Inflection Point. March Joseph Little, Chief Global Strategist

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1 Inflection Point March 2018 Joseph Little, Chief Global Strategist Non-contractual document. This publication is intended for Professional Clients as defined by MIFID only and should not be distributed to or relied upon by Non professional clients. The information contained in this publication is not intended as investment advice or recommendation. For illustrative purpose only, this document is a global view of the recent evolution of the economic conditions. This is a marketing support which does not constitute neither an investment advice or a recommendation to buy or sell investment. This commentary is not the result of investment research and is not subject to legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination.

2 Overview Inflection Point 2017 was a Goldilocks economic environment of surprisingly-good growth, low inflation, low interest rates, policy accommodation, and strong corporate profits This created a spectacular phase for investment returns We argue that the forces that have driven 2017 s Goldilocks economics are beginning to wane Growth trends continue to be strong and synchronized it is a balanced expansion But cyclical inflation pressures are building gradually and globally Even if longer-term, structural inflation remains well-behaved The policy mix now becomes less favourable than what we have recently experienced We are at an inflection point in investment markets The principal shock to the system has shifted away from secular stagnation and deflation toward the risk of higher inflation and much faster-than-expected interest rate hikes This means that the risk properties of global bonds have changed Price is the principal determinant of asset class attractiveness Selective exposure to risk assets offers the best way to back the balanced expansion (late cycle equities like Europe & Japan; Emerging Market asset classes) The outlook for fixed income asset classes is more tricky. Conventional notions of safety have changed Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 2 Non-contractual document

3 LOW TO HIGH IMPACT Summary Macro Outlook Globally, growth trends look like a balanced expansion across sectors and regions, with negligible recession risk Our Nowcast points to continued synchronised global expansion with global growth now at +5.0% in Q1, up from +4.3% in the previous quarter. EMs are providing new momentum to global growth The market has begun to recognise cyclical inflation pressures. Across the major economies, key inflation metrics have bottomed and are rising gradually (even in Europe and Japan) The key macro question is whether the shift in inflation narrative is justified by the fundamentals? Cyclical inflation is on the rise, but we remain in a structural regime of price stability Central Banks Fed policy guidance remains for 3 rate hikes in 2018 in line with market expectations. The risk is that they are forced to deliver more by faster-than-expected inflation The ECB struck a more hawkish tone at its January meeting, confirming the possibility that QE could end in September. But we don t expect the first interest rate hike until 2019 BoE Governor Carney has signalled that rates may need to go up faster than assumed at the November inflation report. Brexit uncertainty and cyclical risks limit a rapid policy normalisation At the BoJ, Governor Kuroda has been nominated for a second five year term and has signaled that the central bank will start thinking about how to exit its stimulus program in 2019 Key Views The market has begun to accept the narrative of cyclical inflation. Investor perceptions of macro risk have moved into strong demand recovery. Is this an inflection point? Bonds have been bad hedges for multi asset investors during the recent episode. We now measure a term premium of +50bps in 10-year USTs. But ROW bonds still carry a significant negative bond premium. We stay UW. Inflation hedges (TIPS) make sense. The dollar is the only true safe haven Risks are asymmetric in global credits. The economic environment remains supportive, but the good news is already priced in. We maintain our UW The recent sell-off increases the case for global equity exposures, given strong fundamentals. We prefer late cycle equities (Japan, Europe) and EM (equities and EMD local FX) Renewed secular stagnation Cyber attack Political uncertainty Key Risks Productivity boom Policy error LOWER TO HIGHER PROBABILITY Inflation shock Market mis-behaviour Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 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. 3 Non-contractual document

4 The economy is in a balanced expansion

5 Synchronised Growth Nowcasting the global economy We track over 1,200 macro-economic indicators in our big data Nowcasting model for global growth We now measure the strongest pace of global growth since the early 2010s The pace of growth is still modest by historic standards, but the breadth of global growth is impressive. There is growth-synchronisation across global economies. And drivers of growth are diversified It is a Balanced Expansion Nowcast big data measure of growth - underlying economic activity strong across DMs and EMs % 8 Latest Nowcast 1 year ago 18 months ago World US Eurozone Japan UK EM ex China China India Brazil Source: HSBC Global Asset Management, Global Investment Strategy, March Non-contractual document

