Market Outlook. September 2015

Market Outlook September 2015

What Does The Chinese Devaluation Mean? In mid-august, we saw a surprise move by China's central bank to engineer a devaluation of its currency. The central fixing rate was weakened by nearly 2% on 11 August, the largest such move since the managed peg regime came to existence in 2005. Citi analysts view this as a double-edged sword with a) positives given a significant capital market reform initiative and better net exports and b) negatives given capital outflow and EPS conversion loss. However, negatives look manageable given a) buffers of capital outflows due to capital controls, ~3% China/US yield gap & RRR cuts, and b) lowsingle-digit negative impact on 2016 EPS. As such, we expect net exports support, favourable policies and pro-reform stance to drive MSCI China back to 10-year average forward P/E at 12X (vs. MSCI AC World 16X). Citi analysts continue to favour H over A-shares but lower mid-2016 MSCI China target to 75 from 93 previously, to factor in GDP downgrades and liquidity concerns. On balance, implications of China s slow growth and weaker RMB on global economy and markets are somewhat complex but they will probably be a modest drag on growth and inflation for the rest of the world. They will therefore reinforce the theme of 'lower for longer' monetary policy in advanced economies and give Asia EM currencies downward pressure. In August, the global equity market saw a big correction driven in part by fears that the China/EM slowdown will broaden into DM economies. While investors appear to be shifting towards pricing in a global recession and China s hard landing, we believe such fears are premature. Macro Overview US: Expect a bounce back in growth to near 3%; First rate hike anticipated in September. Europe: Inflation likely to remain subdued; ECB may maintain accommodative policy stance. Japan: Sluggish consumer spending may weigh on inflation and trigger BoJ easing in 4Q15. Asia: The PBOC recently cut policy rate by 25bps and adjust RRR down by 50bps; expect 4 more RRR cuts and 1 more policy rate cut by mid-2016. Equities: Overweight Overall, while Citi has concerns about a deterioration in the earnings outlook and broader macro background for equities, we have retained an overweight in the asset class. Our overweight is in Japan, Europe and North Asia within EMs. Bonds: Underweight High Yield: Valuations appear attractive and fundamentals remain supportive in the longer term. EMD: Expected to remain volatile given declining trading volume and lower liquidity. Commodities: Neutral Gold: Reiterate negative sentiment. Oil: Bearish bias on crude prices. Currencies: Bullish Fed In A Broken China Shop EUR: Still Range Bound. GBP: Sideways Near Term, Mixed Medium Term. Summary 2

Equity Markets and Commodities United States Economy growing above trend Chart 1 S&P 500 Index Incoming data continue to support Citi s view that the US economy is growing at an above-potential pace of 2.-3%. We see evidence in the healthy growth of payrolls, consumer spending, and construction activity. As such, despite heightened global market volatility caused by events in China, domestic developments point to the first hike in Sep, although the Fed could delay if financial markets are weak. From an equity perspective, earnings are critical for stock prices and investors need to see an EPS pickup to get some conviction. Citi analysts believe that the easing of drags from Energy and a stronger dollar as the year progresses can take the yoy profits trend up to 6% or better by 4Q15. Thus, while markets are likely to remain volatile in the near term, we stick to our S&P 500 year-end 2015 and mid-2016 targets of 2,200 and 2,300, underscoring a moderately bullish stance. 50% 40% 30% 20% 10% 0% -10% 40.21% -1.56% -6.26% -4.21% Euro - Area ECB may remain accommodative as inflation stays low Chart 2 Dow Jones Stoxx 600 Index With a financial assistance agreement formally ratified by the Eurogroup on August 14 and the prospect of further aid disbursement to Greece in coming weeks, we suspect that the euro area economy may grow at a slightly faster pace in 2H15. At the same time, lower commodity (and energy) prices tend to be positive for euro area GDP growth, while reinforcing the likelihood that inflation may undershoot the ECB s target. As a result, we continue to believe that the ECB could likely err on the side of caution, reinforcing our scenario of a likely extension of QE beyond Sep-16. Despite an emerging value case for European companies with Asia- Pac/China exposure, Citi analysts continue to skew towards stocks with domestic or US exposure, positive earnings momentum, and less than 2x price/book. 40% 3 30% 2 20% 1 10% 0% - -10% -1-8.47% 5.91% 6.08% 36.27% Japan BoJ could implement easing between Oct and Jan 2016 Chart 3 Topix Index While the current external environment remains tough for exports, an eventual pickup in economic activity in trading partners probably driven by the US may revive Japan s exports in 2H15. This, along with prospective solid growth in private capex, could put GDP growth back on a modest positive track in Q3 and beyond. Consumer spending on the other hand appears weaker and with inflation likely to remain subdued, we expect the BoJ may be forced to implement additional easing measures somewhere between late October and January 2016. As the market adjusts due to overseas factors, Citi s basic strategy for a "mature bull' period is to "buy the dips" but not chase the rallies. However, we also think it a good idea to select defensive names in preparation for the emergence of downside risk or a growing sense that equities have overheated. We are now overweight defensive sectors like healthcare and consumer staples, while we are neutral on basic materials and industrials. 120% 100% 80% 60% 40% 20% 0% -20% 9.20% -7.38% 20.27% 110.08% Equity Markets and Commodities 3

