Expectations rise for an improved economic cycle. Monthly Strategy Report December Equipo de Estrategia de Mercados de Banca March:

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1 Expectations rise for an improved economic cycle Monthly Strategy Report December 2016 Equipo de Estrategia de Mercados de Banca March: Alejandro Vidal, Unit Director, Market Strategies Rose Marie Boudeguer, Service Director, Research Services Pedro Sastre, Service Director, Market Strategies Sebastián Larraza, Director, Discretionary Management Services Paulo Gonçalves, Specialist Technician, Research Services Miriam Ordinas Sanjuán, Specialist Technican, Market Strategies Joseba Granero, Specialist Technican, Research Services

2 Expectations rise for an improved economic cycle Financial markets discriminate by asset and sector in light of changing economic forecasts. Economic expectations shifted during the month due to several factors: the foreseeable increase in fiscal stimuli with the victory of Donald Trump in the US presidential elections, improved macroeconomic data, and a rebound in oil prices. These factors prompted financial markets to enter a context of discrimination by assets and sectors that may be affected by both new economic policies and higher inflation. Trump s victory in the presidential election prompts uncertainty about potential changes to US economic policy. In the United States, attention focused on the victory of the republican candidate in the general election and the republican control of both chambers of congress (the Senate and the House of Representatives). This result will facilitate approval of the measures in the president-elect s platform, which include: i) lowering the tax burden (cutting corporate taxes from 35% to 15% and reducing income taxes); ii) promoting an infrastructure investment program; iii) implementing foreign policy changes (greater restrictions on immigration and increased tariffs on imports from Mexico, China and Canada); and iv) easing regulations on the financial and energy sectors. Stimulus expectations also rose in Europe as the European Commission president recommended a fiscal expansion equal to 0.5% of GDP to stimulate recovery. The Fed hints at rate hikes Regarding monetary policy, the main central banks cemented their positions. In statements, the Fed chair intimated that a rate hike was likely in the short term, but she reiterated that the cycle of increases would be gradual. while the ECB and BoJ maintain expansionary monetary policies. For his part, the ECB president praised the positive effects of the monetary stimulus and raised concerns about the still-low levels of inflation, which are expected to rise progressively. All of this allayed fears of an imminent reduction in the ECB s asset-buying program. OPEC agreed to cut production and oil prices rebounded as a result. Meanwhile, in Japan, the central bank announced its first unlimited purchases of public debt under a program designed to explicitly control curve rates in an effort to achieve its target of keeping 10-year rates around 0%. Oil prices experienced high volatility over the course of the month as a result of the OPEC meeting, where it was ultimately agreed that production would be cut by 1.2 million b/d to roughly 32.5 million b/d. This is the first cut agreed by OPEC since 2008 and would situate production at levels equal to those at the close of last year. The reduction was agreed for a period of six months and may be extended. In addition, other non-opec countries, like Russia, would participate in these cuts. This decision bolstered oil prices: a barrel of Brent soared +4.5% to exceed $50.. The OECD expects global growth to accelerate next year Macroeconomic data was positive and confirmed a rebound in activity in the second half of the year. In this context, the OECD raised its global GDP growth forecast for next year by one tenth to +3.3%, from the +2.9% recorded for Though it hinted that the global economy would

