The Organization of Petroleum Exporting Countries (OPEC) concluded their formal meeting on Wednesday 30th November 2016 with an agreement to cut production levels. This ratifies the ‘Algiers Accord’ which took place on 28th September, when planned cuts were first announced. The announced cut is a clear positive for near term oil prices and will tighten the oil market in 2017.

Click here to download the complete bulletin OPEC Announces First Production in 8 Years.

What has been announced?

OPEC have opted for a new production limit of 32.5million (m) barrels per day (b/day), representing the first action from the group since November 2014 and the first quota cut since 2008/09. The ‘referenced’ OPEC production, for October 2016, and used as a starting point for the cuts, was around 33.7m b/day, so the announcement represents a cut of 1.2m b/day (all numbers for OPEC-14 including Gabon). This ratifies the ‘Algiers Accord’ which took place on 28th September, when planned cuts were first announced. There is also an understanding that non-OPEC, including Russia, will cut production by 0.6m b/day, which would bring the total reduction to 1.8m b/day – well in excess of most expectations in the lead up to the meeting.

The announcement amounts then to a 5% cut for all members except for 1) Libya and Nigeria, recognising their unusually depressed levels of production due to unrest, and 2) Iran, recognising its journey back to normalised production post the lifting of sanctions in January 2016. Indonesia has been suspended from the group since, as a net importer of oil, it chose not to participate.

The agreed cuts are effective from 1st January 2017, and will be kept in place initially for six months, extendable for another six months depending on how the oil market evolves.

Unexpectedly, the OPEC agreement also contains official reference to non-OPEC production: “This agreement has been reached following extensive consultations and understanding reached with key non-OPEC countries, including the Russian Federation that they contribute by a reduction of 600k b/day production”. It is understood that Russia has agreed to shoulder 300k b/day of cuts, while other unnamed non-OPEC countries will share the other 300,000 b/day.

OPEC have also taken the unusual step of establishing a ‘Ministerial Monitoring Committee”,
including OPEC and non-OPEC members, to monitor implementation and compliance with the
agreement. We think this gives an indication of strong intent to see the cuts through.

To see the OPEC production cuts agreed by each member country and implications of the cut, read our bulletin OPEC Announces First Production Cut in 8 Years.

Sentiment towards the energy sector has generally improved during 2016. Five months in and we have seen Brent crude oil increase by 34% from $37/barrel(bl) to $50/bl and WTI (West Texas Intermediate) increase by 32% to $49/bl, as of 5/31/16. It is easy to remember the positive performance of the last few months and forget the torrid start to 2016, which saw Brent crude oil trough at $28/bl on January 20. To measure the real recovery in the sector, it is fair to mention that Brent crude oil is up 79%, as of end of May, from that low point in January.

So, do fundamentals support the improved sentiment?

Simply speaking, the rebalancing of the global oil market appears to be progressing well. In fact, temporary supply outages in Canada and Nigeria in May have likely brought the market into a near term supply/demand deficit, the first time this has happened since the start of 2014. More importantly, excluding the temporary factors, we believe that the world oil market is on a journey to rebalance that could ultimately herald higher oil prices. The main factors that are causing this to happen are:

• US onshore oil production (i.e shale oil production) has now declined by around 600k(thousand) bl/day between March 2015 and March 2016 and the fact that capital expenditure plans and the oil directed rig count remain at trough levels leaves us confident that US onshore oil production should continue to fall through 2016. The Energy International Agency’s (EIA) own forecasts indicate a further 100k bl/day oil production declines in April and May from the major oil shale producing basins, although we note that their expectations have proved to be too optimistic in recent months. While we would argue that efficiency gains and ‘high-grading’ of drilling activity has allowed US oil production to perform better than guided a few months ago, we still believe that it will take time and significant capital to turn around the declining US onshore shale oil production profile. We think stabilizing US oil production is more likely to occur in 2017.

• Other non-OPEC production (OPEC = Oil Producing Exporting Countries) has also been declining. According to the Energy Intelligence Group, non-OPEC (ex-US) oil production has fallen by more than 300k bl/day between December 2015 and April 2016, reflecting lower investment in projects (and does not reflect the temporary reduction in production from the Canadian wildfires, which we estimate will have reduced production by around 1.0m bl/day alone in May 2016). The disruption from the Canadian fires now seems to have passed, so production from Canada could likely recover in June. Russian oil production has been particularly robust over the last 18 months, assisted by the weak Ruble, which has capped drilling and operating costs, but even there, production has started to weaken.

• Global oil demand maintains a steady rate of growth, with the International Energy Agency (IEA) expecting 1.2m bl/day growth for 2016. After initial concerns at the start of the year over US and Chinese economic data, it now appears that global demand has continued to react positively to generally lower gasoline prices. Most recent data for the US shows a 2% year-on-year (nearly 400k bl/day) demand increase in March 2016, the strongest demand growth data since August 2015. All things being equal, we expect 2016 world oil demand growth to end up being higher than 1.2m(million) bl/day, assuming oil prices stay around these levels.

• OPEC production has remained relatively steady through 2016, averaging 33.0m bl/day so far in 2016 (most recent OPEC data for April 2016 is 33.2m bl/day). Nigerian oil production has been reduced by around 0.4m bl/day as a result of insurgent attacks on oil producing and exporting infrastructure, while Venezuelan production continues its steady decline (now at less than 2.4m bl/day). Relative to the temporary disruption from Canada, we believe that the problems in Nigeria and Venezuela reflect structural issues with respect to low oil prices, and could be sustained for some period. We believe that the market has been too sanguine about the ability of OPEC to maintain high production levels, focusing on potential growth from the economically advantaged Middle East OPEC countries rather than problems amongst the more cash-strapped members. On the positive side for OPEC, Iranian oil production is up 700k bl/day since the start of the year as a result of sanctions being lifted.

