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Investment Quarterly Q2 2014 Outlook for 2014 uu Overview uu Despite a few surprises, 2014 is unfolding much as envisaged uu Emerging market sell-off: the importance of managing risks to optimise returns uu China’s credit boom and deleveraging uu Ask the expert: asset allocation uu Fixed income update: outlook for developed market credit uu Navigating markets uu Global data watch 2 Contents Overview4 Despite a few surprises, 2014 is unfolding much as envisaged 6 Emerging market sell-off: the importance of managing risks to optimise returns 10 China’s credit boom and deleveraging 14 Ask the expert: asset allocation 22 Fixed income update: outlook for developed market credit 26 Navigating markets 28 Global data watch 30 Contributors38 IQ is part of a suite of investment communications produced by the Macro and Investment Strategy Unit of HSBC Global Asset Management. The views expressed herein are as of the end of March 2014 and subject to change as the macroeconomic environment evolves. HSBC Q2 2014 3 Overview Despite a few surprises, 2014 is unfolding much as envisaged When we set out our outlook for 2014 we were, broadly speaking, positive on risk assets which still look attractive on a relative basis to perceived “safe haven” assets, especially given the expected pickup in global growth during 2014. Our long-term investment views have not changed significantly in light of the events of Q1. We argued that the pickup in global growth this year would be led by the developed world and, while it would be more varied in Emerging Markets (EM), growth would stabilise in many regions. We still favour risk assets, such as Developed Markets (DM) and EM equities, corporate credit and EM hard and local currency debt, against “safe haven” government bonds, while recognising the need to be selective – especially for EM assets. We expect EM markets to continue to be volatile, but see potentially attractive prices for long-term investors. Emerging market asset sell-off: the importance of managing risks to optimise returns EM assets sold-off over the past 12 months. This was initially due to a systemic shock when the US Federal Reserve (Fed) signalled its intention to wind down its bond buying programme and, thereafter, on the back of countryspecific issues, like the sharp currency depreciation in Argentina or the annexation of Crimea by Russia. External imbalances were the root cause of the sell-offs, as most EM current accounts gradually fell into deficit over the past few years, increasingly financed by short term, volatile foreign capital. The sell-offs can be seen as a reassessment of risks after a period of relative complacency, a negative side effect of extremely loose monetary policies. However, not all emerging markets are alike, and identifying those with the greatest strengths, like a strong industrial base or positive demographic trends, for example, will be key to benefiting from the still remarkable growth potential of EM countries. China’s credit boom and deleveraging There has been growing concern about China’s shadow banking system and corporate default risks. The investment boom since 2009 has given rise to over-capacity in several sectors, excess supply in the property market in some cities, and a surge in corporate leverage and local government debt. Low deposit rates and the absence of an appropriate risk-pricing mechanism in the financial industry, coupled with lending practices that favoured state-owned enterprises over private companies, have worsened the debt problems. The credit boom and high leverage will inevitably lead to financial losses and corporate defaults, as interest rates rise and economic growth slows. However, managing financial risks will be a major challenge for 4 Chinese policymakers in a delicate balancing act between growth and reform, which will also result in increased financial markets volatility. We think the government should be able to contain the contagion risk from selective defaults to a manageable level, and prevent a credit crunch or a significant economic slowdown. Ask the expert: asset allocation Asset allocation is the key driver of investment returns over the medium term, but many investors have not realised their return objectives over the past decade. We argue that the main causes of this have been poorly calibrated asset return expectations and a tendency to let asset allocations be static and go stale over time. We adopt a dynamic approach to asset allocation, renewing the asset mix as important information changes. Asset returns can be quite volatile over time, but we argue that returns are more predictable over the medium term using valuation indicators. Using this framework, our asset allocation process tilts portfolio weights toward “cheap” assets, even when they may be unpopular with other investors, and seeks to avoid the bubbles that can occur when the valuation arithmetic is stretched to its maximum. Fixed income update: outlook for developed market credit We review the good performance of global high yield over the past six months and consider whether the asset class can continue to provide attractive returns for investors. Growth of the global economy should support corporate sales growth and maintain healthy cash flow generation. Recent corporate results in the US and Europe confirm these trends. In addition, the credit ratings of US and European high yield companies have also been stable. While the yield spreads on high yield corporates have fallen over the past six months, we believe there is some limited room for further yield compression over the next year or two, especially for lower rated credits. In summary, we believe the environment remains positive for lower rated credit with good fundamentals and attractive valuations. We expect lower rated credit to outperform higher rated corporates and government bonds. Navigating markets In the first quarter of the year, equity markets led by EMs sold-off but other risk assets, such as EM debt and global high yield bonds, posted positive returns. In contrast to last year when bonds performed poorly, we have seen both core government bonds as well as riskier fixed income assets, such as EM debt and peripheral sovereign eurozone bonds, perform well in Q1. Peripheral European bonds have generally benefited from the European Central Bank’s (ECB’s) low interest rates and improved outlooks for their creditworthiness. particularly vital in gauging the outlook for US monetary policy. In the first quarter, economic data was weak in the US, but improved towards the end of the quarter. We would argue that the weakness in US data was the result of severe weather, rather than a sign of underlying weakness. In the eurozone, macro data has been modestly stronger with industrial production data in key economies picking up and unemployment in both core and peripheral eurozone economies falling. Secondly, on-going EM volatility is also likely to dominate markets in the near term, as investors reprice risk and weigh the impact of quantitative easing tapering on various EM asset markets. Elections in some key emerging economies, along with geopolitical tensions between Russia, Ukraine and the West are likely to induce further volatility into financial markets. However, from a long-term perspective we continue to believe valuations will be a key driver of expected returns, and these still look attractive for riskier assets relative to perceived “safe havens”. For the rest of the year, we believe risk asset performance is likely to be driven by two key factors. Firstly, global macro data will continue to be important with US data being HSBC Q2 2014 5 Despite a few surprises, 2014 is unfolding much as envisaged Julien Seetharamdoo, Chief Investment Strategist At the end of last year, we set out our outlook for 2014 which was broadly positive on risk assets, as they still looked attractive on a relative basis to perceived “safe haven” assets, especially given the expected pickup in global growth during 2014. We argued that the pickup in global growth this year would be led by the developed world. In particular, by the US and eurozone as “tail risks” in these countries gradually diminished further and the fiscal drag, ie further increases in taxes and cuts in government spending, in these countries faded compared to 2013. As a result of increasing signs of a self-sustaining recovery, we expected the US Federal Reserve (Fed) to continue tapering its quantitative easing (QE) asset purchase programme. Indeed, the Fed has continued tapering asset purchases this year, despite some soft data in the first few months of the year, that was probably a reflection of very severe winter weather and problems with the seasonal adjustment process, rather than something more fundamental. Overall, we still expect growth in the US in 2014 to be stronger than in 2013, and possibly to be even stronger than the consensus forecasts, which currently expects 2.8% growth in 2014. Figure 1: Eurozone government bond spreads continue to narrow as “tail risks” diminish further % 18 16 14 12 10 8 6 4 2 0 The eurozone economy also gradually continues to recover, though with inflation remaining low, and in fact falling further, mainly due to the large amount of excess capacity in the economy. As we highlighted previously, the European Central Bank (ECB) may eventually have to respond by relaxing monetary policy, eg by cutting interest rates again or by taking the bold step of announcing an asset purchases programme of its own. Such a policy response would arguably be positive for risk assets. Indeed, investors continue to price out so called “tail risks” in the eurozone, with the spread between periphery and core eurozone government bond yields falling further in recent months. In the emerging world, we expected growth to stabilise in many regions, but to remain weaker than in recent years. We also highlighted the importance of elections and the need for further reform in order to boost potential growth in emerging markets in the medium to long term. In addition, we highlighted that Chinese growth could be bumpy as policymakers attempted to reduce the economy’s reliance on credit as a source of growth. We thought that policymakers would ultimately be successful in stabilising growth at a lower rate and ensuring orderly deleveraging given the benign inflation backdrop and the scope that exists to ease monetary and fiscal policy should it prove necessary. More or less, these themes have played out so far this year. Emerging Markets (EM) have generally been more volatile than Developed Markets (DM) with Russia annexing Crimea, concerns about Chinese growth and local specific issues affecting EM markets. 01 02 Spain 03 04 05 06 Portugal 07 08 Italy 09 10 France 11 12 13 Ireland However, at the same time, economic data, eg the Purchasing Manager Index (PMI) has generally been encouraging in DM, and has at least stabilised in many EMs (except China where data have continued to weaken since the turn of the year). Source: HSBC Global Asset Management, as of March 2014. Figure 2: Eurozone growth picking up but inflation falling due to substantial spare capacity % yoy 6 In time, higher policy rates should help these economies rebalance and reduce their sizeable current account deficits (for more on this see the article “Emerging market sell-off: the importance of managing risks to optimise returns” by Hervé Lievore). 4 2 0 -2 -4 -6 -8 95 97 99 01 03 Eurozone inflation 05 07 09 Eurozone GDP Source: HSBC Global Asset Management, as of March 2014. 6 Encouragingly, policymakers in a number of EM countries have responded flexibly to asset price volatility and falling currencies by raising interest rates. 