Bond letter (2014.12.01 en ww)

Monthly Bond Letter December 2014

Pictet Asset Management

MONTHLY BOND LETTER | DECEMBER 2014 | 01/12/2014 | 2

CONTENTS

Overview 3

Inflation-linked bonds 5

Credit risk 7

Emerging debt 11

USA 13

Eurozone 15

UK 17

Switzerland 19

Japan 21

3 | MONTHLY BOND LETTER | DECEMBER 2014

OVERVIEW

Recent developments

Slowing economies in China, Japan, Europe, Brazil and

Russia, coupled with mounting geopolitical

tensions, unsettling markets

Investors, though reassured about the health of the US economy in Q3, are concerned that adverse influences from elsewhere will spill over into America. These anxieties, compounded by the widespread deceleration in inflation and the prospect of monetary policies staying accommodating, have underpinned bonds. Yields on long bonds drifted down again, sinking to new lows in Europe, and the yield curve flattened out even further.

US GDP expanded by 3.9% in Q3 2014, and US economic fundamentals remain sound. Inflation was steady at a low 1.7%. This mild rate remains a cause of some disquiet for the US Federal Reserve which, in spite of the uneasy state of financial markets, wound up its programme of monthly asset purchases.

Eurozone economy still struggling, with Commission

forecasts making grimmer reading than in the spring

According to the European Commission, the eurozone is going to take longer to extricate itself from the economic quagmire. In order to give it a push in the right direction, the Commission has devised a far-reaching investment package to kick-

start growth and jobs. It is now forecasting GDP growth of 0.8% for this year, followed by 1.1% in 2015. Individual eurozone economies are still experiencing somewhat mixed fortunes, but the Big Three (Germany, France and Italy) do seem to be limping along. As for inflation, the Commission is projecting annual rates averaging 0.5% for 2014 and 0.8% in 2015.

ECB stirring into action and aiming to expand its balance sheet to its 2012 dimensions

As expected, the ECB made no change to interest rates in November. Its main refinancing rate remains pegged at 0.05%, its marginal rate at 0.30% and its deposit rate at -0.20%. During his press conference, ECB President Mario Draghi was at pains to stress the Governing Council was unanimous in being prepared to press ahead further if required. He also clarified the ECB’s target for the balance sheet: it is aiming to expand it by EUR1,000bn. To achieve that, the ECB will probably have to push through fresh accommodating monetary-policy measures. Buying up sovereign bonds

remains one such possibility.

The impact of the consumer sales tax hike still being felt in

Japan, pushing the economy back into recession

The consensus had been looking for growth of 2.2% in Japan in Q2 of its 2014/15 fiscal year whereas its economy actually contracted at an annualised rate of 1.6%. This dismal showing prompted Prime Minister Shinzō Abe to postpone the second hike in the consumer sales tax and to call a snap election halfway through his term of office.

Credit-risk market rebounded in reaction to ECB statements

Boosted by announcements made by the ECB, European corporates were lifted by a combination of the decline in benchmark government bond rates and a narrowing of credit spreads. They notched up gains for November. Ratings-wise, investors tended to favour superior-grade corporates, but high-yield bonds fared strongly as well, as investors scoured the markets for yield.

RETURNS – NOVEMBER 2014 10-YEAR GOV'T. BOND YIELDS

0.60.3

0.5

-0.6

0.1

-0.4

2.7

1.3

0.5 0.61.0

2.8

-1-10112233

Govt Inflationlinked

IG HY EMD$ EMD LC Equities

% MTD Bonds in $ Bonds in euro

Source: Bloomberg, Barclays, Citigroup, JP Morgan, perf in local currencies

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

11.13 01.14 03.14 05.14 07.14 09.14

% USA Germany UK Switzerland Japan

Source: Bloomberg, 10 Yr Govt yields

MONTHLY BOND LETTER | DECEMBER 2014 | 4

FORECASTS

Forecasts

The Fed turns QE liquidity taps off, but soothed market concerns about the first hike

in the Fed funds rate

Minutes of the last Federal Open Market Committee (FOMC) meeting revealed Fed concerns about the lacklustre state of economies in China, Japan and Europe, aggravated by geopolitical tensions. They also noted though the solid anchoring of the US recovery which continues rebuilding its strength. FOMC members also debated the relevant wording to describe the direction of the Fed’s monetary policy, eventually opting to persevere with the guidance that its benchmark rates would stay close to zero for some “considerable” time. The Fed is still worried about hiking rates too early and made it quite plain the initial hike would remain contingent on positive trends being set by economic data.

Fears about a triple-dip recession and deflation set to

continue haunting Europe

No growth and even a relapse yet again into recession could well reignite concerns over the state of public finances. Governments are still battling with the dilemma of finding it extremely hard to push through requisite reforms. Against this troubled backdrop, the ECB aims to pump the size of its balance sheet back up to 2012 dimensions.

Bank of England also steering a circumspect course

Although the UK economy is faring comparatively better than those of its European neighbours, GDP growth is still expected to slacken in tempo in the run-up to the year-end, with inflation possibly slowing to 1%. The Bank of England (BoE) should, therefore, retain the status quo, biding its time for further evidence that spare capacity is being mopped up.

Reforms in Japan have still not seen the light of day, and

an early election may well muddy the waters

PM Shinzō Abe, keen to take advantage of personal popularity ratings that have not been dented too much, decided to dissolve the Lower House of Japan’s Diet to bolster his political clout to allow him free rein to push through his dynamic and reforming economic policy agenda as well as to distance himself somewhat from the pacifism that has been the hallmark of Japan’s politics since World War II. Japan will go to the polls in an early general election on 14

December to re-elect 480 members of the Diet. Shinzō Abe declared that, if the ruling coalition failed to retain its majority after the election, this would mean the Japanese electorate had rejected the reflationary reformist policy package, commonly referred to as ‘Abenomics’, and that he would step down.

Against this backdrop of economic uncertainty worldwide, subdued inflation and accommodating monetary policy, leading bond markets are likely to hold fairly steady over the next few weeks.

Upside may be limited, but European corporates will be

supported by an activist ECB

European corporate bond markets should continue to be assisted by investors’ quest for yield, but the choice of borrowers will be crucial, influenced by how companies’ fundamentals are developing or possible M&A activity. The state of limbo on the regulatory front offers a good reason to err on the side of caution as regards financials considering current pricing levels. The default rate should stay low, lending support to high-yield corporates.

GDP COMMODITIES

-10

-5

0

5

10

15

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

USA EU UK SZ Japan China

Source: Bloomberg, GDP YoY

0

100

200

300

400

500

600

0

20

40

60

80

100

120

140

160

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Oil WTI (l.s.) Commodities CRB Index (r.s.)

