.4 1.8 2.2 2.4 2.2
Japan 1.5 1.5 0.2 1.2 1.6 1.2
Developing countries 4.8 4.9 4.4 4.8 5.3 5.4
East Asia and Pacific 7.4 7.2 6.9 6.7 6.7 6.7
East Asia and Pacific excluding China 6.3 5.3 4.6 5.2 5.4 5.5
China 7.7 7.7 7.4 7.1 7.0 6.9
South Asia 5.0 4.9 5.5 6.1 6.6 6.8
South Asia exc luding India 5.1 5.7 5.8 5.7 5.8 5.9
India 4.7 5.0 5.6 6.4 7.0 7.0
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financial crisis with high market volatility and a surge in risk aversion among global
investors. If the risk scenario discussed in the previous chapter should become a reality,
Asian markets would certainly not be isolated from that, but may disproportionately
suffer.
Focus on China, India and Japan In the following, we briefly look at the three main determinants of economic growth in
the region, with China and India on the emerging market side and Japan on the high-
income side, and the challenges these countries are facing (including the ESG
perspective).
China – Gradual slowdown of momentum continuesMoving further away from a government-
backed growth model
China will experience a further easing of growth from 7.4 to 7.1%, according to World
Bank estimates, as a result of continued structural reforms and further efforts to slow
credit expansion. The government will move further away from a growth model based
on government-backed investment in infrastructure and heavy industries to supporting
strategic emerging industries such as energy-saving and environmental protection,
new-generation information technology and high-end equipment manufacturing. In
the rest of the East Asia-Pacific region, growth is expected to strengthen to 5.2% in
2015, partly offsetting China’s slowdown.
Credit growth in China (credit in % of GDP)* – Further efforts to slow expansion to
be expected
* data are for credit from the financial system to the govern ment and the private sector
Source: World Bank (2015)
Government’s reform eagerness still high Cooling down the property market,
deepening the rural land and financial
reforms
The Xi-Li administration is expected to push some key reforms in 2015. First, a
nationwide property tax is to be gradually implemented, in order to further cool down
the property market and also deepen the rural land and financial market reforms
(interest rate and exchange rate liberalisation) so as to release more market potential.
Second, the government is also aiming for more free-trade agreements – such as the
Regional Comprehensive Economic Partnership with Japan, South Korea, Australia,
India, New Zealand and ASEAN countries. However, ongoing tensions with
37
100
19
55
152
35
0 20 40 60 80 100 120 140 160
General government
Non-financial corporate
Private households
2013 2007
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neighbouring countries over maritime claims may impact trade negotiations. And,
third, the anti-corruption campaign launched in 2013 will continue, and those
disgraced ex-leaders such as Zhou Yongkang, Xu Caihou and Ling Jihua are expected to
face public trials this year. In that context, media censorship may also be further
tightened.
ESG agenda – Focus on bribery and corruption and climate changeCompanies expected to face more probes
and tightened regulations
China’s anti-graft battles are likely to widen in 2015. More companies, especially
foreign and state-owned enterprises, are expected to face more frequent probes and
tightened regulations. The recently initiated anti-monopoly campaign will continue,
and foreign firms involved in malpractices such as price fixing are at much higher risk
than their local peers.
To address climate change, China has pledged to ensure that carbon emissions peak in
2030 and also to increase the share of non-fossil fuels energy consumption to around
20% by 2030. However, as a developing country, China will continue to uphold the
principle of “common but differentiated responsibility” in future climate change
negotiations. In the wake of the 2015 climate change summit in Paris, China has called
for raised ambitions from rich countries on pre-2020 emissions cuts.
India – Easing supply constraints and reduced vulnerability
to financial market volatilityLower oil price increases fiscal flexibility
and lowers current account deficit
Growth in India is expected to continue its recovery from 5.6% in 2014 to 6.4% in 2015
according to World Bank estimates, benefitting from improvements in supply-side
constraints and certainly also from an increased fiscal flexibility due to the sharp drop
in oil prices, further cutting fuel subsidies (see p. 22) and helping to reduce the
country’s current account deficit.
India’s current account deficit – Improved outlook due to sharp oil price drop
Source: World Bank (2015)
-0.8
-3.4
-5.0
-2.5
-1.3-1.5 -1.6 -1.6
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
2000-2010 2011 2012 2013 2014e 2015f 2016f 2017f
P e r c e n
t a g e s h a r e o f n o
i n a l G D P
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Removing hurdles for foreign direct investmentsLack of domestic funds to invest in
growing infrastructure needs
In 2015, prime minister Modi’s government will face the daunting task of reviving the
economy along with improving the ease of doing business in India (the country ranks
142nd out of 189 countries in World Bank’s ease of doing business rankings18) by
implementing structural