11 13 Upcoming elections in many EM countries could add to volatility and uncertainty through the course of this year, but also hold out the possibility that governments with fresh mandates will re-engage with the reform process. Figure 3: Purchasing Managers’ Index (PMI) surveys of business activity generally above 50 and often improving (except in China) Headline PMI New Orders Employment Nov 13 Dec 13 Jan 14 Feb 14 Nov 12 Dec 12 Jan 13 Feb 13 Nov 12 Dec 12 Jan 13 Feb 13 53.6 53.0 53.0 53.3 54.8 54.4 54.4 54.6 50.8 51.3 51.0 51.3 US 57.3 56.5 51.3 53.2 63.4 64.4 51.2 54.5 55.4 55.8 52.3 52.3 UK 58.4 57.2 56.7 56.9 64.6 60.4 61.7 60.7 54.5 54.3 54.1 55.4 Global Germany 52.7 54.3 56.5 54.8 54.5 56.6 59.7 57.1 48.0 50.8 51.7 50.0 France 48.4 47.0 49.3 49.7 46.8 45.6 48.7 49.2 48.6 46.8 49.4 48.5 Eurozone 51.6 52.7 54.0 53.2 52.3 54.1 55.7 54.5 48.8 49.9 51.0 50.6 Japan 55.1 55.2 56.6 55.5 58.4 57.2 59.2 56.2 50.9 52.8 52.7 53.7 Australia 47.7 47.6 46.7 48.6 48.8 47.8 48.8 50.0 50.1 47.0 48.3 47.4 Brazil 49.7 50.5 50.8 50.4 49.3 50.7 52.4 50.9 49.2 49.7 49.5 50.2 China (HSBC) 50.8 50.5 49.5 48.5 51.7 51.6 50.1 48.6 48.9 48.7 47.3 47.2 India 51.3 50.7 51.4 52.5 51.9 51.3 52.4 54.9 50.5 50.8 51.0 50.2 South Africa 52.4 49.9 49.9 51.7 51.6 51.8 50.2 53.4 50.8 45.8 50.7 48.2 South Korea 50.4 50.8 50.9 48.8 50.1 50.7 51.3 49.9 51.5 50.8 51.2 50.6 Russia 49.4 48.8 48.8 48.5 50.6 49.8 49.6 48.6 Taiwan 53.4 55.2 55.5 54.7 55.2 58.2 58.1 57.8 Turkey 55.0 53.5 52.7 53.4 57.1 54.7 53.9 55.1 Mexico (HSBC) 51.9 52.6 54.0 52.0 53.4 54.3 56.6 > 50 + rising > 50 + falling or > 50 + unchanged < 50 + rising or < 50 + unchanged 45.8 47.3 52.3 51.6 51.5 50.9 53.7 53.2 53.1 53.3 50.8 50.5 50.2 < 50 + falling Data unavailable at time of release Numbers greater than 50 imply growth is accelerating, those below 50 imply growth is slowing. Source: Markit data for PMIs, as of March 2014. US data refers to the Institute of Supply Management’s (ISM) manufacturing index. Investment views The bottom line is that our long-term investment views have not changed significantly in light of the events of Q1. We still broadly favour riskier assets, such as DM and EM equities, corporate credit and EM hard and local currency debt, against perceived “safe haven” government bonds while recognising the need to be selective, especially for EM assets. We expect EM markets to continue to be volatile, but see attractive prices for medium- to long-term investors. For more on this see the article by Joe Little: “Ask the expert: asset allocation”. Risks to our scenario and views In terms of risks to this scenario, China’s credit bubble and various ongoing geopolitical tensions are probably the two main ones. As in 2012 and 2013 the first quarter of the year so far has seen soft Chinese economic data, with lower industrial production growth and weaker Chinese business confidence. Broadly speaking we think Chinese policymakers will be able to manage a relatively orderly deleveraging/soft landing for the economy (see the article by Renee Chen: “China’s credit boom and deleveraging”), but there are considerable risks, as well as the chance of a policy mistake. The rest of the year will probably see more negative headlines, such as more defaults of trust companies. At the 12th annual National People’s Congress, Chinese Premier Li Keqiang outlined the government’s official plans and targets for 2014. Most importantly, the growth target for 2014 was maintained at 7.5%, the same as 2013’s. Some form of stimulus, fiscal or monetary, might be needed given the weak start to reach the growth target and an economic package along these lines has recently been announced. The combination of low inflation and ample foreign exchange reserves suggest the government has the ability to restimulate the economy if growth slows too sharply. However, rebalancing the economy and making it less dependent on credit growth will be a bumpy process and HSBC Q2 2014 7 2014 has seen the first corporate and trust defaults in a number of years on the Chinese mainland. Geopolitical tensions, such as the situation in the Ukraine, are also a risk, especially if it deteriorates further. Tensions seem to have diminished somewhat at the time of writing (the end of March), but the situation needs careful monitoring. The US and EU have agreed to impose sanctions in the form of travel bans and asset freezes on key Russian officials. These are modest but the message is that they will be increased, should the situation deteriorate. The situation remains fluid, but it is in no-one’s interests for it to deteriorate further. If it did deteriorate then the outcome would be damaging for both Russia and the West with the former at risk of losing foreign 8 investment and trade, while Europe is primarily exposed through its dependence on Russian energy supplies. In the event of trade sanctions that extend to trade in energy, Europe could face a significant shortage in the supply of oil and natural gas. Political calendar Date Country Event April-July 2014 South Africa General elections 22 May 2014 European Union European Parliamentary elections 14 May 2014 India Parliamentary elections 06 April 2014 Hungary Parliamentary elections 09 July 2014 Indonesia Presidential election 10 August 2014 Turkey Presidential election 05 October 2014 Brazil General elections 26 October 2014 Uruguay General elections 04 November 2014 United States Mid-term Senate and House of Representatives elections Source: HSBC Global Asset Management, as of March 2014. HSBC Q2 2014 9 Emerging market sell-off: the importance of managing risks to optimise returns Hervé Lievore, Senior Macro and Investment Strategist Investors feared a liquidity squeeze would impact emerging markets (EM) EM asset performance disappointed in 2013 and the first quarter of 2014 have seen a continuation of underperformance by EM equities. Last year, EM equities lost 2.3% in USD in total return terms, while DM equities gained 27.4% in total returns. Consequently, advanced market stocks outperformed by about 30 percentage points, a level unseen since the EM crisis of 1997-98. EM bonds also posted negative returns in 2013 (-4.6%, in USD, total return) while US High Yield gained 8%. However, volatility was most visible in the foreign exchange (FX) market, with many EM currencies depreciating by between 5% and 20% against the USD over the year.1 After a relative rebound late in the second half of 2013, EM assets generally continued to underperform early in 2014, with the notable exception of bonds. During this period, the US Federal Reserve (Fed) effectively started to reduce its liquidity injections but Treasuries rallied as the flow of US economic data disappointed. The EM asset sell-off of 2013 was triggered by investors’ growing concern about the majority of EM countries’ reliance on foreign capital. Since 2008, EM countries have seen a significant deterioration in their combined current account balance. As a group, and excluding the specific case of China, their combined current account has been in deficit since 2010, after 11 years of surpluses. By construction, this deficit needs to be financed, which can be done essentially through three channels: foreign direct investments (FDI), international lending and portfolio investments. Between 2010 and 2012, the combined EM current account deficit was entirely covered by FDI net inflows, considering a sample of 18 EM countries that also excludes China. The situation deteriorated at the very end of 2012 and, on 1 The indices used are: for equities, the MSCI Emerging Market and the MSCI World (total returns in USD) and, for bonds, the Barclays EM USD aggregate and the Barclays US Corporate High Yield. Figure 1: EM aggregate current account deficit and portfolio investments average, FDI flows were insufficient to cover current account deficits in 2013. At the same time, international lending was constrained by the derisking of European balance sheets. Bank for International Settlements (BIS) data shows that banks’ aggregate foreign claims outstanding have been plateauing at about USD25 trillion since 2009, with no net increase. EM markets had no alternative but to rely on portfolio investment inflows that can be unstable and sensitive to market sentiment in order to fund their growing current account deficits. This reliance on portfolio investments became an even more worrisome issue after Fed Chairman Ben Bernanke signalled in May 2013 the willingness of the US central bank to gradually unwind its large-scale bond buying programme. Even though the Fed will not withdraw liquidity from the market quantitative easing (QE) tapering means it will just stop adding fresh money and will maintain Fed fund rates at levels close to zero for a considerable time after QE ends. In other words, monetary policy will remain extremely accommodative, markets feared a de facto tightening of financing conditions through higher Treasury yields. This shift in US monetary policy stance had both a material and a wide impact on risk assets, especially EM. The core problem for EM was external imbalances EM dependency on unstable external capital flows is a problem that exists because, in most countries, current account balances have gradually fallen into deficit. There are two key reasons why this deterioration happened. The first one is related to weak global demand. Western countries in general, and the eurozone in particular, had to address substantial external deficits after the credit bubble burst. By construction, a current account imbalance reveals an excess level of investment relative to domestic savings. To say it in a different way, it is a sign of excess domestic demand, particularly consumption. Restructuring and austerity measures implemented in advanced economies after the Figure 2: Foreign claims of banks reporting to the BIS USD bn, 5-month moving average 80 USD tn 32 60 29 40 26 20 23 0 0 -20 -40 17 2006 2007 2008 2009 2010 2011 2012 2013 Current account plus FDI Portfolio investments Source: Datasteam, as of March 2014. 10 14 2005 2007 2009 Source: Datasteam, as of March 2014. 