1. finance
2. investing
3. stocks

Private Banking Americas
March 2013
Volume Seven
Compass
Navigating the Investment Landscape
Portfolio Strategies – How to Approach the Equity Market............ p6
Expert Insights – Outlook on MLPs........................................... p16
Introducing Our New Megatrends Framework..............................p21
Was It a Financial Crisis... or an Oil Crisis?.............................. p30
ForwordFo
Private Banking Americas
Asset Allocation & Investment
Strategy Team
Barbara M. Reinhard, CFA
Chief Investment Strategist
[email protected]
Nicolo Foscari
Director
[email protected]
Jimmy James
Director
[email protected]
Philipp E. Lisibach, CFA
Director
[email protected]
Scott Rosenblatt
Vice President
[email protected]
Ryan Sullivan
Assistant Vice President
[email protected]
Yogi Thambiah, CFA
Managing Director
[email protected]
This publication is not complete without the “Important Legal Information” at the back of this publication.
Please contact your Relationship Manager if you do not receive it. The Private Banking USA business
of Credit Suisse Securities (USA) LLC is a regulated broker dealer and investment advisor. It is not a
chartered bank, trust company or depository institution. It is not authorized to accept deposits or provide
corporate trust services and it is not licensed or regulated by any state or federal banking authority.
The issuers, securities, investment products, and companies referenced herein are not intended as a
recommendation or solicitation to buy, sell, or hold any securities or implement a specific investment
strategy. Contact your Relationship Manager for Credit Suisse investment research or marketing materials that contain the investment thesis, risks and potential rewards of particular securities or investment
products. Any potential investment decision should be based on research and analysis and not on the
limited information set forth herein.
orewordForewordForewo
Investing can be more art than science at times and a solid investment discipline can go
a long way to guide how one navigates the financial markets. We use an approach that
incorporates valuation, fundamentals, and sentiment across all asset classes. It has
served us well. Since June, we have argued that elevated risk premiums in equities and
credit-related fixed income would help produce solid returns. We continue to think that
the return and risk profile is to the upside.
But many markets have come a long way from the financial crisis. In fact, our proxy for
US equities, the S&P 500 Index, is close to its previous all time high of 1565, reached
in October 2007. While we have had conviction in our views, many investors are still
skeptical. However, those same investors realize the peril of sitting in cash, waiting for
the “buying opportunity.” For those readers interested in an approach to the equity markets
in light of the recent move, we would encourage reading our Portfolio Strategy section.
In this article, we help quantify the cost of a phase-in strategy versus going in all-at-once.
Additionally, in this issue of Compass, we feature investment thought leadership from
our Credit Suisse colleagues around the globe. Giles Keating, Head of Global Research,
has authored a thoughtful piece on a timely question, was it a financial crisis or an oil
crisis? His work points out that the consistently high oil prices of the last decade have
spurred new technologies to pull energy resources out of some untraditional places. He
helps us think through the economic growth implications of shale gas and what it means
to us as investors.
We also hear from Michael O’Sullivan, Head of Portfolio Strategy and Thematic Research,
about Megatrends. What are Megatrends? They are major economic, social, and political
forces relevant across decades. We group them into three overarching pillars:
Demographics, Multipolar World, and Sustainability.
Lastly, we tap a thought leader outside our organization to focus on one of the most
interesting sub-sectors within the US equity universe, Master Limited Partnerships.
David Martinelli, founding partner of Harvest Advisors LLC, opines on his outlook for MLPs.
It is a must read for any investor thinking about the energy infrastructure and yield stories
in the US.
We hope you find this issue of Compass insightful.
Barbara M. Reinhard, CFA
Chief Investment Strategist
Head of Asset Allocation & Investment Strategy
Compass
3
Inside this issue:
Page 16
Page 30
“Shale gas and oil is the
game-changing moment
for the US and energy
independence. MLPs are
critical to the shale boom
and development of the
US domestic production story.”
Suppose the world had not
run into an oil constraint in
2008 and instead there had
been sustained strong
growth – would the income
streams of Americans with
sub-prime mortgages and
the tax revenues of southern
European nations have been
enough to service their debt?
Page 21
Megatrends have accompanied mankind throughout
history. From the Neolithic
Revolution to the Information
Age, innovation has been
the catalyst for profound
socio-economic, cultural, and
political transformation.
4
Contents:
Portfolio Strategies
How to Approach the Equity Market
6
11
Strategic Asset Allocation
12
14
Conversations with Thought Leaders
David Martinelli
Introducing Our New
Megatrends Framework
30
40
Panorama
Shifting Dynamics on the World Stage
16
21
Was It a Financial Crisis...
or an Oil Crisis?
Key Forecasts
Summary of American
Taxpayer Relief Act of 2012
Compass
5
Portfolio
Strategies
How to approach the equity market
Written by Barbara M. Reinhard, CFA and Philipp Lisibach, cfa,
asset allocation and Investment Strategy
Back to the Highs
With its recent gains, the S&P 500 Index is quickly approaching
its all-time high of 1,565, which was reached in October 2007.
While equities have been climbing a wall of worry, it is interesting
to note that the recovery from the March 2009 low has taken
about 48 months. In the previous low from the 2000-2003 bear
market, it took 57 months for the S&P 500 Index to return to its
previous peak. What do we think about making an entry into
today’s equity market? We point out that plentiful liquidity, attractive valuations, and low inflation make equities among our best
options in an asset allocation context (see Table 1).
Table 1
Financial Market Statistics Today vs. Previous S&P 500
Index Peaks
Mar-00
Oct-07
Mar-13
1,527
1,565
1,544
23x
15x
13x
S&P 500 Index Dividend Yield
1.1%
1.8%
2.1%
US 10-yr Treasury Yield
6.2%
4.7%
2.0%
Inflation (CPI YoY)
3.8%
3.6%
1.6%
US Inv. Grade Credit Spread (bps)
146
138
135
US High Yield Spread (bps)
631
399
504
9,709
14,126
15,851
136
-169
-1,030
S&P 500 Index Level
P/E Ratio (12-mth fwd)
Nominal GDP ($Bn)
US Deficit/Surplus (LTM, $Bn)
As of 03/07/2013
Source: Bloomberg, Datastream
One of the questions we hear most often from clients is, “How
should one think about re-entering the equity market?” This
question is especially poignant given that investors continue to
maintain relatively high cash holdings in spite of several years of
decent equity market returns. With two secular bear markets
in the past decade so vivid in investors’ memories, we would not
diminish the role investor psychology and emotions play in
determining an entry point.
6
Portfolio Strategies
Why? At the beginning of an initial investment, a pullback could put
an allocation to equities in negative territory, which may lead an
investor to make the classic investment mistake of selling at the
bottom of a turbulent market just as it is about to make a recovery.
One way to soften the ups and downs of the equity market when
considering an initial or new investment is to phase-in over a
defined time period.
Which Is the Better Way, Phase-in or All-at-once?
We analyzed 12-month rolling returns of the S&P 500 Index since
1926, using the index return as a proxy for investing all at once
(i.e., “All-at-once Strategy”) and investing on a quarterly basis (i.e.,
“Phase-in Strategy”). The results are illustrated in Figure 1. The
All-at-once Strategy had an average first year return of 11.0%, the
Phase-in Strategy had an average first year return of 7.4%, -3.6%
versus the All-at-once Strategy. In contrast, waiting in cash for an
opportunity to buy would have generated a 3.3% return. The return
profiles of the two strategies converge in year two, when both are
fully invested.
The All-at-once Strategy had the better average outcome because
equity markets tend, over time, to be upward sloping. However, in
our opinion, that does not necessarily make it the best strategy.
Investing can be an emotional activity, subjecting an investor to
feelings of panic and euphoria. Remember, it was Benjamin
Graham who created the allegory “Mr. Market”, and sometimes Mr.
Market is an emotional wreck, suffering from excessive highs, and,
at times, suicidal lows. He can make investing at times very
challenging. So, while there is an opportunity cost to any phase-in
strategy, especially during rising markets, the simple fact is that
phasing-in can help investors leg into equities rather than sit idly in
cash, waiting for the “right time” to buy. Lastly, an extra benefit of
a phase-in strategy is seen in Figure 1: the Phase-in Strategy had
a lower standard deviation of return – almost 30% lower – than the
All-at-once Strategy.
A Look at a Few Phase-in Strategies
As with any phase-in strategy, there is more than one way to
execute for investors who have high cash allocations or who are
simply looking to re-allocate towards equities. We analyzed three
unique strategies – each with different upfront initial purchases and
As the US equity market approaches its
all-time high, many investors are maintaining high cash or short-duration fixed
income positions. It is natural to ask, what
is the best approach to think about reallocating to the equity market?
Figure 1
The Phase-in Strategy Has a Cost, but One of the Benefits
Is Lower Volatility
Average 12-Month Total Return and Standard Deviation of
Returns using the All-at-once Strategy (using S&P 500 Index),
Phasing-in Strategy, and Cash since 1926
Total Return
12%
11.0%
Standard Deviation
25%
10%
8%
20.4%
20%
7.4%
15%
6%
14.1%
3.3%
4%
10%
5%
2%
0%
All-at-once
Strategy
Phase-in
Strategy
2.8%
30-Day US
T-Bill Index
0%
Average 12-Month Total Return
Annualized Standard Deviation of Returns
As of 02/28/2013
Source: PB Americas Asset Allocation & Investment Strategy, Ibbotson,
Bloomberg
Note: Phase-In Strategy: 25% initial investment with 25% every 3 months
thereafter
Compass
7
Figure 2
The Fastest Phase-in Strategy Yields the Highest Return,
but That Is Not Always the Right Path
Average 12-Month Total Return and Standard Deviation of
Returns using Three Phase-In Strategies, Since 1926
Total Return
12%
Standard Deviation
20%
9.7%
10%
8.9%
8%
18%
7.4%
17.5%
16.5%
16%
6%
14%
4%
14.1%
12%
2%
0%
Phase-in Strategy 1
Phase-in Strategy 2 Phase-in Strategy 3
10%
Average 12-Month Total Return
Annualized Standard Deviation of Returns
As of 02/28/2013
Source: PB Americas Asset Allocation & Investment Strategy, Ibbotson,
Bloomberg
Note: Phase-In Strategy 1: 25% initial investment, 25% every 3 months
thereafter
Phase-In Strategy 2: 33.3% initial investment, 33.3% every 3 months
thereafter
Phase-In Strategy 3: 50% initial investment, 25% every 3 months
thereafter
Figure 3
Phase-in Strategy 1 Will Lag during Big Market Upswings
but Preserve Capital during Market Weakness
Average 12-Month Total Return of the All-at-once (S&P 500
Index) Strategy and Phase-In Strategy 1 Since 1926, Sorted
Lowest to Highest by Quartile
Total Return
150%
Average Return
Bottom Quartile
100%
S&P 500 Index -14.5%
Phasing-In
-9.4%
Average Return
2nd and 3rd Quartile
All-at-once +11.5%
Phasing-in +8.1%
Average Return
Top Quartile
All-at-once +35.6%
Phasing-in +22.9%
50%
0%
-50%
258
Observations
-100%
517
Observations
All-at-once Strategy
258
Observations
Phase-in Strategy 1
As of 02/28/2013
Source: PB Americas Asset Allocation & Investment Strategy, Ibbotson
8
Portfolio Strategies
varying time periods to become fully invested. 1) Phase-in
Strategy 1 is investing an initial 25% in equities, followed by a
subsequent 25% investment every three months, so as to be fully
invested after nine months. 2) Phase-in Strategy 2 is an initial
purchase of 33.3%, followed by a subsequent 33.3% investment
every three months, which leads to full investment in six months.
3) Phase-in Strategy 3 is an initial 50% allocation, followed by a
subsequent 25% investment every three months, which leads to
full investment after six months. The results are illustrated in Figure
2. Phase-in Strategy 1 had the lowest average return at 7.4%,
and had the lowest standard deviation. While Phase-in Strategy 2
and Phase-in Strategy 3 had higher returns the first year, the drag
of not participating in a potential gain was manageable, in our
opinion, between 2.3% and 1.5%.
As equity markets tend to be upward sloping, generally, the time
delay factor associated with a phase-in strategy has a cost. The
average cost of a phase-in strategy should be weighed against
personal investment objectives and emotional comfort levels. For
investors who are nervous about investing in equities, but recognize the potential pitfall of holding a large cash position, Phase-in
Strategy 1 is the least aggressive tactic. But the above analysis
assumes average returns over a very long time period. Let’s take
a look at periods of weak and strong equity market returns.
The Cost of a Phase-in Strategy during Various Return
Environments
We segmented the returns of the S&P 500 Index into quartiles to
see what Phase-in Strategy 1 results would look like across various return environments. As illustrated in Figure 3, in the second
and third quartiles, the Phase-in Strategy delivered an average
return of 8.1%, 3.4% worse than the All-at-once Strategy. What
we found interesting is that the results of the Phase-in Strategy are
not symmetrical, meaning the results are not similar in the top and
bottom quartiles. In periods of strong market returns, an all-atonce strategy would have generated an average return of 35.6%
and the Phase-in Strategy would have generated an average
return of 22.9%, a drag of 12.7% during the first year of working
toward full investment. On the flip side, during periods of weak
equity market returns, at the bottom quartile, the All-at-once
Strategy generated an average return of -14.5% and the Phase-in
Strategy delivered a return of -9.4%, avoiding about 5.1% in
losses.
