In Credit 13 MARCH 2017

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1 Index Level INFORMATION FOR INVESTMENT PROFE SSIONALS In Credit 13 MARCH 2017 Booming non-farm beats budget boredom David Oliphant Executive Director, Fixed Income Markets at a glance Price / Yield / Spread Change 1 week Index MTD return Index YTD return US Treasury 10 year 2.57% -2 bps -1.2% -0.5% German Bund 10 year 0.47% 0 bps -1.9% -1.7% UK Gilt 10 year 1.23% -1 bps -1.1% 0.2% Euro Investment Grade 121 bps -2 bps -1.0% -0.4% US Investment Grade 121 bps 3 bps -1.4% 0.1% UK Investment Grade 119 bps 0 bps -0.6% 0.9% Asia Investment Grade 193 bps 2 bps -0.8% 0.8% Euro High Yield 363 bps 16 bps -0.2% 1.6% US High Yield 389 bps 29 bps -1.2% 1.7% Asia High Yield 433 bps 7 bps -0.5% 2.3% Ben Myrtle Client Portfolio Analyst, Fixed Income EM Sovereign 332 bps 6 bps -1.1% 2.4% EM Local 6.8% -7 bps -0.6% 3.4% Bloomberg Commodity Index % -4.0% -3.7% EUR % 0.9% 1.5% JPY % -1.8% 1.9% GBP % -1.7% -1.4% Source: Bloomberg, Merrill Lynch, as at 13 March Chart of the week: Global Economic and Inflation Surprise indices Harry Lister Analyst, Fixed Income Yi Ming Oh Analyst, Fixed Income Economic Surprise Inflation Surprise Source: Bloomberg, March 2017.

2 Key markets overview Macro / government bonds Inflation and growth data continues to come in higher than most had expected as illustrated in Chart of the Week. This more optimistic background has weighed on core government bond markets, helping push yields higher in most places and resulting in the virtual certainty of a US interest rate rise on 15 March. After the robust initial claims data last week, the February employment report was expected to show the creation of around 200,000 jobs. In reality, the unemployment rate remained unchanged at 4.7% and there were actually 235,000 new jobs created with upward revisions to previous month s data. Elsewhere, it appears that US trade will be a drag on Q1 growth. The January trade deficit jumped to $48.5bn and imports have risen by 1.3% The UK budget detailed a fall in borrowing of around 16bn, which will result in a fall in gilt issuance. This comes as a result of higher tax receipts from better UK growth. The government upgraded its outlook for 2017 growth to 2%, which sits in line with thinking from the Bank of England. Elsewhere, softer UK data was found in the BRC retail monitor, as well as signs of slowing in the housing market and a dip in industrial production. Sterling remains under pressure and has traded as low as versus the US dollar in the last five days, In Europe, the ECB met amid signs of improving growth and increasing inflation in the region. There was, of course, no change in interest rates or QE at the meeting. Growth risks, however, have become less pronounced in the eyes of the central bank. It recognised signs of cyclical momentum that may be gaining strength with sentiment indicators at multi-year highs, credit growing and decent employment growth. These more optimistic signs remain mitigated by subdued core inflation and a lack of wage increases. In France, the dwindling support for the right leaning Republican Party candidate failed to encourage veteran Alain Juppe to enter the Presidential race. Investment grade credit Bank bonds continue to perform relatively strongly. Recent better results from some previously troubled banks (e.g. Allied Irish and Erste Bank) and further capital raising from Deutsche Bank have been well received. M&A has been in the news with Peugeot acquiring GM s European assets (Opel and Vauxhall) to become Europe s second biggest auto producer. German property giant Vonovia reported a sharp rise in the valuation of its portfolio, up by around 17%, illustrating the scarcity of housing in large German cities. In the UK, British Telecom has agreed to separate the Openreach network, its most profitable business, into a different legal entity. The network will remain owned by BT. This outcome is less bad for the company than being forced to sell the network consequently, bonds rallied modestly. High yield credit It was a softer week for European high yield. Credit spreads were wider although the market remains up around 1.5% year-to-date. Energy names came under pressure in response to the sell-off in oil (down more than 8% over the week) and US high yield, which has greater exposure to the sector, underperformed. The new issue market was much busier last week and we participated in a number of deals. Overall, as we move towards the end of earnings season, technicals are becoming less supportive (following higher primary market supply), and the outlook is becoming more uncertain as a result.

