investment quarterly april 2015 - hsbca combination of falling commodity prices and a strong dollar...

Investment Quarterly

April 2015

China National People’s

Congress (NPC)

Macroeconomic charts

Financial market charts

Market Data

Executive Summary

US dollar strength: a welcome

long term guest?

Lower oil prices: the implications

of the ‘Big Drop’

A deflationary wave has arrived

in the Eurozone, but it is not

the next Japan

Different directions

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Contents

Executive Summary

US dollar strength: a welcome long term guest?

Lower oil prices: the implications of the ‘Big Drop’

A deflationary wave has arrived in the Eurozone, but it is not the next Japan

China National People’s Congress (NPC)

Macro and Investment Strategy team

Important Information

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Executive Summary

Overview

Global economic growth is becoming more balanced

and less dependent on the US. Economic growth in

the US slowed in the first quarter of 2015, though

partly because of temporary factors. China’s growth

is also slowing and its current trajectory suggests it

could fall below the official target of 7%. In contrast,

other major economies have picked up, most notably

the Eurozone, leaving global growth stable overall.

Slowing growth in the US has also resulted in a more

moderate expectation for rate increases this year and

next.

This ‘lower for longer’ prospect has been a boon for

risk assets. Equities have set new all-time or multi-

year highs in the US, Europe and Japan in the last

quarter. Diminishing prospects for US rate rises have

softened the pace of appreciation of the US dollar,

but it still remains strong and a concern for more

vulnerable Emerging Market (EM) currencies. After

six months of falling prices, crude oil seems finally to

have found some sort of floor. However,

overproduction continues and the swelling glut of

inventory has yet to diminish, suggesting prices could

remain low for some time. This seems likely to keep

inflation in check for the next couple of quarters and

enable lower policy rates globally. However, as we

get to the end of the year, the favourable base effects

from low oil prices will unwind, pushing inflation

higher.

Euro weakness and Quantitative Easing (QE) have

helped create some impressive equity returns in the

first quarter. For example, the German DAX was up

22% in Q1 in local currency terms and was even up

an impressive 10% in US dollar terms. Equally,

stimulus in Japan has pushed Japan’s Nikkei up

10.5%. Asian markets also outperformed with the

Hong Kong Hang Seng China Enterprise Index

(HSCEI) up 17%. Latin America (LATAM) fared

worse, with some equity gains in local terms that

were however outstripped by currency losses. Core

government bond markets also performed well with

many markets hitting record low yields such as

Switzerland, where 10-year yields went negative and

Germany where 10-year Bunds ended Q1 at 0.18%;

the exception was Japan which moved sideways.

The best performer in periphery markets was

Portugal which rallied 100bp after they announced

they intended to repay their International Monetary

Fund (IMF) loans early.

US

The US Federal Reserve (Fed) removed the word

“patience” from its 18 March monetary policy

statement, providing flexibility for a rate hike.

However, it also acknowledged that economic growth

has moderated in recent months and signalled a

more gradual approach to monetary tightening.

Indeed, the Fed significantly revised down its

economic forecasts for both growth and inflation and

also lowered its estimate of the long-run equilibrium

unemployment rate. Furthermore, the Fed’s

expectations for appropriate policy rates over the

next couple of years have dropped significantly,

suggesting a more dovish stance than at the end of

2014. The median forecast for Fed policy rates at the

end of 2015 is now 0.625%, down from 1.125% last

December. This suggests that, on average, the Fed

is expecting between one and two interest rate rises

this year. The downward revisions to the Fed’s

interest rate forecasts also brought the projections

more in line with how financial investors view the

trajectory of policy rates going forward, as implied by

futures and swap markets.

Europe

The Eurozone is enjoying a strong cyclical upswing.

For example, the Markit Eurozone Composite PMI

survey increased for the fourth consecutive month in

March, while money supply and industrial production

growth both accelerated in January. Additionally,

data is consistently surprising to the upside of

consensus expectations. These recent developments

have been reflected by the European Central Bank

(ECB) in their macroeconomic projections, as they

upgraded their forecasts for Eurozone Gross

Domestic Product (GDP) growth from 1.0% to 1.5%

for 2015 and from 1.5% to 1.9% in 2016, citing the

favourable effect of lower oil prices, a weaker euro

and the impact of the ECB’s large scale asset

purchase programme. However, the Eurozone still

remains in deflationary territory, with headline

Consumer Price Index (CPI) inflation recorded at -

0.3% year-on-year (yoy) in February. Although the

effect of lower oil prices is likely to wash out of

headline inflation by the end of 2015, inflation is

expected to remain below the ECB’s target of 2%

until at least 2016 given the spare capacity within the

region.

Julien Seetharamdoo, Chief Investment Strategist

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China

Growth in China continues to slow and risks

undershooting official targets. The risk of a hard

landing remains, although this is not our central

scenario. For example, monthly activity data for Q1

came in much weaker than expected across the

board with domestic investment and manufacturing

particularly weak. Retail sales growth was also below

consensus expectations and down from 2014 growth

rates. The property sector also continues to show

signs of softness. Local government financing

constraints, the reining in of Local Government

Financing Vehicles (LGFV), the decline in land sales

and the on-going anti-corruption campaign likely also

curbed local infrastructure investment. Government

policies have turned increasingly supportive of

growth recently, in line with the overall tone on macro

policy from the National People’s Congress (NPC),

including accelerated fiscal spending, monetary

policy easing, property policy relaxation, and

measures to help local government refinancing.

However, we think the government will need to step

up policy measures, in order to deliver their growth

target of ‘about 7%’ for this year and to create a

stable macro environment for reforms. We explore

these themes at more length in our article, ‘China

NPC: Growth stabilisation and economic

restructuring are two policy priorities in 2015’.

US dollar strength

While the Fed’s new lower growth and interest rate

projections have taken the edge off dollar strength

temporarily, the secular trend remains for a stronger

dollar. In our piece in the next section, “US Dollar

Strength: a welcome long-term guest?”, we examine

how interest rate and growth differentials have been

driving a stronger dollar. We examine the extent to

which this has been a boon or problem for different

markets and the extent to which a stronger dollar has

and could generate headwinds for the US economy.

For example, in theory a stronger dollar should be a

negative for US equities as it chokes exports, but in

practice they have outperformed in historic periods of

dollar strength.

A combination of falling commodity prices and a

strong dollar hit the commodity currencies very hard

during Q1. This was particularly true of the oil-

correlated Russian rouble (RUB) where Ukraine-

orientated sanctions helped create a run on the

currency. This hit crisis levels in December and

January but has eased off considerably since then.

Other commodity currencies fared equally badly with

Brazil, Colombia, Mexico, Nigeria, Malaysia and

South Africa struggling with weakening currencies.

The improvement in the current account due to the

United Sates’ increasing oil independence through

the ‘shale gas revolution’ has strengthened the dollar

and driven oil prices lower, which is the topic of our

next article.

Implications of lower oil prices

The more than 50% fall in oil prices since June 2014

has primarily been supply-driven, although demand

from China has fallen too. Though this balance hasn’t

changed in the first quarter, West Texas Intermediate

(WTI) Crude has stabilised in a USD45-55 per barrel

range. Structural excess supply suggests that lower

crude prices will be with us for a while. While the rig

count is falling, this has yet to feed through and US

production remains high. Department of Energy non-

strategic Cushing inventories, currently around 56

million barrels haven’t been this high since the

1930s. Despite the risk of conflict in Yemen and Iraq,

production in the region has actually expanded as

Iraq and Libyan production volumes have surprised

to the upside. In our article ‘Lower oil prices: the

implications of the Big Drop’ we look at the impact on

global growth and inflation of this dramatic

adjustment in energy prices. We argue that it

provides a net boost to global growth (although there

will be winners and losers) and is largely positive for

risk assets and fixed income in the medium to long-

term.

Eurozone deflation

The oil price drop has been one of the major

influences behind global deflation. Falling consumer

prices have opened the door for easing by over 30

central banks so far this year, especially in Emerging

Market (EM). In our inflation article, ‘A deflationary

wave has arrived in the Eurozone but it is not the

next Japan’, we explore the risk of deflation

becoming entrenched in various global economies as

it did in Japan. We also examine the effect of current

monetary policies, such as QE, on inflation and how

a weak currency can help lift inflation and what the

repercussions would be on financial markets.

Executive Summary

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Conclusions

If current indications for a more balanced global

economy are accurate – with slower growth in the US

versus improving growth in Europe – then this should

be relatively supportive for risk assets. Much faster

US growth with unbalanced global growth, higher

short-end rates and a much stronger dollar could

create headwinds for equities and especially for EM.

As it is, moderate growth and rate expectations, low

inflation and globally accommodative monetary

policies should extend the current, relatively benign,

environment or ‘fragile equilibrium’.

Indeed, the Fed seems more preoccupied with

growth failing to meet expectations. Challenges for

policy normalisation have been pushed back towards

the second half of 2015 and into 2016, but will still

remain as growth starts to pick up and low energy

prices work their way out of inflation data.

A slow steady recovery also suggests lower

correlations between securities and asset classes, as

fundamental drivers assert themselves, presenting

greater opportunities for alpha generation within

portfolios.

Risks to this benign view remain, however. As well

as the risk that eventually the US Fed will have to

raise rates more aggressively than currently

expected, China looks like it might miss its growth

target – though not severely as more stimulus is

likely. Conflicts in Ukraine and the Middle East still

have the potential to deliver surprises to assumptions

about the lower costs of energy. Equally,

negotiations between Greece and its creditors still

look precarious.

Executive Summary

6

US dollar strength A welcome long-term guest? Michael Hampden-Turner, Senior Macro and Investment Strategist

Summary

The US dollar has strengthened on the back of

increasingly divergent global growth rates; this

creates policy implications. For example, the US

will soon be exiting from a long period of

extraordinary stimulus just as Europe and Japan

step-up theirs

A stronger dollar is also a product of structural

changes such as growing US oil independence

which has been shrinking the current account

deficit

Historically, periods of dollar strength have lasted

for more than five years. On a trade-weighted

basis the dollar has been much stronger than it is

now. It is also close to fair value against the euro

and yen. These factors suggest there are no

particular constraints on further dollar strength

Dollar strength has several impacts on the US

economy. A first-round effect is to weaken US

GDP through lower net exports. However, it also

has a deflationary effect which acts like a tax cut

for consumers and enables the Fed to persist with

lower rates for longer than it would otherwise. The

falling prices of crude oil add a similar tailwind

Elsewhere, a weak euro and yen are set to

provide a crucial boost to competitiveness.

Historically, a strong dollar has been bad for EM

economies, attracting foreign investment away

from EM and to the US. The dynamics may be

different this time

In theory, a strong dollar should increase

competitiveness and be a boost for non-US equity

but in practice domestic stocks have

outperformed in periods of dollar strength.