The obvious question is, how does the return strength or weakness
of the S&P 500 Index make a phase-in strategy effective? In
Figure 4, we looked at the distribution of returns showing the
number of observations of rolling 12-month returns in bands, from
worse than -25% up to greater than 40%. We found that the
Phase-in Strategy 1 historically has significantly reduced extreme
outcomes, at the far left and the far right (highlighted). While the
phase-in strategy will cost performance in the initial 12 months
Figure 4
Phase-in Strategy 1 Produces Fewer Periods with Extreme Returns
12-Month Total Return of S&P 500 Index and Phase-in Strategy 1 since 1926, Number of Observations per Return Band
180
160
140
120
110
100
80
60
40
20
0
<-25%
<-10%
<-5%
<-0%
<+5%
<10%
<15%
<20%
<25%
<30%
<40%
>40%
Total Returns
S&P 500 Index; # of Observations
Phase-in Strategy 1; # of Observations
As of 02/28/2013
Source: PB Americas Asset Allocation & Investment Strategy, Ibbotson
during years of very strong S&P 500 Index returns, the protection
comes from going slowly during periods of very weak S&P 500
Index returns.
Incorporating Investor Expectations
Therefore, we can conclude that if an investor expects the
S&P 500 Index to return 25% or greater in the coming
12 months, an all-at-once strategy would produce the more
favorable results. If expectations are that the S&P 500 Index
will return less than 25%, a phase-in strategy can reduce the
volatility of an initial equity allocation, coming at the cost of
manageable underperformance.
One way to soften the ups and downs of
the equity market when considering an
initial or new investment is to phase-in over
a defined time period.
Conclusion
As the US equity market approaches its all-time high, many
investors are maintaining high cash or short-duration fixed income
positions. It is natural to ask, what is the best approach to think
about re-allocating to the equity market? While we know that,
objectively, investing all-at-once produces the best return over the
long run, a phase-in strategy can help investors who are entering
equities neutralize some of the emotion that may arise in the event
of an interim pull-back.
Compass
9
Equities: Regional
Developed Markets
▼
▼ ▼
▼
▼
▼
USD vs. BRL
▼
▼
AUD vs. USD
▼
USD vs. MXN
▼
NZD vs. USD
▼
Asia
▼
Latin America
▼
Europe, Mid East, Africa ▼
Equities: US Sector
Information Technology
▼
▼
US Treasury
Inflation Protected
Consumer Discretionary
Financials
▼
Emerging Markets
Energy
▼
US Investment
Grade Corporate
▼
Consumer Staples
▼
Telecomm Services
▼▼
Utilities
▼▼
Key
Materials
▼▼
Positive
US Municipal
US Securitized
▼
US Treasury
▼
▼
*3-month or 12-month forecasts as indicated
**Level with USD as counter currency,
price change with USD as base currency
Source: Private Banking Americas
Investment Strategy and Advisory Group
10 Portfolio Strategies
▼
Agriculture
▼
Energy
▼
Source: Private Banking Global Research,
Bloomberg, Thomson Reuters DataStream
▼
▼
Livestock
▼
Industrial Metals
Neutral
Negative▼
or ▼ ▼ Indicates a strong investment conviction in over/underweight position.
or ▼
▼
▼▼
Commodities
Precious Metals
▼
Industrials
US High Yield
▼▼
Health Care
Fixed Income
▼
Emerging Markets
▼
Europe ex-UK
GBP vs. USD
▼
Japan
USD vs. BRL
▼
U.K.
USD vs. CAD
▼
Canada
USD vs. JPY
▼
Asia Pacific ex-Japan
▼
Arrows represent the current Private
Banking Americas Investment Strategy
and Advisory Group absolute market
view for 6-12+ months.
EUR vs. USD
▼
(As of March 15, 2013)
US
Currency
▼
Outlook
Summary
Indicates a modest investment conviction in over/underweight position.
Indicates
a neutral investment conviction.
Global Equity Indices
US (S&P 500)
03/15/13
12M (Base Case)
1,561
1,518
Euro Area (Euro Stoxx 50)
2,726
2,654
UK (FTSE 100)
6,490
6,317
12,561
11,500
Japan (Nikkei 225)
MSCI Emerging Markets Index
Key
Forecasts*
(As of March 15, 2013)
1,042
1,071
Brazil (Bovespa)
56,869
70,000
Mexico (IPC)
42,605
46,000
Real GDP (In %)
2012E
2013E
Inflation 13E
3.00
3.40
2.90
1.60
Global
US
Eurozone
Japan
2.10
2.00
-0.40
0.00
1.80
1.70
1.40
-0.40
Non-Japan Asia
6.10
6.70
4.00
Latin America
2.80
3.70
6.60
Interest Rates (10-Year Government)
US
03/15/13
3M
12M
1.99%
1.7 – 1.9%
1.8 – 2.0%
Euro Area
1.45%
1.6 – 1.8%
1.8 – 2.0%
UK
1.94%
1.9 – 2.1%
2.3 – 2.5%
Japan
0.62%
0.7 – 0.9%
0.9 - 1.1%
03/15/13
3M
12M
93.45
96.00
100.00
3.87
3.25
3.50
1591.95
1600.00
1600.00
28.77
30.00
31.00
1589.75
1750.00
1800.00
Commodities
Energy
WTI Crude Oil (USD/barrel)
US Natural Gas (USD/mmbtu)
Precious Metals (Spot, USD/ounce)
Gold
Silver
Platinum
Base Metals (USD/pound)
Aluminum
0.89
0.98
1.02
Copper
3.52
3.76
3.86
Agriculture (USD/bushel)
Wheat
7.23
7.50
7.00
Corn
7.17
7.00
6.50
Currencies (USD vs.)
Euro**
03/15/13
3M
12M
1.31
1.38
1.37
Japanese Yen
95.28
96.00
97.00
British Pound**
1.51
1.50
1.48
Swiss Franc
0.94
0.91
0.95
Canadian Dollar
1.02
1.05
1.01
Australian Dollar**
1.04
1.00
0.98
New Zealand Dollar**
0.83
0.83
0.80
Mexican Peso
12.43
12.40
12.00
Brazilian Real
1.98
1.94
1.93
Source: Private Banking Global Research,
Bloomberg, Thomson Reuters DataStream
*3-month or 12-month forecasts as indicated
**Level with USD as counter currency,
price change with USD as base currency
Compass 11
Strategic Asset Allocation
For US Ultra High Net Worth Individuals
(As of March 15, 2013)
Overview
The Credit Suisse Global Asset Allocation
Framework (GAAF) is a dynamic process
that sets recommended benchmark
weightings for each of the asset classes
we believe should be incorporated in a
balanced asset allocation. It is comprised
of a long-term Benchmark Asset
Allocation (BAA) and a shorter-term
Strategic Asset Allocation (SAA).
The Benchmark Asset Allocation
(BAA) is based on the Credit Suisse
Capital Market Assumptions and is
expected to remain relatively static for a
full market cycle. It is developed from the
ideas and forecasts of the most accomplished senior strategists at Credit Suisse
and incorporates all of the fundamental
concepts of asset allocation.
The Strategic Asset Allocation (SAA)
Based on market behavior and recommendations from Credit Suisse’s global
strategists, the SAA seeks to establish
strategic over- and underweights relative
to the BAA. It utilizes a 6-12 month time
horizon. The primary goal of the SAA is to
generate excess return and/or reduce
risk relative to the BAA.
KEY
Recommended (SAA)
Neutral (BAA)
Source: Private Banking Americas Investment
Strategy and Advisory Group
12 Portfolio Strategies
Risk Budget 1: Low
Risk Budget 2: Low-Medium
5
5
5
15
15
3
20
23
20
80
54
80
55
BAA
Cash
5.0%
SAA
+/-
5.0%
BAA
Cash
20
SAA
3.0% -2.0%
5.0%
3.0% -2.0%
USD
5.0%
5.0%
USD
Equities
0.0%
0.0%
Equities
United States
0.0%
0.0%
United States
Dev. Equities ex-US
0.0%
0.0%
Dev. Equities ex-US
6.0%
6.0%
Emerging Markets
0.0%
0.0%
Emerging Markets
4.0%
4.0%
Fixed Income
80.0% 80.0%
Fixed Income
+/-
5.0%
20.0% 23.0% 3.0%
10.0% 13.0% 3.0%
55.0% 54.0% -1.0%
USD, Tax-Exempt
56.0% 56.0%
USD, Tax-Exempt
38.5% 38.0% -0.5%
USD, Taxable
24.0% 22.0% -2.0%
USD, Taxable
16.5% 14.5% -2.0%
Non-USD, Taxable
Alternative Investments
0.0%
2.0% 2.0%
15.0% 15.0%
Non-USD, Taxable
Alternative Investments
0.0%
1.5% 1.5%
20.0% 20.0%
Commodities
2.5%
2.5%
Commodities
2.5%
2.5%
Gold
2.5%
2.5%
Gold
2.5%
2.5%
Hedge Funds
5.0%
5.0%
Hedge Funds
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
Private Equity
0.0%
0.0%
Private Equity
Real Estate (Property)
5.0%
5.0%
Real Estate (Property)
Important Information: The proposed Benchmark and Strategic Asset Allocations for each of the risk
budgets referenced above are created by the Private Banking Americas Investment Strategy and
Advisory group. The Benchmark Asset Allocation (BAA), for a 3-7 year time horizon, is the neutral
position reflecting the predefined risk budgets and meets investment objectives over a full market cycle.
Risk Budget 3: Medium
Risk Budget 4: Medium-High
5
5
2
25
44
25
Risk Budget 5: High
30
40
59
30
10
5
2
2
55
30
68
30
65
9
29
30
BAA
Cash
USD
Equities
SAA
+/-
5.0%
2.0% -3.0%
5.0%
2.0% -3.0%
40.0% 44.0% 4.0%
BAA
Cash
USD
Equities
SAA
+/-
5.0%
2.0% -3.0%
5.0%
2.0% -3.0%
55.0% 59.0% 4.0%
BAA
Cash
USD
Equities
SAA
+/-
5.0%
2.0% -3.0%
5.0%
2.0% -3.0%
65.0% 68.0% 3.0%
United States
20.0% 24.0% 4.0%
United States
27.5% 31.5% 4.0%
United States
32.5% 35.5% 3.0%
Dev. Equities ex-US
12.0% 12.0%
Dev. Equities ex-US
16.5% 16.5%
Dev. Equities ex-US
19.5% 19.5%
Emerging Markets
11.0% 11.0%
Emerging Markets
13.0% 13.0%
Emerging Markets
Fixed Income
USD, Tax-Exempt
8.0%
8.0%
30.0% 29.0% -1.0%
21.0% 20.0% -1.0%
Fixed Income
10.0%
9.0% -1.0%
0.0%
0.0%
USD, Tax-Exempt
7.0%
6.0% -1.0%
Fixed Income
USD, Tax-Exempt
0.0%
0.0%
USD, Taxable
9.0%
8.0% -1.0%
USD, Taxable
3.0%
1.5% -1.5%
USD, Taxable
0.0%
0.0%
Non-USD, Taxable
0.0%
1.0% 1.0%
Non-USD, Taxable
0.0%
1.5% 1.5%
Non-USD, Taxable
0.0%
0.0%
Alternative Investments
Commodities
Gold
Hedge Funds
25.0% 25.0%
Alternative Investments
2.5%
2.5%
Commodities
2.5%
2.5%
Gold
10.0% 10.0%
30.0% 30.0%
Alternative Investments
2.5%
2.5%
Commodities
2.5%
2.5%
Gold
30.0% 30.0%
2.5%
2.5%
2.5%
2.5%
Hedge Funds
10.0% 10.0%
Hedge Funds
10.0% 10.0%
10.0% 10.0%
Private Equity
15.0% 15.0%
Private Equity
5.0%
5.0%
Private Equity
Real Estate (Property)
5.0%
5.0%
Real Estate (Property)
5.0%
5.0%
Real Estate (Property)
0.0%
0.0%
The Strategic Asset Allocation (SAA), for a 6-12+ month time horizon, expresses views resulting in temporary deviations from the BAA to generate expected excess returns or reduce risk. Alternative investments are typically high-risk investment vehicles which are available only to qualified individuals or entities
that are willing to assume above average risk and sustain limited liquidity with a portion of their net worth. Please refer to the attached “Important Legal
Information” for important disclosures relating to alternative investments.
Compass 13
Panorama is a 10,000-foot
view of notable events and
milestones reported around the
world. Each event contributes
in some way to the accelerating
pace of global change, as independent events collectively shift
our global perspective.
02.05.2013
For the US, the world’s largest
pensions market, the 100 largest
defined benefit corporate pension plans
were underfunded by $500 billion
at the end of October 2012, with assets
covering just 73% of liabilities.
02.14.2013
The Mexican Auto Industry Association
estimates that if more consumers
gradually gain access to banking loans,
annual car sales would rise nearly
60% to 1.6 million vehicles in the
next six years.
BMW, the world’s largest premium automaker, sold a recordhigh number of cars in 2012. 2013 started strong as well,
with a record January, and sales in China rose 15%. China is
BMW’s largest market, with a 25% share of global sales.
02.08.2013
Investment in the US oil and gas sector has grown to reach
approximately $140 billion per year over the past two years.
While only 1% of GDP, the sector has accounted for 10% of
total business fixed asset investment.
12.31.2012
03.12.2013
Industrial production in the UK
fell 1.2% in January from
December, 15% below the prerecession peak, and is now at
the lowest level since 1991.
02.07.2013
Though only 23% of houses there have electricity
and only 9% of its roads are paved, Kenya is ripe
for tech investment, as mobile phone penetration
is 75%. Nearly everything in Kenya can be purchased via text message.