OPEC completed its 169th ordinary meeting in Vienna on June 2, with no significant new information provided at the end of the meeting. Prior to the event, there was some hope that Saudi Arabia may rekindle the production freeze agreement that it scuppered in April 2016, but ultimately no freeze agreement came to pass. The commentary from OPEC remains increasingly positive however, underlined in the press release comment

“… supply and demand is converging and oil and product stock levels in the OECD* have recently shown relative moderation. This is testament to the fact that the market is moving through the balancing process”.
*Organisation for Economic Co-operation Development

We also noted an interesting comment from Saudi’s new oil minister Falih when he was asked if Saudi would add more barrels to the market, his response was “There is no reason to expect that Saudi Arabia is going to go on a flooding campaign”.

This comes in contrast to comments made by Saudi in the immediate aftermath of the Doha meeting on April 16, when suggestions were made that Saudi were ready to raise production.

What does the recent market developments mean for energy equities?

Pulling the various factors together, we still think that the world oil market should rebalance during 3Q 2016. We remind investors that in the 1998/1999 cycle, this point of rebalancing coincided with the trough in oil prices and the trough in energy equities, as represented by MSCI World Energy Index. Given the move in energy equities and oil prices so far this year, it would appear that oil prices and energy equities have already started to move ahead of the rebalancing point this time around.

The factors mentioned above make us increasingly confident in a longer-term recovery to around $75/bl. We believe that $75/bl is not a big stretch in terms of affordability; at this price the ‘world oil bill’ will still only represent 2.5% of world gross domestic product (GDP) versus a 20 year average of 3.2%.

Energy equities have outperformed the broad market in the first five months of 2016, but remember this in the context that the MSCI World Energy Index underperformed the MSCI World Index for 91 months to the end of December 2015.

The valuation sensitivity work that we regularly perform tells us that energy equities, as of 5/31/16, have been discounting an oil price (into perpetuity) of around $55/barrel. (i.e. broadly in line with the four year forward Brent oil price which is currently at $58/bl). When the sector troughed in January 2016, we estimate that the market priced around $45-50/bl into energy equities and for reference, we believe that $80-85/bl was priced in when oil prices were $100/bl in 2013-2014; i.e. we are still near the bottom of the ‘trading range’ for oil prices that are implied in energy equities.

As a group, we see energy equities screening very attractively on a number of longer term valuation metrics. The weighting to Energy in the S&P 500 Index, as of end of May, is still only 7.1% (relative to a long run average of 9.5%), and US energy equities, as represented by energy sector in the S&P 500 Index, are still only trading at 0.48x of the price/book value of the S&P 500 Index, having historically averaged 0.86x. While we do not expect Brent oil prices to recover to $100/bl in the medium term, we do believe that the profitability of the energy industry can improve significantly, as a result of both oil price rising and sustained cost control. Both will be key drivers of improvements in return on capital in the sector, and valuation metrics.

If you believe, as we do, that a recovery in the oil price to $70+/bl is likely, the case for accumulating energy equities at this level looks good, with what we believe to be significant upside potential across the energy complex.

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

Oil Facts:

• During 2015 global oil consumption approximated 94.4 million barrels of oil per day (b/day).
• World production of oil in 2015 was 96.4 million barrels of oil per day.
• For 2016 demand is expected to be 95.6 million barrels per day while supply is estimated to be 96.5 million barrels per day.
• OECD (Organization for Economic Cooperation & Development) oil inventory grew by about 250 million barrels in 2015 taking inventory to 3 billion barrels.
• World oil demand has been growing at an annual rate of 1.2 million barrels per day in 2016.
• The decline in the price of oil has forced US oil industry investment down by 70% and is forcing production to decline sharply.

What will it take to turn this oversupply around and bring world oil inventories back to normal levels?

Read our bulletin, Rebalancing Oil Supply

The financial news in early 2016 hasn’t been good. When we say the news hasn’t been good what we really mean is that the news media has been hyperbolic in their treatment of the weak market. But… News flash! The world isn’t ending. Further, there is a lot of good news and some of the purported bad news is really good news. In this bulletin we debunk some myths that seem to be driving investor worries.

Read 5 Myths of Recent Stocks Decline

It’s darkest before the dawn – but is the time now 1am or 5am?

Historic context is useful to understanding the energy sector.

What is causing oil prices to fall so far?

It has been a pretty brutal summer for the energy markets. Brent oil fell from $65 in May to below $40, and the MSCI World Energy Index was down around 25% over the same period, leaving energy as the worst performing sector year-to-date and the most out-of-favour among all the portfolio manager surveys that we see. Long-dated Brent oil has also fallen; having started the year at $78 and traded in a fairly tight $75-$80 range until the end of June, it fell to a low point of just over $60, over 40% off its highs last year.