6 Synchronised Growth PMI Manufacturing heatmap* Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 World DM United States Canada United Kingdom Eurozone Germany France Italy Spain Ireland Japan EM China Indonesia South Korea Taiwan India Brazil Mexico Russia Turkey Poland *:Red indicates above 50, blue indicates below 50. Source: Bloomberg, HSBC Global Asset Management, as at January Non-contractual document

7 Synchronised Growth Zero risk of recession The Nowcast is our favourite way to understand the global growth cycle The risk of recession is basically zero Many economists have argued that after a historically long economic expansion, we are due a recession But business cycles do not run on clocks, and the usual catalysts for a recession are not in place US treasury yield curve slope and recessions Longest economic expansions in DMs (since 1949) bps 350 Recession 2-10s 10-30s 1 Australia 1992-today ,9 Australia ,8 UK ,7 0,6 0,5 0,4 0,3 France US UK ,2 0,1 0 US 2010-today Length of expansion (no. of consecutive quarters of positive real GDP growth) Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 7 Non-contractual document

8 Cyclical Inflation Gradual and global pressure Low inflation was a mystery to the inflationtargeting central bankers in 2017 There has been a persistent undershoot of inflation targets since the GFC But cyclical inflation pressures are building - gradually. And the US is at the forefront of this global trend There is an inflation undershoot across most DMs yoy Current 10yr average Target 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% but cyclical inflationary pressures are building yoy % Germany HICP ex energy and unprocessed food (6m MA) 3,0 NY Fed UIG: Full data set measure 2,5 US inflation: core goods and core services % Core services (6m annualised) Core goods (6m annualised, RHS) 4,0 3,0 2,0 2,0 1,5 1,0 1,0 0,5 0,0-1,0 0, ,0 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 8 Non-contractual document

9 Tracking Inflation Inflation heatmap* Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 United States Canada United Kingdom Euro Zone France Germany Italy Portugal Spain Sweden Switzerland Japan Australia New Zealand China South Korea India Brazil Mexico Russia Turkey South Africa *:Red indicates above target, blue indicates below target. Source: Bloomberg, HSBC Global Asset Management, as at February Non-contractual document

10 Still a price stability regime Structural inflation remains low Cyclical inflation is rising. But inflation trends are slow-moving and typically play out gradually. What s more, a little bit of over-heating and cyclical inflation today doesn t offset the serial inflation undershoot since the GFC Inflation expectations (the key long run driver of inflation) remain stable. We are still in a price stability world The structural forces that have delivered low medium-term inflation remain intact (i.e. technological change, globalisation, deregulation, independent central banks) for now Actual US inflation versus target Medium term inflation expectations Index 125 US Target Inflation (2%) Actual Core CPI Actual PCE % 4,0 5Y5Y Inflation swap forward FRBNY 3 year University of Michigan 5-10 years 120 3, , , , , Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 10 Non-contractual document

11 Cumulative increase in Fed Funds Rate (%) Policy Mix Cyclical inflation means that policy becomes more of a headwind The interest rate cycle remains slow and low versus historical experience But the synchronised growth and the emergence of cyclical inflation means that the interest rate trajectory accelerates from here Global liquidity conditions remain supportive. But interest rates are - once again - the key policy variable. Central bank balance sheets are less important than commonly perceived US rate tightening cycles Central Bank Balance Sheets USDbn, change from previous quarter ECB FED BoJ G3 total Months -200 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 We are here Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 11 Non-contractual document

