Excellent Earnings Season

Investment Barometer

June 23, 2017

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May saw continued growth in the majority of stock and bond indicesbut the scale of that growth was

unimpressive in many cases. The best performers were definitely indices in emerging Asian countries (+4.4%),

frontier countries, including Argentina, Vietnam and Pakistan (+3.8% for the broad-based MSCI FM index), and in

Japan (+2.4%). By contrast, companies were hit by a strong reduction in prices in Brazil (down by 4.1%) and EM

Europe, including Poland (-2.5% for the broad-based WIG index). The U.S. Treasury bonds and Polish bonds

fared pretty well, with Polish 10Y bonds gaining as much as 2%. HY bonds earned nearly 1%. May was,

however, less successful for commodities, with CRB index losing 1.1% mainly due to a drop in oil prices (-2.7%).

The results of the second round of the presidential elections in France came as no surprise and did not lead to any strong reactions of the financial markets. The geopolitical risk seems to be moving from Europe to Asia, and more specifically to North Korea, which threatens the world more and more often with its nuclear tests. That does not seem, however, to constitute any long-term danger for the global stock exchanges. Investors seem resilient, judging by the fact that the South Korea’s Kospi added a whopping 6.4% in May.

The Q1 2017 results of companies turned out to be a positive surprise as they were the best ones in six years. All the main regions recorded a double-digit growth rate in profits (yoy) (Japan +28%, Europe +23% and the U.S. +14%). High forecasts for full year results are another reason to be optimistic. The stock indices should remain in good condition, unless the figures prove disappointing.

We maintain our neutral view on equities vs. bonds. Given the present risk factors (e.g. the continued uncertainty concerning U.S. economic and trade policy, the still unclear issue of Brexit and the increase in geopolitical risk), the reward-to-risk ratio is currently not conducive to any exposure to equities greater than the investor’s risk profile would indicate.

We still believe that global emerging equity markets are more attractive than the Polish blue chip segment. We also think that small and medium Polish companies should outperform larger ones. Additionally, we are of the opinion that in the medium term, European companies may perform better than U.S. ones in relative terms, mainly owing to better EPS (earnings per share) prospects, a different phase in the economic cycle (also reflected by different central bank policies) and the chance for capital inflows emerging after 2016, which was a poor year in this respect.

We are maintaining a positive outlook on high yield bonds (particularly U.S. ones) and on emerging country debt. In our opinion, these two asset classes continue to exhibit favorable reward-to-risk ratios, mainly owing to high yields, low bankruptcy rates, the improving macroeconomic situation and the still strongly sold-off currencies (in the emerging markets). It is, however, worth noting that the yields we have recently been observing for those bond categories are going further down.

Source: Bloomberg, Citi Handlowy

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92

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100

104

108

112

116

120

124

128

132

May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17

WIG 20 S&P 500 Eurostoxx 50

Source: Bloomberg, Citi Handlowy

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104

May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17

Polish bonds U.S. Bonds German bunds

Karol Ciuk, CFA

Investment Advisor

Szymon Zajkowski, CFA

Securities Broker

Bartłomiej Grelewicz

Securities Broker

Paweł Chylewski

Securities Broker

Maciej Pietraszkiewicz

Investment Advisor

Dariusz Zalewski

Securities Broker

Michał Wasilewski

3

Poland – bonds brought some good earnings this time

In May, the prices of the Polish bonds went up again, and by extension, the yields went down. The

yield of the 10Y bonds dropped to a record low since November last year (3.25%), and so did the

yield on the 2Y bonds (1.9%). The small- and mid-sized companies sector on the domestic stock

exchange has been moving sideways, which started between February and March, while mWIG

and sWIG remained basically flat month on month. After the peaks in April, WIG20 saw a

correction of around 4 per cent.

Positive news from the Polish economy had a key

impact on the good performance of the Polish

debt in May, in addition to the overall trends on

the global markets. It started with another

increase in the PMI manufacturing index (up from

53.5 to 54.1 points); the GDP growth rate for Q1

2017 was another positive surprise (4% yoy vs the

expected 3.9%, and the 2.5 per cent growth rate

recorded in Q4 2016), and so was the

unemployment rate which in April dropped to the

deepest low since 1991 (7.7%). Polish bonds also

benefited from inflation, which stabilized at 2%,

and the Monetary Policy Council’s decision to

uphold its dovish stance, including the conviction

that there is no need for interest rate hikes until

the end of 2018. On top of it, the market received

positive reports on budget execution for this year.

The Ministry of Finance announced that after April

the deficit was a mere PLN 0.9bn (vs the planned

10.5bn and 2.3bn after March). In fact, industrial

output and retail sales data, which were worse

than expected, turned out to be the only

disappointments. Production in April went down by

0.6% yoy (consensus at +2.35%), and retail sales

went up by 8.1% yoy (consensus was looking for

8.9%).

The budget execution report is certainly worth

paying special attention to. The deficit of PLN

0.9bn is merely 1.5% of the 59.35bn planned for

the entire year. During the first four months of the

year, budget revenue went up by 36% on a year-

on-year basis, and expenditure went up by 30.6%.

