Raising The Bar! Key Insights. Global Macro Pulse. Mid-Year Outlook Update - June 2015

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1 Raising The Bar! Mid-Year Outlook Update - June 215 MACRO REPORT Key Insights Monica Defend Head of Global Asset Allocation Research Alessia Berardi Senior Economist Andrea Brasili Senior Economist Riccardo Soggiu Central Banks watcher Qinwei Wang Senior Economist, Central Banks Also contributing Abhishek Gon Edited by Claudia Bertino Head of Financial Communication 215 Outlook: We expect GDP growth to accelerate in 215 and 216, favoured by healthier domestic demand in Europe and in the US. A cyclical uptrend in the developed world could favor the turnaround in Emerging Markets, with easing downward pressures from China and a possible breakthrough of reforms in some key countries. Monetary policy: Monetary policies appear to be appropriate and supportive of economic growth in the main economic areas. Central Banks are providing financial markets with ample liquidity; this has contributed to preserving overall financial stability averting the risks of a deflation spiral that some had feared in past quarters. Fiscal policy has turned positive: Some Eurozone countries have enacted reforms that have improved their economic performance and the focus on austerity has significantly lessened in the region as a whole; in the UK, US and Japan the overall fiscal position is still one of stimulating growth. This should allow for further declines in unemployment rates and improve debt sustainability. Liquidity: Liquidity will be gradually transferred from Central Banks to the real economy. Imbalances: Global imbalances converge, opening internal imbalances. We believe fiscal policy will address these via reforms and investments. Lowflation: Inflation expectations will remain anchored but inflation will stay low for longer. Global Macro Pulse Source: Pioneer Investments. Data as of June 22,

2 Main Scenario High Conviction Ideas Global Themes: No global recession and no structural deflation are expected. Central banks are set to remain asynchronous (European Central Bank and Bank of Japan still enacting Quantitative Easing (QE) 1, Federal Reserve and Bank of England no longer injecting liquidity and pondering when to slowly start normalizing interest rates). Structural reforms are progressively kicking in in those countries that have enacted them. Regional Views: USA: Decent growth with progressive adjustments in the labour market. China: Economic stabilization and clearer picture behind reforms; the growth momentum is weaker, but the policy support is stronger, while deleveraging seems to be going in the right direction. Europe: Region seems to be progressing towards a new path of integration and economic growth; there appears to be a good chance for the recovery to become structural. Japan: The BOJ is busily inflating monetary aggregates, while the Government attends to enacting major reforms. Our Take Going Forward It is a debt super-cycle story, rather than secular stagnation or a savings glut. Growth will solidify but will remain more fragile for the time being. Macroeconomic policies reduce the risk of new mediocre and secular stagnation ( Keynes 2. ), addressing the lack of demand issue. Central banks will play a crucial role, they have purposefully gone beyond their conventional role. They are aware of the risks (liquidity and market manipulation in particular) and are trying to limit them by being vocal and transparent. Fiscal policy needs to address productivity to increase potential growth. Risks to this scenario range from global geopolitical risks to local fiscal inaction and to monetary policy s future exit strategy. What s New Compared to the Beginning of the Year Outlook We have raised our expectations on the volume growth of World Trade, on the basis of a more homogeneous pace in domestic demand across developed markets. We view the weakness of the US economy in Q1 as temporary. We expect economic growth to recover momentum going forward, from 216 onwards. The ECB s unconventional monetary policy progressively dissipates deflationary fears. Empirical evidence confirms this perception. Renewed economic growth in the developed markets will favor the turnaround in Emerging Markets, easing downward pressures from China and supporting possible breakthrough of economic reforms in key countries. 1 QE= Quantitative Easing. Quantitative easing (QE) increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. ECB refers to the European Central Bank. BOJ refers to Bank of Japan, Fed refers to Federal Reserve. 2