Sources: Agence France Presse (2/14/2013), Bloomberg Markets Magazine (2/7/2013), Credit Suisse (12/31/2012, 1/23/2013, 2/5/2013),
Reuters (2/8/2013, 2/14/2013), The Wall Street Journal (3/12/2013)
According to the World Gold Council, global demand for gold
fell last year in its first decline since 2009, as demand in leading
market India slid, narrowing the gap with second-biggest
buyer China.
02.14.2013
In China, the youngest end of the working-age population is
achieving higher income levels. The typical 18–29 year old has an
average monthly income that is 7% above that of 46–55 year
olds and 15% above those in the 56–65 age group.
01.23.2013
Australia has been one of the two
best-performing equity markets over
the past 113 years, with a real return
of 7.3% per year.
02.05.2013
02.05.2013
Today, South Africa has 90% of the world’s platinum,
80% of its manganese, 75% of its chrome, and 41% of its gold.
Panorama
V7.2013
Shifting Dynamics
on the World Stage
Compass 15
Conversations
with Thought Leaders
Interview by Jimmy James,
Private Banking Americas asset allocation and Investment Strategy
2012 was the first year since 1999 that the total return of Master Limited
Partnerships (MLPs) lagged that of the S&P 500 Index. Though still early,
MLPs have started to play catch-up in 2013, as they have returned 13%
this year, versus 9% for the S&P 500 Index. We think this can endure,
as market participants continue to value alternative sources of yield given
the current environment of ultra-low interest rates. Add to that their
role as the infrastructure for US shale grows, and MLPs are compellingly
positioned in 2013. To help us navigate the MLP landscape, we are
pleased to share the insights of David Martinelli, portfolio manager of
the Harvest MLP fund.
16 Private Banking Vol 1. 2013
David Martinelli is a founding partner and serves as the Managing Partner of Harvest Fund
Advisors LLC, the Investment Advisor to the various Harvest MLP and Energy Funds. He
currently serves as Chairman of the Investment Committee and is responsible for the
growth and direction of the Company. Prior to Harvest, Mr. Martinelli served as principal
and majority owner of the General Partner of Buckeye Pipeline Company (“Buckeye”), an
NYSE-listed MLP.
David J. Martinelli
From 1996 through 2004, Mr. Martinelli held numerous positions within the Buckeye organization. During his tenure at Buckeye, Mr. Martinelli engineered the financial restructuring
of the company and directed all corporate acquisitions. He ultimately directed the sale of
Buckeye to the Carlyle Group in 2004 and started Harvest in 2005 with the goal of institutionalizing the MLP investor base.
Prior to joining Buckeye, Mr. Martinelli was an investment banker with Salomon Brothers in
New York; Paine Webber International in London; and Drexel Burnham Lambert in both
London and New York. Mr. Martinelli has a B.S. in Finance from Syracuse University and
an MBA from the Stern School of Business at New York University.
Compass 17
MLPs returned 5% in 2012, versus 16% for the S&P 500 Index. What were the
major factors that lead to the underperformance of MLPs relative to the S&P 500
Index?
Expert Insights
A Closer Look at Shale
with John Edwards, Head of Energy MLP
Equity Research, Credit Suisse
Since many shale plays require significant
infrastructure development, we believe
the shale revolution should provide infrastructure companies and US Master
Limited Partnerships (MLPs) with continued
opportunities for capital allocation. With a
relatively modest rise in price outlook for
natural gas, the INGAA Foundation’s
2011 study1 concluded $338 billion worth
of infrastructure would be required in nominal US dollar terms from 2011 to 2035. The
trend in switching from coal to natural gas
underpinned some of the INGAA’s views,
along with incremental generation from
natural gas.
We believe the study underestimates the
infrastructure opportunity. Given the
110,000 inch miles added each year and
approximately $100,000 per inch mile estimated for 2013, this would translate to
approximately $275 billion in total from
pipelines alone – setting aside storage
and gas processing.
Underscoring the capital investment
opportunity unleashed by the shale revolution, capital spending in the MLP sector
has increased rapidly over the last six
years, rising at a compound growth rate
of over 22% per year, and expected to
exceed $75 billion in 2012–2014.
Significant investor demand for yieldoriented products offered by long-dated
pipeline assets has had a positive effect
on capex. Historically, low interest rates
David Martinelli: We viewed 2012 as a transition year for MLPs. The energy industry has
been the subject of a lot of headline news, and the lead story is one with which everyone
is now familiar – US energy independence. As a result, the demand for new infrastructure
to accommodate supply growth was enormous, and 2012 saw a year of heavy debt and
equity issuance to fund the growth. Most retail investors respond negatively to MLP
equity issuances, which depressed prices, but the reality is the debt and equity raised is
funding enormous future growth. Additionally, we saw some partnerships negatively react
to a weak natural gas, natural gas liquids (NGLs), and coal environment. Avoiding these
names helped our fund outperform its benchmark. A third and final drag that persisted
throughout 2012 was a misplaced concern over tax reform. This worry lifted at year-end,
as investors realized that the MLP structure was unlikely to be dragged into the fiscal cliff
discussions. With tax worries removed and issuances pre-funding multiple years of growth,
we think the MLP sector is poised to see strong returns over the next few years.
Despite lagging the S&P 500 Index last year, you more than doubled the return
of your benchmark, the Alerian MLP Index. Given that your universe is so condensed (there are roughly only 95 publicly traded MLPs), how did you add alpha?
DM: Our proprietary financial models are the foundation of our investment process, and
we feed those models with the very best information flow. Anyone can pull numbers from
a 10-K (annual report) or read a call transcript, but our unique relationships, our individual
and collective experiences, and our operating knowledge are best-of-breed and allow us
to draw unique insights into the companies we cover. Our portfolio manager, Eric Conklin,
who established the MLP research practice at Credit Suisse before joining Harvest, also
has an understanding of the partnerships and insight into valuing energy companies that
is simply unparalleled. He has developed a proprietary eight-factor risk scale that allows
us to properly assess risk versus reward. Overall, this contributes to an institutional
approach to portfolio management that separates Harvest from our peer group.
What is your outlook for MLPs in 2013, and what will be the key drivers of
performance?
DM: We see 2013 as the first in a sequence of expected growth years. We expect total
returns of approximately 15%, two-thirds of which should come from distribution growth.
The fundamentals of what will work and drive alpha in 2013 are similar to what drove our
outperformance last year: being in the right basins, being in the names where growth is
transparent, and avoiding partnerships with capital structure concerns or ambiguous
growth projects. Further, we expect the space will be further buoyed by generalist investors seeking both exposure to the domestic energy story and yield. As much as we
emphasize the growth side of the total return equation, it is worth noting that MLP yields
at 5.5% provide investors a superior yield relative to other income-oriented investments.
This alone has put the sector on the radar for a lot of institutional investors.
Which subsectors of the MLP space look most promising?
DM: The partnerships we own are not subsector-driven, but thematically driven. We see
names we favor and ones we do not in each subsector, although broad themes will sometimes point us to emphasize some fundamentals over others. Three themes we are likely
to be discussing a lot in 2013 and beyond are crude oil infrastructure, NGL basins, and
dropdown stories. On the crude side, we see how undersupplied the US is in takeaway
capacity. There has been an explosion in domestic production, especially in areas like the
Bakken, but the US does not have the infrastructure in place to move and store the crude.
18 Conversations with Thought Leaders
Thus, we continue to buy exposure to quality crude logistics build-out. On the NGL side,
we see the opportunity as basin-specific. Geography can make or break the investment in
an NGL name and that is why we spend a lot of time researching the economics of all the
basins, carefully choosing the ones to which we want to gain exposure. Finally, we expect
dropdown MLPs to be among the highest growth rates in the space. The dropdown story
exists across a number of subsectors, and even though these partnerships are not always
attractive relative to their peers on a yield basis, the distribution growth rates provide very
attractive total returns. Along the same lines, C-corporations levered to high-growth MLPs
look unusually attractive on a valuation basis and should do well in 2013.
Interest in “fracking” and “shale” has exploded in the past year, with the
International Energy Agency (IEA) going as far as saying the US could become
the world’s largest producer of oil by 2020, a feat largely owed to a surge in
unconventional oil sources like shale. How do MLPs fit into the shale boom?
DM: Shale gas and oil are a game-changing moment for the US and energy independence. MLPs are critical to the shale boom and development of the US domestic
production story. As production both increases and shifts its locations, there will be an
enormous demand for takeaway capacity, transportation, and storage for the new supply.
MLPs are hard at work accommodating this build-out throughout the US. Our role as an
institutional manager is to anticipate the areas where the need will be greatest and to
identify the MLPs that can answer the demand most profitably.
While we do not see inflation as an imminent threat, it will eventually rear its
head. Do MLPs provide a hedge against inflation?
DM: MLPs are a sound option in an inflationary environment. As many MLP investors
know, inter-state pipelines have inflation-adjusted tariffs – currently the producer price index
(PPI) plus 2.65% annually. In addition to that automatic tariff adjustment, good MLPs can
essentially “outgrow” inflation. Our investments tend toward partnerships with high distribution growth driven by long-term, demand-driven projects. This growth component should
more than offset potential yield compression in an inflationary environment. I should also
mention that MLPs are hard assets – literally steel in the ground – and for this reason, we
have always believed MLPs are an actual physical hedge against inflation. Finally, in a
period of broad inflation where commodity prices rip, investors will see production companies going at full bore to take advantage. As production flows, a corresponding demand for
infrastructure would direct capital to our space, as MLP management teams raced to meet
takeaway demand and accelerate projects to cater to the boom of new supply.
What’s the bear case for MLPs – what could disrupt your thesis?
DM: Energy demand in the US is fairly inelastic. Broad demand destruction could certainly
negatively affect MLPs, but the fundamentals of energy use in the US, and the role of
MLPs in the transportation and storage of this energy, mitigate this risk. Essentially, as
long as people fly, drive, heat their homes, and take delivery by truck, all that energy will
need to travel from Point A to Point B, and will assuredly travel through an MLP’s system.
provide a rather compelling argument for
the cash flow predictability, duration, and
somewhat unique growth offered by infrastructure companies. The shale revolution
is at least likely to drive demand for
infrastructure through the end of the
decade. Consequently, we are not overly
concerned about the growing capex
figures in the current environment.
Notably, changing sources of natural gas
supply from relatively new shale plays have
altered transportation patterns. These
changes provide investment opportunities,
but can also significantly alter natural gas
basis differentials at various geographic
locations. Very wide basis differentials provide a signal for incremental infrastructure
investment, whereas relatively flat basis
differentials signal that pipeline capacity is
adequately supplied and can raise questions
about the underlying value of existing
assets due to renewal risk with regard to
existing gas transportation contracts.
However, the existing pipelines are largely
needed for basin connectivity, as shale
natural gas produced close to consuming
regions is not necessarily sufficient to
satisfy demand in many cases. Over a
longer period of time, basis differentials
should allow a reasonable return on capital
for the infrastructure assets and for the
producers. Clearly, the changes to natural
gas flows provide considerable opportunities for greater infrastructure buildup.
For more information, please see the Research
Institute publication, “The Shale Revolution”,
published December 2012.
1 “ North American Midstream Infrastructure
Through 2035 – A Secure Energy Future,”
INGAA Foundation, 28 June 2011
Many US corporations are flush with cash on their balance sheets. MLPs, however, distribute a meaningful portion of their earnings and tend to rely heavily on
the capital markets to fund projects. Given that backdrop, do you see merger &
acquisition activity as a potential catalyst for the MLP space?
DM: Absolutely. We just saw an enormous amount of M&A activity at the end of the year.
Almost $10B in deals were announced in November and December 2012 alone. Part of
this, of course, was driven by flush balance sheets and open capital markets, but another
Compass 19
part was driven by various partnerships acknowledging the need to diversify their asset
base to crude and liquids exposure in order to set up long-term growth. For the larger
partnerships, M&A is the best way to do this, literally overnight. Fifteen of the twenty-three
M&A transactions in the space in 2012 were crude-based acquisitions.
Multiples on these transactions are creeping up, and we have benefited a great deal
from the activity by sitting on the seller’s side of such transactions. Given that our research
effort is broader than the MLP universe alone, we have been able to seek out and own
some names with “MLP-able” assets that we have correctly expected would be targets of
MLP M&A.
Further, we have seen the
scope of MLP-able assets
continue to grow...This
expansion will likely provide us with opportunities
to invest in businesses
with the ability to generate
high risk-adjusted total
returns.
Continuing with the capital markets theme, there were three MLP initial public
offerings (IPOs) by mid-January in 2013. In 2012, the third IPO didn’t occur until
the end of July. Why the rush to go public this year, and do you see opportunities
in new issues?
DM: We often see a lot of secondary issuances in the first quarter, if for no other reason
than some partnerships seek to avoid coming to market in December. While it depends
on the name, we often see opportunity in a secondary – assuming we correctly assessed
the near-term capital need, waiting for the offering, and the discount, to build a position.
As far as IPOs are concerned, the backlog has been long and is growing. This, too, is
less a calendar-year rush than a realization by a lot of businesses that there is enormous
value within the MLP structure and that reorganizing a C-corporation with fully depreciated assets as an MLP can unlock enormous value. Further, we have seen the scope
of MLP-able assets continue to grow. Today there are retail gasoline MLPs, refinery
MLPs, and even a petrochemical plant MLP. As the umbrella of MLP-qualified businesses potentially widens further to other utility-like infrastructure businesses, as well as
renewable energy opportunities, we believe we will see more IPO activity. This expansion
will likely provide us with opportunities to invest in businesses with the ability to generate
high risk-adjusted total returns.
