Fed’s Status Quo Investment Barometer...2 September 2015 was yet another month that will not be...

Fed’s Status Quo

Investment Barometer

16 October 2015

2

September 2015 was yet another month that will not be fondly remembered by investors in the stock

market. The correction continued in all markets with the deepest slumps in Japan (-8.2%) and in Latin

America (-7.9%). The smallest Polish companies (-0.8%), those from Asian emerging markets (-1.8%) as

well as U.S. and frontier market companies (-2.6%) performed fairly well in this hostile environment. On the

other hand, September brought price increases in the debt market with declines in yields observed for the

third month in a row.

In September, investors impatiently awaited the Federal Reserve’s decision on U.S. interest rates. The Federal Open Market Committee (FOMC) once again postponed the increase, pointing out the still low inflation and a weakening Chinese economy. Investors interpreted this as a risk to global economic growth and started to offload their shares. The increased supply caused the MSCI World to lose 6.2% in the ten days following the Fed’s decision. It was not until the end of September that calm returned to markets, and since then, we have seen increases in stock indices.

In the bond market, we have observed drops in yields. In the face of heightened volatility and uncertainty in the markets for risky assets, investors were seeking safe havens. Polish treasury bonds also followed in the steps of core markets, although in this case the increases in prices were not as sharp as for similar U.S. or German securities.

Poland did not escape the sell-off entirely but it proved much (for the third month in a row) less severe than in other developing markets. Small companies again proved the most resistant to the adverse environment, recording only slight decreases (-0.8%), and they are currently growth leaders on the Warsaw Stock Exchange in year-to-date terms (+8.2%). In our opinion, this trend may well continue in the coming months given the sound economic prospects, which favor the SME segment, and the upcoming national elections, which may result in pressure on the blue chip one.

Despite another nerve-racking month we uphold our market outlook, seeing greater relative value in equities, which should be supported by the good macroeconomic situation, an improvement in corporate earnings and the very loose monetary policy of central banks. We consider September declines to provide an opportunity to increase our exposure to this asset class, seeing a greater chance for a rebound in risky asset markets in the near future.

We maintain our negative outlook on long-term bonds because we do not see any scope for significant price rises in the medium term. We are neutral on global high yield bonds and continue to see the greatest potential within this group in European corporate securities. We continue to overweight total return solutions since we expect hard times for bondholders.

Source: Bloomberg, Citi Handlowy

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Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15

WIG30 S&P500 Eurostoxx50


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Polish bonds U.S. bonds German bonds

Karol Matczak

Securities Broker

Karol Ciuk

Investment Advisor

Jakub Wojciechowski

Securities Broker

Contributing Authors:

Bartłomiej Grelewicz

Paweł Chylewski

Dariusz Zalewski

Maciej Pietraszkiewicz

Michał Skubacz

Michał Wasilewski

4

Poland – the smallest companies leading the pack

September was another month of declines in the Polish stock market. The WIG broad market index

lost 2.8% in the last month, recording a deeper slump than in August. The largest companies were

hit the hardest with the WIG20 blue chip index dropping by 4.5%. The mWIG40 mid-sized company

index put in a performance similar to the broad market one, losing 2.7%. Small companies fared

the best with the sWIG80 sliding by just 0.8%. Owing to political risks, we advise caution in

purchases of blue chip stocks; on the other hand, we see growth potential in small and medium-

sized companies with greater exposure to domestic GDP growth.

As parliamentary elections in October approach,

Polish banks have remained under pressure. The

banking sector index has dropped for the fifth

month in a row, losing 4.9% of its value. The issue

of Swiss franc loans has not been resolved but it

has been swept under the carpet for the time

being. On the other hand, the introduction of a

bank tax in 2016 appears to be inevitable, as we

already reported in previous editions of the

Barometer. Last month, however, a new proposal

emerged – this time concerning the establishment

of a fund for borrowers, which would amount to

PLN 600 million. The fund is to be financed by

payments from banks made in proportion to the

sizes of their mortgage loan portfolios. The

support (capped at PLN 1,500 per month and

intended to cover all principal and interest

payments for 18 months) is targeted at those

borrowers who have lost their jobs or the amount

of the loan exceeds the value of their home or the

ratio of their liabilities to net income is higher

than 60%. In the draft Act, provisions that limit the

number of potential beneficiaries are also

included, which concern, inter alia, the number of

properties owned and the floor area of their

homes. The support for borrowers is to be

refundable. It is estimated that the establishment

of the support fund will negatively affect net

earnings in the sector and could drive its results

down by a few percentage points. Taking the

above factors into account, the banking sector

Owing to political risks, we advise

caution in purchases of blue chip

stocks; on the other hand, we see

growth potential in small and medium-

sized companies.

Unemployment level and wage growth in Poland


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9

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12

13

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15

Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15

Unemployment (%, left axis) Wage growth (% y/y, right axis)

5

may continue to be shunned by investors despite

the undemanding valuations (the leading P/E ratio

is close to the average value); results of the

upcoming parliamentary elections will certainly

provide important guidance here.

Another September development of note was the

statement by the Minister of Treasury that 100% of

shares in Kompania Węglowa (Coal Mining

Company) had been transferred to Towarzystwo

Finansowe Silesia. This is the first stage of the aid

plan for coal mines involving the establishment of

Nowa Kompania Węglowa (New Coal Mining

Company), which is to take over all the 11 mines

that now belong to Kompania Węglowa. The

capital of Nowa Kompania Węglowa must be

structured so that the European Commission does

not challenge the scheme as unlawful state aid.

