BIL macro’s outlook for 2016 · Financial market news Winter 2015/2016 Concerns about China’s economic growth are omnipresent: this time the focus was on the Chinese currency,

BIL BOARDfinancial market news 07/12

Financial market news Winter 2015/2016

Concerns about China’s economic growth are omnipresent: this time the focus was on the Chinese currency, the renminbi (CNY), as currency is a barometer of a country’s economic health. A devaluation will increase pressure on EM currencies, commodity prices and related financial asset valuations, which in turn affect inflation dynamics and financial stability.

Since the currency policy change in August 2015, CNY has broadly traded in a "stable" Nominal Effective Exchange Rate (NEER) range. China’s central bank (PBOC) abandoned the currency peg against the USD in favour of a broader basket of currencies including the USD, JPY and the EUR. The change was meant to make it easier for China to devalue the CNY without being accused of hurting the competitiveness of Chinese products against US products.

The recent weakness isn’t only of concern because of what it may or may not imply about the health of the world’s second-largest economy. It is also worrisome because it may be self-reinforcing and trigger a vicious circle of currency depreciation: CNY weakness leads

to declines in the currencies of China’s trading partners and a stronger USD. Both cause the CNY to weaken further. Any self-reinforcing system is inherently unstable – just ask any bank that tried to raise capital in 2008.

Although the renminbi may regain short-term stability, it is likely to continue to trend weaker against the USD (the investment bank Goldman Sachs expects a 15% correction), as the authorities focus on their newly introduced NEER index (CFETS). With over 3 trillion in FX reserves, China clearly has the means to stabilise its economy and the FX rate. Nevertheless, uncertainty is likely to keep China in the spotlight as a pivotal driver of global macro developments during 2016.

Global worries were also fuelled by the ongoing slide in oil prices (Brent crude trading at USD 31.5 at the time of writing). Let us be clear: oil is not a proxy for global economic health. If the collapse in oil prices really were the result of sustained soft demand then it should signal a deep recession given that oil is down 70% from 18 months ago, which is something we consider highly unlikely.

Dear Madam, Dear Sir,Dear Investor,

What a horrid start to the New Year for investors! Risk assets have been hammered by fears about global growth. A further slump in oil prices and Chinese authorities’ meddling with the renminbi have caused great concern. Even though the return trajectory is expected to flatten in 2016, we are convinced that there are plenty of opportunities and that fundamentals do not justify the sell-off. This is not a rerun of 2008, as companies in Europe, the US and Japan see earnings growth, albeit only moderately in the US. Valuations are not sky high either. Hardly an outlook worthy of the worst-ever start to a year for the S&P500.

We are here to assist you with your investments. We draw on our impartial expertise to offer you transparent advice and investment services. Please do not hesitate to contact your BIL adviser or any of our investment management experts for assistance.

Yves KuhnChief Investment Officer

A Chinese New YearGlobal stock markets are off to their worst weekly start in at least 27 years, driven by the same oil- and China-driven spectres that were haunting investors in 2015: fears that the global economy is sliding into recession. The US equity benchmark fell 6 percent in the first week.

Yves KuhnChief Inves tment Officer

Olivier Goemans Head of Portfolio Management

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BIL macro’s outlook for 2016

We view the collapse in oil prices as the direct result of ramped-up production at a time when demand growth has been low. Saudi Arabia has made it clear that it is fighting a price war, and it appears determined to keep its production levels and hence market share steady.

So far, higher-cost oil producers have refused to lie down but a sustained period of low prices would eventually force a cut in production. With regard to oil, we find it worrying that a sharp rise in tensions in the Middle East – historically always able to give impetus for oil to rally (according to JP Morgan) – has not prevented oil from continuing its decline. Many observers are now predicting further weakness in oil prices this year.

We should think of low oil prices as being a boost to economic growth and subsequently driving up equities. However, the boost to growth we had expected last year did not materialise. Hence market participants appear more sensitive to disruptions in the oil industry than the boost to consumption that ought to follow from a collapse in oil prices.

Fears about global growth are continuing to shake the markets. The turmoil experienced at the start of the year is evidence of just how fearful investors have become: there is a widespread fear that the financial system is broken and recent monetary policy has papered over the cracks of global economic imbalances. The Chinese renminbi exchange rate and the oil price – both symptoms of these imbalances – need to find their balance in order to allay investors’ concerns. It is entirely possible that we will see crude prices rising some 20% to 30% from their current levels (USD 30) until year-end and we cannot rule out a measured devaluation of the Chinese renminbi against the USD.