Source: Bloomberg, Commodities


INFLATION-LINKED BONDS

The ECB continuing with its softly-softly approach

Eurozone: economic outlook degraded again, and a more contingent monetary policy on the cards

On 4 November, the European Commission published its Autumn 2014 economic projections. The title of the accompanying press release – “Slow recovery with very low inflation” – tells the whole story about the sluggishness of the economy and is in stark contrast to the more upbeat strap-line of “Growth becoming broader-based” for its Spring 2014 forecasts. Its projections for economic growth and inflation were unmistakably downgraded: GDP from +1.2% to +0.8% for 2014 and from +1.7% to +1.1% for 2015; inflation from 0.8% to 0.5% for 2014 and from 1.2% to 0.8% for 2015.

At its monetary-policy session on 6 November, the ECB Governing Council, although deciding not to take any further initiatives, did sketch out more clearly its likely future interventions. The somewhat controversial target for increasing the size of its balance sheet by EUR1,000bn was confirmed, and featured in black and white in the official press release, with the key clarification that it was “signed by the whole Governing Council unanimously”. Moreover, Mario Draghi reiterated the ECB’s readiness to strengthen its accommodating monetary policies subject to a couple of contingencies:

• if long-term inflationary expectations were to worsen;

• if measures already in place were not enough to enable the target for balance-sheet expansion to be met.

Moreover, in a keynote speech at the Frankfurt European Banking Congress on 21 November, Mario Draghi sounded a note of urgency being added to the battle to reverse the softening of inflationary expectations: “We will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us. If, on its current trajectory, our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases”.

ECB: corporate bonds issued by non-financial borrowers likely to be added

to the shopping-list as from December

The next ECB Governing Council meeting will undertake its quarterly review of the central bank’s own economic forecasts. On the basis of the Commission’s recent downgrades, it can be taken for granted the ECB’s projections will follow suit. Its most recent forecast for inflation in 2016 was for a rate of 1.4%. It will be hard for the ECB to lower that. If it did, it would merely fuel market expectations about the deflationary threat. The only way to cushion the blow and counterbalance the negative macroeconomic dynamics would be to announce a series of fresh accommodating initiatives.

Recent comments from Mario Draghi, combined with the ongoing heated debate about the legitimacy and legality of any quantitative-easing programme encompassing sovereign debt, demonstrate clearly that the ECB is likely to activate an extra purchasing drive from December, this time for corporate bonds issued by non-financial borrowers. After the credit channel, then the exchange-rate channel, the ECB is now turning its focus to the portfolio-allocation channel. Will this be enough to do the trick though?

Assuming the ECB confines its buying to securities already deemed acceptable as collateral security for repo transactions, the scale of the underlying market would work out at around EUR500bn. To counter any serious price distortions, the ECB would only be able to buy 10%-30% of that over the next couple of years, i.e. around EUR50-150bn worth. That would indeed be yet one more step in the right direction, but not a big enough one for the ECB to hit its target for balance-sheet expansion. Expectations for inflation do not, therefore, look likely to get that much-hoped-for hardening impetus, and the market will continue to look for the necessary addition of sovereign bonds to the ECB’s buy-list.


INFLATION-LINKED BONDS

PERFORMANCES 2014 (LOCAL CURRENCIES) INFLATION

UK - TREASURY YIELD COMPONENT USA - REAL RATES

USA - 10-YEAR TREASURY YIELD COMPONENT 10-YEAR REAL YIELDS

FRANCE - 10-YEAR YIELD COMPONENT 10-YEAR BREAKEVEN INFLATION POINTS

5.5 6.1

17.2

4.6

13.7

10.7

4.6

11.812.7

3.6

6.4

8.6

0.02.04.06.08.0

10.012.014.016.018.020.0

US EMU UK Japan Canada Australia

% Y

TD

Source: Bloomberg, Citigroup, Barclays, Citigroup

Inflation Linked Government

-3

-2

-1

0

1

2

3

4

5

6

7

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

USA EU UK SZ Japan

Source: Bloomberg, CPI

-2

-1

0

1

2

3

4

5

6

04 05 06 07 08 09 10 11 12 13 14

BP Real Yield Nominal Yield Breakeven inflation

Source: Bloomberg, UK

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

05 06 07 08 09 10 11 12 13

% 5 Year Real yield 10 Year Real yield 30 Year Real yield

Source: Bloomberg, US Treasury

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

04 05 06 07 08 09 10 11 12 13 14

% Real yield Nominal yield Breakeven

Source: Bloomberg, US Treasury 10 year

-1.0-0.8-0.6-0.4-0.20.00.20.40.60.81.0

11.13 01.14 03.14 05.14 07.14 09.14

% USA 10yr EU 10yr UK 10yr Japan 10yr

Source: Bloomberg, Real Yields

-1.0-0.50.00.51.01.52.02.53.03.54.0

09.11 01.12 05.12 09.12 01.13 05.13 09.13 01.14 05.14 09.14

% Real yield 10yr Nominal Yield 10yr Breakeven inflation 10yr

Source: Bloomberg, 10-yr French OAT

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

11.13 01.14 03.14 05.14 07.14 09.14

% USA 10 BEI EU 10 BEI UK 10 BEI Japan 5 BEI

Source: Bloomberg, Break-even Inflation Rates


CREDIT RISK

Yield spreads being squeezed again

Returns in the positive zone

Boosted by announcements made by the ECB, European investment-grade corporate bonds posted gains in November as they were lifted by a combination of declining benchmark government bond rates and narrowing credit spreads. Ratings-wise, investors tended to favour superior-grade corporates, with BBB-category bonds failing to outperform A-rated issues as is usually the case when the market is in an up-phase. As for sectors, sliding commodity prices hurt the energy and mining & metals sectors whereas the best returns were delivered by the automotive, telecom and consumer sectors. Hybrid debt instruments also, generally speaking, produced the best performances. At the other end of the spectrum, bonds from Brazilian borrowers, shaken by Petrobras’ troubles, really struggled.

Financials underperformed by a fraction, but that can be blamed mainly on spreads widening on Lower Tier 2 debt, especially issued by French and Austrian banks. Insurers outperformed courtesy of, on the one hand, some good results being reported and, on the other, by several offers made to swap out of old subordinated debt. Bucking this positive trend, Dutch insurers’ returns were in the red as a result, partly, of decisions to revalue their mortgage portfolios.

Strengthening of banks deemed to be systemically important

The recent G20 summit confirmed governments’ determination to strengthen as much as possible the world-leading banks considered as being ‘too big to fail’. The frame of reference put forward by the Financial Stability Board was accepted and should be finalised by end-2015. As far as their likely direct impact on credit markets, these new regulations would involve a larger supply coming onstream of Lower Tier 2 debt or senior debt issued by holding companies and

included for the purposes of any bail-in arrangements.

