Market Outlook March 2016 INVESTMENT PRODUCTS: NOT A BANK DEPOSIT. NOT GOVERNMENT INSURED. NO BANK GUARANTEE. MAY LOSE VALUE
Negative BoJ interest rate and its implications? In a surprise move, the BoJ introduced a negative policy rate of -0.1% at its January 29 policy meeting, becoming the fifth central bank to introduce a negative policy rate. Going forward, Citi analysts pencil in fresh easing in July, as inflation is likely to remain subdued. As for actual tools, a rate cut from the current -0.1% to -0.3% seems likely, although it depends on economic and financial developments in the coming months Citi analysts believe that Japanese equities are already pricing in a 2016 EPS recession and forecast a near-term rebound, in part on expectations for the upcoming G20 meeting and for a policy response from the government and BoJ. Nevertheless, we lower our end-2016 TOPIX target to 1,500 from 1,650 given recent yen strength and continue to prefer defensive sectors that are dependent on domestic demand such as healthcare, consumer staples, telecoms and real estate. Macro Overview US: Further rate increases may be postponed until June or possibly September. Europe: ECB may ease policy on March 10; Uncertainty around UK referendum poses a key risk Japan: Further reduction in policy rates (from -0.1% currently to -0.3%) expected in July. Asia: China announced a 50bps required reserve ratio (RRR) cut effective March 1st, taking average RRR ratio down to 16.5% from 17%; Expect more monetary policy easing to come. Equities: Overweight While we believe it is too early to call the beginning of the next major bear market, we no longer expect global equity indices to make new highs in 2016. Our lower MSCI AC World end-2016 target of 485 (from 525) reflects a reduction in our top-down 2016 EPS growth forecast to 3.5%. Bonds: Underweight High Grade: USD & euro IG credit spreads are attractive; Favour US financials & consumer driven sectors (lodging, food/beverage). High Yield: Defaults (ex-energy) remain low and valuations are attractive, though volatility to remain Commodities: Neutral Gold: Supported by safe haven flows. Oil: More pain likely before gain Currencies: Revised Fed View = Less USD Upside GBP: BoE On Hold & Brexit Risk Premia. AUD, NZD & CAD: Risks to the Downside. Summary 2
Equity Markets and Commodities United States Next Fed hike likely postponed to June or September Consumption continues to be supported by robust labour market improvements and income growth, even as January payrolls eased to a more sustainable pace. Heightened uncertainty from the latest gyrations in oil prices is likely to further dampen oil-sector, and perhaps economy-wide, investment. Indeed, we do not see strong evidence of an imminent recession, but risk of a growth slowdown is much higher. The Fed's sensitivity to market conditions implies that recent market turbulence is likely to postpone further rate increases until June or possibly September. Looking at equities, expectations for Fed tightening have been scaled back and USD strength is unlikely to be such a drag on future EPS momentum. Thus we expect EPS to grow by 4-5% this year. Our end-2016 S&P 500 target stands at 2,150. Euro - Area UK referendum a key near term risk Chart 1 S&P 500 Index 30% 25% 20% 15% 10% 5% 0% -5% -10% -0.41% 27.57% -5.47% -8.19% Chart 2 Dow Jones Stoxx 600 Index Citi analysts are cutting our 2016 real GDP forecast by 0.4pp to 1.3% to reflect growing headwinds of tightening financial conditions and more signs of softening external demand. With inflation staying low and long-term inflation expectations drifting lower, we expect the ECB to ease policy on March 10 (deposit rate cut and increase in monthly purchases) in order to restore some credibility. The UK s EU referendum (June 23) is a key near-term risk. We believe that the UK is more likely to vote to stay in the EU than to leave (probability of Brexit 30-40%). The effects of Brexit, if it happens, are likely to be large and painful in economic and political terms, both for the UK and the overall EU. Given that Citi expects no significant and synchronized global recession, we therefore see equity markets recovering from by yearend. But, we cut our end-2016 Stoxx 600 index target to 360 given the near-term uncertainty and reduced growth expectations (topdown earnings growth of 0-5% for 2016-17E from 4-7%). 20% 15% 10% 5% 0% -5% -10% -15% -20% -2.44% -8.72% -14.86% 15.17% Japan More BoJ easing measures expected in July We expect the BoJ may implement additional easing measures in the form of a further reduction in policy rates in July this year. However, the uncertainty over BoJ policy especially further reductions in interest rates is quite high now, given concerns over the adverse effect of more negative interest rates on banks profits and on the deposit rate for consumers. Meanwhile, we attached a 50% probability that PM Abe will delay the consumption tax hike (scheduled for April 2017). Real consumer spending in 4Q15 was 2.8% below the 2013 average (i.e. before the tax hike in April 2014) and another tax hike could prolong the slump in consumer spending. In terms of strategy, we lower our end-2016 TOPIX target to 1,500 from 1,650 given recent yen strength and continue to prefer defensive sectors that are dependent on domestic demand such as healthcare, consumer staples, telecoms and real estate. Chart 3 Topix Index 40% 30% 20% 10% 0% -10% -20% -9.37% 33.02% -16.12% -14.83% Equity Markets and Commodities 3
