Market Outlook of the Investment Advisory Bureau Jacek ... · turbulences, ending the month in positive territory (+1.4%). The Polish market also performed poorly, although the smallest

August 2014

21 August 2014 | 25 pages

Markets rattled by geopolitics Market Outlook of the Investment Advisory Bureau

Jacek Janiuk, CIIA

Investment Advisor

Jakub Wojciechowski

Securities Broker

Contributing authors:

Karol Matczak

Maciej Pietraszkiewicz

Dariusz Zalewski

Source: Bloomberg, Citi Handlowy

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WIG30 S&P500 Eurostoxx50

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Jul-13 Oct-13 Jan-14 Apr-14 Jul-14

Polish Treasuries US Treasuries

German Treasuries

It has been another nervous month for equity markets . While the first half of July appeared

to herald the return of positive sentiment to global stock markets, the good mood evaporated

as quickly as it had appeared and geopolitical events proved drivers of negative sentiment

once again. The shooting down of a passenger aircraft over the territory of Ukraine resulted in

an escalation of tensions between Russia and Western countries and, consequently, in

sanctions being imposed on the Russian Federation by the EU.

In this environment, the performance of equity indices has hardly been surprising. The

sharpest fall was recorded in Europe where investors were discounting the impact of sanctions

on the European economy (with the Eurostoxx 50 losing 3.5%). The U.S. equity market

performed slightly better (-1.5%), and emerging markets proved relatively resilient to

turbulences, ending the month in positive territory (+1.4%). The Polish market also performed

poorly, although the smallest companies proved once again to be the most sensitive to political

developments (-6.8%).

Despite the current geopolitical turbulences, we maintain our very positive view on equities

vs. bonds. We believe that the fundamental situation has not changed so much as to justify

the modification of our view at the level of asset classes. In our opinion, the following factors

will support equities: the improvement in global economy (we expect the global GDP to rise by

2.9% this year), the expected growth in corporate earnings signaled by leading indicators,

expansive monetary policy by the Fed, ECB and BoJ as well as positive sentiment among

investors reflected in inflows to equity funds.

At the moment, the greatest risk factor to our scenario is the manner in which the

geopolitical situation will develop. We see three flashpoints that may, if escalation follows,

lead to a change in our views on the market. The most disturbing conflicts are those between

Ukraine/Western countries and Russia, between Islamic fundamentalists and Iraq and between

Israel and Hamas. Additionally, we are looking for potential sources of risk in economic data

as well. Worse than expected macroeconomic readings, negative earnings surprises or an

accelerated increase in interest rates in the U.S. would undoubtedly weigh down equity

indices.

We are still skeptical on the Polish stock market. Although the number of people who

finally opted for open-ended pension funds has probably already been priced in and it is hard

to expect that this outcome will strongly impact the market, it cannot be denied that the these

funds are becoming marginalised, which will be a negative factor for the stock market in the

long term. The Polish stock market may also continue to be weighed down by the conflict

beyond our eastern border and by possible further “retaliatory” measures from Russia.

We maintain our negative outlook on the debt market, where we expect yields to rise and

prices to come under pressure in the medium term.

We remain neutral within Polish debt instruments. Although we do not expect an interest rate

cut at the next MPC meeting in September, we notice that recent events as well as inflation

readings increase the likelihood of such a move by the Council.

Investment Barometer 21 August 2014

2

Poland

The past month has demonstrated once again that it is geopolitical developments

that currently pose the greatest threat to financial markets. Nothing can spoil

sentiment on stock exchanges nearly as much as news on the inflaming of the conflict

between Russia and Western countries or the imposition of economic sanctions. At the

same time, it is clear that these risks are unevenly distributed. Investors who are

interested in European markets (both developed and emerging ones) attach much

greater importance the them, which should not come as a surprise. Owing to the tight

economic linkages between Europe and Russia combined with geographical proximity,

any serious increase in tension drags indices down, which can be seen particularly

clearly in markets with limited liquidity, such as Poland. July was another month that the

Warsaw Stock Exchange ended in the red: the WIG broad market index was 3.7% down

and is now lower than it was the beginning of the year. Small and medium-sized

enterprises performed much worse once again, losing 6.2% and 6.8% respectively.

Chart – Performance of Polish stock indices year in July and in year-to-date

terms


The most important geopolitical event of the last month was the downing of a passenger

plane over the territory of Ukraine. The scale of the tragedy and the subsequent wave of

accusations coming from Russia and Ukraine increased the tensions once again,

resulting in the imposition of severe economic sanctions against Russia by

Western countries (mainly the EU, U.S., Japan and Canada), which is discussed in

more detail in the section of the Barometer devoted to Europe. Additionally, the

Russian president signed a decree banning the import of agricultural produce from

those countries that had imposed sanctions. This will also be important for economic

activity on a global scale, although right now the potential impact is difficult to estimate.