There was some fear that the preferential tax treatment of MLPs was in jeopardy
during the fiscal cliff debates, but MLPs emerged relatively unscathed. Discuss
the tax advantages of MLP investing, and do you think those advantages are in
danger of repeal in the near future?
DM: Interestingly enough, from discussions with various members of Congress and our
lobbyist at the National Association of Publicly Traded Partnerships, there was actually no
talk regarding a change in the tax treatment of partnerships or MLPs during the fiscal cliff
drama. There were sell-side analysts writing about whether MLPs “could” or “might” get
dragged into the debate, but this was pure speculation and bore no connection to the
actual negotiations. I should add that this is not unusual, as unfounded tax chatter tends
to cause self-inflicted volatility in the space a couple of times every year. These moments
create lots of stress for managers and investors alike – but also can present some good
buying opportunities.
The tax mechanics and advantages of investing in MLPs are not complicated, but they are
a little intricate and revolve around the tax-deferral of income until the time of sale. The
fact that MLPs return a form K-1 instead of a form 1099 acts as an impediment, and
frequently has the back office dictating the investment policy.
Finally, I guess I should end the interview where I started, which is to highlight that we do
not see any threat to MLP tax status, principally because both the Obama Administration
and members of Congress realize the importance of energy infrastructure in the United
States and, we most certainly agree.
20 Conversations with Thought Leaders
Introducing Our New
Megatrends Framework
Written by Michael O’Sullivan, Head of Portfolio Strategy & Thematic Research
Megatrends are major economic, social and political forces relevant across decades. We group them under
three overarching pillars – Demographics, Multipolar World and Sustainability. At Credit Suisse, we believe
that the analysis of megatrends enables successful investments into growing markets. But we also
understand that markets move on a very different timescale from these underlying trends. Investors can
become enthusiastic about securities related to a Megatrend theme, driving valuations to high levels, and
then become disenchanted, causing a major sell-off even as the underlying theme remains in place.
Understanding these investment cycles allows for a strategic and sustainable approach to investment in
global Megatrends. With this in mind, we introduce our new Megatrends Framework, which aims to give
exposure to the long-term opportunities of a given Megatrend while also allowing for the tactical aspects of
the megatrend's investment cycle. In addition, it stresses the benefits of a cross asset and portfolio approach
towards Megatrends investing.
Compass 21
Figure 1
Adoption of New Technologies Has Become Faster Over Time
Years to adoption (90% of countries)
180
Steam- and motorships
160
140
Railways
120
Telephone
Telegraph
100
Electricity
80
Cars
60
40
Blast Oxygen Steel
20
0
1750
Aviation
PCs
MRIs
1800
1850
1900
1950
Cellphones
Internet
2000
Invention year
As of 04/01/2008
Source: D. A. Comin & B. Hobijin (2008), An Exploration of Technology Diffusion
What is a Megatrend?
We define a Megatrend as a profound and long-lasting social and/
or economic change that has been spurred by factors such as
technological breakthroughs, shifts in the balance of geopolitical
power, altering demographic patterns and environmental change.
Megatrends are typically long-term in their effect and duration and
involve a steep change in the rate of economic growth in a region,
or in the rate of revenue growth in a particular industry. Megatrends
have accompanied mankind throughout history. From the Neolithic
Revolution to the Information Age, innovation has been the catalyst for profound socio-economic, cultural and political transformation. The major inventions that led to the industrial revolution some
250 years ago affected virtually all aspects of everyday life.
Even the recent wave of globalization that started after the fall of
communism was preceded by a similar episode of very intensive
global trade and unrestrained capital flows which started in 1870
and lasted for over 40 years. While past and present Megatrends
have common features, recent transformations such as the social
media revolution seem to have materialized at a much faster pace:
while it took more than 50 years for steam energy to reshape the
industrial and transportation landscape of Europe in the 19th century, it took much less time for the Internet to change individuals’
lifestyles (Figure 1). Within only 15 years, Internet penetration
reached 2bn people. Even more strikingly, mobile phone subscriptions increased from only 12% in 2000 to almost 80% in 2010.
Clearly, market penetration rates have sped up as technologies
have developed (Figure 2).
The causes and consequences of Megatrends
Technological innovation has been both an enabler as well as a
consequence of Megatrends. For example, advances in medicine
have helped increase the worldwide life expectancy from 48 years
in 1950 to almost 70 years in 2012. In turn, the increase in
chronic diseases that has resulted from aging populations has
been continuously fueling innovation in healthcare, expanding life
22 Megatrends
expectancy even further. While technology has a central role in the
evolution of Megatrends, other factors such as changes in industrial organization can also play an important part. The emergence
of large firms, for example, allowed for greater division of labor as
well as better production management, supervision of workers,
quality control and increase in scale. This permitted the automation
of certain repetitive tasks and later the adoption of the assembly
line and mass production, which significantly reduced the costs
borne by manufacturers by the early 20th century.
Certain Megatrends have far-reaching political consequences. For
example, the 19th century saw a revolution in transportation:
between 1840 and 1910 global railway mileage increased from
5,500 miles to 640,000 miles, while global freight carried in
steamships more than doubled in the 25 years after 1873 . Falling
transportation costs fostered trade but also allowed for greater
centralization in the control of states and colonies, thus increasing
the role of the nation state and the internationalization of conflict,
culminating in the outbreak of World War 1. Over the last 20 years
the rapid expansion of international trade (Figure 3) has also had
far-reaching political consequences. Several large developed
economies have become net debtors, which has changed the balance of power with large emerging economies such as China
becoming net creditors. As a result, the global balance of power is
increasingly shifting towards a multipolar world.
Megatrends and markets
Megatrends have historically had a significant impact on markets,
although this relationship is rather complex. Some Megatrends gave
rise to entirely new markets: in the 1860s, the transatlantic telegraph cable revolutionized communication and paved the way for a
first wave of globalization, including the establishment of a synchronized transatlantic currency and commodity market. Even today, the
dollar-pound pairing is referred to by traders as ‘the cable’.
Other Megatrends have altered either the way existing markets
function or their overall size. Just before the fall of communism for
example, the capitalization of the MSCI Emerging Markets index
was just 1% of that of developed markets, or some $50 billion.
Today, it is almost 13.6% or approximately $4 trillion.
Figure 2
Mobile Phone Penetration
Which Megatrends are likely to shape the future?
We identify Megatrends within three distinct, yet interrelated drivers
or pillars: rapidly changing demographics, the increasing emergence
of a multipolar world, and the rising relevance of sustainability. We
will delve into each of these trends in the coming sections.
Asia & Pacific
The demographic challenge
Rapid population growth in emerging markets and increasing aging
societies, mainly in developed markets, represent the starting point
of the current cycle of Megatrends. The world’s population has
more than doubled in the past 40 years to almost 7 billion – the
highest growth rate ever recorded. The United Nations (UN)
forecast that global population will grow another 50% by 2050.
More importantly, a growing part of the population chooses to live
in urban areas, making urbanization one of the most robust trends
of our times. Advances in medicine have enabled people to live
longer. In turn, longevity and falling fertility rates have also resulted
in declining working populations, putting serious strain on productivity to maintain growth and prosperity.
Urbanization
One key development which has run in parallel to the demographic
shift is Urbanization. Ever since the ancient civilizations of
Mesopotamia, Egypt, China and India, cities have attracted people
in search of opportunities, but never have these dynamics accelerated as dramatically as in recent years: While in 1950, only about
a third of the world’s population lived in cities, the proportion of
urban population is expected to reach two-thirds by 2030.
According to the UN, 83% of this growth will likely occur in Africa
and Asia alone (Figure 4). Over the next 10 years, per capita
income is set to nearly double throughout major cities in Africa and
Asia, creating demand for additional infrastructure, housing and
consumer staples. Today, urbanization is not simply about the
expansion of an urban jungle; it is about transformation. This
inevitably creates a wide range of opportunities for the private sector, including efficient transportation systems and information and
communication technology to manage flows of people and goods.
Health and aging
The healthcare market, worth some $2.4 trillion in 2010, will continue to expand in the coming years. The public sector accounts for
a higher share of this spending than the private sector in advanced
countries. Combatting both old and new illnesses will require technological advances in healthcare, which will stem from fields like
genomics to e-healthcare and medicine delivery. According to the
UN, global life expectancy could rise to more than 75 in 2050
(Figure 5). In the least developed countries, life expectancy will
likely rise by more than 10 years to 69, while in more developed
regions it could exceed 82 years. As a result attention will turn to
combatting illnesses associated with old age such as Alzheimer’s
and cancer, which will rise in prevalence not only in advanced
economies but also in emerging markets. Also, poor diets have
Africa
Syrian
World
Arab World
Egypt
The Americas
Tunisia
Qatar
Europe
Libya
50
100
150
Phones per 100 inhabitants
200
As of 12/31/2011
Source: World Bank, Credit Suisse
Figure 3
Merchandise Exports as % of Global GDP
%
40
35
30
25
20
15
10
5
0
1870
1913 1929
1950 1973
1998
2007 2010 2017E
As of 12/31/2012
Source: A. Maddison, IMF, Bloomberg, Credit Suisse
Figure 4
Net Increase in Urban Population
5-Year Interval
Millions
300
Forecast
250
200
150
100
50
0
1955 1965 1975 1985 1995 2005 2015 2025 2035 2045
DMs
China
EMs ex. China
As of 12/31/2011
Source: United Nations, Credit Suisse
Compass 23
caused a rise in obesity, which has created new opportunities for
the pharmaceutical industry (Figure 6).
Figure 5
Life Expectancy Set to Rise Further Globally
Life expectancy at birth, in years
90
80
70
60
50
40
30
1950/55
1980/85
2010/15
2040/45
2070/75
World
More developed regions
Less developed regions
Least developed countries
As of 12/31/2012
Source: United Nations, Credit Suisse
Figure 6
Global Obesity Prevalence
Americas
Europe
Middle East and
N. Africa
World
Africa
Eastern Asia and
Australia
South and
South-East Asia
0
15
5
10
20
25
30%
Prevalence of obesity among adult population
As of 12/31/2008, Latest data available
Source: World Health Organization
24 Megatrends
Knowledge economy
From a macroeconomic perspective, assembly line manufacturing
and affordable personal computers caused unprecedented jumps
in productivity. In turn, amid declining productivity growth, rising
labor costs and declining working populations, innovation and
knowledge have become key to productivity enhancements and
long-term economic growth. The knowledge economy spans all
areas of human activity, including production. Automation already
dominates many production processes such as car manufacturing,
but it will become the norm in a number of industries from agriculture to medicine. This process has also led to a higher demand for
highly-skilled workers, since the skill to handle and use knowledge
is becoming crucial.
Crowded world
Global population is set to reach 9 billion before 2050, led by
increases in populations in Africa, Asia and Latin America. The rise
in global population and the rapid increase in living standards are
already putting great pressure on natural resources. To meet the
dramatic increase in food consumption (Figure 7), farming will
inevitably need to become more efficient. According to the Food
and Agriculture Organization (FAO), crop production is required to
increase by 70% by 2050 – a very challenging target that is complicated by weather extremes and water stress. As agriculture
accounts for some 70% of freshwater withdrawals, better water
management will be required to meet rising demand. Furthermore,
a recent study by the UN estimates that, at current consumption
levels, two-thirds of the world population will suffer from water
scarcity by 2025 (Figure 8).
Growing energy demand is also a stress point. Oil prices continue
to be at very high levels underpinned by growing demand from
emerging economies. Total oil demand from China and other
emerging markets rose rapidly between 1998 and 2008, by about
16%, from 74.1 million barrels per day (bpd) to 85.8 million bpd.
The global economy is highly geared to non-renewable energy use
as it is an important input for several production processes from
transportation, to cement and steel manufacturing. High oil prices
10
Wheat
Pork
Fish
Beef
Rice
Coarse grains
Sheep
Protein meals
0
Sugar
20
Butter
Globalization
The last two decades have seen global trade in goods and services
rise from 18.5% of GDP in 1990 to 31.5% in 2011, doubling their
value in real dollar terms. Trade integration was particularly strong
between emerging market countries. Companies are looking for
new export markets to mitigate the effects of home market
downturns. Supply chains are increasingly global which benefits
companies who are able to source their inputs at a lower cost.
Mobility is now not only affecting capital and goods but also people.
International travel is no longer dominated by the affluent, but is
increasingly available to lower-income passengers. The advent of
the European Union has opened borders for millions who can travel
30
Poultry
Developing countries
World
As of 06/30/2012
Source: Food and Agriculture Organization, Credit Suisse
ROW
Figure 8
Global Water Stress
BRIC
Emerging world
Emerging and developing economies accounted for approximately
85% of the global population, 38% of global GDP and yet only
13.6% of global investable stock market capitalization as of
December 2012. Since 1990 these economies have grown at a
rate of 5.1%, against 2.1% for developed markets. According to
IMF estimates, emerging economies could grow at a rate of almost
6% over the next five years against 2.3% for developed economies. Consequently, new growth will predominantly originate in
emerging markets (Figure 11). EM consumption has already
surpassed the level of the United States (Figure 12). Emerging
markets are benefitting not only from more favorable demographic
trends but also the spread of technology which allows them to
upgrade their capital stock, and higher educational attainment
which makes their workforce more productive. Capital will inevitably
focus on regions that are developing at a higher pace, so we could
see many emerging markets re-rated in the coming years. Finally,
wealth has also risen considerably over recent years, particularly in
China, where total wealth will outpace that of Japan by 2017
(Figure 13).
