sustainalytics: 10 for 2015 full report

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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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January 2015 10 for 2015

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Foreword

Michael Jantzi

Chief Executive Officer

[email protected]

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

[email protected]

Doug Morrow

Associate Director, Thematic Research

[email protected]

Thomas Hassl

Analyst, Thematic Research

[email protected]

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.

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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


[email protected]

Doug Morrow

Associate Director, Thematic Research

[email protected]

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

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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

[email protected]

Dr. Hendrik Garz


[email protected]

* 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

mailto:[email protected]:[email protected]


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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


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


-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

sustainalytics: 10 for 2015 full report

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