3 Focus on Developed Countries Where Do We Stand On Debt Deleveraging? One of the legacies of the crisis is the huge volume of debt accumulated: the short and long-term debt cycle are drags on growth potential, influencing investment and saving decisions. This is even more the case in a low real growth and low inflation world. We think it is worth taking a look at how the debt mountain has evolved recently in different DMs. Looking at the issue from the private sector perspective, it is easy to see that the US and UK are more advanced in the deleveraging process. Figure 1 A. Household and Non-Financial Corporate Debt Household Debt 11% 1% 9% 8% 7% 6% 5% 4% Q1 99 Q1 Q1 1 Q1 2 Q1 3 Q1 4 Q1 5 Q1 6 Q1 7 Q1 8 Q1 9 Q1 1 Q1 11 Q1 12 Q1 13 Q1 14 NFC Debt 14% 13% 12% 11% 1% 9% 8% 7% 6% 5% 4% Q1 99 Q1 Q1 1 Q1 2 Q1 3 Q1 4 Q1 5 Q1 6 Q1 7 Q1 8 Q1 9 Q1 1 Q1 11 Q1 12 Q1 13 Q1 14 United Kingdom United States United Kingdom Japan Euro area Japan Source: IMF, BIS, Central Banks. Pioneer Investments, as of June 22, 215. United States Euro area In fact, with both household and non-financial corporate debt, a quite significant adjustment is visible in recent quarters in both the UK and US, while in the Eurozone and Japan the decline is mild. Inside the Eurozone the picture is quite differentiated, with some countries experiencing a stronger reduction in debt overhang. Figure 1 B. Household and Non-Financial Corporate Debt in the Eurozone Household Debt 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Q1 95 Q2 96 Q3 97 Q4 98 Q1 Q2 1 Q3 2 Q4 3 Q1 5 Q2 6 Q3 7 Q4 8 Q1 1 Q2 11 Q3 12 Q4 13 Portugal Greece Spain Italy NFC Debt 16% 14% 12% 1% 8% 6% 4% 2% Source: IMF, BIS, Central Banks. Pioneer Investments, as of June 22, 215. % Q1 95 Q2 96 Q3 97 Q4 98 Q1 Q2 1 Q3 2 Q4 3 Q1 5 Q2 6 Q3 7 Q4 8 Q1 1 Q2 11 Q3 12 Q4 13 Portugal Greece Spain Italy 3

4 Even though Eurozone deleveraging is less advanced, ECB actions will favour it in the short/medium term, reducing the debt burden and favouring asset revaluation. Deleveraging can be obtained via growth, or via balance sheet operations that are more painful. Growth simply reduces the debt burden via revaluation of the asset side of the balance sheet. Hence, the first difference is that UK and US deleveraging is primarily a story of growth and profits. It is well known that the deleveraging of US listed firms has been ongoing for 7 years. Surely, one of the explanations behind the different evolutions is the fact that private and public sector deleveraging happened in different phases in the UK and US, with fiscal policy that was widely supportive in the aftermath of the crisis. It is clear that this was also helped a lot by non-conventional monetary policy actions, i.e. by QE that pushed up asset prices. Hence, a first conclusion suggests that deleveraging is less of a worry than some time ago, with notable reduction of the debt burden in some countries and a sort of promise to follow the same route in the Eurozone, thanks to ECB actions. Nonetheless, two sources of worry remain. The first is short-term and is related to the fact that the financial sector in some of the Eurozone countries is burdened by non-performing loans. It is not clear that, once firms increase their demand for loans to support investments, banking systems will be able to easily satisfy that demand. This is why the theme of the public supported bad bank is currently one of the most debated issues in Italy. The second concern is more medium-term. The low level of interest rates will ease the debt service burden for some time; however, the Eurozone must find a way to enhance its potential growth rate before the issue of debt sustainability (on the public side) comes to the fore again. The issue of deleveraging can be also investigated by looking at the flow of fund dynamics in terms of the net borrowing/net lending position of the different operators. Figure 2 A. Net Lending/Borrowing by Sectors Eurozone 6% 4% 2% % -2% -4% -6% Japan 15% 1% 5% % -5% -1% -8% Household NFC Rest of the World General Government Source: ECB, BOJ, Pioneer Investments as of June 22, % Household NFC Rest of the World General Government 4