%
40
Veget. Oils
Transition to a multipolar world
The world is increasingly becoming multipolar. For several years,
economic growth in emerging markets has been outpacing
advanced economies. As a consequence, wealth has transferred
from the developed to the developing world. The size of the global
middle class is expected to grow from its current 2 billion to almost
5 billion in 2030, entirely driven by emerging markets. As a
consequence, Asia’s share of global spending is expected to surge
from 25% today to almost 60% in 2030. Compared to the OECD
countries, emerging markets have been far less plagued by indebtedness and the need to pursue austerity measures. The growing
importance of these countries, especially the BRICs (Brazil, Russia,
India and China), is also reflected in their increasing voice in multilateral bodies, such as the G-20. Investments that account for the
rise of emerging markets in the world’s geopolitical and economic
balance of forces will gain more significance in the coming decades.
Figure 7
Expected Increase in Consumption of Food Products
2012 to 2050
OECD
are making it more profitable to invest in new energy sources such
as shale and tar sands, while deep sea drilling is also becoming
worthwhile. Moreover, the shale revolution in the United States has
the scope to reduce US energy import dependency (Figure 9),
prompting other governments to tap their own shale resources as
well (Figure 10).
2030
2005
2030
2005
2030
2005
0
500
1,000 1,500 2,000 2,500 3,000 3,500 4,000
Million people
Severe
Medium
Low
No
As of 12/31/2012
Source: UNEP, OECD, Credit Suisse
Figure 9
US Production and Imports of Petroleum and Other Liquids
Bn barrels
5
4
3
2
1
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Net Imports
As of 12/31/2011
Source: EIA, Credit Suisse
Production
Compass 25
Figure 10
Estimated Recoverable Shale Gas Resources
Trn cubic feet 0
200
400
600
800
1,000
1,200 1,400
The need for sustainability
The two previous pillars are placing an extraordinary burden on
existing resources, with a potentially catastrophic impact on our
environment. As a consequence, the situation requires investment
in sustainable and cost-effective alternatives to traditional sources
of energy, as well as in technologies that allow for a more efficient
use of scarce resources, such as water. Investments that guide
capital towards projects and companies that help to manage
resource sustainably and responsibly are gaining traction.
China
US
Argentina
Mexico
South Africa
Australia
Canada
Libya
Algeria
Brazil
Poland
France
As of 12/31/2009
Source: EIA, Credit Suisse
Figure 11
Economic Growth is Predominantly Created in
Emerging Markets
2030
EM share:
2020
BRICS add twice 50%
2012 as much as US
EM
share:
1990
2000
EM share: BRICs overtake 50%
25%
Eurozone
Real GDP growth (USD bn)
5,000
4,000
3,000
2,000
1,000
0
-1,000
-2,000
1981
Japan
not only for leisure but also business and employment. In 2011
2.8 billion passengers travelled by air. According to Boeing, this
number could increase by 4% per annum over the next 20 years.
1989
Eurozone
1997
US
2005
2013
2021
2029
Other advanced Other developing
BRICs
Adaptability
Adaptability refers to the ability of people or infrastructure to adjust
to a new or changing environment. The term famously evolved in
the climate change debate. The International Panel on Climate
Change (IPCC) defines adaptation as “adjustment in natural or
human systems to a new or changing environment [...] which
moderates harm or exploits beneficial opportunities.” The need to
reduce vulnerability to the adverse consequences of climate
change becomes very apparent by the fact that the economic
losses from weather-related natural disasters have been
constantly rising (Figure 14). Early warning systems, resilient infrastructure and resistant crops in agriculture are all viable solutions to
moderate the potential damage of natural disasters.
Adaptability is not limited to climate change: There is a potentially
large list of known and less known risks that will require
management. Cyber security has become a major concern for
governments and businesses alike who have to protect information and shield critical infrastructure from potential attacks.
Foodborne diseases and pandemics are potential threats to
global health. Finally, companies increasingly have to address
environmental, social and governance-related matters, all of which
can affect long-term profitability.
Resource efficiency
Alternative forms of energy are not new. In the aftermath of the two
oil shocks of 1970s, countries were increasingly looking to diversify their energy sources. More recently, the increasing evidence of
Figure 12
EM Consumption has Surpassed the Level of the United States the impact of human activity on climate change has led to the
implementation of carbon emission (CO2) targets in several counShare of global consumption
tries, which has increased the attractiveness of alternative energy.
40%
Despite this, global carbon dioxide emissions have almost tripled
since 1965. Emerging economies account for more than 70% of
35%
this increase and are now responsible for more than half of the
30%
global CO2 emissions but they are still behind rich nations on a per
capita basis. Alternative forms of energy are catching up fast: since
25%
2001 wind capacity has increased more than eightfold while solar
capacity has increased 39-fold. Across the board, investment into
20%
renewables has been on a steady rise over the last two decades
(Figure 15). There is still scope for strong expansion, as alternative
15%
forms of energy including hydroelectricity only account for 8% of
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012E
global primary energy consumption, according to BP.
US
Emerging markets
As of 12/31/2012
Source: Datastream, IMF, Credit Suisse
As of 12/31/2011
Source: Datastream, IMF, Credit Suisse
26 Megatrends
Outside energy, better waste management and recycling will also
help make human activity more sustainable. For example, the EU
Choosing the right investments
While Megatrends are ongoing, investment performance can be
mixed. Moreover, a Megatrend can unfold in different ways in different parts of the global economy. For example developing countries are recording rising urbanization rates, while developed countries are already highly urbanized. So in certain regions new housing and infrastructure investment is a high growth area, while in
other regions resources are oriented towards enhancing the quality of life and increasing the efficiency of urban environments. As a
consequence, investment opportunities can differ between regions
and sectors. To account for this, we distinguish between
Megatrends and the underlying Megatrend investments, which
represent the available investment opportunities (Table 1).
Our four principles of Megatrend investment
Principle 1 – Focus on all aspects of innovation
A company’s success in being innovative does not always manifest
itself in its ability to spend large sums on research and development
(R&D) or the amount of pieces of breakthrough innovation it
launches. Innovation is about opening new markets and making
products accessible to people. Some of the successful pieces of
innovation have been disruptive rather than breakthroughs. For
example, cassettes and tapes disrupted the market for vinyl
records in the 1970s, but were eventually replaced by compact
discs in the late 1980s. Ten years later, compact discs were
replaced by downloadable digital music files.
Principle 2 - Don’t believe the hype
As a general rule, investment into early stage Megatrends can
come at significant risks and need to be monitored very carefully.
In this context, the rule often mentioned with regards to growth
stocks – namely that investments need always to be long term –
does not apply at all, as investors need to be prepared to exit from
these themes at virtually any time during the early lifecycle. At the
same time, investors often fail to understand the potential of tech
30
20
Eurozone
2012
60
50
40
China 2012
70
Japan 2012
Japan 2017
China 2017
90
80
Korea 2017
How to invest in Megatrends?
Identifying Megatrends early can reward investors in the long run,
but finding suitable investment opportunities is not always straightforward. This is especially true for Megatrends at the early stages
of their life-cycle, where a small number of unlisted companies can
dominate. In addition, the hype that sometimes accompanies a
trend can lead to a rush of capital in an investment theme, pushing
valuations to bubble territory. In this case, the investor who is willing
to wait for the dust to settle can achieve higher returns than someone who entered early. To guide investors through the lifecycle of
Megatrend investments, we have created a traffic light system for
Megatrend investments.
Figure 13
The Rise of Chinese Wealth
Russia 2017
Korea 2012
produces 2.5 billion tons of waste and statistics indicate that
disposal (including landfilling, land treatment and release into water
bodies) accounted for 50% of the end treatment in 2006.
Households account for only a small portion of waste generated
(about 6%) while hazardous waste is about 3% of the waste
generated. With electronic waste playing an increasing role, waste
remains a great challenge for richer as well as poorer countries.
10
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Total wealth in the US (in trillion USD, constant prices)
Forecast
As of 12/31/2010
Source: Credit Suisse
Figure 14
Insured Catastrophe Losses
USD bn
120
100
80
60
40
20
0
1970
1980
Weather-related
1990
Man-made
2010
2000
Earthquakes
As of 10/24/2012
Source: Swiss Re
Figure 15
New Investment in Renewables
USD bn
80
70
60
50
40
30
20
10
0
Q1-04 Q1-05 Q1-06 Q1-07 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12
1 yr rolling average
Quarterly investment in renewables
As of 09/30/2012
Source: Bloomberg New Energy Finance, Credit Suisse
Compass 27
Table 1
Megatrends and Megatrend Investments
Megatrend
Urbanization
Health and
aging
Knowledge
economy
Crowded
world
Emerging
world
Globalization
Adaptability
Resource
efficiency
28 Megatrends
Megatrend
investments
Description
Construction
Companies exposed to infrastructure, residential and office construction and
urban mobility, primarily in emerging markets but also in developed markets.
Smart cities
Sectors such as navigation, smart grids, traffic management, escalators and
air-conditioning are set to benefit from the emergence of sustainable and smarter cities.
Health
Industries exposed to new trends in diagnostics and treatments, particularly age-related diseases, increased access to
healthcare in developing countries, personalized medicine and e-health.
Lifestyle
Companies set to benefit from increased consumption of lifestyle-related goods and services, including leisure and
recreation, healthy food and cosmetics.
Networks
Industries exposed to hyperconnectivity, including data storage, person-to-person and
person-to-machine communication, or wireless modules and devices.
Automation
Machinery and control systems which aim at increasing precision and efficiency in manufacturing processes, including
human-machine interfaces, industrial robots and self-guided vehicles.
Energy
Companies exposed to new trends in global energy consumption, including increased energy demand in emerging
markets and new energy sources.
Food
Technologies which provide effective solutions to increase agricultural productivity,
including farm machinery, precision agriculture, crop science and fertilizers.
Water
Industries active in water treatment, desalination, filtration, supply and distribution.
Emerging
consumers
Companies, both local and multinational, with strong industry positioning set to benefit from the steady increase in
emerging market consumption.
Emerging
producers
Emerging market industries which penetrate global goods and services markets through unique business models,
brand value or competitive advantage.
Frontier markets
Companies exposed to the next wave of growth markets in Africa, Southern Asia and
Eastern and Central Europe.
Transportation
Companies active in the transportation of goods, particularly those operating on fast-growing trade routes between
emerging markets. Industries include maritime transport, air freight and transportation infrastructure.
Tourism
Includes industries exposed to the global travel industries, including booking services,
hotels and resorts and passenger airlines.
Global workforce
Companies active in human resources, corporate outsourcing and educational services.
Climate change
Includes solutions to cope with the adverse effects of climate change, including climate insurance, resilient infrastructure and early warning systems.
Emerging risks
Companies which provide risk management solutions for emerging technological,
economic and societal risks.
Renewables
Producers of alternative sources of energy, including among others wind, solar,
hydroelectricity and biomass.
Waste and
recycling
Sectors active in the collection, transport, processing and recycling of waste materials.
New materials
Producers of advanced composites, nanotechnology and bio-based or biodegradable materials.
nologies which have been subject to previous bubbles, therefore
ignoring the genuine growth potential of technologies and
industries. To guide investors through these lifecycles, we have
developed the traffic light system.
Principle 3 – Invest across asset classes
Investors should always consider the full range of asset classes
when making investment decisions. Although our Megatrend
investments focus predominantly on innovation and are therefore
geared towards equity markets, there are several examples where
Megatrend exposure can be enhanced by a cross-asset approach.
Early lifecycle-stage investments are often only accessible through
venture capital and private equity. Commodity prices are a direct
consequence of global resources demand. Other Megatrends such
as climate change have created unique asset classes themselves
– for example insurance-linked securities. Finally, currency movements are particularly relevant for long-term investors, since they
can either enhance or offset equity market gains.
Principle 4 – Consider portfolio aspects
Megatrend investments differ from standard equity investments as
they consider non-standard drivers which go far beyond short-term
earnings expectations. However, given the uncertainty of future
earnings, they also tend to be more risky, expressed through
higher betas. In any case, Megatrend investments can add diversification to virtually every asset allocation. Regardless of whether
exposure to Megatrends investments is sought to complement an
asset allocation or intended in the form of pure exposure, we
always advise people to invest in a broad portfolio of companies.
The lifecycle of Megatrend investments
Throughout history, Megatrends have been subject to investor hype
and euphoria, eventually resulting in bubbles and consequent
bursts. The most famous was the dot.com bubble of the early
2000s, when a surge in investor money and initial public offering
(IPO) activity dramatically overestimated the ability of a premature
market to generate revenues at that point in time. In the year
leading up to the dot.com bubble, 40 new internet companies
were listed on the Nasdaq Composite Index, chasing virtually no
revenues at all. Three months later, the index lost more than half
of its value, bringing internet IPOs to a near complete halt for
almost three years.
In retrospect, most investors were right in assuming that
e-commerce and mobile communication were future growth
markets. How genuine the trend was can be seen by the
example of Amazon: the online retailer which raised $54 million
in its IPO 15 years ago now has a market capitalization of $108
billion. During that time, revenues increased from $100 million to
over $60 billion, making it one of the most successful IPOs in
history. On a bigger scale, sales growth of companies listed on
the Nasdaq 100 was close to zero for almost four years before
revenues started to grow consistently.
