Investment Outlook Update 2019

Staying on course despite headwinds

Equities made a remarkable comeback this year. But volatility remains high. Read below how you can deal with the current insecurities.

Contents

Central banks change courseMacroeconomics

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Fed throws lifebuoyAsset class analysis

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Investment strategies policyNeutral overall stance, with moderate tactical bets

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Oil price is the swing factorCommodities

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AEX bull market ends after ten years Technical analysis

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CO2 emissions and human resource policy: important themes

Sustainable investment14

ING’s outlook by sector

Consumer discretionary

Utilities

Industrials

Information technology

Consumer staples

Financials

Energy

Communication services

Materials

Real estate

Healthcare

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42

49

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As much as the fall in the price of equities and other high-risk asset classes was, as unexpected was the policy change of the world’s leading central bank, the US ‘Fed’. It was actually on Christmas Eve that the sentiment and prices on the financial markets reached their low point. Fears of a less ‘flexible’ (i.e. accommodating) central bank policy, weakening economic growth and the flare-up of the US-Chinese trade dispute led to a sell-off on the financial markets. A recession would almost be inevitable. One of the longest periods of economic growth in the United States (US) had to come to an end. And the opinion was that a downturn in the US economy would pull down the rest of the world in its wake.

Fed changes courseThe world’s leading central bank, the Federal Reserve, was still making investors angry in December, not

only by raising policy rates, but also by hinting at a number of further interest rate hikes in 2019. In other words, the money tap would be cut off even further. But at the end of January came a surprising turn. The Fed appeared to be shocked by the sudden deterioration in financial conditions. As a result of the turmoil on the financial markets, the risk premiums on corporate bonds, for example, had risen sharply. Combined with some disappointing figures on the US economy, that was enough reason to reverse policy and change course. The Fed directors unexpectedly decided to take a break in their policy of gradual interest rate increases.

Last March, the US central bank even confirmed that it would not raise policy rates during the remainder of 2019. The Fed is also abandoning the planned sales, at the end of this year, of repurchased bonds on its

Macroeconomics

Our Investment Outlook 2019 was published just over half a year ago. Among other things, we outlined a scenario in which the central banks, led by the US ‘Fed’, would cut off the money supply further in order to slow down economic growth a little. However, following a series of disappointing economic figures, the fear of a global recession increased. For equity investors, 2018 ended with the worst quarter since the financial crisis. The equity markets have now returned to their October 2018 level, thanks to the central banks.

Central banks change course

Simon WiersmaInvestment manager

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balance sheet. Other central banks, including the European Central Bank (ECB), also hinted at cautious (‘dovish’) policies. In fact, the ECB indicated that it would not raise policy interest rates this year. It also announced a new lending programme for banks. All in all, interest rates will remain low for longer than we and others previously expected. In response to central bank policy changes, equity prices shot up almost at the same pace as they had fallen at the end of 2018. Bond yields also fell further.

Economic growth rebounds somewhatFollowing the substantial ‘winter dip’ at the end of last year and the first months of 2019, we are seeing some global recovery in the economic figures. The economy grew stronger in the first quarter of 2019 in both the US (+3.2%, year-on-year) and the eurozone (+0.4%, quarter-on-quarter) than in the last quarter of 2018. Both percentages were higher than expected. The explanation for this better-than-expected growth can to a great extent be found in the levelling off of the growth slowdown in China. The growth of the world’s second-largest economy was +6.4% in the first quarter, which is equal to the growth rate in the last quarter of 2018. This was made possible in part by the large-scale incentives that the Chinese government and central bank have been implementing since last year. The concerns about a ‘hard landing’ of the Chinese economy (rapid slowdown in growth, with a risk of recession) as a result of the trade war with the US have so far proved to be unjustified. With the transition from a production and export-driven economy to a more consumption and services-driven economy, the Chinese economy is less sensitive to the ups and downs of international trade.

Consumer spending support for growthThe global slowdown in growth at the end of 2018, largely due to the US-Chinese trade issues, had a particularly negative impact on the (export-sensitive) manufacturing sector. Since October 2018, the volume of world trade has decreased. In Europe, this was most evident in the unexpectedly sharp slowdown in the growth of German industry. A number of non-recurring factors left their mark here, including the low water levels in the rivers and adjustments to emission requirements for cars. On the other hand, there was a strong contribution to the growth of consumer spending. Historically low unemployment and slightly higher wages support consumer confidence. The services sector, which is mainly oriented towards the domestic economy, benefits from this. Since the end of the first quarter

of 2019, the industrial sector has also seen some recovery. Italy has also recovered from the recession in the last second quarters of 2018. Despite the downward revision of growth expectations, a recession in the eurozone does not seem to be imminent for the time being. Postponement of Brexit will not fundamentally change this scenario.

US: increase in productivity keeps inflation under controlAs expected, the negative effects of the trade war started by President Trump with (among others) China are becoming increasingly visible. The reciprocal import duties mainly affect the Chinese manufacturing sector, but in the US, too, the consequences are weighing heavier and heavier. At the same time, the positive effects of Trumps’ earlier tax cuts are diminishing. A positive development in the US is that wage growth still remains relatively subdued, despite the strong performance of the services sector and the increasingly tight labour market. Furthermore, labour productivity is picking up, after years of weak growth. Partly as a result of this, the upward pressure on inflation from the labour market remains limited. There is consequently no need for the Fed to raise policy rates.

In our opinion, there is thus no question of them being cut, which is the fervent wish of President Trump, as the US economy is still performing much too well for that. For the time being, we assume that the Fed will not change the policy rate (now 2.50%) this year. This is therefore a different expectation from the one we had last year, when we still assumed that the Fed would turn off the money tap even more. However, we are maintaining our earlier expectations for economic growth in the US. We expect US growth to fall from 2.9% in 2018 to 2.4% this year. Clearly cooling down, but certainly not a recession.

Eurozone not yet free from political uncertaintyFor the eurozone, we have further reduced our growth expectations for this year from 1.6% to 1.2% year-on-year. This is slightly below the potential growth estimated by economists. But also for the eurozone, our baseline scenario (thus the scenario we consider most likely) does not assume a recession. The stronger and longer-than-expected downturn in the German economy is weighing on our growth expectations. This so-called eurozone growth engine has sputtered considerably, partly due to the problems in the automotive sector. Slowly but surely, however, we are also seeing some green shoots emerging in the eurozone.

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Also, under pressure from public opinion, there seems to be more room for manoeuvre in the area of fiscal stimulus policy. In contrast to the US, in Europe, under pressure from existing agreements, the tendency is to pursue a ‘countercyclical’ fiscal policy. That is to say, spend less if the economy is doing well and spend more if it is doing worse, so that the economy grows more gradually. In addition, (geo)political concerns such as Brexit, the political direction of the Italian government and the trade war started by Trump continue to occupy the market. We do not expect these concerns to quickly disappear in the near future. In fact, they may lead to increasing uncertainty among consumers and businesses. In such times of uncertainty, our scenario of moderate but positive economic growth also poses the greatest risk.

Low interest rates give emerging markets air...Emerging markets had a difficult time in 2018 due to the fear of sharply rising interest rates. However, as a result of the Fed’s change of course, the main concerns for emerging markets have subsided in 2019, including rising US bond yields and a stronger dollar. With a few exceptions, the exchange rates of emerging market currencies have remained fairly stable since the end of last year. Economic growth in emerging markets is largely determined by the development of the Chinese economy, as China imports many raw materials and semi-finished products from these countries. The good news is that the Chinese stimulus measures seem to be bearing fruit. China has been more vigorous in its efforts to offset the anti-growth effects of US trade policy. We are therefore maintaining our expectation that the growth of the Chinese economy will slow down from 6.6% last year to 6.3% in 2019. Not a ‘hard landing’ of the economy, therefore.

... and growth differential with developed economies is increasingAlthough we have lowered the growth forecast for emerging markets as a whole for 2019 from 4.7% to 4.4%, this growth forecast is still significantly higher than that for the developed economies. For the latter

region, we have reduced our growth forecast for this year from 2.1% to 1.8%. This leaves our scenario of an increasing growth differential between emerging and developed countries intact.

Fears of recession have diminished, but not disappearedDespite lower economic growth expectations, the economic picture is not as bad as the market thought it would be at the end of 2018. For the second half of 2019, we remain reasonably cautious with our expectations. We are not alone in this. In recent months we have seen many downward adjustments to growth forecasts. Both the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) warn of the consequences of protectionism and the absence of structural reforms in countries where they are needed. Factors such as Brexit, US protectionist policy and developments in Italy, for example, call for caution. For 2019, we have adjusted our global economic growth estimate from 3.6% to 3.3%. In 2020, growth could pick up a little to 3.4%.

Sentiment is strongly influenced by political developmentsAs we already wrote in November 2018 in Investment Outlook 2019, the outcome of the scenario we have outlined depends to a large extent on the confidence of consumers and businesses. After all, this confidence also determines the willingness of consumers to consume and of businesses to invest. In doing so, they steer the direction in which the economy is developing. Crucial in this context are the political developments, however frustrating they can sometimes be. It has been a long time since politicians left such a heavy mark on economic sentiment. Geopolitical developments are widely reported in the media and sometimes lead to substantial price fluctuations on the stock markets, as we have seen again in the past six months. At the same time, the influence of political rhetoric should not be overestimated. It is important to distinguish between main and side issues.

Low interest rates drive valuations upAs a result of the about-turn in central bank policies, we have become rather more positive about our return expectations for this year compared to the end of October last year. We now foresee a longer period with low interest rates. If the economic figures do not weaken sharply, central banks ‘remain on the sidelines’ and corporate earnings growth does not slow down too much, valuations of high-risk

Growth differential between emerging and developed economies increasing

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asset classes could rise a little further. You can read what this means for our return expectations in the following section. ‘Analysis of asset classes’.

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Analysis of asset classes

With hindsight, when drawing up the Investment Outlook 2019, our assessment was correct that price volatility would increase further. The waves would get higher. At the end of October 2018, however, we could not have imagined that the decline in the equity markets would be as sharp as at the end of last year.

Fed throws lifebuoy

The strong recovery that followed at the beginning of this year was just as surprising – with thanks to the central banks. This year’s outlook for returns, which we mentioned in Investment Outlook 2019, has been far exceeded (considering the prices at the end of May). What does this mean for our current investment policy? And for the expected returns in the second half of 2019?

So much has happened since the end of 2018... In the six months since our last outlook publication, quite a few things have happened on the financial markets, including the emerging fear of recession, driven by the escalating trade war, the political impasse surrounding Brexit in the United Kingdom and the increasingly less accommodating policies of the central banks. The last quarter of 2018 turned out to be the worst market quarter since the financial crisis.

... that we are reviewing our expectations for 2019 In themselves these developments fitted in perfectly with the scenario we had outlined a few weeks earlier. We could therefore have sufficed with a minor update, except for the fact that the US central bank, the ‘Fed’, made a 180-degree turn in its policy in

January (contrary to our expectations). It decided to take a break in its policy of gradual interest rate increases. In other words, it did not cut off the money supply any further. As other central banks also adopted this rather accommodating policy, we decided to adjust our expectations.

Different policy by central banks was the game changerDue to the sharp price falls in November and December, our expected returns for 2018 were not realised. The correction was mainly due to the revaluation of risky asset classes (such as equities) that took place on the financial markets. Fears of higher market interest rates, caused by the central banks’ less accommodating policies, combined with disappointing economic growth figures, scared investors to death. It was not until January that prices recovered, a development that was subsequently reinforced by the aforementioned policy change by the Fed and other central banks. We cannot underestimate the consequences of this change of course by central banks, with the Fed at the fore. We consider this to be a real game changer, because the new central bank policy means that interest rates will remain low for even longer than we expected.

Simon Wiersma investment manager

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And that makes a lot of difference to the financial markets.