The government has agreed to inject capital

amounting to ca. PLN 1.4 billion into Towarzystwo

Finansowe Silesia by contributing shares that

represent 2% of PGNiG share capital and 1% of

the share capital of PGE and PZU. There is a risk

that if aid to the mining industry in this form is

challenged by the European Commission,

companies from the energy sector will in fact be

forced to take over the mines. In September, the

industrial sector grew slightly. The change was

1.3%. The primary industry stood out among the

rest. During the month, copper prices rose and

this had a positive impact on KGHM (copper

mining company), which gained 5.1%.

A broad based sell-off in the stock market was

accompanied by increases in prices in the debt

one. Yields on 10-year Polish bonds dropped from

2.96% in August to 2.87% at the end of

September. Citi macroeconomists forecast that

interest rates in Poland will not rise until

November 2016 and the interest rate derivatives

market indicates a slight chance of a rate cut

during the coming year. Given the falling oil

prices, which suppress inflation, and the gradual

increase in food prices as a result of drought,

which partly offsets the first factor, the CPI is

forecast to grow slowly from the level of -0.6% in

September and to leave the deflation territory at

the turn of the year.

Negative sentiment in the Polish capital market

should lead to deeper reflection on the state of the

real economy. Global GDP growth forecasts

published by Citi economists have been revised

down to 2.6% in 2015 and to 2.9% in 2016, the

main reason being the slowdown in China and in

the other emerging economies. As a result, GDP

growth forecast for Poland has also been

decreased by 0.3–0.4 percentage points and now

stands at 3.6% for 2015 and 3.3% for 2016. Citi

economists justify a downward revision in the

GDP growth forecast by the negative impact of the

slowdown in China, which will have an effect on

Germany and also on Poland, and by the slower

uptake of EU funds. The revision of GDP growth in

2015 and in 2016 has been much smaller for

Poland than for the other developing countries. In

early September, we learned the August PMI

reading, which was lower than the July one and

stood at 51.1 points. This amounted to the largest

drop in the level of this indicator since January

2005. In October, the September PMI reading was

announced, which came in at 50.9 points. This, in

turn, has been the weakest figure during the

current growth cycle. Judging by the drop in the

PMI, it may be concluded that growth in the Polish

manufacturing sector has decelerated. However,

despite the decline, the PMI remains above the

long-term average and also above the threshold

level of 50 points. The negative sentiment also

improved at the end of the month, when it turned

out that unemployment fell to 10%. The

unemployment rate projected for the end of 2016

is 9.2%, which should help stabilize the situation

in Poland. Another signal of recovery in the labor

market is the fact that the number of new job

offers is growing at a rate of about 30% y/y. The

chart on the previous page shows unemployment

levels and wage growth in Poland since 2013.

Since the start of that year, unemployment has

decreased steadily. Another positive sign is the

increase in wages, which are going up at a rate of

3.4% y/y.

Citi macroeconomists forecast that

interest rates in Poland will not rise

until November 2016.

6

Despite the recent signs of decelerating growth

we still consider the Polish economic situation to

be good. The fact that the economy is growing

faster than the historical average should be

reflected positively in corporate earnings. Owing

to political risks, we advise caution in purchases of

blue chip stocks; on the other hand, we see

growth potential in small and medium-sized

companies with greater exposure to domestic

GDP growth.

Citi macroeconomists’ forecasts of GDP

growth and inflation in Poland in the coming

years

Source: Citi Research, Citi Handlowy

3,6 3,3

3,6 3,6

-0,8

1,5

2,5 2,5

-1

0

1

2

3

4

2015 2016 2017 2018

GDP growth (%) Inflation (%)

7

U.S. – Fed puts off rate hike

The U.S. economy is showing signs of further growth. Nevertheless, the Federal Reserve does not

raise interest rates, paying increasing attention to developments in emerging markets. Following

the change in the views of the Federal Open Market Committee, our economists now forecast that

the first rate rise will not occur until the spring of 2016. Nevertheless, we maintain a conservative

outlook on the U.S. stock market.

After breaking out downwards from a consolidation,

the S&P500 recorded another month of declines. In

September, it dropped by 2.6% to the level of

1,920 points. From the perspective of technical

analysis, the current correction may progress yet

further, and from the fundamental point of view

valuations remain relatively steep compared to

other developed markets. According to FactSet

figures, throughout 2015 revenues of the

companies included in the S&P500 could fall by

2.4% while net profits should grow by

approximately 0.7%. Corporate earnings growth

forecasts in other regions of the world look better.

For this reason, we remain underweight in the U.S.

stock market and prefer other regions such as

Europe or Japan.

In September, the main event in the U.S. was the

Fed’s meeting with most analysts expecting a raise

in interest rates. This, however, failed to

materialize since members of the Federal Open

Market Committee decided to leave monetary

policy unchanged. Interest rates are still close to

zero (within the 0.0–0.25% range). At the press

conference after the meeting, Janet Yellen made it

clear that despite the many internal factors that

favored a rate hike in September, heightened

external risks prevailed and caused the interest

rates to remain unchanged. The signals coming

from the U.S. economy provided arguments for an

earlier rise but these proved insufficient for such a

crucial decision to be made. A certain change in

the Fed’s stance is discernible right now with

external factors becoming ever more important in

the current market circumstances. The Fed’s

evolving view of risk has prompted our economists

to formulate a new forecast of the date when

interest rates will go up. We currently believe that a

rise will only come in the spring of 2016. It should,

however, be remembered that 13 of the 17

members of the Federal Open Market Committee

still think that the first rate hike should occur before

the end of the year. Nevertheless, there has been

a noticeable change in the magnitude and pace of

projected interest rate movements; currently, the

median of the Fed members’ projections indicates

an increase to 1.4% in 2016, while June’s

projection was 1.6%. It is also worth noting that

one of the members believes that the rate should

be reduced even further in 2015 – to negative

S&P500 since 2009 together with the leading ISM manufacturing index


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1 000

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2009 2010 2011 2012 2013 2014

S&P500 ISM manufacturing

8

levels, and should remain there in 2016. Thus we

can see that members of the Fed have a very

difficult decision to make and the heightened risk of

turbulence in the financial markets has caused

them to postpone changes in monetary policy to

subsequent meetings.

