2H16 Investment Strategy: O$ (don’t need to) P$

Brexit is not going to tip the global economy into recession given the economic impact is

highly localised to UK while the financial contagion is limited largely due to ECB and fellow central

bankers’ back-stopping via inter-bank swap lines and outright quantitative easing. But want it did is

to add another layer of pernicious uncertainty to an already precarious state of the global economy.

We have seen 2016 global GDP growth forecast downgraded by 30bps to 2.70% for 2016 since

our last quarter update and post-Brexit. We also see downside risk to current consensus GDP growth

forecast of 3.2% for 2017, which we believe will likely be closer to 2.9%. At those rates, it will mark

the fourth year the global economy has meandered at such sub-par pace; not quite recessionary but

just tepid. It also marked the continual of a bifurcated growth model with consumption looking

robust only to be marred by increasingly worrisome signs of deteriorating manufacturing and

investment outlook (See “Fear to Feh to Faith” Mar 2016, “Book of Job(s)” Jun 2016 for elaborative

comments on the latter).

Consumer spending remains expansionary

2016 growth downgraded and 2017 is at risk too but investment and manufacturing In doldrums

However, we re-affirm the view a global recession in the magnitude of 2008-2009 is

unfounded. In addition to the business confidence indicators we tracked that are pointing a

continuation of growth, market risk barometers and recession modelling analysis do not foretell an

imminent recession. For some of our long-time readers, they may be familiar with our presentation

of Citibank’s recession watch list. The list is a compilation that captures how much risk is being

priced by the equity and fixed income markets, the level of corporate surfeit and balance sheet

vulnerability.

Citibank’s recession watch list: Only a few ambers.

Of the 18 indictors they track, only high Net Debt/EBITDA and elevated High Yield Credit

spreads are at or above past pre-recessions of 2000 (dot-com bust) and 2007 (GFC). Both indicators

are symptomatic of the problems in the energy sector. But with oil prices having double from its low

at the start of the year, we have argued the worst is behind us and arguably, the current elevated

credit spreads of US high yield are over-stating actual default rates. A more sophisticated predictive

recession model employed by Goldman Sachs drew the same conclusion that recession risk is not

elevated on a global scale except for UK and Japan.

GS’s recession model only UK and Japan at risk

Nonetheless, the spectre of earnings downgrade evident in the last three years persist into

2016 and are at significant risk of downgrade for 2017. Despite analysts being prevalently bearish,

2016 earnings estimates continued to be downgraded from 9% at the start of the year to only 2%

currently. But it is 2017, where earnings estimate is forecast to rebound to 13% seems quite out of

sync with top-down macro uncertainty. Our own guesstimate that global GDP growth for 2017

should be at 2.9% which means EPS for that year could be downgraded by another 300-500

percentage points as we head into 2017 setting the stage for global earnings to be range-bound with

-2 to 8% over the last three years; quite uninspiring especially against the backdrop of relatively fair-

valuations for equities.

Precipitous downgrade in 2016 EPS estimate and 2017 too optimistic

With major assets classes at fair to stretched valuations, upside potentials are also capped.

Global equity markets are now trading at 18x trailing PE which is in-line with its 40years average

while on cyclical-adjusted PE it is also at its 30years average at 24x when adjusted for earnings

downgrade. No thanks to a record number of governments adopting negative interest rate policy

(NIRP), there is simply no value to be found in government bonds as they are trading at -2 standard

deviations from its 12years band. A third of government bonds are trading at negative yield and is

expected to rise to 40% by end of this year!

Equity markets fairly valued No value to be found in government bonds

The volatility of major assets classes is rising and on numerous occasion is accompanied by

convergence in cross-asset correlations. Geopolitical risk is amplified acutely and investors vacillate

from fear to feh back to faith often within weeks. This has transgressed portfolio diversification from

a science into art from.

