Weekly Strategy Update 22 October 2015

For professional investors Weekly Strategy Update 22 October 2015 SUMMARY No convincing improvement in Chinese data Too early to give up on constructive view on the US All eyes on the ECB, but no extension of QE yet Asset allocation: long 5-year forward US inflation swaps Joost van Leenders, CFA, Chief economist, Multi Asset Solutions joost.vanleenders@bnpparibas.com +31 20 527 5126 Macroeconomic news from the US and Japan was mixed; from China, it was skewed to the weak side. The earnings seasons in the US and Europe have started poorly. However, this hasn t kept equities from rising, especially in the US. This may be due to a lower probability of a Fed rate hike in December, but without a clear catalyst for an uptrend in equity markets we prefer to be cautious. Tactically we are moderately positively exposed to risk assets. We did not make any changes to our asset allocation this week. CHINESE DATA: ON BALANCE, WEAK At 6.9% year-on-year (YoY) in the third quarter Chinese GDP growth is still close to the official target of 7%. This comes after two quarters where growth was exactly 7%, so at first sight everything looks okay. However, 6.9% is the lowest growth pace since 2009 and comes after five rate cuts and three cuts in reserve requirement ratios for banks. Government expenditure has also increased recently. In September fixed asset investments decelerated to their slowest pace since 2000, with record low growth in investment in manufacturing and real estate (the data started in 2004). Investment in infrastructure has also slowed, although the pace is higher than in the other two categories. This may pick up, though, due to fiscal stimulus. 14 12 10 8 6 China GDP & FAI (% YoY) 4 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 GDP (lhs) Fixed assets investment (rhs) Industrial production growth fell to 5.7% YoY in September, close to the lowest point since the early 1990s reached in April this year. Several components of 50 40 30 20 10 0 Source: Bloomberg, BNPP IP

Weekly Strategy Update 22 October 2015 2 production actually contracted in annual growth terms. The official and Markit PMIs for the manufacturing sector slipped slightly in September and thus did not signal any imminent improvement. The positive news came from the consumer and from housing. Nominal retail sales ticked up to their strongest pace since January and given the decline in inflation, the gain was higher in real terms. In real estate the pace of residential sales improved further, as did prices in the major cities. This should be positive for consumer sentiment, but will not add to growth for the time being given the huge inventory of unsold homes. Credit growth has stabilised since April at a historically low level of just above 13% YoY. However, this is still much faster than GDP growth, indicating that the debt ratio in China is continuing to rise. Overall, we think the Chinese economy is still struggling to gain traction, even though monetary and fiscal stimulus should lead to some stabilisation. Debts are still high and rising, which could mean increasing risks on the road ahead. Overcapacity is causing deflation. Nominal GDP growth was up 6.2% YoY in the third quarter, so the GDP deflator the broadest indicator of prices in the economy was firmly negative. This has happened before briefly in 2009 and for almost two years in 1998/99 but the higher the debt ratio, the bigger the risk of a negative impact of deflation. US: PRODUCTION VS. CONSUMPTION Data from the US this week underlined the dichotomy between the production and the consumption sides of the economy. 2 1 0-1 -2-3 US manufacturing 15.0-15.0-22.5 Regional measures of producer confidence in October the Empire manufacturing PMI and the Philly Fed index moved up slightly, but remained firmly in negative territory. Industrial and manufacturing production both fell 7.5 0.0-7.5-4 -30.0 05 06 07 08 09 10 11 12 Producer confidence (lhs)* Manufacturing production (% 3-months annualised, rhs) * Average z-score of Philly Fed and Empire manufacturing indices Source: Data stream, BNPP IP in September for the second straight month. The strong US dollar and weak foreign demand have set exports on a clear downward trend and inventories have increased. No wonder the manufacturing sector is struggling. However, consumer confidence, as judged from a survey by the University of Michigan, jumped in early October after having fallen for three straight months. Confidence is not far from the high point in this cycle. It is supported by the labour and housing markets. Data this week showed that job openings fell in August after a surge in July. High levels of vacancies, job hires and voluntary job quits and low numbers of layoffs point to a stronger labour market than the employment data in August and September suggested. 75 60 45 30 15 0 05 06 07 08 09 10 11 12 13 14 15 NAHB (lhs) Housing starts (mln, rhs) Confidence among home builders increased in October to a cyclical high. In fact, confidence is getting close to the levels seen at the peak of the housing boom in 2005. This may sound scary, but the situation on the housing market is quite different now. Houses are much more affordable, due to low interest rates and normal prices levels related to household income or rents. New and existing home sales are respectively 60% and 26% below peak levels. Building permits fell from a peak in September, but taking a longer term view, the trend in permits and starts is still upward. Permits and starts are at about half of their peak levels and even below their long-term average. This must be judged against a rising population. All in all we have not seen enough negative data to give up on our constructive view on the US. ALL EYES ON THE ECB US housing Buidling permits (mln, rhs) On Thursday attention will turn to the ECB. We do not expect any action during this meeting. The eurozone economy seems to be holding up well, albeit with low inflation. On balance, the ECB s bank lending survey for the third quarter of 2015 was positive. Banks reported a 2.5 2.0 1.5 1.0 0.5 0.0 Source: Datastream, BNPP IP