The market pattern of the tech bubble is not unique. Indeed,
investing in Megatrends can be demanding in that early and
emerging trends can initially be difficult to access, and then can
command a high investment premium. While only a few investors
are competent or lucky enough to spot the next Amazon, a large
number typically fall victim to what the US advisory company
Gartner has famously termed “hype cycles.” New technologies
which make bold promises are at the heart of what Gartner calls
“inflated expectations,” even if they are not yet commercially
viable. A series of failures usually leads to an abrupt collapse of
investments and a complete loss of interest. Quite interestingly
however, new technologies are not abandoned altogether and
eventually re-emerge in a second generation, eventually making
their way into mainstream production.
How the traffic light works
Megatrends are typically slow moving, taking years or even
decades to unravel. However, as demonstrated by the example
of the dot.com episode, their investment applications tend to
follow market cycles and can be fairly volatile because of uncertainty surrounding future returns. To address this issue, we have
created a tactical (1 – 6 month outlook) traffic light system. It
should help investors navigate through these market fluctuations
by signaling optimal entry points or times to reduce exposure.
Themes with a poor score receive a red signal (denoting underweight/take profits) and those with high scores receive a green
signal (denoting overweight/build exposure). Scores depend on a
variety of metrics that include factors such as relative valuation,
earnings revisions, long-term growth prospects, price momentum, price trend and risk profile. These six metrics are computed
on a bottom-up basis for each Megatrend investment theme, and
are then combined to determine the overall score of each investment theme. The advantages of this approach include the fact
that there is no need for additional forecasts that can potentially
increase the error, while the model is quite flexible and can be
calibrated over time.
Compass 29
Was It
a Financial
Crisis …
or an Oil Crisis?
This essay argues that the financial crisis
was exacerbated by, even caused by, an
energy crisis, as the world ran out of oil
due to surging emerging market demand, illdisciplined OECD energy policies and a lack
of new supply. Looking ahead, this suggests
the world can escape the “new normal” of
slow growth by increasing energy supply
and efficiency via new production processes
and new sources. Some of these are
already well on the way, including shale gas.
Written by Giles Keating, Head of Research for Private Banking and
Asset Management
30 Megatrends
Figure 1
Real Oil Prices
USD/barrel (2012 prices)
140
1973
oil crisis
120
1979
oil crisis
100
80
60
40
20
1994–2005
0
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
As of 10/31/2012
Source: BP, Datastream, Credit Suisse
Note: Data frequency is annual prior to 1957, monthly thereafter. Prices shown are US Average until 1944, Arabian Light posted at Ras Tanura for
1945 to 1983 and Brent dated thereafter.
The global oil shortage
The standard view of the 2007–09 crash and recession, and the
subsequent Eurozone crisis, focuses on excess leverage through
banks and governments. Most of the received views about today’s
world build on that analysis to conclude that growth in Europe and
the USA must stay subdued for a long period as the wounds of
financial insobriety gradually heal. In this essay, I aim to challenge
that view and argue that the financial crisis was exacerbated by,
and indeed largely caused by the explosion in oil prices after 2005,
as rapid Asian expansion ran up against Western profligacy to create an unexpected energy shortage. I show that these high oil
prices are encouraging increased energy supply and adaptation of
our economies and argue that this will allow a resumption of robust
global growth in coming years, which will in turn help resolve the
remaining financial problems.
From consumer power to producer power:
Oil, 1950–80
There is never a clear starting point for a macroeconomic story, but
a convenient place to begin is in the USA and Western Europe of
the 1950s and 1960s. The hydrocarbon boom was shaping an
automobile-based society with its suburban sprawl and roadbuilding, and the baby boom was starting, helped rather literally by
the new freedom of personal transport (Figure 2). In Asia, Japan
shared the same oil-based economic and demographic explosion,
but China’s baby boom was delayed by the terrible famine of the
late 1950s, and hydrocarbon-based economic expansion was
impossible in Mao’s communist economy. As North America and
Western Europe consumed more oil, real oil prices were in a
declining trend in the 1950s and 1960s, helped by the low extraction costs in the Middle East and the domination of global oil
production by the “Seven Sisters” – the giant companies controlled
explicitly or implicitly by their governments in the USA and Europe,
and supported by their diplomatic and military power. The
Organization of Petroleum Exporting Countries (OPEC) was created in 1960, but was ineffective, while other producers like the
Soviet Union were price-takers. The result was that real oil prices
(adjusted to today’s US consumer prices) fell from around $16 a
barrel in the early 1950s to a low of around $10 in 1970. Cheap
oil was a crucial support of the rapid economic growth enjoyed in
the Organisation for Economic Cooperation and Development
(OECD) countries at this time, supporting an
equity bull market that lasted two decades until the late 1960s
(Figure 3).
After 1970, things began to go badly wrong and, by mid-1973,
real oil prices had risen about 40% from their lows. Energy
demand was boosted by money-financed US fiscal expansion to
finance the earlier Great Society and the intensifying Vietnam War.
Supply was constrained by under-investment during the low-price
era, with US oil production peaking in 1970, implying growing
dependency on imports from the Middle East (Figure 4). Rising oil
prices were just one symptom of a broader inflation stoked by lax
US macroeconomic policies, and as Germany, Switzerland and
others followed a tighter monetary path, the system of fixed
exchange rates agreed at Bretton Woods a generation earlier
collapsed (in stages in 1971 and 1973) and the gold price soared.
The OPEC crisis in late 1973 propelled prices to about $58 in
today’s prices. While this may not sound high, it is difficult to overstate the shock effect at the time. It was about six times the lowCompass 31
Figure 2
US Motor Vehicle Registrations Per Capita
point reached just three years earlier. The proximate cause of the
OPEC shock was the oil embargo imposed by Arab nations in
response to the USA supplying Israel during the Yom Kippur War.
More strategically, it reflected a fundamental shift in power from
oil-consuming to oil-producing nations, given the rising US dependence on imports and pent-up geopolitical tensions in the region.
The embargo ended after six months, but OPEC emerged as a
powerful force in global oil, for a while dominant, exercising market
power through a system of quotas on its members that allowed it
to keep real oil prices close to their 1973 peak throughout the
1970s (Figure 5).
Registrations per capita
0.6
Roaring
20s
0.5
0.4
The Great
Depression
0.3
0.2
WW2
Urban
sprawl
1st Gulf War
1st Oil Crisis
T-model
0.1
0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Automobile registrations per capita
As of 12/31/2010
Source: US Census Bureau, Highway Information Administration, Credit Suisse
Figure 3
US Stock-Market Cycle
Real return index (log scale)
64000
32000
Bull market
16000
8000
4000
2000
1000
1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974
As of 03/31/1974
Source: Global Financial Data, Credit Suisse
Figure 4
US Production and Imports of Petroleum and Other Liquids
Bn barrels
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0
1950
1960
1970
1980
1990
Production
Net Imports
As of 12/31/2011
Source: EIA, Credit Suisse
32 Financial Crisis or Oil Crisis?
2000
2011
In response to the oil shock, the USA was reluctant to tighten
macroeconomic policy to cut oil demand, but panic microeconomic
measures were introduced. A blanket 55 mile per hour speed limit
was imposed across the entire Federal interstate highway system,
only to be breached in many cases, especially given the use of
Citizens’ Band radio, which we could think of as a pre-digital audio
social network favored by long distance drivers. Gradually, more
effective measures were introduced, including US federal targets
for fuel efficiency of automobile manufacturers. Globally the supply
response was slow, but one major area ready to grow was the
North Sea, with UK oil production rising from virtually zero in 1970
to one million barrels per day (bpd) as early as 1978.
1979 saw the second OPEC shock, associated with the Iranian
revolution. Prices surged to levels that in real terms look quite high
even from the perspective of 2012, at around $107 per barrel
(again, adjusted using US consumer prices). This time, the macroeconomic policy response was near-textbook among many major
oil consumers, with tight monetary policy in the USA (under new
Fed Chairman Paul Volcker) and many European countries, implying short-term pain, but ensuring that the risks of inflation were
brought under control relatively swiftly.
The emergence of the oil glut: 1980–98
Following each of these two OPEC price shocks, energy efficiency
in the OECD countries began to improve decisively, reflecting both
government measures and the market signals from an enormous
relative price shift. Energy consumption per unit of GDP fell by
22% in the decade after the first shock in 1973, and oil usage per
unit of output fell even more as other energy sources were brought
into play (Figure 6). Equally important, at these elevated prices,
there was an incentive to accelerate existing projects and to search
for and develop oil and gas reserves in previously impractical or
uneconomic locations. New technologies appeared and existing
ones improved, for example making offshore drilling possible at
gradually increasing depths. The industry started a sizeable investment program. In the UK, production from the North Sea rose
rapidly to above 2.5 million bpd in the mid-1980s, while Norway
witnessed a comparable boom and US drilling began in the Gulf of
Mexico (Figure 7).
These new technologies had an important feature – they would
still be available for use even after prices had fallen back. And fall
they did – in fact the 1979 price spike was followed by a
quarter-century that saw a deep bear market and then rangetrading at a radically lower level. The macro forces behind this
change are clear. On the demand side, ongoing energy conservation allowed economic growth to resume without generating a
corresponding rise in oil demand. On the supply side, exploration
and development of oil boosted output and, moreover, with much
of the new production outside of OPEC, the power of that cartel
was progressively weakened and its ability to police quotas among
its members eroded. Rising oil production in Europe and other locations such as Mexico (where output rose sixfold from 1974 to
1984) meant that the world had moved into a period of structural
oversupply for oil, with a pronounced effect on prices. By the mid1980s, real oil prices had fallen into a $20–40 band (at today’s
prices) that lasted for about two decades until 2005, apart from a
brief upward spike during the first Gulf War in 1990 and a brief
downward spike during the Asian crisis in 1997–98.
This long period of broad oil price stability was good for global
financial assets, underpinning simultaneous bull markets in both
equities and bonds, as it allowed a progressive decline in inflation
to be combined with sustained economic growth. Unsurprisingly,
this was also a long bear market for gold. The false sense of security from this long phase of low prices had another effect of eroding
the enthusiasm for energy-saving measures and, more disastrously, creating a global coordination failure between the existing
industrialized countries in Europe and North America on the one
hand, and the newly industrializing ones in Asia, on the other. To
understand this, we must look back to 1978, with the appointment
of Deng Xiaoping as leader of the Chinese Communist Party.
Imperceptible move from glut to shortage: Emerging
market expansion 1978 up to 2008
Mr. Deng was given, in effect, a mandate for profound economic
reform. While the need for this was obvious after the disasters of
the Cultural Revolution, an added urgency was given by the
demographic explosion that had been going on for a decade and a
half. Since the early 1960s, as the economy recovered from the
horrors of the Great Famine, fertility had been running at around six
children per woman and the death rate had fallen. Despite initial
family planning programs from 1970 onward, the result was a
population expansion on an absolute scale not seen before or after
in such a space of time in any other country – a rise from
660 million in 1961 to 994 million by 1980 (Figure 8). Even with
the full One-Child Policy from 1979 (in practice only gradually
bringing fertility below two children per woman), the “echo effect”
from the large new cohort of women of childbearing age born in the
first phase of the baby boom meant that, in absolute terms, population continued to expand rapidly, reaching 1.26 billion by 2000
(and around 1.34 billion now). There was an urgent need in the first
instance to feed everyone, then to provide improved living
standards and beyond that lay the broader basis for restoring
China’s long-lost pre-eminence among nations. The early results of
reform were impressive in percentage terms, with GDP growing at
a compound annual average rate of almost 10% in the 20 years
after Mr. Deng came to power, but the starting point was so low in
absolute terms that the effect on the rest of the world became
Figure 5
OPEC Versus Non-OPEC Oil Production
Million barrels per day
80
70
60
Second oil shock
First oil shock
50
40
30
20
10
0
1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2007 2011
OPEC
Non-OPEC (excl. Soviet Union)
(Former) Soviet Union
As of 12/31/2011
Source: BP, Credit Suisse
Figure 6
OECD Energy and Oil Intensity
Index (1970 = 100)
110
100
90
80
70
60
50
40
1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2011
Energy consumption per unit of real GDP (rebased 1970 = 100)
Oil consumption per unit of real GDP (rebased 1970 = 100)
As of 12/31/2011
Source: BP, Datastream, Credit Suisse
Figure 7
Global Oil Production and Regional Changes: 1973 vs. 1983
Million barrels 35
per day
1973
OPEC
US & Canada
40
45
50
Production:
-31.6%
-12.9
-1.2
+2.4
UK & Norway
China
60
58.5
Mexico
Other Europe
55
+3.0
Production:
+87%
+3.8
+1.1
+1.9
Others
1983
56.6
As of 12/31/1983
Source: BP, Credit Suisse
Compass 33
apparent only gradually during the second of these two decades.
China’s GDP was barely 1.8% of the global total in 1978; by
1998, it was still only 3.4%. This low starting point also meant that
impact of China on global oil demand was virtually negligible over
most of this period; indeed China was actually a net oil exporter
until 1994.
All that changed from the late 1990s onward. China’s GDP,
underpinned by its extraordinary demographic expansion, was now
significant in global terms and yet did not slow down, with growth
slightly faster in the decade after 1998 than before. An economy
that represents 3.4% of world GDP and grows at over 10% a year
when everyone else averages about 3% will end up generating
around one sixth of the world’s increase in output over ten years.
And China was following the hydrocarbon-based economic model
pioneered in the USA, implying high energy intensity at this stage
of development. In Shanghai, cycle lanes in the vast new Pudong
district were segregated from the main highway by portable barriers and, as motor traffic grew, these barriers were taken away,
removing the cycle lanes. China’s oil consumption began to rise
rapidly, going from 4.2 million bpd in 1998 to 7.9 million bpd in
2008. By comparison, total global consumption of oil at this time
averaged about 80.5 million bpd. In India, oil consumption rose by
1.1 million bpd, and the aggregate increase in other non-OECD
countries was almost six million bpd. Over the same period, US oil
demand also rose, from 18.9 million bpd to 19.5 million, reflecting
weakening energy discipline and strong consumer spending
backed by the credit boom. Europe was better disciplined and
slower-growing, so its imports were broadly stable.