Asset Allocation Strategy:

In a convoluted monetary environment where one can O $ (owe money) and yet don’t need

to P $ (pay money), the modal profit maximization mind set of corporates and investors have been

impaired. The ability of negative interest rate policy to induce sustainable growth and raise inflation

in the longer term remains contentious and circumspect as well. Against the backdrop of tepid

growth, earning downside risk, fair valuations and elevated volatility, our asset allocation has moved

away from our usual asset classes and country/sector preferences towards the search for income

across all asset classes. Income can be found from either dividends, coupons, spread compressions

or outright positive carry. Overall, we stay defensive in equities and prefer fixed income assets

classes simply because the volatility of rates is below its norm and lower than that exhibited by

equities and FX.

However, we have to be discerning in our quest for income. We have overlaid value versus

positioning, momentum versus macro-economic/geopolitical risks. Embedded in this view is that

future returns will be lower than in the past while volatility remains higher than history. A lower

efficient frontier is upon us but like any human pre-disposed to hope, our forlorn view could change

if the world government bodies could act in concert to bring upon large fiscal policy ballast and

structural reforms especially in Europe and Japan. For now, we advocate seeking income over capital

appreciation and hence have added to our service offerings: An income seeking, smaller drawdown

and lesser trading oriented income portfolio (Please speak to your wealth advisors for details).

Equities: Neutral. Within equities, our preference is for high-dividend yield stocks which is starting

to outperform only this year after 3 years of underperformance. Positioning is relatively light in

contrast to investment grade and government bonds and certainly offers better value than

government bonds. The dividend yield from equities are above its 30years norm while the spread of

equities yield versus government bond yields is at its all-time high thus scoring high on value. The

NIRP and low interest rate policy are also encouraging more corporates to borrow to engineer

shares buyback or pay higher dividends. For REITs or business trusts, cheap cost of borrowing also

facilitates them to lever up and make acquisitions though finding accretive acquisitions have become

harder as capital rates compressed further both at the term and risk premia levels. Dividend stocks

looks particularly attractive in Australia, Germany, France and Japan. Even in Asia, a change in

business mind-set from growth obsession is increasingly being displaced with capital management as

its previous high octane growth has now peppered to lower levels. Our search for capital

appreciation is confined to small cap managers in Japan and Asia and are looking to add managers in

Europe and to introduce a US small cap manager.

Equities as a surrogate for income AUS, UK, France, Germany and Japan are wide

We have incorporated dividend strategies across our product offerings though a

combination of dividend funds as well as individual stocks selection. A subset of income within

equities that is attractive is infrastructure assets. We prefer brownfield assets that have

predictability in ascertaining future earnings, have high barriers of entry and may also attract private

equity investments. Private equity dry powder is now at its ten-year high at USD775bn, which stands

at 1% of global GDP.

Plenty of private equity firepower to augment government fiscal policy

Fixed Income: Overweight. Within fixed income assets, our preference is for emerging markets and

high yield credits versus government bonds and investment grade. Among the government bonds,

we continue to own UK and US government bonds as the risk-off hedges plus they are the only deep

market that have positive carry left to own.

EM local credits are now trading at highest spread in ten years when compared to G4 government

bonds. A sympathetic Fed, an induced into action BOE, an aggressive ECB and BOJ are also allowing

many EM central banks to ease further in the coming months with almost every country in EM Asia

except India likely to deliver a combination of rate cuts and/or reduction in reserve requirements.

Brazil, Argentina and Russia are likely to cut rates as well which bodes well for EM credit. Within

High Yield aside from EM, we prefer US over Europe due to higher risk emanating from Brexit fallout

on its macro fundamentals and geo-political quagmire.