Primary market

The euro-denominated corporates market retains its particular appeal for issuers from outside the eurozone on account of the ongoing brisk demand and advantageous swap conditions. US borrowers, in particular, made their presence felt, the likes of AT&T, Verizon, Apple, IBM, Praxair or 3M. This trend helped to bolster an already sizeable universe of euro-denominated bonds. The most favoured maturity dates ranged around 7 and 15 years, with borrowers generally having ratings of A to AA.

Looking at financials, both UK and US banks were active in issuing senior debt. The market attitude towards subordinated paper was more reticent though as, on three separate occasions, the size of issues had to be pruned or bonds offered with a premium that had to be made more enticing. In the insurance sector, activity centred on new Lower Tier 2 debt from CNP, Axa and Generali. The latter two insurers were in fact swapping new issues for old subordinated debt that no longer complied with Solvency 2 requirements.

Outlook

The investment-grade corporates segment will continue being underscored by the ongoing non-conventional monetary-policy setting. In this environment, although bonds from better-quality issuers are still offering a premium spread relative to sovereign debt, investors should cast a very discriminating eye over what to pick, looking closely at what is happening to economic and business fundamentals and/or any M&A activity. The uncertainties clouding the regulatory front offer a cogent argument for erring on the side of caution as regards financials considering current pricing levels.


CREDIT RISK

RETURNS ON BONDS IN EURO CREDIT SPREADS (EURO)

YIELD COMPONENT (EURO) RETURNS ON BONDS IN EURO

INVESTMENT GRADE SPREADS BY MATURITY (EURO) INVESTMENT GRADE SPREADS BY SECTOR (EURO)

INVESTMENT GRADE RETURNS BY MATURITY (EURO) INVESTMENT GRADE RETURNS BY SECTOR (EURO)

0.6 1.0 1.3 0.91.0 1.0 1.5 1.5

7.8

5.9

11.8

9.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

IG HY EMU Gvt Germany Gvt

%

Source: Bloomberg, Barclays, Citigroup, Bonds in euro

MTD QTD YTD

0

5

10

15

20

25

30

35

04 05 06 07 08 09 10 11 12 13 14

% Aaa Aa A Baa BB B

Source: Bloomberg, Barclays, EUR yields

0.0

5.0

10.0

15.0

20.0

25.0

04 05 06 07 08 09 10 11 12 13 14

%German Govt swap IG HY

Source: Bloomberg, Barclays, Eur yields

1.20.4 0.6 0.6 1.0 0.8

2.00.8 1.1 1.0 1.3

0.5

13.4

7.2 7.6 8.1 7.5

3.2

0.0

2.0

4.0

6.0

8.010.0

12.0

14.0

16.0

AAA AA A BBB BB B

%

Source: Bloomberg, Barclays, Corporate Bonds in euro

MTD QTD YTD

0.0

0.5

1.0

1.5

2.0

11.13 01.14 03.14 05.14 07.14 09.14

% 1-3 yr 3-5 yr 5-7 yr 7-10 yr 10+ yr

Source: Bloomberg, Barclays, EUR yield spreads

0.5

1.0

1.5

11.13 01.14 03.14 05.14 07.14 09.14

% IG Corporates Ex Financials Financials Industrials Utilities

Source: Bloomberg, Barclays, EUR yield spreads

0.1 0.2 0.6 1.2 1.70.2 0.5 1.1

2.1 3.02.3

5.4

9.9

14.2

20.2

0.0

5.0

10.0

15.0

20.0

25.0

1-3 year 3-5 year 5-7 year 7-10 year 10+ year

%

Source: Bloomberg, Barclays, Corporate Bonds in Euro

MTD QTD YTD

0.6 0.6 0.6 0.5 0.51.0 1.1 1.1 1.0 0.9

7.88.2 8.1

8.8

7.3

0.01.02.03.04.05.06.07.08.09.0

10.0

Global Non-Financial Industrial Utilities Financial

%

Source: Bloomberg, Barclays Corporates Bonds in Euro

MTD QTD YTD


CREDIT RISK

European high-yield corporates initiating a rebound

Favourable environment for credit

The European high-yield market advanced this month, achieving a positive return with limited volatility. In doing so, its pattern of performance proved different from the US high-yield segment which had a flat-to-negative performance in November. Macroeconomic conditions continued to be weak, and headline macroeconomic risks persist in Europe. Towards the end of the month, Mario Draghi again insisted on the need to stimulate inflation to appropriate levels “without delay”. As a result, German business confidence edged up, and risky assets reacted very positively as investors repriced possible implementation of some sort of QE before the year is out. The People’s Bank of China unexpectedly cut its reference rate, and investors still need to assess the exact meaning and consequences of such a decision. The oil price continued its slide in November, breaking the level of USD80/barrel early in the month. Lower oil prices are positive for consumers, but negative for the energy sector.

Corporate news

Idiosyncratic risks dominated the headlines once again in November beyond the usual activity due to the reporting season. Abengoa fell into troubled waters due to communication issues regarding its corporate structure and the level of guarantees. Thanks to proactive communication, bonds from Abengoa partly recovered. The Portuguese business unit from OI attracted several bids, including Altice and a group of private-equity investors made of Apax Partners and Bain Capital. Liberty Global continued to increase its holdings in Ziggo, buying an additional 10% of the capital. Ziggo shares will be delisted as a result. Fiat received official approval to merge with Chrysler, and Isolux, the Spanish construction company, is planning an IPO for next year. Regarding financials, RBS whose subordinated debt is rated high-yield announced that the capital base it reported to the ECB had been overstated. Adjusted figures shows the UK lender is still passing the test, but by a very slim margin.

Technicals

Credit-rating agencies proved active in November. Crown was upgraded to BB by S&P. Wepa was upgraded to B1 by Moody’s. On a less positive note, Obrascon was downgraded to B1 by Moody’s. Piaggio’s S&P rating was pruned by one notch to B+. On the primary market, Jaguar Motors Land Rover issued a 2019 USD bond. Ontex issued a 2021 bond, and Ziggo came with a 2019 bond paying a 7.125% coupon. Rhiag and Belden tapped existing bonds whereas Obrascon called its 2015 bonds with a premium. After several weeks of outflows, investors moved again into the asset class in November.

Outlook

The sell-off experienced in September and October is now behind us. The correction over the last two months led to an increase in overall yield and a widening of spread dispersion. The overall spread-to-worst still stands above its December 2013 level. Spread dispersion offers bottom-up opportunities, primarily in the lower-rated space. Idiosyncratic risks remain key for the high-yield segment though. In Europe, ongoing weak growth and inflation are set to persist, considering the European Commission revised its growth expectations downwards for 2015 and 2016. Hence, Mario Draghi’s actions and communications will be closely scrutinised. A broad-based QE will boost technicals in favour of high-yield corporate bonds, benefiting first the BB segment that is already supported by steady demand from institutional investors and investment-grade funds. On the corporate front, the earnings reporting season proved that fundamentals remain steady. Corporates remain conservative with cash on their balance sheets. Default rates are set to remain low. All in all, fundamentals remain decent in Europe, liquidity is poor, but the liquidity premium encapsulated in bond spreads has accordingly been restored. Technicals slightly improved on the back of the lower slate of primary issuance, inflows picking up and volatility moving down from its recent high.


