Citibank - Market Outlook September 2012

01 Feature Article02 Equity Markets03 Bond Markets04 Investment Insights

MICA (P) 069/10/2011

September 2012

Possible Grexit loomingCiti analysts have put the probability of Greece exiting the Euro Area (Grexit) in the next 12-18 months at about 90% and, within that timeframe, think that it is increasingly likely that Grexit could occur in the next six months or so, conceivably even as early as September/October depending on the outcome of the September Troika (European Union, European Central Bank and International Monetary Fund) report on Greece. There is also a crucial series of meetings and events in the coming weeks that may clarify how this plays out.

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Possible Grexit looming

Likelihood of Grexit becoming even clearer…

The likelihood of Grexit itself is coming into even sharper focus, in Citi analysts’ view. There appears to be a sizeable – and probably

unbridgeable – gap between the Greek government’s ability to quickly cut the fiscal deficit and implement major supply-side reforms

and privatisations, and the measures that creditor nations require to extend further funding. The Greek government has sought a

two-year extension of the latest austerity programme, with a slower pace of fiscal tightening. At the same time, attitudes appear to

be hardening among official bodies and especially creditor nations, with a growing reluctance to do “whatever it takes” to keep

Greece in the European Monetary Union (EMU) and a growing willingness to contemplate the likelihood that one or more countries

will exit EMU.

There is a busy timetable of key meetings and events in the coming weeks that may clarify how this dilemma could play out.

• September 6: ECB meeting and press conference, when the ECB is likely to present details of the Conditional Government

Bond Purchase Programme (CGBPP).

• Around September 11: EU Commissioner Michel Barnier will present the proposal for a single bank supervisor (the ECB) in

the Euro Area.

• September 12: German constitutional court will rule on the legality of the European Stability Mechanism (ESM). If the court

decides in favour, the German President can sign the ESM treaty immediately. Germany is the final signatory needed for the

treaty to enter into effect. Once all ESM member states pay their obligations to the first capital tranche, the fund will become

operational. However, the court may also require additional information, particularly on the ECB’s bond purchase plans under

existing ESM programmes, before making a final ruling. Anything other than a positive ruling from the court will prevent

Germany ratifying the treaty in the short term.

• September 12: Dutch election, with polls pointing to an inconclusive result, which could inhibit approval of further EMU rescue

measures.

• September 13-14: Meeting of G20 Finance Ministers and Central Bank Governors in Mexico.

• September 14-15: Informal meeting of European Finance Ministers (ECOFIN) with Central Bank Governors.

• During September: Troika assessment on Greece.

The precise timing of Grexit, if it happens, remains uncertain. But Citi analysts believe it could even occur as soon as

September/October, if the upcoming Troika report confirms that Greece’s programme is off-track and creditor nations are unwilling

to provide Greece any funding extension or extra time. However, creditor nations may provide enough funding to delay Grexit to after

theDecember review, for example to allow plans for common bank supervision to be finalised. This might ensure that if Grexit prompts

wider bank recapitalisation needs (in the other Euro Area countries), these can be mutualised via the ESM (either immediately or at

a later stage). A deferral beyond September also could be more likely if the German Constitutional Court causes a delay in ESM

ratification. Or, the Greek establishment may accept at some stage that it will be unable (or unwilling) to implement the measures

required to stay inside EMU and decide itself that Grexit is inevitable.

…But the exact mechanics remain uncertain

In the event Grexit happens, Citi analysts envisage an extended bank holiday and some form of capital controls and limits on deposit

withdrawals in Greece (and perhaps some temporary restrictions in some other EMU countries as well). Prior examples highlight that

currency redenomination need not be uniform: for example, when Argentina abandoned its currency peg to the US Dollar in 2002,

the government decided to apply a 1-to-1 exchange rate for Bank loans and a 1.4-to-1 exchange rate to deposits. Moreover, when East

Germany adopted the Deutsche Mark as legal tender on July 1 1990, just ahead of German unification in October of the same year,

the East German mark was converted at par for wages, prices, pensions and savings up to a limit of 4000 East Mark/person. Financial

claims, including corporate and housing loans, and savings in excess of 4000 East Mark were converted at a ratio of 2:1 into the

Deutsche Mark. Citi analysts believe that a new Greek currency could fall by about 60%, pushing inflation markedly higher in 2013-16,

but the scale of currency decline is highly uncertain.