The reasons for this, in our opinion, are as follows:

• The US production trajectory is still unclear, although we think it is now declining. Monthly US oil production data for April and May showed that production had stopped growing and is starting to trend downwards (month over month). Weekly data (including data up to mid-August) contradicts this somewhat. The weekly data is low quality (but timely) while the monthly data is good quality (but heavily delayed). As we are writing, new monthly oil production data from the EIA for June has been released and it shows a clear downward trend in US oil production (June production was 9,296k b/d versus May 9,400k b/d and April 9,612k b/d). We are still in the eye of the storm for the US, but the trend looks downwards to us – it looks like April 2015 probably was the peak for US oil production.
• The rest of non-OPEC has been relatively steady. Russia has been remarkably robust in terms of production (as the weaker RUB has helped domestic producers) but significant capex cuts across the industry will likely lead to big production declines. We’ve seen 6 million barrels/day of new projects being cancelled in recent months – not impactful in 2015, but these will start to have relevance in 2016/17 in terms of re balancing the market. $60 oil or less is clearly not sufficient for new projects to be economic in these regions.
• OPEC production has been substantially stronger than expected. This has been a surprise. OPEC was producing 30.6m b/day in December 2014, and has risen by 1.5m b/day to around 32.1m b/day in July 2015, with Saudi production up by 0.9m b/day and Iraq up by 0.7m b/day. These countries are following their market share strategy very firmly. Both Saudi and Iraq are producing at 30yr+ record levels. We question how much spare capacity remains here. In addition, Iran is likely to restart oil exports later this year, and there is a wide range of opinion on what Iran can add to the mix (Iranian oil minister says 1.2m b/day in six months, we think more like 0.5-0.7m b/day in 6 months). Either way, Iran could delay the global re balancing. There’s also the prospect of Libya returning, although there appears to be no improvement in the political situation at this stage. If Iran and Libya come back, we see little to no spare capacity in OPEC or in the world.
• Concerns over global economic growth (led by China) are driving recent poor performance (both energy sector and the broad market). Despite this, China (representing 10% of world oil demand) is growing oil demand as expected (around 0.5-0.6m b/day in 2015), while the rest of the non-OECD world is robust. US demand is particularly strong. World oil demand growth expectations are being steadily increased (now about 1.6m b/day in 2015, the strongest year since 2010), and will likely trend higher while oil prices should remain low. This is a relief, but not enough to bring balance today, given how strong OPEC production has been.

We can observe these moving parts of the supply/ demand equation for oil, but the question remains: how long does energy equity weakness persist? Answering this with any precision is of course difficult. Energy equities appear to be pricing in around $55 long-term oil prices(on our calculations), while the five-year-forward Brent oil price is around $65/bl. Energy equities will only start to work once Brent oil shows signs of recovering and long-dated Brent oil prices stabilize. 

Why have energy equities not followed spot oil prices?

We usually compare energy equities with forward oil prices (as opposed to spot) – correlation is better and absolute percentage changes tally up better over time. This current bear market appears to be no different to what we would have expected, given the move in long-dated prices. The MSCI World Energy Index is down 36.7% from 23^rd June 2014 (the oil price peak) to 27^th August 2015, while five year forward Brent oil is down by 34.1%. That’s very close in terms of movement, and (as we usually expect) the equities led the commodity price movement at the start of the downturn. We would expect the equities to lead on the way up as well.

On the chart below, five year forward Brent oil has declined broadly in line with the MSCI World Energy Index, and both have outperformed the front month Brent oil price.

Source: Bloomberg

What makes Brent oil stabilize?

The market continues to search for signs of a definitive tightening in the balance between oil supply and demand. Most likely it will be a supply sign: either that US shale oil production is in clear decline, or action from OPEC to reduce their supply. There have been rumors of an emergency OPEC meeting. Various members are under economic stress from the low oil price; a number of Middle East countries are raising debt – their budgets are not covered at current oil prices (and barely covered at $75 oil prices). In terms of an oil price floor, we have judged $40 to be the cash cost of supply for the highest cost oil producers today. That cost is gradually coming down, with notable efficiency gains made this year (maybe we are at $35 or so now), but we have touched the cash cost of supply level in August. Historically this has signified the bottom of the oil price cycle, but this could be sustained for a while yet. Seasonal refinery downtime (and recent unplanned downtime) in the US in the third quarter will probably see US crude oil inventories continue to build, though once through this shoulder period, we would expect solid confirmation of US supply declines, limited OPEC growth and some signs that other non-OEPC production growth is starting to slow.

The history of the oil price over its whole life has been dominated by two key factors. First, small imbalances of supply and demand can cause disproportionately large price fluctuations (because short-run price elasticity of demand and supply is very low). But the second key factor is that these can be dampened by the behavior of one or more large market participants if and when they decide to play a price management role. Standard Oil, the Texas Railroad Commission and the seven sisters have all played this role in the past. Most recently, from 1999-2014, it’s been OPEC who were happy to act as the swing producer.

Shifting to the bigger picture, is there enough world growth to drive demand for oil?

We believe so. We work on the assumption of world oil demand growing, on average, between 1.0 and 1.5m b/day each year. Last year was an exception (as a result of European weakness and China slowdown), with demand rising only 0.7m b/day, while 2015 has seen significant improvements, with demand expectations growing from 1m b/day at the start of 2015 to around 1.6m b/day now. The key driver here has been lower oil prices incentivizing consumers to buy bigger, less efficient cars, and to drive greater distances. Fears of China’s recent devaluation causing economic weakness in Asia (and subsequently in the rest of the world) are only partially relevant for oil demand in our opinion. We are concentrating more on driving and transportation dynamics and, as it stands, the world demand outlook remains robust.

Growth in demand for energy has been a key feature of economic progress for 250 years. For 100 years oil has been the key transport fuel because its energy density is unequaled by any other transport fuel. After a spurt in the 1950-70 period as the developed world adopted the motor car, over the last 19 years global oil demand has grown steadily at between 1 and 2% p.a. behind GDP growth. Thus, from 1995 to 

2014, oil demand has grown 31% (from 70.3 million b/day to 92 million b/day), or 1.4% p.a., while real global GDP has grown 68.4% (from $44.9tn to $77.5tn, or 2.8% p.a. Over this period oil has mostly been displaced from electricity generation and heating by cheaper alternatives. But its place as transport fuel du jour has not been seriously challenged.

