Market Rebounds, Problems Remain

Investment Barometer

18 August 2016

1

2

After a very nervous June, the last month brought some respite to investors with most equity indices

recording significant rebounds and bondholders in consistently good mood. Looking at market behavior, one

could be forgiven for thinking that Brexit is already behind us. The global equity index gained 4.1% in July,

with Japanese (+6.2%) and emerging market indices (Latin America +5.4%, Chinese Hang Seng +5.3%) as

leaders of the month. Risk appetite was also evident in the market for riskier debt such as high yield bonds

or emerging market debt. In this environment, safe government debt only recorded slight gains. Investors

could be quite disappointed by the performance of crude oil, which experienced a deep plunge (-13.2%).

The past month was one of rebounds after the declines that followed the announcement of the UK referendum result. The market reaction was quite dynamic and could look promising, but in our opinion the issue of Brexit will resurface repeatedly and could spoil the investors’ mood. In our opinion there is a risk that the market has not yet fully priced in the deteriorating economic and political outlook for Europe. We see further risks on the horizon, especially in the Italian banking system and on the political scene in Italy.

In Poland, the most important event of the past weeks for the financial market was the announcement of a new idea aimed at resolving the Swiss franc loan issue by the Chancellery of the President. The proposed Act turned out to be softer on banks than the original draft, which was welcomed enthusiastically by investors. We should, however, wait for the government’s and Parliament’s opinion on the matter, because there is still a risk that amendments will be introduced that are less favorable to the financial sector.

We maintain our neutral view on equities vs. bonds. In our opinion the current reward to risk ratio is not conducive to an increased exposure to equities. We suggest that investors keep equities in their portfolios at the strategic, long-term allocation level.

In the longer term, we will be looking for a good moment to gain more exposure to the stock market again and will treat any strong market overreactions as opportunities to buy.

On the other hand, we maintain our positive outlook on high yield bonds, since credit spreads are still at attractive levels in this segment. In our opinion, this asset class currently exhibits the most favorable reward-to-risk ratio.

Source: Bloomberg, Citi Handlowy

75

80

85

90

95

100

105

Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16

WIG30 S&P500 Eurostoxx50

Source: Bloomberg, Citi Handlowy

99

100

101

102

103

104

105

106

107

108

Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16

Polish bonds U.S. Bonds German bonds

Grzegorz Jałtuszyk, CFA

Investment Advisor

Karol Ciuk

Investment Advisor

Jakub Wojciechowski, CFA

Securities Broker

Contributing Authors:

Bartłomiej Grelewicz

Paweł Chylewski

Maciej Pietraszkiewicz

Dariusz Zalewski

Michał Wasilewski

3

4

Poland – we maintain a neutral outlook

For the Polish stock market, July was a good month. This was particularly noticeable in the mid-cap

segment, which recovered the ground lost in the first half of the year. In the Treasury bond market,

we have had a good time and positive news from rating agencies. Following the improvement in

sentiment, we maintain our neutral outlook on the Polish equity and bond markets.

For the stock market, the last few days of the

month are of key importance because this is when

earnings are announced. Among the blue chips, of

special interest are the results in the banking

sector, which remains the focus of many investors’

attention. Most institutions are reporting earnings

that are consistent with market expectations or

slightly better. In this context, however, it should

be mentioned that the so-called market consensus

is pretty low. According to the figures published by

the Polish Financial Supervision Authority, from

January to May profits in the sector decreased by

18% compared to the same period of 2015, which

was mainly caused by the introduction of tax on

bank assets in February. Taking June into

account, the data will probably be much better and

the sector will benefit from the one-off injection of

funds by Visa, which significantly improved the

banks’ results in Q2. However, if the profits were

adjusted for the transaction with the card

organization, we would still see a double-digit

decline. Issues concerning Swiss franc loans also

remain of key importance to the sector. In early

August, we learned the President’s new idea, and

this proved to be much less far-reaching than the

original draft, which assumed a forced conversion

of loans at a cost of up to PLN 60 billion for the

sector in the worst-case scenario. As a result, the

prices of shares in banks that are exposed to

Swiss franc loans rose by double digits. Why the

optimism? The new solution provides for a two-

stage process. In the first stage, which will be

regulated by the Act, the banks will be obliged to

return so-called currency spreads. The

Chancellery of the President estimates that the

August is a crucial month from the

point of view of financial result

publication.

Performance of individual sectors year to date

Source: Bloomberg, Citi Handlowy

-30%

-20%

-10%

0%

10%

20%

30%

40%

2015-12-30 2016-01-30 2016-02-29 2016-03-31 2016-04-30 2016-05-31 2016-06-30

WIG-banks WIG-construction WIG-chemicals

WIG-developers WIG-energy WIG-IT

WIG-media WIG-fuels WIG-foodstuffs

WIG-commodities WIG-telecommunications

5

costs will amount to PLN 4 billion, although some

market analysts think that they could be even

twice as high. In the next stage, key measures are

to be taken by the supervisor (the Polish Financial

Supervisory Authority) and the banks should

voluntarily offer loan conversion on favorable

terms to their customers. This process is meant to

accelerate the imposition of more stringent capital

requirements on individual categories of foreign

currency loans. The additional requirements are to

be sufficiently burdensome that the institutions will

find it more acceptable to convert the loans than

to carry them as assets on their balance sheets.