Such a low deficit would not have been possible

without the dynamic growth of income from VAT,

CIT and PIT, up by 34%, 15%, and 8%

respectively on a year-on-year basis, and without

a drop in expenditures, probably due to the

continued standstill in investments – financial

expenditures, which include, among other things,

investment projects of the local governments,

went down by 17.7% year on year. Citi economists

are of the opinion that in view of those figures and

the expected distribution of NBP profits (around

PLN 9 billion), the overall deficit for the year might

be more than twice lower than the approx. PLN

Budget deficit this year vs recent years

Source: Ministry of Finance, Citi Handlowy

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60bn originally planned. As a consequence, the

total issue of Polish bonds this year may be lower

accordingly. This, in turn, may have a positive

impact on the quotations of the domestic debt.

By contrast, a change in the rhetoric presented by

the Monetary Policy Council may have the

opposite effect on the bonds. Even though in May

Professor Adam Glapiński, President of the

National Bank of Poland, upheld his view that he

did not see the need for interest rates to be

increased up until the end of 2018, Citi’s base

scenario for that period continues to provide for

four hikes, starting from Q1 next year. This view is

supported by the economic growth and the

situation on the labor market, both of which came

as a positive surprise. Those two factors should

translate into higher inflation paths in NBP’s

projections and a more hawkish language of the

Monetary Policy Council in the second half of the

year. To some extent, this has been affirmed in

the latest statement made by Dr. Łukasz Hardt,

member of the Monetary Policy Council, who

stated that end of 2017 and early 2018 could be a

good time to consider making changes in the

interest rate levels. However, he made it

conditional on NBP’s projections showing that

inflation would remain above 1.5% in the 12-

month horizon. The current market expectations

are somewhere between the MPC declarations

and Citi’s forecasts. Interest rate contracts expect

interest rates to increase by around 41bps, which

is less than two increases of 25bps each over the

next 18 months. Consequently, if the economy

and the labor market keep surprising on the

upside, the July projections of the NBP will

probably see an increased inflation path and that

would probably involve adopting a more hawkish

rhetoric on the part of the MPC. Should this

scenario materialize, there would also be more

pressure on increasinge domestic bond yields.

Back in April, we wrote about the record high

optimism among investment experts. This time,

we are pleased to report record high optimism

levels among consumers. Consumer confidence

indices calculated by the Central Statistical Office

in May have hit an all-time high and for the first

time ended up on the plus side. The current

confidence index rose to 3.1 points, and the

leading one to 0.6 points. This means that, for the

first time since the beginning of the readings in

2000, most Poles turned out to be optimists –

readings below zero indicate a higher share of

negative statements, whereas those above zero

show a higher share of positive statements. Poles’

optimism is probably the result of a higher

economic growth, record low unemployment rate,

growing salaries and the government Family 500+

program. As a rule, such index readings should be

a reason for joy; however, from the perspective of

a stock market investor and in light of historic

data, they can be perceived as a warning sign of

an imminent correction – during the peak of the

Inflows to Investment Funds Against Performance of WIG Index

Source: Chamber of Fund and Asset Management, Citi Handlowy

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Net inflows to equity funds (PLN mln, left axis)

WIG index (points, left axis)

Leading consumer confidence index of the Central Statistical Office (points, right axis)

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2007 bull market the indices also recorded record

high levels.

What is interesting, despite such good consumer

sentiments and the bullish market observed over

the past few months, purely equity funds have

recorded systematic capital outflows for more than

a year. There has not been such a significant

discrepancy between stock exchange sentiments

and performance and capital inflows to mutual

funds in the last decade. The total outflows from

equity funds since mid-2015 amounted to PLN

4.3bn. While it could have been understandable at

the beginning of that period, when the Warsaw

Stock Exchange was during a short-lived strong

downward phase, it seems quite surprising over

the last 12 months. During that period, WIG Index

gained approx. 30% and hit the highest level since

2007. The data about transfers to/ from equity

funds do not, however, fully reflect the reality. This

is because total return funds (along with mixed

funds) have been extremely popular in recent

months, and these funds also invest part of their

principal on the local equity market. Total return

funds have recorded inflows amounting to PLN

4.6bn since mid-2015. It seems to us, however,

that the inflows to purely equity funds should grow

alongside economic prosperity and high rates of

return, which should be an additional factor

supporting the quotations. We uphold what we

wrote in previous months and we still believe that

the SME companies should benefit more from that

phenomenon than the ones with the highest

capitalization.

In conclusion, domestic debt listings are

benefitting from the positive momentum of the

Polish economy. It is likely that the prices will

continue to grow until the second half of the year

(a lot depends on the global situation, though);

after that, the listings may be influenced by the

July inflation projection of the NBP and the

possible change in the MPC’s rhetoric. As for the

stock exchange, we believe that as economic

growth accelerates, it still has a chance to perform

well, but we seek investment opportunities in the

small and medium-sized company sector rather

than among blue chips. We may also be in for

another growing wave, this time fueled by the

inflow of retail capital to equity funds.