We see no reason for this picture to change much over the next 30 years as the 6 billion non-OECD population raise their standard of living to match those of the OECD’s 1.25 billion inhabitants. We estimate, for example, that the world vehicle fleet is expanding from 1 billion vehicles in 2010 to 2 billion in 2030. None of the current considered projections of electric or gas powered vehicles make a significant dent in this picture. We forecast oil demand in 2035 to be 115 million b/day.

When might supply and demand get squeezed and we begin to see an impact on oil prices?

When OPEC changed its strategy at the end of November 2014, we thought that US unconventional oil supply growth would slow in the middle of 2015. We are now just past the middle of 2015 and the signs are still tentative that this is happening. US supply is one part of the overall mix and the convergence of supply and demand at a global level has been delayed by substantially greater OPEC production (especially Saudi Arabia and Iraq), more robust non-OPEC production outside the US, and upward revisions of historic US oil production levels. Nonetheless, the convergence is coming and, all things being equal, global oil demand will outpace global oil supply in 2H 2016, with global oil inventories peaking at that time. With little or no spare oil production capacity in the world at that time, the global oil inventory overhang will get worked off and oil prices will have to be stronger to incentivize investment in new production.

What will this imply about the upside for equities?

Energy equities are unloved (institutional under-ownership, for example, is at an extreme level) and the sector’s valuation, on some metrics, is at extreme lows. Energy equities will recover when sentiment towards crude oil improves; given the poor sentiment currently, the recovery is likely to be significant. The fall in the long-dated oil price (five year forward Brent oil trading at $65) explains the fall in energy equities; should sentiment in the commodity markets improve, we would expect to see long-dated oil improve as well. As it stands, we believe that energy equities are reflecting an oil price of around $55/bl long-term (based on current cost and taxation assumptions). If the companies deliver further cost control and efficiency gains then the implicit oil price that they are reflecting will be lower than $55/bl. Nonetheless, on current assumptions we see the sector as pretty close to fair value at around $50-55 long-term oil while offering over 25% upside at $65 oil, over 40% upside at $75 oil and over 100% at a long-term oil price of $100.

Source: Bloomberg

What is the likely timing of all this playing out?

On the basis of analysis that suggests a re balancing may not come until the second half of 2016, perhaps it is only 1am. However, there is an important element this analysis overlooks – Saudi behavior. We believe there is a strong likelihood that when Saudi’s objective is achieved (say evidenced by nine months of successive US production decline, perhaps next March, and signs that global oil inventories are peaking), they will start to manage supply again. At the end of last week, OPEC’s tone shifted somewhat, with the following statement: “Cooperation is and will always remain the key to oil’s future and that is why dialogue among the main stakeholders is so important going forward”; and, “if there is a willingness to face the oil industry’s challenges together, then the prospects for the future have to be a lot better than what everyone involved in the industry has been experiencing over the past nine months or so”. Saudi won’t aim to get the price up to $100/bl immediately, more likely $70-80/bl. On this basis, maybe it is more like 4am, and given equity markets typically are anticipatory by 6-9 months it may even be 5am – the very darkest moment before the dawn.

• The Guinness Atkinson Global Energy team

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The statutory and summary prospectus contains this and other important information about the investment company, and it may be obtained by calling 800-915-6566 or visiting gafunds.com. Read it carefully before investing.

Mutual fund investing involves risk and loss of principal is possible. The Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differences in accounting methods. The Fund is non-diversified meaning it concentrates its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund. The Fund also invests in smaller companies, which involve additional risks such as limited liquidity and greater volatility. The Fund’s focus on the energy sector to the exclusion of other sectors exposes the Fund to greater market risk and potential monetary losses than if the Fund’s assets were diversified among various sectors. The decline in the prices of energy (oil, gas, electricity) or alternative energy supplies would likely have a negative effect on the funds holdings.

MSCI World Energy Index is an unmanaged index composed of more than 1,400 stocks listed on exchanges in the U.S., Europe, Canada, Australia, New Zealand and the Far East. The MSCI World Energy Index is the Energy sector of the MSCI World Index

One cannot invest directly in an index.

Capital expenditure, or CapEx, are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment.

Correlation is a statistical measure of how two securities move in relation to each other.

Standard & Poor’s 5000 (S&P 500) is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

Price to book ratio (P/B Ratio) is a ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.

Standard Deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.

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Opinions expressed are those of Guinness Atkinson Funds, are subject to change, are not guaranteed and should not be considered investment advice.

China and the Renminbi (RMB)

On August 11^th 2015, China surprised us with a change in the RMB fixing mechanism (RMB fix, by which it manages the exchange rate against the US dollar) to a market based methodology. The RMB fix is announced daily and the RMB spot rate is permitted to trade up to 2% above or below it. Previously the mechanism was officially given as being a weighted-average price offered by market makers, but the market believes it is the PBOC that has set the price.

The PBOC (China’s Central Bank) has now asked market makers to base their contribution to RMB fixing on:

1. The previous day’s closing exchange rate (FX rate)
2. RMB supply and demand conditions
3. Market movements in other major currencies.

The effect has been to move the China Yuan Renminbi (CNY) fix from RMB 6.1162 to the dollar (1.52% above the market-driven spot rate) to RMB 6.2298, in line with the spot rate and a fall of 1.86%.

The immediate reaction in the foreign exchange market was similar declines of 1.86% in the onshore RMB spot rate and 2.75% in the offshore RMB spot market as traders seek to work out what the PBOC’s new currency policy is telling us.

