Back from a Long Journey Investment Barometer

Back From a Long Journey

Investment Barometer

19 November 2015

After many months of declines, October brought a long-awaited respite to investors in the stock market, with all major global indices ending the month well in the black. It could be said that we are back from a long journey because since the trough, the global index has managed to recover two-thirds of the ground previously lost. Last month, the best performers were the Japanese Topix (10.4% up) and the European Euro Stoxx 50 (10.2% up). The Hong Kong (8.6% up) and U.S. (8.3% up) stock markets also fared relatively well. This time, Warsaw Stock Exchange indices underperformed vis-à-vis their international peers, which resulted mostly from the investors’ uncertainty in the face of parliamentary elections. Among the emerging markets, Emerging Asia ones were the best performers (7.7% up) and the frontier markets proved the worst (3.6% up).

 In October, central bankers were again the focus of the markets’ 108 attention. While the Bank of Japan did not change its tone significantly, the ECB President’s statement was very dovish and contributed much to the upbeat mood in the markets. Mario 106 Draghi announced a December review of the QE program which was launched at the beginning of the year. The markets 104 interpreted this as a sign of a possible increase in, or extension of, the asset purchase scheme, and investors rushed to buy 102 stocks and bonds. Understandably, European indices turned out to be the largest beneficiaries of this optimism. 100

 In the bond market, we have again observed drops in yields. U.S. 98 Treasuries proved the only exception here. High yield bonds have Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 had a very good month and are slowly regaining the ground lost since the beginning of the year. Polish Treasuries have also Polish bonds U.S. Bonds German bonds

performed very well, especially those with longer maturities. Source: Bloomberg, Citi Handlowy  In Poland, October was the month of waiting for election results. 125 The outcome was not wholly unexpected, and only the fact that 120 the winning party will be able to govern alone was something of a surprise for investors. In our opinion – and as we have already 115 repeatedly stated – this scenario might mean poor performance 110 of the blue chip segment. On the other hand, small and medium- 105 sized enterprises could benefit from those electoral promises that may increase household consumption in Poland. It appears that 100 in October, the investors started out with similar assumptions. 95 The largest companies included in the WIG20 blue chip index fell slightly while the smallest ones included in the sWIG80 one 90 gained nearly 4%. 85 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15  We uphold our market outlook, seeing greater relative value in WIG30 S&P500 Eurostoxx50 shares, which should be supported by the good macroeconomic situation, an improvement in corporate earnings and the very Source: Bloomberg, Citi Handlowy loose monetary policy of central banks. As we have repeatedly stated, we consider the recent months’ declines to have been Karol Matczak merely a correction and we believe that there is a high probability of equity indices returning to trend growth. Investment Advisor Karol Ciuk  We maintain our negative outlook on long-term bonds because Investment Advisor we do not see any scope for significant price rises in the medium Jakub Wojciechowski term. We are neutral on global high yield bonds and given the Securities Broker policy pursued by the ECB, we continue to see the greatest potential within this group in European corporate securities. We Contributing Authors: continue to overweight total return solutions. Bartłomiej Grelewicz Paweł Chylewski Dariusz Zalewski Maciej Pietraszkiewicz Tomasz Jachowicz Michał Wasilewski

Poland – waiting for the new government

In October, politics once again dominated the Polish financial markets. As a result of the elections, the winning party has won a parliamentary majority, which on the one hand reduces the risk of political instability, but on the other may bring the fulfilment of costly election promises. Our outlook on the Polish market has not changed – we still prefer small and medium-sized companies to large ones, which attract more political risk. We continue to advise investors to limit their exposure to the debt market although we see the risk of a cut in interest rates in connection with the appointment of the new Monetary Policy Council.

Just like in the past few months, in October the

Polish financial market focused on the We still prefer small and medium-sized parliamentary elections and the associated companies to large ones, which attract opportunities and risks. 25 October has passed and we still have many questions but we already more political risk, and advise know that the Law and Justice (PiS) party was investors to limit their exposure to the triumphant, winning 37.6% of the vote. The Civic debt market. Platform (PO) won 24.1%, Kukiz’15 got 8.8% of the vote, the Modern (.Nowoczesna) party won 7.6% and the Polish People’s Party (PSL) – noticeable in the large and medium-sized 5.13%. This result guarantees the new company segments. It should be noted that recent government a parliamentary majority, averting the declines have been part of a much longer string of risk of lengthy coalition negotiations. disappointments with the Polish stock exchange Market reactions on the first day after the elections and particularly with the WIG20 blue chip index. reflected the investors’ considerable nervousness We already witnessed sharp declines in May when and indecision – the session started out deeply in the Law and Justice candidate led the first round the red to reverse all the losses and then some by of presidential elections and the threat of the end of the day. In the following days, the additional burden on the banking and energy sentiment deteriorated, which was particularly sectors became more real.

Index performance in Poland year to date

120

115

110

105

100

95 Andrzej Duda wins the first round

90 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15

WIG20 mWIG40 sWIG80

Source: Bloomberg, Citi Handlowy

Expenditures and funding sources suggested by Law and Justice

60 60

50 50 No funding Lowering specified retirement age 40 40 Reducing VAT fraud (realistically) Raising tax 30 30 Tax on large stores allowance 20 20 Bank tax PLN 500 per child 10 10