6

U.S. Market – In Anticipation of the FED’s Decision

Investors who followed the popular adage “Sell in May and go away” last month may be

disappointed. May did not bring any breakthrough on Wall Street and the long awaited correction is

yet to come. What is more, the major stock exchange indices in the U.S. hit record highs again.

With the positive macroeconomic environment, hard economic data and the leading indicators, the

U.S. equity market remains strong. However, demanding valuations may give rise for growing

concern. In addition, the Fed will also deal the cards this month. And the investors will probably

hold their breaths on 14 June in anticipation of the U.S. central bank’s decision and the

announcement after the Federal Open Market Committee (FMOC) meeting.

Let us first have look at the U.S. economy. End of

last month, the U.S. Department of Commerce

released the “second” estimate regarding the GDP

growth rate in Q1 2017. Initially, the annualized

increase in real GDP was estimated at a mere 0.7

percent. In the past, the subsequent revision of the

advance estimate was quite often positive in tone

and the data were adjusted “upwards”. So they

were this time. According to the current estimates,

the largest economy of the world increased by

1.2% in the first three months of the current year.

Consumer expenditures provided a nice surprise,

with a growth rate of 0.6%. This figure is of

particular importance, bearing in mind that

consumer expenditures make up for 2/3 of the U.S.

GDP. Inventory investments and corporate

investments were on the other end of the

spectrum, with a slightly disappointing growth rate.

Unfortunately, it is difficult to make any

unambiguous conclusions regarding the condition

of the U.S. economy based on an analysis of the

individual GDP components’ contribution relative to

the overall performance. Citi analysts are of the

view that the U.S. economy should accelerate in

the second quarter of 2017 and the overall GDP

growth rate in 2017 should be 2.1%. The economic

growth forecast for 2018 is as high as 2.6%. But

that forecast may be highly inaccurate because

next year the U.S. economy growth rate will be

heavily influenced by the country’s fiscal policy.

Donald Trump’s administration has been rather

vaque in its communications on that aspect. We

assume that the budget deficit may increase from

the current 3% to 3.7% in 2018; as a consequence,

the GDP next year will gain an additional 0.6p.p.

The latest readings of the ISM index, based on

surveys conducted by business managers, may

give cause for some concern about the largest

economy of the world. ISM is equivalent to the

European PMI index and it remains way above 50

points, which suggests economic growth; however,

as you can see on the chart above, the published

values are getting lower and lower. It is not yet a

serious warning sign but it would probably be a

good idea to take a closer look at this index in the

nearest future.

The U.S. companies showed pretty good growth

rates in earnings during the first three months of

the year. Three fourths of the companies reported

better-than-expected results, and 64 per cent

reported revenues that were better than the market

consensus. The earnings of the S&P 500

companies gained as much as 13.9% on a year-

on-year basis, which is the best result since Q3

2011 when the growth rate stood at 16.7% yoy.

Such positive surprises are obviously a good

reason to continue shopping on Wall Street; but the

fact remains that the shares quoted on the New

Manufacturing ISM Index

Source: Bloomberg, Citi Handlowy

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Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17

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York Stock Exchange are still pretty expensive.

The market expectations regarding the earnings

rate in the second quarter of the year are also quite

positive. Market analysts assume that the earnings

will grow by 6.8% yoy over the next three months

of the year, and the overall growth rate for 2017 will

be 10%. Nevertheless, bearing in mind the

earnings growth rate for the first quarter and the

2017 forecasts, the U.S. market does not really

stand out relative to other developed markets. The

companies listed on the European markets or in

Japan show even better results, and according to

forecasts those positive trends should continue.

The P/E or price-to-book value ratios also show

better performance on other markets, where

instruments are relatively cheaper in terms of

valuation. The U.S. market is losing the battle not

only compared to other developed countries.

Equity instruments listed in the U.S. look pale also

in comparison with emerging markets.

The Federal Open Market Committee (FMOC)

meeting on June 13 and 14 and the Fed’s decision

regarding the interest rate levels will undoubtedly

be the most importants event on the global

financial markets in June. The interest rate hike

seems inevitable because its probability implied by

the futures and forward prices is currently 100%.

The response of the financial markets is obviously

a big unknown, although they remained relatively

calm during the last three moves of the Fed as part

of the current cycle to tighten the monetary policy.

Let’s keep in mind that an increase of the cost of

money by another 25bps would bring fed funds to

between 1.00 and 1.25%. Investors will also give

an attentive ear to the announcement after the

meeting and listen for Janet Yellen’s comments

regarding the possible interest rate increase this

year – Citi analysts are of the view that the interest

rate hike might take place as soon as in

September. The new information on the plan to

reduce the balance sheet of the U.S. central bank

will also be of key importance. The minutes of the

FOMC meeting in May already gave away some

details. The reduction is supposed to take place by

limiting reinvestment of proceeds of maturing

Treasury bonds and mortgage-backed securities

(MBS). What is important, the balance sheet

shrinking will take place gradually, i.e. the portion

of proceeds from maturing bonds to be reinvested

will be getting smaller and smaller over time. As no

specifics and no details regarding the reduction

mechanism have been given yet, it is impossible to

determine its impact on the financial markets.