No signs of recessionContrary to our expectation of a less accommodating policy, the central banks will therefore continue to pursue stimulating policies for longer. In order to stimulate the economy, they provide easily available capital, which can be borrowed at very low interest rates. Investors are even speculating about new stimulatory measures, including a cut in interest rates by the Fed. The recent policy change by the US central bank extends the economic cycle, as it were, and significantly reduces the likelihood of a recession in the short term in the US. And that, while economic cooling at the end of last year seemed almost inevitable. We do not expect any recession in the US this year or next. And despite the trade war, economic growth in China seems to be stabilising, as the stimulatory measures taken by the Chinese government and central banks are bearing fruit. Moreover, China’s dependence on exports to the U.S. is not as great as was feared. We are even seeing some signs of recovery in the eurozone, while Brexit has not yet been completed (although it has been postponed). The low point in this phase of German economic growth may once again be behind us. At the same time, we are no longer seeing growth return to the strong pace of 2017 and the first half of 2018. We appear to be moving around the structural growth rate, which is clearly lower than in the past. For Europe, this is more than 1%. Nor do we see any signs of an imminent recession. Even the Italian economy seems to be recovering.

Revaluation of equities: ‘correction to the correction’. The prospect of low or even declining interest rates and a slight recovery in economic growth have led to a revaluation of equities on the stock market. This time the revaluation was positive. So far this year, the price increases have been almost entirely driven by higher valuations (such as the price/earnings ratio), thus hardly, if at all, by stronger profit growth or profit growth expectations. At the same time, risk premiums on the bond market fell back to the levels of early October 2018. We therefore refer to this as ‘a correction to the correction’. It was a logical response, since lower interest rates and lower prices had caused risk premiums to rise sharply and equities and corporate bonds to be valued at a lower (‘cheaper’) level. This was an important reason for us to buy additional equities at the beginning of January. As a result of the price declines, the relative weight of equities in our investment strategies had

fallen below the neutral level that we wanted. We did, however, exercise restraint, because the expectations for corporate earnings at that time were negative and very uncertain. Just like at the end of last year, we currently (mid-June 2019) consider a neutral relationship between marketable securities (such as equities and real estate) and fixed-income securities (bonds) to be appropriate.

Investors in December far too pessimisticWill 2019 see the end of the long-term upward trend (bull market) in equities, which has been going on for years? That was the question we asked at the end of October 2018, in Investment Outlook 2019. We still don’t think so. The arguments we put forward at the end of last year are still valid, since the main reason for the end of bull markets is not their duration. No, history shows that this is usually due to a combination of sharply rising interest rates and the bursting of soap bubbles. When we wrote our annual outlook in October, we thought that interest rates would rise a little further – as they did when the Fed raised its policy rate in December. But then the market began to make allowance for very negative scenarios for the different asset classes. In our opinion, this was unjustified. And that is how we still feel, even though the risks of a flare-up of the trade war between the US and China have increased since the beginning of May.

No widespread, excessive credit growth This is because we do not see any widespread, excessive growth in loans to individuals and businesses, while that was the case in the period up to and including 2007. Since the financial crisis, the debts have mainly ended up on the books of governments and central banks. The central banks’ policy of buying bonds to stimulate the economy makes it easier for governments to borrow at very low interest rates. This has been happening in Japan for years and, despite the now sky-high national debt, there do not seem to be any major problems. This low-cost money policy is however regarded as ‘the’ solution to maintain economic growth without creating new problems. There is even a name for it: ‘modern monetary theory’. Time will tell whether there are any drawbacks... Since the financial crisis, borrowing conditions for consumers and businesses have become stricter. But as is often the case, we also see exceptions. Consumer and business loans in China and car and student loans in the US are examples of credit markets with strong credit growth. These markets are therefore closely monitored by investment professionals. There was also strong credit

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growth on the eve of the global financial crisis of 2007 - 2008. But now, apart from the increase in nationaldebt, we do not see any major similarities with thedevelopments at that time.

Equities back where they started, valuations not excessiveAfter the price falls in the last quarter of 2018 and the rapid recovery that followed, global equities are now (3 June) some 3% higher than at the end of October, when we published our expectations for 2019. The average price/earnings ratio for equities in the MSCI All Country World Index, the most widely used benchmark of global equities, rose from 13.6 to 14.7. This is still below the average of 15.7 during the period from 1985 to 2019. Now that interest rates are expected to remain low, we assume that investors will again look for investments that can further enhance the performance of their portfolio of riskier asset classes (such as equities). Given the low interest rates, these investments have become more attractive again. Important conditions for this scenario are a stable (forecast for) global economic growth, a continuation of the central banks’ policy not to raise interest rates for the time being and companies’ positive profit growth (and profit growth expectation). Consumer and business confidence plays a crucial role in this.

Corporate data not as bad as expectedPartly driven by recessionary fears, analysts have been adjusting corporate earnings growth expectations for 2019 since October last year from nearly 10% to now slightly more than 4%. Profits in the first quarter were expected to fall compared to the first quarter of 2018. For the first quarter of 2019, a fall in profit of almost 4% (year-on-year) was expected at the beginning of this year for companies in the US S&P 500 index, the largest and most important stock market indicator. In the end, an average profit growth of 1.5% was realised. European equities in the Stoxx Europe 600 index showed an average profit growth of 0.2%. The expected decline in profits failed to materialise therefore. As a result, following the first-quarter figures we are seeing analysts very cautiously raising their profit expectations for 2019. As a consequence of increased trade tensions and a growth deceleration in the manufacturing sector, we have lowered our profit growth forecast for this year from 6% to 2%, and analysts expect average profit growth of 10% for 2020. We are much more measured with an estimated profit growth of 0%.

Equity returns in 2019 have so far (until 3 June) been higher than expected. This is of course due to the fact that the starting point on 1 January was considerably lower than expected. But the returns since the end of October, when we published our Outlook 2019, are also higher than expected. Despite the strong recovery rally in recent months, but thanks to the correction in the last weeks of May, we still see further upward potential for global equities. In contrast to our baseline scenario in Outlook 2019, we expect central banks to keep the money tap open for the time being or even to open it a little further. We also expect that the stabilisation of growth in China and in the eurozone will provide support. However, we do expect that the geopolitical turmoil, which will undoubtedly flare up from time to time, will cause periods of considerable price fluctuations. We have thus not seen the end of the high waves yet.

Expected total return on equity increased by 4% to 12%.As already stated, we have lowered our profit growth expectations for 2019 to 2%. For 2020 too, we also maintain a very conservative estimate of profit growth. As in our Outlook 2019, we are assuming 0%, while analysts on average expect growth of just over 10%. These are therefore very cautious estimates which, in our opinion, are appropriate at this stage of the economic cycle and in the context of increasing geopolitical uncertainty. For our Outlook 2020 that we will publish at the end of this year, we will reconsider our expectations and adjust them if necessary. However, as a result of changes in central banks’ policies, which are more likely to ease than tighten, we do not now expect a lower, but rather a higher valuation of equities, the price/earnings ratio. On this basis, we expect a total return (including dividend) on global equities (MSCI World AC index in USD) of around 7% in 2019, starting from the price level on 3 June 2019. For the whole of 2019, the equity return would then be around 16% following the loss of 9% in 2018.

Positive return on government bondsAs a result of lower economic growth expectations for the eurozone, low inflation and more accommodating rather than tighter central bank monetary policies, we have adjusted our yield expectations. At the time of writing (3 June), the return on a basket of eurozone government bonds – or the Citigroup Euro Government Bond Index – was around 0.48%. This is a decline of 46 basis points (0.46%) compared to the end of October. Lower interest rates mean higher bond prices. The index therefore stands at a profit of

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4% this year instead of an expected loss. Not only have yields on government bonds from Germany and the Netherlands, which are deemed to be very safe, fallen to record levels, but so have the yields on Italian, Spanish and Portuguese government bonds.

Slightly higher capital market interest rates from current levelAs we expect growth and inflation expectations to recover somewhat in the second half of the year from their current low levels, capital market interest rates in the eurozone could rise slightly. This means slightly lower prices for the bond categories that are considered to be the safest: government bonds and corporate bonds from debtors regarded as creditworthy, so-called ‘investment grade credits’. This also applies to the return outlook for the riskier bond categories. As already mentioned, risk premiums on high-yield corporate bonds and emerging market bonds have already fallen sharply since their peak in 2018. As a result, the effective return has fallen but the price performance has been quite high. However, we expect the prices of these bond categories to come under pressure

in the second half of this year as a result of rising capital market interest rates. This effect is, however, expected to be partly but not entirely offset by higher interest income.

Revised estimated index returns in 2019 In the chart below you can see our revised return forecasts, per asset class, for the investment year 2019 – calculated from the end of October 2018. The value of these figures should not be overestimated. These are possible outcomes, and we underline that these are index returns. The cost of investing, such as transaction costs and the service fee, still has to be deducted therefore. With an active investment policy we try to exceed the index returns.

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The value of your investments may fluctuate. Past performance is no guarantee of future results. The service fee has not been taken into

account. This must be deducted from the return.

Source: ING Investment Office, 12 June 2019

Expected index returns in 2019

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Tactical asset allocation

This is our tactical asset allocation

as at 12 June 2019. Our current

allocation can be found in the

Monthly Investment Outlook

(ING.nl/beursnieuws).

Source: ING Investment Office, 12

June 2019

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Jochen Harkema & Peter Tros sustainable investment analysts

The minimum wage is the minimum remuneration employees must receive, often per hour, and is intended to protect them from being underpaid. Many countries have a minimum wage, but each country has its own legislation in this respect. More than 90% of all countries that are members of the International Labour Organisation (ILO) have a minimum wage. But that is not automatically a living wage. A living wage is defined as a wage that enables the employee to provide for himself and his family. The living wage may differ from the minimum wage. In some countries, the minimum wage for a full working week is significantly lower than the living wage.

Difference between livitng wage and minimum wage sometimes as much as 50%Research by the Netherlands Institute for Social Research (SCP) shows that the number of working poor increased by 60% between 2000 and 2014. According to the SCP, a working person is poor if his net income is lower than the social minimum, the living wage. In 2014, this was the case in the Netherlands for almost one in twenty people in work. Worldwide, the difference between the minimum wage and the living wage can sometimes be as much as 50%. Employees must therefore have two such

jobs in order to live a decent life.

A living wage is a universal human rightAccording to Article 23 of the Universal Declaration of Human Rights of the United Nations (UN), every working person is entitled to just and favourable remuneration ensuring for himself and his family an existence worthy of human dignity. The ILO and the Organisation for Economic Cooperation and Development (OECD) also advocate a living wage. This wage contributes to the realisation of three of the seventeen sustainable development goals (SDGs) drawn up by the UN. A living wage contributes to SDG 1: ending poverty, SDG 8: decent work and economic growth and SDG 12: responsible consumption and production.

Positive side effectsReceiving a living wage is therefore a worldwide human right. It not only provides sufficient income to support the family, but also for human dignity. Raising pay to the level of a living wage has positive side effects. Thanks to a higher family income, it is no longer necessary for children to work. There is also money to send children to school, which also improves their future prospects.

Sustainable investments

CO2 emissions and human resource policy: important themesSome workers receive the minimum wage, but do not earn enough to support a family. A living wage is a human right and contributes to three of the UN’s seventeen sustainable development goals.

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Human resource policy: an integral part of our assessment When we examine companies to assess how sustainable they are, we also look at their human resource policies. Do companies pay their employees enough wages to live on? Do they have a diversity policy? And can employees join a trade union? We also pay attention to how suppliers are doing. Many companies have parts or entire products manufactured elsewhere, for example in low-wage countries. Especially in the clothing sector, use is made of such suppliers, who often pay their employees badly.