0 0 EXPENDITURES FUNDING SOURCES

Source: Citi Handlowy

In this issue of the Barometer, we will examine the amount that could actually be recovered there fundamental aspects in order to decide how the ranges from PLN 5 to 10 billion. The total boost in current political landscape may affect the budget receipts that could be realized by performance of the Polish economy and, implementing these ideas would therefore amount consequently, that of the stock and bond markets. to ca. PLN 18 billion. We are left with a gap of To this end, we should recall the promises made more than PLN 38 billion (see Chart above), which by the representatives of the victorious party raises the question about the probability of throughout the election campaign. electoral promises being fulfilled. Let us start with potential expenditure. Among Irrespective of the final shape of the legal flagship Law and Justice promises was the child amendments to be introduced, the direction in benefit in the amount of PLN 500 per month, to be which the policy of the new government is likely to paid for the second and each subsequent child. lead is clear. Strong fiscal expansion and According to estimates by its proponents, this potentially also monetary one (this will be would cost ca. PLN 22 billion per year. Raising the discussed in more detail further) is on the cards. If annual tax allowance to PLN 8,000 would mean we assume (in line with statements by similar outlays, i.e. ca. PLN 21.5 billion. Finally, representatives of the Law and Justice party) that reversing the increase in retirement age could the priority policy is the “PLN 500 per child” one, cost the budget PLN 14 billion in the next year and this would mean a significant transfer to this amount would continue to rise in subsequent households; according to estimates by our years. Summing up, the expenditure planned economists, such a transfer could accelerate GDP comes to ca. PLN 57.5 billion per year. How could growth by up to 1 percentage point as it would this amount be financed? There are several automatically boost consumption. potential sources – the bank tax is expected to However, the other side of the coin is the burden bring approximately PLN 5 billion. The tax on on those who would finance this benefit. The large stores could mean another PLN 3 billion. introduction of a bank tax has been our baseline However, the largest source of funding is also the scenario for a few months. We assume that part of most uncertain. The idea is to make the VAT the cost of this tax will be borne by customers and system more watertight, which is supposed to it appears that the current movements in share bring more than PLN 50 billion. However, the prices largely reflect the potential shift in the problem of the VAT gap is not new and according environment. Assistance for those who borrowed to estimates by economists and tax experts the

in Swiss francs remains the big unknown for now. would harbor some doubts about this promise According to recent press reports, the new ruling being fulfilled. party may refrain from simultaneously introducing Our positioning within the Polish equity market both the bank tax and a costly scheme to support has not changed after the elections. Still, we borrowers. Therefore we assume that the cost to would recommend a cautious approach to the the sector will be limited to the former. blue chip segment owing to the continuing Let us now look at the tax on large stores in its uncertainty about the final shape of the changes current, preliminary shape (stores larger than 250 proposed. On the other hand, we take a positive sq. m and a progressive rate ranging from 0.5% to view of smaller companies, especially those 2% depending on revenue). According to included in the mWIG40 segment, which are less estimates by our experts from the Bank Handlowy likely to be hit by adverse regulations and their Brokerage House, the implications for the largest profits are more correlated with the continuing companies listed on the Warsaw Stock Exchange economic recovery. should not prove as painful as it could be initially Our approach to the debt market has not changed assumed. First, Polish companies from the retail either – seeing the risk that inflation might rise segment would attract lower tax rates given their alongside bond yields, we suggest that investors current revenue levels. Second, similarly as in reduce interest rate risk. However, in the context Hungary where such a tax has been introduced, of this market, another important implication of the the chains should be able to shift much of the cost Law and Justice victory has emerged, which has to their customers by raising prices. only been publicized in the last few weeks. Among the remaining sectors, the energy and Namely, it turns out that in addition to the fiscal mining ones merit a mention here. There, we stimulus, a monetary one is possible as well and should expect vertical integration processes to that could have a positive impact on bond prices. accelerate, involving the potential takeover of In an interview for the Polish Press Agency, Law unprofitable mines by strongly capitalized energy and Justice MP Henryk Kowalczyk stated that the companies (with questionable benefits for the current level of NBP interest rates is excessively latter). In the case of the Polish copper giant high and there is scope for a reduction. He also KGHM, Law and Justice promised to suspend the pointed out that when assessing candidates for tax on minerals (which brought PLN 1.5 billion last the Monetary Policy Council, the Law and Justice year). This should prove very positive for the would take into account their views on the company, although in the face of the needs possibility of pursuing a more accommodative related to the funding of social programs, we monetary policy. This statement was widely Citi Economic Surprise Index

200

150

100

-50

-100

-150

-200 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Bloomberg, Citi Handlowy

criticized as it reflected a new, unwelcome trend Leaving politics aside for a moment, let us finally towards undermining the central bankers’ look at the condition of the Polish economy. The independence. Such opinions were voiced by both figures that have been reported in recent weeks former and current members of the MPC, who indicate that economic activity in Poland has lost called it “a sign of extreme irresponsibility and some of its momentum, which is best illustrated by incompetence of the politician in question” in an the economic surprise index calculated by Citi open letter. According to the authors, “requiring (see Chart on the previous page), which is now in new MPC members to be willing to loosen negative territory (with a lot of data at levels worse monetary policy essentially comes down to than expected). In the past, such levels were often requiring them to perjure themselves”. Technically, followed by a reversal of negative trends. terms of office of eight of the ten MPC members According to our economists, the current state of end in January and February 2016, and the new affairs only marks a temporary slowdown and the members will be appointed by the lower chamber very pronounced improvement in the labor market of Parliament (Sejm) (3 members), the upper will be reflected by growth in domestic demand in chamber of Parliament (Senate) (3 members) and the following quarters. Better sentiment should by the President (2 members); all these branches also prevail abroad where the economic situation are now controlled by a single party. In June, the appears to be stabilizing after a nervous period President will also appoint the President of the during summer holidays. This is confirmed by, NBP. This does not by itself mean that the Council among other things, recent readings of will become politicized, although the probability manufacturing PMI indices, which have clearly that persons with “dovish” attitudes will be improved both in Poland and globally. Our selected appears to be high. As a result, most baseline scenario assumes a GDP growth of more economists have decided to revise their forecasts than 3% in both 2016 and 2017. of the next year’s level of interest rates. Citi economists expect the NBP benchmark rate to be reduced by a total of 50 basis points in 2016 (see Chart below). Low inflation, the extension of the QE program in Europe or slowing economic growth could provide pretexts for such movements.