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Possible Grexit looming

With policymakers aware that Grexit could be a “Lehman” moment – that causes massive unanticipated disruption – Grexit (if it

happens) is likely to prompt a huge policy response, with policymakers using conventional and unconventional tools. The approach

may be to err on the side of being overly generous rather than emphasise long-run moral hazard or inflation concerns. Greece itself

could probably receive financial assistance from the IMF and EU, while the ECB (and other central banks) may provide extensive extra

liquidity and, in some cases, monetary policy easing as well. In addition, assistance for Italy and Spain is likely to be promptly

activated (if it is not already in place) with little or no extra conditionality on top of what has already been agreed. Fiscal targets for

other periphery EMU countries may also be eased, at least for 2012 and 2013.

Grexit unlikely to be the end-game to the EMU crisis

Even so, Citi analysts doubt that potential Grexit and the resultant policy responses would be a cathartic event that ends EMU strains.

Indeed, they suspect that Grexit, if it happens, could intensify the withdrawal of private sector funds from periphery EMU countries.

Grexit would fundamentally change the nature of EMU, establishing that exit can occur. Greece’s non-compliance with its programme

is unique at present. But, there are echoes of Greece’s economic problems – persistent economic weakness, poor external

competitiveness, fragile banking system and unsustainable fiscal trends – in a range of other periphery countries.

In Citi analysts’ opinion, the EMU end-game is likely to be a mix of EMU exit (Greece), a significant amount of sovereign debt and

bank debt restructuring (Portugal and, eventually, perhaps Ireland, Italy and Spain), with only limited official fiscal burden sharing

(via the ESM, European Financial Stability Facility (EFSF) and ECB losses) and ongoing liquidity support from the ESM and the ECB.

Portugal is still expected to get a second bailout (or a prolonged extension of the current programme), with no private sector

involvement (PSI) initially but a high chance of PSI and official sector involvement (OSI) over the next three years or so. Ireland may

well also need some external assistance beyond the end of the current programme, although – with the deficit likely to undershoot

official forecasts and evidence that the country has some access to markets – this may take the form of partial funding via the

EFSF/ESM and the backstop of ECB market purchases if needed.

Nevertheless, for Portugal, Ireland, Italy and Spain, the crisis looks set to leave a legacy of high unemployment and very high

government debt-to-GDP ratios (90%+, and, in most cases, well above that level). Citi analysts doubt that any of these countries will

be able to sustain normal market access at a tolerable yield without the backstop of official support in coming years. There are

arguments in favour of implementing widespread debt restructuring early, to limit the extent to which restructuring risks hang over

the system and paralyse decision-making. However, in practice the process is likely to be lengthy and drawn-out over several years,

because of hopes that periphery countries can grow their way back to fiscal sustainability and widespread reluctance to inflict early

losses on the already-weak banking system.

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Equity markets

*Denotes cumulative performance

Performance data as of August 31 2012 Source: Bloomberg

Chart 1 :

S&P 500 Index


Performance data as of August 31 2012Source: Bloomberg

Chart 2 :

Dow Jones Stoxx 600 Index

United States

Near-term caution appears appropriate Rebounds in employment and consumer spending in July

have eased fears that the expansion might be at risk. Although major downside threats remain due to scheduled fiscal tightening next year and the ongoing financial crisis in Europe, the US recovery is proceeding on a modest 2% track.

Citi’s base case expects further eventual accommodation but this vigil is likely to extend well beyond the next few months and into 2013. For now, the improvement in key early 3Q12 data is likely to forestall action at their next meeting. In the meantime, Operation Twist has been extended and officials are likely to use public statements to underscore their readiness to buoy financial conditions, most likely through MBS purchases or a new lending program. Action remains contingent on either a serious financial shock or more credible evidence that economic momentum, particularly in labour markets, is stalling.

A near 11% rally by the S&P 500 index off its June lows seem to have caught many within the investment community by surprise, as once again investors turned too defensive after May’s severe market correction. Going forward, while sentiment and valuation still support additional gains, estimate revision momentum and intra-stock correlation no longer generate as much enthusiasm as before.

As such, with political and geopolitical uncertainty rising, possibly to a crescendo in the next couple of months, Citi analysts believe that some caution may be appropriate. It also appears more prudent to stick with high quality dividend yielders at this juncture that also have moderate growth characteristics than chasing high beta or economically leveraged names.