Our quick view

First, an explanation

The Renminbi exchange rate against the dollar has weakened as a direct result of Central bank policy, and in that regard it is correct to say this is a depreciation. However, currency depreciation is often viewed in the context of foreign competition, exports and domestic economic weakness.

The position here is not so straightforward.

1. China is in the process of internationalizing its currency. A major part of this is its current drive to have the RMB included in the basket of currencies that make up the IMF’s Special Drawing Rights (SDRs) alongside the US dollar, euro, pounds sterling and Japanese yen. The IMF’s five-yearly review is taking place this year; they have signalled to China that the currency needs to be usable, convertible and marketable. The previous mechanism, which was both opaque and produced a rate well away from the market spot rate, stood out as running counter to those aims. It is significant that IMF officials have recently concluded a series of meetings in China.
2. In its statement about the strength of RMB’s real effective exchange rate (REER), the PBOC asks the market to take account of currency movements of China’s trading partners, most of which have weakened against the RMB, and of China’s increased cost structure. But the drop itself is not large enough to have a big impact on exports, and seems designed to fend off criticism from trading partners that any currency weakness is unjustified. If the aim was to seek adjustment on REER basis (and we don’t believe so), it has not worked, as many emerging market currencies also weakened.
3. The move from an administered currency pricing mechanism (albeit resulting in a drop) fits with China’s deregulation of interest rates, increasing interest rate competition, opening up of the capital account, establishment of more overseas RMB clearing centres and growing outbound investment. This lends credibility to the PBOC’s position that this is a one-off adjustment for a specific purpose.

Now, the uncertainty

This move came without warning, which is in keeping with the PBOC’s approach to their foreign exchange policy. While understandable, we and the market are not yet sure what will happen next, and the PBOC’s stance over the next few days and weeks will need to be watched. Here are some scenarios:

1. The RMB daily fixing follows (a) the prior day’s closing spot price.

This would likely result in a steadily depreciating currency, which in turn could cause capital outflows to pick up and currency weakness to accelerate. We consider this outcome undesirable from the PBOC’s perspective, and unlikely.

2. The PBOC allows the daily fix to follow (a) the prior day’s closing spot price, but stands ready to intervene to curb volatility and provide an indication of its desired rate.

China may already have been intervening in the spot market, and in the short term this may imply a need for greater intervention before backing off.

3. The daily fix does not become more flexible and greater attention is paid to (b) supply and demand conditions and (c) market movements of other major currencies.

In this case, the setting of the daily fix will remain opaque, and greater uncertainty will have been introduced leading to higher currency volatility.

4. We do not yet know the degree to which the RMB will be permitted to drift lower against the dollar, or the balance that will be struck between stability and support for exports.

Impact of the change

The Renminbi

The currency has weakened against the dollar and could weaken further, but we believe this will be modest. We stick to our view that this move should be seen as a structural change in foreign exchange management and should be seen in the context of structural changes already underway in lending and deposit rates, in interbank markets, in onshore bond markets and in capital account opening.

Offshore RMB bonds

There has been muted impact so far, with some selling from Asian private banks (which tend to be faster money), but buyers appeared as bond prices fell by 0.25 to 0.375 points. The possibility of a weaker RMB over the longer term may result in higher inflation expectations. There has been a small steepening at the 7–10 year end of the sovereign yield curve. For the present, bond market activity suggests concurrence with the view that the move is a change to the mechanism rather than a change in policy.

Equities

China and Hong Kong stock markets didn’t move much on the news. There was greater impact in stock markets elsewhere in Asia Pacific, where currencies fell between 0.5% and 1.3% on the day. The evolution of China’s currency regime is as yet uncertain and markets await more information before taking a view.

—Edmund Harriss

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectus contains this and other important information about the investment company, and it may be obtained by calling 800.951.6566 or visiting gafunds.com. Read it carefully before investing.

Mutual Fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater of emerging markets countries. Investments in derivatives involve risks different from, and in certain cases, greater than the risks presented by traditional investments. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Non-diversified funds concentrate assets in fewer holdings than diversified funds. Therefore, non-diversified funds are more exposed to individual stock volatility than diversified funds. Investments in debt securities typically decrease in value when interest rates rise, which can be greater for longer-term debt securities. Investments focused in a single geographic region may be exposed to greater risk than investments diversified among various geographies. 

Exchange rate (FX Rate) is the rate at which one currency will be exchanged for another.

The currency abbreviation for the China yuan renminbi is (CNY), the general term for the currency of the People’s Republic of China (PRC).

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Chinese stock markets have roared in the past year, since May 2014. The Chinese government has announced a $40 billion “Silk Road” fund to build a network of railways and air links to bring China and Central Asia closer together; China launched the Asia Infrastructure Investment Bank in October 2014, and since then there has been a rush to join, not only from China’s neighbors, but also five of the G7 leading economies, excepting the US and Japan; and recently, the IMF (International Monetary Fund) released estimates, without fanfare, showing the aggregate size of China’s economy is now the largest in the world.  The fashion these days is to decry China’s prospects.  But China doesn’t seem to be listening.

China vs. Hong Kong Stock Markets

Chinese domestic stocks began moving higher in May 2014.  In the year to April 30, 2015 the Shanghai Shenzhen CSI 300 Index rose 127%.  The markets really got going in November after China cut interest rates.  Since November there have been two further interest rate cuts, accompanied by additional liquidity easing measures.  Domestic Chinese stocks that had been trading at a discount to the equivalent Hong Kong-listed lines moved to a 30% premium. 

