Emmanuel Laurina, Managing Director, Head of Middle East & North Africa and Ana Harris, Head of Equity Portfolio Strategists for EMEA, both from State Street Global Advisors, speak with Banker Middle East and explain why the global climate bodes well for investment in the region
How does the investment landscape in the Middle East this fit into the global picture?
Emmanuel Laurina (EL): The big focus in the region right now is on diversifying government revenue from oil and fostering sustainable economic growth. Reductions in subsidies and the introduction of VAT have perhaps been the most visible changes at the consumers’ level but they are part of a much broader economic and fiscal reform agenda which, if successful, could be game-changing. Efforts are being made to increase foreign direct investments and to open up financial markets to foreign capital and Saudi Arabia in particular is going through a drastic transformation which is necessary for Vision 2030 to be a success.
More and more foreign companies are establishing a presence in the Kingdom because there are genuinely attractive business, investment and partnership opportunities for those who are prepared to commit on a long-term basis.
Describe the appetite for ESG investments in this region.
EL: Much like smart beta, the term ESG can have many forms and the criteria used for screening portfolios will tend vary from one region to another. Certainly, first-generation ESG filters in the form of negative screens on portfolios have been in high demand for several years in the Middle East. More recently, we have seen investors adopt more sophisticated approaches to screening out companies that are not in line with Islamic principles, and index providers are also developing customised indices reflecting those restrictions.
We are also seeing growing interest for low carbon investing, SRI and sustainable energy as themes, and more and more Middle East investors are now asking about the potential for ESG factors to serve as a source of alpha. In terms of where we are in the cycle, the current landscape in the Middle East is comparable to smart beta three years ago, in that the concepts have been understood and integrated and key stakeholders are now figuring out how more advanced forms of ESG investing can be implemented and how these can benefit their portfolios and their societal objectives overall.
What are your views on the current market cycle and which factors do you think are successful at the moment?
Ana Harris (AH): Entering the second quarter of 2018, investors face a considerably more uncertain investment landscape in global capital markets than the anomalously benign outlook priced just three short months ago at the close of 2017. Since that time, a bevy of new concerns have been added to the proverbial wall of worry that will need to be overcome if equity markets are to erase year to date losses and advance in 2018.
Despite the first quarter loss for global equities, the positive economic growth and earnings trends that provided foundation for fifteen consecutive monthly gains in global equities through January so far appear to remain firmly intact. Though off the highest readings reported at the start of 2018, global PMIs closed March consistent with global industry growing at an annualised rate of 3.5 per cent according to J.P. Morgan.
Expectations for 2018 corporate earnings growth actually accelerated during the first quarter with US earnings expected to advance 18.3 per cent against an estimate of 10 per cent at the end of 2017 while developed market earnings as a whole are now expected to advance 10 per cent for the year against a 7.5 per cent expectation last December. Expectations that US growth and inflation would continue to advance at a pace consistent with at least three Federal Reserve (Fed) rate increases in 2018 were also bolstered during the first quarter with the market pricing 84bps of total tightening for the year at the end of March against a forecast for just 62bps to start the year.
Looking at factor performances, momentum remains the standout factor this year to date, continuing its strong performance from 2017, but has given up some of its gains in a turbulent March. The recent market volatility has seen the low volatility factor outperform the most, with another defensive factor quality also holding up well. On the other hand, value and high dividend yield have continued their run of poor performance from the end of 2017.
In terms of factor valuations, stocks sorted on low volatility appear somewhat expensive versus their median levels over the last 10 years, whereas quality appears neutral, while value and size appear to be slightly expensive.
How have smart beta strategies grown in the institutional market and what value do they hold compared to traditional asset classes?
AH: Smart Beta are a set of strategies that look to capture well-known and well-researched factors. These factors have shown to deliver a premium above a market capitalisation weighted portfolio and it is possible to capture them through systematic processes that follow a well-defined set of rules and will do consistently over time.
We believe that there are five factors that drive stock returns over time: value, low volatility, momentum, size (or small cap) and quality. These strategies allow investors gain more control of their portfolio risk and return drivers while aiming for specific outcomes. We have seen investors use these as a complement to both their active and passive allocations. Their use has definitely grown over the last few years, especially when it comes to combining several factors within a single portfolio and create multi-factor approaches. This help investors benefit from diversification and potentially remove some of the performance cyclicality associated with single factor investments.
How would you describe the institutional investor appetite in this region?
EL: We continue to see sustained appetite for private and real assets as a longterm portfolio allocation, as well as money being deployed in listed asset classes, with a renewed interest in emerging markets in recent months. Much of the activity we have seen has resulted from asset allocation reviews causing investors to question their mix of strategies and managers. The advent of smart beta and factor investing has certainly helped investors rationalise their cost base by eliminating poor-performing active managers and replacing them with lower cost factor-based portfolios.
In a number of cases, we have seen investors adopt a ‘barbell’ portfolio allocation with a large portion of their assets in indexed mandates at the core, a layer of smart beta portfolios and a greater focus on high-conviction active managers, which we believe is a sensible approach. Even those investors who are not taking such radical steps are keen to understand which factor exposures drive their risk and returns at the total portfolio levels and today’s technology allows to do that across asset classes and make better informed decisions as a result.
In your opinion, what are the opportunities in this market?
EL: There have been interesting developments in terms of increased bond issuance in the GCC, improvements in market access and liquidity and, more recently, FTSE’s decision to include Saudi Arabia in its emerging market index in a few months’ time. The hope is that international investors will see this as an opportunity to access attractive yields and to tap into the region’s growth story. What is for sure is that indexed managers will be leading the way, since they will be adding Saudi Arabia stocks to their indexed emerging market products at the same time as benchmark providers.
On the fixed income side, the high demand for individual bonds on the primary market is a sign that investors are still yield-hungry and the hope is that markets and liquidity continue to broaden and deepen enough to launch credible institutional products.
What is your outlook for the next 18 months?
AH: Looking ahead in our tactical positioning, our view of global equity markets continues to be broadly optimistic on the continuing positive trends in corporate earnings across regions. For the US we recognise the new uncertainties raised by a more aggressive trade stance by the Trump administration and possibility of foreign retaliation but expect the actual economic impact to be contained. Our allocations include overweight positions to international developed markets in Asia-Pacific, and overweight allocations to US and emerging market equities.
We hold a neutral allocation to European equities, US growth and value equities and US small cap equities. Across broad asset classes, our portfolios continue to hold an overweight position in growth assets—primarily equities over fixed income. In fixed income, we are anticipating global government interest rates to continue to gradually rise as policy is normalised across regions. We hold an underweight position in US intermediate investment grade bonds and a smaller underweight position in global government bonds outside the US, where long-term rates relative to fundamentals appear even less aligned.
We expect some continued modest flattening in the US yield curve as near-term policy tightening will have a greater impact on short-term rates, while longer-term inflation and growth expectations that determine longer-term rates are more firmly anchored. In credit, we have become more measured on investment grade and in particular on high yield bonds, as spread compression to new cycle lows may limit further gains in these sectors as the cycle matures.
Across real assets, our portfolios hold an underweight position to REITs which we expect to be challenged in the anticipated continuing rising rate environment. We have also added an overweight position to broad commodities which we expect to provide a measure of diversification in an environment where real assets should benefit as inflation expectations are rising.