Nov/Dec 2015 INVESTMENT PRODUCTS: NOT A BANK DEPOSIT. NOT GOVERNMENT INSURED. NO BANK GUARANTEE. MAY LOSE VALUE

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1 INVESTMENT PRODUCTS: NOT A BANK DEPOSIT. NOT GOVERNMENT INSURED. NO BANK GUARANTEE. MAY LOSE VALUE

2 Perspectives It s all about the fundamentals Dear Clients, After difficult months in August and September 2015, equity markets in October recovered sharply to record one of the strongest months in recent years. This recovery was across most markets as there was a general sense that the falls were overdone and that fundamentals were not as bad as suggested: more a correction than the start of a prolonged decline. Haren Shah Chief Investment Strategist Wealth Management Asia Pacific / EMEA So now where do we go from here? This will depend on a number of issues. Firstly, the markets are no longer as cheap as they had been and in order to move higher, earnings need to grow. This is particularly evident in the United States, where third quarter (Q3) earnings are higher than expectations, but overall we may still see negative year-on-year numbers. With earnings growth flat, current valuations in the U.S indicate a limited upside for the market. However, valuations in Japan, parts of Europe and in emerging markets (EMs) seem to be below their historical averages. Earnings are also expected to remain positive even as expectations have been scaled back. Secondly, central banks are also playing a pivotal role which may benefit markets. In the U.S, the October Federal Open Market Committee(FOMC) minutes show they are ready to begin normalization at the December meeting although the path of rate increase is likely to be very shallow. This comes at a time when the European Central Bank (ECB) is signaling more quantitative easing (QE) by December 2015, and the People s Bank of China (PBOC) has cut rates and reserve requirements in China. All of these central bank actions are creating further confusion on the state of the global economy and outlook for As such, expect markets to consolidate for the next couple of months until the FOMC meeting in mid-december After that time, we should have a better view of how things will shape up for In the meantime, this is a good time to review your asset allocation. Focus on areas of relative risk and position on places where the fundamentals are attractive. Remember, in the short-run, sentiment can affect markets but in the longer-term, it s the fundamentals that dictate the performance. 01 MARKET PERSPECTIVES

3 Views Commodities dominate Australia s exports but they do not necessarily dominate the domestic economy or the equity market... Australia s Equity Market Over the last decade, many international investors were drawn to Australia to gain exposure to the growth in Chinese investment and the consequent demand for commodities. But that growth has clearly begun to wane and the price of iron ore has fallen from over $190 per tonne in 2011 to approximately $50 per tonne today. Similar falls have been seen in the prices of coal, oil, gold and other metals. Yet the S&P/ASX200 Accumulation index of the largest companies in Australia reached an all-time high in the second quarter of this year, up 22% from the exuberant highs of 2007 and up 148% from the lows seen in in early 2009 as of 12 November The bulk commodities dominate Australia s exports. But they do not necessarily dominate the domestic economy or the share market. Mining activity is estimated to account for about 7% of GDP, according the 2012 figures from the Australian Bureau of Statistics. 68% is generated by the service sectors. It is a similar picture for the share market in that Financials, including Real Estate Investment Trusts, in aggregate make up 48% of the total S&P/ASX200 index while Materials make up a little over 13%. Asset Allocations within Asian equities portfolio Asset Class Australia China Hong Kong* India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Relative weight* Underweight Overweight Overweight Neutral Underweight Underweight Underweight Underweight Overweight Overweight Underweight * Citi WM Chief Strategist s relative weights to the benchmark as of 18 November 2015 * Hong Kong refers to H-shares Fig 1: Export Volumes Quarterly, 2012/13 prices, log scale Source: ABS, Citi Research as of November MARKET PERSPECTIVES