5 In the Eurozone and Japan, it can be seen that in the private sector both households and Non-Financial Corporations (NFCs) are actually net savers, and by a nontrivial amount in Japan. This cannot be a situation conducive to a high rate of growth, but it is clearly linked to the balance sheet correction cited above. Note also the increasing negative contribution from the rest of the world in the Eurozone (this is the opposite of the current account position). Figure 2 B. Net Lending/Borrowing by Sectors UK 12,5% US 1% 7,5% 2,5% -2,5% -7,5% 5% % -5% -1% In some countries macroeconomic imbalances are rising, but in general the current situation is more stable than a few years ago. -12,5% Household NFC 29 Rest of the World 211 General Government 213 Source: FED, BoE, Pioneer Investments, as of June 22, % Household The situation in the US looks more in equilibrium, with one private operator (households) a net saver (which is quite natural) and the NFCs mild borrowers, while rest of the world and the public sector are also split with one above the zero line and the other below. This is also the case in the UK but with households and NFCs in the opposite positions, and a general picture that suggests less equilibrium given the widening current account deficit (the positive rest of the world line) and the still wide public deficit. NFC Rest of the World General Government A Look at Wage Dynamics in Developed Markets Wage dynamics give information on the future dynamics of consumption and are obviously related to profits and to productivity, but their evolution is also linked to competitiveness. Figure 1. Labor Costs in the US, UK and Eurozone 6 5 Labor Costs % YoY Q1 23Q4 26Q3 29Q2 212Q1 214Q4 United Kingdom United States Euro Area Source: Datastream, Pioneer Investments, as of June 22,

6 Wage dynamics are tame in Europe, but differentiated enough to favor some improvements in internal equilibrium and the still necessary internal devaluation. Wage growth was tame during the crisis, as an obvious consequence of the rise in unemployment in most of the countries. While in Europe the dynamics are still very weak, something of an uptick was recorded recently in the US and UK. Let s look at the details. In the Eurozone, setting the labour cost index at 1 in 2 Q1, as in the graph below left, in Germany the quite modest increase in labor costs (coupled with good productivity growth) drove a huge increase in competitiveness vs. the other Eurozone countries. The opposite happened in Spain and Ireland (incidentally, note the abrupt correction in Greek labour costs). However, the same data set at 1 in 212 Q1 suggests that recently the evolution has been the opposite, with Spanish and Irish labour costs virtually flat and the Italian and French costs starting to correct. Figure 2. Eurozone Labor Costs Index (Q1 2=1) Q1 21Q2 22Q3 23Q4 25Q1 26Q2 27Q3 28Q4 21Q1 211Q2 212Q3 213Q4 Index (Q1 212=1) Q1 212Q2 212Q3 212Q4 213Q1 213Q2 213Q3 213Q4 214Q1 214Q2 214Q3 214Q4 Eurozone Spain Italy Ireland Germany Greece France Eurozone Spain France Germany Italy Ireland Source: Datastream, Pioneer Investments, as of June 11, 215. Moreover, in Germany, with a very low level of unemployment and an economy in good shape, the evidence suggesting further increases in wages is clear: IG Metal signed a contract in February that implies a 3.4% yearly wage increase. First conclusion: while it is unthinkable to see a strong rise in Eurozone wages in the immediate future given the wide slack in the labour market (except in Germany), the picture is differentiated enough to allow for the necessary corrections of the internal devaluation story, favouring more equilibrium inside the area. The situation in the UK and US is different. In both countries, unemployment declined significantly in recent years but wage dynamics remained tame. With slack in the economy nearly absorbed, will wage pressures arise? 6