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US GDP growth, %, 1Y, MA Oil price, y/y, %, 18m lag, inverted

Oil price and US GDP

Source: Thomson Reuters Datastream, BIL

Upside scenario- US and euro zone growth surprise positively- Fed moves gradually- Limited CNY devaluation

Base case- Euro zone’s GDP growth will be 1.7%- US corporate margins continue to weaken- CNY will devalue (limited to 5% over 12 months)

Downside scenario- US enters a recession- There will be a global earnings fall of 20%- Valuation multiples will compress

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The yuan is adjusted to seven against the dollar

to stimulate exports“

The magnitude of the sell-off outside of China appears exaggerated relative to fundamentals. We expect average growth to remain stable yet unspectacular in the US, Europe and Asia. The fourth quarter 2015 in particular will prove weak for the US economy. Meanwhile, the outlook for emerging markets remains challenging, but 2016 will see less deep recessions in Russia and Brazil. As for China, while the gradual deceleration continues, fears of a sharp slowdown are overdone.

As in 2014, we are witnessing many consensus views among market participants. Rather than burdening our readers with these views (see BIL’s macro outlook dated 27 October 2015), we decided to confront our readers with Byron Wien’s (Vice Chairman of Multi-Asset Investing at Blackstone) top 10 surprises for 2016. This is the 31st year that Byron has given his views on a number of economic, financial market and political surprises for the coming year. Byron defines a “surprise” as an event to which the average investor would only assign a one-out-of-three chance of taking place but which Byron believes is “probable,” i.e. having a better than 50% likelihood of happening.

1. Riding on the coattails of Hillary Clinton, the winner of the presidential race against Ted Cruz, the Democrats gain control of the Senate in November. The extreme positions of the Republican presidential candidate on key issues are cited as factors contributing to this outcome.

2. The United States equity market has a poor year. Stocks suffer from weak earnings, margin pressure (higher wages and no pricing power) and a price/earnings ratio contraction. Investors keeping large cash balances due to global instability is another reason for the disappointing performance.

3. After the December rate increase, the Federal Reserve raises short-term interest rates by 25 basis points only once during 2016, despite having indicated on 16 December that they would do more. A weak economy, poor corporate performance and struggling emerging markets are behind the cautious policy. Reversing course and actually reducing rates is actively considered later in the year. Real gross domestic product in the US is below 2% for 2016.

4. The weak American economy and the soft equity market cause overseas investors to reduce their holdings of American stocks. An uncertain policy agenda as a result of a heated presidential campaign further confuses the outlook. The dollar declines to 1.20 against the euro.

5. China barely avoids a hard landing and its soft economy fails to produce enough new jobs to satisfy its young people. Chinese banks get in trouble because of non-performing loans. Debt to GDP is now 250%. Growth drops below 5% even though retail and auto sales are good and industrial production is up. The yuan is adjusted to seven against the dollar to stimulate exports.

6. The refugee crisis proves divisive for the European Union and breaking it up is again on the table. The political shift toward the nationalist policies of the extreme right is behind the change in mood. No decision is made, but the long-term outlook for the euro and its supporters darkens.

7. Oil languishes in the USD 30s. Slow growth around the world is the major factor, but additional production from Iran and the unwillingness of Saudi Arabia to limit shipments also play a role. Diminished exploration and development may result in higher prices at some point, but supply/demand strains do not appear in 2016.

8. High-end residential real estate in New York and London has a sharp downturn. Russian and Chinese buyers disappear from the market in both places. Low oil prices cause caution among Middle East buyers. Many expensive condominiums remain unsold, putting developers under financial stress.

9. The soft US economy and the weakness in the equity market keep the yield on the 10-year US Treasury below 2.5%. Investors continue to show a preference for bonds as a safe haven.

10. Burdened by heavy debt and weak demand, global growth falls to 2%. Softer GNP in the United States as well as China and other emerging markets is behind the weaker than expected performance.

Please note that the above are Byron Wien’s views and do not necessarily correspond with BIL’s views.

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“Our

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European equities

Global growth threats and new lows on commodity prices

Source: Datastream

We believe emerging market concerns will continue to hit the headlines, weighing on equity market sentiment and leading to consensus earnings downgrades as European companies depend strongly on their exports to these regions. Risks from China/EM are serious, and UBS estimates that a Chinese “hard landing” (i.e. Chinese GDP growth at or below 4%) would drive 2016 European earnings growth to between -5% and -8% versus the +6% growth analysts are currently forecasting. This is clearly a worst-case scenario (we do not anticipate that this will happen), and is also sector specific. We estimate that the semiconductor, metals and

mining, capital goods, chemicals, energy and German auto manufacturers would bear the brunt of any prolonged slowdown in China.