4 A consequence of this nuance has been that the decline in commodity prices has led to a decline in the terms of trade; the relative value of exports compared to imports. Historically, this has tended to bring about a lower exchange rate. However the Australian dollar remained stubbornly high in the aftermath of the global financial crisis as Australian interest rates were very attractive compared to the G4 currencies. But in 2012 and 2013, the Reserve Bank of Australia (RBA) began to cut interest rates more aggressively. As a result, financial flows began to reverse and the Australian dollar lost value against the US dollar in particular. The monetary easing that took place also affected domestic asset prices. The demand for mortgage finance and property ownership rose sharply, particularly in Sydney. Fig 2: Housing Prices Fig 3: Housing Loan Approvals Note: *Excludes apartments; measured as areas outside of capital cities in mainland states Source: Citi Research as of November Note: *Excludes refinancing ** Includes refinancing Source: Citi Research as of November Australian residents receive a tax credit for corporation tax paid on company earnings. This keeps investor demand for dividend distributions very high Lower interest rates also led to higher share prices. The Australian stock market is extremely concentrated. The top ten companies by market capitalisation account for 50% of the S&PASX200 index and tend to have very high dividend payout ratios, the proportion of earnings that is paid out directly as dividends rather than retained to fund future growth. The size of the companies implies that additional growth opportunities may be harder to find. Perhaps more importantly, the Australian dividend imputation system means that Australian residents receive a tax credit for corporation tax paid on company earnings. This keeps investor demand for dividend distributions very high and arguably forces companies to distribute a higher proportion than they would otherwise like. Fig 4: Top ten Australian companies by market cap Source: Bloomberg as of 12 November MARKET PERSPECTIVES

5 As cash interest rates fall, typically share prices adjust upwards as yield-seekers move out of cash and into stocks. Moreover, the highly-weighted of Financials and Real Estate companies were the main beneficiaries of higher demand for property finance. The main banks were able to increase their earnings as demand for lending grew and the corresponding growth in house prices kept provisions for bad debts at relatively low levels. The prospective returns of index have substantially lowered. Unemployment has remained high in 2015 and consumers have very little confidence in the economic outlook. As a result, consumer spending and economic growth show little sign of reaccelerating. Fig 5: Consumer Sentiment and Spending Source: Citi Research as of 27 October Despite the weak economic outlook, the RBA has been reluctant to ease monetary policy further. The strong growth in house prices has become a source of potential macroeconomic instability and a barrier to interest rate cuts. In response to the Reserve Bank s concerns, APRA the banking regulator, increased the capital requirements of the big four banks in Citi now believes that the RBA may cut rates again, most likely in February next year. The increased capital requirements prompted a correction in the share prices of each of the big four banks of more than 25% and the index is currently trading 12% below the April high as of 12 November Investors may draw comfort from the increased financial strength of the banks but the trajectory of future earnings growth has clearly flattened. Australia has a range of niche players in sectors that are able to translate overseas earnings back to Australian dollars at a more attractive rate. Focusing on these headline stories may persuade investors to steer clear of Australia for some time. Yet Citi continues to see attractive opportunities for investment. Many mid cap exporters are now finding that the lower exchange rate offers a much better business environment. Australia has a range of niche players in sectors such as healthcare and medical sciences, packaging and food production that are able to translate overseas earnings back to Australian dollars at a more attractive rate. More broadly, Citi s investment strategists see further opportunities for various companies to support earnings through cost cutting measures. One thing is for sure, stock selection is likely to play a much more important role in portfolio performance in 2016 than it has done in recent years. 04 MARKET PERSPECTIVES

6 Insights Outlook For The Commodity Currencies The outlook for commodity currencies is likely driven by 2 critical factors as below. (a) The outlook for global risk sentiment tied to the Fed outlook that also predominantly dictates US commodity bloc yield differentials (b) Global risk sentiment as affected by China and the outlook for the economy and asset markets in particular together with the outlook for commodity prices (and commodity terms of trade) Global risk sentiment for the remainder of this year and the next will likely be driven by how the Fed navigates its path towards rates normalization that in turn will also drive the extent of policy divergence between the US and commodity bloc to a large degree. China will undoubtedly add to the mix as a further consideration to weigh on global risk and currency sentiment. A Brief History The commodity bloc currencies have fallen anywhere between 25% to 40% from their highs established around mid-2011 (NZD down 25%, AUD down 35% and CAD down 40%) but have been stabilizing at the lower levels since late September. Interestingly, the declines have come in a period that saw sustained gains in US equities (a proxy for risk appetite). The period since mid-2011 until late September 2015 therefore saw a clear de-link between positive global risk appetite on the one hand and the negative sentiment in commodity currencies on the other. This though was largely a result of equity support coming from the QE programs of the Fed, BoJ and later the ECB whereas sentiment in the commodity currencies was sharply undercut by depressed commodity prices as China s economic malaise deepened (translating to a weaker CNY and further adding to the negative sentiment in commodity currencies) coupled with active jawboning and the commencement of monetary easing by the Reserve Bank of Australia (RBA) and later by the Reserve Bank of New Zealand (RBNZ) and the Bank of Canada (BoC). This combination overwhelmed the commodity units resulting in a 25% 40% depreciation over the past 4 years. So Where To Now 1) Yield Differentials The more recent trends since late September have been one of relative stability that can be attributed to the Fed s message of a very gradual path of rate normalization when they commence lift-off, coupled with stability in China s asset markets following the burst of volatility seen early September. 05 MARKET PERSPECTIVES

