Europe Insights Monthly update on European markets

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1 Europe Insights Monthly update on European markets Summary March 217 The Eurozone composite PMI survey rose to 56. in February, its highest level since 211, confirming that economic activity is running well above trend On 9 March 217, the Governing Council of the European Central Bank (ECB) confirmed that it will not rush into monetary tightening as long as core inflation remains below its target and until the European recovery is on solid footing Political risk is the main driver of volatility in sovereign and credit spreads. In France, investors remain wary of anti-euro populist forces ahead of upcoming elections and have started pricing a political premium or redenomination risk. If a Eurosceptic president is elected, organising a referendum on European Union (EU) or Eurozone membership would involve many hurdles European equities: European and Eurozone equities rose by 2.92% and 2.62% respectively over the month. Brent declined by 1%. The euro depreciated from $1.8 to $1.6. Fixed Income: All credit sectors gained ground in February. The euro high-yield market enjoyed a strong February, ending.97% higher. We remain underweight rate duration as we see core European government bonds overvalued and tactically adjust positions in times of volatility In the Spotlight: French elections at centre stage Risks over an EU break-up and redenomination Sovereign bond markets have started pricing a political premium or redenomination risk for France, as well as other peripheral countries (chart 1). Investors remain wary of anti-euro populist forces ahead of upcoming French elections for the presidency and the National Assembly (Lower House). The political landscape is comprised of five candidates holding more than 1% of voting intentions in opinions polls (table 1). However, the French two-round electoral system favours alliances and sticks to mainstream parties, with French institutions designed to support balanced powers between the President, the Prime Minister and the government and National Assembly. Should a Eurosceptic candidate be elected, organising a referendum on European Union (EU) or Eurozone membership would involve many hurdles. Chart 1. Eurozone sovereign bond markets 1-year bond yield spreads versus Germany Year bond spreads In basis points France Italy Spain Ireland Netherlands Source: Bloomberg 8/3/217 The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns.

2 French Presidential elections: 23 April & 7 May 217 France has a two-round election system meaning a candidate must secure 5% of the vote to be elected in the first round (which has never occurred and appears unlikely based on current opinion polls). If there is no winner, a second round is held between the two front runners. Opinion polls do not necessarily predict the final outcome, e.g. in the case of Brexit referendum and US election. Nevertheless, current opinion polls on voting intentions show that anti-euro populist candidate Marine Le Pen leads in the first round (table 1), but would fail by a large margin in the second round (chart 2). Table 1. 1st Round of French Presidential Elections Voting intentions' range in official opinion polls (period: 2/12/216 to 9/3/217) Chart 2. 2 nd round of French Presidential (% of voting intentions / period: 2/1/217 to 8/3/217) Front National En Marche Front National* Candidates > 1% voting intentions Les Républicains En Marche Front National Socialist + Greens France Insoumise* M. Le Pen F. Fillon E. Macron B. Hamon JL. Melenchon Far Right Right Center Left Left Far left Voting intentions (%) in official opinion polls Results' ranges since December Average results of opinion polls - Week 1-8 March * French Eurosceptic populist parties: Front National / France Insoumise Les Républicains Sources: Official opinion polling for the French presidential 217 elections: Ifop Fiducial, Harris Interactive, BVA, Kantar Sofres, Elabe, Odoxa, Opinion Way), as of 9 March 217. Role of French President The French political system is labelled as a semipresidential regime 1. The French President has many responsibilities, ranging from promulgating laws and treaties, signing ordinances and decrees, and asking the National Assembly to revise a law. The President is also the Commander-in-Chief of the French Armed Forces and is the guarantor of the observance of treaties. Article 16 of the Constitution gives full power to the President if he/she considers that the country is under serious and immediate threat. In the past, during cohabitation 2 periods (different party affiliations of the President and the National Assembly s majority), the President was able to delay or veto several government and National Assembly