Euro-Area

ECB likely to cut rates by 50 bps by year-end

Greece might manage to get some more months of funding from the Troika, however, the increasing unwillingness of some creditor countries to expand support for Greece suggests that “Grexit” — to which Citi analysts attach a probability of about 90% — could happen as early as September/October. In particular, if the German constitutional court approves Germany’s ESM participation, this could increase the probability of Grexit soon.

If and when Spain or Italy has sought support from the ESFS/ESM, the European Central Bank (ECB) is also expected to resume its multi-year LTRO programme. Likely backed by a weaker growth outlook, the ECB could cut the refi rate to 0.5% in September and the deposit rate to -0.25%. During 4Q12, Citi analysts expect a reduction of the main refi and the deposit rate to 0.25% and -0.5%, respectively.

Over the last decade, mega cap has been the weakest performing group eight out of the ten years. It has been the best performing twice, both years that the market fell, highlighting defensive characteristics. Indeed, mega caps in Europe have performed much like the Japanese market, while mid caps have delivered EM-type returns.

There are two similarities. One, lack of appetite for equity as an asset class, and two, no market for corporate control. Since the end of the Japanese bubble there has been a consistent switch out of equities, driving the derating. This pattern of outflows has also been seen in Europe. However, all other things being equal, the flows out of equity should have impacted mid caps as much as mega caps. But mid cap has had another buyer, the corporate sector though buy backs and M&A. While mega caps have also been buying back stock, there is very little chance of a cash bid for mega caps. They are effectively bid proof because of their size. This is where European mega caps are like Japan, where acquisitions are very rare.

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Equity markets

Chart 3 :

Topix Index



Chart 4 :

MSCI Asia ex Japan Index



Asia Pacific

Valuations suggest upside probability Growth worries continue to dominate, with forecast

downgrades in India, Hong Kong and Taiwan. Malaysia's and Indonesia's growth remained strong — in Indonesia’s case this prompted a marked current account deterioration and earlier-than-expected rate hike. For others, benign inflation still leaves a window for some cuts, notably Korea, Thailand and Philippines, but sticky inflation likely mean delayed easing room for India.

A slower Chinese economy and flat CNY has important implications for export/China-led Asian currencies. In particular, the Korean Won (KRW), Taiwan Dollar (TWD) and Malaysian Ringgit (MYR) are expected to face the largest downside risks in the medium term.

Based on the last 37 years of price-to-book (PB), Asia ex Japan has traded on a higher multiple 73% of the time and delivered a return of 32% on a 12 month view versus a 27% probability of a 12% loss. Based on mid-cycle earnings, current valuations have led to 21% upside over six months and 44% over 12 months.

Post more than a year of deceleration, balance sheets of central banks are expanding again. Without this, we typically do not see multiple expansion. The average duration of expansion is 11 months, during which the market typically adds 0.3 multiple points to PB which based on current levels is 20% upside. The summer has brought more earnings downgrades and this is likely to carry on into September. 2012 earnings-per-share (EPS) growth estimates has fallen from 16% to 11.8%, but already appears priced in given implied EPS growth to perpetuity of a mere 1% versus a historic average of 8% p.a. The current results season is also turning out better than expected. Moreover, both in the G10 and EM world, economic data is generally coming out better than expected. The same is also true in Asia and China.

Japan

Growth may slow in 2014 due to tax hike Economic growth in this year and next could be pushed up

to 2.7% and 1.8% respectively, by reconstruction demand from the earthquake and frontloaded spending ahead of the consumption tax hike. But GDP growth in 2014 will inevitably slow sharply due to a payback to frontloaded spending and erosion in real household disposable income driven by tax hikes. Citi expects a sharp contraction in GDP right after the tax hike in April 2014, which could in turn make the second tax hike slated for October 2015 less likely.

Citi analysts expect the Bank of Japan (BoJ) to take additional easing action in late October when policymakers publish a semiannual economic outlook report. The BoJ’s inflation forecasts could be revised down somewhat and this may lead to additional easing action, most likely in the form of increasing purchases of short-term and long-term JGBs under the asset purchase program.

Citi analysts see two potential impacts from the strengthening of the Fed policy duration effect on Japanese equities: 1) a negative impact from JPY appreciation versus USD stemming from lower US interest rates; and 2) a positive impact from higher stock prices in the US and increased investor risk appetite. Overall, the negative impact on Japanese equities from JPY strength

is expected to be offset by the potential rise in US equities.