2011 2013 financial crisis took their toll on demand for exports from EM markets. At the same time, EM domestic demand remained Figure 3: EM current account balance and real effective exchange rate (REER) REER 84 % GDP 4 89 94 99 2 0 104 1994 1998 2002 2006 2010 2014 Median EM REER (lhs) EM ex-China current account balance (rhs) % of GDP -2 more resilient and, as a result, trade deficits tended to become the norm in the EM group, a reversal of previous trends. The second reason for higher EM current account deficits is a loss of price competitiveness over the past decade. This appears when currency appreciation outpaces productivity gains in a given economy, for example, after massive capital inflows. Trade-weighted exchange rates, net of inflation, or real effective exchange rates (REER) are convenient proxies for external price competitiveness. Between 2004 and 2012, EM REER tended to rise as nominal exchange rates appreciated against the USD and as the average rate of inflation in EM nations tended to converge towards US inflation. As EM currencies appreciated over time, EM export competitiveness gradually eroded. Combined with softer exports to advanced economies, this decline in price competitiveness played a key role in weakening EM exports. Source:Bloomberg, as of March 2014. HSBC Q2 2014 11 Policy response However, many EM countries, under intense market pressure, have taken bold steps over the past few months to stabilise market sentiment and anchor inflation expectations. For instance, the Central Bank of Turkey raised its overnight lending rate from 7.75% to 12%,the Russian Central Bank also decided to hike its benchmark rate by 150bp at the beginning of March, from 5.5% to 7.0% and the Central Bank of Brazil continued to tighten its policy, pushing the SELIC rate to 10.75%, 500bp higher than headline inflation and up from 7.25% in January 2013. Rebalancing their economies should be a priority for EM policy makers and this goal should be achievable, through reduced domestic demand and/or weaker exchange rates. In India, for example, the Reserve Bank of India (RBI) raised its policy rates by 75bp between September and January, contributing to depress domestic demand, while the rupee depreciated by about 13%. While painful in the short term, these measures allowed the country to reduce its current account deficit significantly from USD21 billion in Q2 2013 to USD5 billion in Q3 and USD4 billion in Q4 (non-seasonally adjusted). Restrictions on gold imports were also imposed as part of this process. India is a good example of the way in which adequate policies can address external imbalances and explains why investors should not disregard EM assets altogether, but rather be selective. EM asset prices now reflect a more realistic economic scenario and embed a higher risk premium To a large extent, the low yield environment that has prevailed over the past five years was the consequence of the historically loose monetary policy adopted by the Fed after the financial crisis. Initially, the Fed pushed money market rates close to zero and, subsequently, extended the flattening to the long end of the yield curve through large-scale bond buying programmes. In doing so, the Fed’s primary goal was to ensure abundant and cheap financial resources to support the US economy. But it came at the Figure 4: Gap between US and EM equity implied volatility Percentage points (pp) 17 12 7 2 Jan-12 Jul-12 Jan-13 Source: Bloomberg, as of March 2014 12 Jul-13 Jan-14 expense of risk premiums not only in the US but also in EM and the sell-off of 2013 also reflected a broad-based repricing of risk, especially macro risk. Implied volatility in US and EM stocks provide an illustration of this mispricing of risk before the Fed signalled in May 2013 the possibility of QE tapering. The typical gap between US and EM stock market volatility stands at around 9 to 13pp. In Q4 2012, the gap narrowed sharply to a 5 to 6pp range, as EM volatility fell and US volatility remained relatively stable. The gap remained at this low level in Q1 2013 before widening back to the previous 9 to 13pp range in Q2, when the market became aware of the upcoming QE tapering. This form of normalisation in the perception of risk occurred in other asset classes, especially in the FX market. Over time, weaker currencies should help EM countries to reduce their current account deficits. As a side effect, they should also contribute to reduced future volatility by reflecting more accurately the current strengths and weaknesses of these economies. The optimisation of EM returns implies a rigorous assessment of risks and selectivity Although it is convenient to lump all the emerging markets together, in truth this can be misleading, given that they are a very diverse set of countries. The EM space is not homogenous, neither in terms of financial performance or economic fundamentals. For instance, some EM currencies proved to be resilient in 2013 gaining while others depreciated sharply. Credit spreads in Asia widened significantly less than in Latin America and, while some local equity markets are close to their all-time highs, others are back at the same levels last seen in the trough of March 2009. When assessing the outlook for emerging markets, identifying external and internal imbalances is important. We saw in 2013 that countries running current account deficits showed greater volatility, a logical consequence of the fact that they are net capital importers. Conversely, countries like South Korea and Taiwan, which have a net financing capacity, were significantly more resilient. Inflation and fiscal deficit dynamics are also key variables, among others, to monitor macro risks for a given country. As a general rule, long-term sustainable economic development rests on productivity gains or, in other words, the capacity of a country or company to increase its output with the same resources. Provided that wage growth stays below productivity growth, inflation pressures will likely remain muted; the appreciation of the currency will not reduce exporters’ price competitiveness; and fiscal deficits, if any, will not fuel excessive public debt. Obviously, it is almost impossible to anticipate the long-term trend of productivity exactly but certain characteristics create a favourable Emerging market sell-off: the importance of managing risks to optimise returns environment. For example, a strong manufacturing base; a high level of trade openness; labour force mobility and education as well as an efficient legal framework to protect intellectual property rights and innovation. On the other hand, an excessive dependence on commodities could limit the long-term prospects of an economy as history has taught us that, over time, commodity prices tend to fall relative to manufactured goods. The diversification of the economy is thus another important parameter to monitor. Figure 5: Equity performance in EM and advanced economies yoy % 100 50 0 -50 -100 When liquidity starts to dry up, markets tend to ignore the differences between EMs. The sell-off of 2013 impacted EM across the board because it was triggered by a “systemic” shock (the decision of the Fed to slow down its liquidity injections and the fear of a liquidity squeeze). Due to this systemic event, and on the back of previously mispriced risks, markets did not really discriminate in the first wave of sell-offs of Q2 2013. The “second wave” of sell-offs, in January 2014, was different in nature, based on idiosyncratic factors like the decision of Argentina to stop slowing down the depreciation of its currency as the country saw a rapid decline in its FX reserves. This time around markets were more selective and countries with robust fundamentals fared better. This suggests investors in EM are gradually becoming more discriminating and is an encouraging sign. Conclusion and investment implications The EM asset sell-offs of 2013 and early 2014 were a useful, though painful, reminder that the intrinsic risks associated with EM countries need to be compensated through appropriate risk premia and that a rigorous and systematic monitoring of these risks would lead longterm investors to adopt a selective approach. The fact that central banks in countries under market pressures took bold measures to stabilise their currencies, at the expense of economic activity, is encouraging in the sense that it shows a heightened level of accountability. By the same token, several countries took unpopular measures to rein in their burgeoning fiscal deficits, like Indonesia. Overall, EM equity and bond attractiveness remains high, but future returns will depend on the appropriate pricing of risks and the prospect for long-term economic development. It is likely that markets will experience volatility in the near term, as investors reprice risk and weigh the impact of QE tapering on various asset markets. We would view this potential rerating as an investment opportunity as many EM assets are being oversold given their positive long-term fundamentals. 2006 2007 2008 2009 MSCI EM Total Return (TR) 2010 2011 2012 2013 MSCI World Total Return (TR) Source: Datasteam, as of March 2014. Figure 6: EM and US High Yield Total Return (TR) yoy % 100 50 0 -50 2006 2007 2008 US High Yield TR 2009 2010 2011 2012 2013 EM USD Aggregate TR Source: Datasteam, as of March 2014. Figure 7: Average EM currencies exchange rate against the USD % 113 108 31 December 2012 = 100 Depreciation 103 100 98 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Source: Bloomberg, as of March 2014. Figure 8: EM bonds (EMBIG) credit spread Basis points 450 425 400 375 350 325 300 275 250 225 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Source: Datasteam, as of March 2014. HSBC Q2 2014 13 China’s credit boom and deleveraging Renee Chen, Macro and Investment Strategist There is growing concern about China’s shadow banking system and corporate default risks. The investment boom since 2009 has given rise to over-capacity in several sectors, excess supply in the property market in some cities, and a surge in corporate leverage and local government debt. Low savings rates on offer in the traditional banking system which have led to savers seeking higher rates elsewhere, as well as the absence of an appropriate risk-pricing mechanism in the financial industry, coupled with lending practices that favoured state-owned enterprises (SOEs) over private companies have worsened the debt problems. The credit boom and high leverage will inevitably lead to financial losses and corporate defaults, as interest rates rise and economic growth slows. Managing financial risks will be a major challenge for Chinese policymakers. Overall, the government should be able to contain the contagion risk from selective cases of default to a manageable level in our view, but policy adjustment to support growth at a lower level will be needed, with incremental steps in structural reforms. Overinvestment and overleverage The leverage in China’s economy, particularly the corporate sector, has risen sharply since 2009 as the government implemented stimulus policies in response to the global financial crisis in 2008. Easy financial conditions fuelled an investment boom – from infrastructure and property investment to capital expansion in the mining and upstream manufacturing industries. Ultimately, the investment boom gave rise to over-capacity in several sectors, particularly metals and mining, building materials, solar equipment and shipbuilding. This resulted in excess supply in the property market in some tier-3 and tier-4 cities as investment and construction have far outpaced sales. There has also been investment misallocation in infrastructure. Among which, credit to non-financial corporations exceeded more than 150% of GDP in 2013. Despite such rapid expansion of credit, GDP growth has slowed. This indicates that debt-fuelled capital spending has become much less efficient at generating growth and/or a lot of credit growth has gone to refinance existing loans (we think both), which flags serious potential problems. The root cause of the excessive leverage build-up was the investment-driven and state-led growth model which resulted in low investment efficiency, diminishing returns to capital/credit, and a deceleration in overall productivity gains. Leverage is concentrated in a few sectors dominated by large enterprises, especially SOEs. These highly leveraged sectors tend to suffer from overcapacity and deflationary pressures, further exerting pressure on their debt repayment. In addition local government debt has increased significantly. It totalled CNY17.9 trillion (31.5% of 2013 GDP) as of endJune 2013, including CNY10.9 trillion directly borne by local governments and CNY7 trillion of contingent liabilities. That represents a 64% increase between end 2010 and June 2013. Among the debt, debt by local government financing vehicles (LGFVs) rose to CNY6.97 trillion (12.3% of 2013 GDP) as of end-June 2013 from CNY4.97 trillion (12.4% of GDP) by end-2010. Local government borrowings were mainly to finance long-term infrastructure and social projects which have been unable to generate sufficient cash flows to service their debt. Non-financial credit (borrowing by the government, households and non-financial corporations) surged from about 150% of GDP in 2008 to over 230% of GDP in 2013. Market distortions and financial vulnerabilities The low savings rates on offer in the traditional banking system and the absence of appropriate risk-pricing mechanisms in the financial industry and the bond market, coupled with an uneven playing field that favoured SOEs over private companies have worsened the debt problems. The absence of defaults and the perception of an implicit Figure 1: Growth in GDP versus bank loans and outstanding total social financing (TSF) Figure 2: Return on invested capital (Shanghai Composite nonfinancials index) % yoy 35 30 25 % yoy 35 % 12 20 11 10 20 15 15 10 8 5 7 10 5 0 1Q03 1Q05 1Q07 TSF stock (lhs) Real GDP (rhs) 1Q09 1Q11 1Q13 Bank loans (lhs) Nominal GDP (rhs) Source: CEIC and HSBC Global Asset Management, as of March 2014. 