A robust labor market, good consumer sentiment

and the steadily improving situation in the real

estate market suggest continued optimism about

the future growth prospects of the U.S. economy.

The real estate market, which is accelerating owing

to the still accommodative monetary policy, clearly

contributes to the economy’s strong momentum. In

Q2, annualized GDP rose by 3.9% (an upward

revision of the previous reading at 3.7%) –

consumer spending and corporate investment

surprised on the upside. Over the entire 2015, we

expect the U.S. economy to grow by 2.5% y/y; as

concerns 2016, owing to the rising risk of a global

slowdown, our economists have revised the growth

forecast slightly downwards (to 2.6% from 2.8%).

Target interest rate levels according to indications by Fed members for the years 2015–2017 and in the long

term

Source: Fed, Citi Handlowy

Sales of new homes in the U.S. vs. the consumer confidence index


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2009 2010 2011 2012 2013 2014

Sales of new homes (thousands, left axis)

Michigan Consumer Sentiment Index (right axis)

9

Europe – close to this year’s lows

In the European stock markets, September brought no breakthrough and volatility was still in

evidence. As a result, the prices of European stocks moved closer to August lows. Despite the

investors’ nervousness, we maintain our positive outlook on the region although we are aware that

the road to growth is bumpy in the current environment.

Investors in the stock market remain nervous and

prices on European stock exchanges continue to

fluctuate within a wide range. The average for the

last 3 months indicates that more than half of

trading sessions ended with the Stoxx 600 index

gaining or losing more than 1%. This demonstrates

that the market remains quite sensitive to the

macroeconomic data reported and also to

messages from central bankers (such as the Fed

statement following the September meeting, which

we discuss in the section on the U.S.).

In September, the main topic in global markets

remained concerns about the slowdown of the

Chinese economy and its impact on companies in

Europe. The simulations run using economic

models (Citi Research and OEF) indicate that if

domestic demand in China drops by 5%, eurozone

GDP could grow by about 0.3 of a percentage point

slower in 2016 and 0.4 of a percentage point

slower in 2017. Current forecasts by Citi

macroeconomists assume that eurozone GDP will

grow by 1.5% in 2015 and 2016; they have already

been revised downwards somewhat owing to the

weaker-than-expected growth in developing

countries. The potential drop resulting from a “hard

landing” in China would undoubtedly drive down

profit projections for European corporations.

However, given the absence of other external

shocks, we should not expect the European

economy to dip into recession right now. Therefore

in our opinion the continued positive outlook on this

region is justified, all the more so that our base

scenario assumes that global GDP will begin to

accelerate gradually and China avoids a sharp

slowdown. Thus we do not see any basis for

further rapid declines in Western European stock

indices, although we are aware that we are now

operating in a slightly more uncertain

macroeconomic environment. We should

remember, however, that the European market is

still supported by a very dovish central bank. The

European Central Bank will pursue its bond

purchase program until September 2016, although

in our opinion is will likely extend the scheme as

long as inflation in the eurozone remains low (the

European stock index and changes in its value by more than one percent (3-month average)


20%

30%

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70%

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90%

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Stock exchange sessions with changes in prices by at least 1% (3-month average) – right axis

Stoxx 600

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ECB inflation target is close to 2%). President of

the ECB Mario Draghi believes that inflation will

start to rise at the end of the year; currently, it is

too early to state whether the softer economic data

reported from the Chinese market are a permanent

trend. At the same time, recent comments from the

central bank suggest that if this proves necessary,

the QE program, which is now worth EUR 60 billion

per month, may be extended both in terms of

duration and scale. Currently, Mario Draghi is using

the time-tested strategy of “verbal interventions”

that are meant to reassure the markets, but also

reaffirms the central bank’s determination in its

struggle to lift the European economy from its

anemic growth. At the same time, current

macroeconomic readings continue to confirm that

Europe remains on a growth path with PMI

indicators in its largest economies above 50 points.

As a result, bond yields in core European markets

remained at relatively low levels (with 10-year

German Bunds now at 0.6%), which does not offer

high return potential to investors. In the European

debt market, we only see potential in the riskiest

segment, i.e. high yield corporate bonds. We hope

that their issuers will benefit from the improving

economic outlook and the falling default rate.

Apart from the Chinese slowdown, the scandal at

Volkswagen proved to be the event of the month in

Europe. The U.S. Environmental Protection

Agency (EPA) reported that the car maker had

installed software that resulted in lower readings

during measurements of diesel engine emissions.

Subsequently, the company stated that 11 million

cars worldwide were affected, which also included

other Volkswagen Group brands. As a result, the

Group will make a write-down of EUR 6.5 billion in

its Q3 report to cover potential costs.

Consequently, VW’s shares dropped by 42% in

September, dragging down the prices of the entire

European automotive sector and negatively

affecting investor sentiment across the market.

Analyses demonstrate that the share of automotive

companies in the Euro Stoxx 50 (5%) and Stoxx

600 (2.7%) indices is small. At the same time, we

do not expect this situation to slow down the entire

European industry. Although many industrial

companies (also in Poland) are suppliers of the

European automotive sector, we hope that

politicians in Europe and – as it turns out – also in

China (as reflected by the recent decision to

reduce tax on the smallest cars), i.e. the two major

markets in which VW operates, will mitigate the risk

of the concern’s current troubles spilling over to

other companies.

In conclusion, the last quarter of the year may bring

a more significant rebound after the weak Q3, and

European equity markets may return to growth.