decisions. However, the President s powers are contained by the National Assembly to some extent. If the President has full power to appoint the Prime Minister (PM) of his/her choice, he/she needs the PM s advice to choose and appoint the members of the government. The PM and the government are then approved via a confidence vote of the National Assembly (by jurisprudence, not an obligation). The PM and the government oversee current state affairs and are accountable to the National Assembly which can bring down the government via a no-confidence vote. French legislative elections: 11 & 18 June 217 French legislative elections for the National Assembly are also held with a two-round electoral system. The National Assembly has 577 members, each of whom is elected to a single-seat constituency (its geography and census were set in 21). If a candidate does not achieve more than 5% of the votes, then those who achieved more than 12.5% move to the second round. This system has favoured candidates able to make alliances. The National Assembly takes prominence over the Senate (Upper House) and has the final say. The National Assembly can use Article 68 of the French Constitution to dismiss the President if it considers he/she violates the Constitution. Since 22, terms for National Assembly members and the Presidency are aligned at 5 years containing the risk of cohabitation periods; French elections in 22, 27 and 212 led to stable majorities. If opinion polls are correct, the French anti-populist party, Front National, would get between 58 and 64 seats at the National Assembly (versus 2 seats currently), short of the 289 seeds needed for an absolute majority 3. Hurdles linked to a referendum in France Organizing a referendum on EU or Eurozone membership in France requires overcoming many hurdles: (1) using Article 89 to change the Constitution (EU membership is written into the French Constitution) would imply a vote by both houses of the Parliament; (2a) using Article 11 (Eurozone membership is not explicitly mentioned in the Constitution 4 ). A change would need to come as a proposal from the Prime Minister, followed by a debate in Parliament and a Constitutional court agreement; (2b) using Article 11 via a referendum (1% of the electorate and 2% of Parliament), in addition to a Constitutional Court validation within one month. As such, organising a referendum would involve the support of either both houses of the Parliament, the Constitutional Court, the Prime Minister or the electorate. (1) In 197, Maurice Duverger, French jurist, sociologist and politician, introduced the concept of semi-presidential government (régime semi-présidentiel) in political science to explain the political system of the French Fifth Republic. (2) Cohabitation is a period of government when a President and a government come from different party affiliations. There have been three cohabitations in France: (Mitterrand-Chirac), in (Mitterrand-Balladur) and in (Chirac-Jospin). Since 2, the term of the President was shortened from seven years to five years, reducing the risk of cohabitations. (3) Opinion Way, La Lettre de l opinion Législatives, vers une recomposition inédite?, 22 June 216 (4) Using Article 11 instead of Article 89 would need validation by the Constitutional Court that the euro membership is considered as reforms relating to economic, social and environmental policy of the Nation reported in Article 11 The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target. 2

3 Real Est Health Care Consumer Dur Autos Energy Hotel/Rest/Leis Telecoms Chemicals Banks Cap Goods HHold & Pers Food Prod Food Retail Insurance Beverages Media Software Utilities Pharma Europe Insights March 217 European equity markets: review and outlook European and Eurozone equities rose by 2.92% and 2.62% respectively over the month. Brent declined by 1%. The euro depreciated from $1.8 to $1.6 February review European and Eurozone equities rose by 2.92% and 2.62% respectively over the month. Brent declined by 1%. The euro depreciated from $1.8 to $1.6. Euro zone government bonds yields increased across the board. Economic data beat expectations: Macroeconomic data from the Eurozone continues to be solid with a February PMI of 56, the strongest expansion in factory activity since April of 211. Factory activity rose faster in the Netherlands, Germany, and Italy but slowed in Spain, Ireland, Austria and France. The rate of contraction in Greece moderated. Styles: Growth strongly outperformed Value, and Small caps slightly outperformed Large caps. Sectors: Technology, Pharma, Food Beverage & Tobacco, Household & Personal Products and Real Estate outperformed while Energy, Financials and Materials underperformed. What market discount for French political