The current state of affairs also has considerable repercussions for the Polish economy.

As it were in revenge for European sanctions, Russia has imposed an embargo on

Polish fruit and vegetables. This will not have a huge direct impact on economic activity,

since in the past year, sales of such produce to Russia amounted to 0.6 billion euro, i.e.

just 0.4% of total exports (less than 0.2% of GDP). It is also worth noting that for quite a

few months, these amounts have decreased (see Chart below). However, a much more

important factor for Poland may be the losses caused by the adverse impact of

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YTD July

Political developments

thwart investors

Long-threatened

sanctions have become a

reality…

…and Poland has been

the first to suffer


3

sanctions on European countries, i.e. its most important economic partners. Potentially

slower economic growth in eurozone countries may reduce demand on their part and, as

a consequence, negatively affect Polish exports. Our economists estimate that the

impact of both channels on the Polish economy could reach 0.3 or 0.4 percentage

points, which would certainly put the Polish GDP growth forecast of 3.4% for 2014 into

question.

Chart – Growth of food exports overall and to the Russian market


Apart from concerns about the impact of external events on Polish economic activity,

macroeconomic readings have also been poor lately. The growth of retail sales in

June slowed to 1.2% y/y (well below the consensus forecast of 4%). Industrial

production disappointed as well with an increase by just 1.7% y/y (with expectations

hovering around 3.4%). The manufacturing PMI reading was also weak and fell for the

fifth time in a row, this time to a recessionary level of 49.4 points (the decrease in new

orders was the largest detracting factor).

These are not data that would suggest serious problems for the Polish economy, but a

slowdown has been evident in the second quarter nevertheless. The only positive

signal has been the consistent improvement on the labor market, where unemployment

is trending down (12% in June), and the increase in real wages has accelerated for

several months now. However, recent readings suggest that the economy has slowed

down in to ca. 3% in Q2, which – although not in itself a bad result – means a figure

lower than in the first three months of the year (when Poland grew at a rate of 3.4%).

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Food export (% yoy) including Russia

Slowdown visible in Q2


4

Chart – Economic growth in Poland vs. manufacturing PMI


July brought the answer to the following riddle: how many people have decided to

entrust part of their salary to open-ended pension funds? Although in recent months it

was estimated that 5% would be a difficult threshold to cross, according to the latest

data around 1.9 million people, i.e. more than 12% of the insured, have opted for the

funds. At the same time, not all declarations have been counted yet and some of them

have been completed incorrectly, so the final results will not come in unt il mid-August.

What implications for the market does this number hide? It seems that they will be

limited, considering the fact that the number of declarations submitted was regularly

tracked in recent months and therefore investors have already discounted most of the

information in equity prices. According to our estimates, net flows to open-ended

pension funds in the coming years should be positive. If we assume that the dividend

yield on the shares held in the funds’ portfolios is close to 3% and the yie ld on the bond

portion is ca. 2.5%, open-ended pension funds probably will not be forced to sell their

assets to meet the needs related to the so-called slider mechanism, i.e. the gradual

transfer of assets to the Social Security Institution a few years before retirement. A

much more important factor, however, may be the direction in which the investment

policy of the funds themselves evolves. In recent months, significant interest in foreign

equities has been noticeable – their share in pension fund portfolios has surpassed 5%,

but statutory limits are much higher. As of 2016, funds may hold even up to 30% of their

assets in foreign shares, which would in turn mean additional pressure on the Polish

market.

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GDP growth yoy (left axis) Manufacturing PMI

P

The issue of pension

funds should fade into

the background


5

Chart – Pension fund membership declarations


We still consider the Polish equity market to be less attractive versus foreign

markets. This results primarily from the issues related to the geographical proximity of

Ukraine and Russia, which might hurt the Polish economy and the prospects of Polish

companies particularly hard if the conflict escalates (e.g. further sanctions or embargoes

are introduced). We also note that open-ended pension funds have been clearly

marginalised and it cannot be denied that these funds, which used to be very important

players, are slowly disappearing from the Polish scene. This in turn makes high

valuations in the Polish market, which until recently could be justified by the presence of

open-ended pension funds, much harder to defend. We remain neutral as concerns

allocations to large and small and medium-sized companies, because we do not see a

case for overweighting any individual segment.