Different sectors and company-types face

different sorts of headwinds and tailwinds from a

strong dollar

A strong dollar has historically been associated

with a flattening of the yield curve, especially in

the period around the first rate hike. There has

also been a weak correlation between rates and

credit spreads

Higher rates are bad for precious metals as higher

treasury yields and a stronger dollar make holding

metals like gold less attractive. A strong dollar is

typically bad for commodities but, later in the

cycle, demand for industrial commodities tends to

pick up

Why has the US dollar strengthened?

Although the US dollar has strengthened 20% in the

last nine months on a trade-weighted basis, it has

been much stronger historically. Trends of dollar

strength can last for several years, as can be seen in

Figure 1. Expectations for the relative performance of

the US economy are already high, but if they are

exceeded then conditions will be in place for further

dollar strength in 2015. These conditions are: further

US economic growth outperformance, increasingly

divergent global economic policies and growing oil

independence. Let’s look at these in turn.

Global growth rates have become increasingly

divergent, with the US significantly ahead of many

developed economies. Bloomberg consensus

forecasts expect US GDP to grow 3.0% yoy in 2015

and 2.8% in 2016. In contrast, European growth is

only expected to be 1.3% and 1.6% in the same time

periods while in Japan 1% and 1.4% are expected.

This divergent economic growth outperformance

leads directly to divergent policy rates and

government bond yields. The Fed has signalled that

it is ready to raise rates in 2015 (although this has

Figure 1: US Dollar Trade Weighted Index is rising but still

low by historical standards

Note: Plaza accord= Plaza Agreement . Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.

Figure 2: USD strength has been driven by relative rate

expectations as central bank monetary policies diverge

Note: LHS= Left Hand Side; RHS= Right Hand Side. Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.

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US dollar strength

recently been moderated to a reduced rate

trajectory). In contrast, Europe is only just starting

quantitative easing (‘QE’), and rates are near zero

and expected to remain low for the foreseeable

future. QE increases the monetary base and is

expressly designed to weaken the currency. There is

a similar monetary policy story in Japan which is also

embarking on a fresh round of QE. The mismatch in

timing of these policies has weakened both the euro

and yen relative to the dollar.

The shale gas ‘revolution’ has had a significant

impact too. The US were the first to exploit this

resource and estimated global reserves will make a

lasting change to energy supply and cost. The US

current account deficit has been shrinking over the

last decade as US energy independence has grown.

This has a long-lasting strengthening effect on the

dollar. In 2005, the US imported 60% of its oil

requirements while in 2013 this dropped to a third.

Looking back at Figure 1 we can see that periods of

relative dollar strength or weakness have lasted

seven or eight years on average from peak to trough.

Periods when the dollar is up to 20% stronger than

average for years at a time are not uncommon. On a

trade-weighted basis the dollar was strongest in the

1980s, prompting central banks to use the Plaza

agreement to engineer a weaker dollar.

However, further dollar strength from here would

require either further US outperformance relative to

current expectations or for the difference between

US, European and Japanese rates to be greater than

expected. We estimate that the USD is now at fair

value, based on relative (GDP-adjusted) PPP,

compared to the EUR and JPY. Hence, further USD

strength from here against the EUR and JPY is most

likely to be driven by relative macro fundamentals

rather than an additional valuation adjustment.

Negative effect on the US economy

What about the impact on the US economy? In this

cycle, as in others, dollar strength is usually

associated with growth and a tightening of

conditions. In a stronger dollar scenario, US goods

become less competitive for foreign buyers and

imported goods cheaper domestically. Therefore, the

first-round effect of a stronger dollar is to weaken US

GDP through lower net exports. The Organization for

Economic Co-operation and Development (OECD)

rule of thumb suggests a 10% appreciation in the

trade-weighted USD subtracts about 0.5% from GDP

growth and 0.3% from CPI inflation in the first year1.

Given that the USD has rallied 18% on a trade-

weighted basis since June 2014 this would suggest

90bp off GDP and 50bp off inflation.

However, these effects are offset by the fact that

lower growth and inflation expectations enable

monetary policy to be looser for longer. The

disinflationary pressure also provides support for

consumers’ real income, acting as a tailwind for

consumer spending and domestic demand.

Macroeconomic Advisers estimate this might add

back as much as 60 basis points (bp) to GDP2.

Of course, an end to easy money and low rates

creates a substantial headwind for business

development and a drag on areas such as real estate

growth. However, with rates still currently low these

effects are very much secondary.

The other coincident move is the positive effect from

lower commodity prices, particularly oil. Lower

energy and commodity prices act like a tax cut for

households and businesses, boosting real incomes.

When combined with low inflation both in the US and

globally it potentially enables the Fed to keep interest

rates lower for longer. It also has a positive, if

uneven, impact on the attractiveness of US

investments, as we shall see further on.

1Michala Marcussen, Societe Generale, “World Economy Stuck in

the Mud” November 2014.

Figure 3: A stronger dollar should weaken growth

through lower net exports

Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only.

Figure 4: A stronger dollar should weaken growth through

lower net exports


2 Macro Advisers, data as at October 2014.

http://www.macroadvisers.com/2014/10/impact-of-a-rising-dollar-on

-the-u-s-economy/

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US dollar strength

Impact of a strong dollar in Europe

Europe is deliberately pursuing a strong dollar / weak

euro policy to help pull it out of deflation and to

stimulate growth. In the same way as a strong dollar

will create headwinds for US corporates, a weak

Euro will provide tailwinds for Eurozone businesses.

Zero rates and quantitative easing make goods more

competitive abroad; the opposite of the effect

described above. It should add to Eurozone GDP in

the same way a strong dollar subtracts from US

GDP.

Europe is also going through a period of low inflation

which has a feedback loop with a weak currency. For

example, the ECB indicate a 10% change in the

currency can generate a 0.4-0.5% change in

inflation. The other key element here, as discussed

earlier, is lower commodity prices which also have a

deflationary effect.

The scenario is very similar in Japan, although the

country has been in a low growth phase for much

longer.

Emerging market economies in a strong

dollar environment

Historically, emerging markets have not fared well in

a strong dollar market. The last prolonged period of

dollar strength was in the late 1990s and it helped

spark the 1997 Asian ‘Financial Crisis’ and the 1998

default in Russia. However, conditions are quite

different now and a strong dollar / rising rate

environment doesn’t necessarily imply a repeat of

these extreme stresses.

At the time, the US Fed sought to fight inflation by

raising rates and allowing the US dollar to

strengthen. This attracted foreign investment to (and

back to) the US, away from EM. This sudden

movement of capital led to the rapid deflation of an

economic bubble that had developed over many

years.

There are several key differences today. In the

1990s, many countries maintained fixed or pegged

exchange rates; now many are floating. Equally, the

amount of internal, regional and local investment was

much smaller than it is today. The economy was

more leveraged, with levels of credit at seemingly

unsustainable levels before the additional burden of

currency moves. Also, the proportion of dollar-

denominated debt held in EM was much higher than

it is today. Finally, current account deficits are

narrower.

Some emerging markets are more vulnerable than

others to currency moves so talking about them

generically is misleading. In this context, it is hard to

separate lower commodity prices from a stronger

dollar. Countries with a combination of large levels of

debt relative to GDP, a substantial percentage of

dollar relative to local currency debt and a high level

of dependence on commodity exports have been the

hardest hit. Chile, Russia and Nigeria are commodity

exporters that have suffered in this environment.

The heatmap in Figure 5 illustrates the vulnerability

of different countries depending on how much hard

currency debt they have and their relative valuations.

If the majority of their debt is hard currency, and the

amount outstanding is large relative to their GDP,

then a strong dollar makes this much less affordable

and adds an additional burden to their economy. In

the heatmap Turkey and Malaysia look vulnerable by

this measure whereas Indonesia and the Philippines

look more resilient to dollar strength.

However, vulnerability is not the only part of the

investment equation. The key is the extent to which

investors are compensated for risks or, to put it

differently, how much of the vulnerability is already

priced into the investment.

Figure 5: EMs with large amounts of hard currency

external debts are vulnerable to a stronger dollar

Note: REER= Real Effective Exchange Rate. Source: World Bank, BIS, Bloomberg, HSBC Global Asset Management Note: External Debt data from World Bank, data as at September 2014, except Venezuela data (December 2013). Nominal GDP data from World Bank as at 2013. Real effective exchange rate data sourced from Bank of International Settlements (BIS), data as at 31 December 2014. For illustrative purposes only.

External Debt

(USD m)

External Debt

(% of GDP)

Valuation

(REER, 5-

year)

Vulnerability

Rank

Turkey 396,800 48.3 -0.3 1

Malaysia 226,398 72.3 -0.2 2

Mexico 418,777 33.2 -0.8 3

Venezuela 118,758 27.1 3.1 4

Peru 60,639 30.0 0.5 5

Bulgaria 49,334 90.6 -1.0 6

Chile 137,416 49.6 -1.9 7

South Africa 142,314 40.6 -1.3 8

Russia 679,422 32.4 -5.2 9

India 455,929 24.3 -0.9 10

Indonesia 292,286 33.7 -0.6 11

Philippines 57,730 21.2 2.1 12

Brazil 540,434 24.1 -1.6 13

Argentina 148,361 24.3 -1.2 14

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US dollar strength

Investment implications: is a strong

dollar bad for US equities?

In theory a strong dollar should be a boost for non-

US equity in local currency terms; in practice US

equity has historically outperformed in strong dollar

periods, especially in dollar terms.

In local currency terms the outperformance is less

dramatic than Figure 6 suggests, however.

Valuations will also be a key driver of long-term

returns in our view.

While in theory a strong dollar should act as a

headwind for US equities the relationship is not

straightforward. Firstly, as we mentioned earlier,

dollar outperformance is a symptom of growth

outperformance, i.e. growth is a prerequisite for a

strong dollar in the first place. Secondly, some stocks

are more exposed to exports than others and

therefore more exposed to a strong dollar.

Within equities the mix between different sectors

and types of business means that some face

much stronger headwinds than others. This is

most complex for US multinational giants with sales

and costs spread globally. According to S&P,

overseas sales accounts for about 50% of the

combined revenue of the 30 companies represented

in the Dow Jones Industrial Average. This figure

drops to 16% of the S&P Smallcap 600 index.

This isn’t evenly spread between sectors either.

Figure 7 illustrates that those sectors that are most

dependent on foreign sales, such as Information

Technology (IT) and Energy, are theoretically most

vulnerable. In contrast, highly domestically-focused

sectors such as financials and consumer staples are

likely to benefit from a stronger USD relative to the

broader market.

There are some areas where vulnerability to the

dollar has been key. Materials and Energy have been

some of the worst performers in the last few cycles of

dollar strength. This is illustrated in Figure 8, which

demonstrates the negative correlation between the

Materials sector and dollar strength. It is far from

consistent, however, while the IT sector is the most

vulnerable, it has also been the best performer in

periods of dollar strength such as the late 90s and

2011-15.