7 Figure 3. US and UK Wages and Unemployment UK 9% 5 US 12 In the UK and US, wages are on the rise, given the increasing tightness of the labor market, even though it has taken longer than in previous recoveries. 8% 7% 6% 5% 4% May-4 Apr-5 Mar-6 Feb-7 Jan-8 Dec-8 Nov-9 Oct-1 Sep-11 Aug-12 Jul-13 Jun-14 Unemployment AWE exl. Bonuses RS Source: Datastream, Bloomberg, Pioneer Investments, as of June 22, 215. AWE: average weekly earnings, AHE: Average Hourly Earnings. % % AHE unemployment Our impression is that, yes, some upward pressure on wages is on the way. Graphical evidence to support this view is provided below. Beginning with the UK, underemployment (the percentage of temporary or part time workers that would prefer working full time) remains above pre-crisis levels, suggesting that some buffer restraining any market power for employees remains. However, two indicators suggest a strengthening mode for wages. The first is the historically low level of claimant counts, while the second is the level of flows from being unemployed or out of the labor market to being employed, which has almost returned to pre-crisis levels. Figure 4. Increasing Tightness in UK Labor Market 5% 4% 3% 2% 1% % May-4 Apr-5 Mar-6 Feb-7 Jan-8 Dec-8 Nov-9 Oct-1 Sep-11 Aug-12 Jul-13 Jun AWE exl. bonuses Unemployment to employment Claimants count RS reverse order Inactivity to employment RS Source: Datastream, Bloomberg, Pioneer Investments, as of June 22, 215. Thousands % Jan- Mar 22 Jan- Mar 25 Jan- Mar 28 Jan- Mar 211 Jan- Mar 214 7% 6% 5% 4% 3% Let s move to the US. Here, it is interesting to see how more sophisticated measures, such as the Labor Market Condition Index of the Kansas City Fed, vindicate in some ways the delay in wage pressures despite an unemployment rate that has dropped from 1% in October 29 to the current 5.5% (see the graph below on the left). 7

8 Figure 5. US: Labor Market Condition Index, Average Hourly Earnings, and the Number of Voluntary Quits % % Thousands Central Banks will likely tighten gradually, but they will no longer have wages as an underlying reason to delay normalizing. Jan-92 Aug-94 AHE Mar-97 Oct-99 May-2 Dec-4 Jul-7 Feb-1 Sep-12 Apr-15 Source: Bloomberg, Pioneer Investments, as of June 22, Lab.mark.conditions index Nonetheless, the Employment Cost Index is already on the rise, and one of the much awaited signals on the labour market, the volume of employees who voluntarily leave their current job for another one, probably better paid, is now back to pre-crisis levels. Second conclusion: in the UK and US wages are on the rise, given the increasing tightness of the labour market, although it has taken more time than in previous recoveries. So while Central Banks will likely tighten gradually, they will no longer have wages as an underlying reason to delay normalizing. Jan-1 Oct-2 Jul-4 Apr-6 Jan-8 Oct-9 Jul-11 Apr-13 Quits numbers from JOLT Jan-15 8