12 The inflection point

13 An inflection point in the growth-inflation mix The balance of risks has shifted Severe Secular Stagnation Fragile Equilibrium Strong Demand Recovery Description of Macro Environment Very weak demand growth Negative interest rates are required There is a meaningful threat to corporate fundamentals and balance sheets There is enough demand relative to supply Inflation remains low The interest rate cycle will be slow-and-low Demand is too strong relative to available supply Output gaps go positive & pressure on real interest rates rises Bond yields move back to historic norms Primary Source Impact on Asset Pricing Market Perceptions Of Macro Environment Growth recession Rapid de-leveraging (China) Positive for: DM Government Bonds, IG Credits Negative for: EM and commodity-linked Equity, EM currencies Fragile Equilibrium is maintained Feb 2016 Aug 2017 Nov 2016 Not part of the current return distribution US-led global reflation Pre-emptive Fed policy tightening USD overshoots, May be positive for EM Equity and EM Local FX Debt Negative for: DM Government Bonds, IG Credit March 2018 Balance of risks firmly in this direction now Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 13 Non-contractual document

14 Inflection Point The risk properties of bonds have changed The change in the inflation narrative has forced bond yields higher It is an inflection point. The risk properties of bonds have changed. The shift in economic risk away from secular stagnation toward faster-than-expected inflation is an important change of regime In the old regime, bonds hedged us against risk aversion. In the new regime, global bonds are bad hedges How much further can this run? If bonds are now risk, where can investors find safety? Bond yields and expectations of future rates have shifted up US treasuries now sell-off on risk-aversion spikes 4,0 (%) US 2y Bond Yields US 10y Bond Yields 10Y3M US Forward Rate Index VIX Index US 10y Treasury Yield (rhs) % ,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan ,5 3 2,5 2 1,5 1 Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 14 Non-contractual document

15 An inflection point The market narrative moves to recognise cyclical inflation Market perceptions of inflation risk have shifted significantly There is a new market narrative around cyclical inflation A trend in our discounted inflation metric has emerged (long/short portfolio) Does this reflect a shift in the quantity of inflation? Or a shift in the price of inflation? Or both? Market-implied growth indicator Market-implied inflation indicator Discounted Growth Discounted Inflation Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 15 Non-contractual document

16 Stylised Expected Returns Valuation is key The risk premium framework We measure market-implied risk premia for 300+ asset classes This enables us to understand where relative valuation exists in global investment markets Cash Government Bonds High-Grade Credit Spec-Grade Credit Global Equities Emering Market Equities Alternatives Expected Risk Cash Rate Term Premium Credit Risk Premium Equity Risk Premium Emerging Markets Risk Premium Alternative Risk Premia Source: HSBC Global Asset Management, December 2017 Simulated results do not represent actual returns and should not be seen as an indication of future returns 16 Non-contractual document

17 Expected Risk Premia (%, Nominal, USD) Implied market odds The pecking order of asset classes Sharpe Ratio Japan Equity H Asia ex Japan Equity EM Equity 0.2 Sharpe Ratio Asia Local Bonds Asia HY Asia IG Sukuk Bonds Global HY BB B US IG Global Credit Hedge Funds US TIPS Global ABS Global ILBs US Treasuries Japanese JGBs UK Gilts German Bunds Eurozone Equity H Local EMD DM Equity Commodities Frontier Equity US Equity GCC Equity Global REITs Private Equity 0.1 Sharpe Ratio Expected Volatility (%) *Global Fixed Income assets are shown hedged to USD. Local EM debt, Equity and Alternative assets are shown unhedged Source: HSBC Global Asset Management, Global Investment Strategy. Any forecast, projection or target 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. Data as at 9 th February Non-contractual document

18 Where is safety now? The US dollar as an insurance policy At the inflection point, bonds are bad hedges for multi asset investors But where is safety? Relative valuation can provide a margin of safety And what about the dollar? Dollar weakness seems to be connected to the synchronised global growth story; the surprise for investors in 2017 was the economic performance of Europe and Japan At this point, there are reasons to be optimistic on the dollar: (i) positive carry, (ii) loose fiscal policy, (iii) tighter monetary policy The dollar has some attractive insurance properties for asset allocators Index Trade weighted dollar USD Trade Weighted Exchange Rate? EUR/USD 1,70 1,60 1,50 1,40 1,30 Euro-dollar versus rate differential EUR/USD, LHS EU-US 2Y rate differential, RHS bps ,20 1, , Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 18 Non-contractual document

