Perspectives March-April 2017

ISSUE 3 PERSPECTIVES MARCH-APRIL 2017

VIEWS INSIGHT French Elections: Europe: Improving Politics Return to Fundamentals vs Centre Stage in Cautious Sentiment Europe MONTHLY PERSPECTIVES

Perspectives

Dear Clients,

Attention is likely to turn to Europe as the first round of the French Presidential Election approaches on 23 April. Despite the center-right presidential candidate Fillon hurt by allegations over jobs for his family, Citi analysts continue to expect that Fillon is likely to become the next French president. The polls are currently showing that the far-right leader Marine Le Pen will win the first round of the election but lose the second round on May 7. Given the low confidence investors have in polling results following Brexit and the US Presidential Election in 2016, investors will inevitably ask what a Le Pen win would mean for France and for Europe.

In this month’s Perspective, we explore the implications of a Le Pen win. Citi analysts believe that markets will react negatively to Paul Hodes a Le Pen presidency. In her 24-page manifesto, she has expressed her intention to leave the EU and to re-introduce a Head of Wealth Management national currency. Citi analysts believe that worries over currency re-denomination will freeze capital spending and hiring Asia Pacific and EMEA plans of French companies, lower France’s economic growth and Citibank N.A. lift inflation. Re-denomination of French government bonds could also reignite a sovereign debt crisis and raise fears of a Eurozone breakup.

We continue to focus on Europe in our second article, highlighting the gap between the recovering Eurozone economy and poor investor appetite for European equities. With the manufacturing and services Purchasing Managers’ Indices (PMI) reaching 6-year highs in January, the Eurozone appears on track to enjoy its strongest growth since the global financial crisis. Although the European equity market is up 4% year to date, concerns over Europe’s busy political calendar this year have led investors to remain relatively cautious towards European equities. While a small net inflow was seen in February 2017, it suggests that there is potential for the European equity market to rally on renewed inflows once political fears subside.

We hope you enjoy reading this month’s edition of Perspectives. Please talk to your Citibank relationship manager to discuss how the developments in financial markets can impact your investment portfolio.

Best regards,

Paul

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All forecasts are expressions of opinion, are not a guarantee of future results, are subject to change without notice and may not meet our expectations due to a variety of economic, market and other factors. Likewise, past performance is no guarantee of future results. MONTHLY PERSPECTIVES

Views French Elections: Politics Return The tail risk in the French Election to Centre Stage in Europe

Politics take centre-stage in Europe as the Investors have focused on the risk that Le first round of the French elections on 23 Pen, the leader of France’s anti-Euro, anti- April approaches. The official campaign for immigrant Front National (FN), will win the the Presidential election begins on 10 April. election. Le Pen is a critic of open borders While François Fillon has been placed under and free trade (See Table 1) and she has formal investigation on suspicion of stated her intention to take France out of embezzling state funds, independent the Euro within six months as well as hold a centrist candidate Emmanuel Macron has referendum on EU membership. Given overtaken Fillon in pre-election polls, these concerns, the spread between the increasingly appearing as the new front- French 10-year and German 10-year yields runner. Marin Le Pen is widely expected to (OAT-Bund spread) has widened to 63 basis make it through to the second round of the points (bps), 30 bps higher than the level a presidential election in May. year ago.

Table 1: Key Proposals of Selected Presidential Candidates

Sources: Citi Research as of 27 Feb 2017

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What are Le Pen’s plans? Could Le Pen become President?

In Le Pen’s 24-page manifesto of 144 Opinion polls currently suggest that Le Pen commitments, regaining monetary, is likely to win the first round of the legislative and economic sovereignty is her Presidential elections on 23 April but lose highest priority. This includes: the second run on 7 May.

• Re-introducing a national currency which Impact of a Le Pen win could eventually fluctuate within a 10- 20% range against an EU currency Citi analysts believe that a Le Pen victory is basket. a low-probability event which could have a significant impact on financial markets.(See • Revoking central-bank independence and Table 2) creating money (French Quantitative Easing) to finance welfare, an industrial • Currency market: Given that France is strategy, and repay debt including one of the largest EU members as well as buying back debt from foreigners. a founding member of the EU, the Euro is likely to be more adversely affected Le Pen’s proposals are essentially a call to than it was during the Brexit episode. abandon the Euro and replace it with a new The European Central Bank (ECB) may national currency, called ‘new French franc’ ease further in response to heightened and subsequently to leave the European risk aversion in markets and among Union. Le Pen also promised to protect businesses. The initial knee-jerk reaction French traditions and national character is likely to result in a weaker Euro. from globalization by reducing immigration.