14 0 9 6 5 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2014 Index-weighted average Simple average Source: Bloomberg, HSBC Global Asset Management, as of March 2014. HSBC Q2 2014 15 China’s credit boom and deleveraging guarantee by product issuers, eg banks and trust companies, and support from the government has been a major distortion in China’s financial system and corporate bond market. Interest rate controls have led to low and even negative real returns on deposits. The strong demand for trust products and wealth management products (WMPs) has been driven by high-net-worth individuals and depositors looking for alternative investment opportunities to low interest rate deposits, and by a perception that product issuers and distributors provide an implicit guarantee. There were several reported cases of the investment failure of trust products or WMPs, but eventually investors were all repaid under various arrangements. The outstanding amount of bank-issued WMPs surged to CNY10.8 trillion (10.1% of bank deposits) as of end-2013, from just CNY1.7 trillion (2.7% of bank deposits) at end-2009. The trust sector’s assets under management (AUM) grew rapidly from CNY2 trillion (6% of GDP) at end-2009 to CNY10.9 trillion (19% of GDP) as of end-2013. Artificially low lending rates resulted in excess demand for bank loans and increased the use of quantitative targets to control credit growth. Banks favoured lending to large corporations, mainly SOEs and LGFVs, perceived to present less risk with implicit guarantees from central or local governments, even in sectors with widespread overcapacity. Consequently, such biased lending behaviour has given rise to moral hazard and crowded out small and medium-sized enterprises (SMEs) from relatively lowercost bank loan financing to high-interest-rate trust loans or other shadow banking channels. Trust funds have been utilised as a channel of alternative financing to offer credit to money-hungry firms and risky borrowers that do not have access to bank loans. This source of credit has allowed banks to arrange off-balance sheet refinancing for maturing Figure 3: Liability-to-asset ratio: by selected industries loans that risky borrowers cannot repay from their cash flow and to keep their businesses and projects afloat to avoid default on bank loans. Outstanding trust loans increased sharply to CNY4.9 trillion as of end-2013 from CNY1.7 trillion at end-2011. Shadow banking lending is less transparent and less subject to supervision, regulation and capital requirement, raising concerns about the systemic risk. Another risk area is credit hidden in the interbank market. Interbank business was initially limited to lending between banks to address short-term liquidity issues. However, since 2010, the interbank business has undergone a fundamental change, expanding a variety of off-balance-sheet assets and creating many types of interbank products. Banks have increased their use of the interbank market to manage their regulatory ratios and maximise returns. The interbank market has facilitated bank co-operation with the shadow banking sector, for example, WMPs investing in interbank assets or claims on trust assets being traded in interbank markets. The previous bailouts in the onshore corporate bond market by the government and/or state-owned banks, by providing last-minute loans to companies in trouble, created moral hazards and encouraged investors to seek the highest yields without considering the underlying credit risks. The corporate bond market has grown significantly in recent years, although issuance is still predominantly by SOEs (including LGFVs). While bank loans remained the biggest component of local government debt, local governments have increasingly relied on bonds and other forms of financing including trust loans. Bank loans accounted for 56.6% of total local government debt as of end-June 2013, down from 79% at end-2010. Local governments enjoyed low financial costs often not compatible with the underlying risks when issuing bonds, due to a perceived implicit guarantee or bailout prospects. Figure 4: Shadow banking credit and corporate bonds outstanding CNY trn 20 Water supply Non-ferrous metals Ferrous metal smelting 15 Chemical fibre Petroleum and coking 10 Ferrous metals 5 Coal Overall 0 20 40 2013 60 2008 Source: CEIC and HSBC Global Asset Management, as of March 2014. 80% 0 2008 2009 WMPs (AUM) 2010 2011 Trust (AUM) 2012 2013 Corporate bonds Note: corporate bond statistics include enterprise bonds, corporate bonds, MTN, STFB and ABS; the numbers have been adjusted for the double counting issue due to duel market listing. Source: BofAML, CEIC, CBRC, WIND and HSBC Global Asset Management, as of March 2014. 16 Deleveraging and default risks The credit boom and high leverage will inevitably lead to financial losses and corporate restructuring and defaults, as interest rates rise and economic growth slows. Interest rates will move higher, due to interest rate liberalisation to gradually end financial repression and policy efforts to rein in credit growth. The People’s Bank of China (PBoC) faces challenges with a fast evolving financial landscape due to the rapid unfolding of interest rate liberalisation driven by market forces via the shadow banking sector and financial innovation. The explosive growth in WMPs has been one major force driving interbank rates up and raising banks’ funding costs, as it reduces the supply of low-cost deposits for banks which increasingly rely on funding from the interbank market. Banks also face intense competition for deposits from money market funds (MMFs) offered by internet platforms. The AUM of MMFs has surged since July 2013, to CNY1.4 trillion as of end-February from CNY304 billion at end-June driven by web-based MMFs. The AUM of MMFs is still very small compared with that of bank WMPs, but the rapid growth of MMFs has surely been a force speeding up China’s marketdriven interest rate liberalisation. The potential risk of deposit outflows has prompted banks to increase their dependence on WMPs and/or roll out similar products. Banks may also raise loan pricing as funding costs rise. Deleveraging in a rising interest rate environment could exacerbate vulnerability among heavily leveraged sectors and investment projects that have cash flow problems and rely heavily on shadow banking financing. Corporate bond default risks In March, a small and heavily-indebted solar equipment maker failed to pay interest on a bond, marking the first onshore corporate bond default in recent history. The event was seen as a landmark which could signal greater government willingness to let lenders be subject to market discipline. Previous cases in which Chinese companies came close to defaulting were averted at the last minute, usually with government intervention. In general, corporate bonds should be less risky than trust credit because the market is more transparent and subject to tighter regulation, but significant risks still exist. SOE bond issuers tend to have lower default risk than non-SOEs, partly because of their relatively easy access to other funding channels. LGFV bonds also have relatively less risk due to lower funding costs, longer duration and stronger incentives for local governments to support them. Analysts from Bank of America Merrill Lynch (BofAML) identified 20 risky bonds with the highest potential default risks from some 6,800 bonds traded both on the interbank and exchange market, worth about CNY20 billion. Bonds issued by non-SOEs in “high-risk” sectors, eg industries that suffer over-capacity and property that had their ratings cut over the past three years and/or issued by companies that made losses over the past two years are particularly vulnerable. Shadow banking credit risks Given their focus on relatively higher interest-paying segments, trusts are exposed to higher levels of credit risks compared with other major financing channels for companies such as bank loans and debt markets. Collective trusts, which are sold to multiple investors and accounted for about a quarter of the trust sector’s AUM in 2013, tend to be riskier than single trusts (sold to a single investor). There is a busy schedule of trust products maturing and LGFVs that need refinancing this year. According to statistics from Use-Trust Studio in February collective trusts worth about CNY900 billion will mature this year. There are likely to be more potential shadow banking product defaults over time. 20% and 16% of total local government debt (as of end-June 2013) will mature in 2014 and 2015, respectively (18% in 2013), which will put near-term pressure on debt rollover. Among various trust types, energy and mining trusts invested in private projects will likely have the largest risk of defaults this year due to a busy maturity schedule, low profitability and less government support, but these trusts account for just a small share of the total. Trust companies have played an important role in infrastructure. While we see a risk of defaults by LGFVs at village and town or even county levels, we think most LGFVs will still enjoy implicit guarantees from local governments which may prevent defaults this year. Infrastructure and LGFV trusts could face severe financing problems if land purchases by developers fall, as land sales are a major source of local government revenue and land is often utilised by local governments as collateral for borrowing. Property market a major risk The property market has been reasonably buoyant in recent years, but tighter credit conditions, rising funding costs and slower economic growth will challenge property sales this year. Supply and demand dynamics remain favourable for property markets in the four tier-1 cities (Beijing, Shanghai, Guangzhou and Shenzhen) and many tier-2 cities (mostly provincial capitals). However, there are problems in some lower-tier cities, where the housing market has cooled considerably with sales declining and prices stagnant or falling. There is also a rising divergence among property markets in different cities. Some property developers will face pressures as transaction volumes slow and cash HSBC Q2 2014 17 flow conditions tighten. This problem is expected to be more severe for small developers with limited funding channels and weak execution in lower-tier cities where the property sector is overinvested. They may face difficulties in refinancing and will likely have to cut prices further. Real estate trusts with lending to small, unlisted developers with single-city operations in tier-3 and tier-4 cities could be in trouble, but default risks by larger and national developers should be low. We believe the government has an incentive to maintain the stability of the property market given the sector’s importance to the economy and its link to the whole fiscal and financial system through land sales and value (as collateral especially for LGFVs). The government will employ differentiated property policies in different cities reflecting local conditions and will adopt a new “two-way” approach that mainly focuses on increasing the supply of affordable housing and curbing demand for commodity housing for investment purposes. Although many of the potential default cases could still get bailed out in some way, given that the underlying problems are corporate insolvency risks, it is just a matter of time before many products will ultimately default, in our view. Bailouts will only delay or even amplify the problem in the longer term. China’s shadow banking is closely connected with the regular banking system. Banks are the largest holder of corporate bonds and may suffer meaningful losses if many corporate bonds default. WMPs have channelled funds to trusts and corporate bonds. An increase in default rates in the trust sector or corporate bond market would pose a high risk to WMPs. A loss of confidence by investors and depositors in trust products or WMPs could risk triggering a negative chain reaction. Policy implications With credit risks likely to rise significantly and some defaults unavoidable this year, it will test the central government’s willingness and ability to allow selective defaults to address Figure 5: Newly increased collective trust funds: investment by industries CNY trn 1.5 1.0 0.5 0 2010 2011 Real estate Infrastructure Financial institutions 2012 2013 Industrial and commercial enterprises Securities market Others Source: CEIC and HSBC Global Asset Management, as of March 2014. 