risk? At first glance, if ever an Eurosceptic is elected, it may have a bearing on the equity market but French companies will retain their attractiveness in terms of sales outside of France (72%) and valuation discount to European peers Some market pundits are concerned by the recent progression of French equities because of the recent decoupling of the spread between Bunds (German Government 1Y bonds) and OATs (French Government 1Y bonds). In other words, tightening spreads between Germany and French bonds (see chart 3, right hand scale) have been correlated with a rising French equity market; however, the market seems to be shrugging off the widening of spreads in the run up to the French presidential election. Chart 3. France OATs spread (vs German Bund) & CAC (1/3/213 3/3/217) 5,3 5,1 4,9 4,7 4,5 4,3 4,1 3,9 3,7 3,5 3,3 CAC OATs spread (rhs) July 216 Oil price Crash 7 8 3/13 3/14 3/15 3/16 3/ At first glance, it seems evident that the increasing risk of the Eurosceptic far right party victory should have a bearing on the equity market but French companies will retain their attractiveness in terms of sales outside of France (72%) and valuation discount to European peers. Chart 4. French companies 12-months forward Price to Book relative to European peers Source for Charts: UBS Research, displayed at 3 March 217.The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 3

4 European equity markets: sector positioning Please note, relative sector weightings are predicated on selecting stocks in sectors which generally have the biggest tailwinds; however, the strategy could potentially overweight sectors where we are not necessarily positive, but which contain a sufficient number of attractive stock candidates. Key sector over and under weights* Sector Weight* Rational Banks OW The overweighting results from our preference for retail Eurozone banks outside of Germany. The sector is bouncing back thanks to higher interest rates; moreover, the regulatory environment seems to be softening due to disagreements over a finalized global framework. The sector is much better capitalized than ever before. Capital Goods OW The overweighting results from continued growth momentum in the sector even though European capital goods have already outperformed significantly on the back of strong consensus earnings upgrades. Commercial Services & Supplies OW The overweighting results mainly from companies with consistent growth and attractive valuations. Autos OW The overweighting results mainly from positions in auto supplier and component companies which are benefitting from sustained demand as well as from auto makers benefitting from a recovery in the European market. The stabilization of key emerging market economies is also contributing to an improved outlook. Food Retailors OW The overweighting results mainly from additions to our positions in attractively valued companies with solid business model. One of our holdings is benefitting from lasting cost and revenue synergies after merging with another retailor having significant exposure (%) to the North American market. Consumer Durables & Apparel UW The underweighting stems from the fact that the sector is composed of a lot of very expensive luxury good companies. * Overweight (OW), Neutral (N), Underweight (UW) Healthcare UW The underweighting stems from the fact that the sector is very sensitive to pricing of drugs in the US which will continue to be under pressure in spite of a Trump presidency. Food & Beverage UW The underweighting stems from the fact that companies are expensive (45% premium to the market) with high (about %) exposure to emerging markets. We prefer cheaper domestic oriented names. Diversified Financials UW The underweighting results from our desire to counterbalance our overweight position in banks. Household & Personal Care UW We are slightly underweight in this sector mainly for valuation reasons. We pared down our holdings because we believe that the sector as a whole is expensive, particularly in an environment of rising inflation. *Position of European strategy in terms of key Overweight (OW) and Underweight (UW) versus MSCI Europe Sources: HSBC Global Asset Management/Factset as of 1 March 217. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. 4