Weekly Strategy Update 22 October 2015 3 net easing of credit standards on corporate loans, mainly driven by competitive pressure. Standards for home mortgages were tightened, though. However, banks signalled rising demand for corporate loans and mortgages. Interest rate differentials between core and peripheral countries have narrowed and money growth in the eurozone has accelerated. Annual credit growth in the private sector turned positive in March this year and reached 1.0% YoY in August. This is not strong, but it shows that accommodative monetary policy has a positive impact. Nevertheless, with inflation still far below the ECB s target, ECB president Draghi may strike a dovish tone. He may still need some time to assess the impact of foreign weakness on the eurozone economy, but he will most likely express readiness to do more if needed. That may include adjusting the current programme of quantitative easing. We think the ECB will extend this programme beyond September 2016 and we expect such an announcement in December. To prevent the risk of running out of eligible bonds, the ECB may also broaden the programme to a wider range of bonds, possibly corporate bonds. Another thing the ECB can do is further cut the deposit rate into negative territory. The ECB cut the deposit rate to -0.20% in September 2014 and has said that this is the floor. Going below that floor could have a negative impact on money markets and even cause a run on banks for cash. However, recent experiences in Sweden and Switzerland have shown that more negative deposit rates have a limited impact domestically. It would be effective in lowering the euro, in our view. In previous meetings, Mr Draghi ducked the question about the deposit rate, so it will be interesting to see how he responds this time. --- Colin Graham, CFA, CAIA, CIO, Multi Asset Solutions colin.graham@bnpparibas.com +44 207 063 7778 ASSET ALLOCATION: NO CLEAR DRIVERS FOR THE EQUITY RALLY Core asset allocation positions US equities have rallied for about a month now. They are up by 8% from the most recent dip (end-september) and just 4.6% below the all-time high of 21 May, according to the S&P 500 index. European equities have also rallied by 8% from their September trough, although the EUROSTOXX 50 index is still further below its cycle peak. The rally in Japanese and emerging markets has been slightly stronger at 11%, but emerging equities are furthest away from the May peak. And that was not even a cyclical high. 130 120 110 100 90 Equities (Local currencies, index, 1 january 2015 = 100) 80 Jan-15 Mar-15 May-15 Jul-15 Sep-15 S&P 500 DJ Eurostox Nikkei 225 MSCI EM in $ Source: Datastream, BNPP IP We do not see clear drivers for the rally, other than technical ones. Economic data from the US has clearly disappointed and while we have not given up on our constructive view, as mentioned above, we do not think the data supports an equity rally. Negative US data increases the probability of a delay of the first rate hike by the Fed into next year. There is clearly no consensus among US policymakers about hiking this year. A lack of consensus between the governors in Washington and regional Fed presidents is not uncommon, but this time there is not even consensus in Washington. Judged by the pricing of fed funds futures, the probability of a rate hike in December has fallen from 35% at the end of September to 30% now. We do not think this justifies the

Weekly Strategy Update 22 October 2015 4 equity rally, especially with disappointing economic data and a weak start to the earnings season. We also think markets underestimate the willingness of the Fed to hike rates. The domestic economy looks strong enough. Headline inflation is low, but the core CPI rose to 1.9% YoY in September. The Fed prefers the core PCE deflator, which is typically 0.3 of a percentage point slower than the CPI. Currently the gap is bigger, though. The PCE has been stable at around 1.3% this year. So inflation, global economic uncertainty and a strong US dollar may still keep the Fed from hiking, but delaying into next year would be another dent in the Fed s credibility. For almost a year now the Fed has said it wants to hike rates before the end of this year. The economic outlook in the eurozone, Japan and emerging markets has not changed much in the past week, so that should not be a driver of the equity rally, either. Judged by sales surprises, which are less easily manipulated than earnings surprises, the earnings season in the US and Europe has had a poor start. Earnings surprises have been better, but after significant downgrades of earnings expectations. So, the equity rally may have been driven by technical factors like the decline of volatility. This may have caused risk-driven investors to return to the market. We prefer to keep a neutral view at this point, though. In Europe we prefer small caps over large caps, as small cap equities are better set to gain from domestic growth. In government bonds we prefer to maintain a neutral position in duration. US and German yields have not shown much direction lately. An extension of the ECB s asset purchase programme could lead to lower yields in the eurozone, but with the sell-off in May after German yields were driven close to zero still in memory, we expect a smaller impact this time. 2.5 2.0 1.5 1.0 0.5 10-year government bond yields 0.0 Jan-15 Mar-15 May-15 Jul-15 Sep-15 US Germany Japan Source: Datastream, BNPP IP We stay moderately positively positioned towards risky assets through our overweights in European and US high-yield corporate bonds. We like the carry on these bonds in the current low-yield environment. Traditionally corporate bonds tend to do well in a low-growth, lowinflation environment. We thought recent spread widening in September was overdone. Indeed, spreads have narrowed recently. Especially in the US, we think that the default rates discounted by the market are too high, while in the eurozone the ECB s asset purchase programme indirectly provides support through portfolio rebalancing away from low-yielding government bonds. For investors unable to buy high-yield bonds we see European equities as a viable alternative. We are also neutral emerging market debt. Spreads have narrowed quickly recently after significant widening earlier. This happened without improvement in macroeconomic data and with investment growth still lagging. Leverage ratios are high in a number of countries. Foreign ownership of emerging market bonds is relatively high, which raises the risk of a sell-off. And should a currency crisis arise, only a limited number of emerging markets have enough reserves to defend their currencies. These negative factors may warrant an underweight position, but we took profit on an underweight a few weeks ago and are not inclined to reinstate that trade at wider spreads. We are neutral real estate and commodities. Flexible multi-asset positions We closed our long 5-year forward US inflation swaps. At the time of implementation of this long-standing trade we thought inflation expectations were too low. But historically low levels did not prevent them to fall further. We have lost our patience and decided to take our loss. We have a long position in US high-yield corporate bonds versus CDS. We implemented this trade as we think the spread differential and spread ratio between the two asset classes will converge. We are long the US dollar versus the Swiss franc and short the euro versus the US dollar. Our currency trades are generally based on an analysis of relative valuations and the outlook for monetary policy. We think the Swiss franc is expensive. The rationale for our short euro versus US dollar position is that we think the Fed will start hiking rates soon, while the ECB will continue its asset purchases. We are long the Mexican peso the South Korean won. We think the peso is better valued. The Mexican economy and the peso should also benefit from