Despite the market’s almost euphoric reaction, it is

worth noting that the costs will limit the potential

for the dividends paid by the sector. The form that

the entire process of raising capital requirements

will take in the future is also unclear. The investors

have certainly breathed a sigh of relief, however,

because the new project does not undermine the

stability of the financial sector as was the case

with the President’s original proposal. As concerns

the stock market, in the coming weeks investors

will continue to focus primarily on the companies’

financial results. At the moment, it appears,

however, that the risks associated with the

liquidation of open-end pension funds and with

Swiss franc loans and their negative impact on the

market are slightly subsiding – although, as we

have already mentioned, the recent signals do not

mean that all uncertainty has been dispelled. In

connection with this, and also with the fact that the

largest sectors have reported deteriorating

financial results (adjusted for non-recurring

events), we maintain our neutral outlook on the

broad stock market in Poland.

From the point of view of the debt market, the

month was fairly quiet. The beginning of August

was somewhat more interesting, bringing a further

increase in domestic debt prices with yields falling

below 2.8% and reaching the lowest level year to

date. We also continue to watch the decisions

made by the rating agencies. In July, we got an

update from Fitch, which (as expected) left

Poland’s rating unchanged and maintained a

“stable” outlook (as against our and the market’s

expectations, which assumed that the outlook

would be downgraded to “negative”). Thus the risk

of further downgrades in domestic debt rating has

decreased recently.

It is also worth mentioning that in the first two

months of the year, foreign investors limited their

exposure to the domestic debt market, but their

Holdings of domestic bonds by type of investor (PLN billion)

Source: Ministry of Finance, Citi Handlowy

0

50

100

150

200

250

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Banks Foreign investors Insurance companies

Pension funds Investment funds Natural persons

Non-financial corporations Other entities

6

portfolios remained stable in the subsequent

months. In June, foreign investors increased their

debt portfolios by PLN 4 billion, and their share in

the domestic debt market rose for the first time

since October 2015 to reach 34.4%. The buyers

included foreign banks and were dominated by

investors from Austria, Japan and Luxembourg.

According to a July statement by representatives

of the Ministry of Finance, the foreign investors’

exposure has most probably decreased, but this

was mainly due to a large pool of bonds that

matured; at the same time, however, investors

added to their medium- and long-term bond

portfolios. We believe that growing interest from

foreign investors is the main reason for the good

performance of the Polish debt market, which still

forms an important part of our portfolios (despite

the neutral outlook). We believe that this is the

right amount of exposure under current market

conditions. In addition, within the debt portion we

supplement our portfolios with developing country

bonds and high yield bonds, which we discuss in

the section devoted to emerging markets.

Summing up, July and early August were a

relatively good period for the domestic stock and

bond markets. In the investors’ view, some of the

risk in the domestic market has subsided recently

(pension funds, Swiss franc loans, rating

agencies). The improved sentiment around

emerging markets certainly provided a foundation

for growth in Poland as well. We believe that it is

still too early to state unequivocally that this is the

beginning of a long-term trend, because in the

case of the broad stock market there are no signs

of an increase in earnings (e.g. from the financial

sector, which accounts for the greatest share of

the domestic stock market). We are, however,

keeping a close look on the attractiveness of our

market compared to other global stock markets

and maintain a neutral outlook on both the debt

and equity sides.

7

U.S. – mixed data did not prevent the S&P 500 from setting new highs

Very solid labor market data have erased the last month’s negative reading, showing the strength

of the U.S. economy. The Fed remains dovish and continues to postpone another interest rate rise.

S&P 500 is posting new historical highs, and the investors’ attention – as usual during this period –

is focused on the ongoing Q2 results season. We maintain a neutral outlook on the U.S. stock

market.

In July, there was a strong growth impulse arising

from technical analysis. The S&P 500 broke out

upwards from the two-year-long broad

consolidation, beating its upper limit at 2,150

points. This development confirms the ongoing bull

market in the U.S. and should contribute to a more

permanent northward movement of the indices.

Owing to the importance of the U.S. market, this

upward breakout also provided strong support to

global equity markets.

Regarding fundamentals, the investors’ attention is

currently focused on the starting Q2 2016 results

season. Only 25% of the companies included in the

S&P 500 have reported their earnings so far, but

positive surprises in this small group have already

led analysts to revise their forecasts. At the

beginning of the season, the EPS (earnings per

share) figure was expected to decline by 5.5%, and

now analysts assume that it will only be reduced by

3.7%. We will attentively monitor the figures being

reported and will, as usual, sum up the entire

quarter after the results season. Valuations in the

U.S. market remain demanding with the current

price/earnings ratio at 17, i.e. still above both its

10-year and 5-year averages. It should be noted,

however, that the market is “buying the future”,

which means that the last year, which was hard for

corporate earnings, no longer drags index

valuations so much. If earnings per share increase

significantly in the future, the P/E ratio may drop,

resulting in more attractive company valuations

from the fundamental point of view. Analysts see a

good chance of an improvement in earnings in

2017 and forecast the profits of S&P 500

companies to grow by 13%. A rebound in the

results of companies from the energy sector should

significantly contribute to this scenario, although

these profits are dependent on rising oil prices,

which are not a foregone conclusion. The Chart on

the next page shows the assumptions behind the

market consensus for earnings growth in individual

sectors in 2017.

From the macroeconomic side, very good data

were reported from the labor market. In June, the

number of jobs increased by 287,000 while

analysts expected a growth of only around

175,000. This demonstrates that the U.S. labor

market remains strong and the figures from the

S&P 500 in the 3-year horizon with the breakout from the consolidation at the level of 1,830–2,150 points

marked

Source: Bloomberg, Citi Handlowy

1600

1700

1800

1900

2000

2100

2200

Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

8

previous month were not the start of a series of

negative surprises. We also learned the GDP

reading for Q2, which turned out to be worse than

expected – the U.S. economy grew by 1.2%

(annualized) during this period, while the expected

rate was 2.5%. The softer data resulted mainly

from a decline in private investment, since

companies are reluctant to invest money in new

projects. On the other hand, the condition of the

American consumer appears robust. Households

increased their spending by 4.2% and this has

been the highest reading since 2014.