Table 2: Projected Asset Class Reactions to the Election of Certain Candidates

Sources: Citi Research as of 27 Feb 2017

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• Rates: The 10-year spread between • Emerging Markets: EM currencies may French-German government bonds experience significant volatility with (OAT-Bund spread) traded at 190bp Central and Eastern Europe (CEE) during the European sovereign debt currencies likely to be most vulnerable. crisis in 2011. A Le Pen win could trigger EM debt may also suffer as yields rise on a significant rise in uncertainty and the the back of higher risk aversion. resulting flight to German government bonds may cause 10 year OAT-Bund • Gold: While Citi analysts do not expect spreads to widen to as high as 200bps. French politics to measurably shift supply/demand fundamentals in • Corporate bonds: Spreads of French commodities, gold is likely to benefit Investment Grade corporate bonds are from safe-haven flows. likely to rise by 30-40bp in the immediate aftermath of a Le Pen victory. • Should Le Pen win the French €-denominated paper from other Presidential elections, the focus is likely continental corporate bonds could widen to shift to the legislative elections on 11 by at least 15bp with a greater impact on and 18 June. Le Pen’s FN party would financials than non-financials. Compared need to win an outright majority in the to core European markets, the impact on June legislative elections in order to be peripheral bonds are likely to be more able to hold a referendum on France’s severe. EU membership. This seems unlikely. Since 1988, the NF party has only • Equities: Investors may lower their managed to secure at most 2 seats in exposure to European assets as risk the lower house, despite double digit aversion rises. While stocks with high support levels. French exposure are likely to be de-rated by investors, European banks and stock markets in Italy and Span may be more directly threatened by concerns regarding the survival of the Euro.

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Key Takeaways

• While investors have focused on the risk that Le Pen, the leader of France’s anti-Euro, anti-immigrant Front National (FN), will win the election, current polls suggest that Le Pen is unlikely to win the French Presidential Elections.

• A Le Pen win is likely to have a negative impact on financial markets. The Euro could weaken and corporate bonds spreads are likely to widen. European equities are also expected to be vulnerable while gold may benefit from safe haven flows.

• Even with a Le Pen win, the FN party is unlikely to win an outright majority in the June legislative elections in order to be able to hold a referendum on France’s EU membership.

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Insights

Europe: Improving Fundamentals But European investor confidence low vs Cautious Sentiment European equity funds suffered outflows Europe has a busy election calendar in 2017 over the last twelve months based on data starting with the Dutch general election on from fund flows tracker EPFR Global. Net 15 March, followed by the French redemptions totaled $113 billion in 2016 with Presidential election in April and May and outflows peaking in mid-2016, even though the German Federal election in September. European equities rebounded strongly by 9.56% in 2H16. Recently, there are signs While heightened political uncertainty has that these outflows are slowing or even revealed investors’ appetite for European starting to reverse. According to EPFR, equities, Citi analysts note that the outlook European equities experienced a small net for the Eurozone economy is brightening. inflow in February 2017, the first net inflow Citi analysts believe that there is potential in over a year (see chart 1). for European equities to rally in 2017 if Chart 1: Monthly Fund Flows political risks in Europe subside.

European economic confidence high

The Eurozone manufacturing and services Purchasing Manager’s Indices, indicators of the economic health of the manufacturing and service sectors, edged up to 55.5 and 53.7 respectively in January, beating both Citi’s and consensus estimates. The PMI reached 6-year highs, suggesting that the Eurozone is on track to enjoy its strongest Source: Citi Research. As of 21 February 2017. growth since the Global Financial Crisis. Mind the gap Political concerns do not appear to be holding back the economy with the PMI Historically, there is a close relationship indicating that the European economy grew between confidence in the European 0.6% in 1Q17 from the previous quarter. economy (PMI) and European equity This is a further acceleration over the 0.4% markets (net inflows). This relationship quarterly growth in the second half of last broke down in the last twelve months given year. a rise in political fears (see chart 2).

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Chart 2: PMIs up vs Equity Flows Down Hedging political risks

With European equity markets likely to

remain volatile amid Europe’s busy political calendar, Citi analysts are tactically underweight European equities, however, European equities are likely to rally in 2017 should political risks subside.

For investors looking for exposure to European equities, Citi analysts prefer

Source: Citi Research. As of 21 February 2017. industry sectors which may be more resilient even under an unfavourable political outcome. This includes the Citi analysts believe that the gap between Commodities sector. Citi analysts are PMI inflows can close in 2017 with European overweight Oil & Gas as well as Basic equity markets attracting inflows if political Resources & Mining sectors given improved risks abate. supply and demand dynamics and the prospect of strong earnings. Citi analysts expect the Euro-Stoxx 600 index to end the year higher at 410 from Citi analysts also favour the Technology currently 373 (as of 10 March 2017), driven sector. Technology companies have by a 10% growth in earnings and renewed generated strong cash flows from their inflows into European equity markets. For operations which help to lower debt levels. earnings to contract in 2017 it would The sector also benefits from stronger require one of the following outcomes: global growth. Local government policies are likely to be supportive of the sector • Oil prices to drop to US$20/bbl given the important role it plays for Europe’s economic future. • PMI to fall back towards the 45 level

• High-level political risks materializing European banks would be vulnerable if with return of systemic risk, e.g. a Le political risks in Europe materialize. Citi Pen win that could lead to concerns over analysts believe that banks with a renewed sovereign debt crisis and international exposure may fare better break-up of the Eurozone. than banks that generate most of their earnings from domestic operations.