18 the moral hazard problem, impose market discipline and improve risk control, while preventing any individual defaults becoming a systemic financial problem, which could result in heavy economic and social costs. We believe China’s deleveraging will be a gradual multi-year process, not a quick fix, so as to alleviate the impact on growth and system-wide liquidity. The government does not intend to cause a systemwide credit crackdown, but instead aims to correct the problems of financial excesses and credit dislocation. Chinese policymakers have the ability to respond to systemic financial risks using fiscal, regulatory and monetary policy. China has a high savings rate and its financial sector is funded primarily by domestic savings. The government holds major stakes in many banks and the central government balance sheet remains sound with significant financial resources, eg owning the country’s natural resources and holding large foreign exchange (FX) reserves, etc. The government has a set of policy options to avert a crisis, including debt nationalisation, securitisation, asset management companies (AMCs), and government-led restructuring. The PBoC has various tools to avert a credit crunch, including the standing lending facility and cuts to the reserve requirement ratio. In addition, it could even loosen the quantitative controls on bank credit expansion. The government will also expand the financial safety net, eg a deposit insurance scheme and exit mechanism for failed financial institutions and improve regulatory and legal process governing company bankruptcy and restructuring. China’s potential GDP growth has slowed, due to a combination of structural factors such as a gradual slowdown in productivity growth in the industrial sector, an unfavourable demographic trend, as well as loss of cost competitiveness and a significant reduction in the export contribution to growth. To enable an orderly deleveraging without a credit crunch or economic hard handing, credit growth needs to be constrained and any reduction in the HSBC Q2 2014 19 China’s credit boom and deleveraging rate of credit growth must be accompanied by extensive measures to ensure that the productivity of each dollar of credit issued is far higher than in the past. Therefore, financial reforms to substantially raise the efficiency of credit allocation and the returns to capital, accompanied with other structural reforms to unlock the economy’s productivity potential, are crucial. This requires more market-based pricing of credit and the diversification of credit channels, via the establishment of a multi-layer capital market. Deposit rate liberalisation and SOE reform will be key to improving productivity of capital allocation. Fiscal reforms will focus on redistributing fiscal revenues and expenditures between central and local governments, which will help improve local governments’ fiscal sustainability, and strengthen control over government debt and associated risks. Overall, we think the government should be able to contain the contagion risk from selective cases of default to a manageable level. Under such a scenario, which is our base case, the government should be able to manage around 7% growth in 2014 and 2015, but policy adjustment to support growth will be needed, with incremental steps in structural reforms, especially on demand- and productivity-enhancing reforms. Investment implications More negative headlines on default risks, expected slower economic growth, tighter financial conditions, and more volatile money market rates and CNY exchange rates could unsettle financial markets from time to time and cause higher volatility. The low valuation of the Chinese stock market has probably discounted many macro risk factors, but a sustained market rebound looks unlikely until there is some conviction that financial risks have been brought under control. The performance of Chinese stock markets will likely be driven by policy and depend on the balance between reform and growth in the short-to-medium term. Effective reform implementation could boost investor sentiment and raise valuations of Chinese stocks, but reform-driven rerating potential is likely to take time to be realised. Stock selection based on corporate fundamentals is the key to outperformance. For fixed income, risk aversion in the event of defaults and perceived elevated onshore credit risks would mean a higher risk premium for credits (both onshore and offshore). There will also be greater differentiation between stronger and weaker credits. It is likely that total return potential will mainly come from carry and credit selection this year. However, greater market discipline with better pricing of credit risks and reduced incentives for financial institutions to continue to 20 channel credit to unproductive and risky entities will lead to a more efficient allocation of capital, which should benefit both onshore and offshore creditors in the long term. Defaults or heightened credit risks could lead to periods of CNY depreciation and weaker CNY expectation/outlook in the near term, but we expect the PBoC to act to prevent any sharp currency moves while encouraging greater two-way volatility of the CNY exchange rate. The PBoC still has good control over the FX market and the CNY exchange rate and it is in the Chinese policy makers’ interest to prevent excessive CNY volatility given the potential negative repercussions on other local financial markets, domestic liquidity conditions, and credit risks. China’s current account surplus, large FX reserves, net FDI inflows and its net creditor position to the rest of the world provide longer-term fundamental support for the currency. HSBC Q2 2014 21 Ask the expert: asset allocation Joe Little, Senior Investment Strategist What do we mean by asset allocation? Asset allocation is all about balancing risk and return by constructing a portfolio of different asset classes (government bonds, corporate bonds, equities, etc) according to investor return objectives, risk tolerances, time horizons and other constraints. We believe that asset allocation is the core driver of investment performance in the medium term1, a view that is supported by academic research, and that we should take a dynamic approach. This means that we are not focusing on every twist and turn in markets. We take a multi-year perspective, seeking to capture phases of normal or exceptionally strong asset returns, and avoid phases of weak or negative asset returns. What do you think are the common mistakes asset allocators make? Over the past decade, many investors have not realised their return objectives. We think there are two common mistakes: (i) expectations of asset returns are typically poorly calibrated which leads to disappointment and (ii) asset allocations are often left static and become stale. During the 1990s bull market, UK pension funds substantially increased weightings to equities. Strong markets fostered a high degree of confidence in future returns which were buttressed by hindsight bias and myopia, ie overemphasising the recent past. By the end of the 1990s, the average UK pension fund had more than 75% of its assets in equities. What came next, a decade of flat equity performance punctuated by two large bear markets, was a major disappointment. The clear conclusion is that historic returns are not a good guide to the future. Rather, the implication is that what you buy and when you buy is more important. Secondly and related, many investors employ a “set and forget” strategy to asset allocation. But asset returns are Rolling 20 year inflationadjusted return Figure 1: US equities rolling returns (inflation adjusted) % 16 14 12 10 8 6 4 2 0 -2 1920 1932 1945 1957 1970 1982 1995 2007 Source:Global Financial Data, as of March 2014. 1 Ibbotson and Kaplan (2000), “Does asset allocation policy explain 40%, 90% or 100% of performance”, Financial Analysts Journal. 22 volatile, even over long holding periods (see Figure 1) and so a “set and forget” strategy can lead to regret. How should we respond to these mistakes? In our view, the short answer is that a valuation-based approach to asset allocation should be adopted, rather than merely applying a standard economic forecasting approach. The distribution of future asset returns is not random; empirical evidence has shown that valuation factors can be good predictors of returns, at least in the long term. We think it makes sense, therefore, to construct asset allocation using forecast returns based on current valuations, updating our views regularly to reflect important new information. We also believe in a policy of systematic rebalancing. Following the crowd is an emotionally-comfortable approach and buying into what has recently been working seems sensible. However, segregating assets into buckets of “winners” and “losers” is a behavioural trap. It means that we under-emphasise portfolio considerations, particularly the benefits of uncorrelated returns. Moreover, while adding to an asset class which has recently fallen in value might feel frightening, it is often the best time to buy. Regular rebalancing of multi-asset portfolios means that they should closely reflect our current views. Can we forecast asset class returns? The influential “efficient markets” approach of modern financial theory proposed that available information was fully incorporated in prices. Dividend yields, for example, were assumed to reflect the market’s view of future dividend growth. This might be a reasonable rule of thumb for the very short run, but as we extend the time horizon to the long term, we find that asset prices are “excessively volatile” relative to what fundamentals would imply. This implies that to some extent, returns can be predictable across asset classes. In equities this means that high dividend yields today predict high equity market returns in the future. In government bonds, the slope of the yield curve forecasts future bond returns, not the direction of interest rates. In credit, higher spreads are not just about increased corporate default risks, instead they forecast higher investment returns. Long run return predictability is pervasive across asset classes.2 How do you construct your return signals? We model asset class returns over the next ten years. Returns for each asset class reflect a risk-free rate and additional “risk premia” compensating investors for uncertainty (see Figure 2). Over the long run, risk premia should revert to asset-specific norms. 