On the back of the recent sell-off, European valuations have come down to 14.2x 12-month-forward price/earnings ratio, a 7% discount to the US. Whilst the valuation gap appears to be in line with history, European earnings have broadly stagnated since the end of the financial crisis and are still at depressed levels, leaving more long-term upside should the European economic climate improve.

European equities had a volatile fourth quarter and a dreadful start to the year. It is not surprising to see that sectors that are relatively insulated from macro shocks tended to outperform the market. On the other hand, energy and materials suffered significantly from the new lows in commodity prices seen during this quarter and in early 2016.

We estimate that European earnings will grow by a decent 6% in 2016, with some downside pressure from specific sectors: the earnings drag from the materials and energy sectors appears limited on consensus numbers and is potentially underestimated at 0% and -3% growth, respectively. Current spot oil prices are some 40-45% below the 2015 average, whilst metal prices are 20% lower, making the current consensus expectation hard to achieve if commodities do not rebound strongly. It is true that the companies’ response has been quick and harsh, cutting operating expenses and capital expenditure drastically (capital expenditure within the oil majors is expected to be cut by 19% in 2016, after a 14% cut in 2015; operating expenditure declined 10-15% in 2015 and is expected to decline another 10% in 2016). Dividend yields are attractive and companies have a strong track record, but over the past four quarters, European

majors have generated operating cash flows of USD 86bn and spent USD 103bn of capital expenditure, leaving a shortfall of USD 17bn before even paying dividends of USD 32bn. We believe defending cash generation is a positive step and that the continued underperformance offers attractive valuations (price-to-book ratio is only 0.8x for the energy sector; 1.3x for the materials sector), but without a turnaround in sentiment regarding Chinese growth prospects and a stabilisation of the demand/production gap, it is still too early to overweight commodities-exposed sectors.

Instead, our preference is for defensive, domestically-exposed sectors as a way to be relatively insulated from the emerging markets’ tumultuous news flow. We are positive on selected peripheral retail-oriented banks with strong capital ratios as we believe the sector is set to benefit from a rising return on equity

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Consensus earnings growth for 2016 (%) - Europe

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US equities

Heading for the worst results season since the third quarter 2009?

Buybacks and M&A seem to continue apace despite gradually higher financing costs and could provide structural support for US valuations. With the US equities trading at a 15.3x 12-month-forward price/earnings ratio, US companies need to provide reassurance regarding their growth profile – they could do so by providing positive 2016 guidance during the next results season.

Our preferred sectors in the US are information technology and healthcare. Information Technology (IT) offers good growth, very robust balance sheets (the sector is the only one to post a net cash position on aggregate) and low payout ratios mean the sector could return more cash

to shareholders. Valuations are not stretched as the sector is one of the most inexpensive sectors versus history, even adjusting for the tech bubble on a relative price/earnings ratio basis. Healthcare is also relatively attractive in terms of growth potential (it is expected to be the second fastest-growing sector in 2016) and whilst US drug pricing is likely to be a key theme in a US election year, pricing changes are unlikely – we would see any weakness as an opportunity to buy the sector. Meanwhile, balance sheets are healthy with a net debt/EBITDA ratio of 1.2x, placing the sector in a strong position to give back cash to shareholders and seek external growth through acquisitions.

Source: Datastream

through a reduction in non-performing loan provisions and trades on a price/book ratio of only 0.7x. These valuations are the lowest seen since mid-2013, whilst their return on equity converges towards 10%. We cannot ignore the regulation and litigation risks, but the two key factors behind provisioning – real estate and unemployment – could positively surprise. We also like the more defensive telecommunication services sector for its European exposure and ongoing market repair (as seen in France, the UK and Spain), which should support positive earnings momentum. Solid balance sheets and superior cash generation should support M&A activity and increasing dividends (the dividend yield of the sector is 4.6%).

2015 Fixed income in review: not a straight line

2015 was a challenging year in which to achieve decent returns on global financial markets. This was particularly true in the fixed income universe. Most sub-categories tracked by Bank of America Merrill Lynch bond market indices ended up within the -5% to +5% total return range last year, whereas in 2014 they returned +5% to +15%.

Inside the European government bond universe, spread compression was led by Italy. Greece was by far the star performer, with total returns of more than 20% at the end of the period. But again, the bumps in the road, with drawdowns of more than 40% during summer ruled it out for most investors.

With a substantial proportion of the European government bond market trading with a negative yield, it seems preposterous to invest in these assets unless you believe that Europe is entering an economic depression or deflation.