Hence, the investors will be waiting on any news

on the topic in the announcement after the June

meeting of the Federal Open Market Committee.

According to Citi analysts, the tapering will not start

until December; still, Janet Yellen will try to prepare

market participants for that event and will start

communicating it in advance. Judging by Fed’s

Price earnings ratio and price to book value

for selected markets

Region / Country Price to earnings ratio Price to

book value

U.S. 18.6 2.9

UK 14.8 1,9

Europe (excluding the UK) 16,0 1.8

Japan 14,2 1.3

Asia (excluding Japan) 13,0 1,6

Latin America 13,9 1,7

Source: Citi Research, Citi Handlowy

Balance Sheet of the Fed (US trn)

Source: Bloomberg, Citi Handlowy

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2,5

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4,5

5,0

2010 2011 2012 2013 2014 2015 2016 2017

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recent moves, we think that we might count on the

central bank’s prudence when taking future

decisions to tighten the monetary policy. Any

moves to shrink the Fed’s balance sheet too fast

combined with subsequent interest rate hikes could

lead to a strong increase in the U.S. Treasury bond

yields, among other things, and also have a

negative impact on the equity market.

To conclude, we are ahead of another month of

Fed’s probably testing the robustness of the equity

market by continuing to tighten the monetary policy

and raising the interest rates. Investors’ response

to the Fed’s decision this time remains to be seen.

Nevertheless, valuations of equity instruments on

Wall Street continue to be demanding and it seems

that allocation in shares quoted in Europe or on

emerging markets is worth considering when

building your investment portfolio.

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Good Momentum for Europe

The situation on the European equity markets in May was in line with our expectations and saw a

continuation of increases. The European equity market Stoxx 600 index gained 0.7%. The yields

we saw on the Treasury debt markets remained at the levels recorded at the end of April; as

regards the high-yield corporate debt, we saw clear spread tightening, which helped the market get

rates of return around 0.8% at the end of the month.

Ever since the elections in France, the equities in

Europe have been outperforming the U.S. equities.

The European equity index gained 3.1% since 23

April, compared with 2.7% recorded by S&P 500.

That shows that the decrease of premium for

political risk allows the indices in Europe show their

clear power, which is what we expected. This is

also confirmed by broad-based indicators which

show that nearly 80% of the companies in the

Stoxx 600 index are above the average after 50

sessions, compared with slightly over 50% in the

U.S. (see the chart below). And so we see that the

equity indices enter the phase of “broad-based”

growth, which, on the one hand, is a certain sign of

maturity of the current increases but on the other

hand, proves the relative power of the stock

exchange markets in the Old Continent.

The current growth rate of financial markets takes

places at a time when the macroeconomic data

remain strong. The May flash reading of the PMI

Composite index for the European economy

remained unchanged at 56.8, a long-term

maximum level which it reached in April. A minor

decrease of activity in services (56.2 points) was

offset by an increase in industry (57 points). The

May reading shows an extension of a marked

upward trend of business activity in the eurozone

(see chart on the next page).

The reading also confirms a growing activity in

France and Germany which are the two largest

economies; this supports the latest stance of the

European Central Bank President who stated that

the current recovery is “resilient and broad-based”.

On the other hand, the latest announcement after

the ECB meeting shows that the inflation forecasts

remain toned and the central bank will most

probably remain quite patient until it notices some

pay pressure. Therefore, we are of the opinion that

% share of companies whose quotations are above the average after 50 sessions

Source: Bloomberg, Citi Handlowy

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Stoxx 600 S&P 500

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“exit” from the QE program, if any, should not take

place until next year. With the continuing strong

economic environment in the eurozone, we remain

positive that it is worth holding an exposure to that

geographic region in your portfolio.

This view is also supported by the good first

quarter results of the European companies. 65% of

the companies in the DJStoxx 600 index beat the

market expectations when it comes to earnings

(77% at the sales level); the aggregated EPS

growth reached 23%, which means the best

earnings season since Q3 2010.

The yields on the European bonds remain low.

This is because there are no strong foundations for

inflation growth, especially on the pay side, which

could mean a major increase in the risk of

monetary policy tightening by the ECB. While the

current signals from the central bank show that the

probability of such a move is close to none, we are

still of the opinion that the Treasury bonds and

corporate bonds in the Eurozone are not a good

way of investing capital, and a decision to

discontinue the quantitative easing program may

mean a marked reduction in prices for investors,

especially as regards the lowest interest-bearing

debt instruments in the eurozone.

In conclusion, we are of the opinion that the

European equity market still has some growth

potential, whereas the debt instruments market is

not the most promising place for capital

investments. The growing economic activity of the

eurozone countries proves that this year we should

witness an accelerated economic growth and an

increase in corporate earnings.