9 EM Macro Pulse Economic Conditions At the end of 214, we said that the support to EM Economies coming from external demand was less potent than in previous years. We said that in order to classify the countries between Champions and Leftovers, we needed to identify the ones with aligned and credible fiscal and monetary policies and with strong reform programs in the works. There is a real opportunity for EMs as a whole to turn around over the next 6-12 months. Nonetheless, the macro picture could vary widely across individual countries. Growth External Conditions to Turn Around but Heterogeneity Remains High All major external drivers of Emerging Economies have turned to the downside over the last few quarters. But there is a good chance for these factors to turn around in the coming quarters, if demand from developed economies recovers some strength, China stabilises its economic conditions and oil prices stay relatively low, as in our central scenario. Global demand has been sluggish so far this year. In particular, the weakness from developed economies has weighed on manufacturing exporters, while China s investment-led slowdown continues to weigh on major metal prices and producers. Meanwhile, the sharp decline in oil prices since late 214 has hit energy producers in many EMs hard, while benefits to consumers do not seem to have been felt much yet. All these could change over the next 6-12 months, which should benefit EMs as a whole. 1. DM demand is likely to recover some strength and benefit manufacturing exporters, if the Q1 weakness in the US economy proves to be temporary, and the Eurozone starts to recover on the back of ECB QE. 2. There are signs that China s economic conditions are stabilising with continued policy efforts in recent months. This could ease downward pressures on commodity prices, although a turnaround is still unlikely. 3. If oil prices stay relatively low, benefits to consumers should be more visible. Nonetheless, the macro picture could vary widely across individual countries, as each economy is driven by a different combination of the above factors and in different directions. In addition, internal policy and reform agendas are also making big differences, with the external vulnerability of each economy to be tested by the Fed s rate normalisation. Figure 1. External Conditions to Turn Around with Divergences Among Countries Major macro factors for EMs H2 214 so far 215 H Champions Leftovers Economic Conditions Stability Conditions External Manufacturing External Metal External Oil Internal Policy; reforms FED policy Normalisation Manufacturing exports have weakened across EMs. China s property/inv-led slowdown has continued to weigh on major metal demand and prices. Sharp fall in oil prices has hurt oil producers markedly, but had limited positive impact on consumers so far. Policy easing in majority of economies with reforms in certain countries. Source: Pioneer Investments, as of June 22, 215. There is a fair chance for global demand to turn around led by US and EU. A bottom is perhaps not very far off, with China s structural adjustment more than halfway. No strong reasons for oil prices to go back to where they were. Support to consumers from low oil prices could start to be felt. Internal policy and reforms could make big difference. Exporters Importers Importers Sound policy/enough policy space; reformers FED QE tapering. FED rate normalisation. Resilient external conditions; enough buffer Weak manufacturing Exporters Exporters Bad policy/limited policy space; nonreformers Poor external conditions; little buffer 9

10 Overall, those who could benefit the most from this scenario would be the economies with relatively large manufacturing sectors and that are big importers of commodities and relatively resilient to external conditions, assuming the appropriate mix of domestic policies. The wild cards will be those countries able to push serious structural reforms. The wild card will be those countries able to push serious structural reforms. Most EMs are heavily reliant on external demand. Value-added data suggest that exports contribute around 2% or more of GDP for most EMs. In some economies, this figure could approach 6%. 2 That said, each EM focuses on different types of exports. In general, Asian economies have mainly manufacturing exporters, which should benefit the most from a recovery of global demand and international trade. In contrast, many in Latam and South Africa have become big commodity exporters over the last decade or so with their manufacturing sectors having been squeezed. They will probably continue to suffer, as commodity prices are set to remain low. Meanwhile, many in Asia are also big oil importers. If oil prices stay relatively low, this should benefit the region the most, via ongoing support to current account balances and gradual benefits to consumers. Figure 2. Exports (% of Own GDP, Value-Added, 29) Singapore * Malaysia * Thailand * Hungary Vietnam * Taiwan * Belgium HK * Chile ** Korea * Poland Russia Germany Israel SA Canada UK Indonesia * Philippines * Italy Mexico ** Argentina ** Turkey Australia Spain China * France India * Greece EU27 Japan * Brazil ** US Agricolture Industrial commodity (mining and metal products, incl. energy and metals) Others (largely msnufacturing) Sources: OECD-WTO TiVA, Pioneer Investments, as of June 22, Economic Policies With respect to internal conditions, we have analyzed the EM universe according to a number of fiscal and monetary policy measures. Fiscal Policy The chart below shows a kind of trade-off between the will of Governments to provide fiscal impulse to their economies and the constraints that they face in terms of Debt position. 2 Gross exports data are overestimating export dependence for many economies due to complicated manufacturing production chain across the region. OECD and WTO have produced data in value-added terms, which provide a fairer picture, although the latest data are for * Asia; ** Latam 1