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Key Takeaways

• High confidence in the European economy has been overshadowed by low confidence in the region’s equity markets. Citi analysts remain tactically underweight on European equities due to political risks in 2017.

• Citi analysts believe that there is room for European equities to rally in 2017 if political risks in Europe subside. Citi analysts expect the Euro-Stoxx 600 to end the year higher at 410, driven by strong earnings growth and renewed inflows into equity markets.

• Citi analysts favour sectors which would be more resilient even under an unfavourable political outcome. This includes the commodity and technology sectors, as well as selected banks.

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World Market at a Glance

Last price 52-Week 52-Week Historical Returns (%) 13-Mar-17 High Low 1 week 1 month 1 year Year-to-date US / Global Dow Jones Industrial Average 20881.48 21169.11 17063.08 -0.35% 2.30% 21.31% 5.66% S&P 500 2373.47 2400.98 1991.68 -0.08% 1.94% 17.37% 6.01% NASDAQ 5875.78 5911.79 4574.25 0.45% 1.94% 23.74% 9.15% Europe MSCI Europe 417.87 418.31 353.59 0.88% 1.53% 5.24% 4.45% Stoxx Europe 600 374.64 376.15 307.81 0.37% 1.22% 9.47% 3.66% FTSE100 7367.08 7394.61 5788.74 0.23% 1.21% 19.99% 3.14% CAC40 4999.60 5022.10 3955.98 0.55% 2.28% 11.28% 2.82% DAX 11990.03 12082.59 9214.10 0.26% 1.83% 21.96% 4.43% Japan NIKKEI225 19633.75 19668.01 14864.01 1.31% 0.90% 15.91% 2.72% Topix 1577.40 1578.51 1192.80 1.45% 1.49% 16.04% 3.87% Emerging Markets MSCI Emerging Market 938.50 956.64 780.68 0.44% 0.33% 17.18% 8.84% MSCI Latin America 2567.38 2719.09 1935.19 -2.02% -1.98% 23.40% 9.69% MSCI Emerging Europe 142.75 153.21 116.92 -2.49% -5.65% 18.67% -2.71% MSCI EM Middle East & Africa 250.31 260.06 214.75 -1.27% -1.80% 12.34% 2.26% Brazil Bovespa 65534.30 69487.58 46520.81 -1.22% -2.14% 32.02% 8.81% Russia RTS 1069.14 1196.99 818.95 -3.72% -8.87% 26.44% -7.22% Asia MSCI Asia ex-Japan 567.30 570.85 474.10 1.15% 1.38% 16.40% 10.30% Australia S&P/ASX 200 5757.35 5833.20 4893.50 0.19% -0.06% 11.44% 1.62% China HSCEI (H-shares) 10258.71 10593.48 8175.96 0.86% 0.01% 19.83% 9.19% China Shanghai Composite 3237.02 3301.21 2780.76 0.10% 0.63% 15.18% 4.30% Hong Kong Hang Seng 23829.67 24364.00 19594.61 0.99% 0.50% 17.97% 8.31% India Sensex30 28946.23 29145.62 24354.55 -0.35% 2.10% 17.11% 8.71% Indonesia JCI 5409.37 5491.70 4690.56 -0.01% -0.00% 12.37% 2.13% Malaysia KLCI 1721.92 1734.07 1611.88 -0.31% 0.68% 1.50% 4.88% Korea KOSPI 2117.59 2129.42 1892.75 1.74% 1.87% 7.41% 4.50% Philippines PSE 7233.09 8118.44 6499.00 -1.10% -0.84% 1.89% 5.74% Singapore STI 3147.15 3158.26 2703.48 0.82% 1.14% 11.25% 9.25% Taiwan TAIEX 9697.34 9869.59 7999.98 0.15% -0.13% 11.39% 4.80% Thailand SET 1535.51 1600.79 1343.13 -1.17% -3.14% 10.20% -0.48% Commodity Oil 48.40 55.24 35.24 -9.02% -8.56% 25.71% -9.90% Gold spot 1204.06 1375.45 1121.03 -1.73% -1.72% -3.73% 4.49%

Source: Bloomberg as of 13 March 2017.

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