Industrial PMI for European Economies

Source: Bloomberg, Citi Handlowy

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Germany France Italy Eurozone

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Japan – positive business environment

Japan benefits from the global revival. The economy accelerates and foreign investors increase

their exposure on the Japanese equity market again. The demographic structure of the population

remains a considerable problem in a long-term perspective though. According to forecasts, the

population may shrink from the current 127 million to 88 million within the next fifty years.

May was a good month for the holders of equities

in Japan. The Nikkei index beat the upper limit on

the four-month consolidation and went up by 2.4%

m/m. From the technical point of view, this opened

the road to the peaks recorded in July 2015, so

around 20600 points. The index would need to gain

around 5% from the current levels (19682 points)

to reach a new high.

The Japanese equity market attracts investors,

with nearly USD 22 billion flowing in to the

Japanese market since the beginning of the year.

By contrast, the U.S. market attracted USD 13

billion, and the European markets attracted USD

12 billion. Relatively attractive valuations,

especially relative to the expensive U.S. market,

seem to be the main factor pulling the foreign

investors. The table below shows that the price to

forecast earnings ratio (P/E 12M) and the price to

book value (PBV) are reasonable. The low

dividend yield and the high CAPE rate which is

based on the average earnings for the last 10

years remain a disadvantage.

Nikkei with a marked peak of 2015

Source: Bloomberg, Citi Handlowy

14 000

16 000

18 000

20 000

22 000

Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17

Valuation of the Japanese equity market against the other markets

Japan U.S. UK Europe

(excluding the UK)

EM

P/E (12M) 14.2 18,6 14.8 16,0 12,6

PBV (12M) 1.3 2.9 1,9 1.8 1.5

DY (12M) 2.2 2,0 4,3 3.1 2,7

CAPE 24.5 27.7 16.3 19,7 15,4

Source: Citi Research, Citi Handlowy

12

Good global economic conditions, monetary easing

pursued by the BoJ and the perspective of a

significant increase in corporate earnings continue

to support the current trend. According to Citi

analysts, the companies in the Topix index may

increase their earnings per share by 15.8%. On the

other hand, we see a potential risk in that the

corporate earnings are quite heavily dependent on

the exchange rate. As an export-oriented economy,

Japan is strongly exposed to the local currency

appreciation. It’s been our experience that the yen

exchange rate is highly volatile. Bearing all this in

mind and considering the profit to risk ratio, we

remain neutral about the equity market in Japan.

Citi economists decided to raise the GDP growth

outlook again. They currently assume an

acceleration to 1.7% in 2017. The higher outlook is

largely related to the considerable strength of the

export and industrial output. The global business

revival is clearly beneficial to the export-oriented

Japanese economy. We expect that the export will

go up by 7.4% in 2017 compared to the import

growing by 3.3%. The capital expenditures of

companies may also record a marked increase.

Business sentiments improved which translates

into new investment projects. On the other hand,

Japan continues to have problems with stimulating

internal consumption. Despite a very good situation

on the labor market – with the unemployment rate

at 2.8% – we expect a merely one percent uptick in

consumer expenditures.

The demographics and ageing society remain a

major issue for Japan in the long-term perspective.

According to the latest research by the National

Institute of the Population and Welfare, the

population of Japan may shrink from 127.1 million

to 88.1 million in 2065. By contrast, the working

age population (the workforce aged 15 to 64) may

record an even more drastic drop from the existing

77.3 million to 45.3 million in 2065. Shinzo Abe’s

government is aware of the problem and is

currently taking measures to address it and ease

the demographics’ impact on the economy.

Increasing the participation of women and the

elderly people in the workforce is one of the main

elements of those efforts, and a higher participation

level of those social groups will help mitigate the

adverse consequences of that trend. First of all, the

government takes measure to increase the

availability of child care facilities, so that women

can be more active in the professional world.

Secondly, the government is gradually extending

the official age of retirement in Japan. Currently,

the Japanese can retire at 62; the government

decided to raise that limit to age 65 by 2025.

Concurrently, the government wants to introduce

upper limits on pension payments to encourage the

elderly Japanese to continue working past the

retirement age. We can see, however, that those

measures may prove insufficient and the country

will not be able to avoid the demographics impact

on the individual segments of the economy. The

sectors with a relatively low share of working

women and elderly will in particular suffer from

shortage of workforce. Construction sector and the

transport sectors, to name a few, may have to deal

with problems finding new workers. From the

macroeconomic perspective, Japan has to

immediately improve productivity to mitigate the

adverse effect of the demographics. Therefore,

investments into robotics and automation are a

priority for Japan.

To conclude, the revival in the global economy has

a good influence on the export-oriented economy

of Japan. Citi economists expect that the GDP will

accelerate to 1.7% whereas corporate earnings will

go up by 15.8% in 2017. Strong dependence on

the exchange rate, continued geopolitical tension

on the Korean Peninsula and a visible problem with

the demographic structure of the society remain

risk factors. Bearing in mind the profit to risk ratio,

we remain neutral about that market.