19 Key portfolio views Globally, growth trends look like a balanced expansion across sectors and regions, with negligible recession risk. Macro imbalances are not yet significant What has changed since the start of the year is that the market has begun to accept the narrative of cyclical inflation. In our view, continuing with a pro-risk positioning in multi-asset portfolios makes sense The recent sell-off increases the case for global equity exposures, given strong fundamentals. We prefer late cycle equities (Japan, Europe) and EM (equities and local currency debt) After the market correction, the global equity premium is 3.3% versus bonds and 3.8% versus cash. This is still a reasonable ERP given where we find ourselves in the profits cycle Many EM debt markets have been impressively resilient in the recent episode they continue to offer attractive and idiosyncratic sustainable return But the re-pricing of inflation risk forces us to re-assess the risk characteristics of global bonds. Bonds are no longer hedging us against spikes in market risk aversion - they are selling-off with equities. This is an inflection point. Global bonds offer low sustainable returns and find themselves in an unfavourable economic environment We prefer index-linked bonds to nominals The dollar seems to be the safe-haven if the risk scenario of faster inflation materialises The outlook for global credits is more tricky. Credit should continue to be a beneficiary of a balanced expansion. But a lot of good news is already priced in we stay UW in multi-asset portfolios Source: HSBC Global Asset Management, Global Investment Strategy, March The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. 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. 19 Non-contractual document

20 Beyond the inflection point?

21 Inflation Risk Can faster inflation materialise? Inflation should be slow-moving and persistent but there is a risk to the upside Wage inflation is accelerating. Investors have given up on the Phillips Curve - perhaps this is premature? Sharply higher oil prices - when cyclical inflation is already rising could be a problem yoy % 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 Breakdown of US employment cost index Management, Professional and related Sales and Office Natural resources, construction and maintenance Production, transportation and material moving Employment Cost Index 0, Non-linear Phillips Curve in US city level data Oil prices and breakeven inflation from TIPS year ahead core CPI, % y = x R² = y = x R² = %, yoy WTI (USD) Brent (USD) US 10yr breakeven inflation (RHS) % 3,0 2,6 2,2? 0 1, , Unemployment rate, % -60 1, Source: HSBC Global Asset Management, Global Investment Strategy, March Non-contractual document

22 Policy risk Will central bankers be more aggressive than we assume? How will inflation-targeting central bankers respond to cyclical inflation? Will they tolerate faster inflation after multi-year inflation target undershoots? Or will new central leaderships adopt a more hawkish profile and seek to get ahead of the curve? We think the risk of a significant policy error is over-played by economists. But a slightly-faster normalisation of policy could still surprise financial markets Parts of the fixed income universe continue to price a very pessimistic economic scenario Fed dot plot versus market implied rate hike expectations Euro Area Nowcast model vs. German 10y Bund yield % 3,1 Fed 'Dots Chart', Median projection, Sep ,9 Fed 'Dots Chart', Median projection, Dec ,7 Market implied estimate on 28 Feb 2018 % 5,0 4,0 Euro Area Nowcast 10 year German Bund Yield 2,5 3,0 2,3 2,0 2,1 1,0 1,9 1,7 1,5 0,0-1,0 1, , Source: HSBC Global Asset Management, Global Investment Strategy, March Non-contractual document