34 Financial Crisis or Oil Crisis?
Putting all this together, oil demand from OECD countries
increased only slightly over the period from 1998 to 2008, but with
demand from China and other emerging markets rising rapidly,
total oil demand rose about 16%, from 74.1 million bpd to 85.8
million. Essentially, energy demand in most countries continued as
if the low oil prices seen for over two decades were set to stay
(Figure 9). Producers also responded to the low prices, so that the
cushion of spare capacity built up in the 1980s was eroded and,
even as this gradually led to upward price pressure in the early
2000s, they were reluctant to invest, remembering the glut from
two decades before. So exploration and development were
subdued even as demand grew.
The result was that slowly and almost imperceptibly, the oil glut of
1998, when prices hit a low of about $18 per barrel (in today’s
prices on an annual average basis, and as low as $13 per barrel
on a daily spot basis in nominal terms), turned into a chronic oil
shortage by 2008, when spot prices for Brent briefly touched
almost $150 per barrel on a nominal basis. Forward prices never
really sounded a warning – 5-year forward prices for WTI never
traded more than 20% above current spot prices in the period
from early 2007 until the oil price peak in 2008 (Figure 10). And
the global community of oil consumers did not coordinate in order
to understand where the various independent policies were collectively leading.
The oil shortage and the financial crisis: 2008
Each component of the credit boom – US consumer borrowing,
expanding bank balance sheets, and exploding deficits in Europe’s
periphery – reflected both permissive financial rulebooks and also
interest rates at ultra-low levels by the standards of the day. These
policy levers were set by regulators and by the world’s central
bankers, led by the Fed under Alan Greenspan first and then
Ben Bernanke. With hindsight their approach appears too lax, but
at the time they acted in good faith on the expectation that
economic growth could continue more or less indefinitely at a
strong pace without inflation or supply shortages. They saw the
digital productivity boom and the benefits to inflation from cheap
imports from China and elsewhere. They discounted the risks of
supply constraints from commodities and oil, for which prices had
been quiescent for a quarter-century and for which the creeping
new uptrend was difficult to distinguish from market noise. Both
the Fed and Bank of England focused on inflation measures that
excluded oil prices! In parallel, China’s authorities continued to
pursue record-breaking growth centered round exports and investment. This is not a matter of blaming any one player, but rather of
noting that all the key players were pursuing paths, which taken
together, would soon be demanding more oil than the world could
produce. It was a coordination failure.
Suppose the world had not run into an oil constraint in 2008 and
instead there had been sustained strong growth – would the
income streams of Americans with sub-prime mortgages and the
tax revenues of southern European nations have been enough to
service their debt? We will never know for sure, but continued
strong growth is by far the easiest way to reduce debt burdens. As
it was, the world did hit an oil constraint, oil prices soared, growth
slowed, debts that previously had seemed good turned sour, and
the financial crisis exploded, further damaging growth and turning
more loans from good to bad. Some people might say that the
surging oil price was the catalyst that caused a nascent financial
crisis to appear. I prefer to put the solid reality of physical energy
ahead of the alchemy of finance, and say that the lack of oil was
finally and shockingly revealed to a complacent world by the
financial crisis, which was the mechanism that forced global
demand for oil down from an unsustainably rapid uptrend.
As rising oil demand pushes prices up, it becomes economically
viable to bring high-cost mothballed supplies on stream to help
dampen the price increase. Economists say the short-term supply
curve is “not very inelastic,” which seems to describe much of the
decade up to 2008. As demand keeps on trending upward, there
comes a point where more or less all of the idle supplies have been
brought on stream. At this point, even a very large rise in price will
not bring forth extra supply (until new oil fields can be developed,
which takes years) – economists now say that the short run supply
curve has become highly inelastic (Figure11). This is roughly what
seems to have happened in the middle of 2008 when the price of
Brent rose to almost $150 a barrel. While there was much talk of
“speculation,” there is no evidence of this – speculative longs were
actually low and falling (Figure 12). The process was described at
the time by my colleague Jonathan Wilmot 1.
To reduce oil demand, a worldwide slowdown was needed, and it
happened. Global industrial production growth (three month
Figure 8
China Fertility Rate and Number of Births
Children per woman
7
Million
35
6
30
5
4
25
3
20
2
15
1
0
10
1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010
Cultural Revolution
Number of births (Ihs)
Great Chinese Famine
Fertility rate (rhs)
As of 06/30/2010, Latest data available
Source: Datastream, Credit Suisse
Figure 9
Net Change in Oil Consumption Since 1998
Million barrels per day
10
8
6
4
2
0
-2
1998
USA
2001
China
2004
Other developed
2007
2011
Other emerging economies
As of 12/31/2011, Latest data available
Source: BP, Credit Suisse
Figure 10
Percent Premium or Discount of Spot to 5-year Forward
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12
Premium of WTI oil spot price versus 5-year forward rate
As of 11/09/2012
Source: Bloomberg, Credit Suisse
Compass 35
Table 1
Sectors Impacted by Higher Oil Prices
Impacted industries & beneficiaries
Oil impact
Transportation (Airlines)
Aerospace & Defence
More efficient aircraft and engines are a competitive advantage, given that fuel accounts for
30%–50%of an airline’s costs. As a result, order backlog at Airbus and Boeing has reached a high.
Transportation (Truckers)
Capital Goods
Truck companies are switching to natural gas engines as natural gas is cheaper than petrol/diesel.
Transportation
Automotive/Capital Goods
CO2 regulation (i.e. basically the same as fuel efficiency) has become tougher globally. While, in
the longer term, the electrification of the powertrain is an important solution, improvement in the
efficiency of combustion engines is more important in the short/medium term. Borg Warner expects
turbocharger growth of 150% between 2012 and 2017 versus vehicle production of ca. 50%.
All producing industries, mainly energy
intensive (e.g. Pulp & Paper, Cement, Steel)
Capital Goods
High energy costs in the production process have increased demand for automated solutions
(a key long-term theme, the other two drivers are wage inflation and product quality). One
example is variable-speed-drives instead of fixed-speed drives. ABB highlights the benefit of
the convergence of automation and power.
Chemicals & other energy-intensive sectors
Chemicals (with operations in the USA)
High oil prices relative to low gas prices in the USA have resulted in investments in the USA,
e.g. BASF modified its US cracker in Port Arthur so that it can also crack light feedstock
(i.e. gas).
Chemicals
Enzyme providers
Chemicals (that offer bio-based chemicals)
Substituting oil as a carbon source with bio-ethanol, methanol, CO2 or the like.
Cement
Construction industry (thanks to lower prices)
Cement companies that can afford investments
Highly energy intensive and local industry. Oil has usually been used as an energy source in
remote areas, but is now being substituted by other energy sources such as electricity, waste, etc.
As of 10/03/2012
Source: Credit Suisse
annualized) peaked at just over 6% in late 2007. As oil prices rose
and financial conditions worsened, it slowed and then fell to –4%
in July when oil peaked, reaching –13% in October, just after
Lehman Brothers went into bankruptcy in September. After this,
the financial crisis began in earnest. Credit and trade contracted
rapidly. By early 2009, the OECD countries were entering the
deepest recession since World War II (Figure 13), with oil demand
falling sharply and oil prices collapsing. With their credit systems
imploding, policymakers in the USA and Europe turned to fiscal
policy for stimulus – but in developed countries, this is a slowacting instrument. By contrast, as China saw its exports declining,
Beijing took urgent action to fill the demand gap, announcing a
major fiscal expansion at the end of 2008 that was far larger as a
percentage of GDP than in any OECD nation, and implemented
more swiftly (right at the start of 2009). Multiple infrastructure
projects were dusted off and given the instant go-ahead: while in
China in February 2009, I remember hearing how engineers had
been recalled from their Chinese New Year celebrations to start
work on these projects. The effect on China’s GDP was dramatic:
within a few months, growth had rebounded strongly (Figure 14).
Naturally, there was a correspondingly rapid rebound in China’s oil
demand, which by late 2009 was also growing strongly again.
Oil prices responded, rising sharply from post-Lehman lows to
establish a new equilibrium range that has persisted until now of
36 Financial Crisis or Oil Crisis?
about $85–125 per barrel for Brent (with West Texas cheaper, the
gap reflecting factors such as periodic excess supply at the
Cushing hub and differing in oil grades). This is high – about triple
the average for the period from the mid-1980s to 2005! Yet, in
contrast to that era, it is happening at a time when OECD demand
has been weak. All of the (modest) increment in supply has been
absorbed by China and other fast-growing emerging markets,
keeping spare capacity low. Periodically, heightened geopolitical
concerns have pushed prices up, but the central part of the price
range seems to reflect a supply-demand balance in which feeble
OECD demand is offset by strong emerging economy demand –
more than offset, in the sense that prices are much higher than in
earlier decades. This is more evidence for the idea that poor
economic growth in developed economies since 2008 is as much
about an energy shortage as it is about credit stress.
Looking to the future: Is there a “new normal” of slow
growth?
The effect of higher oil prices is to reduce domestic spending in
oil-importing nations as incomes are diverted into paying for oil,
with increased spending by oil-exporting nations initially offsetting
only a fraction of this lost demand. If this were the only effect, it
could be countered by oil-importing nations using expansionary
fiscal and monetary policies, temporarily borrowing from the oil
Our production processes, indeed the whole structure of our
economies, are based on the old prices. We make cement using
oil to heat limestone. We operate airplanes built ten years ago
when oil prices were low. We make kitchen utensils from aluminum
that is in turn made by an energy-intensive smelting process. We
build sprawling cities without proper public transport, and install air
conditioning. Even the so-called “virtual” world of data requires
energy-intensive cooling plants for its servers.
When oil prices rise, it becomes uneconomical to make some of
the products that use aluminum, so we shut down that factory.
Less-patronized airline routes cannot be operated any more. To
save fuel, we turn down the air conditioning, making us irritable and
less productive. Our trucks drive more slowly to save fuel, so that
the number of deliveries made on a single shift declines. And so
on. In short, the productive capacity of the economy has declined
(economists say that in the short run, the economy uses fixed
proportions of factor inputs). Is this one of the reasons, perhaps a
major reason, why output has been so disappointing in the USA
and Europe since 2009? We focus so much on financial forces
and government austerity measures that we ignore this – but
surely a tripling of prices to their highest-ever sustained level must
have a major impact.
Of course, this fixed production structure does not apply in the
medium to long run. Once we realize that energy is going to be
much more costly, we start to make adjustments. Cement manufacturers install solar energy to heat limestone. An accelerated
airplane renewal cycle brings fuel efficiency, making closed routes
viable again. Smaller PVC plants are closed and replaced with
larger ones that use economies of scale to reduce costs. Buildings
are built with natural cooling, new cars are more efficient, software
gets smarter and uses less server power. And, we search for new
sources of energy. Shale gas is the key example. As all this happens, economically viable output can gradually go back up again.
It is difficult to measure how far this restructuring process has
gone, but we have now had very high oil prices for about five years
and quite a lot has been done to make production more fuelefficient, as shown by the examples in Table 1. And on the supply
side, shale gas is starting to have a major impact in the USA
(Figure 15). As more and more measures of this kind are implemented, output should start to gradually accelerate, rather than
staying mired in the slow growth of the “new normal.” This
assumes that it is energy supply constraints rather than a lack of
macroeconomic demand that are now the main force holding back
the economy, so that the economy can re-accelerate as restructuring eases those constraints. This seems plausible in the USA
(where macroeconomic demand is supported by the Fed’s
continued aggressive monetary stimulus), as well as in Europe’s
largest economy, Germany, and in most emerging markets. It is
Figure 11
Oil Price Consistent with 0% Growth in Oil Demand Growth
600 USD per barrel
500
400
300
200
100
Global GDP growth
0
1
1.25
1.5
1.75
2
2.25
2.5
2.75
3
3.25
3.5
3.75
4
4.25
4.5
4.75
5
5.25
5.5
5.75
6
producers until the latter were able to boost their own spending.
Unfortunately, there is another, possibly much more important
impact from higher oil prices, which can prevent such policies being
effective: an adverse supply shock.
High
Low
Medium
As of 11/09/2012
Source: Credit Suisse Investment Banking
Note: Chart shows rise in oil prices needed to constrain oil demand to
zero growth on various GDP assumptions.
Figure 12
Crude Oil Net Speculative Long Positions Versus Oil Price
%
14
USD per barrel
140
12
120
10
100
8
80
6
60
4
40
2
20
0
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Crude oil speculative net long positions in percentage of open interest
WTI crude oil price in USD (rhs)
As of 10/25/2012
Source: Bloomberg, Credit Suisse/IDC
Figure 13
Developed Market Industrial Production Versus Trend
Index (January 1998 = 100)
125
120
115
110
105
100
95
90
1998
2000
2002
2004
2006
Developed market industrial production
2008
2010
2012
1998 –2008 trend
As of 08/15/2012
Source: Datastream, Credit Suisse
Note: Developed Market growth after 2008 well below trend – was the
primary cause the Credit Crunch or an oil shortage?
Compass 37
Figure 14
Industrial Production Levels by Region
more debatable in Eurozone periphery countries, where fiscal and
credit conditions remain tight, but even they should benefit from
demand elsewhere. If this is correct, it implies a more positive
outlook for output in the next few years than many expect, which
should help to support equity markets.