Many wonder whether the valuation gap could be closed by a collapse in the Chinese A share markets? We got one answer in April when Chinese regulators made some adjustments to the Shanghai-Hong Kong Stock Connect scheme, which was designed to allow investment in both markets, for Chinese and International investors, for the first time.  The challenge for regulators was to structure this scheme to allow increased movement in flows through the capital account, but in such a way that it did not blow a hole in it.  The structure was necessarily tight with regard to flows coming out of China.  At the end of March restrictions were eased and a wave of Chinese money flowed into Hong Kong and pushed Chinese stocks listed in Hong Kong 16% higher in April 2015.

It appears that Chinese stock investors are still bullish.  The market rally in China and Hong Kong has been driven by broad-based institutional and retail participation and on record high volumes in both markets. This rally has been primarily in response to a relaxation in short-term liquidity and lower interest rates in China; secondarily, it probably reflects negative sentiment toward investment in the real estate market which is dogged by oversupply and which the government has been trying to support by lowering down-payments and easing access to mortgages. However, the premium of Chinese A shares over Hong Kong listed stocks has not narrowed much, and international investors for the most part are still doubtful.

International Investor Skepticism

China is a developing economy weighed down by debt under its investment-led model now seeking to transform its economy and create a financial sector that is suitable to support it.  That is a fundamental change, and investors are rightly cautious.  However, the economies and markets in which they place greater faith, as valuations would suggest, carry potentially greater risks.

The S&P 500 Index has continued to hit new highs, and trading on a Price Earnings (PE) multiple of 18.75x historic earnings, which (except the effects on earnings in the 2008-9 period) is the highest since 2004.  This has come against a backdrop where the average yield on the 10 Year Treasury was 2.39%.  In the 5 years to the beginning of 2008, the average yield was 4.38%.  Economic growth and stock markets have risen in an environment of unprecedented and sustained monetary policy support.  At some point, these policies must normalize, but markets do not appear to be pricing this in.

Contrast this with China.  Everyone is aware that China’s investment-led economic model has passed, and the debt accrued represents a threat to economic stability and future growth.  China’s policies, including currency internationalization, credit tightening, clampdowns on shadow-banking, deregulating interest rates, expansion of open-market operations, increasing bank capital adequacy, restructuring state entities and even anti-corruption drives, are all directed to attacking this problem. 

Chinese companies listed in Hong Kong, known as H shares, which often have an equivalent line of stock trading in Shanghai or Shenzhen, trade on a PE multiple of 10.11x historic earnings.  The five year average has been 9.45x, compared to a ten year average of 12.84x.  Investors have assessed these uncertainties, and market valuations have reflected them.  Chinese domestic investors have clearly taken a more positive view, with domestic A shares trading on a multiple of almost 20x historic earnings, above the ten year average of 18.62x.

Looking Forward

We argue that slowing growth and the economic challenges that are the legacy of investment-led growth are well known. They have been widely discussed over the past four years and therefore are likely priced into current valuations.  Investors should now evaluate what comes next.

There is a framework within which to consider Chinese policy and economic development.  The base line has been the desire to move China from a middle-income to a high income economy, which requires growing domestic consumption and scaling back domestic investment.  There has been progress with the report that services contributed more to economic growth than investment. 

To support the domestic economy, China has emerged with a coherent international strategy whose parameters should likely be set for the next thirty years.  This means using its financial reserves to build political and trade links in emerging markets from South America through Africa and across Central Asia.  China has been doing this ad hoc for years, and often not well, but the “One Belt One Road” strategy ties it together conceptually and financially.   

Investor impatience as China aims to change its economic legacy has likely been a problem.  But the accelerating pace of policy reform signals determination and urgency.  Investors should look at policy changes under three groupings: short term actions to ensure stability, medium term actions to make the transition to a market-led and consumer model, and long term strategic policies to secure a leading world economic and geo-political position to end its comparative isolation.

The short and medium term policy groupings should interest investors.  In the shorter term we expect to see monetary conditions stay loose with economic growth still under pressure.  Money market rates are likely to stay low through additions of liquidity by further releases of banks’ statutory reserves.  Further interest rate cuts are unlikely unless economic growth slows further or consumer price inflation falls close to zero.  These conditions are likely to support the stock market.

In the medium term, we expect to see further moves to cut excess capacity in the state-owned sector, which will drag growth, offset by moves to increase investment in urbanization and affordable housing.  We also expect to see policies supportive of higher value added industry that support higher wages and a focus on environmental issues that pushes the use of alternative energy.  Fears of monetary tightening caused by the inability of local government financing vehicles to repay maturing debt have been alleviated by the establishment of a formal municipal bond market.  The municipal bond market will lengthen maturities, increase transparency and draw a formal distinction between debt with explicit government backing and debt without.  This lifts a weight of uncertainty from the banking sector and is also positive for the market. 

China is working towards an economic plan that sets its path to the middle of this century, while commentators and markets have continued to focus on what economic growth will be this year and next.  We are optimistic about the long-term prospects of investing in China, and foresee a possible continuation of the market rally we have seen in the short-term.  Chinese stocks in aggregate, traded in Hong Kong and available to international investors are significantly cheaper than their mainland counterparts, trading on PE multiples of 12.25x 2015 earnings and 10.82x 2016.  We believe this should continue to attract flows from domestic Chinese investors who are increasingly able to invest in Hong Kong.

Fund Manager Edmund Harriss

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectus contains this and other important information about the investment company, and it may be obtained by calling 800.951.6566 or visiting gafunds.com. Read it carefully before investing.