13

Emerging Markets – An Excellent Month, Save for LatAm

In the latest materials we emphasized that a steady and systematic growth of the emerging

markets could soon result in greater volatility. And the recent weeks certainly did. Large

movements of indexes were primarily triggered by political developments. May proved a very

interesting month for the Emerging Markets; all the more because the developments discussed

below did not hamper their further growth. What’s more, arriving at the impressive 2.8%, the

Emerging Markets Index managed to outclass the Developed Markets Indexes again.

Mid-May saw over 30 world leaders coming to

Beijing to discuss the 2013 proposal of the

President of China. It is an infrastructural project

funded by China and estimated to close at

USD 900 billion. The project is to strengthen trade,

especially with the European Union member

states. The idea draws on the ancient Silk Route

and provides for construction of two ways – a

landway (to Europe) and a seaway (via South-

Eastern Asia to Eastern Africa). The project was

called “One Belt, One Road” (OBOR). The

enormous undertaking covers investment initiatives

in harbors in Pakistan or Sri Lanka, creation of a

fast railway in Africa or construction of gas

pipelines in Central Asia, to name a few initiatives.

It is the largest foreign venture ever launched by

one state.

The project is in its initial phase – computations

show that it may benefit even up to 65 states. It is

beyond any doubt that the second top world

economy will benefit most from it. China wants to

stimulate the recently snail-paced world trade and

become the top beneficiary of this project. It is

further emphasized that the initiative of President

Xi Jinping also serves as a stepping stone for top

Chinese businesses to expand on the global

markets and gain in significance on the world

markets. Many market watchers accentuate that

the assumptions of the “One Belt, One Road”

project are very ambitious and demanding. At the

same time, they suggest that the majority of the

project initiatives are predestined for success, to

say the least. Should it be the case, the center of

the world economy could shift a bit in the very long

term. This will depend, however, to a large degree

on the followers of President Xi – the project is

enormous and its implementation will necessitate

the collaboration of many states also with the

future authorities of China.

Another event that had a serious impact on the

emerging markets last week was the continued

corruption affair in Brazil. We have repeatedly

described the political developments in the largest

economy of South America. Let us only recall that

in August 2016, Dilma Rousseff was impeached

and removed from office due to a far-reaching

Index of shares in Brazil (Bovespa) versus MSCI EM index in 2017

Source: Bloomberg, Citi Handlowy

850

900

950

1000

1050

60 000

62 000

64 000

66 000

68 000

70 000

Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17

Bovespa (left axis) MSCI Emerging Markets (right axis)

14

corruption affair involving top Brazilian companies.

Michel Temer, a darling of financial markets, took

over the reins. Since Temer assumed power, his

promises to fight the bloated social welfare

programs and to support prospective sectors of the

economy made the Brazilian real and the stock

exchange in Sao Paulo respond pretty well, even

vis-a-vis the other emerging markets that

experienced significant gains. On May 18,

investors saw yet again how risky it is to invest

capital in non-developed markets. On that day, the

Brazilian press revealed the existence of

recordings which could allegedly prove that Temer

had accepted bribes and paid a businessman for

keeping his mouth shut. Naturally, the accusations

immediately raised concerns that another president

would soon be impeached, which in turn caused an

immediate sell-off of Brazilian assets. The stock

exchange in Sao Paulo even suspended its

quotations for a while (a procedure applicable

when the main index drops by over 10%); the

Brazilian real also lost approx. 7%. At the moment,

we are not aware of any other consequences of

that development. Markets have calmed down and

public prosecutors are investigating the case. The

President declares that he will not resign from

office. Political watchers in Brazil expect the

president to remain in office until the next election,

which is to be held next year. Still, his political

power has been tarnished. Temer himself is of

significance for investors. Among the key reforms

endorsed by him were changes to the pension

system. Since increasing costs of the system in the

coming years may hamper the economy, the

determination to enforce changes is high. Without

curbing the public pension expenses, Brazil will

become a considerably less attractive place for

investing capital. Hence, the case will remain a hot

potato in the coming months. The turbulence in

Brazil may bring some positive outcomes for the

Emerging Markets, though – looking at the flows on

the Brazilian stock market, it turns out that in the

week after May 19 the market took in USD 760

million, which was the best result over the last 5

years. One can clearly notice that the investors’

propensity to buy on the Emerging Markets, which

continue to be priced below the developed ones, is

high. An additional price cut, caused by the political

situation, only encouraged the investors with higher

risk appetite. The main Brazilian index lost 4.4% in

May. However, this might not be the end of the

high volatility on that market.

In our analyses of the economic situation in China,

we have been frequently emphasizing that the

individual segments of that economy are very

uneven inside. Debt ratio is the most disturbing

ratio in the long term. As at 2016 yearend, the debt

of the entire economy reached 260% of the annual

GDP. Still in 2008, it stood at a “healthy” 160%.