Inflation in Poland against the benchmark interest rate

7 6 5 4 3 2 1 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -1 -2 -3 Inflation (% y/y) NBP benchmark rate (%)

Source: Bloomberg, Citi Handlowy

U.S. – Fed puts off rate hike again

We have seen strong increases in major U.S. indices and the Fed has once again postponed its decision to raise interest rates. Preliminary GDP readings for Q3 show economic growth of 2% y/y. We reiterate our cautious outlook on the U.S. market and point to other equity markets that are more compelling in our opinion.

In October, optimism returned to U.S. stock in EPS by 0.1% throughout 2015 and EPS growth exchanges and the major indices moved north with of 8.6% in 2016. Against the background of the S&P500 gaining 8.3% and the DJIA up by projected growth in corporate earnings in other 8.5%. After the recent declines, the rebound developed markets, these figures are unimpressive demonstrated that the demand for U.S. stocks was and the forward P/E ratio for the next 12 months is still considerable. In the Chart below, the S&P500 at 16.5, i.e. above the 5- and 10-year averages. As has already returned to around 2,100 points, i.e. its a result, we remain underweight in this market. levels before the October correction. The current boom in the U.S. has sometimes been referred to A clear risk factor remains the slowdown in global as “the most hated bull market in history.” This is economy owing to the significant deceleration due to the fact that market corrections have been evident in emerging markets. This has not shallow and valuations have stayed high, making it materialized, however, and has not affected the difficult for new investors to join the trend. This is U.S. economy so far. The data reported from the probably the effect of monetary policy, and more real estate sector and the good standing of precisely of the very low cost of money, which is American consumers suggest that robust GDP conducive to aggressive investments. Our growth will be maintained – our economists approach has always been (and will remain) strictly forecast U.S. economic growth to reach 2.4% in fundamental; seeing demanding valuations and low 2015 and accelerate to 2.5% in 2016. The Table on corporate earning growth forecasts, we prefer to the next page shows a breakdown of GDP growth underweight U.S. equities and to look for value in into individual drivers alongside forecasts for other markets. The Chart below demonstrates that subsequent years. It is clear that Citi economists since the end of 2014, corporate profits have not assume a strong recovery in the real estate market grown while the index continues to show relative with an increase in investment in the sector strength. This means either that U.S. companies reaching as high as 8.3% both in 2015 and in are overvalued or that expectations for the growth 2016. The sound situation of the sector is also in corporate profits in subsequent periods are confirmed by the steady increase in the NAHB rising. Median analyst forecasts indicate a decline housing market index.

S&P500 vs. earnings per share for the index

35 2100 30 1800 25 1500 20 15 1200 10 900 5 600 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 S&P500 (left axis) Earnings per share for the S&P500 (right axis)

Source: Bloomberg, Citi Handlowy

Economic growth and GDP drivers (growth in %) – Citigroup forecasts for 2015 and 2016

Indicator 2015 2016

GDP 2.4 2.5 Domestic demand 2.9 2.8 Consumption 3.2 2.8 Private investment 3.6 4.1 Housing investment 8.3 8.3 Government spending 0.6 0.7 Exports 1.5 2.2 Imports 5.4 3.1

Source: Citi Research, Citi Handlowy

Monetary policy in the U.S. remains expansive as In conclusion, we see solid foundations for the U.S. well. During the October meeting, members of the economy, and Citi economists forecast a GDP Federal Open Market Committee decided not to growth of 2.4% in 2015 and an acceleration to raise interest rates. Arguments in favor of keeping 2.5% in 2016. We expect rates to rise only in the the cost of money unchanged included, inter alia, spring of the next year. Despite the sound the recent softer data from the labor market with macroeconomic situation, we are underweighting the growth in non-farm payrolls at 142,000 against the U.S. equity market owing to relatively high expectations of 206,000. In the most recent valuations. Barometer we stressed that Citi’s economists had changed their baseline scenario for interest rate changes. They now believe that the first increase may only come in the spring of 2016 and the Fed will postpone this key economic decision until that time.

Real estate market index and the house price index in the U.S. since 2012

70 6 5 60 4

50 3 2 40 1 0 30 -1 20 -2 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15

NAHB real estate index (left axis) U.S. housing price index (% y/y, right axis)

Source: Bloomberg, Citi Handlowy

Europe – a strong rebound in October

European stock exchanges have had a good month. The most important event in October was clearly the press conference held by President of the European Central Bank (ECB) Mario Draghi. His message was very dovish and welcomed by investors. Our attitude towards European equities has not changed and we still consider them to be the most attractive asset class. The limited potential for decreases in the yields of European government bonds still leads us to overweight total return debt funds and those that invest in high-yield corporate bonds. The migration crisis has not affected corporate earnings in any appreciable way.

European stock exchanges have had a good probability of this scenario is 80%. During the press month with increases of ca. 10%. The scale of the conference, it was also mentioned that in rebound after the deep August correction confirms December the ECB would examine the degree to our forecasts that the upward trend would be which monetary policy is accommodative; the ECB sustained in Europe. Mario Draghi’s statement is ready to act, using all available instruments; after the ECB meeting points to increasing chances concerns about emerging markets and of a “larger” QE. During its December meeting, the commodities point to the risk of inflation falling Bank will consider increasing the scale of the “euro even further; economic recovery will continue, printing” scheme and extending it beyond although it will be hindered by weak international September 2016. The possibility of reducing the demand. deposit rate by 10 basis points to minus 0.30% has also been considered, which would increase the Purchases in the European bond market by the pressure to shift funds from savings towards ECB will suck liquidity from the market, which will investment. The benchmark rate remains make corporate bonds more attractive. This will unchanged at 0.05%. The suggestion that the increase the spread between corporate and deposit rate in the eurozone could be reduced government debt. This is one of the reasons why even further points to the central bank’s we are maintaining a positive outlook on European determination to stimulate inflation and economic high yield bonds. We currently consider these growth in the zone. All this suggests that an easing securities a more attractive asset class than in December is likely. The market believes that the government bonds (but it should be noted that they

