Strategy Chinese FX policy confusion

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1 Investment Research General Market Conditions 8 January 2016 Strategy Chinese FX policy confusion This year kicked off with global risk-off sentiment led by Chinese equities but also in Europe and the US, equity markets were down 2-3% on the first trading day. In China, trading was halted on Monday as the new circuit breaker system came into effect twice. First, the CSI 300 fell 5%, which led to a halt in trading followed by a resumed decline to 7%, which triggered a complete stop of trading for the rest of the day. Again on Thursday, Chinese shares fell 7% and the stock exchange was closed. Today, things have calmed down a bit and Chinese stocks were up over 2% after the Chinese government suspended the circuit breaker system after it being in place for only four days. The negative sentiment was initially driven by disappointing Chinese Caixin PMI manufacturing together with rising tensions in the Middle East. The decline in the PMI highlights the fragility of the Chinese manufacturing sector but does not change our expectation of a moderate recovery in growth in H1 16 driven by a slight turn in housing investments and monetary and fiscal stimulus. In our view, the disappointing manufacturing PMI and positive surprise in the non-manufacturing PMI reflect the ongoing rebalancing of the economy from investment and export-led growth to more consumer and service sector-driven growth (see Chinese PMI mixed markets off to a rocky start, 4 January 2016). On Wednesday, the CNY was fixed at its weakest level since 2011, prompting concerns that further currency depreciation could lead to liquidity problems in the wider economy. Notably, the USD/CNY fixing was set higher than the closing level the day before, in contrast with the new Chinese fixing regime announced in August, causing speculation of a deliberate CNY weakening. However, this would make no sense as it was reported that China intervened to support the CNY on Tuesday. In line with this, the Chinese currency reserve data for December indicated that China tried to dampen the weakening. Sharp depreciation of CNY versus USD but less so on trade-weighted basis Today s key points 2016 kicked off with global risk-off sentiment led by China. Despite China calming down at the end of the week, uncertainty is high and a big problem is the lack of communication from the PBoC. Increased speculation about easing again is too aggressive due to the better economic outlook. US manufacturing at an inflection point, but the Fed will wait until April to hike again. Chinese housing market to recover Source: Macrobond Financial, Danske Bank Senior Analyst Pernille Bomholdt Henneberg Source: Macrobond Financial, Danske Bank Chief Analyst Allan von Mehren Important disclosures and certifications are contained from page 4 of this report.

2 Today, the CNY fixed at a stronger level than the closing level, which helped to stabilise sentiment but, at the same time, added to the confusion over how the fixing is set. The People s Bank of China (PBoC) may try to use the fixing to calm markets. However, it creates confusion, as the idea of using the closing level in the new fixing regime was that it should be market-based as this was a condition of the IMF. Currently, a significant problem is the lack of communication from the PBoC. Any other central bank would immediately comment on events and try to explain what the goals are and how the system works. The market is left guessing in a situation with very high uncertainty, which is clearly a risk when it comes to further capital outflows from China. See more details about the Chinese foreign exchange system in CNY Outlook: More weakness ahead, 7 January Increased speculation about easing is too aggressive Lower oil price, but base effects fade Source: Bloomberg, Eurostat, Danske Bank Speculation that the will ease again increased this week as the low oil price together with the weaker-than-expected inflation prints for December could force it to defend its inflation mandate. A full 10bp deposit rate cut is priced in for October 2016 while a cut in March is priced with around a 50% probability. In our view, particularly the pricing in March is aggressive and keeping in mind the light menu of easing announced in December, we believe more is needed to convince the majority of the Governing Council to step up the easing. Even the very dovish chief economist Peter Praet said this week, But if oil and commodities prices tumble, it is more difficult to allow inflation to rise. If a whole series of such factors occur, you can t do anything other than somewhat postpone the date on which you seek to reach the higher rate of inflation. Our expectation of a patient should be seen in light of the latest activity indicators, which point to a re-acceleration of activity in 2016 after the soft patch in mid Particularly, the German and Italian figures indicate a pick-up in activity consistent with our view that these countries will be the main drivers of the stronger recovery in Added to this, the unemployment rate in the euro area continues to decline and was 10.5% in November, which is the lowest level since October 2011 and not far from the structural level, which is estimated to be as high as 9.9%. The structural unemployment rate could be lowered towards pre-crisis levels of 9.0% when the actual unemployment rate approaches it but while this is happening more easing is, in our view, quite unlikely. Particularly the March deposit rate cut seems to be priced too aggressively, in our view. At the March meeting, the will release updated inflation projections and for the first time it will include a forecast for This horizon is close to what is seen as the medium term; hence, a low forecast could be expected to be accompanied by more easing. But when the in March 2014 for the first time included a three-year inflation projection, it did not ease although it forecast inflation to be only 1.5% in the third year. In the latest forecast from December, the expected inflation to be 1.6% in 2017 and although this forecast might be lowered, we expect the to release a 2018 inflation forecast above 1.5%. In our view, an unwarranted financial tightening could force the to ease again. This could follow through a stronger effective euro or higher real rates as a consequence of lower inflation expectations. US manufacturing inflection point US economic data has also added some uncertainty about a more severe downturn in the global manufacturing cycle as the manufacturing ISM index declined to 48.2, which is the lowest since June The weak print was driven by a drop in the easing is priced aggressively bp date Eonia swaps assuming 6bp spread to Deposit rate Jan-16 Mar Apr Jun-16 Source: Bloomberg, Danske Bank Euro-area activity re-accelerates Source: Eurostat, Markit PMI, Danske Bank Euro unemployment rate declining quickly Source:, European Commission, Eurostat, Danske Bank -8.7 Jul Sep Oct Dec January 2016