Working conditions touch on various sustainable issuesWe assess how companies deal with employees on the basis of various themes. For example, we examine whether companies pursue policies aimed

at good working conditions. We check whether there is freedom of association – the possibility of becoming a member of a trade union. And we verify whether employment contracts are covered by a collective labour agreement. At ING, we assess the sustainability of investments on the basis of the main themes of ‘people’, ‘environment’ and ‘society’. The assessment of employment conditions and circumstances is included within the theme of ‘people’ and partly determines the final Nfi score.

Below is the score on employment conditions for some companies active in the clothing industry on the list of companies followed by our analysts. The final Nfi scores of these companies are Nfi + for Nike and Nfi ++ for the other four.

Suppliers’ employee policy at least as importantWhen selecting investments, we not only look at the employment conditions of the company’s own employees – its personnel policy – but we also pay attention to companies in the supply chain. Although it is difficult for companies to monitor personnel policy throughout the chain, we do think it is the responsibility of the end producer to ensure that a living wage is paid throughout the chain. And not only that: we also check whether companies

Living wage contributes to three ‘sustainable development goals’

Scores on employee policy Sources: ING Investment Office, Sustainalytics, June 2019

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pursue a deliberate policy in the field of occupational safety, maximum working hours, child labour and the prevention of discrimination. Moreover, they must assess this policy at their suppliers and enter into dialogue with them about it. Below you will find the relative scores on employee policy of the aforementioned companies on our master list, but then with regard to their suppliers. Because it is a relative score, compared to others in the subsector, and the average is zero, negative scores also occur. Scores within the subsector range from -1.34 to 2.33. Inditex has good policies, the best in this subsector. The other companies score fair (LVMH) to very good

(Marks and Spencer).

Good employee policy does not guarantee a living wage throughout the chainA good employee policy throughout the chain is a strong indicator of a living wage and responsible working conditions. But good policy does not offer any guarantee that a living wage will actually be paid. Especially in the clothing sector, it is very difficult to control the entire supply chain and to enforce a living wage. Thus for example, the chain lacks transparency due to the large number of players, the supply is very fragmented – it comprises countless small businesses

– and temporary contracts are often used. Despitegood initiatives, all five of the abovementionedcompanies have had to deal with incidents in thechain that have revealed questionable workingconditions.

ING encourages companies to pay a living wage Three Dutch asset managers launched an initiative in 2016 aimed at better remuneration in the clothing industry in low-wage countries. In 2018, this has developed into the Living Wage Financials Platform, which includes several banks and asset managers. The participants enter into discussions with the

clothing companies in which they invest. ING has also joined this initiative. In this way, we encourage companies in the clothing sector to pay a living wage and thus contribute to a more sustainable world.

We still have 12 years to deal with CO2

The Intergovernmental Panel on Climate Change (IPCC), the scientific advisory body of the United Nations on climate change, paints a clear picture in its report of October 2018. According to this report, the sharp rise in global temperatures has negative consequences. The IPCC does not mention headwinds, but more storms, drought and heat.

Scores on employee policy at suppliers Sources: ING Investment Office, Sustainalytics, June 2019

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If mankind wants to slow down the negative developments, the temperature rise must be limited to 1.5 degrees Celsius. We are already on the verge of an increase of about one degree. The IPCC comes to the conclusion that we still have 12 years to change course and keep climate disruption manageable.

Taxing CO2 can work quickly and effectivelyUnfortunately, 12 years leaves us very little time to formulate policy and implement it worldwide. Within this period, the economy should largely switch from fossil fuels to renewable energy. A global tax on CO2 emissions can be effective and work quickly. Such a tax increases the price of using fossil fuels. Price increases are immediately noticeable and encourage users to consider alternatives or reduce their fossil fuel consumption. Such a tax is a good thing economically as well, since the price of products balances supply and demand. A CO2 tax will therefore quickly be accepted and processed in the economy. Moreover, a CO2 tax will bring in money. We can use this for investments to limit global warming and for the changes that are required as a result of climate disruption.

Interest in pricing of CO2 emissions also outside the EU A number of places in the world are already experimenting with such a tax. Within the European Union, we have already had a market for CO2 emission rights for some time, ever since the emissions of companies were subject to stricter EU rules. In the first few years, this market did work and thus CO2 emission rights prices were established, naturally with financial consequences. But in the following years the price subsided. It is only in the last two years that the price has risen again, as can be seen in the chart. In order to raise prices, the EU has modified the trading process. The market stability reserve was introduced on 1 January 2019. This reserve is intended to ensure that, in the event of a surplus of emission rights, these rights are withdrawn from the market, thereby leading to an increase in the price. It is also important that bidders and suppliers have confidence in the trading system and that the EU continues to support it. In this context, it is a good thing that non-EU countries article are also showing interest in such a market.

Canada will tax emissions from 2019, China from 2020China introduced a CO2 market for electricity producers in 2018. This market should be twice the size of that of the EU. 2018 was spent on improving

the reporting by Chinese electricity companies; 2019 will be a transition year for the market. The actual implementation will only take place in 2020. Australia, on the other hand, has decided to close the emissions trading market. This country, the world’s largest coal exporter, prioritises its short-term economic interests. Various companies, including large oil companies such as Exxon and Royal Dutch Shell, have expressed their support for a tax on CO2. Canada proves that things can be done differently. Prime Minister Justin Trudeau has kept his election promise: the country has had a tax on CO2 since the beginning of 2019. This ranges from 20 Canadian dollars per tonne of CO2 in 2019 to CAD 50 in 2022.

Companies’ CO2 policy assessed by sectorWe have assessed per sector the extent to which companies pay attention to limiting greenhouse gas emissions. To this end, we examined CO2 emissions and the participation of companies in the Carbon Disclosure Project (CDP). This is an initiative to create transparency with respect to greenhouse gas emissions. We also took into account the usage of renewable energy and sector-specific indicators. We related the scores per company to the average in the sector, which we set at 1. DSM, for example, has a score of 1.8, which means that this company scores 80% better than the average for its sector.

A company’s CO2 policy is a risk factor for investorsWith increasing social and political pressure, we can expect a tax on CO2 to be introduced in more places in the world. The platforms for emissions trading will also be strengthened. We expect that the 11 best companies listed above will suffer less from this and in some cases will even be able to benefit greatly from it. In any case, it is clear to us that the extent to which companies emit CO2 is a risk factor for investors. Companies that have a clear vision of reducing greenhouse gas emissions, and design their products and processes accordingly, are included in the Duurzaam investment strategy.

Exxon and Shell are also in favour of CO2 pricing

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Price CO2 emission rights

The best scoring companies per sector

Source: Bloomberg, April 2019

The best scoring companies on CO2 emissions per sector from our master list.

Sources: Sustainalytics, ING Investment Office, June 2019.

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Neutral overall stance, with moderate tactical betsThe focus of our Actueel investment strategy within the equity investments is on the global spread across business sectors. Technological development is an important theme that plays a major role in several sectors. With this investment strategy we also focus on the growth of emerging markets. Government bonds, corporate bonds and real estate are fixed elements of the broadly diversified investment strategy. Our tactical asset allocation is currently (end of May) neutral. In the equity portfolio the energy sector is overweight and financials underweight. At regional level, Japan is underweight and the United States is overweight in relation to the neutral allocation. Within bonds we have an increased weighting of emerging market bonds with the higher risk being offset by a significantly higher expected yield. Government bonds have a reduced weight and also a reduced average remaining maturity. The sensitivity to rising interest rates is consequently lower.

Duurzaam strategy: more than just climate changeThe aim of our Duurzaam investment strategy, in addition to financial returns, is to make a contribution to a more sustainable society. Although we also exclude investments in companies with certain undesirable activities and conduct (such as tobacco production) from the regular investment strategies, the bar is set higher for the inclusion of investments in the Sustainable strategy.

But we do not just exclude, we also specifically select those companies that score well on sustainability policy. Strongly represented are companies that are seeking solutions for the consequences of climate change, such as by means of the production of wind and solar energy or increasing energy efficiency. Other sustainable themes, such as good corporate governance, good working conditions throughout the production chain and the prevention of environmental pollution, are also reflected in the Duurzaam investment strategy. We are increasingly investing in companies that use their products to contribute to a more sustainable society. Because we also base the selection of investments in equities and bonds on sustainability aspects, the investment strategy has a number of recognisable accents. Thus for example, the weighting of the oil and gas sector is very low and that of (industrial) technology relatively high. After all, the latter category includes many companies that offer innovative solutions to the problems associated with climate change.

Index strategy: neutral asset allocation The Index investment strategy consists entirely of index trackers. The policy is directed towards diversified investments in efficient ETFs (exchange traded funds) and good quality index funds. The strategy follows the tactical asset allocation of the ING Investment Office. The equity portfolio has an emphasis on the United States. Japanese equities are underweight due to the less favourable outlook.

Investment strategies policy

Henry van Heijster, Nathan Levy and Friso Rengers investment managers

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less favourable outlook. Within bonds we have an increased weighting of emerging market bonds with the higher risk being offset by a significantly higher expected yield. Relatively ‘expensive’ high-yield corporate bonds are underweight. Government bonds also have a reduced weight as well as a reduced average remaining maturity. The sensitivity to rising market interest rates is consequently limited since rising interest rates mean falling bond prices.

Dynamiek strategy: wide spread across investment themesOur Dynamiek* investment strategy also entails a wide spread across various asset classes, regions, business sectors and investment themes. We currently maintain a neutral weighting for marketable securities (equities, real estate, commodities and alternative investments) with respect to fixed-income securities (bonds). Within equities, we currently have a preference for equities from the United States and the energy sector. Japanese equities and financials (banks and insurers) are underweight due to a weaker outlook. Within fixed-income securities, we find emerging market bonds attractive. Relatively ‘expensive’ high-yield corporate bonds are underweight. Government bonds have a reduced weight and also a reduced average remaining maturity. The sensitivity to rising interest rates is consequently limited

Within bonds we have an increased weighting of emerging market bonds with the higher risk being offset by a significantly higher expected yield. Relatively ‘expensive’ high-yield corporate bonds are underweight. Government bonds also have a reduced weight as well as a reduced average remaining maturity. The sensitivity to rising market interest rates is consequently limited since rising interest rates mean falling bond prices.

Inkomen strategy: attractive in a low interest environmentThe focus in our Inkomen investment strategy is on interest income and dividend yield. We invest as much as possible in ‘defensive’ equities, which are slightly less sensitive to market fluctuations. The corporate earnings of defensive companies are usually more predictable and dividends are almost always paid out. In the geographical spread, there is a strong emphasis on European equities, which reduces the foreign exchange risk of this investment strategy. In addition to dividend stocks, we are also diversifying into other possible sources of return, such as low-volatility equities, real estate equities and, to a limited extent, equities from other regions. We currently maintain a neutral weighting for marketable securities (equities) with respect to fixed-income securities (bonds). The equity portfolio currently has an overweight position in the United States. Within bonds we have an increased weighting of emerging market bonds with the higher risk being offset by a significantly higher expected yield. Relatively ‘expensive’ high-yield corporate bonds are underweight. Government bonds also have a reduced weight as well as a reduced average remaining maturity. The sensitivity to rising market interest rates is consequently limited since rising interest rates mean falling bond prices.

Comfort strategy: emphases on the United States and emerging marketsCharacteristic of our Comfort* investment strategy is the broad spread across asset classes and regions. We currently maintain a neutral weighting for marketable securities (equities, real estate, commodities and alternative investments) with respect to fixed-income securities (bonds). The equity portfolio has an emphasis on the United States. Japanese equities are underweight due to a

*Available for ING Private Banking customers

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Oil price is a swing factor within the commodities indexWith the current rate of economic growth, we estimate that commodity prices are more likely to recover slightly in the second half of 2019 at a slightly higher rate than that they are likely to fall even further. Commodities are not highly valued in comparison with other asset classes. But there is currently sufficient supply, given the level of consumer spending and investment. Within the commodities index, oil, oil products and natural gas are the strongest ‘swing factors’ to set the index in motion. Thus the increasing tensions surrounding Iran could suddenly cause the price of oil to rise sharply.