The key takeaway is that periods of dollar strength

are much better correlated with cyclical

outperformance. IT, Consumer Discretionary,

Industrials and Financials outperformed in 1997-2000

and 2011-2015, while Utilities, Energy, Materials and

Staples underperformed.

Figure 6: S&P 500 has outperformed when the USD

Index (DXY, weighted basket of currencies) is strong.

Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns. S&P 500 and Stoxx 600 in USD terms.

Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns.

Source: Bloomberg, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.

Figure 7: Sector breakdown of S&P 500 foreign sales

as a % of total sector turnover

Figure 8: Materials sector tend to underperform in

periods of USD strength. DXY vs relative performance

of materials

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US dollar strength

Developed market equities

A weak currency against the dollar is a mixed

blessing for developed market equities. It provides a

critical boost for earnings by making exports cheaper

but is a major negative for investors from stronger

currency areas. US, Chinese and Gulf based

investors are going to be wary of potential currency

loss.

Let’s take Japan as an example, where the currency

has devalued by more than 15% since mid-2014

relative to the dollar. This has tempered the

otherwise impressive over 25% gain in the Nikkei

225 in yen terms (Data as at 31 March 2015).

A weak currency is partially a product of Quantitative

Easing (QE) and it is this factor that is likely to

dominate in weak currencies such as the yen and the

euro. The size of the Fed’s balance sheet and the

positive performance of the S&P have been highly

correlated, as can be seen Figure 9, even taking into

account associated dollar weakness during the same

period. This provides constructive guidance on the

considerable tailwind for European and Japanese

equities as they begin their QE programmes.

A stronger dollar is typically created by higher US

rates, or at least an expectation of higher rates,

relative to other major currencies. So a strong dollar

should be characterised by fixed income

underperformance. However, this characteristic is

more typical of late phases of the cycle once growth

outperformance has really taken hold. Early in the

cycle, treasuries tend to rally until the first rate hike.

This has especially been the case in this cycle with

the addition of QE.

Mixed for US Corporate Bonds

The link between a strong dollar and credit spreads

mostly has to do with the credit cycle. Following a

bust corporates deleverage, repair their balance

sheets and start to make profits. Credit starts to look

quite attractive at this point and spreads compress,

causing corporate bonds to rally. Corporates then

start to engage in capex, Merger & Acquisition (M&A)

etc and at some point Earnings Before Interest,

Taxes, Depreciation and Amortization (EBITDA)

stops expanding and they become more leveraged

and less credit worthy, even if still attractive from an

equity/earnings perspective. Historically, this tends to

carry on until another credit bust occurs and the

process repeats.

A strong dollar period tends to correspond with that

initial growth period, i.e. when credit is initially

attractive but becomes less so as the Fed raises

rates to combat increased borrowing and leverage.

Mixed effects for industrial commodities

Historically, a strong dollar has been bad for

commodity prices in the first phase of the cycle and

better for them as growth gets into full swing.

As can be seen in Figure 10, industrial metals and

crude declined in the late 90s until the end of 1998

when growth really took off after the end of the Asian

Financial Crisis.

Figure 9: US equities rallied in periods of QE

Note: TR= Total Return. Source: Bloomberg, data as at 31 March 2015. For illustrative purposes only. Past performance is not indicative of future returns.

Figure 10: Goldman Sachs Commodity Index (GCSI) and sub

indices sold off and then rallied in a strong dollar

environment

Source: Bloomberg, data as at March 2015. For illustrative purposes only. Past performance is not indicative of future returns.

11

Higher rates bad for precious metals

A strong dollar has historically been negative for gold

as it is associated with higher treasury yields. As an

asset class, precious metals tend to react badly to

perceived ‘risk-free’ assets such as treasuries

offering more attractive yields. In 2011, gold

achieved record prices in a crisis and at a time when

it seemed likely that US yields would remain low for a

very long time. As the current period of dollar

strength has progressed, and expectations for rate

rises have increased, gold prices have fallen. Even

precious metals such as palladium, that have

industrial uses, tend to lose value in a strong dollar

environment.

US dollar strength

Figure 11: Correlation between gold and US treasuries


12

Lower oil prices The implications of the ‘Big Drop’ Shaan Raithatha, Macro and Investment Strategist

Summary

The over 50% fall in oil prices from June 2014 to

January 2015 was primarily supply-driven, though

weak demand also played a part. Oil prices have

stabilised somewhat in the first quarter of 2015

Lower oil prices should provide a net boost to

global growth, though there will be winners and

losers. Inflation, particularly across the developed

world, has already fallen considerably, though a

rebound is expected later in 2015 assuming oil

prices remain relatively stable

With the exception of the energy sector, equities

proved to be fairly resilient to falling oil prices.

Historically, defensive stocks such as healthcare

and utilities appear to outperform relative to the

broader market index when oil prices are falling

Within fixed income markets, nominal developed

market government bond yields have fallen,

driven by deteriorating inflation expectations,

while US high yield spreads have widened

The net boost to global growth should be

supportive of risk assets. An attractive entry point

for high yield credit may also arise should oil

prices remain relatively stable, or even rebound,

given the observed spread widening

Falling oil prices have led to perceived safe-haven

developed market government bonds becoming

increasingly less attractive, given that yields have

fallen considerably since June. However, the

recent bouts of market volatility and increased risk

aversion highlight the need to construct a well-

diversified portfolio

Why have oil prices fallen?

From June 2014 to January 2015, oil prices tumbled

by over 50%, with both WTI and Brent crude oil

falling by around USD60 per barrel. However, oil

prices have stabilised somewhat in the first quarter of

2015 (Figure 1).

The ‘Big Drop’ in oil prices was driven primarily by a

surge in supply, though weak demand has also

played a part. Since June, oil produced by

Organisation of the Petroleum Exporting Countries

(OPEC) members has accelerated considerably.

This is partially due to Iraq being able to meet its

production targets, despite escalating geopolitical

tensions, and a better-than-expected recovery of

Libyan oil production. In addition, non-OPEC oil

supply has continued to grow at a strong rate, driven

by the US shale revolution.

On the demand side, weaker global economic growth

expectations also exerted downward pressure on oil

prices. Despite the US experiencing robust growth in

the second half of 2014, the Chinese economy

continued to slow, growth in the Eurozone was

stuttering and Japan briefly entered recession.

The cyclical growth outlook between regions has

changed slightly in recent months, with economic

data suggesting US growth slowed in the first quarter

of 2015. However, this was offset by a pick-up in

growth momentum within the Eurozone, supported

by a weaker euro and ‘ultra-loose’ monetary policy.

It is important to note that weaker demand has also

contributed to considerable falls in other commodity

prices, such as coal, copper and steel.

Figure 1: Oil prices collapsed by over 50% from June

2014 to January 2015, but have stabilised since


Figure 2: The fall in oil prices was primarily

driven by a surge in global supply

Source: Energy Intelligence Group, HSBC Global Asset Management, data as at February 2015. For illustrative purposes only.

13

Although global supply and demand forces had been

pointing to an oil supply glut for many months, oil

prices were supported by the belief that OPEC would

react by cutting their production targets, as they have

done in the past. However, at the November OPEC

meeting, the oil cartel decided to take no action,

thereby maintaining its aggregate production target

of 30 million barrels per day. Indeed, Saudi Arabia’s

oil minister stated that it was “not in the interest of

OPEC producers to cut their production” given that at

current lower prices their market share is likely to

increase. The outcome of the meeting caught the

market off guard and triggered a steep sell-off in oil

prices.

As a result of recent developments, financial market

participants have revised down their oil price

forecasts significantly, both in the short and long

terms. Interestingly, the current prices of crude oil

futures contracts imply that lower oil prices are

expected to persist. Futures prices are currently

suggesting that West Texas Intermediate (WTI)

crude oil will remain below USD60 per barrel for the

next twelve months (Figure 3). This likely reflects an

expectation that global oil supply will remain

relatively high, with both OPEC and the US unlikely

to cut production soon, while global demand is

expected to remain subdued, particularly as China

attempts to rebalance its economy and make it less

commodity-intensive. However, market expectations

and implied futures prices can change rapidly,

especially in the face of a significant supply shock

such as a sudden escalation of geopolitical risk or a

cancellation of oil projects as producers react to

lower oil prices.

Macroeconomic implications

Lower oil prices should provide a net boost to

global growth, though there will be winners and

losers

A fall in oil prices will likely provide a net boost to

global economic growth, primarily through higher

consumption as real household incomes rise, and

through lower input costs. Indeed, a recent

simulation conducted by the International Monetary

Fund (IMF) estimates that global GDP growth in

2015 will increase by 0.3-0.7% compared to a

scenario without the drop in oil prices. Although the

global economy is likely to benefit in aggregate, there

will be a significant distribution of wealth from oil

producers to oil consumers. Oil consumers, such as

the US, Eurozone, Japan and China, are likely to

benefit from lower oil prices through a boost to real

household disposable income, lower manufacturing

input costs and improved current account positions.

Of course, the strength of these effects will vary

across countries. For example, China and India are

likely to benefit the most from the real income effect

given they have a large share of oil consumption as a

percentage of GDP. Similarly, US consumers are

likely to benefit more than UK consumers due to the

lower level of fuel taxes in the US than in the UK,

though there may be potential job losses in the US

shale energy sector.

However, the effect of falling oil prices on oil

producers will undoubtedly be negative and will

detract from economic growth through falling oil

Figure 4: Oil producing countries that have high

fiscal breakeven prices are the most vulnerable

Figure 3: Crude oil futures currently suggest that

the recent fall in oil prices is likely to persist


Source: IMF, HSBC Global Research, Ecuador Finance Ministry, data as at 31 March 2015. For illustrative purposes only.

Lower oil prices

14

Lower oil prices revenues and profits. The economies that are most

vulnerable are likely to be those that have high fiscal

break-even prices, that is, the price of oil at which

governments of oil-exporting countries are able to

balance their government budgets. These notably

include Venezuela, Nigeria and Saudi Arabia (Figure

4). Russia is also particularly vulnerable given that

energy accounts for 70% of its exports and half of

government revenues.

Headline inflation has fallen considerably across

the developed world, though the effect of lower

oil prices is expected to be transitory

Falling oil prices have already translated into lower

inflation within developed market economies. Indeed,

the decline in oil prices drove the Eurozone into

deflationary territory from December 2014 and even

the US experienced negative inflation in January

2015, though it has bounced back since. Inflation

amongst the OECD economies has fallen from 2.1%

yoy in June 2014 to 0.6% in February 2015 (Figure

5).