5 Euro Fixed Income: review and outlook Euro credit market posted decent performance in February, although largely due to sovereign bonds as credit spreads were a touch wider than at the end of January Euro rate and Credit environment In February, the market environment was similar to January. The credit quality of most of issuers remains solid, supported by the economic recovery in Europe and worldwide. Euro credit posted decent performance in February, although largely due to sovereign bonds (German 1Y yields fell 22 basis points (bps) to.21% in a flight-to-quality move), as credit spreads at month end were a touch wider than at the end of January (iboxx Corporates index +3 bps wider). French Government OATs slowly recovered lost ground relative to Bunds but the spread between the two remains high (8 bps on February 22th). French corporate issuers, particularly in the financial sector, saw some volatility (while in most cases outperformed their treasury counterpart). German Schatz (2y) printed-.95%, a new record low. Peripheral government bonds remain volatile, with the BTP/Bund 1 years spread crossing the 2bps mark. All credit sectors gained ground in February, with corporate hybrids and CoCos bonds outperforming year to date. The Euro highyield market enjoyed a strong month, ending.97% higher All credit sectors gained ground in February with corporate hybrids and CoCos bonds outperforming year to date (sectors posting two consecutive months of positive returns). The Euro high-yield market enjoyed a strong month, with prices ending.97% higher. Gains were steady throughout the month, volatility was rock-bottom. New issue volumes has been steady and the new deals have not seen a shift in pricing dynamics: books remain well oversubscribed and final pricings are still inside initial guidance. French 1Y sovereign bond yield spread versus Germany Source: Bloomberg, as at 28 February 217 We remain underweight rate duration as we see core European government bonds overvalued and tactically adjust positions in times of volatility Outlook 217 Political risk in Europe remains the main driver of volatility for sovereign spreads and, thus, credit spreads. Economic indicators are positive in Europe and the USA, and the market has adequately priced in the Fed s expected rate hikes. The ECB will likely not rush into monetary tightening as long as core inflation remains anchored well below its target and until the European recovery is on solid footing. Balance sheets are stable in Europe, leverage is lower compared to the US and Merger & Acquisition is neutral. The upgrade-downgrade ratio is supportive for the asset class and earnings support. These factors provide support to the credit markets but valuations are neutral. The beta range for our portfolios remains steady at Euro credit spreads are fairly valued, positioning in the cycle is favourable (early stage of a growth recovery) and corporate fundamentals are still supportive (default rates expected to hover around 2%/3% over the coming years). The Euro credit market offers appealing pockets in term of risk-adjusted returns. We remain underweight rate duration as we see core European government bonds overvalued and tactically adjust positions in times of volatility. Sources: HSBC Global Asset Management / Bloomberg / Barclays - Bank of America / Merrill Lynch indices as of end of February 217. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 5

6 Data watch 9 March 217 Indicator Data as of Actual Consensus Previous data PMI composite Feb GDP quarterly, % QoQ Industrial production % YoY Unemployment rate Trade balance, monthly EUR Bn (12Mth cumulative) Retail sales % YoY Inflation: - Headline CPI, % YoY Inflation: - CPI core*, %YoY ECB Refinancing rate Q4.4%.4%.4% Dec. +2.% +1.7% 3.2% Jan. 9.6% 9.6% 9.6% Dec Jan. 1.2% 1.5% 1.2% Feb Flash** 2.% 2.% 1.8% Feb..9%.9%.9% 9 March.%.%.% Deposit rate -.% -.% -.% Analysis The Eurozone composite PMI survey rose to 56. points for February, its highest level since 211, reiterating the notion that economic activity in the region is currently running well above trend. The final estimate of Eurozone Q4 GDP was confirmed at.4% qoq (+1.7% yoy), matching the previous quarter s rate of expansion. Household consumption remained the largest growth driver, contributing.3ppts to headline growth, whilst fixed investment, government spending and inventories all added.1ppts each. For the first time since Q4 215, net trade dragged on growth (-.1ppts).GDP growth accelerated in Germany (.4% qoq vs..1% in 3Q) and in France (.4% qoq vs..2% previously), while Italy weakened slightly (.2% qoq against.3%). Spanish growth remained relatively strong (.7% qoq). The increase in Eurozone industrial production was mainly driven by energy (+6.5% yoy), durable consumer goods (+3.9% yoy) and intermediate goods (+3.4% yoy). IP declined in Germany (-.7% yoy vs. 2.3% in Nov), while it accelerated in Italy (6.6% yoy vs. 3.3%) and slowed down in France (1.3% yoy vs. 1.9% in Nov) and in Spain (1.9% yoy against 2.8% previously). The Eurozone unemployment rate remained at 9.6% in January, twoand-a-half percentage points below the peak in mid-213, highlighting the progress made in the last few years. Across countries, the unemployment rate is historically