We think that gold is correctly valuedUnlike the oil price, the price of gold has been relatively stable for years. From a long-term perspective, we consider gold to be neither overvalued nor undervalued at a price of €1100 per troy ounce.

Deal between the US and China would be positive factor for commodity pricesOn the basis of our macroeconomic outlook, we

believe that a neutral commodities outlook is the best fit. Investment trends and (geo)political changes can influence the supply of and demand for commodities. A weaker US dollar (the currency in which commodities are traded on the world market) could also increase demand for them. Globally, there are many dollar loans outstanding, which would then become more affordable for debtors, so that more capital would become available. This then leads to increased demand for commodities. Finally, a trade agreement between China and the US would be beneficial for world trade and investment, stimulating demand for commodities.

In 2019, the commodities index lost more ground, despite the strong US and European economies. Only the price of oil has recovered strongly from the fall in the last quarter of 2018. Contributory factors are the closely complied with OPEC production agreements, the US sanctions against oil exporter Iran and the declining growth of US shale oil production.

Oil price is the swing factorCommodities

Friso Rengers investment manager

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Bloomberg Commodity Index (EUR/USD hedged, total return)

Source: Thomson Reuters Datastream, ING Investment Office, May 2019

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Technical analysis

The upward trend in the AEX, the ‘bull market’, has come to a halt after ten years. Many other European equity indices, including the German DAX, have also ended their bull trend.

AEX bull market ends after ten years

What is technical analysis?

Technical analysis is a method of analysis where trends and recognisable price patterns are sought in price charts and other market data. Technical analysis is therefore very different from fundamental analysis, which studies financial-economic data. Bas Heijink’s technical vision will regularly deviate significantly from ING’s fundamental vision. Our vision is mainly based on fundamental analysis.

Bas Heijinktechnical analyst

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Downward breakthrough since 2009 rising bottom line... In the second half of 2018, the AEX index fell sharply: by more than one hundred points. During this decline, it broke downward through its rising bottom line, which had been increasing since 2009, on the logarithmic monthly chart. This marked the end of the bull market, which lasted almost ten years. However, the AEX did not continue its downward trend this year. At the beginning of 2019, a recovery trend started, which resulted in a new test of the heavy resistance zone of 574 to 577, which contains three old AEX tops. This means that the major top formation process, which started at the beginning of 2018, has not yet come to an end.

... but the downward trend is not yet continuing At the beginning of May, the AEX halted the strong rise from its December 2018 bottom at 574. A

quadruple tops zone thus appears to have formed. A following upward phase would only start with a structural movement above the 574 - 577 zone. However, we do not consider the likelihood of a new long-term upward trend to be very high at the moment. A downward continuation in the second half of 2019 seems more likely, with the 472 possibly coming under pressure again. That was the starting point for the recovery in December 2018. However, it will take considerably longer for the AEX to reach levels below 472, due to the powerful recovery trend in the first few months of 2019. Important in-between support points are at 530 and 517.

AEX-index Source: Reuters Metastock, 20 May 2019

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Source: Reuters Metastock, 20 May 2019

Bron: Reuters Metastock XIV, 29 mei 2017

Xetra DAX

Xetra DAX: target remains below 10,000 In 2018, the main German index Xetra DAX (DAX) broke through its rising bottom line, which had been increasing since 2009, earlier than many other indices. The contours of a very large head and shoulders pattern already became visible in the DAX since the beginning of 2017. This top pattern was completed in October 2018, also ending the ten-year bull market. The DAX fell back from 13,600 to 10,300 points. The recovery that also took place at the German stock market in the first four months of 2019

resulted in a very strong, but technically ‘normal’, correction test. The long-term chart still shows a pattern of repeatedly lower tops. The downward trend, the ‘bear market’, could continue in 2019 and bring the German index down to lower levels. After the bottom at 10,300 (an important support point), the zone at 8,700 to 9,300 forms a target zone. On the other hand, a structural (i.e. repeated) movement above 12,500 could start a longer ‘sideways’ consolidation phase before the downward trend is resumed.

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Sectors

Within equities, we currently have a preference for the financial sector (such as banks). We are also positive about the information technology

sector. Themes that play a role in many sectors are technological innovation and sustainability.

ING’s outlook by sector

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Consumer discretionary

The trade policy of the United States (US) is leading to a great deal of uncertainty in large parts of the sector. However, luxury goods sales in Asia are not affected. Global car sales, on the other hand, seem to be past their best.

Strong demand for luxury goods in growth market Asia

Cor Blankestijninvestment analyst

Strong influence of trade feud on the sector Looking back at our statements at the end of last year about a number of subsectors, we can conclude that we have assessed the developments fairly well so far. We foresaw that several subsectors would be affected by the negative impact of the US-China trade feud and the resulting import duties. Revenue and profit expectations are affected by the decline in US exports to China. But also the export of many goods from Europe to China has been negatively affected. Furthermore, as a result of changing insights and business models, subsectors, in particular the automotive sector, will have to invest billions in the coming years in order to comply with the current or future rules.

Too cautious about the luxury goods sector...Following the severe stock market correction at the end of 2018, we appear to have been too cautious about our outlook for 2019 for companies in the luxury goods sector. These companies have been making high profits for years, which translates into excellent returns on the stock market. We were afraid that global economic growth would be held back by the effects of the trade war to such an extent that

spending on jewellery, bags, watches and other luxury goods would fall. In this sector, the majority of sales and profits are generated in the US, but in Asia, most of the investments are made by companies. This is where the growth in turnover is expected to come from in the coming decades, especially from China and more specifically Hong Kong, the city where most of the ‘ultra-rich’ (with assets of $30 million or more) currently live. There were 10,000 at the end of last year, but in view of the price rises on the equity markets and the relatively large number of investors in Hong Kong, that number has probably risen since then. It is not without reason that Hong Kong has for several years now been one of the largest markets for the sellers of jewellery, bags and watches. Nothing seemed to change this trend. Even the Chinese government’s long-running anti-corruption policy caused only a ripple in the price chart of watch, bag and cognac manufacturers.

... or is the sting in the tail of 2019?Investors were afraid that the intensified customs controls at China’s borders would lead to a cooling of the Chinese luxury goods market. But these concerns, too, have so far proved unfounded. The

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grey import market, called ‘daigou’, was created by the fact that many Chinese in Paris, London, Milan and other European cities stocked up on large quantities of luxury goods. Although the daigou has shrunk since the tightening of Chinese border controls, the turnover generated by companies such as Kering (Gucci) and LVMH (Louis Vuitton, Dior) in China has actually grown faster. Their turnovers in China are now even close to that in Europe. The expected cooling of the market has thus not yet taken place. However, the US has still not concluded any trade agreements with China and the European Union; negative negotiation results could still throw a spanner in the works.

Was 2018 the year of ‘peak car’?Our expectations for the car market may be closer to our October 2018 estimate. The year is not yet over, but the number of cars bought in all major regions of the world is considerably lower than it has been in recent years. We thought that 2018 would be the year of the most sold cars ever. This would turn out to be a ‘peak car’ moment: an absolute high point in car sales (derived from the term ‘peak oil’ used in the oil industry). It may still turn out that ‘peak car’ was the case in 2018. Of course this is mainly due to the Chinese-US trade feud, but also to the fact that many consumers are postponing their buying decision because of the possibility of affordable electric cars in the near future.

Enormous investment in new technology neededConsumers have had to wait a long time for fully electrically-powered cars with an acceptable range of, say, 500 kilometres. While we could only turn to Tesla until recently, now every month manufacturers are producing new electric models with a comparable range. These are, however, far from being profitable for the car manufacturers. They therefore need to sell more of their other, but profitable, models in order to be able to make the enormous investments in new technologies. But that is not yet the case...

It is therefore going to become even more exciting for the large car manufacturers, because they also need the electric models to compensate for the CO2 emissions of their fuel-powered models. From 2021, new cars will only be allowed to emit an average of 95 grams of CO2 per kilometre in order to meet the requirements of the various regulators. Otherwise, it will not be the disappointing sales that will give rise to profit warnings, but the sky-high emission penalties. The car manufacturers have little choice.

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In February 2019, Kraft Heinz had to cut its dividend by 36% and write off no less than $15.4 billion on the value of some of its brands. Especially the Kraft and Oscar Mayer brands turned out to be worth less than their book values. Furthermore, profits and sales in the final quarter of last year were disappointing and the company announced that the US stock exchange watchdog SEC would be performing an audit. This combination of announcements, on one day in February 2019, led to a significant loss on the Kraft Heinz share on the stock exchange. In one fell swoop, the company lost $16 billion in market capitalisation and was only worth less than half of its 2015 level. In that year, Heinz’ top investors 3G and Berkshire Hathaway (the fund of superinvestor Warren Buffett) bought the H.J. Kraft group and merged the company with Heinz to form Kraft Heinz. Following the merger, the company had a value of $89 billion on the stock exchange; after the profit warning there was just $40.2 billion left. Since then, the price has barely recovered.

From top-of-mind…A few years ago, the company was still in the race to acquire Unilever, for a market price that the British-Dutch group has now achieved on its own. In

retrospect, we can be happy that the shareholders and management of Unilever did not opt for the quick profit at the time. The Unilever share is now listed at around its highest price ever, with Kraft Heinz at less than half its peak.

... to wake-up call.Merger companies like Kraft Heinz are often focused on achieving synergy benefits. That goes quickest by cutting costs. In the case of the takeover by 3G that was to cut back substantially on all marketing expenditure (such as advertising). The Kraft Heinz disaster is therefore a clear wake-up call for other manufacturers of consumer goods that have one or more so-called ‘blockbuster’ brands: brands with more than $1 billion in annual sales. Because it can be disastrous for manufacturers if brands, which are often carefully developed over a long period (in some cases decades), are forgotten due to inadequate marketing.

As we already described in Investment Outlook 2019, the consumer staples sector experienced several years of weaker growth than in previous years. As a result, many companies came into the crosshairs of activist shareholders, who demand a higher return

Consumer staples

Why advertise a brand that everyone already knows... Manufacturers of consumer staples sometimes make the wrong choices in an attempt to increase profitability.

Cutting back on marketing turns out to be a bad choice

Cor Blankestijninvestment analyst

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on their investment billions. Since it is difficult to sell more products at higher prices, the aim is often to achieve extra return by spending less on advertising and other marketing activities for products that are already known to everyone. The wrong choice, it appears. Many of Kraft Heinz’ competitors, such as Nestlé, Procter & Gamble and Unilever, have actually scaled up advertising and marketing expenditure. In the figures for the first quarter of 2019, the comparable growth of many companies had once more already exceeded 3%. This is more or less the minimum achievable growth rate, given the sector’s above-average valuation (such as the price/earnings ratio).

Healthy, healthier...Another point we touched on in the Investment Outlook 2019 were changing consumer needs. People have started to live more consciously and healthily, a trend that has been going on for some time, but one that has accelerated in recent years. More and more people are paying attention to the amounts of sugar, salt, dairy and meat they consume and are changing their lives, whether or not stimulated by their doctor, family or by social media. The response to this from companies is improving. Nestlé, Unilever and Danone, for example, have been busy for years introducing healthier variants of their top brands. With less, or absolutely no sugar, salt or meat.

Another trend in recent years has been to acquire local businesses with a healthy image, with the intention of marketing their products worldwide. In the past year, Nestlé and Unilever in particular have taken over many small businesses from the vegetarian sector. Danone made a billion-dollar investment in a company specialising in soya milk when it saw that the demand for dairy products was not increasing. We hope that these companies will realise that, in order to make and keep these products successful, they have to continue to advertise.