7 And so for the year ahead, the outlook for global risk sentiment will critically depend on whether the Fed is able to set and maintain an ultra-gradual path towards rate normalization and also on whether the current stability in Chinese asset markets and CNY can be sustained. Such an outcome may help provide a more supportive backdrop for commodity prices and currencies resulting not so much in accelerated gains but more so supporting a higher floor in the commodity currencies than many analysts are currently suggesting (the area in AUDUSD, the level in NZDUSD and the in USDCAD). This view however carries significant risks as a sharper pickup in US wages growth or a US economy stalling would significantly alter the path of Fed rate normalization that will have a direct bearing on risk sentiment and yield differentials and where the commodity currencies are able to find a durable floor. But if all goes well for the Fed, then the ultra gradual path of Fed rate normalization will be driven by an equally gradual economic recovery in the US and the strength of the USD itself. The latter has received a lot of attention from Fed officials lately given that the US economy is now only one of two G10 major economies recording decent growth (the other being the UK) and Fed officials clearly do not want to see runaway USD strength as a by-product of monetary tightening that would pull the rug from the expected growth recovery in the US. This means that the USD will be a key calculation in Fed policy that would likely be calibrated with other central banks (including the RBA, RBNZ and BoC) to minimize USD gains and would also help provide better support to the commodity currencies at the lower end of their trading range. This presumably means that the RBA, RBNZ and BoC are also close to the end of their easing cycle. The recent commentary from the respective central banks certainly seems to back that up - the RBA s on hold in November has punctuated a turnaround in market thinking on how much further the RBA is likely to cut (only one more rate cut is discounted in current rates pricing see chart). To be sure, the RBA has left rate cuts on the table but its outlook on Australia s economic outlook and in particular, business investment and jobs has been more upbeat. Market s Expectations On RBA Rate Cuts Market s Expectations On RBNZ Rate Cuts Source: Bloomberg as of 11 November Source: Bloomberg as of 11 November MARKET PERSPECTIVES

8 It is a similar view on New Zealand where recent stabilization in domestic data has been accompanied by a 56% gain in dairy prices since August. This has resulted in a number of major domestic banks moving from expecting multiple rate cuts from the RBNZ to now expecting only one more sometime in 1Q16. If the markets are correct, then we are much closer to the end of the easing cycle from the RBA and RBNZ. This would also strengthen support for the AUD and NZD at the lower end of their trading range. Canadian fundamentals also continue to emerge from the shadows cast by last year s oil price shock and overall sentiment remains subdued. But as is the case for Australia and New Zealand, much of the economic hardship that Canada faces is probably discounted into market prices and further BoC easing is seen as highly unlikely, thus also strengthening support to CAD at the lower levels. 2) China And the Commodities Terms Of Trade - From a terms of trade perspective, Australia fares the worst among the 3 (see chart) where iron ore and base metals are hit the most by weaker Chinese demand. Our Citi Commodities Strategy team continues to expect a larger shakeout in iron ore prices post-chinese New Year, with sizeable cuts seen in Chinese steel production to push iron ore prices below 40/t. This is likely to weigh on AUD sentiment. The NZD real effective exchange rate on the other hand remains relatively elevated, having declined about 10% and once again, sentiment will be weighed by pressure to protect agricultural incomes and create a sustainable current account balance. CAD still trades with a high beta to WTI, and the recent bounce in crude oil has undoubtedly helped Canadian terms of trade. But our Citi Commodities Research team also expects WTI to fall to a high thirty handle in 4Q15 and this would also keep CAD sentiment in check. $Bloc terms Of Trade: Canada (green), New Zealand (red) and Australia (blue) Source: Citi Research Foreign Exchange Forecasts as of 16 October MARKET PERSPECTIVES