It is possible that expectations could rise not only for a strengthening of the policy duration effect, but also for QE3. As expectations of QE3 mount, Citi analysts believe the following sectors may be worth keeping an eye on: 1) exporters with high US sales weightings, on mounting expectations of a US economic recovery (Transport Equipment, etc.); 2) Real Estate, on a decline in longer-term call rates; 3) resource-related sectors (Wholesale Trade, etc.), on higher resource prices; and 4) Brokers, on recovering share prices.

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Bond markets

Positive on High-Grade Corporates and Emerging Market Debt

US TreasuriesCiti analysts expect yield curves to flatten, and for gains to be potentially generated in the intermediate- to longer-dated maturity range.

US CorporatesA strengthening technical backdrop, large cash balances, low default rates, decreasing net issuance, and a smaller universe of safe haven assets continue to remain supportive. Meanwhile, although high yield valuations have become more attractive, Citi analysts remain cautious due to festering concerns in Europe and expectations that global growth could continue to slow. As such, they selectively favour high quality, double-B rated issuers and select single-B rated issuers with strong fundamentals.

Euro BondsAs global growth slows further and heightened uncertainties persist, high quality government bonds in safe haven markets, particularly UK Gilts are likely to be well-supported.

Emerging Market DebtIncreased corporate bond issuance in emerging markets may present opportunities to pick up yield while benefiting from stronger domestic growth.



Chart 5 :

MSCI Emerging Markets Index

Emerging Markets

Outlook for CEEMA equities appears challenging CEEMEA1 remains hostage to growth and deleveraging risks

from the Eurozone. In particular, growth prospects in Poland appear to be rather gloomy plus the risk of further escalation in the conflict surrounding the Middle East is what Citi analysts would pay attention to.

In Latam, stability appears to be still the name of the game when it comes to monetary policy (except in Brazil). Resilient growth has kept most central banks in "wait-and-see" mode but Citi analysts continue to expect easing later in the year.

Performance of CEEMEA currencies, particularly Czech Koruna (CZK) and Hungarian Forint (HUF) are likely to remain generally weak, held back by association with EUR weakness. On the other hand, Latam currencies such as Mexican Peso (MXN), may perform relatively well short term but give back some gains medium term.

Citi analysts have an end-2012 target of 4,000 on the MSCI Latam index. Although earnings-per-share (EPS) growth appears to be slowing, policy flexibility implies that the region can weather the European economic slowdown. They favour Brazil and Peru, and prefer the Financials, Energy and Consumer Discretionary sectors.

While the CEEMEA region is attractively valued, there is reason for continued caution given relatively weak growth and higher exposure to the Euro Area. Under such conditions, Citi’s preferred market is South Africa thanks largely to its strong and resilient earnings growth outlook. Their end-2012 target for the MSCI EM EMEA index stands at 350.

1. CEEMEA is the collective term for Central and Eastern Europe, Middle East and Africa.

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Investment insights

QE3 and Emerging MarketsThough market talk of an imminent third round of quantitative easing (QE3) by the US Federal Reserve have been tempered by better-than-expected economic data out of the US of late, the general expectation remains for QE3 to be announced over the next couple of months. In this month’s issue, we take a look at the effects of previous rounds of QE on emerging markets.

Source: Citibank N.A., Singapore Branch, Regional Wealth Management.

MSCI Global Emerging Markets (GEMs) Index and Quantitative Easing

Since the end of the 2007-8 bear market, periods of QE have been positive for emerging market equities, while post-QE periods have been negative. During QE1 (from mid-December 2008 to end-March 2010), MSCI GEMs shot up by 80%; during QE2 (from late-August 2010 to mid-2011), the rise was

a more modest 18.7%.

All regions have, on average, risen sharply during the two QE periods. The sector performance picture has been less clear. Three of the high-beta sectors outperformed during QE periods (Consumer Discretionary, Materials

and IT). However, rather unexpectedly, other higher-beta sectors – Energy, Financials and Industrials – underperformed during QE. Most surprisingly, one of the classic defensive sectors (Consumer Staples) outperformed on average during the two QE periods.

Source: MSCI, Datastream and Citi Research. As of August 15 2012. Source: MSCI, Datastream and Citi Research. As of August 15 2012.

GEMs Regions: Average performances during QE GEMs Sectors: Average performances during QE

Source: MSCI, Datastream and Citi Research. As of August 15 2012.

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Economy & Finance

Citibank - Market Outlook September 2012