Emerging Markets (Asia, CEEMEA and Latam) Overweight Asia; Underweight EMEA and Lat Am Chart 4 MSCI Emerging Markets Index Return On Invested Capital (ROIC) in EM has fallen to the same level as that of Europe, yet Europe has seen US$80bn of flows ytd vs US$30bn outflows for EM. Within EM, Asia leads in terms of ROIC, followed by EMEA and then Lat AM. ROIC has fallen in all markets barring Taiwan. Asia generally has better capex discipline and a lower correlation with declining terms of trade. On ROIC vs P/BV, the markets that are cheap are China, HK, Korea, Taiwan, Russia and Turkey, while the Philippines, India and Indonesia are expensive. Elsewhere, Mexico is richly priced, as is South Africa. In EMEA and Lat Am, corporate profits are determined by the terms of trade. Until these improve, the profit outlook is unlikely to turn around. In contrast, Asia is showing the biggest improvement since the late 1980 s. 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -9.20% -14.39% -24.74% -13.57% Gold Reiterate negative sentiment Chart 5 GOLDS Commodity Index Following the 11 August RMB devaluation, RMB denominated bullion in Shanghai headed to the biggest two-day gain in four years, rising 5. to 232 yuan per gram. Indeed, Citi saw Asian safe haven buying not just in China, but other Asian countries, as a hedge against competitive devaluations in the region, while G10 currencies have also rallied versus the USD adding to gold support. However, we suspect these fluctuations are a relatively short-term phenomenon, and the market may most likely to go back to focussing on rate hike timing and USD strength, which has been the driving factor for much of the year to date. Indeed, gold s price stalling on the back of PBoC intervention to stabilize the RMB s new lower rate in our view support s this thesis. Citi analysts reiterate our negative sentiment on gold, projecting prices to average $1,050/oz. in Q4, with a downside spot target of $1,000/oz. 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -35.0% 3.56% -4.22% -11.88% -32.93% Oil Bearish bias on crude prices So far, the oil price path is more an 'L' than a 'W'', resisting a rapid recovery. Fundamentals, geopolitics, market expectations and financials flows should continue to dominate price movements into 2016. Of these, expectations and financial flows are likely the most important in the short term, contradicting each other and balancing each other out. By this autumn and winter, bearish factors look to win out - huge crude and product inventories are likely to bloat further during refinery maintenance season. We are revising down our oil price outlook, with a base case (5 probability) of a double or triple W-shaped price path around $50 over 4Q15-2016, with a bearish bias. In the bear case (30%), Brent falls to the high $30s over 4Q15-1H16 before ticking up. Chart 6 Brent Oil 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% -50.0% -60.0% 3.72% -5.5-47.52% -52.74% Equity Markets and Commodities 4

