ISSUE 4 PERSPECTIVES 2Q 2017 VIEWS What will Drive Markets in 2Q17? INSIGHT Emerging Markets Turn to Shine
Perspectives Dear Clients, Paul Hodes Head of Wealth Management Asia Pacific and EMEA Citibank N.A. Global equity markets delivered a strong performance in the first quarter 2017 with the MSCI World Index up 6.5%. Since then, markets have flattened as investors reassess their earlier expectations regarding President Trump s expansionary fiscal policy. Intentions by the US Federal Reserve to reduce its growing balance sheet, slower jobs data in the US and rising geopolitical tensions have also dampened investor sentiment. Citi analysts consider higher geopolitical tensions given the increasingly hostile overtures from North Korea and the new balancing act between the US and China. They believe the US, China and Russia may resort to sanctions and diplomacy in the short to medium term. As political tensions ease, corporate earnings and economic growth will be important to drive markets in the months ahead. Citi analysts remain positive on the outlook for both earnings and economic growth and believe that there are still opportunities available for investors. In particular, Citi analysts have turned more positive on Emerging Markets (EM) recently, expecting EM debt and equity to benefit from improved macro fundamentals, increased resilience and attractive valuations. With the six-year rally of the USD expected to be close to peaking, non-usd assets potentially offer investors more attractive investment returns going forward. We hope you enjoy reading this quarter s edition of Perspectives. Please talk to your Citibank relationship manager to discuss how the developments in financial markets can impact your investment portfolio. Best regards, Paul PERSPECTIVES 2
Views What will Drive Markets in 2Q17? Global equity markets delivered a strong performance in the first quarter with the MSCI World Index up 6.5%. Since then, markets have flattened as investors reassess earlier drivers including a dovish Fed, expansionary fiscal expectations and a constructive global economic outlook. What has changed since Q1? The key drivers of the uptrend in bond and equity markets in Q1 were based on expectations of gradual rate hikes in the US, optimism on President Donald Trump s announcement of an expansionary fiscal policy and a positive outlook for the global economy. Investors now appear to be adjusting their earlier assumptions relating to: US reforms: After President Donald Trump failed to repeal Obamacare, market expectations have partially adjusted to slower progress on US tax reforms as reflected in the current market trends of a softer USD and lower US bond yields. Citi analysts have warned that the Trump administration's economic agenda could be delayed or even derailed by unpredicted and external events. While Republicans focus on tax reforms and infrastructure spending in the coming months, investors would likely need more details for risk appetite to rise again. Global growth: Despite upbeat sentiment indicators including the Purchasing Managers Indices, investors may be becoming concerned that actual economic readings of labour market data are softer than expected. In March, only 95k new jobs were created in the US, significantly below consensus expectations of 175k. This raises concerns of a potential slowdown in the US economy. US monetary policy: The US Federal Reserve (Fed) raised short term interest rates in March but Fed Chair Yellen s dovish statement dispelled the fear of sharply higher US rates. The recent minutes of the March FOMC meeting revealed that the committee members discussed the possibility of reducing the Fed s balance sheet later this year. Since the beginning of the Global Financial Crisis in August 2007, the Fed s balance sheet has grown in size and changed in composition driven by the Fed s program to stimulate the economy, known as Quantitative Easing. To keep bond yields low, the Fed bought Treasuries and Mortgage Backed Securities. Although these purchases ended in 2014, the Fed continued to reinvest the proceeds of its maturing securities. Total assets of the Fed have increased 5-fold from $869 billion in August 2007 to $4.52 trillion in April 2017. PERSPECTIVES 3
