The ECB takes tiny steps towards policy normalization

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1 Europe Insights Monthly update on European Markets June 27 The ECB takes tiny steps towards policy normalization Summary In the Spotlight. This month, we focus on the European Central Bank s (ECB) June 8th policy meeting. The Bank kept rates unchanged and maintained asset purchases at a monthly pace of 6bn (until the end of 27, and beyond, if necessary). More important was the ECB s shift in tone, moving its risk assessment for the economy from tilted towards the downside to broadly balanced. According to officials, eurozone growth has picked up more than expected. Core inflation has been signaled as a main focus and determinant for policy normalization PMI surveys signal further upside potential for growth PMI Composite 3-Month average % var. LT average 25-7(Rhs) Real GDP % QoQ (Lhs) Source: Bloomberg, as of 8 June 27 This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 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 Europe Insights June 27 In the Spotlight: tiny steps towards policy normalization At the latest policy meeting (8 June), the European Central Bank (ECB) increased its forecasts for economic growth in the eurozone while keeping interest rates on hold (main refinancing rate at.%, marginal lending facility rate at.25% and deposit facility rate at -.4%). New macro-economic projections: higher growth but lower inflation profiles According to the ECB, the eurozone economy is recovering quicker than anticipated. The ECB now sees GDP growth at.9% in 27 (vs.7% previously),.8% in 28 and.7% in 29. Although up, these forecasts remain closely tied to () accommodative monetary policy (3-month Euribor at -.3% in 27, -.2% in 28 and % in 29), (2) improved bank lending conditions, (3) an improving labor market and (4) rising exports. If confirmed, this improved growth scenario should lead the way to a pick-up in underlying price pressures (see figure). Regarding the inflation outlook, the ECB, however, downgraded its inflation outlook from March projections. The ECB s preferred measure of inflation, the core inflation (excludes energy and food) is anticipated to rise very gradually from.% in 27 to.4% in 28 and.7% in 29. Wage formation, a key element of core inflation, seems taking time to materialize: wage negotiation for 27 based on recent low inflation is already locked in while short term productivity gains have contributed to contain upward price pressures. Looking forward, excess capacities and global competitiveness will likely undermine wage formation a bit longer than initially estimated in the March outlook. The ECB also revised key projections with indirect effects on domestic prices, including lower oil prices (from $55.9 per barrel to $5.5/bbl for 29) and a slightly stronger USD/EUR (up 2% to.9 for 29). Figure. ECB signals confidence for economic growth, potentially leading to positive inflation dynamics over time ECB projections GDP growth YoY - LhS Core CPI YoY - RhS Sources: Bloomberg, European Central Bank, as of 8 June 27 Market participants are watching for discussions on tapering to happen According to a recent Bloomberg survey, many market participants see tapering starting in January 28 and ending in June-Sept. 28, with a first rate hike occurring in 29. If the ECB were to start mentioning discussions on Quantitative Easing (QE) tapering, this would most likely imply the end of QE, potentially triggering a rise in bond yields. We believe ECB President Draghi would prefer to avoid a rise in bond yields at this stage. In addition, lending conditions are still uneven across the eurozone with weakness in the periphery compared to the core countries. Conclusion Firming core inflation across the region remains one of the key factors that will lead to the ECB s normalization on monetary policy. Using the US as a proxy (see figure 2), we can see that inflationary pressures would need to materialize in the next few months for formal discussions on QE tapering to begin. In the meantime, the ECB has moved its risk assessment to broadly balanced versus the previous tilted towards the downside, removing any reference to rate cuts. The governing council now appears more confident about inflation moving towards its 2% target. The ECB s statement continues to confirm the possibility of increased QE purchases if needed and the exit sequencing (QE first, rates later). Figure 2. US vs eurozone policy normalisation: euro core inflation has stood below its historical average since