Such an improvement would certainly be catalyzed

by better-than- expected economic figures, while

the greatest risk to our scenario is a further

deterioration in the Chinese economy as discussed

in the Barometer section on emerging markets.

PMI indicators in the largest EU countries


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48

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Germany UK France Italy Eurozone

11

Japan – nervous September on the Tokyo Stock Exchange

We have had a very nervous month in the Japanese stock market. The investors’ moods, and thus

also stock exchange indices, kept swinging from day to day; it is clear that the market is currently

driven by emotions rather than fundamentals. Despite the less than stellar macroeconomic data

recently reported from the Japanese market, our outlook on this country remains moderately

positive. All the factors that have fueled growth in recent months should prove favorable to the

Japanese market in the coming quarters.

September began with declines in most global

stock exchanges. The investors’ hopes for the end

of the correction and a rapid return to growth were

restored by the 9 September session when the

Nikkei rose by as much as 7.7%, chalking up the

best result since 2008. Unfortunately, the market

quickly brought investors back to the ground by

recording new declines and piercing the bottom

reached in August, which demonstrated that the

correction was still underway. The performance of

the Japanese market in the short term will of

course depend on sentiments on other global stock

exchanges; in the long term, it will be conditioned

by the fundamentals, which we believe should

improve.

We should now examine the state of the Japanese

economy; unfortunately, it does not look very good.

As concerns the macroeconomic data that were

recently reported from the Land of the Rising Sun,

of note is the final GDP growth reading for Q2,

which came in at -0.3% q/q. However, contributions

of individual components to the Japanese GDP are

important here. The main factors behind the low

reading are exports (a drop by 4.4%) and the

shrinking private consumption (a decrease of

0.7%), which accounts for about 60% of the

Japanese economy. Given these and other

important figures that are being published as well

as growing concerns about the downturn in the

global economy, Citi analysts have decided to

revise the GDP growth forecast for Q3 downwards

to just 0.1% q/q (from 1%). In these circumstances,

we cannot rule out negative GDP growth in Japan

in Q3, which would mean that the Japanese

economy has entered a “technical recession”.

However, we think that the pessimistic

recessionary scenario is unlikely to materialize in

the subsequent quarters. We think that Japanese

GDP growth for the entire 2015 will be 0.6% and in

2016 it will reach 1.2%. This, however, is not the

end of gloomy news from the Japanese economy.

The condition of the manufacturing sector could

also have been better as evidenced by a PMI of 51

points and a small negative growth in industrial

production (-0.5% m/m).

Haruhiko Kuroda, who heads the Bank of Japan, is

Inflation in Japan (% y/y) against GDP (% q/q)


-2,5

-1,5

-0,5

0,5

1,5

2,5

3,5

Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15

Inflation GDP

12

probably worried about the persistently low

inflation. The most recent CPI reading was in

positive territory at +0.2% but the core inflation

reading (excluding food prices), which is more

salient to the policymakers who shape the

Japanese monetary policy, came in at -0.1%,

which has been the worst result since 2013.

Since there are black clouds hanging over the

Japanese economy, why do we believe that the

Tokyo Stock Exchange should bring profits to

investors in the near future? This is because the

current situation increases the likelihood of an

increase in the scale of “money printing” and in the

past this was a very important factor supporting

Japanese equity market indices. As we already

mentioned in the previous editions of the

Barometer, under our base scenario the Bank of

Japan may extend the quantitative easing program

between October this year and January 2016. We

think that monthly bond purchases by the BoJ may

rise to JPY 1.5 trillion and the annual volume of

ETFs (which invest in Japanese stocks) may be

increased to JPY 2 trillion.

Having been re-elected as head of the Liberal

Democratic Party, the Japanese Prime Minister

reiterated his “three arrows” policy. He announced

measures to increase Japan’s gross domestic

product by 20% (to JPY 600 trillion) by 2020;

unfortunately, most economists think that this

target is certainly ambitious but probably

unattainable. Investors expect in particular a

reduction in CIT below 30%, which according to

Mr. Abe will be possible in the next fiscal year

(starting in April 2016). We estimate that a

reduction in CIT to 29% from the current 32.11%

rate would result in an additional increase in the

Japanese companies’ profits by 4.6% over the next

12 months. If we compare the tax rate applicable in

Japan against those in other countries, it remains

relatively high despite the fact that it has already

been cut in recent years.

In the coming months, the Japanese stock market

should be supported by the GPIF (Government

Pension Investment Fund) and other public funds,

which should make purchases in the Japanese

equity market amounting to JPY 4.5 trillion in an

effort to rebalance their portfolios. We also assume

that some support will come from the yen, which

has recently appreciated owing to global risk

aversion but has been in a downward trend for

several years now. It is probable that the USD/JPY

rate, which remained within a narrow range from

119 to 121 JPY/USD in September, will break out

upwards from the consolidation, which will send a

positive signal to investors. Other arguments for

buying Japanese shares include the forecast

double-digit growth in company profits, which will

be helped by the weak currency and low crude oil

prices. Despite the unfavorable mood on the Tokyo

stock market, Citi analysts have not changed their

forecast for the TOPIX index, which should reach

1,750 points by the end of 2015. In this scenario,

we should see a rebound in the Japanese stock

market in the last quarter of this year. We think that

this is a plausible scenario, but one should keep in

mind that it is largely dependent on sentiments in

global stock markets, which are still looking for the

bottom of the correction.

CIT rates in selected countries and in Japan

in the last three years

Source: Citi Research, Citi Handlowy

37%

35%

32%

41%

33%

30%

25%

24%

23%

17%

0% 50%

Japan fiscal 2013

Japan fiscal 2014

Japan fiscal 2015

U.S.