CREDIT RISK

EURO SWAP SPREADS MOODY'S - DEFAULT RATES

FINANCIAL INVESTMENT-GRADE RETURNS (EURO) MOODY'S - RATING DRIFT

STOCK MARKET AND HY SPREAD MOODY’S – DEFAULT RATES

HIGH-YIELD SPREAD AND DEFAULT RATE (EURO) HIGH-YIELD RETURNS BY SECTOR (EURO)

-10-505

1015202530354045

11.13 01.14 03.14 05.14 07.14 09.14

BP 2 Yr 5 Yr 10 Yr 30 Yr

Source: Bloomberg, Swap spread EUR

1.15%

2.28%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Source: Moody's

Global All Corp Global Speculative

0.5 0.4 0.4 0.5 0.3 0.8 0.7 1.0

7.0 6.7 6.4

8.4

5.3

9.38.0

11.7

0

2

4

6

8

10

12

14

%

Source: Bloomberg, BoA Merill Lynch

MTD YTD

-35-30-25-20-15-10-505

1015

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

%

Source: Moody's

Global USA Europe

* Rating drift = (issuer upgrades - issuer downgrades) / rated issuers

0

5

10

15

20

25

150

200

250

300

350

400

450

500

04 05 06 07 08 09 10 11 12 13 14

Euro Stoxx 600 HY credit spread

Source: Bloomberg, Barlcays

0%2%4%6%8%

10%12%14%16%18%20%

06 07 08 09 10 11 12 13 14 15

Source: Moody's

MOODY'S - Speculative Default Rates & baseline scenario

Global US Europe

Realised Forecast

Default Rate

Current Rate 2.28%Central 1.89%

Pessimistic 7.17%

Optimistic 1.05%

HY spread 3.79%

0%

5%

10%

15%

20%

99 01 03 05 07 09 11 13 15

Source: Moody's and Merrill Lynch HY Index

Current Default Rate HY spread

* See methodology details in Moody's Special Comment “Introducing Moody’s Credit Transition Model” and "A Cyclical Model of Multiple-Horizon Credit Rating Transitions and Default", August 2007.

0.9 0.9 0.8 1.0 1.0 0.9

5.7 5.75.3

7.4

8.3 8.5

0.01.02.03.04.05.06.07.08.09.0

%

Source: Bloomberg, BoA Merill Lynch

MTD YTD


EMERGING-MARKET DEBT

Headwinds continue in the short term, but valuations attractive

Local-currency debt – Recent developments

In November, the market was down 0,4% in USD terms. Currencies weakened by more than 1,5%, but this was partly offset by the yield and capital appreciation in bond prices. A primary driver was the stronger US dollar whereas a weaker Japanese yen meant many Asian economies needed to maintain currency competitiveness. Weaker oil prices hurt commodity exporters, but manufacturing exporters benefited from lower costs. Latin America was the worst-performing region given its heavy commodity focus, and growth has remained sluggish. The Brazilian real, Chilean peso and Colombian peso were all down by between 2.5% and 4%, but yield and capital appreciation partially offset this weakness. Mexico is less commodity-reliant than its neighbours and benefited from manufactured exports to an improving US, but Mexico’s central bank downgraded growth to 2%-2.5% for 2014. Russia has seen increased tax receipts whilst a small turnaround in oil prices helped to slow rouble weakness. Romania cut rates by 25bp, triggering weakness in the currency. The South African rand appreciated as the central bank indicated rates would have to rise eventually. Indonesia hiked rates by 25bp to 7.75% to contain inflation after the government raised fuel prices by over 30%. China unexpectedly cut its lending rate by 40bp, but ensured that interest paid to savers was protected.

Local-currency debt – Outlook

Yields look attractive for investors while some currencies remain vulnerable, though for some countries a weaker currency is part of the solution to stimulate exports and improve their current-account balances. There is more differentiation, with the Philippines and Mexico examples of strong fundamental stories; correlations have exhibited some signs of breaking down. The asset class still needs to recover fully and has not seen a meaningful return in investor demand. With expected gradual improvement in developed-market growth, emerging markets should move stronger as well, but this will not be in a straight line as growth remains uneven while potential for rising US Treasury yields could continue to have an impact. Notwithstanding short-term challenges, the asset class remains one the most attractive areas in the fixed-income segment given the transition to more normalised global monetary policy.

External debt – Recent developments

External debt was slightly lower, with all the weakness due to spread widening, whereas the US Treasury and yield component were contributors. Investment-grade countries were positive overall given their closer correlation with US Treasuries, but below-investment-grade countries were down by almost 1%, driven by Latin America. High-grade countries such as Chile, China and Poland all returned around 20-30bp, largely in line with US Treasuries. However, Brazil was down by about 25bp given weaker growth expectations and slashing of the budget-surplus goals. Venezuela was down by over 10% as current oil price levels are not seen as sustainable for the government’s debt-servicing capabilities. A bright spot in Latin America was the credit-rating upgrade to B+ for the Dominican Republic. In Eastern Europe, Russia fell by over 2% and Ukraine declined by 6%. However, Romania was up by over 1% on the back of the market-positive Presidential election win for Johannis who aims to crack down on corruption. In Asia, attention was on Vietnam which was upgraded by Fitch to BB- from B+, citing improved macroeconomic stability. This was exploited as an opportunity to issue new bonds for the first time in nearly 10 years. Malaysia was down by about 0.20% given concerns over lower oil prices denting the trade surplus.

External debt – Outlook

As developed-market monetary stimulus moves towards normalisation, we expect to see more significant differentiation between markets, which is already becoming evident. While gradually improving global growth will be positive for many emerging-market countries, higher borrowing costs could be a negative for some – the same can be said for lower commodity prices. The potential for US T-bond yields to be range-bound to steadily increasing would be supportive and add weight to the argument that there is value given the spread level relative to other high-grade-spread asset classes. However, a rapid and disorderly rise in yields could create downward pressure in the short term while, on the whole, prudent fiscal and economic management will be recognised by investors over the long term.


EMERGING-MARKET DEBT

PERFORMANCES (USD) US DOLLAR DEBT - YIELD & SPREAD

JP MORGAN EMBI GLOBAL DIVERSIFIED LOCAL CURRENCY DEBT - YIELD

JP MORGAN GBI-EM GLOBAL DIVERSIFIED PERFORMANCE JP MORGAN GBI-EM G.D.