July was a fairly upbeat period in the Polish debt market thanks to the developments

movements in core markets as well as signals from the domestic economy and from the

Monetary Policy Council. For most of the month, Polish bonds followed 10-year

German Bunds, which reached very low yield levels (down to 1.12%) owing to low

inflation readings and possible further measures by the European Central Bank. At the

same time, CPI inflation in Poland does not cease to surprise on the downside. The

price index in June came to 0.3% y/y, and Citi economists expect that – for the first

time in history – inflation in July and August will drop below zero , i.e. deflation will

be recorded. The deflationary scenario is also supported by the introduction of the

Russian embargo on Polish food. However, in the longer term, given the cur rent rate of

economic growth and the low base, CPI inflation should start to rise at the end of the

year (see Chart below).

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Polish bonds continue to

rally…


6

Chart – CPI inflation against the NBP benchmark rate


In these circumstances, the MPC may decide to cut interest rates, although this is not

our baseline scenario. Our economists assume that rates in Poland will remain

unchanged until the end of the year and for most of 2015. We also note that the

yields of 10-year Polish bonds are at levels unseen for over a year, while both economic

growth and the labor market situation have improved significantly. Inflation – albeit still

low – should start to rise at the end of the year for two reasons: the uptick in economic

activity and the low base effect. Therefore we remain negative on the long end of the

yield curve.

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CPI YoY NBP reference rate

Inflation target

Forecast

…and what will the MPC

do?


7

United States

In July, a wave of sell-offs swept across most developed markets and Wall Street was

not spared. As a result, the rate of return on the S&P500 broad market index was

negative at -1.5%. Although the American economy should not suffer too much as a

result of the economic conflict between Russia and the West, emotions still count and

investors turned away from risky assets regardless of fundamentals.

Chart – Index performance in developed markets year to date


And the latter still look robust. Recent weeks have confirmed that the winter slowdown

was only temporary and the U.S. economy is overcoming stagnation at a brisk pace.

Retail sales, industrial production, car and home sales readings all pointed to

accelerating economic activity in the United States. Economic growth in Q2 also

speeded up significantly, amounting to 4% in annualised terms (with expectations

around 3%). At the same time, we see a steady improvement in leading indicators such

as the ISM, which gives reasonable hope that favorable trends will be sustained (see

Chart below).

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Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14

S&P 500 Topix Eurostoxx 50

U.S. remains strong

although affected by the

correction

Economic recovery is

confirmed by

macroeconomic data…


8

Chart – ISM Manufacturing in the U.S. vs. GDP growth


For the U.S. economy, the labor market is of particular importance – it is not without

reason that apart from price stability and long-term interest rates, the Federal Reserve

aims for high (maximum) employment, which in practice means an unemployment rate

of around 5%. According to most recent figures, 6.2% of Americans are out of work; at

the same time, it is often emphasized that as the unemployment rate drops, the rate of

participation in the labor market declines as well, which means that more and more

people are no longer looking for work and this “artific ially” improves the official readings.

Another argument that is made is that more Americans than usual are choosing to work

part-time. Although it is hard to deny the existence of such relationships, we would like

to point out that drawing far-reaching conclusions can be risky. When we look at people

who have been unemployed for up to six months, an entirely different picture of the

labor market emerges. The unemployment rate among this group is only 4%, i.e. at a

level almost as low as during the two most recent economic activity peaks. Some

segments of the U.S. industrial and services sectors are already indicating clear staffing

problems, which is essentially a good signal.

Chart – Relationship between the improvement in the labor market and retail

sales


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ISM Manufacturing GDP growth yoy (right axis)

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Retail sales Employment change yoy (right axis)


9

So how has been the improvement in economic situation in the private sector

reflected in the companies’ results? Clearly positively. We are approaching the end of

the earnings season in the U.S. (we already know readings for more than 400

companies in the S&P500) and it can be said that this will be a satisfactory one. While it

is true that the U.S. market has a tendency to underestimate profits and surprises are

mostly on the upside, this time companies have reported results that were much better

than expectations. Revenues grew by 4.34% (a surprise of 1.4%), but earnings turned

out to be much better with a jump by 10.12% (a surprise of 5.31%). Interestingly, in July

we recorded a clear increase in upwards revisions – these concerned 57.5% of the

companies included in the S&P500 (an increase from 49.9% in June), which means that

according to analysts, prospects for generating profits in the U.S. private sector have

improved.

Chart – Earnings season in the U.S.