Core inflation June 23: FED tapering announcement ECB tapering? Source: Bloomberg, as of 8 June 27 US EUR EUR Average US Average 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 Europe Insights June 27 European equities Positive earnings revisions likely to support Earnings revisions (ER) are a key driver of equity performance in Europe as they are closely linked to earnings growth. In other words, the ultimate corporate earnings growth number for a given year will depend on the trends in earnings revisions. ER s indicate whether predicted earnings growth are actually being delivered or not. When earnings are revised up, it implies that earnings growth is beating expectations. Conversely, when earnings are being revised down, earnings growth will likely come below expectations. Positive ER trends are one of the reasons investors will maintain or add to their equity holdings. As of 6 June, ER s have progressed strongly: at end November 26, the consensus for 27 EPS of the European market () was 99.6 versus 5.95 today (2)! There is often also a strong correlation between ER s and market returns as shown in the exhibit below. In addition, the market tends to rise and fall coincidentally with ER s yet market returns will sometimes lead ER s (for example, from July 22 to mid-25). Figure 3. A positive Earnings Revision Ratio (ERR) should drive the market higher /2/88 3//9 3/2/93 29//96 29//99 3/9/2 3/8/5 3/7/8 3/6/ 3/5/4 28/4/7 Source: Factset / MSCI on 6 June 27 Opinion We believe that the positive ER cycle has further potential and our optimism is based on: () past cycles which typically last up to one year longer and (2) strong and improving economic indicators, particularly in the eurozone. Also supportive is the composite PMI which, in May, reached its highest level in six years alongside business confidence, which hit an 85- month record high. In short, a positive ER cycle (in the absence of a market bubble) is probably the single best reason to overweight the Eurozone equity market. Sector positioning Sector Weight (3) Rationale Commercial Services & Supplies Next 2M ERR - 3M Moving Average (Lhs) MSCI Europe Returns - 2M Rolling (Rhs) Many companies in the sector offer sustainable growth and attractive valuations Banks Capital Goods Autos Telecoms Consumer Durables & Apparel Household & Personal Care Preference for eurozone retail banks (ex-germany). The sector is bouncing back thanks to higher market interest rates and the regulatory environment has softened due to disagreements over a finalized global framework. The sector is better capitalized than ever before. Continued growth momentum in the sector is favorable even though European capital goods have already outperformed significantly on the back of strong consensus earnings upgrades. Positions are mainly in auto suppliers and component companies which are benefitting from: () sustained global demand and (2) auto makers benefitting from a recovery in the European market. The stabilization of key emerging market economies is also contributing to an improved outlook. We recently moved to due to undervaluation, defensiveness and the potential for M&A and consolidation. The sector is composed of very expensive luxury good companies. Slightly due to valuations. We believe that the sector as a whole is expensive, particularly in an environment of rising inflation. Diversified Financials Healthcare to counterbalance our overweight position in banks. The sector is very sensitive to the pricing of drugs in the US which will likely continue to be under pressure due to government scrutiny. Semi-conductors After strong outperformance, this cyclical sector has become too expensive. () MSCI Europe (2) Factset at 9 June 27 (3) Position of European strategy in terms of key Overweight () and Underweight () versus MSCI Europe Sources: HSBC Global Asset Management/Factset/MSCI as of 6 June 27. 