... healthiest.We have often discussed the tobacco subsector in our outlook publications - also in those for 2019. That is why we are letting you know that we will not be doing so any longer. Some investors may perhaps wonder why we made that decision. After all, the return was good, wasn’t it? Indeed, for a long time the tobacco sector was one of the best-performing equity investments, financially speaking. In the past, ING has also invested in tobacco companies for its asset management (with the exception of the sustainable investment strategies), and has delivered these

returns for our customers. But the big international tobacco companies have been struggling lately. The regulations are becoming ever stricter, which is understandable given the harmful effects of tobacco consumption. Just consider the increase in healthcare costs for governments worldwide. And, above all, the large number of deaths. Figures from the World Health Organisation (WHO) show that in 2017 no less than seven million people died from tobacco-related diseases. Six million from smoking themselves, the remaining million from indirect exposure to tobacco smoke.

We are stopping tracking tobacco companiesFor the above reasons, ING Group decided some time ago to stop investing in tobacco equities. Since the end of 2017, ING no longer includes equities from this subsector in the investment strategies for its asset management. We are also no longer following the tobacco companies. The equities of Altria and British American Tobacco (BAT) are therefore disappearing from the ‘universe’ of equities that are eligible for inclusion in any of the strategies.

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Materials

Little chemistry between businesses and politicians

Jenny Overmaninvestment analyst

Cost inflation and trade war start to make themselves felt2018 was an unstable year for the materials sector. On the one hand, there was strong economic growth, with rising volumes and prices. On the other hand, uncertainty began to hit home: is this the end of the economic cycle? Add to this rising commodity prices and the adverse effects of the trade war between the US and China.

Steel producers and construction companies were the main victims of complex trade restrictions, higher costs and forced changes in the production chain. Although the sector is priced as though we were already in the middle of a recession, the same risks play a role this year. Political and economic uncertainties dominate the news and costs are rising. Specialisation paid off last year in the chemicals sector, while in the case of mining firms it was mainly large companies with several types of raw materials that performed well. This year too, with the end of the economic cycle in sight, we believe that specialisation in the chemical industry and a broader view in the mining industry is a good choice. However, it is important to remain selective. The upheaval of globally connected production chains leads to major differences between material companies.

Mining firms down in the dumps?With every indication that the end of the economic cycle is near, the prices of mining firms take a step

back. The political uncertainty on both sides of the Chinese-US trade conflict is undermining stability. The valuation of the mining firms subsector is now again well below that of the broad stock market. This creates opportunities. However, a new round of import tariffs in the trade war or disappointing economic figures could undermine this recovery again.

Valuation premium of chemical companies at a low pointThe premium in the market valuation that chemical companies normally enjoy in relation to the broad equity market shrank rapidly last year. The end of a period of acquisitions, the trade war, rising costs and the risk of overcapacity were the reasons for this correction. Although a further escalation of the trade war will always remain a risk, commodity prices are decreasing somewhat in several production chains and this increases the ability of chemical companies to demand higher prices. Thanks to cheap shale gas in the US and China’s need to be more self-sufficient, production capacity will be added in these regions in the coming years. In Europe, investments have been limited this year.

Subsector in debtA period of major takeovers by chemical companies is behind us. As a result, the total outstanding debt with a BBB credit rating (only one small step above

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Price/earnings ratio world index and materials sector index

MSCI All Country World Index and MSCI All Country Materials Index. Source: Thomson Reuters Datastream, ING Investment Office, June 2019.

the ‘junk loans’ status) in this subsector has increased by 91% compared to four years ago. In comparison: mining firms have halved their debt in the last three years. Does the debt of the chemical companies represent a major risk for the sector? Not directly. With this money, the chemical companies have made acquisitions which, if all goes well, will contribute to their income. However, in view of the cautious profit forecasts, there is still a great deal of uncertainty about this. By no means all acquisitions succeed and high interest charges leave little room for new investments or dividend increases. For companies that are already weak, disappointing corporate data can therefore lead to a drop in their credit rating.

Counting on Trump?When President Trump took office, the US construction industry hoped for substantial investments in infrastructure. So far, no such investments have been made, while the costs of personnel and raw materials are rising. With a view to a possible re-election next year, infrastructure may return to the fore. This can give a welcome boost to producers of building materials. Although US companies seem to be the most logical suppliers in that case, many European building materials

companies also have a strong position in the US.

Price recovery for fertiliser producers does not yet make a summerWith China as a major consumer of agricultural products, the trade war also played a role in the fertiliser market last year. Political uncertainty is not the biggest challenge, however. The many years of decline in crop prices, resulting in low incomes for farmers, is much more important. In 2018, US farmers had the highest interest costs in thirty years, despite the historically low capital market interest rates. On the supply side, the market is expected to remain in balance this year. Chinese fertiliser production is not profitable this year either, in view of the higher input prices in that country. As a result, the price development on the world market may turn out to be slightly positive, but this will probably not be enough to compensate for the higher raw material costs. What remains are internal savings in order to maintain margins. With a view to the end of the economic cycle, fertiliser producers with access to cheap raw materials and that implement a strict savings programme can be a defensive choice. Caution is called for, however.

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Utilities

How do utilities respond to change?

Jenny Overmaninvestment analyst

‘Safe haven’ in less favourable times, thanks to relatively high and stable dividendsIn recent years, utilities’ equities have been relatively popular on the stock market, due to historically low bond yields. Investors looking for a direct return (interest or dividend) often chose the equities of utilities, which are known to be defensive. After all, the dividend is generally stable and, even in economically difficult times, there continues to be demand for the products and services of utilities, such as waste processing, energy and drinking water. Utilities’ equities consequently represent an alternative to (government) bonds. As economic conditions become more uncertain and central banks remain reluctant to raise policy rates, the utilities equity sector continues to offer a relatively stable investment option. But there is a price to pay: because of the years of ‘support’ from low interest rates, the valuation is no longer very attractive.

Traditional energy market production model undergoing overhaul… The necessary transition from fossil to renewable energy is also changing the structure of the energy markets. For example, via a ‘capacity market’: an auction where the energy production rights for the supply of the (expected) required energy are sold by auction. The United Kingdom and Italy already have such a capacity market, with varying results. Such an auction makes it possible to generate renewable energy without subsidies. At the same time, this system offers the guarantee that sufficient (regular) electric current is generated. France has a different

model. Here, the regulator establishes supply contracts whereby large producers have to offer part of their energy production at a fixed price. This stabilises prices for other market players. In the US, local production agreements are increasingly used. Large parties, together with the utility concerned, finance sustainable (renewable) energy production and purchase the entire production. This method is also receiving increasing attention in Europe, but there is still much to be done in terms of regulation before it works properly. It is clear that the traditional energy production model of the utilities sector will change in the future, and we expect that this change will be more rapid than most utilities assume.

... with specialisation expected, especially in Europe The changing energy market is forcing utilities to review their strategies and to specialise. This is clearly visible, for example, with the two major German players in the energy market, E.ON and RWE. E.ON will focus on the transport and supply of energy, RWE on the production of energy. Coal and nuclear power generation is declining, public subsidies for renewable energy are decreasing and the European energy markets are becoming increasingly interlinked. It is consequently less advantageous for utilities to be active in all areas at the same time. On the contrary, thanks to lower costs and superior technology, specialisation offers a competitive advantage. We would not be surprised if more utilities were to make pronounced strategic choices in 2019, especially in Europe.

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Stable network requires investmentsIn order to increase their earning capacity and improve the quality of the network, utilities will have to invest heavily again in the coming years. Smart meters, energy storage and infrastructure for charging electric cars will attract attention. But above all, balancing supply and demand on the network will require the largest investment. With the phasing out of nuclear and coal-fired power plants, energy supplies will become increasingly dependent on renewable energy sources that are difficult to predict. Utilities that are well organised in this respect are able to manage their network more efficiently and save costs.

CO2 pricing reduces profitability of coal-fired power plantsDue to the higher price of CO2 emission rights and the lower gas price, coal-fired power stations are becoming less and less profitable. Although the yields of gas-fired power stations are far from being more attractive everywhere, this point is fast approaching. In Spain and Poland, the fate of many coal-fired power stations has now been sealed. These polluting power stations will be closed down in the coming years. With the further reform of the CO2 market, the withdrawal of British producers from the market (due to Brexit) and new European gas production on the agenda, this trend also appears to be continuing this year.

Oil companies are also looking for a place in the sunNot only will the structure of the energy market be overhauled, but competition will also change. In more and more European countries, foreign producers can join the bidding for energy projects. This is taking place gradually, but may eventually become a challenge for large, domestically-oriented utilities. And competition from outside the sector is also increasing. Various oil and gas producers are looking for a place in the sun in the utilities sector. For example, through the acquisition of an existing gas network, the construction of gas storage facilities or through transport solutions for solar or wind energy. These entrants, the ‘challengers’ from outside the sector, naturally represent a threat to the existing parties. However, for many newcomers, these initiatives are only supplementary activities for the time being. Without the necessary scale, focus and long-term investments, we believe the impact on the sector will be less than expected for the moment.

Price/earnings ratio world index and utilities sector index

MSCI All Country World Index and MSCI AC Utilities Index.

Source: Thomson Reuters Datastream, June 2019.

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Financials

No Fed funds rate hikes: spanner in the works The interest rate policies of the major central banks, with the US Federal Reserve (‘Fed’) at the fore, have a major impact on profits and earnings growth expectations in the financial sector, since the central banks influence the interest rates on short-term loans (up to two years), including credit card loans, with their policies. Higher interest rates mean that banks can charge higher interest rates on new loans and existing loans with a variable interest rate. And with higher bond interest, insurance companies are also better able to cover their liabilities and risks. In general, higher interest rates are beneficial for the financial sector.

Earnings model under pressure...While at the end of last year we were expecting further increases in US policy rates in 2019, we have scaled back our expectations. The markets are going one step further and have even factored in a fall in the policy interest rate in the prices of financial instruments, such as interest rate swaps, before the end of 2019. As Simon Wiersma already wrote: such a scenario seems unlikely to us. However, the change in central bank policy does affect the earnings model of US banks as things are not getting any easier for them. They will not now be able to raise interest rates on their credit products. This is disadvantageous because many banks have recently been giving back an increasing proportion of the interest margin to customers by increasing the interest rates on savings deposits. On the other hand, the percentage

of defaults will increase less sharply than previously expected due to unchanged interest rates. This is particularly favourable for the riskier credit segments, such as credit cards.

... but worse for European banks than US banksExpectations for possible increases in central bank interest rates in Europe have also been revised downwards. While at the end of 2018 it was still expected that the European Central Bank (ECB) would announce its first interest rate hike after the summer of 2019, ‘the market’ now expects the policy rate to remain at its current level throughout the year. This means that the difficult conditions for the banks, with low interest rates pushing down the interest margin, will still continue for a while. However, the ECB has indicated that it is looking for ways to reduce the problems facing banks because of low interest rates. It could do this, for example, by ‘freeing up’ the reserves held by the banks at the ECB, on which the banks currently pay a negative interest rate (in order to encourage them to lend money to businesses and consumers). This policy is already applied by both the Japanese and Swiss central banks. However, while such a measure would be beneficial to European banks, it might send out a signal that the ECB has lower economic growth expectations. Which, in turn, is negative for confidence and therefore for economic growth. In short, market conditions remain challenging for European banks in the second half of 2019.