The July meeting of the Fed did not bring any

surprises. Interest rates in the U.S. remain

unchanged, and despite much improved data from

the labor market the message from the Federal

Reserve was not overly hawkish. The statements

suggested that rates could be raised before the

end of the year and that short-term risks to the

economy have receded significantly. The market

reacted to the meeting with a slight increase in

interest rate futures, implying that the probability of

a rate increase by December 2016 rose from 47%

to 53%. The slight depreciation of the U.S. dollar

Forecast 2017 profit growth by sector

Source: FactSet, Citi Handlowy

0%

25%

50%

75%

100%

125%

150%

175%

200%

225%D

iscre

tiona

ry g

ood

s

Tele

com

mun

ications

He

althcare

Sta

ple

good

s

Utilit

ies

Industr

y IT

Fin

ance

Ma

teri

als

Energ

y

S&

P 5

00

July

June

Initial public offerings vs. the issuance of investment-grade bonds (USD million)

Source: Citi Research, Dealogic, Citi Handlowy

0

10 000

20 000

30 000

40 000

50 000

60 000

70 000

80 000

90 000

100 000

200 000

400 000

600 000

800 000

1 000 000

1 200 000

1 400 000

1 600 000

2002 2004 2006 2008 2010 2012 2014 2016

Bond issues (12-month moving average, left axis)

Share issues (12-month moving average, right axis)

9

on the next day could suggest that the market had

expected a more hawkish tone. According to the

Citi economists’ baseline scenario, we will only see

a single interest rate rise this year, and this only in

December. The persistently low cost of borrowed

money is persuading enterprises to change the

composition of the capital they raise. Recently, we

have seen a slew of investment-grade bond issues

while the value of capital raised on the stock

market (the volumes of new share issues) has

been falling.

Summing up, we maintain a neutral outlook on the

U.S. stock market. On the one hand, the market is

not being supported by current valuations and

consensus earnings growth estimates may be

optimistic, but on the other hand the fact that

interest rate rises are being postponed and the

economic situation is improving should provide

support for U.S. indices. From the macroeconomic

point of view, we can see that the labor market

remains strong, and our economists expect the

U.S. economy to grow by 1.8% this year and

accelerate to 2% in 2017. We maintain our

exposure to speculative-grade corporate bonds,

since we believe that these provide an attractive

exposure to risk in the U.S. market.

10

Europe – no “stress”?

In the European equity markets, July brought a clear rebound, and many indices managed to

recover the ground lost after the announcement of the result of the UK referendum. In our opinion

there is a risk that the market has not yet fully priced in the deteriorating economic and political

outlook for Europe. We see further risks on the horizon, especially in the Italian banking system

and on the political scene in Italy. We maintain a neutral outlook on European equities and still see

value in high yield corporate bonds.

The performance of European financial markets in

recent weeks may be described as surprising. After

much turbulence and the sell-off of risky

instruments following the announcement of the

result of the UK referendum, the investors have

seemingly forgotten about that event. After

reaching local lows in the first week of July, the

markets became filled with considerable optimism,

which allowed many indices to make up for their

post-referendum losses. Throughout the last

month, European stock markets moved up by ca.

4% and the rebound was similar to the trends

observed throughout the world. The situation is

interesting insomuch that objectively speaking,

fundamentals in Europe have not improved since

before the referendum; quite on the contrary, there

is a new risk on the horizon in the form of the

unforeseeable consequences of Brexit.

The market, however, very often tends to “forget”

about such events (at least for some time) and

turns its attention to new factors that may be

crucial in the short term. This month, these

certainly included the results of so-called stress

tests at European banks, which were published on

29 July. Every two years, the European Banking

Authority (EBA) runs simulations that are meant to

verify the resilience of the banking system given

extraordinary shocks. This year, we learned the

results of such a review for 51 European Union

banks, of which 37 were eurozone ones. In its

negative scenario, the EBA assumed, inter alia, a

sharp decline in economic activity and sector

profitability, exacerbated debt problems in the

public and private sectors, the increase in global

risk premium with reduced liquidity in the markets,

and negative developments in the shadow banking

sector. The estimated impact of these

developments on economic prospects is shown in

the Table below.

GDP growth assumptions in stress test scenarios and Citi forecasts

2016 2017 2018

Eurozone

Baseline scenario 1.8% 1.9% 1.7%

Negative scenario -1.0% -1.3% 0.6%

Citi forecast 1.5% 1.1% 1.5%

Italy

Baseline scenario 1.5% 1.4% 1.7%

Negative scenario -0.4% -1.1% 0.0%

Citi forecast 0.7% 0.3% 0.4%

United Kingdom

Baseline scenario 2.4% 2.2% 1.2%

Negative scenario -2.2% -0.7% 1.6%

Citi forecast 1.7% 1.0% 1.6%

Source: EBA, ESRB, Citi Research, Citi Handlowy

11

The results of stress tests were interpreted as

positive, since all of the analyzed banks with the

exception of a single Italian one (whose problems

have been known for many months) were able to

maintain their capital at the required levels even in

the negative scenario. For the sector as a whole,

the simulation pointed to a decrease in the CET1

core capital ratio to 9.4%, but the improvement

compared to the previous stress tests was evident

as seen in the Chart above.

According to the EBA, “the result demonstrates the

resilience of the European banking sector in

general, thanks to a significant increase in

capitalization”, although as one EBA board

member pointed out, it is not yet a sign that the

sector is entirely healthy. What awaits the banks in

the coming months? The results of the EBA

simulation will serve as guidelines for individual

financial institutions, but no revolution is expected.

The focus will probably be again on the Italian

banks, which came out the worst in the tests and

we believe that the state’s involvement in support

for the Italian banking sector appears very likely.