3 remain in an environment of sluggish growth, fiscal stimulus would drive activity. Among the major economies, it expects 2017 growth of +2.3% y-o-y for the US and +1.6% for the eurozone, with Spain advancing +2.3%. On the downside, more moderate growth of +1.2% and +1% is expected for the United Kingdom and Japan, respectively. while the data confirmed activity improvement in the US in Q3. With regard to the macroeconomic figures published in November, growth rebounded in the United States, with Q3 GDP advancing at its highest rate in the last two years (+3.2% annualised quarterly), consumer spending being the main driver (+2.8% annualised quarterly). Moreover, the outlook for the holiday push is encouraging with the National Retail Federation expecting retail sales to climb +3.6% y-o-y, exceeding last year s figures. The eurozone repeated its growth rate In the eurozone, the economy maintained a healthy GDP growth rate, increasing +1.6% y-o-y in Q3. Despite an uptick, inflation remains low with CPI at +0.6% y-o-y in November. It is also worth noting that the region s business confidence indicators rose to the highest levels of the year, with the composite PMI at with positive figures from Spain. The Spanish economy remained one of the most dynamic in the region, with Q3 GDP up +3.2% y-o-y, having accumulated six consecutive quarters of advances in excess of +3%. Inflation continued to recover and the CPI again gained +0.7% y-o-y in November, the third month in positive territory. Data were also encouraging in Asia. In Asia, activity data were positive, with Japan growing +2.2% annualised quarterly in Q3, driven mainly by the foreign sector. Meanwhile, in China, activity indicators were mixed: industrial production repeated +6.1% y-o-y, while retail sales slowed to +10% y-o-y. Leading indicators, however, point to improvements in activity: the official manufacturing PMI escalated to 51.7 and the services PMI reached while in Latin America, discrepancies between the monetary policies of the two largest economies persisted. In Latin America, discrepancies between the monetary policies of the two largest economies persisted: in Brazil, for the second consecutive month the central bank slashed interest rates 25 b.p. to 13.75%, while rates rose in Mexico, 50 b.p. to 5.25%, in an attempt to curb depreciation of the peso. Deflation concerns are allayed, affecting government debt... Bond markets were adversely affected by the expectations of higher inflation. As a result, in November we saw a hike in the most pronounced interest rates on the long portions of the curve and, particularly, in the United States: the required yield on a 10-year bond rose 56 b.p. to 2.38%, its highest level since Meanwhile, in Europe, the required yield on the German equivalent climbed 12 b.p. to 0.28%. The more modest increase of rates in Europe is the result of divergent monetary policies and lower inflation prospects for the region. Peripheral debt also registered losses due to political uncertainty in Italy in the run-up to the constitutional referendum. In the case of Spain, 10-year rates rose 35 b.p. to 1.55% and the Spanish sovereign bond index shed -2.3% in the month.

4 and spread to the credit market. The sharp rise in sovereign rates also put pressure on corporate debt: overall, investmentgrade credit dipped -2%, while high-yield corporate debt lost -0.5% because narrower spreads absorbed part of the sovereign rate increase. Finally, emerging debt fell sharply on concerns of more protectionist measures from the US president-elect and the adverse effect of a Fed rate hike. Sovereign debt in local currency experienced the most significant declines, falling -6.7% in November. Stock performance was mixed: US shares closed higher on corporate results and improved growth forecasts. Global stock markets were bolstered by improved activity and a positive Q3 corporate earnings season: with 99% of S&P500 companies reporting, the ratio of positive surprises was 76% and profits rose +2.7%, confirming a turning point in corporate profits. This factor, coupled with fiscal stimulus expectations, drove US stocks, which gained +3.4%. In Europe, stock markets failed to close with gains; the EuroStoxx50 closed flat, while the Ibex35 slumped -5% given the weakness of some of its main securities with greater exposure to emerging markets. As with bonds, emerging stock markets experienced the poorest relative performance, with the MSCI Emerging Market Index slipping -4.7% in dollars. The dollar appreciated on activity data and rate-hike expectations... The dollar strengthened on expectations of higher economic growth and a subsequent rate hike from the Fed in the short term. In the dollar/euro crossover, the greenback appreciated +3.3% to close at 1.06 EUR/USD. The pound sterling also regained ground, earning +5.4% against the euro to 0.85 EUR/GBP. The yen, meanwhile, depreciated -5% against the euro to 121 EUR/JPY. factors that weighed on gold. The prospect of a US interest-rate hike and the strength of the dollar weighed on the price of gold, which declined -7.7% in November.

5 Strategy for December 2016 Equities Bonds ASSET ALLOCATION Positive Neutral Negative Cash Variable income Fixed income ASSET ALLOCATION Positive Neutral Negative Eurozone EE.UU. Europa del Este Asia Corporate Debt High Yield Emerging debt Convertible Bonds Latinoamérica Government Bonds (AAA, AA+) Corporate Debt Inv. Grade Good data and improved prospects after the corporate earning season. In November, economic growth in the United States and the eurozone advanced at a reasonable pace and leading activity indicators suggest that this expansion should continue or even gain more traction in the coming months. Commodity prices, though far from maximums, have ostensibly recovered and corporate profits in the United States have returned to the path of growth. Moreover, the new US president has called for short-term measures that may augment this process with fiscal stimuli and public investment. Higher inflation is expected due to the Trump effect. The markets have anticipated and reflected certain factors in prices, perhaps somewhat brusquely and hyperbolically, and have begun to assess whether stimulating a growing economy near full employment with lower taxes and infrastructure investments will lead to significant growth in wages and prices. As a result, long-term interest rates have risen sharply. Interest-rate curves adversely affected. We are seeing a repositioning toward a scenario of higher growth and higher inflation. This has gravely affected long-term investment-grade bonds due to rate hikes, steepening curves, and a major divergence between equity indices, with increases in more cyclical sectors and declines for those more sensitive to higher rates. A scenario of more robust growth and inflation is much more likely today than it was six months ago. The stabilisation of commodity and production prices, coupled with more expansionary fiscal policies, particularly in the United States, will trigger an upward trend in consumer prices: inflation will escalate. European monetary assets remain stable awaiting ECB action. Few changes are expected in European monetary asset yields. Eurozone money market rates will remain relatively stable in light of expectations that the ECB will keep benchmark rates unaltered in December while extending its bond-purchase program. Sharp increase of upside risks on government rates on both sides of the Atlantic. In government bonds, an increase in yields is expected along the US curve, which will widen