Mike Muldersinvestment analyst

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Investors cautious: fewer stock market transactions for banks The sharp falls in prices in December 2018 have made many investors anxious. A consequence of this is that there is currently a lot of money ‘on the sidelines’: it is not invested but saved. This puts pressure on the income from asset management. On these activities, banks earn a percentage of the assets under management. And although stock markets have recovered considerably since the beginning of the year, inflows of assets to be invested are still lagging behind. Several explanations can be given for this. Some investors, for example, are still hesitant due to the uncertainty surrounding Brexit and the trade war between the US and China. However, this could mean that in the second half of 2019, when this uncertainty diminishes, the inflow of assets to be invested will resume.

Strong capital positions: more possible for shareholders US banks currently have healthy capital positions. In other words, they have a considerable buffer to take hard knocks, should for example the economic situation deteriorate. The regulatory authorities perform annual stress tests to assess the stability of the banks. If a bank has a stronger capital position than the minimum required by the regulator, this gives it financial scope to distribute more profit to shareholders by means of dividend payments or the repurchase of own shares. The results of the stress tests in the United States are published annually in June. Banks that fail the stress test are forced to distribute less capital to shareholders and retain more capital on their balance sheets. A bad stress test result could therefore significantly limit the possibility of increasing dividends, but until now, US regulators have been very accommodating to US banks. And it is expected that the favourable, flexible regulatory regime for US banks will remain in place under the current Republican administration. The banks are therefore expected to be able to distribute a larger part of their profits to the shareholders.

Dividend, superdividend or repurchase of own shares?If a listed company has more capital on its balance sheet than it needs, this surplus can be distributed to the shareholders in various ways. The company can choose to increase the ‘direct return’: the dividend or a one-off extra high super dividend. Another commonly used method is the repurchase of own shares. As a result, fewer shares will be issued in respect of the company’s book value and profit and profit forecast. Normally, the market price will then

rise: ‘indirect return’ for the shareholders.

Brexit makes it more difficult for British insurersGlobally active non-life insurers have survived the hurricane season well, thanks to strong capital buffers and fewer claims than expected. In addition, the growth of the global economy helps to sell policies. For the reinsurers, who thus insure the risks of the regular insurers, this is disadvantageous because their services are less in demand and there is no opportunity to increase prices. In the meantime, the uncertainty surrounding Brexit is making things more difficult for British insurers. In the event of a no-deal Brexit, they will probably have to meet higher capital requirements in order to better withstand a reduction in the average creditworthiness of their debtors and the downward pressure on the property market. Since the beginning of 2019, more attention has therefore been paid to the debt position of British insurers. A further increase in bond yields is particularly important for life insurers. Life insurers with bond portfolios that have relatively short average remaining maturities and companies with large investment portfolios would benefit the most from this. It will therefore not be an easy second half of the year for the sector, given the various economic and political uncertainties. Nevertheless, we see compelling opportunities for some individual equities within the financials sector.

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Reasonable outlook for the remainder of 2019, but few spectacular developments expectedAs an asset class, real estate performed relatively well in the first four months of 2019. This was mainly due to the about-turn in the interest rate policy of the US central bank (the ‘Fed’). It has indicated that it does not want to raise interest rates further in 2019, so as not to slow down the economy too much. As a result, the risk of a sharp rise in bond yields has decreased for the remainder of this year. Nevertheless, the economic outlook in most regions is reasonable. Also, the valuations of globally listed real estate are not exceptionally high from a historical point of view. With a dividend yield of around 4%, we believe that the real estate asset class remains an attractive investment, especially against the backdrop of interest rates remaining low in the longer term. Moreover, real estate can contribute to the diversification within an investment portfolio. However, we are late in the economic cycle. In the second half of the year, unexpected inflationary surprises could again lead to upward pressure on bond yields. Partly in view of the structural problems faced by retail outlets and shopping centres in the US and Europe as a result of the growth in online

shopping, we have a neutral outlook on the real estate asset class. Therefore, we do not expect any extraordinary returns on listed real estate for the remainder of 2019.

Bond yield important factor in North America...As the world’s largest real estate market, the United States plays a decisive role in the North American region. The country therefore enjoys considerable interest from both domestic and foreign real estate investors. The current investment climate, with continuing economic growth, is favourable. But there are risks, resulting from the US-Chinese trade conflict and the possibility of rising bond yields. Both factors can slow down demand for real estate investments and thus the development of property values. However, US ten-year yields fell sharply in the first four months of 2019. This is due to the aforementioned about-turn in the Fed’s policy, making further interest rate hikes unlikely during the remainder of 2019. The central bank policy has therefore become considerably more ‘flexible’ (less focused on combating inflation). Previously, two interest rate increases were expected for 2019. This is a positive factor for real estate, but any signs of

Real estate sector

Real estate is a stable source of dividend income for many investors. A few percent of real estate in an investment portfolio, about 5% to 10%, also improves its spread as real estate prices regularly move differently from equity prices.

Dividends attractive, interest rate risk temporarily reduced

Jan Kleipoolinvestment manager

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surprisingly high inflation could still lead to a change in the Fed’s interest rate policy. We therefore remain cautious.

... where innovation can create opportunities in the retail marketConsiderable attention is currently being paid to the office market by real estate investors in North America. But the logistics centres for e-commerce activities (such as distribution centres for Amazon) also offer interesting investment opportunities. And although there is some oversupply in this sector, the same applies to the retail market. Innovative management companies, such as the large US real estate fund Simon Property, are accommodating modern, popular retail formulas in mostly renovated premises, with above-average returns. The rental housing market is an investment market that is growing in popularity, partly due to the increasing demand.

European real estate market picks upThe real estate market in Europe has recently been producing attractive returns. Germany in particular has been performing above average for many years and will probably continue to do so in 2019. There is constant, strong interest in retail property, offices and homes – especially in the seven largest cities. But real estate in the slightly smaller German cities is also gaining in popularity. The French real estate market has improved considerably in recent years and interest is still growing. With their office portfolios in France and Germany, many real estate funds now have an <<occupancy rate>> of well above 95%, which is high. However, in many European countries, as in the US, there are clearly structural problems with retail real estate. In this respect, we should mention France, the United Kingdom (UK) and the Netherlands. Retail chains are struggling due to the rise of e-commerce, resulting in an increasing number of bankruptcies, a lower occupancy rate

and decreasing numbers of visitors. In the UK, the uncertainty surrounding Brexit also has a negative impact on consumer confidence. As a result of these developments, the valuation of retail real estate is – rightly in our view – on the low side.

Opportunities: e-commerce real estate and officesThe e-commerce subsector is a relative newcomer to logistics real estate in Europe. This market is growing rapidly. Centres that focus on <<local distribution>> have the best future prospects. These are large centres in sparsely populated areas in Western and Central Europe, and smaller distribution centres on the outskirts of larger cities. The growth of e-commerce does however have negative consequences for the returns on retail real estate because retail rents are often based on a percentage of the turnover realised. The conditions for offices are improving, however. This market can benefit from the improving economic conditions – especially when it comes to ‘sustainable’ real estate, which, for example, is CO2 neutral in use.

Real estate market in Asia different from the WestThe Asia-Pacific region comprises the world’s fastest growing economies and offers plenty of opportunities for real estate investments. The region is dominated by China, where major economic changes (such as urbanisation) have led to rapid growth of the middle classes. Investors can benefit from this by focusing on shopping facilities in the larger Chinese cities. The average consumer in Europe or the United States is not attracted to super luxury branded stores. But the new middle class in the Asia-Pacific region, like many ultra-rich consumers, wants to buy its products in this type of high-end stores. Here, the demand for retail property remains high. Of course, the real estate market in Asia is very diverse, and developments differ from country to country and per subsector (offices, shops, homes, etc.).

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Although the economic developments of recent years have had a positive effect on the turnover of many companies, the risks are increasing in this late phase of the economic cycle. Global demand, which is picking up thanks to growth, has led to greater production. But not all business sectors have sufficient capacity for (strong) expansion of production. New investments would be required for this. For the industrials sector, of course, this is good news. The increasing demand also leads to higher prices of raw materials. The profitability of industrial companies is therefore linked to the possibility of incorporating the price increases of raw materials into the prices. This is an uncertain factor. Besides economic developments, political developments also have a strong influence. Recently, this influence has been predominantly negative. On the other hand, the economy is performing better than expected at the end of last year, which has had a positive effect on the price development.

Airline companies: no straight ascending lineCompetition remains fierce in the airlines subsector. Over the years, this segment has acquired a bad reputation with investors, partly due to the many strikes and bankruptcies. In previous years we expressed our preference within this subsector for US ultra-low-cost carriers: extremely low-cost airlines that are able to offer tickets at low prices. The business model of this sub-segment and the

growth of the consumer market have had a positive impact on the results of these companies. But in recent months a reversal has occurred in the results and profit expectations. Increased competition from regular airlines – so-called premium carriers – rising fuel costs and increasing overcapacity are important causes of this. Most US low-cost airlines only fly on domestic routes. They were able to maintain their growth for years by offering more routes and flights at ever lower fares. However, this business model seems to be rather worn out, now that there is greater market saturation. Air transport capacity is growing faster than ticket demand, which is weighing on profit margins, and thus on the result below the line. Adapting to the new market situation takes time. Not all parties seem to have found the right answer, so that large differences in returns have arisen. We expect this development to continue. In addition, there are the problems with Boeing’s 737 MAX aircraft, which has been grounded since March following two fatal accidents in half a year. This aircraft is relatively widely used by the ultra-low-cost airlines. The (temporary) taking out of service leads to extra costs for them.

Transport: helped by the economy, hampered by rising costsTransport is a very diverse and highly specialised sub-sector. Broadly speaking, transport companies can be divided into two groups. On the one hand, the

The industrials sector is not only sensitive to the economy, but also to political factors. Sea freight, for example, is very dependent on the growth of world trade. Import tariffs pose an additional source of uncertainty.

Is growth finished?Industrials

Eric de Graafinvestment analyst

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railway companies and ship carriers, which focus on the transport of bulk goods. On the other, the postal companies and package carriers, which take care of the smaller consignments. The US railway companies keep the industrial sector in the US running by transporting raw materials and finished products. This automatically makes them an important indicator for the – still smoothly running – US economy. Volumes are healthy, although some bulk goods, such as coal, have fallen out of favour somewhat. Besides volume, efficiency and reliability are important aspects for profitability. For the time being, this subsector is still enjoying average revenue growth of 3-4%, leaving room for double-digit profit growth rates. Driven by this profit growth, there has been above-average price performance in recent months. As a result, valuations, such as the price/earnings ratio, have now exceeded the subsector’s long-term average, however.

Parcel hauliers, as expected, are having a hard timeSea transport is highly dependent on international trade and although most economies are running smoothly, global trade is growing at a lower rate. This is due to political factors, such as Chinese-US trade tensions. We expect that the maritime transport sector will continue to find things difficult for the time being. Another aspect that makes us less positive about this subsector is the overcapacity among shipowners. On the other hand, e-commerce turnover (webshops) continues to develop favourably in line with our outlook and that means: high parcel volumes. We previously wrote that parcel carriers, and postal companies to a lesser extent, can benefit from these higher volumes. A condition for this, however, is that these companies invest heavily

in capacity, in order to be able to cope with the volumes, even at peak times. It looked good for the subsector, but recent market developments have tempered our expectations somewhat. For example, online sales giant Amazon – which accounts for a significant proportion of all parcels sent in the United States – has indicated that it wants to do the delivery itself, which is a disappointment for parcel carriers. Labour costs within the sector are also rising due to a lack of personnel. Another setback was the extreme

winter weather in the United States, which caused the year to start disappointingly.