We think that in the second half of this year and in the first half of 2015, trends in the

U.S. market will largely be conditioned by corporate earnings and board forecasts.

Credit conditions in the United States remain favorable and any increases in interest

rates appear a distant prospect; moreover, recent data on the labor market, planned

investment expenditure by companies and M&A activity look encouraging. From the

point of view of the capital market, is also worth noting that the support comes from the

companies themselves as they decide to conduct larger than usual share buybacks. Citi

U.S. market strategists maintain their target for the S&P500 at the level of 2050 points

by mid-2015, which means that they assume a single-digit increase in the index. We

also continue to see moderate potential in the U.S. equity market , but as concerns

fundamentals, we are afraid of ever higher valuations, which will at some point drive

investors away from that market.

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Surprise Change

Revenues Earnings

…and company results.


10

Developed Europe

Equity indices in Western Europe continued the declines that started in the second half

of June. The German DAX lost 4.3% while the Eurostoxx 50 and Stoxx 600 broad

European indices finished the month respectively 3.49% and 1.75% down. Supply

heavily outweighed demand in the last week of July. The main reason for this sell-off

was the introduction of EU sanctions against Russia. The sanctions introduced are

sectoral ones and concern the financial sector (cutting off Russian banks from new

funding in EU markets), the military one (no new export contracts will be signed) and the

sector related to technology and crude oil extraction. The sanctions are a double -edged

sword, however, since effects of the restrictions introduced will also be felt throughout

the eurozone. The cost of sanctions is estimated by Citi analysts at 0.3% of EU GDP in

2014 and 0.4% in 2015. Russia is the sixth largest trading partner for the EU. In 2013,

EU exports to Russia amounted to 103 billion US dollars, which represents ca. 2.4% of

total EU exports. Companies with significant exposures to the Russian market will be hit

the hardest. For instance, the share price of Adidas plunged by 20% over the month and

company representatives issued a warning about a downward revision of financial

results caused by developments in the Russian market (a key market for Adidas); the

company also decided to close some of its stores in Russia.

Chart – Adidas share price


Another company that is already feeling the slowdown in sales in the Russian market is

Volkswagen. In the first half of 2014, the company saw an 8% drop in revenue in

Russia. In July, Volkswagen’s share price dropped by almost 9%.

Looking at the Eurostoxx 50 chart, however, we still see an upward trend. The last fall

brought the index closer to the lower boundary of the uptrend channel. We believe that

the current declines are a deeper correction after which we can expect a return to the

upward trend. This scenario is stil l supported by the relatively attractive valuations of the

companies listed on European stock exchanges, positive inflows into the equity funds

that invest in Western Europe and the expansionary monetary policy pursued by the

ECB. An open question remains, however: just how deep will the current correction

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Retreat from Europe as a

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prove? From 19 June to 1 August, the Eurostoxx 50 lost more than 6%. And the

uncertainty concerning the precise economic impact of the “economic war” with Russia

remains. An additional risk factor is the performance of European companies, since the

profit forecast that assumes a growth of 10% this year will be difficult to meet. A

downward revision of forecasts by analysts is becoming ever more real. On the other

hand, some investors will certainly try to take advantage of the prevailing concerns to

take a long position in European companies whose valuation is relatively attractive.

Chart – Eurostoxx 50 from 2011 to 2014


On the eurozone bond market, a strong rally was in progress. The yields on 10-year

Italian and Spanish bonds reached new lows of 2.69% and 2.5% respectively at the end

of July. German bonds also gained, with yields dropping to 1.12% in July. The rally in

the German bond market has been the result of the expansionary monetary policy

pursued by the ECB, the lack of inflationary pressure and the “risk off” mood that

prevailed on the markets in July. However, the steady reduction in premium for the risk

of default in peripheral countries of the eurozone appears dangerous. Readers should

be reminded that in 2012, Italian and Spanish bond yields oscillated around 7%. In July,

yields in peripheral eurozone countries reached new lows despite the disturbing event

involving the Portuguese Espirito Santo bank whose subsidiary failed to redeem its

maturing debt on time.

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The situation in the debt

market is slightly different.


12

Chart – Yields of 10-year German, Italian and Spanish bonds from 2007 to 2014


In macroeconomic terms, we still see divergence between the two key eurozone

economies: an increase in the manufacturing PMI in Germany and another decline in

the French PMI. In July, manufacturing PMI for the entire eurozone did not change

relative to the previous month and is still at a fairly satisfactory level of 51.8.

Chart – Manufacturing PMI in the eurozone


On the other hand, the increase in services PMI is encouraging. For the entire

eurozone, it rose from 52.8 to 54.4. France has recorded significant growth in this

respect and its index has exceeded the threshold value of 50 points.