2 See Cochrane (2011), “Discount Rates”, Journal of Finance. HSBC Q2 2014 23 So, we start with a projection of where policy and cash rates will be in ten years’ time and, using a combination of thirdparty data and in-house interest rate modelling, we construct a trajectory for short-term interest rates for various markets. These predicted short rates will vary across economies depending on estimated real interest rates and inflation. We then build-up our asset class return signals by modelling asset-specific “risk premia”, or excess returns, over this cash scenario. For government bonds we assess the “term premium” today in relation to long-run averages. For credits, we incorporate the so-called “credit risk premium”, the additional yield reward the market is offering for taking credit risk in excess of likely default or downgrade losses. Finally for equities, we incorporate a measure of the “equity risk premium”, which we measure using a version of the dividend discount model. Today, cash still hardly offers a positive return in inflationadjusted terms across developed markets. Prospective returns on government bonds, particularly in Germany and Japan, remain very low. Return signals for bond markets with with steeper yield curves, like the UK and US, are stronger. Emerging market government debt currently looks attractively priced in aggregate. During boom periods, cash rates rise but “risk premia” compress as investors become less risk-averse. These moving parts create a dynamism in our expected return signals. What follows is a consistent and systematic process which models asset returns by emphasising: (i) starting valuations, (ii) projected economic fundamentals, and (iii) mean-reversion in “risk premia” (excess returns). How does this feed into a multi-asset portfolio? When we construct portfolios, we quantitatively and robustly “optimise” the trade-off between asset risk and return to maximise expected return for a given level of risk or volatility. There is also an important element of experience and common sense; asset allocations are fine-tuned to reflect “tail risks” and scenario-analysis. Finally, portfolios are systematically rebalanced back to their strategic mixes to ensure client experiences are aligned with our asset class return signals. What about currencies? Are they not hard to forecast? When we take exposure in a foreign asset we have to decide whether to leave our currency exposure unhedged or hedged. Our work is focused on thinking about this as a longrun decision rather than trying to gauge foreign exchange (FX)market direction in the short term. We model asset returns in local currency terms and then translate these into hedged and unhedged returns for, say, a sterling or dollarbased investor. We construct hedged returns using country interest rate differentials implied by our modelling work. Unhedged returns are calculated using a modified version of the socalled “Purchasing Power Parity” theory which proposes that a basket of goods should, in equilibrium, trade at the same price across countries. This is a reasonable longrun model for forecasting currencies. We take unhedged exposures in assets where we believe that the currency will appreciate over the medium term. We have moderated our enthusiasm for global equities which are now broadly in line with equilibrium. US equities, for example, offer a prospective return over cash somewhat below long run averages of around 4% per annum. EM equities have become more attractive but they have not yet reached compelling valuations in the aggregate. However, there do appear to be some selective country-specific opportunities in EM for the long term. What do you consider to be the benefits of this approach? The potential advantage is the “dynamism” around the asset allocation mix which comes from our return signal work. Our core belief is that asset allocation is the central driver of investor returns over the medium term. We also take a valuation-based approach, different to the traditional forecast-based style. This means that there is a repeatability and transparency to the process. There is also flexibility in the assets we allocate to, and the vehicles we use to fulfil, those exposures. Figure 2: Stylised pecking order of equilibrium asset real returns % 5 4 What are you saying today? We update our return signals each quarter. The recent picture has been one of extremely low returns to perceived “safe haven” assets such as cash and government bonds, which therefore appeared to be quite dangerous. In contrast, more volatile assets such as credit and equities have been attractively priced relative to our sense of equilibrium. 3 2 Term premium 1 0 Cash Inflation-linked bonds Govt bonds Credit Credit risk premium Equity risk premium Duration premium Inflation risk premium Real short rate Source: HSBC Global Asset Management, as of March 2014. 24 Global equities HSBC Q2 2014 25 Fixed income update: outlook for developed market credit Marcus Pakenham, Director, Product Specialist Six months ago we were expecting improving global growth and continued good corporate performance. We expected that government yields would rise modestly and that lower rated corporate bonds would provide attractive yields and low sensitivity to higher government yields. Over the past six months, global economic growth has been slightly higher than expected last summer. Expectations for 2014 have not changed much overall, although US growth forecasts have moved higher while LatAm growth forecasts have moved lower. Figure 1 shows Consensus Economics’ GDP growth forecasts for 2014 and 2015. The picture is positive with good overall global growth driven broadly by developed and emerging countries. In particular, eurozone prospects continue to improve and global growth is expected to accelerate slightly from 3.1% in 2014 to 3.3% in 2015 as the pace of growth accelerates in the eurozone and is maintained at a decent pace in Asia Pacific and the US. Over the past six months, 10-year US Treasury yields have traded in a range of 2.5% to 3.0% with US economic factors and emerging market problems the main influences. Corporate yield spreads have moved considerably lower since last summer as risk appetite has remained strong and the corporate sector has performed well. The lower rated parts of the credit market have outperformed the more highly rated areas. We believe that, over the next couple of years, lower rated credit will likely continue to provide positive returns for investors. Growth of the global economy should support corporate sales growth and maintain healthy cash flow generation. While we expect government yields to rise, we also believe that lower rated spreads in particular can fall further. Looking at the global economy, while the overall growth rates are good, there have been concerns about banking systems and the ability of banks to extend loans to support company activities. However, there have been some reasonably positive developments. Figure 2 shows the balance of banks in the US and eurozone that are tightening or loosening lending conditions. If the lines are falling, credit conditions are getting tighter, as we can see in 2008. Recent surveys show that the balance of lending conditions in the US is back to pre-crisis levels, while banks in the eurozone are close to pre-crisis levels. Banks have made great strides in improving the quality of their balance sheets and increasing their capital levels so that they are in line with new regulatory requirements. This puts banks in a better position to extend loans to both individual and corporate customers and should also make banking systems more resilient in times of crisis. The corporate sector continues to perform well in most countries with the last set of US company results, from Q4 2013, showing good revenues and cash flows and broadly stable balance sheets. Cost cutting has continued and we expect revenues to pick up in 2014. In Europe, sales have been slightly disappointing, but cost cutting has kept profits stable. When buying corporate bonds it is important to seek stable or improving credit quality. Figure 3 shows one metric that helps illustrate the health of the higher risk high yield sector. This data is from US high yield companies and shows how the ratio of cash flow to debt cost is close to an all time high. In other words, companies can still comfortably afford to service their debt. This stability of high yield fundamentals is also shown in figure 4. Migrations show how the rating agencies are Figure 1: Forecasts for 2013 and 2014 GDP growth Figure 2: Lending conditions in the US and eurozone % 5 % -40 -20 0 20 40 60 80 100 4 3 2 1 0 World US Eurozone 2014 Real GDP % growth UK Asia Latam Pacific 2015 Real GDP % growth Source: Consensus Economics, as of March 2014. 26 lending standards tightening 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 US Net % of Domestic Respondents Tightening Standards – C&I Loans for Large/Medium Companies ECB Survey Change Lending to Business Last 3 month net percentage Bank's (change in bank's credit standards) Sources: Bloomberg, as of 31 December 2013. upgrading or downgrading individual bonds. You can see the sudden increase in downgrades during the credit crunch in Q4 2008. The more recent data shows stability in US and EUR migrations, but still a net balance of downgrades in EM. We are cautious about EM high yield and prefer investment grade and higher quality high yield companies. We expect migration rates to remain low and default rates to also stay well below historic levels. Figure 3: US fixed charge ratio: EBITDA/interest expense (rolling 12 months) Figure 4: Rating migration rates for US, EUR and EM HY, % of issuers In summary, we believe the opportunity for positive returns still remain for lower rated developed market credit with good company fundamentals and attractive yields. % yoy 8 5 4 4 0 3 -4 -8 2 -12 1 -16 0 1998 2000 2002 2004 2006 2008 2010 2012 HY Coverage ratio Sources: Bloomberg, as of 31 December 2013. EBITDA – earnings before interest, tax, depreciation and amortisation. -20 1998 2000 2002 2004 2006 2008 2010 EU HY EM HY Trailing 3 month Rating Migration Rate – US HY 2012 2014 Source: Bloomberg, as of 31 December 2013. HSBC Q2 2014 27 Navigating markets Paras Patel, Associate, Macro and Investment Strategy Figure 1: Q1 Performance Equities Asian IG US Corp Global HY Global EM Gold Commodities Global Agg WTI Crude oil Shanghai Comp MSCI EM India Sensex Nikkei 225 FTSE 100 Euro Stoxx S&P 500 8 6 4 2 0 -2 -4 -6 -8 -10 MSCI ACWI % Bonds Note: MSCI and fixed income indices are USD based, all other indices are based on local currencies. Source: Bloomberg, as of 31 March 2014. Equity markets started off the quarter on a weak note with most major equity markets falling in January on the back of a combination of some poor US macro data (specifically December’s payroll numbers) and on increasing EM volatility. However, in February, markets shook off concerns about EM tensions as central banks tightened policy. Turkey’s central bank raised rates aggressively on 28 January. Brazil (26 February), South Africa (29 January), India (28 January) and Russia (3 March) also raised rates. Markets once again came under pressure in early March, on geopolitical tensions between Ukraine and Russia, but recovered later in the month as tensions eased. Overall, the MSCI EM (USD) was down 0.4%in Q1, while the US S&P 500 and the Euro Stoxx 50 were up modestly. The Japanese Nikkei 225 was the worst performing major developed world equity index losing 9% on investor concerns about the resilience of the yen against the USD (which benefited from safe haven flows), the impact on corporate earnings from exports and the outlook for consumption given the sales tax rate hike on 1 April. In contrast to last year when bonds performed poorly, we have seen both core government bonds as well as riskier peripheral sovereign eurozone bonds, corporate credit and EM debt perform well so far in Q1. European bonds have generally benefited from the European Central Bank’s (ECB’s) low interest rates and improved outlooks for their creditworthiness. Furthermore, Ireland became the first eurozone country to exit an EU/IMF bailout successfully selling EUR1 billion of 10-year paper at a yield of below 3%, in its first regular bond auction since their suspension three and a half years ago. Credit fundamentals for the peripheral eurozone economies have also improved; Moody’s upgraded Spain’s credit rating to Baa2 with a positive outlook and Ireland’s sovereign rating was upgraded to Baa3, with its outlook changed to positive. 