JP MORGAN ELMI+ PERFORMANCE JP MORGAN ELMI+

0.71.8

5.6

0.1

1.8

10.0

-0.4

1.1 1.1

-1.5 -2.0

-3.7-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

MTD QTD YTD

%

Source: Bloomberg, Index JP Morgan

US Treasury EMBI g.d. GBI-EM g.d. ELMI+

4

5

6

7

8

100

150

200

250

300

350

400

450

11.11 03.12 07.12 11.12 03.13 07.13 11.13 03.14 07.14

% EMBI g.d. Spread EMBI g.d. Yield

Source: Bloomberg, JP Morgan Indices

-15.0-10.0-5.00.05.0

10.015.020.025.0

%

MTD YTD

Source Bloomberg: Index JP Morgan

1

2

3

4

5

6

7

8

11.11 03.12 07.12 11.12 03.13 07.13 11.13 03.14 07.14

% Bond markets - GBI-EM g.d. Money Markets - ELMI+

Source: Bloomberg, JP Morgan Indices

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

%

MTD YTD

Source Bloomberg: Index JP Morgan

1.2

3.3

9.4

-1.6 -2.1

-8.2

-0.4

1.1 1.1

-10.0-8.0-6.0-4.0-2.00.02.04.06.08.0

10.012.0

MTD QTD YTD

%

Source: Bloomberg, Index JP Morgan GBI-EM Global Diversified

Performance in Local Currencies Exchange gain/loss USD returns

-12.0-10.0

-8.0-6.0-4.0-2.00.02.04.06.08.0

%

MTD YTD

Source Bloomberg: Index JP Morgan ELMI+

0.2 0.5

3.4

-1.7-2.5

-7.1

-1.5-2.0

-3.7

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

MTD QTD YTD

%

Source: Bloomberg, Index JP Morgan ELMI+ Global Diversified

Performance in Local Currencies Exchange gain/loss USD returns


USA

Fed turns QE liquidity taps off, but is reassuring on rate hikes

Recent statistics have pointed towards the US economy sustaining its growth momentum

After registering 3.9% GDP growth in Q3, the US economy is still being underpinned by a sturdy platform of fundamentals. The labour market continued to pick up in October: the jobless rate inched down to 5.8%, non-farm payroll numbers for the private sector showed a rise in jobs of 209,000, and weekly jobless benefit claims have remained below the 300,000 threshold over the last ten weeks. Consumer confidence barometers continued to move in an upwardly direction, retail sales rose by 0.3%, the Purchasing Managers’ Index (PMI) for Manufacturing advanced from 56.6 to 59, and the leading economic indicator progressed by a further 0.9%. Overall, the latest data on the housing market were, on balance, reassuring. The National Association of Home Builders/Wells Fargo Housing Market Index, regarded as a forward indicator for the market, rebounded from 54 to 58, and property prices continued to climb. Housing starts did drop by 2.8%, but building permits were up by 4.8% and sales of existing houses rose by 1.5%. The US economy looks set to continue on its forward march, but the slowdown in evidence in other corners of the globe, compounded by the fraught geopolitical landscape, might well have a damaging knock-on effect which should, on a plus note, be offset by the slide in oil prices giving consumer spending a fillip.

Inflation staying below the Fed’s 2%

target rate, with inflationary expectations softening further

Consumer prices held steady in October, but tell-tales signs are starting to surface that pressures on pricing are bubbling up even though, for now, wage increases are still moderate. In the month, tumbling petrol prices offset the hike in medical and health-care costs. The headline rate of inflation was unchanged at 1.7% y-o-y, but the core rate

inched up a notch from 1.7% to 1.8%. The subdued rates of inflation remain a cause for concern at the Fed.

The Fed’s focus switching from unemployment to low inflation

In late October, in spite of financial markets being noticeably unsettled, the Fed pressed ahead with winding up its programme of monthly asset purchases. Minutes released for that FOMC meeting revealed the Fed’s concerns about the lacklustre state of economies in China, Japan and Europe, coupled with all the geopolitical tensions. They also noted though the solid anchoring of the US recovery which should continue rebuilding its strength. Some Fed Board members voiced their fears about watching inflation, already pitched below the Fed’s target, sinking even deeper as oil prices tumble and the dollar climbs. FOMC members also debated the relevant wording to describe the direction of the Fed’s monetary policy, eventually opting to persevere with the guidance that its benchmark rates would stay close to zero for some “considerable” time. The Fed is still worried about hiking rates too early and made it quite plain the initial hike would remain contingent on positive trends being set by economic data.

Considering the likelihood of moderate, non-inflationary growth,

the yield curve became even flatter

Mild inflation, economic concerns, geopolitical worries and the likelihood of the Fed sticking with its accommodating monetary stance for much of 2015 should see the US Treasuries market holding comparatively steady over the next few weeks.


USA

SHORT-TERM RATES (USD) US TREASURY BOND YIELDS

RETURNS FROM GOVERNMENT BONDS BY MATURITY MOVEMENTS IN YIELD SPREADS

INFLATION HOUSING

LABOR MARKET PMI AND NAHB

0.00.20.40.60.81.01.21.41.61.82.0

11.13 01.14 03.14 05.14 07.14 09.14

%Libor 3M Fut. 3M Sep-15 Fut. 3M Sep-16 Fed Funds T-Bill 3M

Source: Bloomberg, Money Market, USA

0.0

1.0

2.0

3.0

4.0

5.0

6.0

04 05 06 07 08 09 10 11 12 13 14

% 2 year 5 year 10 year 30 year

Source: Bloomberg, Us Treasury

0.6 0.1 0.4 0.7 1.02.21.6

0.41.2 1.8

2.6

5.14.6

0.82.4

4.8

8.5

21.5

0.0

5.0

10.0

15.0

20.0

25.0

Bonds 1-3 year 3-5 year 5-7 year 7-10 year 10+ year

%

MTD QTD YTD

Source: Bloomberg, Citigroup, US Treasury

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

04 05 06 07 08 09 10 11 12 13 14

% 2-10 year 5-10 year 10-30 year

Source: Bloomberg, US Treasury

-4-3-2-101234567

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

CPI CPI Core PCE core deflator PPI

Source: Bloomberg, USA

0

50

100

150

200

250

0

500

1'000

1'500

2'000

2'500

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

New home Sales Existing home SalesHousing start Bulding PermitsHome price-SPX Shiller 10 Home price-SPX Shiller 20

Source: Bloomberg, USASource: Bloomberg, USASource: Bloomberg, USA

-1000

-800

-600

-400

-200

0

200

400

600

0

2

4

6

8

10

12

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Unemployment Rate Nonfarm Payrolls Private Nonfarm Payrolls