Conglomerates such as GE and Siemens: end of an era?For decades, the Siemens industrial conglomerate has been regarded as an important indicator of the state of the German economy. The same was true for General Electric (GE) in the US. But the attractiveness of conglomerates – their spread across different sectors – has declined in recent years. Investors are increasingly able to attend to diversity in their investment portfolios themselves. Furthermore, conglomerates are currently unable to take sufficient advantage of their range of activities. Because they do not maintain sufficient oversight and focus, certain activities do not perform as well. GE and Siemens are now increasingly focusing on their strengths. For GE in particular, this is a difficult and far-reaching process, characterised by extra write-downs on its book value and major reorganisations. During the past two years, the company lost more than half of its going-concern value, but in recent months, GE’s share price has shown a strong recovery. Neither Siemens nor GE appear to be particularly highly valued. Time and again, however, new problems arise, which put pressure on profits. Both companies have a large division for the construction of power plants. These divisions are suffering from poor results due to limited investment in new power stations. Investors and governments are increasingly interested in reducing greenhouse gas emissions and many utilities are consequently shifting their focus to renewable energy. GE and Siemens are also active in this field, but on a small scale for the time being. This makes these companies less profitable.

How profitable will wind energy become?The current share of wind energy in global electricity generation is about 7%. But it is generally expected that wind turbines will have an ever increasing share in the coming years. The estimates for this vary, but we consider a doubling of the amount of electricity generated from wind power by 2040 to be realistic. However, there are many players in the market and there is increasing pressure on prices. The fact that governments have switched to public tenders plays an important role in this.

Temporary employment agency sector: heading for contraction?At the rising start of the economic cycle, we see strong growth in the temporary secondment of personnel. Companies may then see opportunities

Amazon wants to deliver parcels in the US itself

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for growth, but hardly dare to hire permanent staff. At the moment, we are much further in the cycle, i.e. in the final growth phase. It is then more realistic to assume a period of at most limited growth and ultimately even contraction in this part of the industry sector. Valuations have also risen sharply in the temporary employment sector, because it appears that the economic trend will remain positive for a longer period of time. Nevertheless, we see a structural risk for the temporary employment sector. More and more companies are using apps to make direct working arrangements with standby workers and self-employed persons. Temporary employment agencies no longer play much of a role in this process, as a result of which their market is shrinking.

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The demand for oil in the sector is still growing. In addition, the oil market is currently in a state of ‘backwardation’. This is a term from the commodity futures market, meaning that prices for future delivery are lower than prices for immediate delivery. It is therefore less attractive for traders to store oil. It is also a sign that the market does not believe that any major shortages are imminent. We, too, believe that the oil market is more or less in balance and expect the price of oil to continue to fluctuate between $50 and $75 (STI) in the coming period. This is a price that is acceptable to most members of OPEC+. Many analysts expect that at this oil price, the supply of oil will not exceed demand.

Super majors, upstream/downstream and oil servicesIn the energy sector, major oil companies such as Royal Dutch Shell, ExxonMobil (Exxon) and BP have both an upstream division (for pumping oil and gas) and a downstream division (refineries, petrol stations). The combined market value of these so-called ‘super majors’ amounts to around 47% of the sector’s total market value. In addition, this sector also includes companies that focus only on the pumping up of oil and gas (upstream), and companies that only refine (downstream). But the sector also includes oil service providers (oil service companies). These supply, for example, the cranes for oil rigs or the specialist technical knowledge for

Energy sector

Not yet done with oil

David Wolters investment analyst

Oil and gas prices strongly influence the profits of companies in the energy sector. The price of oil has now risen by about 25% in 2019. At the end of May 2019, when this text was being written, the price of a barrel of crude oil fluctuated around $56 (US STI oil) and $65 (European Brent oil). This is partly due to the agreements made by ‘OPEC+’. The members of this cartel body keep closely to the agreements made on reducing production. The idea is that if oil production in the US increases sharply, it will need to be limited in order to maintain the price. The members of OPEC+ do not want the price of oil to be too low, because their economies depend to a large extent on oil revenues and therefore on the level of the oil price. But the sanctions against Iran and Venezuela are also curbing oil production.

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the offshore drilling for oil, sometimes at a depth of many kilometres. Examples of oil service providers are Schlumberger and SBM Offshore.

Pressure on prices in the market for oil services for the time beingDue to the volatility of the oil price in recent years, the major oil companies pay much more attention to costs. This also means that the super majors invest less in exploration and production. As a result, the profits of the major oil companies have increased considerably, while those of oil service providers have fallen drastically. Some oil service companies are making a loss. However, there are signs that more and more is slowly being invested in exploration and production. That is essential, because oil and gas production will fall if there are no investments. Exxon, for example, recently announced a substantial increase in its investment budget. The group expects to invest a total of $63 to $65 billion in 2019 and 2020, including $46 to $48 billion in the upstream division. This is good news for the oil service providers. However, we think that we are only at the beginning of a structural recovery, with the profits (and prices) of oil service providers remaining under pressure for the time being.

Our preference: large oil companies For the second half of 2019 we have a preference within the energy sector for the super majors BP, Chevron, Exxon, Total and Royal Dutch Shell. In recent years, these groups of companies have had a strong focus on cost savings. Their break-even points, i.e. the oil price levels at which operational cash flows equate to investments and dividends, are therefore significantly lower than a number of years ago. The exception is Exxon, where the break-even point (the required oil price) is higher because the group invests more. In the assessment of the super majors, we pay particular attention to the operational cash flows, the investments and the dividend. What we like to see are companies that pay strict attention to costs, only make the right investments and operate fields that produce a lot of gas and oil. These are prerequisites for a strong increase in free cash flow and for an increase in profits in the coming years. Within the super majors we have a preference for European players. Shell, BP and Total have lower valuations and higher dividend yields than the US super majors. Furthermore, Shell and Total also have a higher profit growth rate. In the event of a sharp increase in free cash flow, these companies will be able to distribute more capital to the shareholders by means of

dividends and the repurchase of own shares. In view of the expected average growth of free cash flow in the coming years, we believe that these companies will also be able to maintain their shareholder-friendly policy for a long time to come.

Oil services sector is still struggling We are less positive about the oil services sector, because turnover and profits in this subsector are still under severe pressure. The list of equities that we follow includes several names from this subsector, such as Schlumberger and Baker Hughes. Both companies are major players with strong market positions and ‘generate free cash flow’ (i.e. make a profit). But there is still overcapacity which puts pressure on prices. Moreover, there are fewer orders worldwide due to the fact that the oil companies are investing far less than a few years ago. Analysts have therefore significantly reduced their profit estimates for both companies for 2019 and 2020 during the past twelve months. Moreover, the valuations (such as the price/earnings ratio) are on the high side. We therefore do not expect any strong price performance from the oil service companies in the second half of 2019. However, it seems that the worst is over for this subsector.

Investments in renewable energyWhile the European super majors are investing in ‘sustainable’ (i.e. renewable) energy, their US counterparts have done little so far. Nevertheless, the investments of the European super majors are still relatively limited in comparison to those in oil and gas extraction. For example: In the coming years, Shell will invest $1 to $2 billion a year in, for example, the development of hydrogen, biofuels, wind and solar energy and other green energy technologies. That is only a few percent of the total investment budget. Shell and pension administrator PGGM are, however, investigating a possible acquisition of green electricity supplier Eneco. The oil group is making all these investments because it foresees a strong growth of the electricity market. We consider such investments to be positive, because they demonstrate that the oil companies are responding to a changing future.

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Following a volatile end of the year, the sector started weakly in 2019. As economic confidence recovered in the first quarter, the qualities of the sector became relatively less attractive to investors. Moreover, the election season started in the US: not only will there be presidential elections again in 2020, but half of the Congress will also be re-elected. The sector is being blamed this year by both the Democratic and the Republican side. Despite this pressure, the sector is in good shape: development pipelines are well filled, the debt position has fallen and the valuation has been normalised. As the year progresses, the political risks for the sector will become easier to assess and the underlying quality will become visible again.

The development of new medicines and market presents opportunitiesFollowing a period of high expectations, disappointing product development and expiring patents (allowing ‘unbranded’ medicines to gain market share), the pharmaceutical companies generally now have a well-filled product development pipeline again. Thanks to targeted acquisitions and a sharper focus on the internal processes in the research departments, a variety of product portfolios have recently been created that are able to compensate for the expiring patents of most manufacturers. New areas of research, such as cancer immunotherapy and gene therapy, will bring a lot of news from product development. Pharmaceutical companies with a less well-filled or poorer quality product development pipeline will have to enter the market in order to make an acquisition. These will mainly be purchases from small players or specific know-how,

which can be quickly integrated into the existing product development, since large takeovers require a lengthy integration process and can count on considerable attention from regulators, thereby increasing the risk of failure.

Opportunities in emerging marketsThe healthcare system in emerging markets is modernising at a rapid pace. Insurance systems are being introduced, lifestyle diseases are beginning to occur and the demand for high-quality care is growing. This offers opportunities for Western healthcare companies in terms of sales, production and development. By offering medicines and medical products that have ‘outgrown’ the home market in the emerging countries, these older products are given a second life. Caution is called for, however: in the field of patents and quality control, the differences with Western markets are considerable. A strong focus, local knowledge and a long-term perspective are required to succeed here.

Boring is sometimes an advantageIn recent years, many pharmaceutical companies have disposed of their activities in areas such as vaccines, healthy foods, veterinary medicine, personal care and agricultural chemicals. The reason: these ‘related’ products usually have weaker growth and lower profit margins. Such activities are however less sensitive to political risks and, if run efficiently, can contribute to stable revenue streams. Companies in the pharmaceutical sector that have retained and optimised their related activities can benefit from this if political pressure on healthcare costs increases

Healthcare

Quality and innovation as an answer

Jenny Overmaninvestment analyst

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further. The steady flow of income then supports the equity price, compared to that of pharmaceutical companies that no longer have related activities.

Political risk remains presentThe discussion about the healthcare costs in the US will continue for the time being. For both prominent Democratic and Republican politicians, these costs are an important issue on which they can make a name for themselves in the run-up to the Congress and Presidential elections in 2020. Election rhetoric and extreme proposals, such as the abolition of the private insurance system, will continue to put pressure on the prices of companies in this sector, despite the limited feasibility of such plans. Both health insurers and pharmaceutical companies with the majority of their activities in the US are affected by this. Some new rules will lead to changes as early as next year. We believe that this could reduce some of the pressure on prices, because a very negative scenario already seems to have been incorporated into the prices.

‘Generic’ medicines: a solution for higher healthcare costs?When a branded medicine’s patent expires, it paves the way for other pharmaceutical companies to

replicate the medicine and market it at a lower price. These so-called generic drugs can save patients and the healthcare system a lot of money. But the producers of generic medicines do benefit from the existence of healthy pharmaceutical companies that introduce high-quality products; they are then able to copy them. That is why the firm government intervention directed towards pharmaceutical companies also affects them. Looking at the trends in the business operations of pharmaceutical companies, a recovery can be seen after years of high debts and overcapacity. If the fall in prices stabilises and confidence in the financial diligence of the large corporations increases, generic medicine manufacturers will be able to show a price recovery on the stock market.

Another difficult year for biotechnologyProducers of innovative medicines based on biological material, so-called biotech companies, are once again entering a challenging phase. The setbacks in the product development of some of the major biotech companies do not do any good to the nascent confidence in the product pipeline. In addition, the expiring patents continue to put pressure on revenues. It was expected that the very low valuation would stimulate interest in acquisitions

Price/earnings ratio world Index and healthcare sector index

MSCI All Country World Index and MSCI All Country

Healthcare Index. Source: Thomson Reuters

Datastream, ING Investment Office, June 2019.

Healthcare

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by large pharmaceutical companies. But apart from a few transactions, they are keeping a tight hand on their purses for the time being. It therefore also seems unlikely that the prices in this subsector will be boosted by the major pharmaceutical companies.

Remote care and medical technologyManufacturers of medical equipment and medical service providers are usually not affected by political discussions. Their products and services form a relatively small – albeit indispensable – part of a medical treatment and their share in the total costs is also limited. However, these companies do benefit from the increasing digitisation, individualisation and

remote care. In addition, they often operate on a global scale and also supply part of their products to companies outside the healthcare sector. The average valuation in this segment is therefore well above the average for the sector. This year too, it looks as if they will continue to live up to the high expectations, although caution is called for.