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Unemployment in the eurozone remains high, but a steady decrease in its rate since

September 2013 (see Chart below) is a good sign.

Chart – Unemployment rate in the eurozone (%)


In the foreign currency market, the euro depreciated against the dollar. The EUR/USD

exchange rate fell to 1.3388 from 1.3690 in the previous month. In the long term, a

weaker euro is favorable for Europe’s economy, affording a better competitive position

to European exporters. The strong euro was repeatedly mentioned as one of the major

risk factors for the European equity market, but given the recent weakening of the euro

against the US dollar, this factor should recede into the background.

To sum up the month, we maintain our positive view on the European equity

market. We believe that the fear currently prevailing in the market in connection with

geopolitical tensions is a temporary phenomenon. The impact of sanctions on the

European economy will be noticeable (European Commission estimates indicate an

effect equivalent to 0.3% of GDP in 2014 and 0.4% in 2015), but in the long term the

fundamentals (relatively low valuations, expansionary ECB monetary policy, inflows in to

European equity funds) favor the overweighting of European equities.

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Europe still holds potential


14

Japan

On the Japanese stock market, July was not an overly emotion-filled month for

investors. The TOPIX (main index of the Tokyo Stock Exchange) ended the month 2.1%

up. A good sign is that since May, the index has approached its January peaks,

steadily regaining lost ground; investors are seemingly becoming oblivious of the weak

first months of the year. The stock exchange was helped by the exchange rate of the

yen, which lost ground against the US dollar. The USD/JPY pair ended July at 102.80,

which allows us to hope that the consolidation that has lasted for almost half a year end

will be followed by a breakout and the further depreciation of the Japanese currency.

This should, of course, support the performance of the Japanese stock exchange, since

this relationship with the currency market has been observed for a long time now (see

Chart below).

Chart – Relationship between the TOPIX and the USD/JPY exchange rate


Investor sentiment could, however, be adversely affected by the data recently reported

on the Japanese economy. This is because the picture they paint leaves much to be

desired. A PMI reading at 50.5 suggests that the condition of the Japanese industry is

not satisfactory yet. Analogous Tankan leading indicators have also deteriorated (see

Chart below).

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USD/JPY (right axis)

TOPIX regains lost ground


15

Chart – Tankan index and GDP growth in Japan


Preliminary data on production also point to a decline amounting to as much as 3.3%

m/m. The Japanese economy is still feeling the impact of the VAT rise (from 5% to 8%),

which has adversely affected retail sales and the increasingly lower household

spending. Moreover, changes in taxation still affect the inflation level, which has turned

out to be high another month in a row (3.6% y/y).

Chart – CPI inflation in Japan


The labor market, on the other hand, still remains in good condition with the

unemployment rate in July at just 3.7%. Stock market investors are convinced that

mixed signals from the Japanese economy will influence further measures to be taken

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16

by the Bank of Japan, which should maintain the monetary policy it has pursued for

some time. We expect the BoJ to expand its current bond purchase program in October,

which should support the performance of the Japanese equity market.

Undoubtedly, local company valuations encourage investment in the stocks traded

in the Land of the Rising Sun. Our analysts believe that earnings per share for the

stocks included in the TOPIX should increase by as much as 17.2% compared to the

previous year. Comparisons with other developed markets also favor the securities

listed on the Tokyo Stock Exchange. A brief analysis of the P/BV (price to book value)

and P/E (price to earnings) ratios calculated on the basis of nex t year’s projected

company profits demonstrates that we have reasons to be optimistic about rising share

prices on the Japanese equity market going forward (see Table below) .

Table – Citi forecasts for selected equity markets

Earnings growth P/E ratio

2013 2014 2015 2013 2014 2015

World 7.3% 9.7% 11.7% 16.7 15.2 13.6

U.S. 7.7% 9.1% 12.0% 18.2 16.5 14.8

Developed Europe -0.7% 9.4% 13.4% 16.1 14.9 13.1

Japan 63.5% 17.2% 9.1% 17.0 14.5 13.3

Emerging Asia 7.0% 8.1% 10.1% 14.4 13.2 12.0

Latin America 5.0% 9.4% 14.4% 15.5 14.3 12.5

CEEMEA 0.7% 6.1% 7.3% 9.9 9.3 8.7

Source: Citi Research, Citi Handlowy

Investors in the Japanese stock market listen carefully to statements by Prime Minister