Within Emerging Markets (EM), falling oil prices have

so far had a mixed impact on inflation. In China, CPI

inflation fell to a low of 0.8% yoy in January 2015, but

has bounced back. In India, inflation actually

increased in the first two months of the year as a

result of a sharp rise in food prices, but has since

fallen. Moreover, in both Brazil and Russia, inflation

has increased sharply, but this has been driven by

sharp depreciations in the Brazilian Real (BRL) and

Russian Rouble (RUB) respectively. Nevertheless,

lower oil prices are still expected to act as a drag on

EM inflation in the coming months.

However, assuming oil prices remain relatively stable

for the rest of 2015, as they have done in Q1, the

drag of lower energy prices will wash out of headline

inflation completely by early 2016. Figure 6 illustrates

this for US inflation, assuming that WTI crude oil

remains at around USD50 per barrel.

What has the impact been on other asset

classes?

Although falling oil prices have triggered bouts of

volatility and increased investor risk-aversion over

recent months, developed equity markets have

proven to be fairly resilient. Indeed, the MSCI World

index excluding the energy sector has posted gains

of almost 10% in local currency terms since 20 June

2014, while energy stocks have fallen over 20%

during the same period (Figure 7). Within emerging

markets, it is noticeable that Asian equity markets,

which are majority oil consumers, have outperformed

their Latin American counterparts, who are generally

highly reliant on commodity exports, including oil. For

example, since 20 June 2014, the MSCI EM Asia

index has outperformed the MSCI Latin America

Index by over 14% in local currency terms. (Data as

at 31 March 2015)

Figure 7: Developed market equities excluding energy

have rallied despite falling oil prices

Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only and does not constitute any investment recommendation. Past performance is not indicative of future returns.

Figure 5: OECD inflation has fallen significantly,

driven by falling oil prices

Source: Bloomberg, HSBC Global Asset Management, data as at 31 March 2015. For illustrative purposes only.

Figure 6: Assuming oil prices remain at current

levels, the energy contribution to inflation will

wash out completely by early 2016


15

Over the last 30 years, we have identified three

previous occasions when the oil price has fallen by

over 50% in the space of a few months (Figure 8).

Interestingly, the two supply-driven oil price collapses

identified (in 1985-1986 and 1990-1991) coincided

with equity market rallies. For example, from

November 1985 to March 1986, the over 60% fall in

the oil price, triggered by Saudi Arabia ramping up its

production to full capacity in order to defend its

market share, facilitated a 14% rally in the MSCI

World index in local currency terms during the same

period. Developed market equities have not

experienced as strong a rally this time around, with

the MSCI World Index returning just over 2% in local

currency terms from 20 June 2014 to 30 January

2015.

However, during this period, there were large

differences between regions. Japan’s Nikkei 225

rose over 15% as the Bank of Japan provided further

monetary stimulus, while US stocks were weighed

down by a stronger USD and concerns over the

normalisation of monetary policy. European equities

were also held back by concerns over growth

momentum and disinflationary pressures, though

they have subsequently rallied strongly on the back

of the European Central Bank’s (ECB) sovereign QE

programme, a weaker euro and a more optimistic

growth outlook. Emerging market equities also

experienced differences within regions, with

commodity-consumers broadly outperforming

commodity-producers. Looking forward, equity

markets should be supported by a falling oil price if it

translates into a much-needed boost for the global

economy, benefitting energy consumers the most.

Within sectors, energy stocks have significantly

underperformed since June, as expected. However,

across other equity market sectors, the impact of

falling oil prices has been more varied. Defensive

stocks such as healthcare and utilities appear to

outperform relative to the broader market index as oil

prices fall, while materials and industrials

underperform. Indeed, these sector trends appear to

be fairly consistent over time, as illustrated in Figure

9.

Within fixed income markets, yields on developed

market government bonds have fallen since June,

reflecting deteriorating inflation expectations. Both

10-year US Treasury and German Bund yields fell by

around 100bps to 1.64% and 0.30% respectively

from 20 June 2014 to 30 January 2015. Since the

end of January, US 10-year Treasury yields have

picked up to 1.92%, while German 10-year Bund

yields have fallen further to 0.18% as the ECB began

its sovereign QE programme (as at 31 March 2015).

The fall in “safe-haven” government bond yields is

consistent with what has been observed through time

– developed market government bond yields have

fallen in each of the three previous occasions

identified where the oil price has fallen by over 50%,

again driven by falling inflation expectations.

In contrast to the strong performance of developed

market government bonds, the US high yield market

experienced significant spread widening between

June 2014 and January 2015 (Figure 10).

Figure 9: Historically, defensives such as healthcare

and utilities have outperformed as oil prices fall

Figure 8: Previous occasions when oil prices have fallen by over 50%

Note: MSCI World Index expressed in local currency terms.


Past performance is not indicative of future returns.

Source: Bloomberg, HSBC Global Asset Management, data as at February 2015. For illustrative purposes only. Past performance is not indicative of future performance.

Start End Dynamics No. Months

Start Price

(WTI,

USD/bbl)

End Price

(WTI,

USD/bbl)

Price fall (%) Change in MSCI World Index (%)

Change in US Treasury 10Y

Yield (bps)

Change in Barclays

US HY Spread (bps)

1 Nov-85 Mar-86 Supply-driven 4 31 12.3 -60.3 14.0 -189 -

2 Oct-90 Feb-91 Supply-driven 5 39.7 17.9 -54.9 16.4 -91 1260

3 Jul-08 Dec-08 Demand-

driven 5 145.3 33.9 -76.7 -30.0 -185 1274

4 Jun-14 Jan-15 Supply-driven 7 107.3 48.2 -55.0 2.1 -96 260

Lower oil prices

16

This is driven by the fact that energy companies have

significantly increased their share of the US high

yield benchmark, with a weight of approximately 15%

in 2014, compared to less than 5% ten years ago.

Looking back to the previous periods of large oil price

falls identified, US high yield spreads also widened

substantially. However, the spread widening

observed in both 1990-91 and 2008 was each time

associated with recessions and rising default rates,

which is not the case today.

Lower oil prices

Investment Implications

Assuming oil prices remain at or around current

levels, the global economy should receive a net

growth boost over the coming months, which should

be supportive of risk assets such as equities. An

attractive entry point for high yield credit may also

arise should oil prices remain relatively stable, or

even rebound, given the observed spread widening.

Perceived safe-haven developed market government

bonds have become increasingly less attractive given

yields have fallen considerably since June, driven by

deteriorating inflation expectations. However, the

recent bouts of market volatility and increased risk

aversion highlight the need to construct a well-

diversified portfolio, including this asset class.

Moreover, the anticipated transfer of wealth from oil

producers to oil consumers will likely cause

differences in performance between regions, with the

US, Eurozone, Japan and China all likely to benefit

from a boost to real household disposable income

and improved current account positions.

With the exception of the energy sector, equities

have proven to be fairly resilient to falling oil prices.

Historically, defensive stocks such as healthcare and

utilities appear to outperform relative to the broader

market index when oil prices are falling, while

materials and industrials tended to underperform.

Figure 10: US high yield spreads experienced

significant widening as oil prices tumbled

Source: Bloomberg, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only. Past performance is not indicative of future returns.

17

A deflationary wave has arrived in the Eurozone but it is not the next Japan Rabia Bhopal, Macro and Investment Strategist

Summary:

Low oil prices drove Eurozone inflation into

negative territory in December 2014

The current outlook for deflation is not necessarily

dangerous, as it is mainly driven by the oil price

drop, which only has a temporary impact on

energy price inflation

However, low core inflation could continue as

wage growth will remain weak due to a large

amount of slack in the labour market

The ECB’s QE programme reduces headwinds to

inflation through a weaker currency

By the end of 2015, we expect inflation to pick up

in Europe as there is a positive base effect from

the decline in the oil price in 2014

What is deflation and why is it so bad?

Deflation in the Eurozone is a “protracted fall in

prices across different commodities, sectors and

countries. In other words, it is a generalised

protracted fall in prices, with self-fulfilling

expectations”. This is the definition of deflation that

ECB President Mario Draghi gave in the summer of

2013. At the time, Draghi said that the Eurozone was

just on a disinflationary trend (falling inflation rates),

while risks of deflation (falling prices) were, however,

subdued. Nearly two years later, inflation in the

Eurozone has turned negative. This report looks at

what forces are dragging down inflation, mainly in

Europe, but also elsewhere. Is prolonged deflation a

real threat for the Eurozone?

Most consumers would, of course, regard falling

prices as good news, given the boost to their

spending power. After all, the burst of deflation in

2009 arguably contributed to the subsequent global

recovery by boosting consumer spending. What’s

more, it is reasonable to distinguish between

deflation due to some favourable external shock or

supply-side development, such as the slump in oil

prices, and a more general decline in the prices of

goods and services due to weak demand. The former

is sometimes described as ‘good’ deflation, which

may simply increase the amount of money that

people have to spend on other items. But even where

falling prices are a symptom of weakness in

domestic demand, sometimes described as ‘bad’

deflation, the resulting boost to real incomes may still

mean that deflation is part of the cure.

What is going on in the Eurozone?

High levels of spare capacity across the developed

world, in addition to deleveraging forces, have

exerted downward pressure on global consumer

prices. The recent tumble in commodity prices has

exacerbated this trend. In the US and Eurozone,

inflation has already dipped below zero while the UK,

Japan and most of Asia are experiencing

disinflationary trends. The Federal Reserve and the

Bank of England are likely to ‘look through’ a period

of deflation and begin raising rates. However, a

phase of falling headline consumer prices has

opened the door for easing by over 30 central banks

so far this year, particularly in emerging markets.

It is worth highlighting that the Eurozone has been in

deflation before. As Figure 1 shows, having remained

remarkably steady and close to the ECB’s 2% ceiling

in the first eight years of the euro’s life, inflation

climbed sharply above 4% in 2008, before dropping

equally sharply and entering negative territory in

2009. That bout of deflation lasted only five months,

however, and inflation then rose quickly back to 3%

before embarking on its latest long descent.

In December 2014, Eurozone inflation turned

negative to -0.2% yoy for the first time since October

2009, falling further in January (-0.6% yoy). However,

figures show February’s headline inflation at -0.3%

yoy. In line with the recent drop in oil prices, the main

drag came from energy price inflation (-7.9% yoy).

Core inflation (defined as headline excluding energy,

food, alcohol & tobacco) was stable at 0.7% yoy in

February. The breakdown showed that the decline in

headline inflation was broad-based across the

Eurozone, with 16 out of 19 countries reporting a

negative inflation rate. Only Malta (+0.6% yoy), Italy

(+0.1% yoy) and Austria (+0.5% yoy), listed a

positive inflation rate.

Figure 1: Eurozone headline CPI inflation entered

deflationary territory in December 2014


18

A deflationary wave has arrived in the Eurozone but it is not the next Japan

What has caused the fall in Eurozone

inflation and will the latest bout of

deflation be just as brief as the last one?