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 Europe Insights June 27 Euro Fixed Income: outlook & overall portfolio positioning In May, the decline in Y government bond yields continued despite some weakness in the last week of the month, with peripheral spreads under pressure again. Italy resumed its widening bias after a short-lived relief rally in the middle of the month. Ongoing threats of early general elections and expectations of possible new issuance in the ultra-long end mitigated positive investor sentiment. In Spain, Banco Popular story (capital increase and level of provisions needed) sparked bondholders concerns, and weighed on Spain government spreads. On duration, our short position on the euro curve is maintained with economic momentum gaining traction and inflation slowly building up. Actual levels of the Y German yield is still far from the equilibrium level (.9%). We continue to be tactical on the position with the German Y range-boundbetween.2% to.5% year-to-date. On credit, we took some profit in High Yield and Investment Grade reflecting fairly tight valuation levels while fundamentals remain well oriented, with low default rates and strong balance sheets for European corporates. Economic, political and inflation momentum has been supportive but risk premiums offered by the market are less attractive and we want to protect the performance of recent months. We have reduced the credit beta of our portfolios. However, certain market segments, such as financials and subordinated bonds, remain attractive. Data watch 9 June 27 Indicator Data as of Actual Consensus Previous data PMI composite May GDP quarterly, % QoQ Industrial production Unemployment rate Trade balance, monthly EUR Bn (2Mth cumulative) Retail sales Inflation: - Headline CPI, Inflation: - CPI core*, %YoY ECB Refinancing rate Q.6%.5%.5% March +.9% +2.3%.4% April 9.3% 9.5% 9.4% March April 2.5% 2.% 2.5% May Flash**.4%.5%.9% May.9%.%.2% June 8.%.%.% Deposit rate -.4% -.4% -.4% (*) Eurozone CPI Core is CPI excluding energy, food, alcohol & tobacco Analysis (**) Flash estimate: Eurostat terminology for advanced headline inflation improved or better-than-expected data on month-on-month/quarter-on-quarter basis worsened or below-expectations data on month-on-month/quarter-on-quarter basis unchanged data or in line with expectations on month-on-month/quarter-on-quarter basis The eurozone composite PMI consolidated in May at its highest level since April 2, signaling robust growth in 2Q. Germany shows the best acceleration in manufacturing, while France has gained momentum over the past six months. The composite PMI declined sharply in Italy, albeit to a still relatively high level and still above March release, and was roughly unchanged in Spain. The final release of eurozone s Q GDP was revised a notch higher. The expenditure breakdown showed gross fixed capital formation contributing.3ppt to quarterly growth, followed by private consumption (+.2ppt). Positively, net exports were no longer a drag on growth (+.ppt versus -.8ppt previously). Eurozone industrial production weakened in March, mainly driven by soft releases for Germany and Spain, while the unusual mild weather reduced the region's energy output. The eurozone unemployment rate fell to its lowest level since March 29. The decline in the unemployment rate has become broadbased, with rapid improvement to five-year lows in Italy (.%) and in France (9.3%). The unemployment rate also decreased in Germany (5.7% against 5.8% in March) and Spain (7.8% after 8.% in March) On a 2-month cumulative basis, the trade balance surplus (ex eurozone) remains elevated. The 2-month trend for exports keeps accelerating (3% yoy versus.6% yoy in February), at a faster pace than imports (2.3% yoy against.4% previously). Eurozone retail sales came in better-than-expected, with solid reports in France, Italy and Spain. The broad-based improvement in the unemployment rate as well as the ECB's monetary accommodation should keep supporting households' consumption in the region Eurozone headline inflation dropped to.4% yoy in May versus.9% April. Core inflation was back to.9% yoy, leaving the year-to-date trend at.9%, still short of the ECB s estimate for an average of.% in 27. Downside surprises to the May headline releases were broadbased: France (.9% yoy after.4% previously), Germany (.4% yoy versus 2%), Italy (.5% against 2%) and Spain (2% after 2.6%) The monthly pace of 6bn net asset purchases are intended to run until the end of December 27, or beyond, if necessary. The ECB dropped the reference to taking rates lower if needed. President Draghi reflected on the stronger momentum in the eurozone economy and stated that the risks to the growth outlook were now broadly balanced. However, the economic expansion had yet to translate into stronger inflation dynamics. F: Final estimate A: Advanced estimate Sources: Bloomberg, Datastream, Eurostat, HSBC Global Asset Management, as of 9 June 27. 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. 4

5 Europe Insights June 27 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 27. 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. Issued by HSBC Global Asset Management (Hong Kong) Limited 5