As the Fed s low interest rates and balance sheet expansion played a key role in boosting financial markets in the post-crisis years, some investors fear that a reduction in the balance sheet would lift bond yields potentially hurting global bond markets. New concerns are confronting investors: Rising geopolitical tensions: Political tensions have risen following the US military action in Syria and reports of China deploying troops near the North Korean border. While the market response to the US military strike against a Syrian air base was relatively muted, Citi analysts believe that geopolitical risks are higher now given the combination of increasingly erratic behaviour from North Korea and a new balancing act between the US and China. While the risk of further instability and possible confrontation on the Korean Peninsula is rising, Citi analysts believe sanctions and diplomacy remain the most likely options in the short to medium term. Fundamentals to take center stage Against such a backdrop, it will not be surprising to see greater volatility in the markets ahead. Fundamentals will be key in determining market direction if political uncertainties fade: Global growth: Citi analysts consider current economic weakness to be temporary and expect a moderate pickup in global growth in 2017. Citi analysts project the global economy to grow 2.8% and 3.2%, respectively in 2017 & 2018, up from 2.6% in 2016 (see chart 1). Citi analysts are also not overly concerned about the recent weak jobs reading in the US, attributing it to weather-related distortions. Citi analysts note that the average jobs growth of 178k over the last 3 months is still healthy. Chart 1: Global Citi s Real GDP Growth Forecasts (%) Seasonality: Historically, financial markets have shown to be more volatile during the mid-year period. Sell in May and go away" is a popular market adage. Stock markets exhibit seasonal tendencies driven by flows of investment capital or sentiment, rather than by fundamentals. Sources: Citi Research, Factset Consensus Estimates as of 4 April 2017. Earnings growth: Citi analysts expect the majority of companies traded in major equity markets to report healthy earnings growth in 2017 underpinned by a rise in the global economy and higher commodity prices. PERSPECTIVES 4
Multi market earnings growth would be the first synchronised increase in earnings growth since 2010. Citi analysts expect global earnings to grow 10% in 2017, up from 2% in 2016. The earnings of cyclical sectors, including Energy, Materials, Industrials, Financials, IT and Consumer Disc, are expected to grow 18%, significantly higher than the 5% earnings growth of the defensive sectors (see chart 2). Chart 2: Consensus 2017 EPS Growth Citi expects the Fed to taper its bond purchases by US$10-US$30 billion per month, which potentially has the same effect as a 25 basis point (bp) rate hike per year. Citi analysts maintain their 4Q17 forecast for the 10-year US Treasury yield at 2.65%, a modest increase from the current level of 2.25%. A portfolio for all seasons Citi continues to suggest that investors have well diversified portfolios which can take advantage of market opportunities as well as help them ride through the next market correction. Sources: Citi Research, Factset Consensus Estimates as of 4 April 2017. Muted rise in US bond yields: Citi expects the Fed to announce that it will start shrinking its balance sheet in December 2017. They expect the Fed to gradually reduce its holdings of mortgagebacked securities (MBS) and Treasuries by not rolling over its maturing proceeds. With the Fed expected to clearly communicate its intentions of its balance sheet reduction in advance, Citi analysts do not expect a sharp sell-off in bonds. The reduction in the Fed s balance sheet is also expected to lessen the need for the Fed to raise interest rates aggressively. Citi's model portfolios are currently overweight Emerging Market (EM) equities and debt. A slow pace of Fed rate hikes, contained USD strength and attractive valuations are all positives for EM. At the same time, potential downside risks to the US economy and geopolitical tensions suggest that bonds remain a key part of investors' portfolios. Citi analysts are overweight US investment grade corporate bonds. Alternative solutions including long-short strategies can also help dampen portfolio volatility and increase diversification. PERSPECTIVES 5