A key issue here is what has caused the fall in

Eurozone inflation. The chart below sheds light on

this by showing the contributions to annual inflation

of the three key components that are energy, food,

and core. It shows that the 2009 bout of deflation was

very strongly driven by a deeply negative contribution

from energy prices, reflecting the sharp drop in oil

prices from over USD 130 per barrel in mid-2008 to

just USD40 per barrel by the end of that year.

With oil prices doubling in 2009, however, the

negative impact on inflation quickly went into reverse

and with core price pressures remaining more

robust, the headline inflation rate rebounded sharply.

Indeed, only 12 months after troughing at -0.6% in

July 2009, inflation was back close to the ECB’s 2%

ceiling and its subsequent further climb towards 3%

even prompted the ECB to raise interest rates twice

in 2011.

Of course, falling oil and energy prices have also

played an important part in the latest drop in inflation

and it is worth noting that core and food price

inflation are low from a historical perspective. During

the summer of 2014, food price inflation turned

negative for the first time since the financial crisis,

while core inflation has balanced around its new

historical low of 0.6% since September.

Deflationary pressures are already

broader

Although energy effects have been the primary

downward force, deflationary pressures are generally

broader than they were in 2009. Not only is core

inflation lower than it was then (+0.7% versus a low

of +0.8%) but more components of the CPI have

entered negative territory. Key components such as

household goods, communication, and recreation &

culture all have low or negative inflation.

Inflation expectations have fallen

markedly which could give rise to

prolonged deflation

Another rather less comforting development is the

fact that the drop in inflation appears to have caused

inflation expectations to become distinctly detached

from the ECB’s 2% target. For example, as the chart

below shows, the implied market expectations for

consumer price inflation has fallen markedly over the

past year.

Figure 2: Main contributions to Eurozone

headline inflation

Source: Eurostat, data as at March 2015. For illustrative purposes only.

Figure 3: Eurozone inflation by key sectors –

June 2009 and December 2014



Figure 4: Eurozone inflation expectations have

deteriorated significant since mid 2014

19


Admittedly, the chart also shows that the same

measure dropped equally sharply back in 2009, only

to rebound just as quickly when inflation itself picked

up again. But if deflation lasts longer this time – if

only because energy effects are not so quickly

reversed – it will create a risk of prolonged deflation

where the danger of a more permanent shift in

inflation expectations could feed back into lower

wage growth and a delay in consumer spending

could presumably increase.

So what are the risks of prolonged

deflation in the Eurozone?

If there is a severe negative economic shock, the risk

of prolonged deflation in the Eurozone could rise and

past experiences of deflation suggest prolonged

deflation may significantly harm economic activity.

There are three potential risks if deflation becomes

entrenched:

1. The cost of servicing existing debt rises as

inflation falls. Falling inflation leads to higher real

interest rates as nominal rates are often fixed. So

rather than simply boosting spending power, falling

prices may lead to outright declines in nominal

incomes – including wages, profits and government

revenues. This means that the current low rates of

inflation in the Eurozone are increasing the

importance of member countries’ already high public

and private debt levels. Rising debt service costs

may in turn reduce consumer spending and business

investment.

2. The second risk is that a surge in debt defaults

drives asset prices lower, particularly property and

other assets used as collateral, further increasing the

fragility of the financial system. This in turn, could

lead to an even more catastrophic decline in

economic demand.

3. The third risk is that expectations of ever-falling

prices become entrenched and a debt-deflation

spiral develops. This could encourage households to

delay spending, in the hope that they will eventually

be able to buy goods more cheaply. It could also

prompt companies to cut back on investments, for

fear that future returns will be lower. This sort of

deflationary spiral was avoided in 2009 partly

because major central banks responded with bold

monetary easing to boost inflation expectations and

keep real interest rates positive. But with nominal

interest rates now near zero, they have much less

room for manoeuvre

Who is most at risk in a prolonged

Eurozone deflationary environment?

Not all Eurozone countries are expected to face the

same issues in a prolonged deflationary

environment. Heavily-indebted economies with high

unemployment, low-trend real growth and already

low expectations of inflation are particularly

vulnerable to deflationary spirals as well as countries

that have a large output gap. To create a list of the

countries most likely to be impacted, the IMF in its

World Economic Outlook October 2014 publication,

selected the Eurozone countries that have a budget

deficit larger than 3.0%. The forecast output gap in

2014 for those countries was also noted. The IMF

then ranked the countries for both variables, and

added the two results to rank the countries again

based on this combined score. That final ranking was

thus based on an unweighted average of the other

two ranked scores.

Those most susceptible to lowering prices were

generally the peripheral countries that are currently

working to recover from the crisis and to regain

competitiveness relative to the core countries, as

shown in Figure 6. But one of the core countries,

France, also made the list. Taking into account the

weak economic growth in France and Italy over the

first half of 2014, these two are especially likely to

face further disinflationary pressure.

Source: Bloomberg, data as at March 2015. For illustrative purposes only.

Figure 5: Falling prices make debt burdens

harder to service

20


Deflation is rare

Persistent deflation, with prices falling over many

years, is an exceedingly rare phenomenon, at least

in the post-World War II era. There have been only

14 occurrences of deflation in the past 54 years, of

which only three (including Japan) occurred in

developed economies. With the exception of Japan –

which has had two separate periods of deflation

since the late 1990s – all of the remaining examples

of deflation were in countries operating fixed

exchange rate regimes.

This shows just how harmful entrenched deflation

can be for an economy. Following the bubble’s

bursting, Japanese corporations held high levels of

debt, which remained the same in nominal terms.

Then, as prices fell, the real value of corporate debt

increased. To avoid further increases in debt, these

firms reduced investment which in turn lowered

growth, deepening the economic downturn,

increasing unemployment and widening the output

gap. Japan’s greatest weakness was the policy

response to its economic woes, including

unsuccessful experiments in quantitative easing.

Japan is still suffering from effects of the ‘Lost Two

Decades’. Economic indicators finally seem to be

returning to healthier levels as Abenomics sets in,

with its ’three-arrowed’ reform programme (fiscal

stimulus, monetary easing and structural reform) to

address chronically low inflation, decreasing worker

productivity, and an ageing population. However, the

implementation of structural reform has been

delayed.

There are some similarities in the causes of deflation

in Japan and the recent experience in parts of

Europe. Like Spain and Ireland, Japan saw a

significant property bubble that, when it burst, threw

the economy into recession. However there has not

been a Europe-wide property bubble. Like Japan,

European banks were slow to write off bad loans,

and credit growth has stagnated.

However in Europe, the stock market bubble was not

as large and its bursting was part of an international

phenomenon in the wake of the Lehman collapse.

Furthermore, in the absence of exchange rate

devaluations, crisis-hit countries reacted with a raft of

reforms to regain competitiveness, including wage

and price moderation and, where possible, a shift

from labour taxes to consumption taxes. This so-

called “internal devaluation” aims to depreciate the

real effective exchange rate by realigning labour

costs with productivity, thereby restoring

competitiveness and, as a result, unwinding current

account deficits, a first step toward a sustainable

growth path for these economies. Countries in which

the internal devaluation has been the most

successful are generally those where structural

reforms have also been readily implemented such as

Ireland, Portugal, Spain, and, to some extent,

Greece. By contrast, France and Italy have fallen

behind in the reform race.

Overall, the fact that Japan is the only relevant

(modern) example provides some reassurance that

deflation is not something that occurs easily or

frequently in developed countries.

Figure 6: Vulnerability rankings

Source: IMF World Economic Outlook, data as at October 2014. For illustrative purposes only.

Overall

Rank Country

Fiscal

balance

2014 (% of

GDP)

Output gap

2014 (% of

GDP)

1 Spain -5.7 -5.0

2 Portugal -9.2 -3.5

3 Cyprus -5.0 -3.4

4 Greece -3.6 -9.4

5 Italy -3.3 -4.3

6 France -4.0 -2.8

7 Ireland -4.7 -2.5

8 Slovenia -4.0 -3.3

Figure 7: Deflation is unusual in advanced

economies

Lessons from Japan

Japan’s case was characterised by a series of

negative and mutually reinforcing factors, some,

but not all, of which are shared by the Eurozone.

At the end of the 1980s, Japan saw an asset price

bubble, prompting the Bank of Japan (BoJ) to step

in with sharp monetary tightening. This caused the

stock market to crash, asset prices to plummet

and the economy to fall into recession.

Consequently, non-performing loans increased

dramatically and credit became extremely

constrained. In the absence of an expansionary

monetary policy from the Bank of Japan, deflation

set in a couple of years after the crash.

Developed Market (DM) Emerging Market (EM)

Hong Kong Argentina

Japan (x2) Bahrain (x2)

Malta Libya (x2)

Niger

Saudi Arabia (x2)

Senegal

Syria Source: OECD and IMF. Deflation definition: 3years or more of negative inflation. For illustrative purposes only.

Sample 1960-2013 (54 years), 180 countries, annual CPI inflation

21


What about core Eurozone inflation?

Where will core inflation go?

Just how deep deflation becomes and how long it

lasts will depend most importantly on the behaviour

of core inflation. A quick look at the past behaviour of

core inflation would appear to provide some

reassurance. As the chart below shows, it has

tended not surprisingly to be more stable than the

headline rate, fluctuating in a much narrower band

and at a record low of -0.6% yoy in January 2015; it

is already at the bottom of that band.

This might suggest that the general stickiness of

prices in the Eurozone will prevent core inflation from

falling any further over the coming months. This is

also supported by our own Core Inflation Leading

indicator model (based on the output gap, trade-

weighted euro and a survey measure of inflation

expectations), which expects core inflation to remain

stable. If that is the case, deflation will remain an

energy-driven and relatively short-lived phenomenon.

Indeed, it could readily be classified as “good

deflation” insofar as it will boost private consumption

through higher real wage growth and could therefore

help to revive the Eurozone’s flagging economic

recovery. Added to this, low core inflation primarily

reflects low inflation in non-energy industrial goods,

while service price inflation, which is highly

dependent on labour as an input and closely related

to wage growth, has remained relatively stable.

Spare capacity has also exerted

downward pressure on core inflation

High levels of spare capacity have also exerted

downward pressure on consumer prices in the

Eurozone. Eurozone core inflation (the ECB has little

control over food and energy prices) is highly

correlated with the output gap, which is the difference

between how much an economy is producing and

how much the economy could produce. A lot of spare

capacity in factories or a lot of unemployed workers

discourages firms from raising prices because their

competitors can use their idle capacity or labour to

produce more and undercut them. The output gap is

notoriously hard to measure but an expanding output

gap has usually pushed core inflation down, and a

narrowing output gap has pushed core inflation up.