Those banks that performed poorly in the stress

tests have already announced a blueprint for

private support for the sector amounting to 5 billion

euro as well as for reducing the portfolio of “bad”

loans by ca. 10 billion euro. This may be a step in

the right direction, although it appears that the

Italian banking sector requires assistance on a

much larger scale and developments in this area in

the coming months may prove one of the most

important topics for investors.

The banking sector is not the only flashpoint in the

8th largest economy in the world. It should be noted

that already in October, Italians will vote in a

constitutional referendum concerning the reform of

the upper house of Parliament. Currently, the

Italian Senate has the same political clout as the

lower house, and this has historically been an

obstacle to introducing reforms and led to a

situation where the Italians have changed their

government more than 60 times since WWII. This

obviously does not favor the pursuit of a stable

economic policy and the implementation of

ambitious reforms. The current Prime Minister

Matteo Renzi is aware of the problem and wants to

limit the Senate’s role, which is supposed to make

it more difficult for the upper house to block the

government’s ideas. To this end, the

aforementioned referendum will be held, which is

to give the government a mandate to carry out the

changes. If Renzi manages to persuade the

Italians to accept his vision, it could be a step

towards the stabilization of the country’s political

situation and potentially towards the introduction of

the long-announced reforms. The risk is that the

referendum, as in the UK, could turn into a vote of

confidence in the government and instead of

answering the specific question, citizens could

express their disapproval in many other areas.

Such a scenario would mean a serious risk of the

government collapsing and could precipitate chaos

in a major eurozone economy. Although this is not

our baseline scenario, the outcome of the UK

referendum tells us to be extremely cautious in this

case as well.

Our outlook on European equities remains neutral.

We treat the UK’s exit from the European Union as

an event of local significance, which should not

lead to an economic or banking crisis in the

eurozone. On the other hand, the vague and

unquantifiable consequences of such an important

event as Brexit prompt us to maintain a

conservative approach to European equities. We

see a risk that the market has not yet fully priced in

the deteriorating economic and political outlook for

Europe, and we also see further risks on the

horizon, especially in the Italian banking system

Core capital ratio in the European banking

sector. Starting and final values for the negative

stress test scenario

Source: EBA, Citi Research, Citi Handlowy

0%

2%

4%

6%

8%

10%

12%

14%

2011 2014 2016

Starting value Final value

12

and on the political scene in Italy. Therefore we

maintain a neutral outlook on Old Continent

equities going forward, which means that we

suggest that investors keep these stocks in their

portfolios at the strategic, long-term allocation

level. At the same time, we maintain exposure to

risk by investing in high yield bonds, which still

appear to provide a compelling alternative in

current market conditions. First of all, Brexit is an

event that is likely to pose risks to corporate profits,

but probably not to corporate solvency.

Additionally, in the corporate bond market in

Europe we still have a major player – the European

Central Bank, which purchases investment-grade

debt securities and some issues that can be

classified as high yield (due to differences in rating

methodology) each month. This appears to make

the risk of a negative scenario in this market lower

than in the case of stocks. We expect that the

period of heightened volatility in the markets for

risky assets in Europe has not ended yet, and thus

we are watching the situation closely and are ready

to take advantage of opportunities at times when

the market overreacts.

13

Japan – BoJ fails to meet market expectations

On the Tokyo Stock Exchange, July saw moderate recovery after the June sell-off, which was

largely the result of the UK referendum. Investors were primarily waiting for the central bank’s

decision on monetary policy. The Bank of Japan, however, did not meet market expectations and

disappointed the investors to some extent, since they expected broader and bolder moves from

Governor Haruhiko Kuroda. Having assessed the current monetary policy and market

fundamentals, we remain neutral on the Japanese market.

The yen appreciated at the beginning of the last

month, which adversely affected equity prices.

Later, however, the Japanese currency weakened

and bulls started to prevail in the stock market. The

fuel for growth was provided by information about

the outcome of the parliamentary elections. The

ruling coalition of Prime Minister Shinzo Abe’s

Liberal Democratic Party and the Buddhist Komeito

triumphed, winning a qualified majority in

parliament. As a result, in the latter part of the

month the USD/JPY exchange rate rose to 108 to

subsequently dive to 102 at the end of July.

Volatility (not only in the currency market) is very

high in Japan and the last few months will certainly

not be remembered fondly by investors. The

relative weakness of the Tokyo market compared

to against other stock exchanges has been evident

for some time. This has also contributed to the

weak performance of the Japanese Government

Pension Investment Fund (GPIF), which invests a

significant portion of its assets in domestic stocks

and is the largest entity of this type in the world. In

the last financial year, the Fund recorded a loss of

3.8%, posting its worst result since the financial

crisis of 2008.

Many investors hoped that a key development for

the next few months would be the 28–29 July

meeting of the Bank of Japan and the decision

expanding the asset purchase scheme and

modifying monetary policy parameters. The central

bank increased the scale of its purchases of ETFs

that invest in Japanese equities to JPY 6 trillion per

year from the current JPY 3.3 trillion. In this

respect, investors were surprised on the upside,

because the BoJ was expected to increase the

volume to JPY 4.3 trillion. It also doubled the value

of the scheme under which loans denominated in

U.S. dollars are made available to Japanese

companies operating abroad. However, that was

the end of the good news. The BoJ decided not to

cut the interest rate, which remained unchanged at

0.1%, while the market consensus assumed its

reduction to the -0.3% level. The scale of the

Treasury bond purchase program was also

maintained at JPY 80 trillion per year. The central

bank’s statement pointed to global problems

connected with Brexit and the slowdown in

emerging markets as well. Haruhiko Kuroda

stressed that during its September meeting, the

BoJ intended to conduct a comprehensive

TOPIX vs. the USD/JPY exchange rate

Source: Bloomberg, Citi Handlowy

95

100

105

110

115

120

125

1100

1200

1300

1400

1500

1600

1700

Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16

Topix (left axis) USDJPY (right axis)