Shinzo Abe and his announcements concerning the implementation of the so-called

“third arrows” (the name is connected with a legend from the Yamaguchi region from

which the Prime Minister hails). Mr. Abe’s first two measures related to the fiscal

stimulus package and expansionary monetary policy. “The third arrow” involves

economic reforms and its aims include deregulation, reducing barriers to doing business

and lowering the corporate tax rate. Unfortunately, in the Japanese political system and

bureaucracy everything takes a long time. Before any change is introduced, tedious

negotiations with all parties concerned are indispensable and hence the change process

has dragged on for a few months already. Nevertheless, the implementation of these

ambitious reforms will probably be welcomed by stock market investors and will provide

a potential catalyst for growth, which we will watch with great attention.

Despite the risks present in the Japanese market, we maintain our positive outlook

for this market. The performance of stock market indices in the last three months may

indicate that the declines at the beginning of the year were only a corrective movement

within the framework of the upward trend observed since 2012. Investors should also

view the economic policies of Prime Minister Shinzo Abe and the measures taken by the

Bank of Japan as supportive. Combined with attractive valuations, all these factors

should continue to boost the prices of Japanese stocks.

Japan offers the cheapest

equities among developed

markets


17

Emerging Markets

The MSCI Emerging Markets gained 1.43% in July. The investors’ interest in the region

stems from the earlier relatively weak performance of emerging markets compared to

developed ones. It is worth emphasizing that as far as valuations are concerned, we are

below the long-term average (the current price/earnings ratio is 13.44 while the long-

term average for these markets is 15). Looking at the P/BV ratio, the discount relative to

developed markets is more than 20%.

It is worth mentioning that in recent weeks, we have seen positive trends in inflows

into the funds that invest in this asset class. The annual balance remains negative,

but a marked improvement can be observed. This may be due to the valuation issues

mentioned but also to fundamental factors, which are discussed below.

Chart – Chinese equity index performance vs. PMI


Investors are still looking at China. 2014 GDP growth forecasts for China remain at

the level of 7.5%. This result was also achieved in the second quarter of this year, which

surprised the market on the upside. In July, the manufacturing PMI reading also

returned above the 50 point threshold (at 50.7 points). Additionally, the central bank

together with the party are trying to mitigate the potential risks associated with the so -

called shadow banking system and with the bubble in the real estate market. As

concerns the second threat, the safety buffer is the target urbanization rate, which is

60% for 2020 (in 2012 it was 50%), and which makes it necessary to invest in residential

property and infrastructure. However, recently concerns have intensified about the

solvency of real estate developers in connection with interest payments on bonds. So

far, defaults have been avoided but the market sentiment towards that industry remains

very negative.

17000

18000

19000

20000

21000

22000

23000

24000

25000

26000

45

46

47

48

49

50

51

52

53

2011 2012 2013

Manufacturing PMI in China HSBC (left axis) Hang Seng Index

Investors are returning to

Emerging Markets

Favorable data from China

help


18

Chart – Relative performance of selected stock markets


A noteworthy fact is the establishment of the New Development Bank by the presidents

of Brazil, Russia, China and South Africa and by the Prime Minister of India; the bank

will be headquartered in Shanghai. Its mandate will include stabilization measures and

investment projects. However, for the moment there is no detailed information on its

activities.

Politically, the year 2014 is exceptionally rich in events. Many doubts will be

dispelled concerning the future direction of Brazil. The importance of this year’s political

events is illustrated by the example of India, where Prime Minister Narendra Modi has

won majority in the parliament, reflecting the local population’s determination to

implement change. He is an experienced politician with a significant track record. The

markets have responded with optimism and are currently awaiting for his pro-business

plans to materialize. In addition, India will be strongly influenced by the global recovery,

which in our opinion will support such industries as IT.

In view of concerns about the gradual phasing out of the asset purchase scheme by the

U.S. Federal Reserve, current account surpluses lend further support to emerging

markets as the asset class relatively resilient to this process (the exception is Brazil

where the ratio of current account balance to GDP is -3.6%). These countries are

relatively better prepared for the so-called tapering (limitation) of bond purchases by the

U.S. Federal Reserve within the framework of QE3.

90

95

100

105

110

115

120

125

Jan-14 Jan-14 Feb-14 Mar-14 Apr-14 Apr-14 May-14 Jun-14

SENSEX MSCI Emerging MSCI World

Much happening in politics

this year


19

Chart – Improvement in current account deficit in India


Brazil has been a negative exception on the emerging market map; alongside the high

expectations related to elections, the government has revised the forecasts of economic

growth downwards from 2.5% to 1.8% and raised the inflation projection from 5.6% to

6.2%, which already constitutes a serious risk. Taiwan provides a counterweight to t he

hosts of the last football World Cup owing to strong demand for semiconductors and

electronic components. This has boosted its industrial production by 8.63% against

expectations that were slightly above 6%. Despite the fact that these economies can

hardly be compared due to their size, this clearly shows the importance of careful

picking.