Emerging Markets (Asia, CEEMEA and Latam) Asia remains the preferred region Chart 4 MSCI Emerging Markets Index Given the current sentiment, valuations and currency levels, we think most of bad news is already priced in. Additionally, given that Citi no longer expects significant hikes from the Fed or subsequent strength in the US$, this should remove one of the major headwinds for EM equities in our view. Within EMs, Asia is the most defensive of the three regions and within Asia our preference is for North over South. A major risk for Asia, which has an asset turn driven model, is a worsening of the global trade environment, which hard hit earnings and domestic liquidity. In contrast, we are underweight in EMEA and LatAm. Weaker commodity prices and an increase in political tensions are the two big risks for EMEA. While in LatAm, we see weak EPS and expensive valuations as the biggest concerns. 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% -35.0% -0.27% -6.78% -25.24% -29.80% Gold Supported by safe haven flows in near term Chart 5 GOLDS Commodity Index Gold rallied early in 2015 before falling to multi-year lows by yearend, but this year is shaping up to look quite different than last. For one, US dollar appreciation is likely to remain contained this year with US monetary policy looking increasingly less divergent from other central banks as the Fed seems biased towards at least a very slow hiking path going forward, with further policy easing on the table if global markets continue to deteriorate. Given the elevated volatility in global markets this year, we believe safe-haven flows into gold should continue to dominate trading in the short- to medium-term. At the same time, we expect gold imports in China to remain robust by strong investment demand for bars and coins, with the latter driven in part by concerns over further devaluation of the Renminbi. Further ahead, gold outperformance could be reversed if panic subsides and investors move back into equities and dump their gold insurance. 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% 10.78% 16.71% 2.10% -21.58% Oil More pain before gain Chart 6 Brent Oil The market remains in a state of oversupply, with the US absorbing the bulk of excess oil so far in 2016. Indeed, Iranian crude exports are ramping up following sanctions relief, and this adds more oil to the market compounding oversupply. If Iran can produce upwards of the 300-500-k b/d that the market expects, then the call for higher prices may be deferred. In Citi s view, support is more likely to materialize if gasoline cracks have a strong showing this summer as it will help clear oversupplies much more than the heavily reported OPEC output freeze would. All in, Citi analysts believe that short-term market imbalances should keep near-dated prices at least in the low $30 s, while the rationing of supply should justify higher prices later in the year. 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% -50.0% -60.0% -70.0% -80.0% 3.54% -3.51% -42.52% -67.71% Equity Markets and Commodities 4
Bond Markets High grade corporate bonds: Valuations have become attractive US Treasuries We expect US yields to stay subdued in 2016 as the combination of slowing global growth, low inflation and underperformance of risk assets continue to benefit Treasuries. High Grade Corporates High-Yield With wider spreads and benchmark yields near 3.6%, valuations are attractive. We favour US financials (vs. nonfinancials), considering significantly reduced balance sheet risks. Concerns over large US bank energy exposures are overdone, in our view. Energy exposures range between 2-3% of total loans and are not likely to cause a crisis. We also favour sectors linked to a strengthening US consumer, such as food/beverage and lodging. Growth and disinflationary concerns have also impacted euro credit spreads, despite the ECB s growing QE bond buying program. Idiosyncratic banking concerns over loan portfolios and their ability to make coupon payments on certain subordinated securities, have agitated risk sentiment. Financials are likely to remain volatile, but favour longterm. We also favour consumption-related sectors, such as retailers. In our view, both the US and European high yield markets are attractive. HY default rates are likely to rise, but largely from the energy sector. Current energy default rates are around 11%, though non-energy is closer to 2.5%. We remain underweight the energy sector, as stable (but low) oil prices still have negative implications for lower quality issuers. That said, much of the fall in oil has been priced in. Nearly 100% of CCC-rated energy credits trade at distressed levels. Volatility should persist, though higher quality issuers could see a sharp bounce as dynamics improve. Emerging Market Debt Euro Bonds With growing correlations