14

assessment of its policy and its impact on

economic activity and inflation in Japan. Moreover,

he acknowledged the need to improve

communication with the market so that the

decisions made are more predictable and do not

cause major short-term ripples in the market. Citi

analysts point out that any change in monetary

policy parameters at the September meeting is

rather unlikely. Our baseline scenario assumes that

only during the January 2017 meeting will the Bank

of Japan decide to make the next move and it may

conceivably cut the interest rate to -0.3%. The

governor of the Japanese central bank stressed

that limited measures by monetary authorities

following the July meeting are also related to the

introduction by Prime Minister Shinzo Abe of an

economic stimulus package for Japan, which is to

amount to JPY 28 trillion. A fiscal program of this

size would amount to as much as 6.5% of Japan’s

GDP. It would include, among others, funds

earmarked for infrastructure and grants for the

poorest citizens alongside the promotion of tourism

and development of agriculture. Prime Minister

Abe’s government also intends to support export

companies, which may face Brexit-related

problems in the near future. The additional support

will be spread over several years and the

government hopes that it will boost GDP growth in

the near term by ca. 1.3 p.p. Citi analysts are a bit

more skeptical concerning its effects and believe

that the fiscal package will allow Japan to grow at a

rate higher by 0.5–0.6 p.p. in the next year.

Sources of funding for this idea are another matter.

It should be recalled that Japan’s public debt

currently stands at 229% of GDP, and in recent

years Japan’s budget deficits were very large

compared to the balance of expenditure and

income in other developed countries.

Nevertheless, Haruhiko Kuroda believes that the

aforementioned fiscal package combined with an

expansionary monetary policy are sufficient and

further increasing the scale of quantitative easing

would be inefficient.

In summary, although the BoJ made rather

cautious decisions at its latest meeting, it should be

stressed that Japan’s current monetary policy

should still support the prices of equities on the

Tokyo stock exchange. It should also be

remembered that when compared with other

developed markets, Japan looks quite attractive in

terms of valuations. The price to earnings and price

to book ratios and the expected growth of

corporate profits encourage purchases of

Japanese stocks. However, given the problems

with the appreciating currency and global threats,

we remain neutral on Japanese equities.

Budget deficits in Japan in the past 10 years (as percentages of GDP)

Source: Ministry of Finance, Citi Handlowy

-10,0%

-8,0%

-6,0%

-4,0%

-2,0%

0,0%

2006 2009 2012 2015

15

Emerging markets – an attractive region to invest

In the past month, our expectations for emerging markets as an attractive region to invest were

confirmed. The index that groups companies listed on stock exchanges in developing countries

recorded an increase of approximately 6%. Many figures indicate that this positive trend will

continue, particularly in relation to developed markets. We expect the positive sentiment towards

emerging markets to be sustained, and would also like to expand the range of our interests to

include emerging economy debt.

In the financial markets, July was defined by the

response to the outcome of the UK referendum.

Analysts and managers around the world are trying

to find answer to the question concerning Brexit’s

possible effect on specific regions, markets and

asset classes.

In the context of emerging markets, the situation

looks relatively good, but individual regions are

certainly exposed to various risks. A key factor will

definitely be the volume of trade between the

economy in question and the United Kingdom or,

more broadly, United Europe. The most painful

consequences of the UK’s exit from the European

Union would be felt by the economies of Central

and Eastern Europe owing to their strong economic

dependence on the United Kingdom as well as on

the entire Union. However, the slowdown we are

speaking of here would be of the order of 0.25–

0.5% over several years.

In the short term, the turmoil caused by the

referendum in late June did not cause particularly

violent reactions in emerging markets. In recent

weeks, we saw cases where capital fled to safe

havens and negative yields on Swiss or Japanese

bonds became even lower. On the other hand,

such a reduction in yields caused capital to seek

places where interest rates are higher. Such assets

can be found in emerging markets and this was

visible in capital flows (see Chart below).

This explains the enhanced attractiveness of

emerging country debt. In addition, the response to

global uncertainty was the loosening of monetary

policy in mature markets. This process provides

some space for interest rate cuts in emerging

markets, which is another argument in favor of

emerging region bonds. The position of the Federal

Reserve has always been essential for valuations

in EM regions. The environment that we are in

following the referendum outcome has forced the

Fed to postpone interest rate rises, giving space for

emerging currencies to depreciate.

Portfolio flows to the Emerging Markets region in billions of U.S. dollars

Source: Institute Of International Finance, Citi Handlowy

-15

-10

-5

0

5

10

15

20

25

May June July

Debt

Equities

16

Risk factors remain considerable. Developing

economies will always exhibit higher risk and offer

higher potential returns. For instance Brazil – one

of the largest issuers of emerging market debt –

will record negative GDP growth in 2016 and will

only come out of recession in 2017. Political

developments will pose risks that we have to keep

in mind in the near future. Exceptionally, in this

context, we will not discuss changes of

governments in emerging countries, since this time

the threat appears to come from presidential

elections in the United States. Donald Trump’s

potential election is perceived as a threat to global

trade. The Republican candidate has repeatedly

emphasized his desire to support the world’s

largest economy by introducing import tariffs and

limiting the range of regions with which trade would

be unrestricted by duties and similar measures.

Such changes would obviously have the most

impact on Mexico but would also affect many

emerging Asian economies.