Weekly Strategy Update 22 October 2015 5 US economic growth, while the won is vulnerable to weakness in China. Furthermore, domestic debt vulnerability is lower in Mexico than in South Korea. Bloomberg and Datastream are the sources for all data as at 21 October, unless mentioned otherwise. For earlier issues of the Weekly Strategy Update: WWW.BNPPARIBAS-IP.COM > STRATEGY & RESEARCH > WEEKLY STRATEGY UPDATE For more on the Multi Asset Solutions team HTTP://INSTITUTIONAL.BNPPARIBAS-IP.COM > OUR CAPABILITIES > MULTI ASSET SOLUTIONS

Weekly Strategy Update 22 October 2015 6 MARKET OVERVIEW* Indices Close 5D %CHG 1M %CHG 3m %CHG YTD %CHG Currency MSCI WORLD 1.678 1.48 2.98-5.64-1.88 USD Barclays Global Agg 212-0.03 0.23 1.07 0.93 EUR Barclays Global High Yield 345 0.56 0.13-1.49 1.83 EUR FTSE EPRA Global REITs 2.394 2.78 6.22 2.72 1.94 USD Regional Indices S&P 500 2.031 1.35 3.24-4.17-1.37 USD MSCI EUROPE x UK 134 1.71 1.16-10.08 6.62 EUR FTSE 100 6.384 1.83 4.51-5.69-2.77 GBP NIKKEI 225 18.554 3.71 2.68-10.98 6.32 JPY MSCI Asia Ex Japan 529 1.67 4.67-6.70-6.19 USD MSCI EMERGING Markets 864 1.77 5.99-8.02-9.60 USD J.P. Morgan EMBI $ 680.38 0.60 0.47 0.67 2.69 USD J.P. Morgan GBI-EM local 84.99-0.13 0.90-5.29-13.39 Local Regional Bond yields PX_LAST % PX_CLOSE_5D % 5D PX_CLOSE_1MPX_CLOSE_3M % % PX_CLOSE_ytd %YTD currency US Generic Govt 10 Year Yield 2.04 1.97 2.20 2.33 2.17 USD Germany Generic Govt 10Y Yield 0.59 0.54 0.68 0.78 0.54 EUR UK Generic Govt 10Y Yield 1.83 1.76 1.88 2.09 1.76 GBP J.P. Morgan EMBI $ 6.34 6.41 6.34 6.21 6.15 USD J.P. Morgan GBI-EM local 6.79 6.86 7.08 6.68 6.50 Local FX USD 1.14 1.15 1.12 1.09 1.21 USD GBP 1.36 1.35 1.39 1.42 1.29 EUR JPY 136.27 136.35 134.90 135.48 144.85 JPY CHN 7.23 7.27 7.16 6.79 7.52 CNH * As at 21 October 2015; source: Bloomberg, BNPP IP

Weekly Strategy Update 22 October 2015 7 DISCLAIMER This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. ( BNPP AM )* a member of BNP Paribas Investment Partners (BNPP IP) **. This material is produced for information purposes only and does not constitute: 1. An offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or 2. Any investment advice. Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice. BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. The value of an investment account may decline as well as rise. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. *BNPP AM is an investment manager registered with the Autorité des marchés financiers in France under number 96002, a simplified joint stock company with a capital of 67,373,920 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris 319 378 832. www.bnpparibas-am.com. ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.