Therefore, to avoid a prolonged period of deflation,

the output gap needs to close and GDP growth to

pick up. Based on estimates from the OECD, the

Eurozone’s output gap was quite large at -3.3% in

2014, which means that core inflation could pick up if

the ECB’s QE programme succeeds in boosting

growth and closing the output gap.

Figure 8: Japan CPI and Core CPI inflation


Figure 9: Eurozone CPI and Core Inflation, ECB

target


Figure 10: Eurozone core goods and services

inflation


22


Wage pressures have been subdued in the

Eurozone. While Eurozone unemployment remains

high, the fact that the unemployment rate has

stopped rising and even fallen modestly over the last

year suggests wages could soon start to pick up from

recent very low levels, with corresponding potential

upward effects on headline inflation.

Even a quick look at the Eurozone’s monetary

dynamics might suggest that disinflationary pressure

may soon ease. The chart below shows the

relationship between broad (M3) money growth and

CPI inflation with the recent pick-up in M3 growth

pointing to rising inflation ahead. Furthermore, this

might become clearer if the ECB’s quantitative

easing (QE) programme results in a further pick-up in

money supply growth.

Other factors also suggest that the Eurozone could

avoid a prolonged downward slide into deflation. For

instance Eurozone business and consumer

confidence has picked up since the dip in September

while household savings as a proportion of gross

disposable income have continued to edge lower

since the start of the year, suggesting that spending

could be set to rise in the coming months and boost

aggregate demand.

The largest Eurozone banks also appear to be in

better shape than expected, with capital shortfalls

identified by the ECB’s latest asset quality review

coming in at the lower end of expectations. No

French or German banks were required to source

more capital.

How can low inflation be addressed?

The tricky part is determining how to fight low

inflation and avoid prolonged deflation. With interest

rates already close to zero, standard monetary policy

virtually ceases to be effective. Over the last months,

the ECB has tried hard to ease financial conditions,

using various non-standard monetary policy

measures, such as providing ultra-cheap loans

targeted to those banks that lend to small and

medium-sized enterprises, and purchasing private

sector assets (covered bonds and asset backed

securities).

Finally, as an antidote to deflation, the European

Central Bank (ECB) rolled out its aggressive QE

program in March 2015. The package includes

injecting EUR1.1 trillion through the purchases of

government bonds and private sector assets, worth

EUR60 billion a month, until at least the end of

September 2016 or when the inflation rate shows

signs of improvement towards its target. But QE in

the Eurozone has arrived late. The US is winding

down the QE programme it embarked on 6 years ago

when low inflation rates first started to raise alarm.

The ECB’s QE programme reduces

headwinds to inflation

The ECB’s QE programme is expected to lift inflation

through various channels:

Figure 11: Output gap and 12-month change in

core CPI inflation

Source: Bloomberg, data as at March 2015. For illustrative purposes only.

Figure 12: Eurozone inflation and M3


23


The first channel is the currency. On a trade-

weighted basis, the euro depreciated significantly in

2014 (-6.0%) and this decline has accelerated since

the beginning of 2015 (an additional -6.4%), following

the ECB’s announcement that it would purchase

sovereign bonds and increase its balance sheet

further. Euro depreciation should put upward

pressure on inflation. The lower exchange rate has

already raised manufactured import prices in H2

2014 by 1.9%, according to Eurostat, and these are

expected to increase further in Q1 2015. This

increase alone should help lift core goods price

inflation in the first half of the year. The weaker EUR

will also lift food-price inflation this quarter and

dampen the impact of lower oil prices.

The second channel at play is inflation

expectations. The ECB’s QE programme should

support inflation expectations as it signals the ECB is

committed to its mandate of maintaining price

stability. Hence, the current monetary easing should

support wage growth if the stimuli convinces wage

earners that they should expect 2% inflation. Related

to this, easing should limit second-round effects and

the risk of a dangerous kind of deflation, where

wages follow inflation lower.

The last channel is the growth outlook. The ECB

expects GDP to grow by 1.5% in 2015 (up from 1%

in the December projections), 1.9% in 2016 (up from

1.5%) and 2.1% in 2017, and QE poses upside risks

to this view.


The obvious question is: will QE make a difference,

especially as government bond yields in Europe are

already so low? There is certainly scope for bond

yields in peripheral Europe to fall further, and for

those lower interest rates to feed through to the real

economy via the banking system. However, we feel

that the ECB’s QE programme will eventually benefit

the Eurozone economy by reducing the risk of

prolonged deflation and that the main impact will

come through from the weaker euro. This should

make European exporters more competitive

internationally and provide a boost to GDP and

corporate earnings growth, and therefore be a

positive for risk assets such as European equities.

Looking ahead, we expect oil prices to eventually

increase from current very low levels. We are not

there yet, but if they rebound eventually over the

coming year as they did in 2009/10, then it is likely

that headline inflation will also rise again quickly and

the current burst of deflation might prove to be just as

brief as the last one. Even if the oil price does not

increase but remains at its current level, headline

inflation should turn positive towards the end of this

year. However, the price dynamics will continue to be

limited by a large negative output gap, high

unemployment and the absence of wage pressures.

Furthermore, with Eurozone inflation already in

negative territory, investors could remain sensitive to

any negative exogenous shocks, for example from

Greece or from the situation in Ukraine and Russia,

that may put further pressure on the outlook for

inflation and growth.

Over the long-term, we continue to favour riskier

assets, such as equities, over perceived safe-haven

developed market government bonds. The ECB’s QE

programme supports the view that the world’s major

developed market central banks are ready and willing

to provide monetary stimulus if necessary to support

their economies and to ward off entrenched deflation.

24

China National People’s Congress (NPC) Growth stabilisation and economic restructuring are two policy priorities in 2015 Renee Chen, Senior Macro and Investment Strategist

Summary:

Chinese Premier Li Keqiang delivered the

Government Work Report at the National People’s

Congress on 5 March, outlining the

macroeconomic and policy targets and reform

agenda for 2015

The macroeconomic and policy targets for 2015

reflect the balancing act between growth

stabilisation and economic restructuring, the two

priority policy objectives, and are broadly in line

with expectations

The lower “about 7%” growth target for 2015, in

our view, likely reflects the government’s

awareness of the “new normal” of growth on the

back of economic rebalancing and restructuring

The overall tone on macro policy sounds more

supportive of growth, with the mention of more

flexibility in monetary policy and more

expansionary fiscal policy. The government has

also loosened property policies

Allowing local governments to swap existing Local

Government Financing Vehicles (LGFV) debt with

municipal bonds marks a major step in

restructuring local government debt. It could help

lower funding costs for local governments, credit

risk for banks, and the systemic financial risks

Premier Li covered a wide range of key reform

areas for 2015, including financial, fiscal/tax,

State-Owned Enterprises (SOE) and hukou

reforms and opening up, etc. and laid out key

growth strategies. He also addressed key topics

such as the fight against pollution and anti-

corruption

The government’s strong intent to maintain a

stable growth and its focus on reforms could help

ease concerns about China’s growth outlook,

earnings prospects and credit risk, and support

the financial markets in the near term, amid a

more supportive macro policy backdrop

‘New normal’ growth targets

Chinese Premier Li Keqiang delivered the

Government Work Report (“the Report”) at the Third

Session of the 12th National People’s Congress

(NPC), the nation’s parliament, on 5 March, outlining

the macroeconomic and policy targets and reform

agenda for 2015.

The government has set a growth target of “about

7%” and CPI inflation target of “around 3%” for 2015,

lower than “about 7.5%” and “around 3.5%,”

respectively, for 2014. The actual 2014 GDP growth

was 7.4% and inflation was 2.0%. The growth goals

for foreign trade, fixed asset investment (FAI) and

retail sales have also been reduced to 6%, 15% and

13% for 2015 from 7.5%, 17.5% and 14.5%,

respectively, for 2014. However, the 2015 target for

retail sales growth is still higher than the actual rate

of 12% in 2014 while the target for FAI is lower than

the 2014 actual rate of 15.7%. This could imply the

government’s goal to restructure and rebalance the

economy, in our view.

Other specific economic and social targets include

keeping the target for urban job creation at 10 million

for 2015 (the 2014 actual figure was 13.2 million) and

ensuring that personal income growth keeps pace

with overall economic growth. In 2014, the nation-

wide disposable income per household increased by

8% in real terms, faster than real GDP growth

(+7.4%).

Figure 1: Selected key economic targets for 2015

Source: Government Work Report, data as at March 2015. For illustrative purposes only. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets

2015 Target 2014 Target 2014 Actual

GDP (% yoy) ~7.0 ~7.5 7.4

CPI (% yoy) ~3.0 ~3.5 2.0

Fixed asset investment

(% yoy) 15.0 17.5 15.3

Retail sales (% yoy) 13.0 14.5 12.0

Trade (% yoy) 6.0 7.5 3.4

Urban job creation (mn) 10.0 10.0 13.2

Urban unemployment

rate (%) <=4.5 <=4.6 4.1

Budget deficit (CNYtrn) 1.62 1.35 1.13

Budget deficit % of GDP -2.3 -2.1 -1.8

M2 (% yoy) 12.0 13.0 12.2

25


Premier Li said that the “about 7%” growth target takes

into consideration what is needed and what is possible.

We think the growth target reflects the government’s

awareness of the “new normal” of slower growth for the

economy, its intent to maintain stable growth to ensure

employment, and its resolve to push forward structural

reform. The government views “about 7%” growth to be

consistent with stable employment conditions, as the

service sector becomes larger, the number of small

and micro businesses grows and the economy gains in

size.

The lower inflation target – which tends to mean an

upper limit – for this year is unlikely to become a

binding constraint, given the current low inflation

environment. The Chinese economy faces

disinflationary pressure from lower energy/commodity

prices, sluggish demand conditions and overcapacity in

some industries. This would open room for factor-input

pricing reform and monetary policy easing, if

necessary.

The government’s work for 2015 will focus on: (1) to

ensure continuity in and make improvements to

macroeconomic policies; (2) to strike a fine balance

between ensuring steady growth and making

structural adjustments; and (3) to foster new drivers

for economic and social development. The Report

highlighted increasing provision of public goods and

services as well as innovation and entrepreneurship

as two new growth sources.

Macro policy stance

Premier Li reiterated the stance of a proactive fiscal

policy and prudent monetary policy for 2015.

However, he also called for a more “forceful and

effective” fiscal policy and an “appropriate” and more

flexible monetary policy to help stabilise growth. The

tone for property policies appears to be more

supportive than in 2014.

Recent economic data showed weakness in China’s

growth momentum, particularly still sluggish

domestic demand (investment). Industrial activity

continued to be constrained by overcapacity, an

uncertain demand outlook, and environmental

concerns. We think local government funding

constraints, higher real interest rates/costs of capital,

deflationary expectations, and the ongoing anti-

corruption campaign likely also weighed on domestic

activity (and hence prompted the rate cut in March).