Apart from political developments, in July we

received data about the emerging economies’

performance in the first half of 2016. The largest

emerging economy has surprised analysts on the

upside. Chinese growth in Q2 amounted to 6.7%

year-on-year, which was a result better than both

the market consensus and the forecasts of Citi

macroeconomists. When the data are analyzed in

more detail, it appears that the growth was

supported by the government fiscal stimulus

program and by easier access to credit. This is

indicated by a significant increase in infrastructure

investments, which provided considerable support

to the economy and grew by more than 20% year-

on-year. On the other hand, we observed a

considerable slowdown in private investment,

which raises certain concerns about the

sustainability of robust macroeconomic results in

the second half of the year. So far, we can see that

the measures taken by the Chinese authorities are

effective and the programs aiming to maintain high

economic growth announced at the beginning of

the year are working and have been rapidly

reflected in national statistics. We cannot rule out a

further loosening of both monetary and fiscal policy

in the Middle Kingdom in the latter part of the year.

The first six months of the year in the largest

economy in Latin America does not look as good,

although we indicate a high probability that Brazil’s

macroeconomic statistics will improve significantly

in the coming quarters. It appears that Q2 could

have been the last period in which Brazil’s

economy shrank. We expect a stabilization in Q3

and the beginning of a slight recovery afterwards. It

appears that the process of recovering from the

recession will differ from similar episodes

witnessed in previous years. Looking at history, we

can see that Brazil recovered particularly rapidly

after the crises of 2009 and 2013. For the next

year, we forecast sustainable but at the same time

quite low growth (0.6% in 2017). Currently, markets

hold high hopes for the changes that will be

introduced along with the change of the

government, and this probably explains the recent

significant rebound of the local currency and

domestic debt.

As an asset class, emerging markets appear to us

to be a place where one can still find attractive

opportunities. While noting the persistently high

volatility that characterizes emerging markets, we

consider them to be an important element of our

investment portfolio.

Chinese exports broken down by region

Source: Citi Research, Citi Handlowy

18%

13%

20% 15%

6%

5%

23%

U.S.

European Union

Asia ex Japan

Hong Kong

Japan

Latin America

Others

17

Commodity markets – only metals in the green

Last month, for the first time since February, the CRB broad commodity index ended up in negative

territory (-6%). The decline was so deep that it obliterated the advances from the previous two and

a half months with the deepest sell-offs suffered by energy commodities and agricultural crops. On

the other hand, metals, both precious and industrial, advanced.

Oil

“Black gold” was the commodity that surprised

investors the most perhaps. WTI futures lost 14.3%

in July, bringing crude prices to mid-April levels.

There are two main causes for the developments

observed in the market. First, the appreciation of

the U.S. dollar, which was discernible after the

referendum, resulted after some lag in a higher

cost of crude in local currencies and thus

depressed that part of the demand which was the

most sensitive to price fluctuations. This factor,

however, has a good chance of being reversed in

the coming months. The July meeting of the U.S.

Federal Reserve ended in a relatively dovish

statement, postponing the most likely date for the

continuation of the interest rate increase cycle. The

later it happens, the higher the chance for a

weakened dollar and therefore an increase in oil

prices.

Another important factor that contributed to the

July sell-off was the supply-side situation. The data

on the change in the amount of U.S. crude oil

inventories published at the end of the month

unexpectedly showed an increase instead of the

expected decline. This was the first such case

since May 2016. Additionally, the number of active

wells in the U.S. has increased by more than 18%

since the beginning of June after falling by ca. 80%

in less than two years. This was the result of the

rapid appreciation of crude year to date. For some

investors, this was reason enough to bring online

their wells, the extraction profitability threshold for

which is relatively low. It is worth noting, however,

that despite this change, the data being published

still point to a gradual decrease in supply both in

the U.S. and in those countries outside the United

States that do not belong to OPEC.

Given these factors, Citi analysts consider prices

hovering within the range from USD 42 to 50 per

Number of active wells and the change in crude inventories in the U.S.

Source: U.S. Energy Information Administration, Baker Hughes Incorporated, Citi Handlowy

-10000

-5000

0

5000

10000

15000

0

200

400

600

800

1000

1200

1400

1600

1800

Change in inventory levels (thousand barrels, right axis)

Number of active wells (left axis)

18

WTI barrel as the most likely scenario in the near

future. This stems on the one hand from the

potentially positive impact of U.S. dollar

depreciation and of the still decreasing supply, and

on the other hand from the concerns about high

inventory levels and the relatively quick response

to higher prices, which were reflected by new wells

coming online in the U.S.

Gold

In the first half of the month, when the dust was

falling after the announcement of the result of the

UK referendum, gold prices were falling as well.

The investor’s concerns about the global economy

post-Brexit were effectively allayed by e.g. positive

news from China where data on Q2 GDP growth

(6.7%) beat expectations. The more optimistic

investors are about the market situation, the less

attractive gold is as a “safe haven”. Additionally,

U.S. dollar depreciation played a role in the

precious metal’s prices falling.

In the second half of July, however, a piece of

news came that disturbed the investors’ peace of

mind. This was the publication of UK PMI figures –

PMI is a widely used leading indicator of business

climate. The reading was worse than expected and

indicated that the British economy would shrink.

Subsequently, we saw the depreciation of the

dollar in response to the persistently

accommodative policy of the U.S. central bank.

Those factors allowed gold to make up for the

ground lost in the first weeks of July with a

vengeance, finally chalking up a monthly increase

of ca. 2.6%. The weaker dollar still has a chance to

boost gold prices, but for the growth wave to

continue, more negative macroeconomic

information would have to be reported from key

economies.