Key Takeaways With potentially soft economic data, relatively tighter financial conditions, rising geopolitical tensions as well as a seasonally low volume summer, market volatility may increase in the coming months. When political tensions ease, fundamentals including earnings and economic growth are likely to be supportive for equity markets. Citi continues to suggest that investors have diversified portfolios which can take advantage of market opportunities and help investors ride through the next market correction. Citi analysts are positive on Emerging Market equities and bonds as well as investment grade corporate bonds which can help dampen portfolio volatility and increase diversification. PERSPECTIVES 6
Insights Emerging Markets Turn to Shine The US dollar (USD), after adjusting for inflation, has surged more than 25% during the past six years, its third strongest rally in the last four decades. Citi analysts believe that dollar strength may peak in 2018, potentially increasing the attractiveness of selected non-usd assets. Given improving economic growth and attractive valuations, Citi analysts increased their Asian and Emerging Europe allocation to an overweight, while increasing to their previous overweight in Latin America. The six-year rally in the USD may be coming to an end The US dollar may strengthen further in the near term before peaking given US policies, including the repatriation of US corporate profits at lower tax rates, are USD supportive. However, this is likely to be a one-off driver. The six-year rally in the USD may be coming to an end in 2018 (see chart 1). Chart 1: US Dollar Index vs All trading partners (Inflation adjusted) As such, the six-year rally in the USD may be coming to an end in 2018 (see chart 1). Dollar strength had benefitted from high real interest rates during the past when inflation fell sharply. There is no inclination that real interest rates could rise to near the 9% levels of the early 1980s or even to that of the late 1990s. While the consumer price inflation reading for March disappointed (-0.3% vs expectations of +0.2%), the Federal Reserve is focused on pushing inflation higher. The Fed's upcoming rate hike cycle is also expected to be more modest. Citi analysts expects 2 more rate hikes in 2017, followed by 3 hikes in 2018. Historically, rates have risen by an average 225 basis points during the Fed's rate hike cycle of 6 years on average. As such, the long term drivers of USD strength may be abating. Source: Citi Research. As of 23 March 2017. The end of the USD rally has important implications for investment portfolios raising the attractiveness of selected non-usd assets. Citi analysts recently turned more positive on Emerging Markets (EM), moving Asia and Emerging Europe to an overweight, while adding to their previous overweight in Latin America. EM equities typically outperform when dollar is weak EM equities have historically fared better when the dollar is weak as shown in 2016 (see chart 2). PERSPECTIVES 7
Chart 2: EM Relative vs US Dollar) Source: Citi Research. As of 4 April 2017. A weaker dollar makes it easier for EM to service their dollar denominated debt. A weaker dollar also increases commodity prices, benefitting EM economies that depend on commodity exports as a major source of foreign earnings. During the period from May to September 2013, the Indian Rupee (INR) fell 19%, the Indonesian Rupiah (IDR) dropped 16% and South African Rand (ZAR) lost 13%. The Fragile 5 countries: Brazil, Turkey, India, Indonesia and South Africa had sizeable USD denominated debt and large current account deficits, making them vulnerable to USD strength and capital outflows. The significant downward pressure on their currencies prompted large rate hikes by their respective central banks, which amplified market volatility and slowed economic growth. Since then, current account deficits in the Fragile 5 countries have fallen sharply, with India leading the pack (see chart 3). Chart 3: Current Account Balances of the Fragile 5 In EM, improving economic fundamentals lead Citi analysts to expect a continued rise in growth to 4.2% and 4.7% in 2017 and 2018 respectively, from 3.9% in 2016. Recovery in China still has an old-economy tilt, with the rebounding property sector contributing sizeable growth while the stabilisation in commodity prices may help larger Emerging European and Latin America economies. EM turning more resilient In the 2013 Taper Tantrum episode, the Federal Reserve announced that it would begin tapering its monthly purchases of bonds and mortgage backed securities and caused significant currency volatility in selected EM countries. Source: Citi Research. As of 31 March 2017. For Asia, the sharp decline in trend inflation, together with a large accumulation of foreign reserves acquired since the 1997 Asian financial crisis, led the region to be less sensitive to US interest rate hikes. This has helped to mitigate the rise in USD denominated debt in the region in recent years. Within Asian equity markets, Citi analysts favour China, Hong Kong, India and Indonesia. PERSPECTIVES 8