Strength of the rebound in major European indices after the correction

130

120

110

100

90 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15

DAX (Germany) CAC40 (France) Stoxx 600 (Europe)

Source: Bloomberg, Citi Handlowy

Yields on 10-year government bonds from selected European countries (%)

18 16 14 12 10 8 6 4 2 0 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15

Portugal Spain Italy

Source: Bloomberg, Citi Handlowy exhibit higher investment risk and are positively by 12.7% this year, by 8.5% in 2016 and by 10.5% correlated with the stock market). Market in 2017. curiosities that reflect the investment environment we currently find ourselves in include the fact that So far, the economic slowdown in China has not Italy, a country considered to be among the “weak hurt the eurozone economy too much. The links” of the eurozone, has joined the group of unemployment rate in the zone fell to the lowest countries able to sell their bonds (worth EUR 1.75 level since January 2012 and is now at 10.8%. billion) at a negative yield level (of minus 0.023%). Eurozone manufacturing PMI rose from 52 points This means that in theory, investors are willing to in September to 52.3 points in October. The pay in order to hold these securities. In the autumn Purchasing Managers’ Index (PMI) is a leading of 2011, i.e. at the time when the crisis in Italy business climate indicator based on monthly culminated, Italian 10-year bond yields went as surveys of private manufacturing company high as 7.45%. In late October, yields on 10-year executives. The PMI tracks, inter alia, variables Italian Treasuries dropped to 1.4%, which was the such as new orders, production, inventory and lowest level since April. The situation with Spanish employment levels. One positive surprise was the debt was similar. This became possible thanks to manufacturing PMI reading for Italy, where it Mario Draghi who succeeded (also using QE) in reached 54.1 points, i.e. the highest level in three restoring the investors’ confidence in eurozone months. The Netherlands (53.7 points – the highest government bonds. figure in two months) and Austria (53 points – the highest figure for 20 months) also performed well. The Q3 results season of European companies No improvement, however, was discernible in has already reached its halfway point with 55% of France (50.6 points – the same as in September), all issuers included in the EuroStoxx index Spain (51.3 points – the lowest figure in 22 publishing their results. Corporate profits increased months) and Germany (52.1 points – the lowest by 7% y/y, and excluding the energy sector they level in three months). Surprisingly good data were rose by 14%. The strongest sectors proved to be reported from the UK with manufacturing PMI rising finance (51% up), industrials (16% up) and from 51.8 points in September to 55.5 points in healthcare (15% up). The worst performers October. This result – the highest since June 2014 included companies from the following sectors: – was better than the market consensus at 51.3 energy (35% down), staple consumer goods (13% points. It is assumed that the United Kingdom will down) and discretionary consumer goods (8% be the first country in Western Europe to down). Citigroup analysts expect earnings to grow commence a cycle of interest rate increases. Sound readings (above 50 points) of leading

indicators are in line with our positive outlook on of annual GDP. Jean-Claude Juncker is currently European equities and high-yield corporate debt. pressuring EU countries to plug the EUR 2.3 billion hole in the budget caused by the plan, which may The migration crisis has figured in headlines for lead to a slight increase in deficits. In late October, some time now. According to EU data, more than the EC and Balkan countries agreed a 16-point 710,000 people reached Europe in the first nine plan to stop the migration wave. A similar months of 2015. For Europe itself, this crisis is agreement was reached with Turkey – the funds more significant in socio-political and demographic transferred to that country (estimated at EUR 3 rather than in economic terms and its impact on billion) are supposed to help it contain the more financial markets should be small. It should be than 2 million refugees it received within its recalled that the EU’s annual budget is ca. EUR borders. 145 billion and while this amount may seem considerable, it only represents approximately 1 In summary, the average annual growth of per cent of the annual GDP of all EU countries European corporate earnings in the coming three taken together. In mid-October, an aid plan was years should reach 10%. The persistently low agreed at the EU summit. The funds available for inflation in the eurozone gives considerable leeway resolving the migration crisis under that plan (in to the ECB to extend the QE program. Capital 2015 and 2016) will total EUR 9.2 billion, which markets may begin to price in this scenario, which represents 6.3% of the annual budget. Compared should translate into increases in Old Continent to the scale of the EU’s economy, this is just 0.06% indices.

Japan – TPP presents an economic opportunity for the Land of the Rising Sun

Just like on other global stock exchanges, October brought a rebound on the Tokyo stock exchange. Indices moved north for the most part of the month, regaining the ground lost during the August/September correction. We believe that the coming months should prove positive for Japanese equities with support coming from both the central bank and the improving fundamentals.

In the past month, investors awaited the Bank of row. Japan’s decision on monetary policy changes. Many market participants saw chances that the In 2014, the jump in VAT from 5% to 8% boosted scale of printing money would increase and these inflation significantly. Prime Minister Shinzo Abe’s expectations fueled increases in Japanese indices. administration is planning another VAT increase to During the meeting on 30 October, which was 10% for April 2017. Recently, the International chaired by Haruhiko Kuroda, the current scale of Monetary Fund recommended that Japanese the asset purchase program was maintained by an policymakers start to prepare for another tax 8-1 vote. It should be recalled that the amount of increase in order to balance the budget and reduce bonds purchased by the central bank currently debt. Japan’s public debt is as high as 230% of stands at JPY 80 trillion annually. In a statement GDP while the budget deficit stands at 7.7%. issued after the meeting, the BoJ pointed to the Low inflation is probably partly caused by the slowdown in emerging markets, and especially in persistently low oil prices as Japan is a major China, which could negatively affect Japanese importer of this commodity. Therefore we still exports; on the other hand, it stressed that maintain that it is highly probable that the scale of domestic demand should support a moderate money printing will increase during the next three economic rebound in Japan. However, inflation meetings in November and December 2015 and in trends are the biggest worry for Haruhiko Kuroda. January 2016. This should in turn fuel further rises Current inflation levels do not even come close to in the stock market. Let us recall that the last the inflation target at 2%. Moreover, the trend is increase in the scale of money printing by the BoJ downward. Recently published data suggest that was in October 2014, which caused euphoria in the prices in Japan have not moved year on year and equity market and supported price growth for this has been the worst inflation outcome since nearly three quarters. It should also be mentioned May 2013. Core (base) CPI inflation has recorded that some market analysts assume no further negative growth at -0.1% for the second month in a