3 Emerging markets Emerging market spread tightening came to an end with the move in US rates and decline in oil weighing on the asset class in the latter half of last week; overall spreads widened 7bps to finish at 322bps. The focus last week was on inflation prints as we saw higher than expected inflation in Hungary and the Czech Republic alongside Mexico, where inflation rose to 4.9% y/y, its highest level in almost seven years. This inflationary story was in sharp contrast to Brazil and Russia where the former saw inflation come down to 4.86% from 5.35% y/y last month and closer to the 4.5% central bank target. Similarly in Russia, inflation y/y came in at 4.6%, down from 5% the prior month further supporting the disinflationary story. In monetary policy committee meetings last week, Poland stayed on hold as expected with rates kept at 1.5%. Newsflow was relatively quiet with initial discussions on the key Brazilian social security reform highlighting the likely concessions that will have to be made to pass this in congress. Finally, the political noise in Brazil could increase as the 78 depositions relating to the Odebrecht corruption scandal are reviewed in the coming weeks. Commodities The WTI crude oil price slid below $50 per barrel for the first time since late This is being led by a significant inventory build in the US. The measure of oil prices has declined by over 9% since last month and consequently we are looking to cover our underweight at these levels. Base metals were also weaker with copper -4% down over the week due to Chinese environmental concerns and strikes at Freeport s Cerro Verde mine in Peru.

4 Summary of fixed income asset allocation views Strategy and positioning (relative to risk free rate) Overall Fixed Income Spread Risk Views Following the US election, markets have priced in the growth-positive Trump policies (tax cuts, infrastructure spending) while ignoring much of the growth-negative proposals (trade, immigration). Markets need to provide greater risk premiums to make overall spread risk attractive given the uncertainty surrounding the new administration. Risks to our views US data turns over A broadening of the default cycle beyond commodity sectors Geopolitical tensions escalate China hard landing Reflation trade prolongs the credit cycle Duration (10-year) ( P = Periphery) Short P $ Long Long Australia u/w Periphery Long France vs Belgium / Netherlands Divergence of US rates to Europe Heightened perception of Trump reflation Improved sentiment towards Italy Currency Short $ Long Remain strategically negative RMB 3 Hikes on table but terminal rate is key in US Tactically long Euro on position squeeze and ECB Peoples Bank of China liquidity squeeze Trump Emerging Markets Local (rates and currency) Emerging Markets Sovereign Credit (USD denominated) Monetary policy is expected to ease across a number of major EM countries where inflation is rapidly falling such as Brazil and Russia Fundamental picture of EM is expected to improve External rebalancing has come a long way Valuations less attractive post election rally Concerns around China have subsided Fundamental performance across EM becoming more idiosyncratic. High uncertainty regarding Trump administration trade policies. Growth in EM appears to be stabilizing, albeit at slower than historical levels Better China data is positive for the sector broadly Heavily influenced by commodity price reflation Spreads quickly tightened following post-election selloff Trumponomics : protectionist trade policies from the US Continued US dollar strength Higher core rates squeezing liquidity Capital flight out of EM Hard landing in China, RMB devaluation Outflows from asset class Significant US dollar strength Policy error Further significant geopolitical risk Major China stimulus and sustained rally in oil prices risks to the upside Isolationist trade policies from new US administration present further risks to the downside Investment Grade Credit High Yield Credit Corporate behaviour turning slightly more balance sheet friendly at the margins Corporate credit fundamentals have likely peaked for this cycle, remain vigilant for signs of further deterioration Given the fundamental backdrop, valuations only fair to slightly stretched Poor liquidity remains a major concern Spreads are tight but default environment has improved and the energy sector has fully recovered. Risks to further fundamental deterioration already in the price. Liquidity is a major concern, especially in regards to fund outflows Credit cycle stress Policy mistake: tightening cycle With Treasury yields low, spreads could widen as treasurers become less spread sensitive at issuance Europe further along in the credit cycle than we believe ECB tapering US data surprises to the upside Default rates trend higher than expected Signs of stress / maturing credit cycle Rush to the exits / crowded trade Weakness spreads to non-resource sectors Commodities o/w Base metal Copper Covering u/w Brent, o/w gasoline o/w Kansas vs. Chicago wheat Bought sugar, cocoa U.S. recession Trade war

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