The debt risk was also noticed by one of the 3 top

rating agencies, Moody’s. Towards the end of May,

it downgraded China (investment rating) for the first

time since 1989. The Aa3 rating to-date (the fourth

top rating among the 21 listed by Moody’s) was

replaced with A1 (one notch lower). These ratings

prove a very high assessment of the capacity to

repay debt all the time. In their report, Moody’s

named the doubts about the debt reduction in the

situation where the past economic growth numbers

prove hard to deliver as the main reason for

downgrading. As we have accentuated many times

in our materials, specially the debt of Chinese local

governments and public companies is reaching

more and more disturbing figures. Downgrading

showed more what investors should be focusing on

in the coming years than stirred rapid response

from the financial markets. The mere fact that the

external debt accounts for 12% of the annual GDP

of China causes that the downgrading does not

have such serious consequences as in the case of

the states indebting themselves abroad.

The last month showed once more that when

investors want to earn on dynamic emerging

markets, they need to accept extra risk. Despite

constant changes, political instability and less

stable financial systems remain the drivers of

higher pricing discounts in the Emerging Markets.

We are of the opinion that despite their volatility, a

portion of the most active investing portfolio should

be still invested in the emerging markets. The bear

market experienced by the Emerging Markets for

many years continues to reverse and May showed

that those markets kept their strength with their

assets being strongly capitalized.

15

Commodity Markets – OPEC Extends Production Cuts

Despite relative volatility during the month, for investors, May closed with the CRB Commodity

Index being 1% below that in April. Commodity quotes were much impacted by the USD

deceleration, which traditionally favors appreciation of commodities. This effect was offset,

nonetheless, by the tightening of the monetary policy in China, which affected the demand of the

key player on most commodity markets, among other factors.

Crude oil

In the first week of May, crude oil continued to

observe the price reduction from April, whereby the

quotes of WTI futures reached USD 43.77 per oil

barrel. The drops were fueled by e.g. new data on

the reserves accumulated by the United States of

America which proved above analysts’

expectations. Stopping of the reduction overlapped

with the second round of the presidential elections

in France, the results of which turned out to be

favorable for the investors on most financial

markets, due to a lower political risk. Reignited

interest in risky assets was among the factors

which caused crude oil to soar above USD 50 per

barrel once more in the short term.

Another growth booster were the decisions to

curtail oil production made by the OPEC countries

and selected non-OPEC manufacturers. Before the

meeting on May 25, the market consensus, which

so far had assumed an agreement extension by

another 6 months (by 2017 yearend), started to

shift towards 9 months. This was due to the

statement made by the Saudi Arabian Minister of

Energy, who mentioned that a longer applicability

period of output cuts would be a wise decision and

the other agreement members seemed to shore it

up.

These announcements were confirmed. Reduced

output cuts will apply until the end of March 2018,

while Libya and Nigeria continue to be exceptions

here as exempt from cuts. It is worth noting that in

April and in March, the OPEC countries outdid their

obligations, while the manufacturers from outside

the cartel still did not reach the assumed outputs

(Russia is most behind when one thinks about

quantities). Since the potential impact of the

signatories' decisions on the physical commodity

market will only become known in the coming

quarters, Citi’s short-term forecast remains

unchanged and assumes around USD 50 per

barrel with the situation to improve step by step in

Q3 and Q4 2017.

Actual output cut by OPEC and non-OPEC countries vis-a-vis the agreed cuts (thousand barrels per

day)

Source: Bloomberg, Citi Handlowy

0

500

1000

1500

January February March April

OPEC agreed cuts for OPEC countriesnon-OPEC countries agreed cuts for non-OPEC countries

16

Gold

At the beginning of May, this noble ore lost value

just like most other commodities did. However, it

started to gain after the election winning by

Emmanuel Macron. This was a reverse reaction

from the one expected in the case when the

market risk falls. The investors who hoped that

gold would depreciate were surprised to see it rise

after the results in France were announced. It

turned out that due to unambiguous pre-election

polls, gold fell in value still before the mere election

day.

The weakening USD which is used to settle the ore

was another factor to affect gold quotes in May.

USD depreciation against EUR and other

currencies of the emerging markets (e.g. China

which is the largest off-taker of physical gold)

helped make up about a half of the pre-election

losses. Reduction in USD price was driven by the

risk of Donald Trump’s impeachment amid the

accusations about the pressure exerted on the

former FBI Chief. Despite the indirect impact via

USD, a new political threat impacted gold directly

as well. This is because of the safe asset

mechanism which applies whenever market risk

rises.

The gold prices could continue to go up should the

above factors (USD deceleration, new political risk)

sustain – this is not our base scenario

nonetheless. Since IR futures in the U.S. estimate

the probability of the interest rate increase by the

American FED in June at 100%, the decision is

discounted and it should not affect the gold quotes.