11 Figure 3. EM Fiscal Policy General Governemt Debt % of GDP No Fiscal Room Intertemporal Budget Constraint Hungary India Brazil Malaysia Mexico Poland Argentina South Africa Thailand China Philippines Korea Colombia Turkey Indonesia Russia Peru' No Intertemporal Budget Constraint Chile Fiscal Room Cyclical Adjusted Primary Balance % of GDP Source: IMF, CEIC, Pioneer Investments, as of May 31, The majority of EM are seeking to provide some fiscal impulse, as identified in the right side of the chart. There, we find the countries that want to stimulate their economies through some relevant fiscal expenditure, allowing a worsening of their budget positions. However, the bottom right quadrant shows the winners : those countries that are going for a loosening fiscal policy in the current year, without a significant inter-temporal budget constraint (high Government Debt) 5 that will need to be dealt with, sooner or later. In our opinion, one of the most interesting conclusions here is the opposite ways Russia and Brazil are dealing with their current deep recessions. On one side, Russia is rushing towards a significant worsening of its budget position, recently accommodating a huge decline in revenues (oil prices driven) without changing the fiscal expenditure target. Russia intends to finance its expenditures by using up its emergency Reserve Fund. On the other side, the key word in Brazil is austerity. Brazil has an ambitious fiscal target surplus for 215. It was recently revised down, while keeping the target challenging for a country in recession. The non-mandatory spending (public investments) will be the most impacted. Other countries, like Indonesia, are in the winner quadrant by relying on a recent decision to cut subsidies expenditures and a safe debt position. However, Indonesia is struggling to collect revenues and, as a consequence of that, is delaying the infrastructure spending promised by the new President. Tax realization is running short and notwithstanding the fiscal savings gained with the subsidies cut, the Fiscal Deficit target will likely need to move above 1.9% of GDP (the legal limit is 3%). Monetary Policy At the end of 214, we said that the huge collapse in oil prices since September 214 had prompted a big downward revision in inflation forecasts by Central Banks globally. Many of the EM Central Banks cut their policy rates, but not Brazil and Russia, who actually raised them in an attempt to fight persistent strong inflation 4 The Fiscal Impulse is measured as the difference between the Cyclical Adjusted Primary Balance in 214 and the one in The threshold of Government Debt as % of GDP at 4% for the EM economies has been identified by the IMF. 11

12 and significant currency depreciation. More recently, Russia started to cut rates as well, as it tried to rescue the domestic economy. Today, according to our internal EM Taylor Rules, under the current economic conditions we are still in an environment of widespread Monetary Policy easing, with some exceptions. Asia offers a mixed picture. There are economies such as the Philippines, where the economic cycle is heating up (notwithstanding a weakerthan-expected first quarter of 215) and inflation remains under control. Another example is Indonesia, where the inflation rate is well above the Central Bank target while economic conditions are somewhat sluggish. Figure 4. EM Monetary Policy Philippines Indonesia Malaysia Colombia China Brazil Turkey Mexico Chile Czech Republic South Africa Peru India Israel Poland Taiwan Romania South Korea Hungary Thailand Source: CEIC, Pioneer Investments, as of May 31, 215. Looking at the chart above, everything appears rosy. However, the situation is more complex and there are two main risks: In many countries, the inflation rate has bottomed and the recent recovery in oil prices will push inflation higher. As a result, the condition necessary, if not sufficient, to lower rates will disappear. Some countries in the chart above will move to an on hold posture with respect to monetary policy, while others could easily turn to a tightening stance. The Federal Reserve is expected to hike rates in the time horizon under consideration. For many of these countries (e.g. Mexico), that may be enough to counter any willingness to lower policy rates, independent of domestic economic conditions. Stability Conditions At the time of the Fed tapering announcement, we developed an internal tool to measure the external vulnerability of EM countries and rank them accordingly. The parameters considered are the most common in the literature on this topic: they go from the Current Account as % of GDP, to the Reserve Ratios and to some domestic indicators such as Consumer Price Index or GDP composition 6. 6 The Vulnerability Index is a composite weighted index of normalized indicators. 12