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Within the information technology sector there are large differences in growth. The US market leaders generally perform well in their business operations. And in 2018 they were clearly helped financially by the Trump administration’s tax cuts. In a number of areas, some slowdown in growth is visible, however.

Market leaders perform strongly, but cracks appear

Information technology

Eric de Graafinvestment analyst

At best, the markets for smartphones and PCs will only grow to a limited extent in the coming years. The semiconductor sector is also currently experiencing a cyclical slowdown. At the moment, the strong growth is mainly in the providers of cloud services and data processing.

Operational growth translates into strong price performanceEquities from the IT sector have in 2019 up until now, as in previous years, on average been performing well on the stock markets. For the time being, this investment performance is fairly evenly distributed across all subsectors. For example, the equity prices of companies from the semiconductor industry have made up lost ground, with the expectation that the cyclical slowdown has already passed its low point. There are also clear differences in price performance within the subsectors, where the market leaders often did better than average in other years.

Following an adjustment in the sector classification, IT has a more hardware character

On 1 October 2018, the leading index manager Morgan Stanley Capital International (MSCI) made significant changes to the sector allocation. We (ING Investment Office) also use the MSCI indices for our sector allocation. Social media companies such as Facebook and Alphabet (Google’s parent company) and game software developers such as Nintendo and Electronic Arts (EA) are now classified in a different equity sector. As a result of this shift, semiconductor manufacturers and IT service companies have become much more important within the IT sector. You could say that the IT sector has become much more hardware-based.

Limited growth for PCs and smartphones, consolidationIn recent years, many initiatives have been presented that could eventually generate a significant proportion of the turnover in the hardware segment. In doing so, they create growth. Examples include (self-driving) electric cars, all kinds of robotics applications and virtual and augmented reality (VR and AR). Although the outlook for the long term still

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remains good, a number of these markets appear to be under pressure in the short term. Causes are the US-Chinese trade war and a slightly overoptimistic inventory accumulation.The hardware subsector also needs new growth markets, since the more traditional PC and smartphone markets are expected to grow at best to a limited extent in the coming years. Consolidation is taking place throughout the chain, although global regulators regularly veto this. The clearest example of this is that Qualcomm’s acquisition of NXP Semiconductors in the semiconductor sector ultimately did not receive approval from the Chinese regulator. The Chinese veto has certainly slowed down the pace of consolidation.

Semiconductor prices have already risen sharply during the cyclical slowdownSemiconductors are particularly sensitive to fluctuations in demand due to their production process with high start-up costs and round-the-clock production. The production has to be sold, so prices are very volatile. There have especially been positive effects in the memory chip market in recent years due to strong demand and insufficient supply. Extremely high margins, sometimes exceeding 50% net margin, pushed up prices, although valuations only partly reflected this. An increasing supply combined with weakening growth in demand leads to a fall in prices: and this is the phase in which we currently find ourselves. For the time being, it does not appear that there is anything more than a normal cyclical slowdown. Equity prices have already risen considerably on that assumption. In addition, restraint in the trade war would be very beneficial for the sector. After all, China and the United States are important links in the production chains.

Impressive growth in cloud services, but not all companies reap the benefitsMany technology companies have invested in a presence in the cloud in recent years. The impressive growth figures of major players in this field, such as Microsoft, Amazon, Alphabet and IBM, therefore did not come as a surprise. The growth rate will slow down slightly, but will remain strong, as will the

necessary investments. Here too, we expect smaller players to realise that profitability on an autonomous basis is ultimately unrealistic. Cooperation or consolidation seems to them to be the only way to continue playing a role alongside the big players with a much larger budget. For the moment, the construction of large data centres is an important source of income for companies such as Intel and Nvidia, but also for all kinds of other suppliers.

IT service providers: data processors very successfulThe largest companies in the IT services subsector are data processors, such as Mastercard and Visa. Thanks to the growing flow of payments, these companies have performed extremely well in the past quarters. The fear that Apple Pay and Google Pay would have a negative effect on these companies has largely faded away. More cooperation than displacement is taking place. It certainly does not appear that turnover growth is exhausted, even though the market value (such as the price-earnings ratio) has become high.In a structural sense, things are slightly more difficult for the pure consultancy firms. But they are benefiting from the economic recovery thanks to previous selective acquisitions and cost optimisation. Due to the ongoing economic recovery in large parts of the world, we also anticipate turnover growth in 2019 and the first years thereafter. But a significantly higher average profit margin is not automatic. In the longer term, we only see relatively limited growth. IT specialists are often hired by external IT service providers. As a result of the structural transfer of activities to external cloud services, customers of IT service providers ultimately require fewer IT specialists who, as already stated, are then often hired in by these IT service providers. We therefore do not expect profit margins, and thus stock market valuations, to return to historically high levels again.

A decrease in trade tensions would be beneficial for the IT sector

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The most important themes in the new sector are advertising growth and the constant craving for content. For the telecom companies it is important that the regulators approve mergers and takeovers, so that they obtain more and better content in order to maintain consumer loyalty. In addition to feature films, this also includes sports broadcasts with examples including VodafoneZiggo’s broadcasts of foreign football and Formula 1 races. The financing and construction of 5G networks are also prerequisites for growth.

Launch of new sector: ‘communication services’The fact that telecom, media and IT companies are increasingly seeking one another out has not escaped the notice of MSCI, an index compiler. That is why, since the start of the fourth quarter of 2018, this leading institution has included the businesses in the telecommunication sector in the newly formed communication services equity sector. In addition to all companies from the former telecom sector, this also includes digital service providers such as Facebook, Alphabet (Google) and the Chinese company Tencent. Media companies such as Disney, Netflix, WPP and Electronic Arts are also included in the communication services sector. Measured in terms of total market capitalisation, telecom companies now only account for 35% of the market

value of the communication services sector.

Digital service providers: stronger growth, greater risksThe shift from traditional newspaper advertisements and radio and TV advertising to online advertisements that was started some time ago is continuing at full speed. Facebook and Alphabet are benefiting enormously from this. Together they have a market share of about 50% of global online advertising. Amazon is nibbling away at that, however. Growth is therefore slowing down. Discussions about market abuse, tax avoidance and the distribution of fake news will lead to additional costs and possibly increased supervision. It is still unclear what measures will be taken to limit the dominance of the internet giants. But this is a source of concern, even though the financial implications appear to be limited.

In the second half of 2018, this combination of negative factors put considerable pressure on equity prices within this sector. Because there is still above-average profit growth while prices did not rise, valuations have generally fallen sharply. In the first months of 2019, prices have already risen sharply and valuations have returned to a level that is more in line with the expected growth.

Communication services

The profile of the communication services sector has changed drastically as a result of the change in the classification of the global equity sectors. Telecom companies now account for only 35% of the sector’s market value. The rest consists of ordinary and social media companies.

New sector offers a lot of choice; differences are considerable

Eric de Graafinvestment analyst

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Media and entertainment: great opportunities, major threatsWith media and entertainment companies, there are now two groups in the new communication services sector that have completely different growth patterns and valuations. After all, they do not have the same function and earning models as the rest of the sector. For media companies, it is mainly the case that the money must be earned with advertisements. This is certainly not an easy task, because the offline part of those markets is under pressure. The shift to online advertisements has resulted in the loss of a lot of revenue, because in many cases they require less involvement from intermediaries (such as advertising agencies) and can be booked directly.

Most entertainment companies create their own content, ranging from films, series and music to computer games, and also remain owners of them. This can be seen in the above-average growth and valuation (such as the price/earnings ratio). The acquisition of these companies, popular because of their attractive content, leads to discussion. It goes too far to say that all companies in this sub-sector will eventually become part of a larger whole. But given the considerable costs involved in developing new films and games, it is logical to expect that acquisitions will follow in this segment. Companies such as Alphabet and Tencent are also looking for content to make their offering more attractive to consumers.

Telecom companies seek growth in mergersIn recent years, many takeover initiatives have been started in the telecom sector. Some of these have also been completed. The reason for this is clear: the years of declining revenues and the increase in digital solutions, which are replacing traditional telephony services. Relatively new is that proposals have been made for horizontal integration in both the US and in Europe. In recent years, such acquisitions have almost always been rejected by the relevant regulator in order to maintain market relations and thus also competition. It is still unclear how the regulators now look at this, but they seem to be rather more inclined

to grant approval because the smaller providers have great difficulty continuing to compete and invest. Following the acquisition of Time Warner by AT&T and Sky by Viacom, mergers between various media companies are still planned in the US. In Europe, too, regulators have to assess a number of major acquisition plans. Given the difficulties with mergers in the past, a consolidation bonus in the prices is currently hardly anywhere to be found. No extra high prices, therefore, due to speculation about a takeover bid.

Necessary investments drive up expenditureAll these acquisitions cost money, while the necessary investments will increase in the coming years. The start-up of 5G, expansion of fast internet and other investments are expected to lead to higher expenditures in the coming years. The auctioning of the frequency spectrum for 5G networks in Europe alone is expected to cost the sector 10 billion euros. However, the average corporate debt in the sector is lower than a few years ago, although the expected revenues have also decreased. A period of rising investment costs and declining cash flows is on the horizon. This increases the sector’s sensitivity to higher interest rates, which would increase funding costs and reduce the relative attractiveness of equities over bonds.

In addition to the intended synergies, which should result from the many telecom mergers, cost savings should make a significant contribution to cash flows. Fortunately, there are still opportunities here, such as switching off outdated networks. With a fully operational 4G network and the stable 3G as a backstop, older technologies are no longer needed. Another possibility is to switch to ‘unlimited subscriptions’, which would make the administration of telephony, text messaging and data bundles superfluous. The digitisation of maintenance, services and network management can also save a lot of costs.

5G must fulfil future dreamsThe promise of the blessings of 5G is not new. But with the actual start of commercial roll-out in the US and Asia at the end of 2018 the application of this new technology is finally coming closer. With 4G, telecom companies mainly supplied the infrastructure and other parties provided the innovation. With 5G, however, they hope to return to the forefront of digital innovation again. 5G offers internet speeds that are many times higher than 4G. More importantly, there is less delay in sending a

‘Content is king’ in the seduction of media consumers

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digital command from A to B, which should facilitate the large-scale use of drones, self-driving cars and other technological pipe dreams. But in many cases these are still just dreams.

Turning investment in 5G into actual income is a challengeFor the time being, consumers will have to wait for their new 5G phone. By the way: it is already possible to watch an episode of your favourite series on your smartphone. Converting the investments in 5G into actual income is the big challenge for telecom companies in the coming years. Companies that take the lead in this can quickly build up an advantage over competitors. This is perfectly feasible in cooperation with a company that needs large amounts of data. This also applies to a company with self-driving cars such as Waymo – a subsidiary of Alphabet – which could, for example, be a forerunner in this field.

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Disclaimer

This investment recommendation was prepared and issued (in Dutch) by ING Investment Office, part of ING Bank N.V., for the first time on 13 June 2019, 4.30 p.m. For the preparation of this investment recommendation, use was made of the following substantive sources of information: BofA Securities, Goldman Sachs, KeplerCheuvreux, Bloomberg, CreditSights, Standard & Poor’s, Moody’s, Fitch, ING FM, Citi, J.P.Morgan, Thomson Reuters Datastream, Sustainalytics, Credit Suisse and/or Reuters Metastock. This investment recommendation was based on the following accounting principles, methods and assumptions: price/earnings ratio, price/book value ratio and/or net asset value (NAV). No protected models were used for this investment recommendation. A description of the ING policy regarding information barriers and conflicts of interest can be found here.

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