Summing up the situation in the commodity

market, changes in the U.S. dollar exchange rate

could prove an important force driving the prices of

most commodities in the near future. According to

Citi analysts’ forecasts, it is more likely that the

dollar will depreciate and thus commodity prices

may be pushed upwards. In the case of oil,

however, this effect may be offset by the still high

inventory levels and the new wells that have come

onstream recently in the US. As concerns gold,

downward pressure could come from the

stabilization of the macroeconomic situation, which

would reduce the desire to flee from risk.

19

Rates of return and ratios for selected indices (as at 31 July 2016)

Equities Value Month YTD Year P/E P/E

(12M) Dividend

yield

WIG 46,171.7 3.2% -0.6% -12.5% 26.6 11.9 3.5%

WIG20TR 2,950.1 1.3% -3.4% -18.3% 25.3 11.3 3.8%

mWIG40 3,596.9 6.0% 0.8% -5.7% 23.1 14.5 3.4%

sWIG80 13,690.8 3.9% 3.6% 3.0% 56.3 11.8 2.2%

S&P 500 2,173.6 3.6% 5.3% 3.3% 20.3 18.4 2.1%

Eurostoxx 50 2,990.8 4.4% -9.0% -16.9% 22.3 14.0 4.0%

Stoxx 600 341.9 3.6% -7.0% -13.7% 28.1 16.2 3.7%

Topix 1,322.7 6.2% -14.5% -20.3% 16.6 13.5 2.2%

Hang Seng 21,891.4 5.3% 0.0% -11.1% 11.0 12.3 3.7%

MSCI World 1,721.8 4.1% 2.7% -2.5% 22.0 17.5 2.6%

MSCI Emerging Markets 873.5 4.7% 10.4% -3.1% 15.4 13.2 2.7%

MSCI EM LatAm 2,391.4 5.4% 31.5% 3.8% 39.1 16.0 2.7%

MSCI EM Asia 426.1 4.6% 5.9% -3.1% 13.6 13.2 2.5%

MSCI EM Europe 264.7 -0.2% 8.0% -9.7% 16.6 8.4 4.0%

MSCI Frontier Markets 493.8 1.0% -2.0% -11.8% 10.8 10.8 4.2%

Raw materials

Brent Crude Oil 43.5 -13.2% 2.9% -26.8%

Copper 222.2 1.2% 3.5% -6.0%

Gold 1351.0 2.2% 27.3% 23.3%

Silver 20.3 8.7% 46.4% 37.6%

TR/Jefferies Commodity Index 181.0 -6.0% 3.5% -10.6%

Bonds

Duration

U.S. Treasuries (>1 year) 395.3 0.3% 6.3% 6.1% 6.6 German Treasuries (>1 year) 434.4 0.2% 7.1% 6.9% 7.7 U.S. Corporate (Inv. Grade) 273.8 1.5% 10.9% 10.6% 8.6 U.S. Corporate (High Yield) 243.2 2.3% 10.8% 4.0% 3.9 EUR Corporate (High Yield) 168.4 2.1% 5.7% 3.4% 4.3 Polish Treasuries (1–3 years) 320.0 0.2% 1.1% 2.3% 1.6 Polish Treasuries (3–5 years) 361.0 -0.1% 1.8% 3.6% 3.6 Polish Treasuries (5–7 years) 260.2 -0.1% 2.4% 4.1% 4.9 Polish Treasuries (7–10 years) 430.5 0.3% 2.9% 4.1% 7.1 Polish Treasuries (>10 years) 329.3 0.4% 5.1% 6.6% 9.2

Currencies

USD/PLN 3.90 -1.1% 0.1% 3.4%

EUR/PLN 4.36 -0.5% 2.3% 5.2%

CHF/PLN 4.02 -0.4% 2.1% 3.1%

EUR/USD 1.12 0.6% 2.2% 1.7%

EUR/CHF 1.08 -0.1% 0.2% 2.0%

USD/JPY 102.06 -1.1% -15.3% -17.6%

Source: Bloomberg

20

Macroeconomic forecasts

GDP growth (%) 2015 2016 2017 Poland 3.6 3.2 3.2 United States 2.4 1.8 2.0 Eurozone 1.6 1.5 1.1 China 6.9 6.4 6.0 Developing countries 3.5 3.6 4.3 Developed countries 1.9 1.6 1.5

Inflation (%) 2015 2016 2017 Poland -0.9 -0.6 1.6 United States 0.3 1.3 1.9 Eurozone 0.0 0.3 1.2 China 1.4 1.9 2.0 Developing countries 5.2 5.5 5.4 Developed countries 0.3 0.6 1.9

Source: Citi Research

Currency forecasts (end of period)

Currency pairs Q3 16 Q4 16 Q1 17

USD/PLN 4.03 3.90 3.75

EUR/PLN 4.43 4.37 4.31

CHF/PLN 4.06 3.97 3.92

GBP/PLN 5.03 4.91 4.79

Source: Citi Handlowy

21

Glossary of Terms

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

(Bunds)

bonds issued by the government of the Federal Republic of Germany; figures used for the

Bloomberg/EFFAS 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 (High

Yield)

bonds issued by US corporations which have been assigned a speculative grade by one of the recognized

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.

Grade)

bonds issued by U.S. corporations which have been assigned an investment grade by one of the recognized

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 Maturity) the yield that would be realized on an investment in bonds on the assumption that the bond is held to

maturity and that the coupon payments received are reinvested following YTM

Gold figures based on the spot price per 1 (one) ounce of gold

18

Au

g 2

01

6

22

Additional Information

Prior to your analysis of the material produced by Bank Handlowy w Warszawie S.A., please be informed that:

This commentary has been prepared by Bank Handlowy w Warszawie S.A. (hereinafter referred to as the “Bank”). Market commentary

preparation and publication does not fall within the scope of broking activities within the meaning of Article 69 of the Act of 29 July 2005

on Trading in Financial Instruments.