France

Germany

China

South Korea

UK

Singapore

13

Emerging Markets – an overreaction

After a very turbulent August, emerging markets remained in the spotlight in September. In our

opinion, the sell-off in Emerging Asia has the traits of an overreaction and we remain moderately

positive on stocks from this region. We still see many risks in Latin America and look at the

situation in the region as neutral observers.

In the financial markets, September once again

forced us to reconsider emerging markets

thoroughly. One more time this year, this region

became the focus of the investors’ interest. This

time, the importance of this asset class was

underscored by the Chair of the Board of

Governors of the Federal Reserve System. When

issuing a statement after the Fed’s decision to

leave interest rates unchanged, Janet Yellen cited

precisely the turmoil in financial markets caused by

the slowdown in emerging economies as an

argument supporting this decision. This is probably

a symbolic event, since this has been the first time

that the U.S. central bank justified his actions in

this manner. Emerging markets have long been

noticed by policymakers around the world, but 17

September 2015 (the date of the Fed’s decision)

clearly marks the importance of financial

instruments from emerging markets as an asset

class.

The entire September can be described as quite

calm in Emerging Asian markets, especially

considering the volatility that was evident in these

markets in August. Nevertheless, the Hong Kong

stock market remained below the level recorded at

the beginning of the month (-3.8%). The Chinese

authorities tried to reassure the rather nervous

markets. Intervention in market mechanisms is

common in China and, perhaps surprisingly, the

belief in the effectiveness of such measures

appears to be widespread too. For instance, in

early September the President of the People’s

Bank of China announced that the declines in the

stock markets were coming to an end and that it

was actions by the authorities that had stabilized

the situation. This illustrates the peculiarity of the

Chinese stock market, since it appears that if such

a statement were made by a government

representative a developed market, market

participants would promptly call the bluff, probably

resulting in yet more volatility.

After weak leading manufacturing PMI readings in

August (47.3 points), market participants awaited

September figures. Preliminary readings turned out

to be even worse at 47 points and the final data

published at the beginning of the next month

proved only slightly better at 47.2 points. It appears

that market participants have already priced in the

economic slowdown and there has been no strong

reaction to the September PMI figure. We also

think that a lot of bad news has already been

absorbed by the prices of Emerging Asian assets;

the economic slowdown is definitely there and will

continue but the scale of the reaction in the

previous months appears exaggerated. Therefore

emerging markets in the Far East appear to be an

attractive place to invest capital.

If September can be considered to have brought

relative calm to Asia, Latin American markets

remained under very strong pressure and

responded nervously to yet more bad news coming

from the economies in the region. On 10

September, the public opinion was electrified by

the reports that Brazil’s credit rating had been

downgraded by one of the credit agencies. The

most important piece of information, however, was

that Standard & Poor’s lowered the rating from

BBB- to BB+, i.e. that the bonds of South

America’s largest economy were no longer

investment grade. Having become “junk”, these

securities are now perceived much less favorably

and also remain on the “watch list”, which could

mean further downgrades in the future. The

pressure on Brazil’s debt may soon become quite

substantial; the other major agencies have not yet

cut their ratings, but such moves may well take

place in the near future with outlooks being already

14

negative. It should be noted that the articles of

association of many investment funds stipulate that

they may only invest in investment grade bonds;

these investors are now forced to sell their

positions irrespective of the conditions prevailing in

the market.

Recent months have brought yet more very bad

news. The falling prices of iron ore, crude oil, sugar

and soybeans have all contributed to the country’s

woes as Brazil is a major exporter of these

commodities. Its largest trading partner is China,

which also has its share of problems. Another

issue is the still rising inflation. The central bank’s

inflation target is quite high at 4.5% +/-2

percentage points. However, even this high target

and broad range are insufficient; the inflation now

stands at over 9%, which has in turn forced the

central bank to increase interest rates this year.

Such measures are of course not conducive to

economic growth and prevent any monetary

stimulus for the economy, which is still mired in a

recession. The sell-off on the Brazilian real has

been the most talked-about subject in the recent

weeks; the currency has been among the weakest

in year-to-date terms, having depreciated by about

33% against the U.S. dollar since January. This

gloomy image has been amplified by the unstable

political situation. We have mentioned the

corruption scandal surrounding the oil company

Petrobras many times. The investigation

concerning bribes there is becoming increasingly

broad-based. Of note here is that during the period

covered by the scandal, the present President

Dilma Rousseff was Minister of Energy and chair of

the company’s supervisory board. Speculation

about her participation in illegal activities is fairly

common, which significantly increases political

risks. These risks certainly include the rumors that

circulated in September concerning the possible

resignation of Joaquim Levy from the post of

Finance Minister. Mr. Levy is a highly respected

economist with considerable academic

achievements and for many market participants his

presence is a guarantee of rational economic

decisions by the country’s authorities. He himself

has categorically denied the rumors that he would

resign. These factors make us extremely cautious

about investing in the entire Latin America region.

We remain neutral on this asset class – we see

numerous hazards, but also take into account the

fact that we may be approaching the trough of the

economic cycle. In the future, we will continue to

closely watch the rapidly changing situation in

Brazil, among other things.

Composition of Brazil’s exports


China; 28,6%

U.S.; 16,8%

Argentina; 7,9%

Japan; 5,3%

Netherlands; 5,0%

Germany; 4,2%

Chile; 3,1%

India; 3,0%

Others; 26,0%

Decrease in the prices of the main commodities

exported by Brazil year to date

Source: World Bank, Bloomberg, Citi Handlowy

-25%

-20%

-15%

-10%

-5%

0%

Iron ore Soy Crude oil Sugar Meat

15

Frontier markets – another turbulent month

In September, developments in frontier markets were as rapid as in August. In the first half of the

month, stock exchanges managed to maintain the levels attained after rebounding from the August

lows. In the second half, however, a strong sell-off began, just as in other markets around the

world.