3 employment index but the December ADP job report was strong and new jobs were still added to the manufacturing sector, despite the ISM index being in recessionary territory. The weakness in the US manufacturing sector does not seem to follow on from weaker demand, which together with the difference between orders and inventories suggests US manufacturing is at an inflection point. In our view, the latest weak figures reflect the global manufacturing slowdown, the stronger USD and spill-over from a challenged energy sector. These uncertainty factors are likely to have implied that businesses have lowered inventories in fear of a more severe slowdown despite real demand having remained high. In such a scenario, production eventually needs to catch up with the higher demand. When this happens, the previous reduction in inventories can strengthen the recovery additionally as stocks also need to be built up again. Although we look for higher ISM manufacturing in coming months, the weak figure is one reason why we expect the Fed to wait until April to hike again. In line with this, the minutes of the December FOMC meeting, where the Fed delivered its first hike since June 2006, were more dovish than the statement and Janet Yellen s tone at the press conference. Despite a unanimous hike, it was a close call for some FOMC members. In particular, the subdued core inflation seems to be a major concern for the most dovish members (see FOMC Minutes: Not all members are as confident as Yellen despite the unanimous hike, 6 January 2016). US demand above ISM manufacturing Source: ISM, Macrobond Financial, Danske Bank The difference between orders and inventories points to higher ISM man. EUR/USD set to go higher in 2016 At the end of this week, EUR/USD moved higher, defying the sell-off in equities and oil prices. The former suggests that the single currency is increasingly regarded as a safehaven currency while the latter underlines that the historically close co-movement of the oil price and EUR/USD is challenged. One reason for this is that the weaker oil prices now benefit the euro area relatively more than the US. Thus, an oil price that is set to stay 'lower for longer' boosts the potential for EUR/USD to move higher further out. Currently, EUR/USD is in our view caught in the range, but later on we expect a rebound on no renewed policy divergence and strong EUR fundamentals. Source: ISM, Macrobond Financial, Danske Bank Global market views Asset class Equities Moderately positive on 3M horizon, posive on 12M horizon Main factors We expect the current market turmoil led by confusion over China's FX policy and scare over its growth outlook to pass as it did in August After which the earings growth differences between Europe, Japan and the US will continue to support our overweight in Europe and Japan vs. US. Despite we find it likely with less strong growth in Q1, we still expect sufficient growth ahead to support equities Bond market Core yields: Bund yields bottoming, higher medium term US-Euro spread: Wider Peripheral spreads to tighten further from here Spreads to stay stable/tighten as central bank boost liquidity FX EUR/USD - rangebound near term, rebound further out USD/JPY - rangebound on a medium-term horizon EUR/SEK - stuck between near term, lower medium term EUR/NOK - higher short term, then lower as cycle turns is done easing and spill-overs from US yields Policy divergence to widen spread QE, improving fundamentals and search for yield support but emerging markets instability the risk Caught in range for now, then rebound on no renewed policy divergence and strong EUR fundamentals Upside from Fed hikes and BoJ on hold countered by stretched fundamentals Battle between Riksbank and the market for now, further out EUR/SEK to fall on strong Swedish fundamentals Relative rates and liquidity to cap downside short term, but eventually lower due to positioning and fundamantals Commodities Oil prices - range-bound near term, subdued recovery in 2016 Metal prices - staying low Gold prices - flat near term Agricultural risks remain on the upside Price support from OPEC is gone; now awaiting non-opec supply cuts ahead as costs weigh on producers Chinese manufacturing slowdown to cap upside; consolidation in mining industry puts a floor under prices Low oil price and Fed getting ready to hike keeps a lid over gold price Trending up again as El Niño weather is key upside risk Source: Danske Bank 3 8 January 2016

4 Disclosures This research report has been prepared by Danske Bank, a division of Danske Bank A/S ( Danske Bank ). The author of the research report is Pernille Bomholdt Henneberg, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report. 4 8 January 2016

5 This research report is not intended for retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. Disclaimer related to distribution in the United States This research report is distributed in the United States by Danske Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Inc. directly and should be aware that investing in non- U.S. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission. 5 8 January 2016

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