The US corporates are expected to post some mid-single-digit earnings growth for 2016, in line with Europe, but that appears optimistic (note that the materials sector is seen to be growing at 8%). The EUR/USD rate headwinds are abating, but wage pressure, increasing financing costs and falling corporate margins should provide some downward pressure. In addition, the fourth quarter 2015 results season should highlight the difficulties seen by US companies: fourth quarter revenues for the S&P500 are expected to be down 3% and earnings down 4% – this could potentially be the worst quarter since the third quarter 2009.

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As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of January 15, 2016. This publication is based on data available to the public and upon information that is considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the accuracy or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information expressed herein. This document has been prepared only for information purposes and does not constitute an offer or invitation to make investments. It is up to investors themselves to consider whether the information contained herein is appropriate to their needs and objectives or to seek advice before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability whatsoever for any investment decisions of whatever nature by the user of this publication, which are in any way based on this publication, nor for any loss or damage arising from any use of this publication or its content. This publication may not be copied or duplicated in any form whatsoever or redistributed without the prior written consent of Banque Internationale à Luxembourg.

This publication has been prepared by: Banque Internationale à Luxembourg ı 69, route d’Esch ı L-2953 Luxembourg ı RCS Luxembourg B-6307 ı Tel. +352 4590 6699 ı www.bil.com

Conclusions

Although we might see a relief rally in the next six weeks (the date of writing being mid-January 2016), we prefer to be cautious and position ourselves defensively in the short term. We are increasing cash so that we have the opportunity to harness volatility to our advantage. Markets are currently driven by macro news (opaque by nature) and panic-selling remains on the cards (as was mentioned in the November edition of BILBoard).

- Overall, we see a flattening return trajectory with increasing risks; however, on a 12-month basis, equities still offer the best return prospects compared to other asset classes. We see little scope for further multiple expansions in 2016 and expect only moderate earnings growth.

- We prefer Europe, as cyclical growth and accommodative policy support earnings growth. We have become more cautious on Japan as its economy is closely linked to the Chinese economy.

- High US valuations reduce the buffer for shocks and increase risk of drawdowns in particular.

With regards to fixed income, inflation is globally not an enemy to investors in the short term. However, US investors are pricing in too little inflation compared with the underlying wage and price dynamics. In 2016, we expect:

- An increase in the market pricing of medium- and long-term inflation, particularly in the US; and US Treasuries to underperform Bunds. We remain bearish on duration.

- We remain directionally constructive and expect credit spreads will move tighter on what we think is a low level of US recession risk. We view lower-for-longer oil prices as the top risk for credit, particularly for high yield.

With regards to emerging markets and commodities, we expect that both asset classes will find a bottom during 2016. In the short term, volatility will put off any investors, but over a longer horizon, we remain more optimistic and see more funds allocated to these asset classes by 2016 year-end.

Yves KuhnChief Investment Officer

In the US, government bond prospects will largely depend on how far inflation rises and whether they will even exceed the Federal Reserve’s medium-term target of 2%.

If you strip out the base effects caused by lower oil prices, inflation will be driven by labour market conditions and in particular wage growth. Economic theory tells us that the current low level of unemployment will act as some kind of bottleneck, creating pressure for higher wages. Under these conditions, at least, labour market dynamics clearly gave the Federal Reserve a “carte blanche” to hike up interest rates last December.

We are focusing on determining the final path of the Fed Funds rate in the current cycle. Weakness in the global economy and the poor job done by central banks up to now in meeting their inflation targets is supporting the expectation that this time should be different. This means that Fed tightening will likely be unusually slow, cautious and well communicated to markets. If this is the case, then the reaction from the bond markets is likely to be relatively benign.

The continued debate on the direction of US Treasury markets is centred on the liquidation of emerging economies and their reserve currencies and bonds. Since these reserves are typically held in government bonds, massive selling pressures could be a risk. Nevertheless, a powerful opposing force is also at work, with US Treasuries being quoted as a carry trade versus developed market government bonds, mostly in Europe. The balance between those driving forces is considered critical to the speed of the US Treasury sell-off and US dollar strength.

In an environment where yield enhancement and yield hunting prevail, corporate bonds, especially EUR-denominated issues, should still be preferred. We expect credit spreads will move tighter on what we think is a low level of US recession risk. We view lower-for-longer oil prices as the top risk for US credit, particularly for high yield. We are clearly more nervous about the credit quality trend in US-based corporates.

In the emerging fixed income market, the build-up of private sector debt (mostly in USD) in association with risks of further capital flight is a significant development even if valuations are appealing.

A flattening return trajectory

with increasing risks