1. Prudent monetary policy with more flexibility

The government has lowered the broad money

supply M2 growth target for 2015 to 12%, from 13%

for 2014 (2014 actual: 12.2%), but Premier Li said

the actual figure may be slightly higher than 12%

depending on the needs of economic development.

We do not interpret a lower M2 growth target as a

signal of policy tightening, but we view it as a realistic

adjustment to lower economic growth and inflation

targets.

The Report states that the People’s Bank of China

(PBoC) will use various monetary policy tools,

including open market operations, interest rates,

reserve requirement ratio (RRR) and re-lending, to

maintain the stable growth of money supply/bank

loans/total social financing, lower funding costs for

the real economy and prevent any sharp deceleration

in growth. Li said monetary policy measures should

focus on fine-tuning and targeted adjustment,

indicating no intention for big stimulus measures. We

expect monetary policy to remain accommodative

and supportive of growth in the near term. Further

Figure 2: Selected activity indicators

Source: CEIC, HSBC Global Asset Management, data as at March 2015. For illustrative purposes only.

Figure 3: Inflation trajectory

Note: PPI= Producer Price Index; CPI= Consumer Price Index.


26


policy easing is likely, both to lower (real) financing

costs for corporates and to ensure sufficient liquidity.

The timing and magnitude of policy moves will be

data-dependent.

2. A more “forcefully” proactive fiscal policy

The government has set the 2015 fiscal deficit target

at CNY1.62 trillion (2.3% of GDP), compared with the

target of CNY1.35 trillion (2.1% of GDP) for 2014.

The actual deficit for 2014 was CNY1.1 trillion (1.8%

of GDP). The 2015 target includes CNY1.12 trillion

deficit for the central government (versus CNY950

billion for 2014) and CNY500 billion (versus CNY400

billion for 2014) for local governments. In addition to

a quota of CNY500 billion for local government bond

issuance to fund new projects this year, the

government will also allow local governments to

issue special-purpose bonds (CNY100 billion) to roll-

over debts and fund existing projects.

However, the actual fiscal policy could be more

expansionary than the budget plan or the 2.3% GDP

deficit target indicate, taking into account the

CNY112.4 billion of unspent funds carried over from

the previous year and funding from special-purpose

bond issuance. Finance Minster Lou Jiwei estimated

that the actual fiscal deficit could be 2.7% of GDP for

2015, if the two items are included, compared with

2.1% of GDP in 2014.

Meanwhile, the Ministry of Finance (MOF) has

granted a CNY1 trillion debt-issuance quota to local

governments to allow them to convert their existing

higher-interest debt scheduled to mature this year

into lower-yielding municipal bonds. The existing

debt largely includes debt issued by local

government financial vehicle (LGFV) entities, and

borrowing from banks and the shadow banking

sector (e.g. trust loans). The funds raised can only be

used to repay the debt that the National Audit Office

(NAO) identified as debt for the repayment of which

the local governments have direct responsibility. The

2013 NAO Report estimated that there is CNY1.86

trillion of such debt maturing this year, so the CNY1

trillion quota covers about 53.8% of the debt

maturing in 2015.

The debt-swap scheme marks a major step forward

in restructuring local government debt. It will

introduce more oversight, transparency and

discipline over debt issuance by local governments. It

could lower funding costs and the interest burden for

local governments, extend their debt maturities, and

ease their refinancing and liquidity risk in the near

term. The MOF estimated that the refinancing could

reduce local governments’ interest payments on

existing debt by around CNY40-50 billion a year. The

savings from the lower interest burden could be

spent on other expenditure areas such as

infrastructure investments. The debt-swap scheme

could also help reduce the credit risk of banks’ LGFV

portfolios in the near term and help reduce banks’

direct LGFV exposure if the existing debt was

refinanced away from bank loans. Consequently, this

could free up funds for bank lending to more

productive sectors, and lower the systemic financial

risks in the economy. The scheme could be

expanded later, if needed.

However, we are also cautious that the debt-swap

scheme does not cover the portion of the debt local

governments do not have direct responsibility to

repay and debt issued after June 2013. While the

scheme reduces immediate risks around the

refinancing of the debt maturing in 2015, the impact

on longer-term sustainability remains to be

addressed. The risk of excessive local government

indebtedness also remains unaddressed as the debt

stock continues to be rolled over.

Despite a larger fiscal deficit target and more local

government bond issuance this year, local

governments will likely still face financing constraints

given weaker land sales revenues and tightened

rules over LGFV borrowing. Reform of the

investment and financial mechanism is important,

including more private sector participation [(e.g. the

public-private partnership (PPP)] and the disposal of

local state assets, etc. However, it remains unclear

how quickly the PPP will be effectively launched.

Figure 4: Bank lending rates vs. inflation


27


Finance Minister Lou Jiwei said that for local

government projects that could generate some profits

or stable cash flows, part of the debt could be repaid

via fee collections while some could be restructured

into corporate debt via the PPP. Another option is to

restructure local government debts by refinancing

some upcoming projects through bank loans.

3. Supportive signals in property policies

The overall tone for the property market this year in

the Report sounds more supportive at the margin

compared with 2014. The government pledges to

support stable “housing consumption” and promote a

stable and healthy development of the real-estate

market. The government will adhere to differentiated

guidance in setting policies, supporting home

ownership and increasing demand for housing and

allowing local governments to set property policies

based on local market conditions. The social housing

construction target is set at 7.4 million units this year,

of which 5.8 million units were shanty town re-

development, an increase of 1 million units from

2014. This could also provide some cushion against

a significant slowdown in real-estate investment this

year.

The authorities on 30 March announced measures to

support the property market, including loosening

housing mortgage policies and shortening the

holding period for business-tax exemption. The

down-payment requirement for second home

mortgages will be lowered to 40%, from 60% and

above previously. For mortgage borrowing from the

Housing Provident Fund, the down-payment for first-

time home buyers will be cut to 20% (from 20-30%

previously) and, for second-home buyers who have

fully paid down their first mortgages, will be lowered

to 30% (from 60% previously).

Regarding housing transactions in the secondary

market, the MOF also shortened the minimum

holding period to 2 years from 5 years for sales of

ordinary housing to get the business-tax exemption.

For luxury properties, the tax will be imposed on the

net revenue (i.e. resale value minus the purchase

cost) if resale occurs more than two years after the

purchase. If resale occurs within two years, the tax

will be imposed on the entire resale value. These

easing measures were largely expected by the

market, on the back of further weakness in property

market activities in January-February.

These policies should provide some support to

increasing demand for housing and bolstering

sentiment in the property market in the short term,

especially in upper-tier cities. These should help slow

the pace of property market adjustments and limit the

downside to property sales and investment growth.

However, we do not expect these measures to lead

to a strong rebound in the property market

nationwide or to boost real-estate investment much

in the near term given the severe over-supply and

inventory overhang in tier-3 or 4 cities. Meanwhile,

the mortgage policy easing also showed the

government’s determination to stabilise growth this

year, as the housing market correction remains one

of the key drags on domestic demand/activity.

Figure 5: Gauge of capital flows


Figure 6: Selected property market indicators

Note: FAI= Fixed Asset Investment.


28


Reform plans for 2015

Premier Li pledged to deepen reform and economic

opening up. Li laid out a wide range of reform areas,

although he made no mention of the timetable for

implementation. These include pricing, fiscal and tax,

the investment and financing mechanism, financial,

state-owned enterprise (SOE) and household

registration (hukou) reforms, among others.

Below are some highlights in selected reform areas:

Reform of the investment and financing-

mechanism.

• To significantly reduce the number of investment

projects that require government approval and

delegate more powers of review to lower-level

governments.

• To loosen entry restrictions for private investment

and encourage the use of private capital to set up

equity investment funds.

• To deepen reform of railway investment and

financing by making good use of railway

development funds.

• To promote the PPP scheme to fund infrastructure

projects.

Resource pricing reform.

• To significantly reduce the scope of government

pricing.

• The government to stop setting prices for most

pharmaceuticals.

• To delegate to lower-level governments the power

to set prices for certain basic public services.

• Pricing reform of electricity, water and energy to

be more conducive to environmental protection.

Fiscal/tax reform.

• To implement a comprehensive and transparent

budgeting system.

• To increase the percentage of funds transferred

from the budgets for state capital operations to

general public budgets.

• To reform the transfer payments system and to

clearly define spending responsibilities and make

appropriate adjustments to the division of revenue

between the central and local governments.

• To complete work to replace business tax with a

value-added tax (VAT) across the board.

• To adjust and improve policies on consumption

tax.

• To extend price-based resource taxes to cover

more types of resources.

Financial and capital-market reform.

• To promote the establishment of small and

medium-sized financial institutions by private

capital.

• To establish a deposit insurance scheme.

• To further liberalise interest rates.

• To increase two-way flexibility in the CNY

exchange rate while keeping it relatively stable at

an appropriate and equilibrium level.

• To continue efforts to expand the CNY’s global

use while gradually opening up the capital

account.

• To launch the Shenzhen-Hong Kong Stock

Connect on a trial basis at an appropriate time.

• To reform the IPO system from approval-based to

registration-based.

• To encourage the securitisation of credit assets,

the expansion of corporate bond issuance and the

development of the financial derivatives market.

• To promote tax-deferred pension insurance.

The PBoC on 31 March officially introduced the

deposit insurance scheme, to be implemented on 1

May. The scheme will cover all deposit-taking

financial institutions in China (except for foreign

banks’ branch offices). The maximum level of

protection is CNY500,000 per depositor per financial

institution, with more than 99% of depositors to be

covered. The introduction of deposit insurance marks

an important step toward full interest rate

deregulation and market-based capital allocation.

The scheme is seen as a prelude to the removal of

the deposit rate ceiling, which is currently capped at

130% of the benchmark rate, by ensuring that savers

are protected (up to the maximum insured amount)

even if increased competition for deposits leads to

excessive risk-taking and bank failure. The scheme

also removes the government’s implicit full deposit

guarantee and, at least in theory, could lead to better

pricing of risks by banks and depositors, given the

shift in perception over the government’s bailout

promise which could increase differentiation between

strong and weak banks by market forces. With

deposit insurance in place, the government could

also move on introducing bankruptcy rules or an exit

framework for failed financial institutions, and

accelerating capital market liberalisation, as the

government expands the financial safety net.

SOE reform.

• To push forward with targeted reform of SOEs on

the basis of having clearly defined their functions.

• To accelerate carrying out the trials on setting up

state capital investment companies and operating

companies.

• To take systematic steps to introduce mixed

ownership of SOEs.

• To encourage and regulate equity investments

made by private capital in SOE investment

projects.

29

China National People’s Congress (NPC) Opening-up.

• To transform and upgrade China’s foreign trade.