Bond Markets Favour high yield credit US Treasuries We expect the market to price in one rate hike by end of 2015, and a path of rate hikes that is gradual, but slightly above the pace of hikes priced in the market. Low inflation and subdued global growth together imply a benign picture for the longer end of the curve. High Grade Corporates The largest drag on High Grade performance remains the direction of core rates. Citi s analysis shows that 65-7 of HG credit returns are tied to the movement in core government bond. Considering our benign view on rates this year, we are comfortable maintaining a neutral duration view on credit. High-Yield While oil prices and summer seasonality is expected to drive some near-term volatility, longer-term expectations remain positive. Fundamentals (ex-energy) are solid, balance sheet liquidity is robust and yields continue to provide relative value in a low yield environment. Emerging Market Debt Though we continue to prefer opportunities in external EM debt markets, we are turning more defensive. Markets are expected to remain volatile, especially over the summer months, which are characterized by declining trading volume and lower liquidity. Although high beta markets have outperformed over recent months (i.e., Russia, Ukraine, Venezuela), these countries are likely to be most vulnerable when risk sentiment turns. Asia remains our most-favoured region. Euro Bonds 10y Bund yields are expected to edge lower despite Citi s expectation of a Fed rate hike in September. The key dynamics at play are, firstly, that the ECB finds itself getting further behind its inflation objectives as the Asian devaluation against the rest of the world forces a greater degree of disinflation. Secondly, growth momentum has waned in Europe (and globally). The net effect is that the Fed rate hike signal is being priced as a small and slow-paced hike cycle. This infers that bearish correlation risk for Bunds is muted and that the market can continue to trade a lower for longer theme. Japan Bonds There is an increasing political risk in Japan. Firstly, the declining approval rating of the Abe cabinet (currently around 3) could cause PM Abe to lose the LDP leadership election in September (likely on the 20th) and put an end to Abenomics including QE by the BoJ. Secondly, the decline in Abe s approval rating, along with weaker-than-expected growth, implies an increasing risk that the 2nd consumption tax hike scheduled for Apr 2017 may be postponed ahead of the upper-house election in summer 2016. Such a postponement would make it extremely difficult to achieve the primary balance target by 2020 and could push up fiscal premiums in the market. We expect markets to continue to rally but political risk is likely to increase in coming weeks. Asia Bonds We expect that fixed income markets that have traditionally had strong correlation to FX performance, or where currency weakness has been materially large, may again underperform. In EM Asia these would be Indonesia and Malaysia. But markets with smaller FX pass-through effects should be better supported instead, we expect these markets to see bull flattening. Accordingly, we hold onto our Thai duration overweight and add an underweight in Malaysia where the large foreign ownership could pressure the bonds with concerns about the currency. Bond Markets 5

Currency Bullish Fed In A Broken China Shop Slow growth and low inflation in China likely means weaker commodity prices and world trade, with multiplier effects to developed economies and an extension of a period of low DM inflation and accommodative monetary policy. This likely manifests itself in USD gains vs commodity exporters but less obvious upside vs other DM currencies because Fed normalization is likely to be more limited, delayed and stretched. EUR: Still Range Bound Euro is likely to continue consolidating in a 1.08-1.13 range. Helping to hold EUR up are (1) an oversold currency that has also overshot levels consistent with real expected short term interest rate differentials, and (2) supportive net portfolio inflows. With Euro data looking ok, the ECB will likely be on QE auto-pilot at least through 1Q16 while FOMC tightening may be extended, lowered or delayed by events in China, keeping Euro range bound. GBP: Sideways Near Term, Mixed Medium Term Citi economists now expect the MPC to wait a little longer than the Fed to commence raising rates with only 2 hikes likely next year due to: (1) a lower 2015-16 inflation outlook; (2) less weight on financial stability arguments for tightening; (3) greater sensitivity to risks that early tightening could produce an undesirably sharp FX appreciation. With GBP currently pricing in line with rate differentials therefore, sterling is likely to trade sideways versus EUR and USD over the next 3 months but strengthen versus EUR medium term. JPY: Rising Trend Still Further upside in USDJPY is likely in the medium term with the main drivers being: (1) US cyclical outperformance and generalized USD gains; (2) Rising yield divergence between US and Japan; (3) Continued expansion of Japan s monetary base (QE) against a stable US monetary base; (4) A more broad-based rise in credit and money in the US. AUD, NZD & CAD: Medium Term Weakness AUD: China s growth risks plus the RBA lowering its growth forecast for 2016 from 3.2 to 3.0% (that are still subject to further downside risks) could see the RBA cutting a further 25bp cut before the end of the year. This should see AUD/USD weakness continue over the medium term. NZD: Dairy prices at 11-year lows contributing to the low CPI prints in NZ and massively hitting NZ s terms of trade (ToT) combined with uncertainty on China, point towards RBNZ and NZD having more work to do. Citi economists now forecast two more 25bp cuts for the RBNZ, rather than just one and forecast further NZD depreciation vs. the greenback that should add to further weakness in NZD in the months ahead. CAD: With CAD tracking oil, the potential impact of higher Iranian sales, a rising US rig count and stronger USD should remain CAD negative. And with current Canadian fundamentals still yet to emerge from the shadows cast by last year s oil price shock (the hit on ToT in particular), this suggests an extended period of low interest rates following the BoC s 25bp policy rate cut in July (to 0.50%) with the risk that it could consider lowering interest rates further, thus adding to the weak tone in CAD. EM Asia: More Volatility With Fed lift-off likely in Sep, market attempts to digest the implications of the more market-determined RMB may likely compound volatility significantly at a time when continued domestic concerns and weakness in commodity prices already makes for a very challenging environment in EM FX. Turning to China, the PBoC s decision to let the market play a bigger role in the setting of the central parity for RMB has increased flexibility in the currency though PBoC interventions are expected to continue to stem the pace of depreciation. The RMB however appears overvalued in real terms since despite a very large current account surplus, capital outflows have absorbed supply of foreign currency and led to a gradual loss of international reserves. All in, this points to significant RMB declines to the 6.80 level over the next 12m. Currency 6