Core inflation in Japan against Brent crude oil price (USD per barrel)

120 3,0 100 2,5 80 2,0 60 1,5 40 1,0 20 0,5 0 0,0 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15

Brent crude (left axis) Core inflation (% y/y, right axis)

Source: Bloomberg, Citi Handlowy

increases in money printing by the BoJ in their baseline scenarios since they do not believe that the expansion of the asset purchase scheme will In our baseline scenario, a decision to have any positive effect as the size of the program increase the scale of the money is already too large. printing program could be made at The healthy foundations of Japanese companies one of the next three meetings of the should be another factor propping up Tokyo stock Bank of Japan. indices. The P/E ratio (current price divided by the earnings projected for the next four quarters) stands at 14.6. On the other hand, P/BV (price to Risk aversion and the strong correction that began book value) is just 1.3. A brief glance at other in August caused Citi analysts to revise downward developed markets shows that this favors the their forecasts for stock exchange indices. We Japanese market. It is expected that Japanese think that in mid-2016, the TOPIX could reach companies should reach double-digit profit growth, 1,750 points, which would in any case translate to which is likely to encourage investors to purchase double-digit growth potential. Our outlook on the stocks in Tokyo. Japanese market remains positive and our case is supported by attractive valuations, low oil prices The completion of Trans-Pacific Partnership (TPP) and the involvement of the Government Pension negotiations was an important event that was Investment Fund, which guarantees demand for widely discussed in the media. The U.S., Japan Japanese equities. In our baseline scenario, a and ten other countries announced the success of decision to increase the scale of the money printing five-year talks, enabling the conclusion of the program could be made at one of the next three largest free trade agreement in the world. The meetings of the Bank of Japan, which should also Trans-Pacific Partnership will include countries that provide an important argument for further contribute 40% of the global GDP in total. It will increases. enable the elimination or reduction of numerous barriers to trade and facilitate the movement of goods and services between its member states. The Trans-Pacific Partnership is also meant to promote innovation and support labor market development. As a member state of the agreement, Japan should be a major beneficiary but its advantages will only become visible in the long run.

Emerging markets – a rebound less pronounced than in developed ones

We believe that the very rapid rebound in emerging markets in the last month has confirmed the potential of their stock exchanges. A slight improvement in sentiment was reflected in a strong market recovery. At the same time, however, we continue to emphasize the need for a selective approach to this heterogeneous group. Within the emerging markets category, we still prefer Asia.

On emerging markets, October certainly was a perception of the Chinese economy begins to very good month. The main player this month was change. As the largest country among the once again the U.S. Federal Reserve, which emerging markets, it is undergoing the largest and postponed interest rate rises and thereby most dynamic transformations. It should be noted supported stock prices in emerging markets. that the services sector already contributes more (48.2%) to the Chinese domestic product than At the beginning of the month, we received industry (42.6%; the rest is agriculture). This important updates on the Emerging Asia region. An reflects relatively high level of development and the important event in this part of the world was the shift in production structure towards that of completion of negotiations on the Trans-Pacific developed countries. It also changes the Partnership (TPP). The agreement still must be perspective of market analysts – domestic demand ratified by individual countries, but if it is adopted, it could become the main driver of growth in the will be the largest free trade agreement in the world coming years, replacing industry and the related as discussed in the section on Japan. It is worth exports. noting that the agreement does not include China, and this may lend support to other emerging The above theses have been confirmed in the economies in the region. statements published following the plenum of the Communist Party of China, which took place from As concerns China, World Bank has issued 26 to 29 October. Reports suggest that in the next forecasts of Chinese GDP growth of 6.9% in 2015 five-year period, we can expect an increase in the and of 6.7% in 2016. These figures have not role of consumption as the driver of economic affected the markets significantly. The slowdown in growth and also a further liberalization of most the second largest economy of the world has sectors of the Chinese economy including the already been discounted by most market financial services segment. Clearer boundaries will participants. We are at a juncture where the also probably be drawn between public

Chinese copper imports vs. changes in import value in USD

1400 100 1200 80 1000 60 800 40 600 20 400 0 200 -20 0 -40 2010 2011 2012 2013 2014 2015

Copper imports by quantity (thousand tonnes, left axis) Chinese imports in USD (change % y/y, right axis)