23 Where is the system vulnerable to faster rates? Are economic imbalances a worry? The idea of the balanced expansion is that growth is sustainable and macro-economic imbalances are not yet significant. Recession risk remains very low for now But in the scenario of faster interest rate hikes, where are the vulnerabilities? True sovereigns are able to run economies at higher government debt levels than we thought. But some Euro zone government debt levels look high Canada & Australia private sector debt is a well-known risk A number of emerging markets also show high and rising indebtedness (China, Turkey, Mexico, Russia) Sovereign and Nonfinancial Private Sector Debt-to-GDP Ratios Advanced Economies Emerging Market Economies JPN CAN USA GBR ITA AUS KOR FRA DEU CHN BRA IND ZAF TUR MEX RUS SAU ARG IDN General ## Government Latest Households ## Latest Nonfinancial ## Corporations Latest Total ## Latest Source: HSBC Global Asset Management, Global Investment Strategy, March Non-contractual document

24 Where is the system vulnerable to faster rates? EM vulnerability heatmap Internal Macro Vulnerabilities External Macro Vulnerabilities Non-fin. Corp. Debt (Δ , % of GDP) Hard Currency Non-fin.Corp.Debt (% of GDP) Household Debt (Δ , % of GDP) Government Debt (% of GDP) Inflation Primary (2018f) minus Deficit (2017f, central bank % of GDP) target Return on Equity (%) Real Interest Rate (%) Current Account Deficit (2017f, % of GDP) Net External Assets (% of GDP) Ratio of FX Reserves to Monthly Imports Net FDI Inflows (% of GDP) Brazil China Colombia Hungary India Indonesia Korea Malaysia Mexico Poland Russia South Africa Thailand Turkey Sources: AMG Global Investment Strategy, Institute of International Finance, International Monetary Fund WEO Database, Bloomberg, MSCI and various national sources as of Q Non-contractual document

25 Important Information

26 Important information This document is distributed in France, Italy, Spain and Sweden by HSBC Global Asset Management (France) and is only intended for professional investors as defined by MIFID. In Switzerland by HSBC Global Asset Management (Switzerland) Ltd and is only intended for qualified investors in the meaning of Art. 10 para 3 CISA. The information contained herein is subject to change without notice. All non-authorised reproduction or use of this commentary and analysis will be the responsibility of the user and will be likely to lead to legal proceedings. 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 commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. Consequently, HSBC Global Asset Management (France) will not be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. All data are from HSBC Global Asset Management (France) unless otherwise specified. Any third party information has been obtained from sources we believe to be reliable, but which we have not independently verified. The material contained herein is for information only and does not constitute legal, tax or investment advice or a recommendation to any reader of this material to buy or sell investments. You must not, therefore, rely on the content of this document when making any investment decisions. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe to any investment. Any views expressed were held at the time of preparation, reflected our understanding of the regulatory environment; and are subject to change without notice. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Important information for Luxembourg investors: HSBC entities in Luxembourg are regulated and authorised by the Commission de Surveillance du Secteur Financier (CSSF). Important information for Swiss investors : Important information for Swiss investors: 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. This document may be distributed in Switzerland only to qualified investors according to Art. 10 para 3, 3bis and 3ter of the Federal Collective Investment Schemes Act (CISA). HSBC Global Asset Management is the brand name for the asset management business of HSBC Group. The above document has been produced by HSBC Global Asset Management (France) and has been approved for distribution/issue by the following entities : HSBC Global Asset Management (France) HSBC Global Asset Management (France) RCS Nanterre. Portfolio management company authorised by the French regulatory authority AMF (no. GP99026) with capital of euros. Offices: HSBC Global Asset Management (France) - Immeuble Coeur Défense - 110, esplanade du Général Charles de Gaulle Courbevoie - La Défense 4 France. (Website: HSBC Global Asset Management (Switzerland) Limited Gartenstrasse 26, P.O. Box, CH-8002 Zurich. Paying agent: HSBC Private Bank (Suisse) S.A., Quai des Bergues 9-17, P. O. Box 2888, CH-1211 Geneva 1 (Website: Non contractual document, updated on : March AMFR_EXT_2018_118b Copyright : All rights reserved HSBC Global Asset Management (France), Non-contractual document