The downward wave was triggered by the event that

had a historic effect on global stock exchanges. This

was of course the Fed’s decision to leave interest

rates unchanged. Theoretically, frontier markets

should benefit from a delay in increases in interest

rates. The later the yield on U.S. assets rises, the

longer investments in less-developed markets

remain relatively attractive. Interest rates, which are

close to zero in most mature economies, push

capital to seek higher risk and higher returns at the

same time.

However, this mechanism does not work when panic

reigns in the markets. First, in these circumstances

investors are not willing to assume additional risks

despite the expected premium. The overarching

criterion becomes capital protection, which is

traditionally associated more with developed

countries. Second, markets were put off not so

much by the Fed’s decision itself but rather by the

concerns about the situation in China that were

expressed during the press conference. As the U.S.

central bank paid so much attention to

developments in the East that it postponed a

decision to raise interest rates, investors also

focused on the Chinese economy, fearing the effect

it would have on the rest of the world.

As concerns individual countries, the most

interesting reports came from Egypt, where the

largest ever offshore natural gas field was found.

The additional 850 km3 increase Egyptian reserves

by as much as 40%. According to the authorities,

the deposit will come on stream in about three

years. This means that by the end of the decade

Egypt should become independent from gas imports

and may even achieve a small surplus of exports

over imports. This, in turn, implies a problem for

Israel and Cyprus, i.e. the countries that expected to

export this commodity mainly to Egypt.

On the other hand, the new Suez Canal, which was

commissioned on 6 August 2015, has run into

unforeseen difficulties. According to forecasts, the

increase in the capacity of the Canal was to

supposed to increase revenue from USD 5 billion to

USD 12.5 billion per year. In fact, low crude oil

prices, which mean cheap fuel for ships, have

resulted in shipping routes from Asia to Europe that

bypass the Suez Canal, going south of Africa. If

prices of this commodity depreciate further, this

phenomenon may become widespread, reducing the

profitability of the newly opened Canal.

Among the Arab countries, a particularly sharp

reaction to the September wave of declines was

observed in Saudi Arabia. Despite the relatively low

cost of oil production, the country is unable to

balance its budget at current prices. In order to

cover the deficit, it must deplete its foreign exchange

reserves and issue bonds. This was reflected in

negative reports on the amount of its reserves, but it

should be remembered that these are so large that

they would last for a few more years at the current

depletion rate.

Saudi Arabia’s foreign exchange reserves (USD

million)


0

20

40

60

80

100

120

140

160

300 000

350 000

400 000

450 000

500 000

550 000

600 000

650 000

700 000

750 000

2007 2008 2009 2010 2011 2012 2013 2014

Saudi Arabia’s foreign exchange reserves (USD million, left axis)

Brent crude price (USD, right axis)

16

A more proactive attitude in the face of budget

deficit risks has been presented by the United Arab

Emirates where work on the introduction of the

corporate income tax and VAT is closing completion.

In addition, the authorities have decided to release

local gasoline prices, which will remove the burden

of ca. USD 7 billion in subsidies from the budget.

In summary, the main factor affecting stock prices in

frontier markets has continued to be the situation in

stock exchanges in China and the related Federal

Reserve decision. In the near future, the Far East

will probably still be of key importance and local

events will carry less weight. Most frontier funds

focus on the financial rather than the mining sector,

and this should, at least in theory, be relatively

resilient to the slowdown in China. In practice,

however, indirect links between banks and

commodities may pose certain obstacles. Since in

the early market development stage, many

investment projects are funded precisely by banks,

cheaper commodities translate into declines in the

value of loan collateral. Thus the emerging

correlation between financial and energy sector

stock prices leads to a situation where concerns

related to the possible reduction in demand result in

a further stock sell-off.

Brent crude oil price (USD) vs. the MSCI World Bank Index


75

80

85

90

95

100

40

50

60

70

80

90

100

110

120

Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15

Brent crude (left axis) MSCI World Bank Index (right axis)

17

Commodity markets – a moment of calm

This time, commodity market prices stirred fewer emotions than in recent months. The difference

between the highest and lowest values of the CRB index, which groups the prices of a wide range

of commodities, amounted to just 4.9% in September. This relative calm may be interpreted as the

investors’ wait for further developments in China, which is the key consumer of most industrial

commodities.

Most commodities exhibited less volatility, and one

of the most striking examples was crude oil, which

moved sideways after two very turbulent months.

Copper, however, provided an example at the

other end of the scale. In the first half of the month,

the metal gained almost 9% and then lost 11% to

finally go 6% up again (the movements quoted are

in comparison to local peaks and troughs). One of

the reasons behind these twists was a report from

Glencore, which announced a significant reduction

in copper production in its mines in Zambia and

Congo.

The factor that drove the prices of commodities in

the past month was the Federal Reserve’s decision

to leave interest rates unchanged, and even more

so the associated statement. The statement by

Chair of the Fed Janet Yellen that included a

reference to the situation in China surprised some

investors, since to date U.S. decisions on interest

rates were determined by the domestic situation.

The fact that the Fed is looking east increases the

likelihood of the start of the tightening cycle being

delayed. This may in turn result in a short-term

weakening of the U.S. dollar against other

currencies. On the other hand, there is a negative

correlation between the appreciation of the USD

and commodity prices. Thus the dovish attitude of

the U.S. central bank is a factor that encourages

the appreciation of dollar-denominated

commodities.