6 moderately relative to the German curve. The uptick in inflation and expected Fed rate hikes imply that the interest rates on the US and German curves will rise. However, contagion to the European curve would be limited by the different cycles of the US and Europe, political risk within Europe, and the possibility that, at its next meeting, the ECB decides to extend its purchase program and make its policy more expansionary than was expected a few days ago. Peripheral bonds will remain under pressure in the coming weeks from heightened political uncertainty. Strong credit fundamentals persist. Credit is buoyed by reasonable spreads in a context of default rates that are expected to decline in the coming months and a global economy wherein growth is expected to accelerate. Nevertheless yields remain very low despite a slight increase last month. The upward trend in benchmark rates (sovereign curves) poses significant risks, especially for the higher credit categories. The short-term, high-yield category shows relative strength. In an environment of rising base rates, the least-exposed private debt is in the high-yield category. Emerging bonds suffered a double blow from the appreciation of the dollar and an increase of interest rates, and convertible debt was enhanced by growth acceleration. Better-than-expected corporate earnings, especially in the US. After five consecutive quarters of declines, a turnaround in corporate profits was confirmed. The results of the corporate earnings season beat expectations. At the sector level, consumer goods, healthcare services, and technology maintained solid profit growth, while the main surprise was the financial sector, which emerged from negative territory. In recent months, however, sector rotation has accelerated on the improved economic cycle and the rebound of commodity prices. The Q3 corporate earnings season saw a turnaround in the analysts revisions. Expectations for the coming year remain high, assuming double-digit increases in profits. Reasonable valuations with good future prospects for equities. Global stocks are pricey and still exposed to risk: in terms of P/E ratio, the MSCI World is situated at its historic average in a context that will continue to be affected by political uncertainty and a less expansionary monetary policy. As such, it is essential to confirm that global growth will continue and with it, corporate profits. We maintain a positive outlook for the dollar and a negative outlook for the pound, with more limited movement. Following the victory of D. Trump in the US elections, the dollar s upward trend persists. A highly expansionary fiscal policy, coupled with an economy in full employment and increasing inflation, could precipitate a faster-than-expected process of interest-rate hikes in the medium term. Moreover, the greater fiscal deficit, generated by increased spending and heightened uncertainty, should limit the appreciation of the dollar. The GBP has been the main beneficiary of Trump s win, given the spike in interest rates and the president-elect s comments that the United Kingdom will be first on the list in new trade relations with the US. The British currency is likely to depreciate further, however, due to expectations of a slowdown in the United Kingdom, the increasing current account deficit, and uncertainty about the Brexit. Risks promoted by political events and central banks. Perhaps what we are seeing is an overreaction from markets in favour of the most obviously

7 overvalued assets following a prolonged period of rock-bottom rates. Several important events will take place in the coming weeks, including the constitutional referendum in Italy and the meetings of the major central banks, which could result in changes to the ECB s monetary expansion plan and an increase in the federal funds rate on the part of the Federal Reserve. Albeit cautiously, there is a gradual shift toward more cyclical risk premia in portfolios. Trump s propensity for protectionism as well as his willingness to ease regulations in the financial sector, for example, are two factors that could stimulate further growth in the world s largest economy. Therefore, we are faced with a negative scenario for long-term high-grade bonds, and a positive scenario for the more cyclical equities sectors, short-term medium-grade corporate debt, and the dollar. If this trend persists over time, our portfolios should be overweighted in this asset class.

8 Euribor Euribor 12 months (3 years) Currencies Government Bonds EUR/USD (3 years) 10 years government yields Corporate Bonds (1 year spread) Commodities Equity Indices IBEX35 (3 years) Data: Bloomberg

9 Equity Indices performance (3 years)

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