To round up the commodity market standing, for

crude oil – despite the positive outcome of the

negotiations between the signatories of the

agreement to limit oil production cuts, we expect

that the prices will respond positively only in the

coming quarters. In the meantime, extension of the

existing cuts should help keep the levels close to

USD 50 per barrel. For gold, the recent weakening

of USD and the fall in trust in President Trump

seem to exhaust their potential to support gold

quotes any more. Should no new surprising

political developments occur, the commodity

stabilization around the present levels would seem

a probable scenario.

17

Rates of return and ratios for selected indices (as at 31 May 2017)

Equities Value May YTD Year P/E P/E

(12M) Dividend

yield

WIG 60092,1 -2,5% 16,1% 31,1% 17,5 12,6 2,4%

WIG20TR 3868,4 -3,8% 17,4% 29,7% 17,7 12,2 2,2%

mWIG40 4798,7 -1,2% 13,8% 37,7% 14,9 14,5 3,0%

sWIG80 16220,6 -0,5% 13,8% 18,7% 19,7 11,5 2,1%

S&P 500 2411,8 1,2% 7,7% 15,0% 21,4 18,6 2,0%

Eurostoxx 50 3554,6 -0,1% 8,0% 16,0% 19,9 15,1 3,5%

Stoxx 600 390,0 0,7% 7,9% 12,2% 25,6 16,0 3,3%

Topix 1568,4 2,4% 3,3% 13,7% 16.5 14,2 2,0%

Hang Seng 25660,7 4,2% 16,6% 23,3% 14,3 12,7 3,2%

MSCI World 1911,7 1,8% 9,2% 14,2% 21,5 17,3 2,4%

MSCI Emerging Markets 1005,3 2,8% 16,6% 24,5% 15,3 12,7 2,4%

MSCI EM LatAm 2532,3 -2,6% 8,2% 24,2% 18,2 13,9 2,8%

MSCI EM Asia 505,5 4,4% 20,7% 26,5% 15,4 13,0 2,1%

MSCI EM Europe 307,6 -1,8% 3,6% 14,6% 9,2 8,0 3,7%

MSCI Frontier Markets 561,5 3,8% 12,4% 10,5% 14,4 11,7 3,9%

Raw materials

Brent Crude Oil 50,3 -2,7% -11,5% 1,2%

Copper 258,0 -0,6% 3,0% 23,1%

Gold 1272,0 0,3% 10,4% 4,7%

Silver 17,3 0,7% 8,8% 8,3%

TR/Jefferies Commodity Index 179,8 -1,1% -6,6% -3,4%

Bonds

Duration

U.S. Treasuries (>1 rok) 384,3 0,7% 2,1% 0,0% 6,3 German Treasuries (>1 rok) 418,9 -0,1% -0,8% -0,8% 7,4 U.S. Corporate (Inv. Grade) 273,6 1,4% 3,9% 4,2% 8,3 U.S. Corporate (High Yield) 264,1 1,0% 4,3% 12,0% 3,6 EUR Corporate (High Yield) 178,7 0,8% 3,2% 8,0% 3,3 Polish Treasuries (1-3 lat) 324,7 0,4% 1,4% 1,7% 1,9 Polish Treasuries (3-5 lat) 365,5 1,0% 2,5% 1,8% 3,9 Polish Treasuries (5-7 lat) 262,6 1,4% 3,6% 2,1% 5,2 Polish Treasuries (7-10 lat) 432,8 1,6% 5,2% 2,4% 7,6 Polish Treasuries (>10 lat) 336,3 2,2% 6,0% 4,6% 9,0

Currencies

USD/PLN 3,72 -4,1% -11,2% -5,6%

EUR/PLN 4,18 -1,1% -5,1% -4,6%

CHF/PLN 3,85 -1,3% -6,4% -3,0%

EUR/USD 1,12 3,2% 6,9% 1,0%

EUR/CHF 1,09 0,4% 1,5% -1,7%

USD/JPY 110,78 -0,6% -5,3% 0,0%

Source: Bloomberg

18

Macroeconomic forecasts

GDP growth (%) 2016 2017 2018 Poland 2,7 3,7 3,2 United States 1,6 2,1 2,6 Eurozone 1,7 2,0 1,9 China 6,7 6,6 6,5 Developing countries 3,9 4,4 4,8 Developed countries 1,6 2,0 2,2

Inflation (%) 2016 2017 2018 Poland -0,6 2,0 2,4 United States 1,1 1,7 1,9 Eurozone 0,2 1,6 1,4 China 2,0 2,0 2,2 Developing countries 4,3 4,0 3,6 Developed countries 0,7 1,6 1,7

Source: Citi Research

Currency forecasts (end of period)

Currency pairs Q2 17 Q3 17 Q4 17

USD/PLN 3,77 3,81 3,85

EUR/PLN 4,25 4,21 4,17

CHF/PLN 3,89 3,89 3,89

GBP/PLN 5,01 4,95 4,89

Source: Citi Research

19

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 (12M), leading P/E a projected price/earnings ratio providing information on the price to be paid per one unit of 2016 projected

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

(consensus) for a specified period (12M)

P/E (price/earnings),

trailing P/E

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

23

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20

Additional Information

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

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21

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