Oil

In the energy market, we have seen an

exceptionally small price differential between Brent

and WTI crude. In mid-August, the spread came to

USD 7, and a month later it narrowed to just USD

1.5. These two crude types differ slightly in their

physical properties (principally density and sulfur

content) and therefore have different prices. The

extremely low spreads have been due mainly to

OPEC forecasts of oil supply and demand in the U.S., million barrels per day

Source: OPEC Monthly Oil Market Report – September 2015, Citi Handlowy

20,1 19,8 19,7 20,1 20,4

13,7 13,8 13,9 14,0 14,2

0

5

10

15

20

25

Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016

Demand Supply

18

the slightly lower production in the U.S. (WTI

crude) combined with an increase in the capacity

of the refining industry. At the same time, the

supply of Brent crude oil increased. An example

here is Norway where August production was

13.5% higher than expected. Thus we are

witnessing a situation where in the short term,

different types of the same commodity may be

subject to pressures from the opposite directions.

Apart from the aforementioned support from the

Fed, which should be of considerable importance

for crude, the surplus of supply over demand

continues to have a negative impact on prices.

Production in Saudi Arabia and in Iraq remains at

historically high levels and the total production of

OPEC countries also continues to be strong. The

only signs of reduced supply are coming from the

U.S. The shale industry is very sensitive to pricing.

Given low crude prices, it is able to reduce

production relatively quickly, limiting the scale of

declines. This mechanism, however, works the

other way as well; when prices rise, more

producers come on stream, flooding the market

with additional supply.

One piece of information that interested investors

was the announcement by the U.S. authorities that

they are considering the possibility of lifting

restrictions on oil exports to foreign markets. It

should be noted, however, that this is not a factor

that should exert downward pressure on prices.

The U.S. still does not meet its oil demand

domestically and therefore possible exports would

have to be offset by more imports. This decision

would not alter the amount of oil in circulation and

should be neutral for prices.

Gold

The negative correlation between the strength of

the U.S. dollar and the price of gold is among the

strongest relationships in the commodity market.

Therefore the Fed’s dovish attitude is favorable to

gold prices. This situation is illustrated by the

inverse correlation between bond yields in the U.S.

(reflecting interest rate expectations) and the price

of gold. In fact, the U.S. central bank’s decision to

leave interest rates unchanged caused gold to

appreciate by several percent. As long as Janet

Yellen postpones the decision to commence the

tightening cycle, gold may remain above the USD

1,100 per ounce level where the support that was

successfully defended in the first half of September

had formed.

Information on the supply side is less optimistic,

however. The marginal cost of gold mining in key

exporting countries (China, Australia and Russia)

Gold price against yields on 10-year U.S. Treasury bonds (inverted scale)


1,0

1,3

1,5

1,8

2,0

2,3

2,5

2,8

3,01000

1050

1100

1150

1200

1250

1300

1350

1400

Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15

Gold (left axis) Yield on 10-year U.S. Treasuries (right axis)

19

has fallen below USD 1,000 per ounce, mainly due

to the depreciation of the local currencies against

the U.S. dollar. News on demand are not favorable

either. The Indian Minister of Finance has

proposed two new solutions that are meant to

reduce gold imports. One of them is offering

investors interest in exchange for depositing

bullion and jewelry. The second idea is the

issuance of government bonds that would be

denominated in gold. In exchange for the metal

obtained (the amounts will be calculated on the

basis of different bar sizes) cash coupons will be

paid, amounting to a percentage of the current

market value of gold. In this manner, the Indian

authorities intend to collect the metal held by

households and introduce it into wholesale

circulation, thus becoming independent of imports.

Therefore Citi forecasts that when Fed support is

discontinued, gold prices will come under pressure.

In the second quarter of 2016, a slide to USD

1,050 per ounce is expected.

Summing up the situation on the commodity

market, it is worth noting that expectations

concerning the future monetary policy of the U.S.

Federal Reserve may also set the tone in the

coming months. On the one hand, the delay in

interest rate rises weakens the dollar and promotes

commodity appreciation. On the other hand, the

reason for the delay raises concerns about

consumption levels. In the absence of unequivocal

declarations from the central bank, commodity

prices may consolidate around current levels.

20

Rates of return and ratios for selected indices (as at 30 September 2015)

Equities Value Month YTD Year P/E P/E (2015)