13 Figure 5. Vulnerability Index 1 5 Index Source: Bloomberg, CEIC, Pioneer Investments, as of May 31, 215 Our conclusion today is that Brazil is the least appealing country in the EM universe, while at the opposite end we have a number of Asian economies that are adjusting and doing better. Among the so-called fragile five we identified at that time, India is the only country that has made significant forward strides. We can t say that the country is fully safe in the event of a disorderly exit from QE by the Federal Reserve, but the coordination between the political and monetary authorities is working well in India and it s visible in the results obtained on the inflation and current account deficit (CAD) fronts. Brazil, South Africa and Turkey remain fragile. Turkey ranked lowest in the Index, mainly due to deterioration in CAD at USD 4.9bn in Q1 15 compared to USD 3.6bn in Q4 14, along with a consistent fall in foreign direct investments and portfolio investments over the last three quarters. Deteriorating exports over the last 12 months due to reduced external demand for manufacturing products have resulted in a high external debt to exports ratio. Conclusions The EM universe is quite heterogeneous. According to the parameters identified below the external conditions, internal conditions and vulnerability our conclusion today is that Brazil is the least appealing countries in that universe, while at the opposite end we have a number of Asian economies that are adjusting and doing better. Figure 6. EM Rank Manufacturing Overall Oil & Metals Fiscal Policy Monetary Policy Vulnerability cycle Score China 3 Korea 3 Philippines 3 Thailand 3 Poland 2 Taiwan 2 Mexico 1 Indonesia 1 Malaysia 1 India 1 Chile Russia Turkey SA -2 Brazil Source: Pioneer Investments, data as May 215. External demand includes manufacturing cycle, vulnerability index includes reserves on short term external debt. The overall score is calculated as sum of single items. 13

14 Focus on China Source: Pioneer Investments, as of June 22, 215. Economic Conditions China s economic momentum further weakened in early 215. The weakness so far has largely come from property and commodity-linked areas, including the mining, heavy industry and state sectors. Exports have been downbeat as well, weighing on the private sector, which still has been holding up reasonably well on the back of relatively strong domestic consumption. A recent slowdown in retail sales has been largely due to lower inflation and oil prices and sales. Such weakness has triggered strong policy responses. In particular, the People s Bank of China (PBOC) has cut benchmark rates 3 times and the reserve requirement ratio twice since late 214. As a result, market rates have dropped markedly in recent months. Meanwhile, Beijing has enhanced its fiscal supports over the last few weeks. There is increasing evidence that economic conditions are stabilizing, particularly in property prices and sales. Despite continued easing, China still seems to be headed in the right direction with respect to deleveraging, but with an updated strategy. Beijing is relying largely on regulations to tighten shadow banking and control out-of-budget borrowing by local governments and lending towards sectors at overcapacity. Meanwhile, China has eased credit through relatively transparent and accountable channels, such as municipal bonds and IPOs. These moves are helping shift debt burdens from local governments, corporates (largely SOEs, State-Owned Enterprises) and banks to the central government and households, who still have very strong balance sheets. Such efforts should help improve the balance sheet for the economy as a whole while easing downside risks. Stability Conditions Ultimately, the key is reform, where momentum has been relatively strong. We have observed continued movement in key areas. In particular, the PBOC has lifted the cap on deposit rates to 1.5 times the benchmark and rolled out certificate of deposits (CDs) to nonfinancial investors, which means China is probably only one step away from full rate liberalization. Beijing has also started a debt swap scheme to exchange local governments out-of-budget borrowing through various financial vehicles to appropriate municipal bonds, with RMB 2trn currently scheduled for this year. Along with solid steps toward domestic reform, China is also further opening its financial 14

15 markets, including mutual funds and the repo market in recent weeks, with the Shenzhen-Hong Kong equity Connect scheme likely to be announced soon. These efforts should not only enable China to transform its domestic economy and avoid a hard landing, but also help increase China s role in global financial markets markedly over the coming years. 15

16 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of June 22, 215. Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: June 23, 215. Follow us on: 544_615 16