EM equities offer attractive valuations Risks to our view Citi s decision to turn more positive on EM is also driven by the region s attractive valuations. The cyclically adjusted price to earnings (CAPE) ratio compares current share prices to the 10-year average Earnings Per Share (EPS) indicates EM looks cheap, especially against US equities (see chart 4). Chart 4: MSCI Regional CAPEs 10 Year long run average If US trade policies became more restrictive adding new tariffs on imports, North Asia and Mexico are likely to be most affected. Citi analysts do not believe the US will implement trade wars or radical changes to existing trade agreements. Emerging Europe is least exposed to US trade but vulnerable to European political changes. The big risk remains a Marine Le Pen victory in the French presidential election, as her party has been advocating that France should exit the Eurozone. Citi analysts believe that Le Pen has only a 25% chance of winning, but the Brexit and Trump victories have indicated that unlikely electoral outcomes should not be dismissed lightly. Source: Citi Research as of 4 April 2017. Key Takeaways The six-year rally in the USD appears to be peaking and is positive for selected non-us equities. Citi analysts recently increased their allocation to Asian and Emerging Europe to overweight, while adding to their previous overweight in Latin American equities. Emerging markets are now more resilient. Current account deficits have fallen for the Fragile 5 economies and most Asian economies are less sensitive to US rate hikes. Amid improving economic fundamentals, EM equities look cheap, especially against US equities. Potential US trade restrictions could hurt EM. In Citi analysts view, trade wars and radical changes to trade agreements are unlikely. PERSPECTIVES 9
World Market at a Glance Last price 52-Week 52-Week Historical Returns (%) 24-Apr-17 High Low 1 week 1 month 1 year Year-to-date US / Global Dow Jones Industrial Average 20763.89 21169.11 17063.08 0.62% 0.81% 15.33% 5.07% S&P 500 2374.15 2400.98 1991.68 1.07% 1.29% 13.51% 6.04% NASDAQ 5983.82 5989.92 4574.25 2.17% 2.66% 21.96% 11.16% Europe MSCI Europe 437.58 437.92 353.59 3.18% 2.81% 7.08% 9.38% Stoxx Europe 600 386.09 386.23 307.81 1.45% 2.54% 10.80% 6.83% FTSE100 7264.68 7447.00 5788.74-0.86% -0.98% 15.12% 1.71% CAC40 5268.85 5295.47 3955.98 3.90% 4.94% 15.30% 8.36% DAX 12454.98 12456.18 9214.10 2.86% 3.24% 20.07% 8.48% Japan NIKKEI225 18875.88 19668.01 14864.01 2.84% -2.01% 7.42% -1.25% Topix 1503.19 1578.51 1192.80 2.56% -2.64% 6.80% -1.02% Emerging Markets MSCI Emerging Market 971.36 979.75 780.68 0.90% 0.23% 14.93% 12.65% MSCI Latin America 2637.89 2719.09 2010.63-0.49% 0.62% 19.63% 12.70% MSCI Emerging Europe 149.09 153.21 116.92 2.89% -0.06% 14.53% 1.61% MSCI EM Middle East & Africa 260.09 262.39 214.75 2.16% -0.77% 7.68% 6.26% Brazil Bovespa 64389.02 69487.58 48066.67 0.08% 0.84% 21.70% 6.91% Russia RTS 1116.58 1196.99 873.58 2.04% -0.72% 19.87% -3.10% Asia MSCI Asia ex-japan 586.02 589.86 474.10 0.60% 0.30% 14.42% 13.94% Australia S&P/ASX 200 5871.78 5950.10 5051.00-0.31% 2.06% 12.13% 3.64% China HSCEI (H-shares) 10107.63 10698.28 8175.96-0.95% -3.53% 10.82% 7.59% China Shanghai Composite 3129.53 3301.21 2780.76-2.87% -4.28% 5.75% 0.83% Hong Kong Hang Seng 24139.48 24656.65 19594.61-0.50% -0.90% 12.45% 9.72% India Sensex30 29655.84 30007.48 25057.93 0.82% 0.80% 14.78% 11.38% Indonesia JCI 5664.48 5680.24 4690.56 1.56% 1.75% 15.25% 6.94% Malaysia KLCI 1756.05 1759.76 1611.88 1.28% 0.59% 2.22% 6.96% Korea KOSPI 2173.74 2182.42 1892.75 1.30% 0.22% 7.85% 7.27% Philippines PSE 7588.88 8118.44 6499.00 0.00% 4.39% 4.60% 10.94% Singapore STI 3144.03 3189.81 2703.48 0.18% 0.04% 6.92% 9.14% Taiwan TAIEX 9717.95 9976.61 7999.98 0.02% -1.87% 13.85% 5.02% Thailand SET 1564.66 1600.79 1343.13-0.71% -0.56% 10.91% 1.41% Commodity Oil 49.23 55.24 39.19-6.50% 2.63% 12.58% -8.36% Gold spot 1276.19 1375.45 1121.03-0.66% 2.63% 3.54% 10.75% Source: Bloomberg as of 24 April 2017. PERSPECTIVES 10
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