Index (2005 = 100)
280
260
240
220
200
180
160
140
120
100
80
2005
2006
2007
2008
2009
2010
2011
Advanced Economies
Emerging markets (incl. China)
As of 08/15/2012
Source: Datastream, Credit Suisse
2012
China
Figure 15
US Natural Gas Versus Oil Production Forecasts
(Net Change Since 2009)
Million barrels per day equivalent
2.5
2.0
Forecast
1.5
1.0
0.5
0.0
-0.5
-1.0
20092011 2013 2015 2017 2019 20212023 2025 20272029 20312033 2035
Shale gas
Crude oil total
As of 06/30/12
Source: EIA, Credit Suisse
Natural gas excl. shale
Future energy prices: Toward a new supply boom, but
demand also strong
For oil prices, there are two broadly offsetting effects: OECD
economies that are gradually becoming less energy-intensive, but
that are set to grow somewhat faster than central estimates
expect. This suggests that oil prices remain in roughly the same
elevated range seen over the last five years (about $75–105 for
WTI, about $85–125 for Brent, with trading usually closer to the
center than the edge of these ranges). Oil production growth has
risen over these last five years, thanks to deep-water drilling and
the surge in shale oil production, but we are still much closer to
capacity constraints than during the 1980s and 1990s, and new
oil supply comes at a much higher cost than in the past, with oil
sources from tar sand or shale being much more capital-intensive
to produce than the “traditional” Middle Eastern oil. If anything, this
implies an asymmetric risk, with prices more likely to break out on
the upside temporarily, partly because monetary policy is likely to
be kept too expansionary for too long, pushing demand into the
area where supply becomes inelastic, and partly because of the
danger of a geopolitical shock.
We cannot be sure how long this historically high range might
persist, but over the medium to long term it almost certainly
contains the seeds of its own destruction. Over a 10–15-year
horizon, the supply of oil and other energy is likely to be very
responsive to high prices, which encourage large-scale investment
and foster new technologies that reduce costs permanently and
open up totally new sources of supply.
Shale gas is the most visible of the new energy supply sources.
Already present on a large scale in the USA and expanding rapidly,
this is the leader in a range of new supply sources that many
people believe could turn North America into a net energy exporter
within about ten years, which is not only a crucial event for energy
prices, but also geopolitically. It can also encourage growth of
energy intensive activities in the USA. Countries around the world
are keen to emulate the success of the USA, though geological
and environmental considerations vary widely. China is aiming to
exploit is substantial shale gas reserves as are others including the
UK and Argentina, although exploration in continental Europe has
so far been mixed 2. Other new sources include those based on
deep-water drilling technology, which, with the appropriate postMacondo safeguards, is increasingly crucial – not just in Brazil, but
other areas such as the Eastern Mediterranean and off the coast
of East Africa.
Investment opportunities, new energy sources, new
energy efficiencies
The current era of high oil prices, the technologies it is spawning,
and the new energy sources it is helping to uncover, will change
the world energy map beyond recognition in the next decade. To
38 Financial Crisis or Oil Crisis?
take a few examples, Tanzania and some other east African
countries will face an oil and gas boom and, if they can manage to
avoid the resource curse seen in the West of the continent, there
will be prosperity for their peoples as well as impressive investment
opportunities. Brazil may be able to finance the next phase of its
economic development, and Cyprus and even perhaps Greece
may eventually be able to repay all their debts. Nuclear energy is
part of the story: Germany and Switzerland are stepping back, but
emerging countries from Turkey to China have tried to adapt the
technology to the lessons of Fukishima and move forward. Electric
car technology will likely improve substantially within a decade, but
will probably take longer to become a dominant force, while other
energy-switching and saving technologies like smart meters could
have a bigger impact sooner.
As investors, we should be starting to look beyond the financial
crisis and its sibling, the Eurozone crisis, focusing instead on the
way that the current era of high energy prices is changing our
economies, potentially allowing output to surprise to the upside,
thus supporting equity markets without necessarily causing major
damage to bonds initially. The focus can be on the opportunities for
investment in energy, while being aware that at some point,
perhaps after a decade or so, the pendulum will swing back once
again to an era of lower energy costs with a whole new set
of opportunities.
Wilmot et al, “How Much Demand Destruction?”, Market Focus,
Credit Suisse Fixed Income Research, 17 July 2008
2
Credit Suisse Research Institute is planning to publish a report on
shale gas in December 2012
1
Compass 39
Wealth Planning
Summary of American Taxpayer
Relief Act of 2012
Written by ALVINA LO,
PRIVATE BANKING USA
WEALTH PLANNING GROUP
The “American Taxpayer Relief Act of 2012” (the Act) became effective as of
January 1, 2013. The Act is intended to avoid some of the issues related to the
so-called “Fiscal Cliff”, which would have automatically increased taxes for most
individuals. Below is a summary of the major tax provisions contained in the Act related
to high net-worth individuals.
Income Tax
The Act increases the top Federal ordinary income tax rate to 39.6% (up from 35%)
for taxable income over $400,000 (for individuals) or $450,000 (for married couples
filing jointly).
The tax rate for qualified dividends and long-term capital gains also increases to
20% for taxable income over $400,000 (for individuals) or $450,000 (for married
couples filing jointly). The rate remains at 15% for amounts below this threshold.
Note: Although not a part of the Act, the new “Medicare tax” is also effective beginning
in 2013. A 3.8% surtax is applied on the lesser of net investment income or modified
Adjusted Gross Income (AGI) in excess of $200,000 (for individuals) or $250,000
(for married couples filing jointly). Furthermore, there is an additional 0.9% increase in
the Medicare hospital insurance tax on the amount of earned income in excess of
$200,000 (for individuals) or $250,000 (for married couples filing jointly), bringing the
total tax to 2.35% (up from 1.45%).
Estate, Gift and Generation Skipping Transfer Tax
The Federal estate tax exemption remains at $5 million, indexed for inflation since
2011, which is projected to be $5.25 million in 2013 for individuals or $10.5 million
for married couples. In addition, the gift tax is “unified” with the estate tax so that the
Federal lifetime gift tax and the Generation Skipping Transfer (GST) tax exemptions are
also projected to be $5.25 million for individuals or $10.5 million for married couples.
The new top estate, gift and GST tax rate is 40%, which is an increase from the temporary rate of 35% in 2011 and 2012. Individuals who fully utilized their exemptions
last year may leverage their existing trusts and/or other wealth transfer vehicles for
additional gifts.
“Portability” – the ability for a surviving spouse to use the exemption of a deceased
spouse for gift and estate tax purposes – is also made permanent under the Act.
Although portability may appear to simplify estate planning, taxpayers should consult
with counsel on the various implications of relying on this provision.
Itemized Deduction Limitation and Personal Exemption Phase-out
The Act reinstates the phase-out on certain itemized deductions and personal
exemptions for those with AGI over $250,000 (for individuals) or $300,000 (for married
couples filing jointly). Under the “Pease” limitation, the total amount of itemized
deductions that can be claimed is reduced by the lesser of 3% of AGI in excess of this
40 Wealth Planning
threshold amount or 80% of the itemized deductions. Under the Personal Exemption
Phase-out, the personal exemption is reduced by 2% for each $2,500 of AGI that is in
excess of this threshold amount.
Social Security Payroll Tax
The Act does not extend the 2% reduction on Social Security payroll taxes that had
applied for 2011 and 2012. As a result, wages earned up to $113,700 (per individual)
will be taxed at a rate of 6.2% (compared to 4.2% in such years).
Alternative Minimum Tax
The Act provides a permanent patch for the Alternative Minimum Tax (AMT) by
indexing the AMT exemption for inflation. The exemption amount for 2012 is $50,600
(for individuals) or $78,750 (for married couples filing jointly). This provision is effective
retroactive to the 2012 tax year.
Distributions from IRAs to Charities
The Act permits tax-free distributions from Individual Retirement Accounts (IRAs) to
charity for 2013. Specifically, an individual that is age 70 ½ and older may distribute up
to $100,000 from his or her IRA directly to a qualified charity without tax consequences
through the end of the year. In addition, an individual making the charitable distribution
in January, 2013 may elect to treat the distribution as being made in 2012.
The new top estate, gift
and GST tax rate is 40%,
which is an increase from
the temporary rate of 35%
in 2011 and 2012.
Individuals who fully utilized
their exemptions last year
may leverage their existing
trusts and/or other wealth
transfer vehicles for
additional gifts.
In-Plan Roth Account Conversion
The Act permits individuals to convert an existing 401(k) plan to a Roth account, if
employers offer Roth accounts in the employers’ retirement plans. This applies to the
entire 401(k) balance, as compared to only the amount eligible for distribution under
prior law.
Qualified Small Business Stock
Under previous law, gain for qualified small business stock was excluded if the stock was
acquired between September 27, 2010 and January 1, 2012 and held for at least five
years. The Act extends the exclusion for two years so that it will now include stock
acquired before January 1, 2014. Therefore, if a taxpayer acquires qualifying small
business stock before January 1, 2014, and holds it for at least five years, the taxpayer
may dispose of the stock without incurring any Federal income tax.
GRATs and FLPs
The Act does not contain any provisions related to Grantor Retained Annuity Trusts
(GRATs) or Family Limited Partnerships (FLPs). Later rounds of revenue increases,
likely in conjunction with Congressional action to increase the debt ceiling and cut
entitlement spending, may, however, include a robust discussion of extending
GRAT terms.
Compass 41
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party may desire prior to making an investment
and, in fact, provides only a limited view of a
particular market. This material may not be used
or relied upon for any purpose other than as
specifically contemplated by a written agreement
with CSSU. CSSU does not provide legal or tax
advice. Consult your personal accounting, legal,
and tax advisor with respect to any legal or tax
implications.
Unless otherwise specified, the term “Credit
Suisse Private Banking” generally refers to the
combined capabilities of Credit Suisse Group
subsidiaries and affiliates that provide private
banking services to high net worth clients worldwide. Each legal entity in Credit Suisse Group is
subject to distinct regulatory requirements and
certain products and services may not be available in all jurisdictions or to all client types. There
is no intention to offer products and services in
countries or jurisdictions where such offer would
be unlawful under the relevant domestic law.
This material has been prepared by the Asset
Allocation and Investment Strategy Team of the
Private Banking USA business of CSSU and
not by the CSSU research department. It is
intended only to provide observations and views
of the Investment Strategy and Advisory Group,
which may be different from, or inconsistent with,
the observations and views of CSSU research
department analysts, CSSU traders or sales
personnel, or the proprietary positions of CSSU.
Observations and views expressed herein may be
changed by the Asset Allocation and Investment
Strategy Team at any time without notice. Past
performance is not an indication or guarantee
of future performance, and no representation or
warranty, expressed or implied is made regarding
future performance. The material set forth above
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believed to be reliable but CSSU does not represent or warrant its accuracy or completeness and
is not responsible for losses or damages arising
out of errors, omissions or changes in market
factors. The material does not constitute objective research under FSA rules. The most recent
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Private equity funds, hedge funds, and other
alternative investments are complex instruments
that are not suitable for every investor, may
involve a degree of risk, and may be appropriate investments only for sophisticated investors
who are capable of understanding and assuming the risks involved. Before entering into any
transaction, an investor should determine if the
product suits his or her particular circumstances
and should independently assess (with his or her
professional advisors) the specific risks and the
legal, regulatory, credit, tax and accounting consequences. CSSU makes no representation as to
the suitability of any alternative investment product for any particular investor nor as to the future
performance of any such products. Any offering
of interest in any private equity fund, hedge fund
or other alternative investment product shall only
be made pursuant to the offering material for
each such product, which will be provided to each
prospective investor before making his or her
investment decision and which contains information about such product’s investment objectives,
the terms and conditions of an investment in such
product and tax information and risk disclosures
that involve significant risks, such as loss of the
entire investment, illiquidity, restrictions or transferring of interests, volatility of performance, and
currency risks.
Master Limited Partnerships (MLPs) combine
the tax benefits of limited partnership with
the liquidity of common stock. An MLP has a
partnership structure but issues investment units
that trade on an exchange like common stock.
In order to qualify, a firm must earn 90% of its
income through activities or interest and dividend
payments relating to natural resources, commodities or real estate. MLPs are not subject
to corporate income taxes. Instead, unitholders of an MLP are personally responsible for
paying taxes on their individual portions of the
MLP’s income, gains, losses, and deductions.
Tax-exempt institutional investment funds such
as pensions, endowments, and 401(k) plans are
restricted from owning MLPs because the cash
distributions received are considered unrelated
business taxable income (UBTI) – income that
is unrelated to the activity that gives the fund
tax-exempt status. This could create a tax liability
on any distribution of more than $1,000. This is
also true for individuals when holding MLPs in
an IRA account. CSSU does not provide tax or
legal advice. Please consult your legal and tax
advisors to understand the tax implications of
investing in MLPs.
For the definition of certain benchmark indices
referenced herein, please refer to: https://www.
credit-suisse.com/us/privatebanking/en/glossary_indices.jsp
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As provided for in Treasury regulations, advice (if
any) relating to federal taxes that is contained
in this communication (including attachments) is
not intended or written to be used, and cannot
be used, for the purpose of (1) avoiding penalties
under the Internal Revenue Code or (2) promoting, marketing or recommending to another party
any plan or arrangement addressed herein.
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an offer or an invitation to enter into any transaction or purchase any security or investment
product that may not be undertaken under
Mexican applicable regulation.
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