28 In terms of the macro environment in the first quarter, economic data was weak in the US at the beginning of the year but improved over the quarter. The second estimate of Q4 GDP was revised down to 2.4% qoq from the preliminary estimate of 3.2%, US payroll data surprised to the downside in January but were stronger in February and March, retail sales and housing market data have also been weak while the Institute of Supply Management’s (ISM’s) manufacturing index has generally been resilient during the first quarter. However, we would argue that the weakness in US data was the result of severe weather, rather than a sign of underlying weakness. In the eurozone, macro data has been modestly stronger with industrial production data in key economies picking up and unemployment in both core and peripheral eurozone economies falling. Fourth quarter GDP growth also showed that for the first time since 2011, all four of the major eurozone economies expanded (Germany: 0.4% qoq, France: 0.3% qoq, Italy: 0.1% qoq and Spain: 0.3% qoq), with overall growth for the region accelerating to 0.3% qoq in Q4 from 0.1% qoq in Q3. However, deflationary concerns continued to play on investors’ minds with the latest reading in March showing inflation falling to just 0.5% yoy from an already low 0.7% yoy in February, while the unemployment rate held steady at around 12%. On the policy front, new US Federal Reserve (Fed) Board Chair, Janet Yellen, gave her first testimony before Congress as Fed Chair at the end of January. She signalled that no changes would be made to the schedule of quantitative easing tapering and that interest rates are likely to remain low for some time. This was positively received by investors. However, during the Federal Open Market Committee (FOMC) meeting in March, the Fed flagged a potentially more aggressive policy tightening path than previously anticipated by financial markets. Specifically, the Fed released new forecasts showing officials predicting the benchmark rate (now at almost zero) would rise to at least 1% by the end of 2015 and then to 2.25% by the end of 2016. At the end of January, Congress approved a deal to raise the government’s debt ceiling until March 2015 with no strings attached. This boosted markets amid relief that October 2013’s government shutdown would not be repeated. While in Europe, the ECB did not announce any major change in monetary policy this quarter but hinted it could take action if inflation stayed below target with the latest reading in March showing a drop of 0.5%. In EM, equity and currency markets came under strong selling pressure from mid-January, due to specific local factors such as civil unrest and political uncertainty in some countries as well as concerns about a slowdown in China. However, EM assets rebounded at the end of January and in February, as EM central banks responded to market volatility by taking some action. Turkey’s Central Bank raised rates aggressively on 28 January. Brazil (26 February), South Africa (29 January), India (28 January) and Russia (3 March) also raised rates. In addition, the recently announced Chinese reform plan should help support long-term growth. However, in March the evolving crisis in Ukraine hurt investor sentiment with geopolitical tensions adding another layer of uncertainty to already risk-averse sentiment towards EM assets. Overall, EM equities were down 0.8% (MSCI EM USD index) on the quarter. For the rest of the year, we believe risk asset performance is likely to be driven by two key factors. Firstly, global macro data will continue to be important with US data being particularly vital in gauging future Fed monetary policy. In terms of analysts’ expectations, although much of the developed world is expected to keep rates on hold, policy rates in the emerging world are expected to be mixed with some economies raising rates in the next 12 months (Brazil, Turkey and Mexico) while others are expected to cut rates (Russia and Thailand). of quantitative easing tapering on various EM asset markets. Elections in some key emerging economies, along with geopolitical tensions between Russia, Ukraine and the West are likely to induce further volatility into financial markets. In terms of the long-term outlook for asset markets more generally, we continue to favour corporate assets on a relative return basis, ie equities and corporate bonds over core government bonds. It is worth noting that the size of the valuation gap between equities and perceived “safe haven” government bonds is not as large as it was a year or so ago, but it still favours riskier assets in our view. The “risk premium” on global equities is a little below its long-run historic average, at around 4% versus cash. Against global government bonds, we think equities offer excess returns of around 3.5%. The additional expected return for taking equity risk has compressed as valuation ratios have moved higher. As this process continues, it will present some risks for equity investors. However, when we consider the balance of risks to growth and inflation, we think corporate profits remain well supported in developed markets. On-going EM volatility is also likely to dominate markets in the near term, as investors reprice risk and weigh the impact HSBC Q2 2014 29 Global data watch Paras Patel, Associate, Macro and Investment Strategy Key highlights uuGrowth: Economic growth in the developed world generally accelerated in Q4 2013, with the US, the UK, Japan and the eurozone posting higher year-on-year Q4 GDP numbers. In contrast, most of the BRIC economies saw their GDP growth rates stabilise or fall marginally. uuIndustrial production: Industrial production in the developed world came in weaker with the US and the eurozone posting lower levels of growth in Q4 versus Q3, while the UK posted the same level of growth as in Q3 2013. Industrial production growth for all the BRIC economies fell in Q4 compared to Q3. uuInflation: Inflation in the UK, Japan and the eurozone slowed down in Q4, while US inflation picked up modestly. The latest monthly inflation figures for the eurozone dropped to 0.5% in March 2014, well below the European Central Bank’s (ECB’s) inflation target of close to, but below, 2%. Inflation trends in the BRIC economies were more mixed with China and India posting falls while Brazil and Russia posted higher inflation figures for Q4. Annual real GDP growth – developed markets (% yoy) uuLabour market: The labour markets in the developed world improved in Q4 with the US, the UK, Japan and the eurozone all posting falls in unemployment. Annual real GDP growth – BRIC markets (% yoy) % 10 % 20 5 10 0 0 -5 -10 -10 Dec-07 Dec-08 Eurozone Dec-09 Dec-10 Japan Dec-11 UK Dec-12 US -20 Dec-07 Dec-08 Brazil Dec-09 China Dec-10 Dec-11 India Dec-12 Russia GDP growth picked up on a year-on-year basis in the developed world in Q4 2013, with the US, the UK, the eurozone and Japan all posting faster growth than in Q3. In contrast, most of the BRIC economies saw their economic growth rates stabilise or fall marginally in Q4. Year-on-year growth rates in China, India and Brazil all fell marginally compared with the previous quarter. Headline inflation – developed markets (% yoy) Headline inflation – BRIC markets (% yoy) % 6 % 20 4 10 2 0 0 -2 -4 Dec-07 Dec-08 Eurozone Dec-09 Dec-10 Japan Dec-11 UK Dec-12 US Inflation in the UK, Japan and the eurozone slowed down in Q4, while US inflation picked up modestly. Inflation dropped to 0.5% in March 2014, well below the ECB’s inflation target of close to, but below 2%. Sources: MSCI, Thomson Reuters Datastream and Bloomberg, as of March 2014. 30 -10 Dec-07 Dec-08 Brazil Dec-09 China Dec-10 Dec-11 India (WPI) Dec-12 Russia Inflation trends in the BRIC economies are more mixed with China and India posting falls while Brazil and Russia posted higher inflation figures for Q4. Industrial production – developed markets (% yoy) Industrial production – BRIC markets (% yoy) % 30 % 40 20 02 10 0 0 -20 -40 -10 Dec-07 Dec-08 Eurozone Dec-09 Dec-10 Japan Dec-11 UK Dec-12 US -20 Dec-07 Dec-08 Brazil Dec-09 China Dec-10 Dec-11 India Dec-12 Russia Industrial production in the developed world generally came in weaker in Q4. The US and the eurozone posted lower levels of growth in Q4 than in Q3, while the UK posted the same level of growth and Japan’s Q4 industrial production growth came in higher than in Q3. Industrial production growth fell in the BRIC economies in Q4, with China, India, Russia and Brazil all posting lower growth rates than in Q3. Retail sales – developed markets (% yoy) Retail sales – emerging markets (EM) (% yoy) % 30 % 12 9 20 6 3 10 0 0 -3 -6 -10 -9 -12 Dec-07 Dec-08 Eurozone Dec-09 Dec-10 Japan Dec-11 UK Dec-12 US -20 Dec-07 Dec-08 Brazil Dec-09 China Dec-10 Dec-11 Russia Dec-12 Taiwan Retail sales growth figures for most of the major developed economies were disappointing in the last quarter. The US, Japan and the eurozone all posted weaker retail sales growth than in Q3. The UK was the only exception posting faster retail sales growth than in Q3. Consumer spending patterns in the EM countries were mixed in Q4 with China and Russia posting rising retail sales growth, while Brazil and Taiwan posted falling retail sales growth figures. Unemployment rates – developed markets (%) Unemployment rates – emerging markets (EM) (%) % 15 % 10 8 10 6 5 0 4 Dec-07 Dec-08 Eurozone Dec-09 Dec-10 Japan Dec-11 UK Dec-12 US Labour markets in the developed world improved in Q4 with the US, the UK, Japan and the eurozone all posting falls in unemployment. 2 Dec-07 Dec-08 Brazil Dec-09 China Dec-10 Dec-11 Russia Dec-12 Labour markets in emerging markets were relatively mixed with unemployment rates in China and Russia rising modestly while in Brazil the unemployment rate fell. Sources: MSCI, Thomson Reuters Datastream and Bloomberg, as of March 2014. HSBC Q2 2014 31 Economic forecasts for 2014 and 2015 uuGrowth: The Consensus Economics’ global growth forecast for 2014 has been revised upwards significantly since we published our last IQ. The most notable upward revisions over the past three months have come in the US and the UK. uuInflation: The Consensus Economics’ 2014 global inflation forecast has also been revised upwards since December 2013. The most notable changes are for Japan. Japanese 2014 inflation forecasts have been revised up from 1.6% to 2.6%. Consensus Economics’ growth forecasts December 2013 Consensus March 2014 Consensus 2014F 2015F 2014F 2015F United States 2.6 – 2.8 3.1 Canada 2.3 – 2.2 2.5 Japan 1.6 – 1.4 1.3 UK 2.5 – 2.7 2.5 Developed markets Eurozone 1.0 – 1.1 1.4 France 0.8 – 0.8 1.2 Germany 1.8 – 1.8 2.0 Spain 0.6 – 0.9 1.5 Italy 0.5 – 0.5 1.0 2.3 – 1.8 2.1 China 7.5 – 7.4 – India 5.4 – 5.4 – Emerging markets Brazil Mexico 3.4 – 3.0 4.0 Russia 2.3 – 1.3 2.1 South Africa 2.8 – 2.6 3.3 South Korea 3.5 – 3.5 – Turkey 3.7 – 2.2 3.8 World 2.4 – 3.0 3.3 Any forecast, projection or target is indicative only and not guaranteed in any way. Source: Consensus Economics, as of March 2014. 