This commentary has been prepared by reference to available, reliable data, with a proviso that the Bank has not been authorized to

assess the reliability or accuracy of the information serving as the basis for this publication. Considering the preparation method, the

information contained herein has been processed and simplified by the Bank. Therefore, it may be found to be incomplete and

condensed compared to the source materials.

The information presented herein shall be used for internal purposes, exclusively. It shall not be copied in any form whatsoever or

disclosed to third parties.

Neither the commentary nor the information contained herein shall be distributed in any other jurisdiction where such distribution would

be in violation of the law.

Any opinions and conclusions presented in this publication are valid as of the date hereof. The information provided in the Bank’s

commentaries does not take into account the investment policy, financial position or the needs of a specified recipient. Therefore, in the

context of the investment decision-making process, it may not be suitable for all investors using the materials produced by the Bank.

The Customer’s investment decision should not be made solely on the basis of the commentaries prepared by the Bank.

While making a decision on the purchase or sale of securities or other financial instruments, the Customer ought to consider the risk

inherent in the investment decision-making process, including, in particular, the risk of changes in the price of the financial instruments

affected by the aforementioned decision in a way contrary to the Customer’s expectations, and thus the Customer’s failure to earn the

expected profit and even a loss of the invested capital.

Investment products shall only be offered to holders of bank accounts maintained by the Bank.

Investment and savings insurance products shall only be offered to holders of bank accounts maintained by the Bank, and selected

products shall also be made available to holders of the Citibank master credit card. Insurance and investment products, including

investment funds, which may be purchased by the Customer through the Bank, are neither a deposit nor an obligation, and they are not

guaranteed by the Bank or any of its related parties operating within Citigroup, save for such investment products which may be issued

by the Bank or its Citigroup related party. In the case of investment products, protection of capital and/or guarantee of interest, if

applicable, represent an undertaking on the part of the issuer of the investment product.

The investment products and insurance products offered by the Bank are not guaranteed by the State Treasury, Bank Guarantee Fund

(except for the amounts due from certificates of deposit and dual currency investments covered by the obligatory cash guarantee

system consistently with the provisions of the Act on the Bank Guarantee Fund of 14 December 1994 or any other government

institutions.

Investment products involve investment risk, including the possibility of loss of the capital invested. While making a decision on the

purchase or sale of an investment or investment insurance product, the Customer ought to consider the risk inherent in the investment

decision-making process, including, in particular, the risk of changes in the price of the financial instruments affected by the

aforementioned decision in a way contrary to the Customer’s expectations, and thus the Customer’s failure to earn the expected profit.

Investment insurance products involve investment risk, including the possibility of losing a portion of the capital invested. Claims under

insurance contracts shall be secured by the Insurance Guarantee Fund in accordance with the Polish Insurance Guarantee Fund Act.

This means that if the Insurer becomes insolvent in such circumstances as specified in the aforementioned Act, the Insurance

Guarantee Fund shall satisfy a portion of claims filed by eligible individuals under life assurance contracts, representing 50% of their

receivables, no more, however, than the PLN equivalent of EUR 30,000.

The past performance of investment funds, investment portfolios, stock market indices, foreign exchange rates and unit-linked funds on

which the yield on the investment may be conditional, do not constitute a guarantee of their performance in the future.

While making investment decisions at the Bank or another institution, Customers should consider asset concentration, understood as a

substantial share of an investment product of a specified entity or issuer, or of a specified asset class in the investment portfolio. The

exact level or the maximum percentage share of the respective investment products or asset classes suitable for each Customer may

not be specified precisely. Concentration of assets may generate greater risk than a diversified approach to financial instruments and

their issuers.

The Customer should aim at diversification, understood as proper combination of a variety of financial instruments in the portfolio, with

the objective to reduce the global risk level.

18

Au

g 2

01

6

23

This material has been published for information purposes only. It shall not be regarded as an offering or encouragement to purchase or

sell securities or other financial instruments. This commentary is not intended as an investment or financial analysis, or another general

recommendation with respect to transactions involving the financial instruments referred to in Article 69(4)(6) of the Act of 29 July 2005

on Trading in Financial Instruments. This commentary shall not be considered an investment recommendation. Neither shall it be

regarded as a recommendation within the meaning of the Regulation of the Minister of Finance of 19 October 2005 concerning

information which constitutes recommendations with respect to financial instruments or their issuers. Furthermore, the commentary

does not constitute “information recommending or suggesting investment strategy” or “investment recommendations” within the meaning

of Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse. The Client shall be

liable for the outcome of his or her investment decisions made on the basis of the information contained herein. The Client’s past

investment returns based on the use of the Bank’s materials shall not be regarded as a guarantee or serve as the basis for a conc lusion

that similar returns will be generated in the future.

The author of this publication hereby represents that the information contained herein reflects their own opinions accurately and that

they have not been remunerated by the issuers, directly or indirectly, for presentation of such opinions.

This material reflects the opinions and knowledge of its authors as of the date hereof.

Additional information is available at the Bank’s Investment Advisory Bureau.

The Bank’s business activity is overseen by the Polish Financial Supervision Authority.

Bank Handlowy w Warszawie S.A. with its registered office in Warsaw at ul. Senatorska 16, 00-923 Warszawa, entered in the Register of

Entrepreneurs of the National Court Register by the District Court for the capital city of Warsaw in Warsaw, 12th Commercial Department of

the National Court Register, under No. KRS 000 000 1538; NIP [tax identification number] 526-030-02-91; the share capital is PLN 522 638

400, fully paid-up. Citi and Citi Handlowy are registered and licensed Citigroup Inc. trademarks. Citigroup Inc. and its subsidiaries also hold

rights to certain other trademarks used in this document.