Source: Bloomberg, USASource: Bloomberg, USA

0

10

20

30

40

50

60

70

80

90

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

PMI Mfg PMI Non Mfg NAHB Housing Market

Source: Bloomberg, USA


EUROZONE

The ECB stepping up to the plate

The European Commission has downgraded its economic forecasts

The eurozone economy is still struggling and the Commission’s Autumn 2014 forecasts make for grimmer reading than the Spring 2014 set. According to the European Commission, the eurozone is going to take longer to extricate itself from the economic quagmire. In order to give it a push in the right direction, the Commission has devised a far-reaching investment package to kick-start growth and jobs. It is now forecasting GDP growth of 0.8% for 2014, then 1.1% in 2015. Back in May, it had been predicting growth of 1.2% for 2014 and 1.7% in 2015. The Commission’s revised autumn forecasts are more downbeat than the IMF’s projection for 1.3% in 2015. The downgrade can be blamed on confidence being knocked by creeping geopolitical tension and the slowdown in Asia. Individual eurozone economies are still experiencing mixed fortunes, with the Big Three (Germany, France and Italy) seemingly limping along. As for inflation, the Commission is projecting annual rates averaging 0.5% for 2014 and 0.8% in 2015.

Recent data not inspiring optimism and the spectre of deflation still haunting the eurozone

The eurozone economy remains very sluggish, but is still just about growing: GDP expanded by 0.2% in Q3 whereas consensus projections had been forecasting a mere 0.1% rise. France sprang a pleasant surprise, recording 0.3% growth, Greece returned to growth (+0.7%) and Germany missed slipping back into recession by the slimmest of margins (+0.1%). The unemployment rate has remained pitched up at about 11.5% for several months. The Manufacturing PMI has just about managed to keep above the 50-point threshold for the past four months, but the Services PMI has slipped back since the summer, retreating from 54.2 to 51.3. Consumer confidence has been waning since the summer too, and retail sales shrank by 1.3%. Knock-on effects from the crisis in

Ukraine and the sanctions slapped on Russia will continue to hamper European economies. Headline inflation was flat at 0.4% y-o-y in October, with the underlying rate steady at 0.7%, but that means both bellwether rates are a long way below the ECB’s 2% official target.

ECB stirring into action and aiming to expand its balance sheet to its 2012 dimensions

As expected, the ECB made no change to interest rates in November. Its main refinancing rate remains pegged at 0.05%, its marginal rate at 0.30% and its deposit rate at -0.20%. During his press conference, Mario Draghi was at pains to stress the Governing Council was unanimous in being prepared to press ahead further if required. He also clarified the ECB’s target for the balance sheet: it is aiming to expand it by EUR1,000bn. To do that, the ECB will undoubtedly have to launch several new measures. Buying up sovereign bonds remains one such possibility. Last month, the ECB had made a start on buying covered bonds and, on 21 November, it initiated its programme of buying asset-backed securities in its drive to swell the size of its balance sheet. We await the outcome of the second Targeted Longer-Term Refinancing Operation (TLTRO) in December, which comes after the outcome of the bank stress testing and AQR, to see whether the projected volume of EUR400bn can be reached. Mario Draghi reiterated in his speech to the European Parliament his determination to push through non-conventional monetary measures, if they prove necessary, to get the eurozone economy back on the growth track.

10-year sovereign bond yields, which have sunk to record lows, look set to stay there

Geopolitical risks, an anaemic economy, low inflation and the latest measures pushed through by the ECB should continue underpinning the eurozone bond market, especially helping peripheral eurozone bonds that are still offering a premium.


EUROZONE

SHORT-TERM RATES (EURO) BUND YIELDS

RETURNS BY MATURITY (EMU GVT) 10-YR GVT SPREADS VS GERMANY

EUROZONE - M3 AND LENDING TO PRIVATE SECTOR EUROZONE - PUCHASING MANAGER INDICES

EUROZONE - INFLATION EUROZONE - ECONOMIC SURVEYS

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

11.13 01.14 03.14 05.14 07.14 09.14

% Euribor 3M Fut. 3M Sep-15 Fut. 3M Sep-16ECB Repo Eonia Overnight

Source: Bloomberg, Money, EU

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

04 05 06 07 08 09 10 11 12 13 14


Source: Bloomberg, Bund

1.30.1 0.3 0.9 1.6

2.81.5

0.0

0.2 0.92.0

3.7

11.8

1.6

5.3

10.3

15.3

25.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0


%

MTD QTD YTD

Source: Bloomberg, Citigroup, EMU Gvt Bonds

-100

0

100

200

300

400

500

600

700

04 05 06 07 08 09 10 11 12 13 14

BP France Netherland Austria Belgium Spain Italy

Source: Bloomberg, Govt yield spreads

-4

-2

0

2

4

6

8

10

12

14

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% EU M3 Money Supply EU Lending to private sector

Source: Bloomberg, Eurozone

40

42

44

46

48

50

52

54

56

11 12 13 14

EU PMI Mfg EU PMI Services EU PMI Composite

Source: Bloomberg, Eurozone PMI index

-10

-8

-6

-4

-2

0

2

4

6

8

10

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% EU Inflation EU Core Inflation EU Producer Price

Source: Bloomberg, Eurozone

0

20

40

60

80

100

120

140

-50

-40

-30

-20

-10

0

10

20

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

EU Business Climat Industrial ServicesConsumer Construction Economic

Source: Bloomberg, Eurozone Economic Survey


UK

The BoE has revised its economic forecasts downwards

The UK economy is doing well compared to the economies of neighbouring countries

After recording 0.7% growth in Q3 2014, the UK economy has been exhibiting a more mixed set of signals, suggesting to commentators that economic growth is likely to lose a little speed in the final quarter of the year. The ongoing sluggishness of the eurozone economy adds further weight to this supposition. The UK housing market has lost some of its momentum. The index compiled by the Royal Institute of Chartered Surveyors, regarded as a reliable leading indicator for the housing sector, has been on the slide for several months, slipping from 30 to 20 in October, and house prices have also begun to flag. PMIs have also dipped in recent months. The jobless flat held firm at 6% in September and wages growth is pedestrian, edging up from +0.7% to +1.0%.

Prime Minister Cameron, who will go to the polls in next May’s general election, has

alluded to risks menacing the UK economy

In an article which appeared in The Guardian daily newspaper on 17 November, Prime Minister David Cameron pointed out that, “in our interconnected world, wider problems in the global economy pose a real risk to our recovery at home”. He commented that “the eurozone is teetering on the brink of a possible third recession”, along with outlining other problems facing the global economy and the mounting geopolitical risks. This array of uncertainties is also worrying the Bank of England (BoE) which has adopted a more doveish tone as regards the likely onset of the next cycle of rate hikes.