Div. Yield

WIG 49824,6 -2,8% -3,1% -9,2% 17,5 11,9 3,0%

WIG20TR 3394,7 -3,2% -7,8% -14,5% 15,6 11,0 3,4%

mWIG40 3576,8 -2,7% 2,7% -1,7% 24,1 13,4 2,3%

sWIG80 13105,0 -0,8% 8,2% 3,8% 16,8 14,5 1,6%

S&P 500 1920,0 -2,6% -7,7% -2,6% 17,0 16,3 2,2%

Eurostoxx 50 3100,7 -5,2% -1,1% -3,9% 17,2 13,5 3,8%

Stoxx 600 347,8 -4,1% 2,0% 1,4% 20,6 15,3 3,6%

Topix 1411,2 -8,2% 0,3% 6,4% 15,0 13,7 1,8%

Hang Seng 20846,3 -3,8% -11,3% -9,1% 8,9 10,4 4,1%

MSCI World 1581,9 -3,9% -8,1% -6,9% 17,0 15,8 2,7%

MSCI Emerging Markets 792,1 -3,3% -17,0% -21,2% 11,6 11,5 3,1%

MSCI EM LatAm 1894,6 -7,9% -30,4% -40,2% 18,6 15,0 3,3%

MSCI EM Asia 391,4 -1,8% -14,0% -14,9% 10,8 11,3 2,9%

MSCI EM Europe 258,9 -4,7% -15,0% -30,9% 9,8 7,3 4,5%

MSCI Frontier Markets 513,3 -2,6% -16,1% -26,7% 9,9 9,4 4,2%

Raw materials

Brent Crude Oil 48,4 -12,0% -25,6% -50,4%

Copper 234,1 0,1% -18,0% -22,2%

Gold 1115,1 -1,7% -7,1% -7,7%

Silver 14,5 -0,7% -11,0% -14,5%

TR/Jefferies Commodity Index 193,8 -4,1% -17,0% -30,4%

Bonds Duration

U.S. Treasuries (>1 year) 376,3 1,2% 2,1% 4,2% 6,1

German Treasuries (>1 year) 407,3 1,3% 0,7% 3,5% 7,2

U.S. Corporate (Inv. Grade) 248,3 0,9% -0,4% 1,7% 8,0

U.S. Corporate (High Yield) 222,8 -3,1% -3,7% -4,0% 4,3

Polish Treasuries (1–3 years) 314,2 0,3% 1,5% 2,2% 1,9



Polish Treasuries (7–10 years) 417,7 1,0% -0,1% 4,2% 7,2

Polish Treasuries (>10 years) 312,3 1,1% -1,8% 4,7% 10,1

Currencies

USD/PLN 3,80 0,6% 8,0% 14,8%

EUR/PLN 4,25 0,3% -0,7% 1,6%

CHF/PLN 3,90 0,0% 9,7% 12,6%

EUR/USD 1,12 -0,3% -8,1% -11,5%

EUR/CHF 1,09 0,3% -9,5% -9,8%

USD/JPY 119,88 -1,1% 0,3% 9,3%

Source: Bloomberg

21

Macroeconomic forecasts

GDP growth (%) 2014 2015 2016 Poland 3,4 3,6 3,3 United States 2,4 2,5 2,6 Eurozone 0,9 1,5 1,5 China 7,3 6,8 6,3 Developing countries 4,2 3,6 4,0 Developed countries 1,7 1,9 2,1

Inflation (%) 2014 2015 2016 Poland 0,0 -0,8 1,5 United States 1,4 0,3 1,6 Eurozone 0,4 0,1 1,1 China 2,0 1,5 1,9 Developing countries 4,3 4,7 4,0 Developed countries 1,4 0,3 1,4

Source: Citi Research

Currency forecasts (end of period)

Currency pairs Q3 15 Q4 15 Q1 16 Q2 16

USD/PLN 3,81 3,92 4,04 4,07

EUR/PLN 4,24 4,18 4,13 4,09

CHF/PLN 3,85 3,84 3,82 3,82

GBP/PLN 5,89 5,98 5,98 6,01

Source: Citi Handlowy

22

Glossary of Terms

Polish Shares denote shares traded on the Warsaw Stock Exchange (WSE) and included in the WIG index U.S. Treasuries bonds issued by the government of the United States of America; figures used for the Bloomberg/EFFAS US

Government Bond Index > 1Yr TR, measuring performance of U.S. Treasuries whose maturity exceeds 1 (one) year

Citi Research A Citi entity responsible for conducting economic and market analyses and research, including that concerning individual asset classes (shares, bonds, commodities) as well as individual financial instruments or their groups

Div. Yield the amount of dividend per share over the share’s market price. The higher the dividend yield, the higher the yield earned by the shareholder on the invested capital

Long Term a term of more than 6 (six) months Duration a modified term of a bond, measuring the bond’s sensitivity to fluctuations in market interest rates. It provides

information on changes to be expected in the yield on bonds in the event of a 1 (one) p.p. change in the interest rates

Short Term a term of up to 3 (three) months Copper figures based on the spot price per 1 (one) ton of copper, as quoted on the London Metal Exchange German Treasuries (Bunds)

bonds issued by the government of the Federal Republic of Germany; figures used for the Bloomberg/EFFAS Germany Government Bond Index > 1Yr TR, measuring performance of German treasury bonds whose maturity exceeds 1 (one) year

P/E (2015) a projected price/earnings ratio providing information on the price to be paid per one unit of 2015 projected earnings per share, measured as the ratio of the current share price and the earnings projected by analysts (consensus) for a specified year (2015)

P/E (price/earnings) the historic price/earnings ratio providing information on the number of monetary units to be paid per one monetary unit of earnings per share for the preceding 12 (twelve) months, measured as the ratio of the current share price and earnings per share for the preceding 12 (twelve) months

Polish Treasuries bonds issued by the State Treasury; figures based on the Bloomberg/EFFAS Polish Government Bond Index for the corresponding term (>1 year, 1–3 years, 3–5 years, over 10 years)

Brent Crude Oil figures based on an active futures contract for a barrel of Brent Crude, as quoted on the Intercontinental Exchange with its registered office in London

Silver figures based on the spot price per 1 (one) ounce of silver Medium Term a term of 3 (three) to 6 (six) months U.S. Corporate (High Yield)

bonds issued by US corporations which have been assigned a speculative grade by one of the recognized rating agencies; figures based on the iBoxx $ Liquid High Yield Index measuring performance of highly liquid US corporate bonds with the speculative grade

U.S. Corporate (Inv. Grade)

bonds issued by U.S. corporations which have been assigned an investment grade by one of the recognized rating agencies; figures based on the iBoxx $ Liquid Investment Grade Index measuring performance of highly liquid U.S. investment grade corporate bonds

YTD (Year To Date) a financial instrument’s price trends for the period starting 1 January of the current year and ending today YTM (Yield to Maturity)

the yield that would be realized on an investment in bonds on the assumption that the bond is held to maturity and that the coupon payments received are reinvested following YTM

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

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Additional Information

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

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

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

on Trading in Financial Instruments.

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

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

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

condensed compared to the source materials.

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

disclosed to third parties.

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

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

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

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

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

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

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

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

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

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

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

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16

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24

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

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information which constitutes recommendations with respect to financial instruments or their issuers.The Customer shall be liable for the

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

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