Model Portfolios CONSERVATIVE MODERATE 53% 47% US/Global Investment Grade Bonds APAC ex JP / Emerging Market Bonds 2 29% 11% 3% 22% US/Global Investment Grade Bonds US/Global High Yield Bonds APAC ex JP / Emerging Market Bonds US/Global Equities Europe Equities Japan Equities Asia ex Japan Equities Changes from 2Q 2015 Changes from 2Q 2015 Fixed Income Equity No exposure Fixed Income Equity AGGRESSIVE VERY AGGRESSIVE / SPECIALIZED 4% 31% 12% 4% 1 8% US/Global High Yield Bonds APAC ex JP / Emerging Market Bonds US/Global Equities Europe Equities Japan Equities Asia ex Japan Equities GEM ex-asia 38% 13% 19% 11% 9% US/Global Equities Europe Equities Japan Equities Asia ex Japan Equities GEM ex-asia Commodities Hedge Funds Commodities 16% Hedge Funds Changes from 2Q 2015 Fixed Income Equity Changes from 2Q 2015 Fixed Income No exposure Equity Europe Equities -1% Japan Equities +1% Model Portfolios 7

Spotlight on Allocations Asia Model Portfolio This section shows the revisions to asset allocations decided by Citibank Asia Model Portfolio Committee on 11 August 2015. Citibank s Asia Model Portfolios provide a guide to possible diversification of investment portfolios and serve as an asset allocation reference tool both for periodic evaluation and prospective investments. Citibank Model Portfolios are developed by Citibank s in-house Global and Regional investment specialists to cater to investors with various risk profiles (based on Citibank s risk assessment) and provide them with: Diversified asset allocations, made uniquely relevant for Asian investors Up-to-date asset allocations which are reviewed and revised periodically by Citibank s Research teams to reflect changing market conditions in respect of relevant asset classes Access to our best-in-class research from the Global Investment Committee It is important to note that while Citibank Model Portfolios represent Citibank s best thinking in terms of asset allocation and diversification, they serve only as a guideline for investors based on certain risk profiles. Market movements, changing market views, time horizons and liquidity constraints (among others) may result in a portfolio s asset allocation deviating from the model allocation. Citibank does not monitor and/or manage individual customer portfolios. For a long term investor, it is advantageous to diversify his/her investment portfolio and consider using Citibank Model Portfolios as a reference in diversification reviews. The suggested allocations are intended to be general in nature and are not to be construed as specific investment advice. Investors are encouraged to consult with their Relationship Managers to determine their allocation needs based on their risk tolerance, suitability and goals. Model Portfolio Disclaimers Investment products are (a) not insured by any government agency; (b) not a deposit or other obligation of, or guaranteed by, the depository institution; and (c) subject to investment risks, including possible loss of the principal amount invested. Past performance is not indicative of future results: prices can go up or down. This is neither an offer nor solicitation to purchase or sell any security, other investment or service or to attract any funds or deposits. This document does not constitute the distribution of any information or the making of any offer or solicitation by any one in any jurisdiction in which such distribution or offer is not authorized or to any person to whom it is unlawful to distribute such document or make any offer or solicitation. Investors investing in investment products denominated in non-local currency should be aware of the risk of exchange rate fluctuations that may cause a loss of principal. Investment products are not available to US Persons and may not be available in all jurisdictions. Portfolio diversification is an important element for an investor to consider when making investment decisions. Concentrated positions may entail greater risks than a diversified portfolio. Certain factors that affect the assessment of whether your overall investment portfolio is sufficiently diversified may not be evident from a review of only your account with Citibank. It therefore is important that you carefully review your entire investment portfolio to ensure that it meets your investment goals and is within your risk tolerance, including your objectives for asset and issuer diversification. To discuss your asset allocations and potential strategies to reduce the risk and/or volatility of a concentrated position, please contact your personal banker/relationship manager. Citibank s Model Portfolio is not a program or offering, but is a diversification tool that is meant for reference purposes only. Model Portfolios are: (i) not binding on the part of the customers; (ii) not monitored by Citibank with respect to customers individual investment holdings; and (iii) not personalized to the specific needs of any individual customer. Citibank s Model Portfolios are not available to US Persons and may not be available in all jurisdictions. Spotlight on Allocations 8

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