In Turkey, interest rates have been cut in line with forecasts (from 8.75% to 8.25%) and

unemployment fell from 9.7% to 9%. In fundamental terms, Turkey is slightly above the

average for emerging markets, as its P/E ratio is currently at 14.

In our opinion, carefully chosen emerging markets may enable effective

diversification of the investment portfolio, particularly in the context of the planned

phasing out of the asset purchase scheme by the Fed.

-6%

-5%

-4%

-3%

-2%

-1%

0%

Q2 13 Q3 13 Q4 13 Q1 14


20

Frontier Markets

Judging from the change in the MSCI Frontier Markets, which increased by 1.65%

during the month, July was fairly calm. This does not mean, however, that no interesting

events happened during that period.

Chart – Performance of the MSCI Frontier Markets against crude oil prices


The August meeting of President Barack Obama with leaders of African countries

shapes to be the most important event looking forward. During the summit, apart from

arrangements concerning closer cooperation between United States and Africa, U.S.

corporate investments in the region amounting to more than 900 million US dollars are

to be announced. Additionally, it is worth mentioning that the capital market in Saudi

Arabia is slowly opening to foreign investors. This may result in the inclusion of this

market in the MSCI. Its size remains a problem, however, as its share in MSCI Frontier

Markets would be over 60% and in MSCI Emerging Markets it would account for ca. 4%.

It is nevertheless evident that countries in the region are looking increasingly favorably

on foreign capital inflows. This also includes the debt market, where a successful bond

issue has been completed by Côte d’Ivoire with demand significantly outstripping

supply. The positive sentiment also supports local IPOs – the capital raised in the first

half of the year has already exceeded the amount for the entire 2013.

One should watch North African states particularly closely – according to analysts,

their economic growth should surpass that of the Gulf states. An important factor here is

consumption, which is projected to double. The upbeat scenario for the African region is

partly related to natural resources as the International Monetary Fund has been very

positive about the outlook for natural gas production in Tanzania. Zambia, on the other

hand, puts strong emphasis on the development of transport infrastructure (planning the

102

104

106

108

110

112

114

116

540

560

580

600

620

640

660

680

700

720

Jan-14 Feb-14 Mar-14 May-14 Jun-14

MSCI Frontier Markets Crude oil

Frontiers continue their

northward march

In the meantime, a lot is

happening…


21

construction of five railway lines), which should contribute to reducing transportation

costs of e.g. mined minerals.

In Asia, Vietnam is committed to boost lending. In order to speed up the process, the

state will probably offer soft (low-interest) loans to specific business groups.

Less pleasant for investors was the fact that Argentina failed to come to an

agreement with its creditors. This was no major surprise, however, as the U.S. court

judgment was passed back in June so the market had time to discount the event. China,

which wishes to emphasize its growing role in the region, has become involved as a

result. It has offered infrastructure funding and currency derivatives to Argentina. This

may partly explain the performance of the Buenos Aires stock market, which gained

3.8% in July.

Conflicts in Ukraine, in Gaza and in Libya are still festering. Another risk factor is the

Ebola epidemic, which is spreading rapidly, especially in West Africa. However, such

events have been priced in by the investors who interested in frontier markets. The

impact of socio-economic turbulence can be clearly seen in Turkey (see Chart below),

where over a year ago, the market used to react nervously to any news about riots, but

then concentrated on the fundamentals. This example demonstrates that the impact of

such events should be considered to be short-term. Moreover, no negative impact of the

slump in oil prices on the valuation of companies in the region has been noticeable.

Chart – Equity index performance in frontier markets and in Turkey


In summary, we see sustained positive trends in frontier markets, but after a stint of

strong increases, the MSCI Frontier Markets should be allowed some time to rest. Of

course, there are known risks in this region, but these are accounted for in risk premia

and therefore should not have a significant adverse effect on frontier markets. Long-

term projections point to consistently very good prospects for the regions in question.