As expected in early November, the BoE made no change to its monetary policy, and shaved

its growth and inflation forecasts

Lacklustre wages growth and the fact the falling jobless rate is unlikely to filter through into pressure on pay in the near future owing to the ongoing slack in the economy explain

why the BoE is preferring to err on the side of caution, especially as inflation has slipped well short of its target. The minutes of the last Monetary Policy Committee (MPC) meeting revealed that, although two MPC members were still in favour of an immediate quarter-point hike in the base rate, the other seven voiced a broad range of views in their assessment of the UK economic outlook. The most circumspect among them are fearful of the economy running out of steam more than expected and of inflation staying well below the official BoE target. Moreover, in its quarterly report on inflation, the BoE is projecting that the rate will slide to 1% over the next six months and not move back up to its target level before 2017. Inflation in Britain worked out at 1.3% y-o-y in October, a shade up on the 1.2% rate reported for September, but it is still bumping along at five-year lows. The underlying rate of inflation was, however, steady at 1.5%.

Sedate inflation, pedestrian wages growth and worries over the lethargic state of the eurozone economy, which is weighing on UK exports, suggest that most of the MPC will continue advocating making no changes in the coming months. The MPC will doubtless wait for further real evidence that slackness in capacity is being mopped up before taking any action.

Expectations about hikes in the UK base rate have been unmistakably reined in

Yields on UK gilts fell in November, as they did on other leading government bond markets worldwide. Market operators in the UK are no longer expecting the BoE to lift its base rate before the end of 2015, so the gilts market should hold fairly steady over the next few weeks, buoyed by the mix of economic uncertainties and low inflation.


UK

SHORT-TERM RATES (GBP) UK TREASURY YIELDS


LABOR MARKET AND EARNINGS HOUSING AND RETAIL SALES

INFLATION ECONOMIC SURVEYS

0.0

0.5

1.0

1.5

2.0

2.5

3.0

11.13 01.14 03.14 05.14 07.14 09.14

% Libor 3M Fut. 3M Sep-15 Fut. 3M Sep-16BOE Base Rate Swap Sonia 3M

Source: Bloomberg, Money Market, UKSource: Bloomberg, Money Market, UKSource: Bloomberg, Money Market, UKSource: Bloomberg, Money Market, UK

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

04 05 06 07 08 09 10 11 12 13 14


Source: Bloomberg, GILT

3.3

0.41.2 1.7

2.6

5.34.7

0.92.2

3.14.2

7.2

12.7

1.6

4.5

7.2

11.1

21.0

0.0

5.0

10.0

15.0

20.0

25.0


%

MTD QTD YTD

Source: Bloomberg, Citigroup, UK Treasury

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

04 05 06 07 08 09 10 11 12 13 14

% 2-10 year 5-10 year 10-30 year

-4

-2

0

2

4

6

8

10

12

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% Unemployment Rate Average Earnings Ex Bonuses Average Earnings


-120

-70

-20

30

80

130

-20

-15

-10

-5

0

5

10

15

20

25

30

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% Retail Sales (l.s.) Nationwide House Price (l.s.) RICS House Price Bal.(r.s.)


-4

-2

0

2

4

6

8

10

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% CPI Core CPI PPI Output


-45

-40

-35

-30

-25

-20

-15

-10

-5

0

5

20

25

30

35

40

45

50

55

60

65

70

07 08 09 10 11 12 13 14

% PMI Mfg PMI Services PMI Construction Consumer Confidence



SWITZERLAND

Franc climbing ahead of the key referendums on 30 November

The Swiss economy still in robust shape despite GDP growth stalling a little in Q2

Although Switzerland’s economy has lost a little impetus, it is still doing better than the eurozone, as can be seen from the upswing in findings from October economic and business surveys. The KOF economic barometer ticked up from 99.1 to 99.8, the Manufacturing PMI advanced from 50.4 to 55.3 whilst the ZEW-CS index improved from -30.7 to -7.6. The UBS Consumption Indicator also recorded a modest bounce from 1.28 to 1.41, but it is still heralding a decline in consumer spending over the coming months. Findings from the quarterly survey conducted by the State Secretariat for Economic Affairs (SECO) also hint at a probable downturn in consumer spending. Since 2013, the overall consumer confidence index compiled by SECO has been cruising along above its long-term average reading, but, in October this year, it slipped underneath that line, sliding from -1 to -11. Sub-indices for confidence about expectations for the economy, job security and unemployment fell quite noticeably in October. Retail sales in real seasonally adjusted terms slumped by 0.9% in September. Some barometers for the property sector appear to be signalling a slight dip in prices, suggesting that measures adopted by the Swiss National Bank (SNB) to cool mortgage lending may well be starting to bear fruit. Despite that, conditions in the property sector are still quite taut, as the new record high of 1.29 set by the UBS Swiss Real Estate Market Bubble index would appear to demonstrate.

Switzerland’s rate of GDP growth looks set to be fairly moderate over the next few quarters owing to the stubbornly high Swiss franc, anaemic eurozone economy and less brisk domestic demand.

The outcome of popular referendum votes on 30 November and the ongoing lethargy of

eurozone economies may well make the SNB’s job that much more awkward

The SNB, whose foreign-currency reserves now total almost 80% of the country’s GDP, has not changed its tune. It still regards the franc as overvalued and intends to continue fighting to stop the franc climbing above its ceiling against the euro in order to scotch any threat of deflation taking hold. The SNB remains determined to buy foreign currency in unlimited quantities and push through further measures, with the prospect of setting negative interest rates not being ruled out, if it needed to defend this exchange-rate threshold. However, the SNB has acknowledged that, if the Swiss electorate vote in favour of restoring gold reserves, it would complicate its conduct of monetary policy. As for the property sector, the SNB is likely to press ahead with its counter-cyclical initiatives to keep the market from overheating. The SNB has trimmed its GDP growth forecast for 2014 to 1.5% and is projecting inflation of just 0.1% for 2014, 0.2% for 2015 and 0.5% in 2016 even with interest rates being pegged at zero. The SNB’s Thomas Jordan made it quite plain that deflationary risks had mounted in Switzerland.

Swiss bond market set to remain range-bound in next few months

The strong franc, ongoing deflationary risks and the uncertain global economic outlook are likely to maintain the pressure on the SNB to keep interest rates and the ceiling exchange rate for the franc against the euro unchanged for a few more months. The outcome of the key 30 November votes – when the electorate will, as well as voting on the SNB’s gold reserves, be asked to rule on the Ecopop initiative (geared to capping immigration at 0.2%) and an initiative to abolish flat-rate tax packages – could seriously muddy the waters, but, even if that were to happen, bond yields should not flinch much.