versus risk assets and EM FX, a boost in commodities could provide a driver for mediumterm outperformance. However, we remain cautious and favour high quality issuers. FX volatility is likely to persist, so we prefer US dollar opportunities over local markets. With the German Bund curve trading with negative yields through 2024 and 30-year maturities yielding below 1.0%, we find little value. Though better opportunities exist in periphery markets, political uncertainties (i.e., Spain) are likely to keep spreads volatile. Japan Bonds Asia Bonds The BOJ extended the life of QQE by introducing negative rates. Investors are likely to keep JGBs for capital gain due to expectations of further BOJ cuts, and JGB yields are likely to drop with the lack of sellers, given that the gross BOJ purchase size almost equals MOF gross issuance. We expect volatility to increase as a small additional demand for duration such pension funds could push yields lower, while possible large profit taking on banks JGB portfolio could cause a large correction in yields. Though recent China policy allowing the reduction in minimum down-payments for first time home buyers should boost the HY property sector (45% of China HY), further currency weakness and growth risks remain. Citi analysts prefer an up-in-quality bias, as these credits are better suited to withstanding heightened volatility. Bond Markets 5
Currency USD: Revised Fed View = Less USD Upside USD is expected to trade slightly weaker against G10 basket in near term. This is driven by elevated risk aversion that may likely continue to see short covering in G10 currencies (CHF, JPY, EUR etc) and the market expecting a more dovish Fed arising from weak economic data. Medium to long term though, Citi forecasts USD positives. Even in times of recessions, USD is often seen as a safe haven; and if otherwise, strong economic data may likely further rally the USD. EUR: Pushed Around by Positioning In the euro zone, short term bias is towards possible near term Euro appreciation but still highly dependent on the March 10 ECB meeting. A second successive market disappointment could see EUD/USD stronger; whereas if Draghi delivers rate cuts and extend QE efforts, EUR may fall back a little but less dramatic as its potential upside movements Medium to long term, EUR is expected to trade close to current levels or maybe slightly lower if Fed commits to tighten and USD proves its resilience as a safe haven. GBP: BoE On Hold & Brexit Risk Premia Near term, volatility in GBP is likely to continue to build as Brexit remains a key concern with rising risk premia as the June 23 referendum date approaches-- likely to increase downward pressure on the sterling More medium term, assuming a no-brexit base case, GBP may likely see a relief rally from depressed levels. JPY: Trading US Yields In near term, JPY is likely to continue its rally as demand is expected to remain strong for JPY in periods of risk aversion and as markets continue to question the effectiveness of BoJ s monetary policy Medium term, much depends on the global growth outlook - stronger US growth would raise USD/JPY above the CitiFX forecasts but a global recession may boost JPY more as it plays into the hands of a risk-off currency. AUD, NZD & CAD: Risks to the Downside AUD: Australia is showing signs of consolidation but real risks to the economy lie in weak exports and while short term, AUD/USD could rally a bit further, such gains are subdued by the decline in iron ore prices. In medium term, AUD/USD may be weighed by the prospect of further RBA easing should the global backdrop worsen. NZD: The New Zealand economy also looks to have reasonable momentum in parts of the domestic economy so it is likely that the RBNZ may likely keep the OCR stable for now, however possibly with downside risks should dairy prices remain under pressure. On the exchange rate, akin to AUD, Kiwi is being driven by the prospect of a more neutral RBNZ in a short run but in medium term, NZD may likely decline against USD once the Fed signals it is ready to tighten again. CAD: Although the recent gains in CAD reflect CAD-USD swap rate differentials moving in favour of CAD, CAD is likely to remain a hostage to oil prices overall - Citi Commodities Research think that the eventual evidence of production cuts in oil may likely materialize later this year, potentially improving CAD s terms of trade that could see USD/CAD trade lower by year end. EM Asia: In The Shadow of RMB In Asia EM, USD/CNY is expected to remain in an upward trajectory over the medium term which is likely to pressure other Asia EM FX to weaken further. Meanwhile in China, RMB is expected to depreciate further, bringing CNY to over 7.2 over the 6-12m horizon, as the PBoC acts to restrain the current unsustainable pace of capital outflows. But with FX reserves having fallen to USD3.2trn, losses towards USD2.5-2.8trn is likely to make authorities feel uncomfortable in carrying out further FX intervention and the only option left might be for the currency to weaken further until an equilibrium point is reached. Currency 6
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