70

80

90

100

110

120

130

140

150

160

Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14

MSCI Frontier Markets MSCI Turkey Index

…although the news is not

always good


22

Rates of return and indicators for selected indexes/asset classes (as of 31.07.14)

Equities Value Month YTD Year P/E P/E (2014) Div. Yield

WIG 50037,1 -3,7% -2,4% 5,6% 23,3 14,4 3,9%

WIG30 2493,7 -3,6% -1,7% 1,4% 22,9 14,2 4,2%

WIG50 2891,6 -6,2% -9,8% 5,9% 17,0 15,4 2,4%

WIG250 1158,0 -6,8% -16,1% 1,2% 26,6 2,3%

S&P 500 1930,7 -1,5% 4,9% 13,1% 17,4 16,1 2,0%

Eurostoxx 50 3115,5 -3,5% 0,5% 10,9% 22,1 14,2 3,7%

Stoxx 600 336,0 -1,7% 2,7% 10,8% 21,0 15,1 3,7%

Topix 1289,4 2,1% -1,0% 10,8% 15,4 14,3 1,8%

Hang Seng 24756,9 6,8% 6,5% 12,1% 10,8 11,4 3,7%

MSCI World 1714,3 -1,7% 3,5% 12,4% 18,0 15,7 2,6%

MSCI Emerging Markets 1065,8 1,4% 6,4% 11,7% 13,3 11,8 2,7%

MSCI EM LatAm 3399,4 0,9% 6,0% 5,8% 18,1 14,3 3,3%

MSCI EM Asia 485,0 2,8% 8,9% 16,1% 12,9 12,0 2,4%

MSCI EM Europe 403,0 -7,3% -8,2% -4,5% 8,4 7,0 3,8%

MSCI Frontier Markets 704,5 1,6% 19,2% 26,4% 12,1 10,9 3,7%

Commodities

Brent Crude 106,0 -5,4% -2,1% 3,8%

Copper 7135,5 1,3% -3,4% 2,1%

Gold 1282,6 -3,4% 7,2% -2,1%

Silver 20,4 -3,0% 4,2% 3,9%

TR/Jefferies Commodity Index 294,4 -4,5% 4,2% 3,3%

Bonds Duration

US Treasuries (> 1 yr) 358,7 -0,1% 2,9% 3,0% 5,9

German Treasuries (> 1 yr) 387,4 0,7% 5,6% 4,5% 7,0

US corporate (Inv. Grade) 243,8 -0,2% 5,8% 8,3% 7,5

US Corporate (High Yield) 233,9 -1,6% 3,4% 7,0% 4,0

Polish Treasuries (1-3 yrs) 303,7 0,2% 2,7% 3,9% 1,8




Polish Treasuries (> 10 yrs) 282,0 0,5% 13,1% 13,0% 10,7

Foreign Currencies

USD/PLN 3,12 2,7% 3,9% -3,3%

EUR/PLN 4,18 0,5% 0,8% -2,0%

CHF/PLN 3,43 0,2% 1,5% -0,3%

EUR/USD 1,34 -2,2% -3,0% 1,4%

EUR/CHF 1,22 0,2% -0,7% -1,7%

USD/JPY 102,80 1,5% -2,2% 3,3%

Source: Bloomberg

FX Forecasts (period-end)

Currency Pair IIIQ 14 IVQ 14 IQ 15 IIQ 15

USD/PLN 3,14 3,18 3,22 3,18

EUR/PLN 4,17 4,23 4,28 4,26

CHF/PLN 3,36 3,44 3,45 3,41

GBP/PLN 5,35 5,49 5,56 5,53

Source: Citi Handlowy

Macroeconomic Forecasts

GDP Growth (%) 2014 2015 2016

Poland 3,4 3,6 3,6

United States 2,1 3,2 3,2

Eurozone 1,1 1,7 1,9

China 7,5 7,1 6,7

Emerging Markets 4,5 5,0 5,1

Developed Markets 1,9 2,5 2,5

Inflation (%) 2014 2015 2016

Poland 0,3 2,0 2,7

United States 1,6 1,8 2,2

Eurozone 0,5 0,9 1,2

China 2,3 2,6 2,9

Emerging Markets 4,9 5,0 4,7

Developed Markets 1,6 1,8 1,5

Source: Citi Research


23

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

(Dividend 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 (2014) a projected price/earnings ratio providing information on the price to be paid per one unit of 2014 proje cted

earnings per share, measured as the ratio of the current share price and the earnings projected by analysts

(consensus) for a specified year (2014)

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 I ntercontinental

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 given the 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


24

Additional Information

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

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

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25

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

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Documents

Market Outlook of the Investment Advisory Bureau Jacek ... · turbulences, ending the month in positive territory (+1.4%). The Polish market also performed poorly, although the smallest