The Investment Case for January 8, 2016

In the shadow of recent developments in Brazil, including the departure of the well-respected finance minister Joaquim Levy, the country’s downgrade to below investment grade by Fitch in December, as well as the start of impeachment proceedings against President Rousseff, many investors are unnerved. However, in spite of the headlines, our conviction in Brazil remains strong. We think that much of the negative news is reflected in attractive valuations and we continue to believe the investment case for Brazil is compelling. In this update, we address our views on the recent developments in Brazil and our outlook on sovereign bonds, local rates and the Brazilian real.

Overview of recent developments ability of Brazil's political parties to work together, implement the necessary reforms, and collectively pay the price of the necessary fiscal adjustment. The  Departure of finance minister Levy success of the implementation of the fiscal reforms will depend heavily on Barbosa’s ability to navigate the Although the December 18, 2015 departure of Joaquim political dynamics within a fragmented legislature. Levy, Brazil's respected pro-austerity finance minister (who lasted in the role less than a year), had been widely discussed and anticipated, the market's initial  Threat of impeachment reaction to his departure was nevertheless negative. Political collaboration has proven difficult, not in the least (The Brazilian real depreciated by about 2% on the due to the looming threat of the presidential official news, while CDS spreads widened by about 10 impeachment. In December, members of Congress basis points.) began deliberating the impeachment proceedings of Levy was replaced by planning and budget minister President Rousseff, on the grounds that the president —who also served as deputy finance had tampered with public accounts to hide the true size minister during Rousseff's first term in office. Although of the fiscal deficit. Following the initiation of the Barbosa is perceived to be less fiscally hawkish than impeachment process, Brazil's Supreme Court made Joaquim Levy, we believe his appointment may help the several decisions with regard to putting the president on country move past its current political gridlock. Levy was trial, including rules for the formation of the a highly credible and determined technocrat; however, impeachment committee and requiring a simple Senate he ultimately lacked the necessary political support and majority. (In our view, these rules favor became a polarizing figure which hampered his ability to and reduce the likelihood of impeachment.) On February execute. 2, Congress returns from its recess and the process is likely to last until at least April or May, and will certainly Compared to Levy, Barbosa will likely favor a slower generate a lot of headlines. Regardless of the outcome, pace for fiscal adjustment. However, the new finance a final decision on the impeachment could be a positive minister has already expressed a willingness to push for catalyst for Brazil. Should Rouseff stay in power, she will fiscal consolidation and can likely garner support from have the opportunity to build a majority. If Rousseff is the ruling party. It is important to remember that Brazil's impeached, current vice president would fiscal situation has been deteriorating due to deeply have the opportunity to govern with a new strong rooted structural issues, including unsustainable majority. government social expenditures, one of the most burdensome and complicated tax regimes in the world and a growth model dependent on credit expansion and domestic consumption. The way out depends on the

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 Loss of investment grade status Figure 1: Brazil sovereign and quasi-sovereign spreads To add to the mix of negative news, Fitch downgraded

Brazil to BB+ on December 16, 2015, leading to the 800 country's loss of investment grade status. Brazil's Brazil BB sovereign spreads had been trading wider than weaker 700 BBB BB rated countries for some time (Figure 1). And, while B some near-term technical selling pressures may remain 600 as passive managers reduce their exposures to Brazil, 500 once it is removed from investment grade crossover indices at the end of this month, we believe that the 400

large part of the adjustment in spreads has already Spread level occurred, as the Fitch downgrade was widely anticipated 300 following the S&P downgrade in September 2015. 200

100 Jan-05 Jun-06 Oct-07 Mar-09 Jul-10 Nov-11 Apr-13 Aug-14 Jan-16 Outlook

 Brazil hard currency sovereign bonds Source: Bloomberg, January 7, 2016 Despite recent headlines, we continue to believe that  Brazil local bonds much of the negative news is reflected in attractive valuations. Brazil's sovereign spreads and credit default According to the central bank’s weekly survey of market spreads, for example, are now trading in line with B- analysts, inflation expectations for year end 2016 have rated countries. been steadily increasing in the past 3-4 months and are now close to the 6.5% upper limit of the inflation target. Meanwhile, looking at the fundamentals, it is important Inflation expectations in Brazil have been rising despite to remember that Brazil's floating currency and ample the deep economic contraction in 2015 and the liquidity buffers allow it to smooth the overall economic anticipation of further declines in growth in 2016. This adjustment and buy time for the implementation of shift in inflation expectations largely reflects the pass- reforms. through impact of weaker currency on import prices, the The floating exchange rate helps absorb the economic impact of indexation to inflation of government benefits shock through the positive impact of a weaker currency and a potential further increase in administered prices on the trade component of the economy. and taxes given the challenging fiscal outlook. As for liquidity buffers, first, Brazil's reserves of $370 In December, Brazil's central bank released its quarterly billion are 19.5% of GDP and, according to IMF’s inflation report, confirming that monetary policy must composite reserve adequacy measure, are at 190% of remain vigilant to ensure that short-term pressures do the level that would be considered optimal. The most not impact long-term inflation; the report also changed obvious role of reserves is to provide a cushion that its statement regarding inflation expectations, could potentially be used to smooth out excess currency acknowledging that expectations for 2016 have been volatility. The second buffer is the cash account of the rising since August. In light of the increasing inflation Treasury at the central bank, which is about 16% of expectations and a hawkish tone from the central bank, GDP. This cash is available to the government in the we think the central bank is likely to increase rates in event that funding in the local markets should become 2016. However, we believe the amount of tightening prohibitively expensive. And finally, from the perspective priced in by the market is excessive. Currently, the Brazilian local bond market is pricing in almost five 50- of the hard currency investor, we must remember that 1 less than 5% of Brazil’s government debt is basis-point hikes for 2016 with at least four of these denominated in foreign currency. hikes taking place consecutively, leading to the Selic rate of 16.25% by mid-2016 and to 16.75% by year-end. The combination of attractive valuations and our This level of nominal rates would lead to a 10% real rate confidence in Brazil's capacity to pay back its external after subtracting an expected inflation of 6.8% for 2016. obligations given ample liquidity buffers, a floating currency regime and the currency composition of its obligations, continues to support our favorable view on Brazil's hard currency bonds. 1 Source: Bloomberg, January 6, 2016.

Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (France) acceptsNon no contractual liability for any document failure to meet such forecast, projection or target. 2

We believe this represents a very aggressive scenario, Figure 2 illustrates how the strengthening of external given that the average historical real rate in Brazil is indicators, such as the trade balance and currency around 6%. It was 7.5% from 2004-2010 when the action, is an important part of the macroeconomic central bank pursued an aggressive monetary policy adjustment and signals that the currency has become with high level of rates in order to combat inflation and to attractively valued. We continue to favor the Brazilian establish credibility with market participants. Given the real due to fundamental indicators, but also due to the recent stabilization in currency and given that inflation is attractive carry of over 16% on the currency and skewed expected to decline next year from double digits in 2015 technical positioning (elevated short positions by to closer to the upper band of the target in 2016, modest speculators) vulnerable to sudden reversals. tightening will likely be sufficient in our view. We believe Figure 2: Brazil's trade balance that the central bank is will probably implement a more measured tightening in 2016 provided the currency remains stable, with potentially two more hikes of 50 25 12 month trade balance 4.5 basis points as a base scenario. Then we think it will Bazilian Real FX spot rate 4.0 remain on hold at 15.25% to ensure inflationary 20 3.5 pressures are firmly anchored. Based on this analysis, we are currently overweight duration in our EM local 15 3.0 portfolios. 2.5 10

 Currency 2.0

Rate Spot FX A number of Brazil’s recent domestic economic 5 1.5 indicators have been disappointing, particularly related 1.0 to domestic consumption. However the improvement in 0 Trade Balance (USD billion) (USD Balance Trade 0.5 the external dynamics, including the trade balance and shrinking current account deficit, have been bright spots. -5 0.0 The trade balance data continue to surpass expectations Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 as the weaker currency is leading to a sharp contraction in imports. Source: Bloomberg, January 7, 2016

Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (France) accepts no liability for any failure to meet such forecast, projection or target.

About the Author Olga Yangol, CFA, FRM, CAIA, Vice President, Portfolio Manager Emerging Markets Debt Olga is a portfolio manager on the Global Emerging Markets Debt capabilities. Prior to joining HSBC, Olga was responsible for large corporate relationships at PIMCO, representing USD15 billion in AUM across multiple asset classes, and advised institutional clients on emerging markets, asset allocation and hedge fund investments. Prior to this, Olga was an executive director at CIBC World Markets, specializing in interest rate, foreign exchange and equity derivatives structuring, and working with corporate and private equity clients. She holds an MBA from MIT Sloan School of Management and she received her undergraduate degree in Information Systems and Finance from McGill University. Olga is a CFA Charterholder, and holds Financial Risk Manager and Chartered Alternative Investment Analyst designations. She is fluent in Russian and proficient in French

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Important Information This document is distributed by HSBC Global Asset Management (France) and is only intended for professional investors as defined by MIFID. The information contained herein is subject to change without notice. All non-authorised reproduction or use of this commentary and analysis will be the responsibility of the user and will be likely to lead to legal proceedings. This document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any financial instrument in any jurisdiction in which such an offer is not lawful. The commentary and analysis presented in this document reflect the opinion of HSBC Global Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from HSBC Global Asset Management. Consequently, HSBC Global Asset Management will not be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. 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. All data from HSBC Global Asset Management unless otherwise specified. Any third party information has been obtained from sources we believe to be reliable, but which we have not independently verified. Investments in emerging markets have by nature higher risk and are potentially more volatile than those made in developed countries. Where overseas investments are held, the rate of exchange of the currency may cause the value to go down as well as up. As interest rates rise debt securities will fall in value. The value of debt securities is inversely proportional to interest rate movements. Issuers of debt securities may fail to meet their regular interest and/or capital repayment obligations. All credit instruments therefore have potential for default. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Important information for Swiss investors: This Marketing Material is intended exclusively towards qualified investors in the meaning of Art. 10 para 3, 3bis and 3ter of the Federal Collective Investment Schemes Act (CISA). HSBC Global Asset Management is the brand name for the asset management business of HSBC Group. The above document has been produced by HSBC Global Asset Management (France) and has been approved for distribution/issue by the following entities: HSBC Global Asset Management (France) - 421 345 489 RCS Nanterre. Portfolio management company authorised by the French regulatory authority AMF (no. GP99026) with capital of 8.050.320 euros. Postal address: 75419 Paris cedex 08, France. Offices: Immeuble Ile de France - 4 place de la Pyramide - La Défense 9 - 92800 Puteaux – France. Website: www.assetmanagement.hsbc.com/fr HSBC Global Asset Management (Switzerland) Limited - Bederstrasse 49, P.O. Box, CH-8027 Zurich, Switzerland. Website: www.assetmanagement.hsbc.com/ch Non-contractual document updated in January 2016. Copyright: All rights reserved © HSBC Global Asset Management (France), 2016 AMFR_Ext_2016_18

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