Mutual Fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater of emerging markets countries. Investments in derivatives involve risks different from, and in certain cases, greater than the risks presented by traditional investments. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Non-diversified funds concentrate assets in fewer holdings than diversified funds. Therefore, non-diversified funds are more exposed to individual stock volatility than diversified funds. Investments in debt securities typically decrease in value when interest rates rise, which can be greater for longer-term debt securities. Investments focused in a single geographic region may be exposed to greater risk than investments diversified among various geographies. 

Shanghai Shenzhen CSI 300 Index measures 300 Chinese A share stocks listed on the Shanghai and Shenzhen exchanges.

G7, or Group of Seven, is the economic alliance of Canada, France, Germany, Great Britain, Italy, Japan, and the U.S.

PE, or price earnings multiple or ratio, measures how expensive a stock price is.

S&P 500 Index is based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. You cannot invest directly in an Index.

Shadow-banking refers to financial intermediaries involved in facilitating the creation of credit across a financial system, but whose members are not subject to regulatory oversight.

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One of the benefits of dividend investing is that dividends can grow over time. Dividend growth is a key objective of the Guinness Atkinson Dividend Builder Fund. In fact, we push this objective further: we seek to have the Fund grow its dividend at a pace that exceeds the inflation rate.  This objective is a distinguishing factor of the Fund’s income strategy, and it is important to many investors. The key to this strategy is investing in high quality companies that consistently create wealth. But how, exactly, do we identify high quality companies?

We start with the recognition that the dividend is the end product—the result of wealth creation. Without wealth creation there can be no sustained and growing dividend.  In our search for high quality companies, we’re looking for companies that have consistently demonstrated a well above average return on capital. We have identified quality companies by systematically looking for companies that have produced a 10% cash flow return on investment (CFROI) over each of the last 10 years. This is a very, very selective screen; in any given year about one in four companies has achieved a 10% CFROI.  But well less than 3% have been able to achieve this wealth creation for 10 consecutive years. These high quality companies can be found in almost all industry sectors, suggesting that our screen for high quality is identifying the best of breed companies that have demonstrated some sort of competitive advantage that has permitted them to earn consistently high returns on capital. This competitive advantage could be some sort of intellectual property or superior management or maybe a valuable brand.

We have found that consistent, above average wealth creation is a better indication of the ability to raise dividends than simply a history of rising dividends. That last sentence might seem a bit confusing. The point is that a history of rising dividends, often used as a method of selecting dividend building stocks, doesn’t offer the same ability to identify dividend growers as identifying quality companies that achieve a high level of return on capital consistently over a long period of time. This is because it is quite possible for a company to increase its dividend payment even in the face of deteriorating business conditions. In fact, dividend aristocrats will often do just that to maintain their status as dividend aristocrats.

Two well-known companies, Kmart and Eastman Kodak, were once considered blue chip dividend payers. Both of these companies continued to increase their dividend despite declining business fortunes. Investors looking at just the history of dividends without looking at the quality of the underlying business may have well missed the coming dividend cuts and indeed the decline of these once great companies.

We require 10 years of consecutive high rates of return on capital for a reason: most business cycles are less than 10 years and we’re looking for companies that can demonstrate their competitive advantage through the good and bad portions of a business cycle. Maintaining profitability throughout business cycles has also been a good indicator of the potential sustainability of the dividend and dividend growth.  

So what types of companies do we find that are able to meet the strict criteria to be considered high quality?  Many of the companies that meet our definition are the obvious dividend payers, companies like Coca-Cola, Wal-Mart and Microsoft. But many others might be considered unexpected, companies like Schneider Electric, Aberdeen Asset Management and L-3 Communications.

Some of the companies we identify as high quality will be trading at a value that we might find too dear. We are value biased investors and seek to invest in a portfolio of high quality companies at reasonable prices.  In short, we’re looking to invest in these high quality companies at prices that might be more appropriate for average companies.

As our Dividend Builder Fund has just reached its 3 year mark, the question must be asked: How has this strategy done and how has the Fund performed?

In its Lipper Global Equity Income category, the Fund has become the top ranked fund in the three year time period out of 96 Funds, as of 3/31/15.  The Fund was ranked 43 of 143 for the one year time period.  These rankings are as of 3/31/15 and based on total returns with dividends and distributions reinvested. 

Fund Managers Dr. Ian Mortimer, CFA and Matthew Page, CFA

Click here to view the Dividend Builder Fund’s standardized performance.

Click here to view the Dividend Builder Fund’s top 10 holdings.

Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectus contains this and other important information about the investment company, and it may be obtained by calling 800.951.6566 or visiting gafunds.com. Read it carefully before investing.

Mutual Fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater of emerging markets countries. Investments in derivatives involve risks different from, and in certain cases, greater than the risks presented by traditional investments. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility.

Past performance does not guarantee future results.

Dividend Aristocrat- A company that has continuously increased the amount of dividends it pays to its shareholders. To be considered a dividend aristocrat, a company must typically have raised dividends for at least 25 years.

Return on Capital is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business.

Cash Flow Return on Investment (CFROI) is a valuation model that assumes the stock market sets prices on cash flow, not on corporate earnings. It is determined by dividing a company’s gross cash flow by its gross investment.

CFROI is a proprietary metric prepared by HOLT, a division of Credit Suisse. CFROI is a registered trademark of Credit Suisse AG or its affiliates in the United States and other countries. For more information on HOLT, a corporate performance and valuation advisory service of Credit Suisse, please visit their website at https://www.credit-suisse.com/investment_banking/holt/en/index.jsp

Lipper Analytical Services, Inc. is an independent mutual fund research and rating service. Each Lipper average represents a universe of Funds with similar investment objectives. Rankings for the periods shown are based on Fund total returns with dividends and distributions reinvested and do not reflect sales charges.