Source: Bloomberg, Citi Handlowy

administration and business. The past month social dimension. The investors’ warm welcome, demonstrated once again the importance of a however, was mostly due to the waning of thorough analysis of macroeconomic data from uncertainty and an end to the political stalemate, behind the Great Wall. Recent data on imports, which lasted from June as the previous elections which emerged in the middle of the month, rattled did not produce a clear-cut outcome. Since it the financial markets again. Imports by value fell by proved impossible to build a coalition at the time, 20.4% in U.S. dollar terms and by 17.7% in yuan. the investors who took positions on the Istanbul These data were commented upon as the stock exchange could hardly sleep peacefully. confirmation of the slowdown in the Chinese However, in our opinion Turkey’s problems are economy, which is supposed to import less raw much more serious than just a temporary inability materials. However, when we examine quantitative to find a ruling majority. Looking at macroeconomic aggregates, it can be noted that the decline in the indicators, we can see a sizeable imbalance that value of imports has mostly been due to a drastic has persisted for a long time. This manifests itself fall in commodity prices; in terms of volume, mostly as a very large current account deficit (more Chinese purchases of e.g. copper or iron ore are than USD 44 billion), which alongside the close to historical peaks. depreciating currency undermines the country’s financial stability. Additionally, Citi economists Given this rapidly changing situation in the Middle predict that inflation will hit 8.5% by the end of Kingdom and a number of thorough reforms that 2015 with interest rates currently at 7.5%. are currently taking place in the region, this Weakening domestic consumption may put appears to be the right time to take small positions downward pressure on economic growth, in Emerging Asia markets whose valuations are especially given the not-so-good prospects for the currently very low. industry (the leading business climate indicator for the industry is currently at 48.8%, i.e. below the 50- Moving on to other markets, it is worth noting that point threshold between growth and recession). As the most rapid growth among emerging markets in we focus on economic indicators and analyze them late October and early November was probably against the background of a still very turbulent enjoyed by the investors who took positions in the geopolitical situation, our outlook on the Turkish Turkish market. The strongly appreciating lira could stock market is still not positive. have brought additional benefits to those market participants. All those events have been the result Summing up, Emerging Asia stands out among the of yet another election in Turkey. The markets emerging economies; we are neutral on Latin reacted with euphoria to the decisive win for the American and Central and Eastern European stock Justice and Development Party, which will allow it exchanges, and maintain a negative outlook on to govern alone. The party, from which President exposure to the Russian market. Erdogan originates, is seen as conservative in the

Performance of Chinese equity indices year to date

230

180

130

80 Jan-15 Apr-15 Jul-15 Oct-15 Hang Seng Shanghai Composite Shenzen Composite

Source: Bloomberg, Citi Handlowy

Frontier markets – the weakest in relative terms

In frontier markets, October brought a mixed picture just as the previous months. Within this broadly defined group of assets, we see both signals that support economic growth and information that indicates that the risk for investors is heightened.

Major changes that have been welcomed by that it will continue to monitor the changes in financial markets are taking place in Argentina. On Argentina and does not rule out further upgrades to 25 October, presidential elections took place there. its investment rating. Quite unexpectedly, and for the first time in history, a run-off will be held on 22 November. Pre-election Another frontier market that is currently undergoing polls used to put Daniel Scioli quite clearly in the positive changes is Vietnam. At the end of the lead. He is the candidate of the ruling camp and has month, the government presented a report been anointed by the incumbent President Cristina summarizing the period from 2011 to 2015 in the Fernández de Kirchner. In the run-off, his rival will economy and also its assumptions and goals for the be Mauricio Macri, a businessman who is currently next five years. Government institutions expect governor of the Buenos Aires province. Both annual average economic growth at 6.5–7%. The candidates promise reforms, which will be forecast for 2016 is 6.7%. In their comments, necessary given the current state of the economy. independent institutes assess these assumptions There are several problems that require immediate and also the goals for the next five years as fairly attention: central bank reserves, which are running realistic. Therefore Vietnam will remain among the very low, must be replenished, budget deficit must fastest growing economies in Asia. The last two be reduced and the excessively high inflation reined years have brought considerable economic success; in. Financial markets see more hope for inflation was effectively subdued and ever closer improvement in breaking the long string of center- integration with the world economy achieved. These left governments associated with the Kirchner trends should be sustained owing to, inter alia, the family. Currently, Mr. Macri is leading presidential signing of the aforementioned Trans-Pacific polls. Partnership (TPP). The TPP covers a very broad range of issues from regulating trade rules Recognizing the changes that are taking place in (eliminating thousands of tariffs) through the South America’s second largest economy, the protection of intellectual property to environmental Moody’s rating agency raised its outlook for the protection standards. The relatively small country’s rating from negative to stable. It should be Vietnamese economy should clearly benefit from noted that this rating remains seven notches below participation in the agreement, which brings together investment grade at Caa1, but Moody’s stresses 40% of global GDP.

Saudi Arabia’s budget receipts and expenditure (million Saudi riyals, left axis) vs. WTI oil price (USD per barrel, right axis)

1 400 000 120

1 200 000 100 1 000 000 80 Saudi Arabia’s budget receipts 800 000 60 600 000 Saudi Arabia’s budget expenditure 40 400 000 Crude oil price per barrel

200 000 20

0 0

Source: Bloomberg, Citi Handlowy

Less optimistic news has been reported from the a very clear correlation between budget receipts and Gulf region. Once again, the economies in the oil prices in global markets. At the same time, state region have proven sensitive to oil prices. One of the spending grows at a steady, constant pace. The rating agencies downgraded Saudi Arabia. The U.S. most important question currently is whether given agency in question – Standard & Poor’s – changed such a rapid rise in expenditure in recent years, the its rating from AA- to A+. S&P cited persistently low government can afford to make sharp cuts. It should crude prices as the main argument behind its be remembered that in 2008 and 2009, the difficult decision, since this state of affairs makes balancing situation in the oil market failed to force the the country’s budget more difficult. Saudi Arabia is authorities to introduce deep-cutting expenditure currently making efforts to reduce budgetary reforms. spending and thus plug the hole in its public finances. In the long run, such measures could Summing up, it appears that exposure to economies depress economic activity and thus harm the that are at early development stages is worth remaining sectors of the economy. In his summary, considering as a small part of a broader investment however, the S&P analyst stresses that the portfolio. By taking considerable risk, we invest in foundation of the banking sector is solid and there economies that exhibit rapid (though often quite are no risks to financial stability. The Chart presents volatile) GDP growth.

Commodity markets – a moment of calm

October was the second consecutive month of relatively stable raw material prices. Compared to the breathtaking pace of decline seen in July and August, this time we observed movements that could be described as a fairly broad sideways trend. During the first few sessions of the month, the CRB commodities index mounted a brave attempt at scaling local peaks, but immediately after these had been captured, the index began to slide towards September lows.