low in Germany (5.9% in February, unchanged), and continued to improve in Spain (18.6% in Q4 vs. 18.9% in Q3). The unemployment rate remained elevated in France (mainland rate at 9.7% in 4Q after 9.8% in 3Q) and in Italy (rather unchanged at 11.9% in January). On a 12-month cumulative basis, the trade balance surplus (ex- Eurozone) surprised to the upside, leaving the full year at a record level. This was driven by the decline in imports (-.6% yoy over the 12-month period) and by rather stable exports (.3% yoy). Eurozone retail sales continued to surprise to the downside in January. The overall 3-month trend has remained solid (1.7% yoy). Consumer spending across the region have been supported by the ECB's very accommodative monetary policy and the improvement in the labour market. Eurozone CPI inflation accelerated to 2.% yoy in February from 1.8% the previous month, reaching its fastest pace in four years. The boost came mainly from the volatile food and energy components. Core inflation remained stable at.9% yoy for the third consecutive month, well below the ECB s target of 2.%, suggesting that underlying domestic price pressures remain muted. The ECB s Governing Council (GC) appears to be more confident in the macroeconomic outlook, with President Draghi stating at the press conference that the risks to the economic outlook have tilted less to the downside. The GC reported that the recent acceleration in inflation releases was mainly driven by a strong increase in energy and food prices, with no signs yet of a convincing upward trend in underlying inflation. The Asset Purchase Programme (APP) will remain at 8bn for March, before falling to bn per month from April to December. (*) Eurozone CPI Core is CPI excluding energy, food, alcohol & tobacco (**) Flash estimate: Eurostat terminology for advanced headline inflation F: Final estimate A: Advanced estimate Indicates improved or better-than-expected data on month-on-month/quarter-on-quarter basis Indicates worsened or below-expectations data on month-on-month/quarter-on-quarter basis Indicates unchanged data or in line with expectations on month-on-month/quarter-on-quarter basis Sources: Bloomberg, Datastream, Eurostat, HSBC Global Asset Management, as of 9 March 217. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The views and opinions expressed herein are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 6

7 Important information The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All non-authorised reproduction or use of this document will be the responsibility of the user and may lead to legal proceedings. The material contained in this document is for general information purposes only and does not constitute advice or a recommendation to buy or sell investments. Some of the statements contained in this document may be considered forward looking statements which provide current expectations or forecasts of future events. Such forward looking statements are not guarantees of future performance or events and involve risks and uncertainties. Actual results may differ materially from those described in such forward-looking statements as a result of various factors. We do not undertake any obligation to update the forward-looking statements contained herein, or to update the reasons why actual results could differ from those projected in the forward-looking statements. This document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any financial instrument in any jurisdiction in which such an offer is not lawful. The views and opinions expressed herein are those of HSBC Global Asset Management and are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Past performance contained in this document is not a reliable indicator of future performance whilst any forecasts, projections and simulations contained herein should not be relied upon as an indication of future results. Where overseas investments are held the rate of currency exchange may cause the value of such investments to go down as well as up. Mutual fund investments are subject to market risks, read all scheme related documents carefully. We accept no responsibility for the accuracy and/or completeness of any third party information obtained from sources we believe to be reliable but which have not been independently verified. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain for making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided as an "as is" basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively 'the MSCI Parties') expressly disclaims all warranties((including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Copyright HSBC Global Asset Management Limited 217. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Global Asset Management Limited. 7