EM credit spread widest in ten years Yields on US, EU, EM HY are above its norm

Commodities: Neutral on Oil but long Gold looking precarious; time to exit. We have exited our oil trade given our core view of a $50 oil has already been achieved. We think over the next 6 months; oil will be range bound with $40-60 per barrel. Any levels out of these ranges will trigger supply responses. While we have previously like Gold, its recent run-up and positioning have curtailed our enthusiasm. Gold represents the archetypical antithesis to our search for income. There is no carry and positioning are heavy. Speculative long position on Gold is at all time, while short positions are at its near lows. Supply forecast for Gold is easy to determine but the demand forecast as highly subjective to ETF and futures flows and Citibank forecast is for gold oversupply to increase

in the next two years. Furthermore, as explained below our bullish view of USD will crimp Gold advance.

Gold long speculative demand high, short specs low and oversupply forecast to increase

FX: Time to go back to long USD and Short JPY and SGD. We have held a six-month long contrarian view to Short USD against JPY, EUR and SGD which have fair well with all of the above three currencies pair appreciating significant against the greenback. But as of last month, we believe the DXY has found a bottom particularly against the Yen and SGD. USD will always remain a good proxy as possible risk-off hedge but is the positioning against it that we have reversed short USD to long. The US yield curve is complacent about inflation risk and the belief that Fed will not hike till December. SGD NEER is now at the bottom end of MAS band and is in fact at 10-year high simply does not tally with a challenging domestic macro outlook. The carry trade of SGD is also fast disappearing as well.

Strong SGD doesn’t gel with weak macro and SGD positive carry has disappeared.

Alternatives Investments: Increasing for non-correlated market returns We continue to like non-correlated strategies like our quantitative trend follower manager, long/short equities managers in the US and Asia. We have also been very bullish about real estate particularly in Europe and Japan and look to introduce more private equity real estate managers.

Featured Picture/Quote:

From March 2016 “From Fear to Feh to Faith”: King Solomon on a good name. “A good name is more desirable than great riches; to be esteemed is better than silver or gold.” Proverbs 22:1

From Apr 2016 “The sign says valetudinarian people need not apply”: ― Thea Harris on authority.

“An individual with no covenant can operate in an anointing, but will have no authority.”

From May 2016 “Money no enough”: Prince on capitalism.

“All people care about nowadays is getting paid, so they try to do just what the audience wants

them to do. I’d rather give people what they need rather than just what they want.”

Edward Lim, CFA

Chief Investment Officer

cov·e·nant (kŭv′ə-nənt):

1. an agreement, usu. formal, between two or more persons to do something specified

2. the conditional promises made to humanity by God, as revealed in the Scripture

3. a formal agreement of legal validity, esp. one under seal

Our mission

At Covenant Capital, our mission is to embrace the three covenants we set for ourselves and use

them as the guiding principles to create a tripartite collaboration that is meaningful, purposeful and

rewarding.

Our 3 covenants

1. To clients as their priorities are of the utmost importance to us. 2. To stake holders - employees, business partners and service vendors - as they form the

bedrock of our collaborative enterprise. 3. To shareholders as they champion and support our vision.

Our belief

We trust unequivocally that if we look after the first covenant well, the second covenant will be

taken care of, and shareholders will eventually be rewarded.

Our logo

In the Scripture, the number three is one of the "perfect numbers." It signifies completeness and

points to what is solid, real, and substantial. Our logo is a testament to that philosophy.

The 3 colours:

1. White in the background symbolises purity of heart, clarity of vision, and illuminates the path in our quest.

2. Grey, evident in ‘Capital’, de-emphasizes money and it is impartial and composed. Whilst the grey in the second arc creates an unspoken balance in the circle of unity.

3. Black on ‘Covenant’ and the arc signifies solidarity, determination and the relentless pursuit of our core values.

The 3 arcs:

1. The inner most arc is shaped to form the letter ‘C’. It is our first covenant, our clients. It is also emblematic of our intent, that the client is the epicentre of everything we do.

2. The inner arc represents the second covenant, where stakeholders act as the bridge between clients and shareholders. The arc serves as a continuum and represents open dialogues and transparent transactions. It is in the colour grey; a symbolic amalgamation of interests and colours.

3. The outer ring is made of 2 arcs to form a full circle. It represents an unbreakable bond and trust of our shareholders.