While agricultural commodities such as soybeans, scenario to inflate prices, demand for copper (in wheat and corn are often assets with the highest China, among others) must be maintained. These (or lowest) rates of return, this time they turned out relationships are reflected by dwindling copper to be particularly stable. Much stronger emotions stocks. ruled the precious metals’ market where metals such as silver, platinum and gold are traded (more Oil detail on gold further in the Barometer). In the summer season, one of the main forces Copper is also worth mentioning here; according to driving the demand for crude oil was gasoline Citi forecasts, it could prove an exception among whose low price favored high consumption. On the the universally declining commodities. Recent other hand, in winter this demand will be driven by reports on supply-side problems suggest that the other oil raffinates, such as diesel and fuel oil. upside potential is greater than the downside one. However, these energy carriers have less chance Rio Tinto, which is one of the largest copper of balancing oil oversupply than gasoline. Firstly, producers worldwide, disclosed Q3 2015 figures exports from the Middle East and Asia have according to which production was reduced by increased; secondly, demand from industry has 24% y/y. Such a big drop results, inter alia, from slowed down. A more optimistic picture, particularly the fact that as much as 70–80% of the total for fuel oil, could emerge if the winter proves very extraction cost is denominated in USD. The still cold. However, in the short term, there are no strong U.S. dollar discourages investments in grounds for price increases during the transitional copper production technology, thus driving down period when seasonality has already dampened the metal’s supply. However, in order for this the demand associated with holiday travel, and the heating season has not yet fully arrived.

LME Copper Inventories (t)

6 000 000

5 500 000

5 000 000

4 500 000

4 000 000 Jan-15 Mar-15 May-15 Jul-15 Sep-15

LME copper inventories

Source: London Metal Exchange, Citi Handlowy

On the supply side, the continuing decline in the Gold number of new wells drilled in the U.S. remains good news. In the Chart, this is illustrated with the In markets for precious metals, the first half of last example of Baker Hughes, one of the leading month was marked by rapid growth. The main companies engaged in operating oil fields. reason was the negative correlation with the U.S. However, it should be recalled that this is a factor dollar, which is often mentioned in the Barometer. that responds elastically to changes in prices, and From the local trough to the peak, gold gained thus the decreased number of wells will only last nearly 8% in just 10 trading sessions. However, the as long as crude prices remain low. Supply may October meeting of the Fed brought a sharp also increase even without new sources. According change in the situation. The statement of the to Citi analyses, potential additional production Federal Open Market Committee (FOMC) proved from the wells that have already been drilled but slightly more hawkish than in September. This have not yet been exhausted is estimated to time, turbulences in global financial markets were average 0.35 million barrels per day in 2016. not listed among the reasons for the delay in initiating the cycle of interest rate rises. This seemingly minor change has reduced the Number of new oil and gas wells by Baker uncertainty surrounding the strength of the U.S. Hughes dollar. The lower the Fed’s dependence on market 2000 turbulence, the greater the probability of a relatively early commencement of rate increases 1750 and thereby of heightened expectations for USD 1500 appreciation. 1250 1000 The possibility that U.S. monetary policy could be tightened as early as the end of this year exerted 750 pressure on gold prices, which may persist until the 500 2010 2011 2012 2013 2014 2015 Fed sends a more dovish message. On the other hand, the pressure will become even stronger if a Source: Bloomberg, Citi Handlowy rate increase is actually announced at the next meeting. Citi’s baseline scenario assumes that this Therefore upside price potential may be limited. On will not happen until the spring of 2015, but the the other hand, similar considerations apply to very tone of the statement by Fed members will downward movements. In the short term, the have a considerable impact on precious metal futures market should favor the stabilization of prices. prices and a sideways trend. Compared to 2015, the hedges maintained by both oil consumers and In conclusion, the most likely scenario in the case producers with respect to 2016 prices are relatively of oil is the continuation of the lateral trend that low. Therefore producers may use any spike in emerged in September. The persistent oversupply prices to sell contracts, and consumers may exploit is conducive to maintaining prices near the lower any decrease to purchase such contracts for the boundary of the channel and any upward or commodity. downward move may be inhibited by the process of hedging the next year’s prices using futures. In the case of gold, the lack of support that would be provided by a dovish FOMC stance implies a

return to the long-term downtrend.

Rates of return and ratios for selected indices (as at 31 October 2015)

Equities Value Month YTD Year P/E P/E Div. (12M) Yield WIG 50271.7 0.9% -1.7% -6.8% 17.6 12.0 3.0%

WIG20TR 3384.3 -0.3% -7.5% -13.5% 15.4 11.1 3.4%

mWIG40 3681.3 2.9% 6.0% 3.7% 24.4 14.3 2.2%

sWIG80 13605.2 3.8% 13.1% 9.1% 17.4 15.2 1.6%

S&P500 2079.4 8.3% 1.0% 3.0% 18.8 17.8 2.1%

Eurostoxx 50 3418.2 10.2% 8.6% 9.8% 21.1 15.0 3.4%

Stoxx 600 375.5 8.0% 9.6% 11.5% 23.7 16.4 3.3% Topix 1558.2 10.4% 9.4% 16.8% 16.0 14.7 1.8% Hang Seng 22640.0 8.6% -4.1% -5.7% 10.0 11.5 3.7% MSCI World 1705.8 7.8% -0.2% -0.1% 19.1 17.1 2.5% MSCI Emerging Markets 847.8 7.0% -11.3% -16.6% 12.9 12.4 2.9% MSCI EM LatAm 2006.9 5.9% -26.4% -36.5% 21.5 16.0 3.0% MSCI EM Asia 421.6 7.7% -7.8% -9.7% 12.1 12.2 2.7% MSCI EM Europe 273.1 5.5% -7.9% -26.0% 11.1 8.0 4.2% MSCI Frontier Markets 531.9 3.6% -13.1% -20.5% 10.8 9.9 3.9%