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The Guinness Atkinson Global Innovators Fund invests in companies with innovation in their DNA.  We think innovation is the intelligent application of ideas and can be found in most industries, and not just the technology sector as is often assumed. We believe good companies with a culture of innovation and strong capital discipline can deliver what we believe are the key factors behind superior shareholder returns:

How do we identify innovative companies?

We approach the challenge on a number of fronts, but the first step is to recognize that an innovative company can be at any stage within its business lifecycle: from a start-up raising seed capital, right through to a decades-old multinational conglomerate. The process of identifying innovative companies must therefore take this fact into account and cannot simply be boiled down to a one-size-fits-all methodology.

We do believe, however, that innovative companies can broadly be split into two distinct classifications:

1. Smaller, earlier stage, more disruptive companies, or
2. More mature companies that are using innovation to continue to create profitable growth

For simplicity we classify the smaller, more disruptive companies as Group 1 and the more established, seasoned companies as Group 2. We do not look at ‘start up companies’, as they are often below our $500 million market cap cut off or unlisted.

Defining early stage Group 1 companies can be highly subjective since they may not yet have had the time to prove themselves. It is also easy to fall into the trap of confirmation bias when looking at these types of companies by only recognizing and giving credit to ideas and processes that you already believe in or have seen work in the past. We therefore seek third party acknowledgement of a company’s innovative status and also look for ideas from as wide a range of sources as possible. For example, there are several academic and business reviews (MIT, Boston Company, for example) that aim to identify, or quantify in some way, innovative companies. We regularly scour these publications to add to our list of Group 1 companies.

Identifying the more mature companies in Group 2 is slightly less subjective, as they have a longer history of financial results to analyze and have had ample time to demonstrate their advantageous qualities. We believe that innovative companies that have successfully transitioned through the initial growth phase are much more likely to be able to earn a higher return on their investments than their non-innovative peers.  Also, if they remain innovative, they should be able to maintain this advantage over time.

In order to quantify these characteristics we search through companies’ reports and accounts and try to identify only those companies that have consistently earned a high return on capital for an above average period of time. This may not prove they are innovative (they might simply just have a monopolistic advantage, for example), but it does provide a consistent marker that, in our experience, can frequently identify innovation. Despite their size and maturity, these companies have shown an ability to adapt and react to changing market forces. These companies create fairly steady profits, are able to continue to operate well in most economic environments, and often have strong balance sheets

Investing in innovative companies

Before considering a company for inclusion in the portfolio, we first analyze it to identify:

1. The level of innovation (disruptive, accelerating, continuous).
2. The driver of that innovation (science or technology, product or service, business model).

The level of innovation is indicated by financial metrics such as valuation premium, revenue growth, and consistency of return on capital. The driver of innovation is a more qualitative analysis based on an understanding of the industries and sectors the company operates in. If we cannot easily place a company within this innovation matrix, then we will likely exclude the company from the portfolio.

The aim is to invest in the 30 ‘best ideas’ from the innovative companies in our investible universe. We do this with a strict value discipline. Simply being identified as an innovative company is not in itself sufficient to be selected for the portfolio.

We regularly seek to generate ideas for further due diligence by screening the universe for different combinations of factors. The screens are designed to focus our minds towards companies that offer exceptional value relative to their own history, attractive value with improving sentiment, or have underperformed their peers.

Once we’ve selected candidates for further analysis from within our investment universe, we subject these companies to a thorough due diligence process. We construct models to understand how the company has evolved over the previous 15 years (if possible). Covering factors include: growth; margins; uses of cash amongst capital expenditure, acquisitions, share buybacks and repayment of debt; balance sheet evolution; drivers of return on capital; key geographic regions; valuations relative to peers and the company’s own history; earnings sentiment; and dividend cover. We also seek to understand what the analyst community is forecasting for the company and understand the drivers behind the analyses. They will seek to form an opinion on more subjective factors surrounding industry trends and company-specific issues.

We are keen to meet with the management of companies we are analyzing, but this is not a prerequisite for investment. We have a preference for attractive metrics over good themes (or catalysts), as we believe informational advantage is of diminishing value. Identified themes or catalysts are often priced into the valuations of companies, with commensurate stretched expectations of growth leading to higher risk than is often perceived.

We like to distil our investment philosophy and process into four key tenets that describe the way we invest and what we are aiming for in our management of the portfolio:

Matthew Page, CFA and Dr. Ian Mortimer, CFA
Guinness Atkinson Global Innovators Team

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectus contains this and other important information about the investment company, and it may be obtained by calling 800.951.6566 or visiting gafunds.com. Read it carefully before investing.

Mutual Fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater of emerging markets countries. Non-diversified funds concentrate assets in fewer holdings than diversified funds. Therefore, non-diversified funds are more exposed to individual stock volatility than diversified funds. Investments in derivatives involve risks different from, and in certain cases, greater than the risks presented by traditional investments. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility.

Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.

Past performance does not guarantee future results.

Return on Investment is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

Return on Capital is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business.

Morningstar Proprietary Ratings reflect risk-adjusted performance as of 9/30/2015. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating™ based on a Morningstar risk-adjusted return measure that accounts for variation in a fund’s monthly performance including effects of sales charges, loads, and redemption fees, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. The Guinness Atkinson Global Innovators Fund (IWIRX) received 5 stars for the three-, five- and ten-year time periods ended 9/30/2015 among 1001, 758, 393 World Stock Funds, respectively. Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in distribution percentage. Other share classes may be rated differently. ©2015 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

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