9 The bottom line therefore is that the currency weakness driven by the deteriorating terms of trade are probably likely to be triumphed by lesser pressure emanating from yield differentials, provided the Fed can successfully maintain a very gradual path towards rate normalization. This probably means that the lower end of the trading ranges ( in AUDUSD, in NZDUSD and in USDCAD) would probably end up holding, barring a China catastrophe. But the negative terms of trade is probably going to check any upside gains resulting in a 4 to 5 big figure trading range in each of these 3 pairs for much of MARKET PERSPECTIVES

10 World Markets At a Glance Last price 52-Week 52-Week Historical Returns (%) 20-Nov-15 High Low 1 week 1 month 1 year Year-to-date US / Global Dow Jones Industrial Average % 3.52% 0.59% 0.00% S&P % 2.88% 1.77% 1.47% NASDAQ % 4.59% 8.57% 7.79% Europe MSCI Europe % -1.13% -5.73% -2.76% Stoxx Europe % 5.27% 12.86% 11.46% FTSE % -0.17% -5.15% -3.53% CAC % 5.07% 15.98% 14.94% DAX % 9.58% 17.25% 13.40% Japan NIKKEI % 9.19% 14.91% 13.92% Topix % 6.93% 14.71% 13.90% Emerging Markets MSCI Emerging Market % -2.43% % % MSCI Latin America % 2.09% % % MSCI Emerging Europe % -2.11% % 4.74% MSCI EM Middle East & Africa % -4.37% % % Brazil Bovespa % 2.26% -9.86% -3.74% Russia RTS % 1.46% % 12.35% Asia MSCI Asia ex-japan % -2.54% -8.58% -8.58% Australia S&P/ASX % 0.39% -1.13% -2.86% China HSCEI (H-shares) % -3.26% -0.75% % China Shanghai Composite % 5.99% 48.02% 12.24% Hong Kong Hang Seng % -1.02% -2.55% -3.60% India Sensex % -5.27% -7.83% -5.93% Indonesia JCI % -0.53% % % Malaysia KLCI % -2.53% -8.80% -5.64% Korea KOSPI % -2.43% 1.63% 3.88% Philippines PSE % -1.81% -4.62% -4.12% Singapore STI % -3.35% % % Taiwan TAIEX % -2.17% -6.76% -9.04% Thailand SET % -1.75% % -6.93% Commodity Oil % % % % Gold spot % -8.35% -9.72% -9.03% Source: Bloomberg as of 20 November MARKET PERSPECTIVES

11 Currencies Forecasts Last price Forecasts Currency 20-Nov-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 G10-US Dollar Euro EURUSD Japanese yen USDJPY British Pound GBPUSD Swiss Franc USDCHF Australian Dollar AUDUSD New Zealand NZDUSD Canadian Dollar USDCAD EM Asia Chinese Renminbi USDCNY Hong Kong USDHKD Indonesian Rupiah USDIDR ,209 14,395 14,500 14,500 14,500 14,500 Indian Rupee USDINR Korean Won USDKRW ,196 1,215 1,221 1,212 1,203 1,194 Malaysian Ringgit USDMYR Philippine Peso USDPHP Singapore Dollar USDSGD Thai Baht USDTHB Taiwan Dollar USDTWD EM Europe Czech Koruna USDCZK Hungarian Forint USDHUF Polish Zloty USDPLN Israeli Shekel USDILS Russian Ruble USDRUB Turkish Lira USDTRY South African Rand USDZAR EM Latam Brazilian Real USDBRL Chilean Peso USDCLP Mexican Peso USDMXN Colombian Peso USDCOP Source: Citi Research, Bloomberg as of 20 November 2015; Forecasts as of 20 November MARKET PERSPECTIVES

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