Raw materials Brent Crude Oil 49.6 1.0% -24.3% -44.9% Copper 231.8 -1.0% -18.0% -23.9% Gold 1142.2 2.4% -3.6% -2.7% Silver 15.5 7.1% -1.0% -3.8% TR/Jefferies Commodity Index 195.6 1.0% -14.9% -28.1%

Bonds Duration U.S. Treasuries (>1 year) 374.6 -0.4% 1.5% 2.7% 6.1

German Treasuries (>1 year) 409.7 0.6% 1.4% 3.4% 7.3 U.S. Corporate (Inv. Grade) 250.0 0.7% 0.3% 1.2% 8.0 U.S. Corporate (High Yield) 230.1 3.3% -0.5% -2.5% 4.1

Polish Treasuries (1–3 years) 315.7 0.5% 2.0% 2.1% 2.1

Polish Treasuries (3–5 years) 355.4 1.4% 2.9% 2.7% 4.0

Polish Treasuries (5–7 years) 256.0 1.6% 2.4% 2.2% 5.6

Polish Treasuries (7–10 years) 424.5 1.6% 1.5% 2.0% 7.7

Polish Treasuries (>10 years) 317.7 1.7% -0.1% 0.9% 9.9

Currencies USD/PLN 3.86 1.7% 9.0% 14.4% EUR/PLN 4.25 0.1% -0.9% 0.5% CHF/PLN 3.91 0.2% 9.6% 11.5% EUR/USD 1.10 -1.5% -9.0% -12.1% EUR/CHF 1.09 -0.1% -9.6% -9.8%

USD/JPY 120.62 0.6% 0.7% 7.4%

Source: Bloomberg

Macroeconomic forecasts

GDP growth (%) 2014 2015 2016 Poland 3.3 3.6 3.3 United States 2.4 2.4 2.5

Eurozone 0.9 1.5 1.6 China 7.3 6.9 6.3 Developing countries 4.2 3.6 4.0 Developed countries 1.7 1.9 2.0

Inflation (%) 2014 2015 2016

Poland 0.0 -0.8 1.5 United States 1.4 0.3 1.6 Eurozone 0.4 0.1 1.0 China 2.0 1.5 1.9

Developing countries 4.3 5.0 4.4 Developed countries 1.4 0.3 1.4

Source: Citi Research

Currency forecasts (end of period)

Currency pairs Q4 15 Q1 16 Q2 16 Q3 16 USD/PLN 3.69 3.75 3.82 3.80 EUR/PLN 4.22 4.17 4.11 4.08 CHF/PLN 3.84 3.79 3.74 3.71 GBP/PLN 5.71 5.79 5.96 5.83

Source: Citi Handlowy

Glossary of Terms /11/2015 19

Polish Shares denote shares traded on the Warsaw Stock Exchange (WSE) and included in the WIG index U.S. Treasuries bonds issued by the government of the United States of America; figures used for the Bloomberg/EFFAS US Government Bond Index > 1Yr TR, measuring performance of U.S. Treasuries whose maturity exceeds 1 (one) year Citi Research A Citi entity responsible for conducting economic and market analyses and research, including that concerning individual asset classes (shares, bonds, commodities) as well as individual financial instruments or their groups Div. Yield the amount of dividend per share over the share’s market price. The higher the dividend yield, the higher the yield earned by the shareholder on the invested capital Long Term a term of more than 6 (six) months Duration a modified term of a bond, measuring the bond’s sensitivity to fluctuations in market interest rates. It provides information on changes to be expected in the yield on bonds in the event of a 1 (one) p.p. change in the interest rates Short Term a term of up to 3 (three) months Copper figures based on the spot price per 1 (one) ton of copper, as quoted on the London Metal Exchange German Treasuries bonds issued by the government of the Federal Republic of Germany; figures used for the Bloomberg/EFFAS (Bunds) Germany Government Bond Index > 1Yr TR, measuring performance of German treasury bonds whose maturity exceeds 1 (one) year P/E (12M) a projected price/earnings ratio providing information on the price to be paid per one unit of 2016 projected earnings per share, measured as the ratio of the current share price and the earnings projected by analysts (consensus) for a specified period (12M) P/E (price/earnings) the historic price/earnings ratio providing information on the number of monetary units to be paid per one monetary unit of earnings per share for the preceding 12 (twelve) months, measured as the ratio of the current share price and earnings per share for the preceding 12 (twelve) months Polish Treasuries bonds issued by the State Treasury; figures based on the Bloomberg/EFFAS Polish Government Bond Index for the corresponding term (>1 year, 1–3 years, 3–5 years, over 10 years) Brent Crude Oil figures based on an active futures contract for a barrel of Brent Crude, as quoted on the Intercontinental Exchange with its registered office in London Silver figures based on the spot price per 1 (one) ounce of silver Medium Term a term of 3 (three) to 6 (six) months U.S. Corporate bonds issued by US corporations which have been assigned a speculative grade by one of the recognized (High Yield) rating agencies; figures based on the iBoxx $ Liquid High Yield Index measuring performance of highly liquid US corporate bonds with the speculative grade U.S. Corporate (Inv. bonds issued by U.S. corporations which have been assigned an investment grade by one of the recognized Grade) rating agencies; figures based on the iBoxx $ Liquid Investment Grade Index measuring performance of highly liquid U.S. investment grade corporate bonds YTD (Year To Date) a financial instrument’s price trends for the period starting 1 January of the current year and ending today YTM (Yield to the yield that would be realized on an investment in bonds on the assumption that the bond is held to maturity Maturity) and that the coupon payments received are reinvested following YTM Gold figures based on the spot price per 1 (one) ounce of gold

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