32 Consensus Economics’ inflation forecasts December 2013 Consensus 2014F 2015F United States 2.6 Canada 2.3 March 2014 Consensus 2014F 2015F – 1.7 2.0 – 1.5 1.9 Developed markets Japan 1.6 – 2.6 1.7 UK 2.5 – 2.0 2.2 Eurozone 1.0 – 0.9 1.3 France 0.8 – 1.1 1.4 Germany 1.8 – 1.5 1.9 Spain 0.6 – 0.5 1.1 Italy 0.5 – 0.9 1.2 Brazil 6.0 – 6.0 5.6 China 3.1 – 2.9 – Emerging markets India 8.0 – 8.0 – Mexico 3.9 – 4.1 3.5 Russia 5.2 – 5.8 5.1 South Africa 5.7 – 5.6 5.9 South Korea 2.1 – 2.1 – Turkey 6.6 – 8.1 6.8 World 2.7 – 3.0 3.1 Any forecast, projection or target is indicative only and not guaranteed in any way. Source: Consensus Economics, as of March 2014. HSBC Q2 2014 33 Policy rates uuMonetary policy: Consensus forecasts for interest rates in the US, the Eurozone and Japan indicate that policy rates are likely to be on hold, at least for the next 12 months. However, market implied policy rates suggest further rate hikes in Brazil and now possibly in South Africa and Mexico in the coming 12 months. Market implied policy rates Current (%) 3 months (%) 12 months (%) FED 0-0.25 0-0.25 0-0.25 ECB 0.25 0.25 0.25 BOE 0.50 0.5 0.75 BOJ 0-0.1 0-0.1 0-0.1 Developed markets Emerging markets Brazil 10.75 11.0 11.5 India 8.00 8.00 8.00 Korea 2.50 2.50 2.75 Mexico 3.50 3.50 3.75 South Africa 5.50 5.75/6 6.50 Taiwan 2.00 1.75/2 2.00 Turkey 12.00 12.25 12/12.25 Sources : Merrill Lynch, JP Morgan, Barclays, Deutsche Bank, Danske, Westpac, HSBC, Nomura, Credit Agricole, Société Générale, UBS, Citigroup, Commonwealth Bank and HSBC Global Asset Management, as of 31 March 2014. Central bank interest rate setting meetings Date Country Event 06 May 2014 Eurozone ECB interest rate decision 20 May 2014 Japan BoJ interest rate decision 05 June 2014 Eurozone ECB interest rate decision 06 June 2014 UK BoE MPC interest rate decision 13 June 2014 Japan BoJ interest rate decision 18 June 2014 US Interest rate decision 03 July 2014 Eurozone ECB interest rate decision 10 July 2014 UK BoE MPC interest rate decision 30 July 2014 US Interest rate decision 07 August 2014 Eurozone ECB interest rate decision 08 August 2014 UK BoE MPC interest rate decision 08 August 2014 UK BoE MPC interest rate decision 17 September 2014 US Interest rate decision Source: HSBC Global Asset Management and Bloomberg, as of March 2014. 34 Currency expectations (quoted versus USD) Spot 3 months ago 1.38 1.38 6 months 12 months ago ago 2 months forward 6 months forward 1.38 1.38 9 months 12 months forward forward Developed world Eurozone (EUR) UK (GBP) Japan (JPY) Sweden (SEK) 1.35 1.29 1.38 1.38 1.67 1.66 1.62 1.52 1.66 1.66 1.66 1.66 103.4 105.3 98.0 93.2 103.3 103.3 103.2 103.1 6.45 6.45 6.36 6.52 6.46 6.47 6.48 6.49 Norway (NOK) 5.97 6.07 6.00 5.83 5.98 6.01 6.03 6.05 Switzerland (CHF) 0.88 0.89 0.91 0.95 0.88 0.88 0.88 0.88 Australia (AUD) 0.93 0.89 0.94 1.04 0.92 0.91 0.91 0.90 Canada (CAD) 1.11 1.06 1.03 1.02 1.11 1.11 1.11 1.12 New Zealand (NZD) 0.87 0.82 0.83 0.84 0.86 0.85 0.85 0.84 6.21 6.05 6.12 6.21 6.25 6.26 6.27 6.28 Asia China (CNY) 7.76 7.75 7.75 7.76 7.76 7.75 7.75 7.75 India (INR) Hong Kong (HKD) 59.88 61.92 62.63 – 60.55 62.01 63.19 64.22 Indonesia (IDR) 11313 12180 11401 9725 11387 11637 11853 12037 Malaysia (MYR) 3.26 3.28 3.24 3.09 3.28 3.30 3.31 3.33 Philippines (PHP) 44.76 44.39 43.33 40.81 44.80 44.94 45.03 45.14 Singapore (SGD) 1.26 1.26 1.25 1.24 1.26 1.26 1.26 1.26 South Korea (KRW) 1058 1056 1074 1115 1060 1067 1071 1074 Thailand (THB) 32.37 32.95 31.23 29.31 32.46 32.67 32.83 32.96 Czech Republic (CZK) 19.90 19.90 18.96 20.08 19.90 19.88 19.86 19.84 Hungary (HUF) 223.2 216.4 218.9 236.7 224.0 225.6 226.7 227.8 Poland (PLN) 3.03 3.02 3.12 3.25 3.04 3.06 3.08 3.10 Russia (RUB) 35.11 33.71 32.21 31.14 35.59 36.55 37.32 37.95 2.15 2.15 2.01 1.81 2.19 2.27 2.33 2.38 10.61 10.53 10.13 9.20 10.71 10.93 11.12 11.31 8.00 – 5.80 – 8.34 9.40 10.24 11.24 EEMEA Turkey South Africa (ZAR) LatAm Argentina (ARS) Brazil (BRL) Mexico (MXN) 2.27 – 2.22 2.02 2.31 2.39 2.44 2.50 13.07 13.05 13.16 12.36 13.13 13.25 13.35 13.45 Source: Forward currency rates sourced from Bloomberg, as of 31 March 2014. HSBC Q2 2014 35 Global equity market performance (MSCI indices) Total return (% in USD terms) – MSCI indices -1M -1Q -1Y YTD Developed world 0.2 1.4 19.7 1.4 Emerging world 3.1 -0.4 -1.1 -0.4 North America 0.7 1.8 20.9 1.8 Europe -1.0 2.2 25.2 2.2 0.1 2.8 34.1 2.8 Eurozone Europe ex-UK 0.1 3.7 29.5 3.7 Asia Pacific ex-Japan 2.4 3.0 1.6 3.0 Australia 4.0 6.0 1.3 6.0 Austria -2.8 -2.7 16.5 -2.7 Belgium -0.2 2.4 21.1 2.4 Brazil 11.0 2.9 -12.7 2.9 Canada 1.5 1.8 7.2 1.8 Chile 3.0 -2.2 -26.5 -2.2 China -1.7 -5.9 2.5 -5.9 15.7 5.1 -11.3 5.1 2.1 7.6 15.1 7.6 Denmark -1.9 16.5 40.6 16.5 Egypt -2.4 9.2 32.5 9.2 Finland -2.1 0.3 44.0 0.3 France -0.1 3.0 30.6 3.0 Germany -1.7 -0.3 31.7 -0.3 Colombia Czech Republic Greece 1.1 18.1 58.1 18.1 -2.2 -3.4 3.7 -3.4 Hungary 1.5 -8.7 -7.9 -8.7 India 8.7 8.2 6.7 8.2 Indonesia 5.5 21.2 -17.8 21.2 Ireland -7.0 14.2 43.4 14.2 Italy 6.4 14.6 54.1 14.6 Japan -1.2 -5.5 7.8 -5.5 Hong Kong Korea 0.2 -2.0 5.5 -2.0 Malaysia 1.4 -0.4 8.2 -0.4 Mexico 5.5 -5.0 -10.2 -5.0 Netherlands 1.1 1.1 30.1 1.1 New Zealand 6.8 16.7 18.0 16.7 Norway 1.5 2.2 12.3 2.2 Peru 1.9 4.4 -24.9 4.4 Philippines 0.2 10.3 -9.1 10.3 Poland -2.0 3.4 21.1 3.4 Past performance is not an indication of future returns. Source: MSCI, Thomson Reuters Datastream and HSBC Global Research, as of 31 March 2014. 36 Total return (% in USD terms) – MSCI indices -1M Portugal -1Q -1Y YTD 1.7 9.7 23.6 9.7 Russia -2.5 -14.4 -10.5 -14.4 Singapore 2.6 -0.9 -2.1 -0.9 South Africa 6.7 4.9 8.4 4.9 Spain 2.4 4.8 46.5 4.8 Sweden 0.0 3.0 18.2 3.0 Switzerland 0.2 5.1 20.1 5.1 Taiwan 2.8 1.1 11.2 1.1 Thailand 5.0 7.5 -16.4 7.5 Turkey 16.8 4.8 -28.8 4.8 UK -3.2 -0.8 16.8 -0.8 US 0.7 1.8 22.0 1.8 Past performance is not an indication of future returns. Source: MSCI, Thomson Reuters Datastream and HSBC Global Research, as of 31 March 2014. GEMs equity valuations End year PE (x) End year EPSg (%) PEG 2012e 2013e 2014e 2012e 2013e 2014e 2014e China 8.4 7.5 7.5 8.9% 11.7% -0.3% -22.8 India 14.3 12.5 9.5 17.3% 14.5% 32.2% 0.4 Indonesia 14.7 13.0 11.4 9.5% 13.1% 13.5% 1.0 9.0 8.1 7.3 25.1% 11.7% 10.6% 0.8 Korea Malaysia 15.8 14.4 13.6 5.2% 10.0% 6.1% 2.4 Philippines 18.9 16.5 15.6 7.9% 14.8% 5.8% 2.8 Taiwan 14.6 13.2 9.9 8.6% 10.7% 34.2% 0.4 Thailand 12.0 10.7 9.9 13.5% 11.4% 8.9% 1.2 Czech Republic 11.9 12.7 12.9 -10.1% -6.2% -1.4% -8.9 9.2 7.8 7.0 -12.6% 17.9% 12.4% 0.6 Poland 13.4 12.0 11.1 -1.5% 11.8% 8.2% 1.5 Egypt 10.8 9.8 6.2 57.2% 10.4% 58.3% 0.2 Hungary Russia 4.2 4.3 3.7 -1.4% -1.7% 13.8% 0.3 14.5 13.2 11.9 13.7% 10.4% 10.3% 1.3 Turkey 9.5 7.9 7.0 -4.7% 20.4% 11.6% 0.7 Argentina 6.4 6.2 5.9 -4.7% 2.9% 5.3% 1.2 Brazil 9.0 8.1 7.3 14.2% 11.1% 11.4% 0.7 Chile 14.8 12.3 11.4 36.1% 20.3% 7.6% 1.6 Colombia 14.8 13.5 11.7 16.4% 9.7% 15.4% 0.9 Mexico 17.4 15.3 13.0 12.8% 13.9% 17.5% 0.9 Peru 12.2 10.5 8.5 75.5% 16.3% 23.3% 0.4 GEMs 10.3 9.3 7.9 11.0% 10.6% 17.4% 0.5 South Africa PE = price earnings; EPSg = earnings per share growth; PEG = price/earnings to growth ratio. Data is for end year. Source: IBES estimates, MSCI, Thomson Reuters Datastream and HSBC Global Research, as of 31 March 2014. HSBC Q2 2014 37 Contributors Julien Seetharamdoo, Chief Investment Strategist Hervé Lievore, Senior Macro and Investment Strategist Renee Chen, Macro and Investment Strategist 38 Julien Seetharamdoo is Chief Investment Strategist within HSBC Global Asset Management’s Macro and Asset Strategy team where he provides analysis and research on the key issues facing the global economy and asset markets. Prior to joining HSBC, Julien has worked for Coutts Investment Services, RBS and Capital Economics. He holds a first class degree in Economics from Cambridge University and a PhD. in Economics from the Management School, Lancaster University focusing on the implications of the European Monetary Union. Hervé Lievore is Senior Macro and Investment Strategist based in Hong Kong. Before joining HSBC, he spent five years at AXA Investment Managers in London and Hong Kong as an economist and strategist, covering Asia and commodities. He was also involved in the firm’s tactical asset allocation committees. He started his career 18 years ago at Natixis in Paris, where he mostly covered Asian markets. Renee Chen joined HSBC Global Asset Management as Macro and Investment Strategist in April 2012. Prior to this role, she held Economist roles at Macquarie Capital Securities, Nomura and Citigroup and has over 13 years’ experience in economic and policy research. Renee holds a master’s degree in International Affairs and Economic Policy Management from Columbia University, New York and an MBA in Finance and Investment from George Washington University, Washington DC. Joe Little, Senior Investment Strategist Marcus Pakenham, Director, Product Specialist Paras Patel, Associate, Macro and Investment Strategy Joe Little is a Senior Investment Strategist specialising in Multi Asset Research. He works on Asset Allocation and Portfolio Strategy for HSBC’s Multi Asset funds. Previously he was a Fund Manager on the HGIF Global Macro Fund and a sell-side Economist at JP Morgan Cazenove. He holds an MSc in Economics from Warwick University and is a CFA charterholder. Marcus Pakenham is the Product Specialist for the global and sterling fixed income funds managed in London and New York and has been working in the industry since 1985. Previously he has managed GEM and Asian portfolios. Prior to joining the firm in 1999, Marcus worked for Global Asset Management. He holds an MA degree in Politics, Philosophy and Economics from Oxford University. Paras Patel is an Associate Macro and Investment Strategist within HSBC Global Asset Management. Prior to joining HSBC Asset Management, Paras worked in the sell side with HSBC Global Research as an Associate in the Global Emerging Markets team. He holds a first class degree in Engineering from the University of Warwick and a master’s degree in Finance from Warwick Business School. This document has been written by HSBC Global Asset Management (UK) Limited. This document has been approved for distribution in UAE, Qatar, Bahrain, Lebanon and Jordan by HSBC Bank Middle East Limited and in Oman by HSBC Bank Oman S.A.O.G. HSBC Global Asset Management is a part of HSBC Group. The views expressed are those of HSBC Global Asset Management and do not constitute investment advice. No liability is accepted to recipients acting independently on its contents. Past performance should not be seen as an indication of future returns. The value of investments and any income from them can go down as well as up. 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. This material is distributed by HSBC Bank Middle East Limited. Regulated by the Jersey Financial Services Commission and in Oman by HSBC Bank Oman S.A.O.G regulated by Central Bank of Oman and Capital Markets Authority of Oman. CRN 140510 © Copyright HSBC Global Asset Management Limited 2014. ALL RIGHTS RESERVED.No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Global Asset Management Limited.