• To speed up the implementation of the “go global”

strategy, encourage Chinese companies to

participate in overseas infrastructure projects, and

broaden the use of FX reserves.

• To develop the New Silk Road and the 21st

Century Maritime Silk Road (the “One Belt One

Road” strategy).

• To actively develop pilot free-trade zones (FTZ) in

Shanghai, Guangdong, Tianjin and Fujian and to

extend these pilot FTZ to the rest of the country.

• To strengthen investment and trade connections

with neighbouring countries.

The “One Belt One Road” initiatives aim to boost

trade, investment and economic relations, as well as

financial and infrastructure connectivity with the rest

of Asia, Africa, Europe and the Middle East with

more roads, railways, ports, power grids, oil and gas

pipelines, and other projects.

Hukou reform, a key to promote a new type of

people-oriented urbanisation.

• To reform the hukou system and relax controls

over the transfer of hukou.

• To grant migrant workers who live in urban areas

but have yet to gain urban residency access to

basic public services on the basis of their

residence certificates.

• To link the transfer payments of cities to their

performance in granting urban residency to

eligible migrant workers.

Rural land reform.

• To prudently carry out pilot reforms related to: (1)

rural land acquisition, (2) putting rural collective

land designated for business-related construction

on the market; (3) the system of land use for rural

housing; and (4) the rural collective property rights

system.

In addition to the new type of urbanisation, the

Report also highlighted the growth strategy in other

areas, through encouraging consumption,

increasing effective investment in public goods,

modernising agriculture, and promoting

industrial upgrading.

The government will encourage consumption in a

wide range of services, including elderly care, health,

leisure and tourism, information, education, and

housing, etc. To support major public investment

projects in areas such as social housing, transport

(railway, roads and waterway), oil and gas pipelines,

and clean energy, etc., the central government will

increase its budgetary investment but also

encourage private participation. Railway investment

should exceed CNY800 billion in 2015 (versus a

target of CNY800 billion in 2014).

The government will support industrial innovation and

upgrading through fiscal subsidies and accelerated

amortisation and will support industrial consolidation

in over-capacity industries. Initiatives such as “Made

in China 2025” and “Internet Plus” will be promoted

to support emerging industries, focusing on scientific

and technological innovation and green development.

“Internet Plus” includes promoting cloud computing,

online banking, mobile Internet, along with logistics to

help e-commerce expansion. The government will

also deepen the reform and opening up of the

services sector.

The Report also covers other social issues and

reforms ranging from education, the medical and

healthcare system, social security, environmental

protection, energy conservation, and anti-

corruption, among others. In terms of the social

security system/ pensions, the basic pension benefits

for enterprise retirees will be increased by 10%, and

the monthly basic pension benefits for rural and non-

working urban residents will be raised to CNY70 from

CNY55 per person. In the area of the medical and

healthcare system, the government plans to increase

subsidies for basic medical insurance and roll out

serious illness insurance across the country. The

annual government subsidy for basic medical

insurance will increase to CNY380 per person (from

CNY320). The government will also work toward a

national pooling system for basic pensions and

increase portability of its healthcare insurance.


The Report showing the government’s strong intent

to maintain stable growth and implying a more

supportive macro policy should help ease investor

concerns about a sharp slowdown in the Chinese

economy and the implication for corporate earnings

growth (prospects) and default risks. The debt

swapping also suggests that the government is

taking a more moderate and gradual approach in

China’s deleveraging process, to prevent the

economy from falling off a cliff. While concerns about

macro headwinds and debt overhang will likely

remain, we believe the Chinese authorities have

deep tool kits to cushion the downside risk to the

economy and contain financial stability risks.

Overall, there is little surprise in the Government

Work Report. The lower growth and inflation targets

are in line with our and market expectations, given

the ongoing economic rebalancing and restructuring

and the current low inflation environment. The Report

emphasizes that growth stabilisation and economic

restructuring remain the two priority policy objectives

in 2015, and the government will try to strike a

balance between them.

30


Supportive policies and reform initiatives are near-

term positives for Chinese equity and credit markets.

For example, SOE reform could help improve

transparency, governance and efficiency of the SOE

sector, providing support for potential earnings

revisions and driving the market’s re-rating potential.

Policy/regulatory efforts (e.g. the repo rule, margin

trading and umbrella trusts) to contain speculation on

the market could tighten liquidity in the near term, but

they are positive for improving risk pricing and a

healthier market development in the longer term.

The local government debt-swap scheme could be

positive for banks from a credit risk perspective.

Lower financing costs on the back of an

accommodative monetary policy could help highly-

leveraged companies and the property sector at the

margin in the near term. The property sector could

also get support from the recent policy relaxation and

the government’s pledge to maintain a stable

property market. The government’s emphasis on

environmental protection, the fight against pollution

and for energy conservation could support the

alternative and clean energy sector. The “Internet

Plus” strategy could support the e-commerce/

logistics sector. We continue to like sectors and

stocks with strong earnings growth prospects, those

that stand to gain from reforms, and those that offer

high and stable dividend yields. There could also be

selective opportunities from a comprehensive plan

for the deepening healthcare reform, the “One Belt

One Road” initiatives, the new urbanisation (and the

hukou and land reforms), a stock connect between

Shenzhen and Hong Kong and China’s capital

market opening-up. The “One Belt One Road”

initiatives could be positive, in the long term, for the

Engineering and Construction (E&C) sectors with a

stronger overseas franchise, larger overseas

exposure and higher absolute margin levels.

An overall macro backdrop of tepid growth

momentum and low inflation coupled with lower

financing costs on the back of a more supportive

monetary policy should be positive for the Chinese

fixed income market in the near term. The risk

premium in the China credit complex due to concerns

over economic and financial risks could narrow if the

government continues to demonstrate that it remains

in control. We see the debt swap scheme as the start

of local government debt reforms. In the near term,

an anticipated sharp increase in local government

bond supply, to an estimated CNY1.6 trillion in gross

issuance in 2015 (from CNY400 billion last year) has

pushed up onshore bond yields. However, we think

the debt-swap scheme is a positive for China’s

sovereign credit profile and should help reduce the

risk premium priced in Chinese bonds due to

leverage concern in the medium term, as it reduces

local government’s near-term refinancing risk and

overall liquidity and credit risk.

However, financial markets will likely remain highly

volatile in the near term. Earnings growth, corporate

fundamentals, policy initiatives to manage risks, and

effective reform implementation are key to the

medium-term outlook for Chinese financial markets.

31

Macro and Investment Strategy team

Julien Seetharamdoo

Chief Investment Strategist Julien Seetharamdoo is Chief Investment Strategist

within HSBC Global Asset Management’s Macro

and Asset Strategy team where he provides analysis

and research on the key issues facing the global

economy and asset markets. Prior to joining HSBC,

Julien has worked for Coutts & Co, RBS and Capital

Economics. He holds a first-class degree in

Economics from Cambridge University and a PhD in

Economics from the Management School, Lancaster

University focusing on the implications of the

European Monetary Union.

Renee Chen

Senior Macro & Investment Strategist Renee Chen joined HSBC Global Asset

Management as Macro and Investment Strategist in

April 2012. Prior to this role, she held Economist

roles at Macquarie Capital Securities, Nomura and

Citigroup and has over 14 years’ experience in

economic and policy research. Renee holds a

master’s degree in International Affairs and

Economic Policy Management from Columbia

University, New York and an MBA in Finance and

Investment from George Washington University,

Washington DC.

Herve Lievore

Senior Macro & Investment Strategist Hervé Lievore is a Senior Macro and Investment

Strategist based in Hong Kong. Before joining

HSBC, he spent five years at AXA Investment

Managers in London and Hong Kong as an

economist and strategist, covering Asia and

commodities. He was also involved in the firm’s

tactical asset allocation committees. He started his

career 18 years ago at Natixis in Paris, where he

mostly covered Asian markets.

Michael Hampden-Turner

Senior Macro & Investment Strategist Michael Hampden-Turner is a Senior Macro

and Investment Strategist based in London

having recently joined HSBC Asset Management

in December 2014.

He previously held global macro, asset allocation,

fixed income and credit strategy roles at Citigroup

and RBS over a twenty year career both as a

publishing top down strategist and a desk

analyst. He studied at Trinity College, Cambridge

and Harvard University.

Rabia Bhopal

Macro & Investment Strategist Rabia Bhopal is a Macro and Investment

Strategist and provides analysis and research on

the key issues facing the global economy and

asset markets, with particular focus on Frontier

Markets. Rabia has been working in the industry

since 2003. Prior to joining HSBC in 2012, Rabia

held Economist roles at Standard & Poor¹s,

Lloyds TSB Corporate Markets, Financial

Services Authority and the Economist Intelligence

Unit. She holds a degree in Economics from

Brunel University in London.

Shaan Raithatha

Macro & Investment Strategist Shaan is a Macro and Investment Strategist

within HSBC Global Asset Management’s Macro

and Investment Strategy team. Prior to this role,

he spent 18 months on the HSBC Global Asset

Management Graduate Programme working as

an analyst on both the Global Emerging Markets

Equity and Equity Quantitative Research teams.

Shaan holds a bachelor of arts degree in

economics from the University of Cambridge.

32

This document is prepared for general information purposes only and the opinions expressed are subject to change without

notice. The opinions expressed herein should not be considered to be a recommendation by HSBC Global Asset

Management (Singapore) Limited to any reader of this material to buy or sell securities, commodities, currencies or other

investments referred to herein. It is published for information only and does not have any regard to the specific investment

objectives, financial situation and the particular needs of any specific person who may receive this document. This

document does not constitute an offering document. Investors should not invest in the Fund solely based on the information

provided in this document and should read the offering document of the Fund for details. Investors may wish to seek advice

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financial adviser, he should consider whether the fund in question is suitable for him.

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trends/forecasts are not necessarily indicative of the future or likely performance of the fund. The value of investments and

units may go down as well as up, and the investor may not get back the original sum invested. Investors and potential

investors should read the Singapore prospectus (including the risk warnings) which is available at HSBC Global Asset

Management (Singapore) Limited or its authorised distributors, before investing. Changes in rates of currency exchange

may affect significantly the value of the investment.

HSBC Holdings plc, its subsidiaries and other associated companies which are its subsidiaries, and including without

limitation HSBC Global Asset Management (Singapore) Limited (collectively, the “HSBC Group”), affiliates and clients of the

HSBC Group, and directors and/or staff of any of the foregoing may, at any time, have a position in the markets referred to

herein, and may buy or sell securities, currencies, or any other financial instruments in such markets.

HSBC Global Asset Management (Singapore) Limited has based this document on information obtained from sources it

believes to be reliable but which it has not independently verified. Care has been taken to ensure the accuracy and

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responsibility or liability for any errors or omissions contained therein.

HSBC Global Asset Management (Singapore) Limited

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