SWITZERLAND

SHORT-TERM RATES (CHF) CONFEDERATION BOND YIELDS

RETURNS FROM GOVERNMENT BONDS BY MATURITY CONFEDERATION - MOVEMENTS IN YIELD SPREADS

SNB EXCHANGE RESERVES INFLATION

HOUSING ECONOMIC SURVEYS

-0.5-0.4-0.3-0.2-0.10.00.10.20.30.40.5

11.13 01.14 03.14 05.14 07.14 09.14

%Libor 3M Fut. 3M Sep-15 Fut. 3M Sep-16 SNB min/max 3M Libor

Source: Bloomberg, Money Market, CHF

-1.0-0.50.00.51.01.52.02.53.03.54.0

04 05 06 07 08 09 10 11 12 13 14


Source: Bloomberg, Confederation

0.60.2 0.3

0.7 0.91.7

0.80.2 0.3

0.7 0.8

2.5

3.7

0.1

1.1

3.5

7.0

12.5

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0


%

MTD QTD YTD

Source: Bloomberg, Citigroup, Switzerland Gvt Bonds

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

04 05 06 07 08 09 10 11 12 13 14

% 2-10 year 5-10 year 10-30 year

Source: Bloomberg, Confederation

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

80

90

100

110

120

130

140

150

160

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% CHF Trade Weighted Index BNS - Foreign Currency Reserves CHF

Source: Bloomberg, Switzerland

-8

-6

-4

-2

0

2

4

6

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% CPI Core CPI Producer & Import Price


0

50

100

150

200

250

300

350

400

450

500

-3

-2

-2

-1

-1

0

1

1

2

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% UBS Real Estate Bubble House Construction PermitsSingle Family House Price


0

0.5

1

1.5

2

2.5

3

30

40

50

60

70

80

90

100

110

120

130

07 08 09 10 11 12 13 14

% PMI Mfg Kof Leading UBS Consumption



JAPAN

Sales tax hike impact persisting, tipping Japan back into recession

The consensus had been looking for growth of 2.2% in Q2 of the 2014/15 fiscal year in Japan

whereas its economy actually contracted at an annualised rate of 1.6%

Japan had already seen its GDP shrink by 7.3% in Q1 2014/15 when the economy had been heavily penalised by the hike in the consumer sales tax rate from 5% to 8% in early April. The slump in consumer spending, dented by April’s hike in the consumer sales tax rate and some inclement weather, had prompted businesses to curtail their production and exports had been faltering despite the lift from a depreciating yen. The slide in the yen’s value has not resulted in any upsurge in exports, but has raised the cost of the import bill and further eaten away at households’ spending power, already dented by the hike in the consumer sales tax rate. The plentiful supplies of liquidity made available to banks by the Bank of Japan (BoJ), with the end-goal of encouraging them to lend to business, have not fed through into a significant increase in lending. The budgetary reflationary measures, together with the quantitative easing put in place by the Bank of Japan (BoJ), have not been able to bring about a sustainable upswing in the economy, and reforms pledged by the government have still not come off the drawing-board. This turn for the worse has reignited fears of a repeat of the 1997 scenario when the two-point hike in the consumer sales tax rate caused the economic upswing to grind to a standstill. The BoJ’s announcement in late October that it would be again boosting its already unprecedentedly expansionary programme, and the economy’s relapse into recession pushed the yen even lower.

Dismal showing by Japan’s economy prompted Prime Minister Shinzō Abe to postpone second hike in the consumer sales tax and call a snap

election halfway through his term of office

Japan’s government find itself in an awkward predicament. In order to bring ballooning debt (already riding above 230% of GDP) under tighter control, it had been expecting to be enjoying the benefits of increased streams of tax revenue. In contrast, sluggish growth, depressed

by shrinking consumer spending, has painted the Prime Minister into a corner, forcing him to postpone the second hike in the consumer sales tax, due to be raised from 8% to 10%, by 18 months (to April 2017). Moreover, PM Shinzō Abe, keen to take advantage of personal popularity ratings that have not been dented too much, decided to dissolve the Lower House of Japan’s Diet to buttress his position as Head of Government to allow him free rein to push through his dynamic and reforming economic policy agenda as well as to distance himself somewhat from the pacifism that has been the hallmark of Japan’s politics since World War II. Japan will go to the polls in an early general election in mid-December to re-elect 480 members of the Diet. Shinzō Abe declared that, if the ruling coalition failed to secure a majority in the Lower House after the election, this would mean the Japanese electorate had rejected the reflationary reformist policy package, commonly referred to as ‘Abenomics’, and that he would step down.

The BoJ is set to expand its monetary base at a rate of JPY80,000bn a year, with the BoJ Governor indicating that Japan is today in a critical phase of its battle to conquer deflation. Consumer prices have been sliding again over the last few months. Once the hike in the consumer sales tax rate is stripped out (effect of boosting inflation by two percentage points), inflation works out, using the BoJ’s method of calculation, at just 1.2%, still some way short of the 2% target set.

The BoJ’s activist line on monetary policy likely to continue underpinning the market

for Japanese government bonds (JGBs)

The change in the weighting accorded to bonds by the Government Pension Investment Fund (GPIF) from 60% to 40% and the outcome of the forthcoming early general election might well create some volatility for JGBs. Nevertheless, yields on JGBs are likely to continue bumping along at rock-bottom levels in the coming months on account of the BoJ’s approach to monetary policy.


JAPAN

SHORT-TERM RATES (YEN) JAPANESE GOVERNMENT BOND YIELDS


INFLATION JAPANESE YEN VERSUS DOLLAR

CONSUMPTION LEADING INDICATOR AND INDUSTRIAL PRODUCTION

0.00.10.10.20.20.30.30.40.40.50.5

11.13 01.14 03.14 05.14 07.14 09.14

% Libor 3M Fut. 3M Sep-15 Fut. 3M Sep-16BOJ Target BoJ Discount

Source: Bloomberg, Money Market, JapanS

0.0

0.5

1.0

1.5

2.0

2.5

3.0

04 05 06 07 08 09 10 11 12 13 14


Source: Bloomberg, JGB

0.7

0.1 0.1 0.2 0.3

1.61.2

0.1 0.30.5

0.8

2.6

3.6

0.30.8

1.9

3.6

7.4

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0


%

MTD QTD YTD

Source: Bloomberg, Citigroup, Japan Gvt Bonds

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

04 05 06 07 08 09 10 11 12 13 14

% 2-10 year 5-10 year 10-30 year

Source: Bloomberg, JGB

-3

-2

-1

0

1

2

3

4

5

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% CPI CPI Ex-Fresh Food CPI Ex-Food & Energy

Source: Bloomberg, Japan

70

80

90

100

110

120

130

04 05 06 07 08 09 10 11 12 13 14

1 USD in JPY

Source: Bloomberg, exchange rates

0

10

20

30

40

50

60

-10

-8

-6

-4

-2

0

2

4

6

8

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% Bank Lending Household Spending Consumer Confidence


-50

-40

-30

-20

-10

0

10

20

30

40

20

40

60

80

100

120

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

% PMI Coincident Index Leading Index Industrial Production YoY


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Documents

Bond letter (2014.12.01 en ww)