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BCGE group investment strategy

1st quarter 2017

EDITORIAL

SerendipiTrump?

FOCUS

Bond markets in the face of

anticipation or science fiction?

EDITORIAL

2

Constantino Cancela BCGE Group Chief Investment Officer

SerendipiTrump?

Serendipity is often defined as the ability to discover things by chance. In reality, discoveries are not really made by chance. They are made possible because the person who makes the discoveries has a certain mind-set consisting of openness, availability, surprise, astonish- ment and an analogical and symbolic thought process which enables him to see what brings together rather than what divides.

2016 will certainly stand out as a year which left an impression across the whole world as being the year of surprises. After the Brexit political shock, here we had the world's largest econom- ic, political and military power, the United States, going into the unexpected presidency of the billionaire Donald Trump. During the campaign running up to his election, the new master of the White House had strung together slogans which, after the elec- tion and in the eyes of financial investors, had moved on from being a pipe dream, now to become a Keynesian-style econom- ic programme. For the second time in the year, the ballot box had thrown up financial consequences, unexpected, to say the least, by the markets! Immediately, as from 8 November, we saw the rise in interest rates, which had already been initiated, pick up pace, with the dollar and stock markets heating up. All of a sudden, the world rediscovered the virtues of reflation after having wept for so long over the risks of deflation. 2016, having kicked off with unjustified fears of imminent recession, signed off with risks of inflationary overheating. How can this move from extreme pessimism to somewhat irrational exuberance be explained?

Has the frenzied quest for solutions to growth, held back by debt burdens, demographics and low productivity, become a thing of the past, by accident, as a result of the foresight and wisdom of some highly colourful character? That is the expla- nation when relying on the term serendipity. History will tell whether the surprise election of one single man will align with the other proposals hidden under this somewhat exotic name!

Enough of the allegory. Back to the fundamentals! Donald Trump's line is broadly based on the fiscal stimulus and deregulation meas- ures introduced in the 80s by another unexpected president. This is why a lot of observers are immediately comparing the arrival of Donald Trump with that of Ronald Reagan. The financial mar- kets, nostalgic, want to believe in the virtues of a massive reflation programme; let's hope that they are not disillusioned too quickly. In fact, the new American president's reflation equation contains too many unknowns. The reduction in taxes, particularly for busi- nesses heavily taxed at 36%, combined with the announced in- creases in defence and infrastructure spending, imply growth of 3.5% a year in order to stabilise public debt at its current level.

Yet, for several years now, American growth has been fluctuating around the 2% mark; the American economy is near full employ- ment; inflation has stabilised at a level close to the Fed's target; borrowing conditions are extremely attractive and public debt is very high. This 2016 reality is diametrically opposed to that of the Reagan years, which is why, at the time, the fiscal and financial largesse almost systematically translated into job creations, invest- ment in businesses, an acceleration of growth and productivity. Consequently, it is hard to accept merely the virtues of reflation when the main unknown factor in the current growth equation is the business sector, its will to invest and its ability to generate pro- ductivity gains and sources of profitability. In practice, labour costs are rising, price-fixing power is limited, the potential limitation on earnings from globalisation (possible increase in protectionism) is looming on the horizon: very logically, this means a reduction in profitability and in the capacity to invest and generate productiv- ity over the long term! The mere "Make America Great Again" slogan momentarily convinced the markets. They are not immune to disappointments and adjustments as soon as the presidency settles in. As from 21 January 2017, the reality of American politics will catch up with the president elected. To conduct his economic policy and turn his promises into actions, he will have to grapple with Congress, presided over by Paul Ryan who is far from favour- able to his cause. Budget, public spending, investment expendi- ture, raising the debt ceiling, all these issues will soon come and highlight the boundaries between intentions and achievements.

BCGE Group Investment Strategy 1st quarter 2017

CONTENT

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Having said that, let's get back to the world economy! The springboard compressed by central banks with their active policy of interest-rates, liquidity and exchange rates is bolstering the growth take-off. At the moment, it resembles a ski-jump- ing champion ready to launch an even more marked take-off: technical and weather conditions are ideal, the equipment too and the jumper is in perfect form! The length of his jump now only depends on the optimisation between his experience, skill and preparation on the one hand, and his equipment being cut- ting-edge in terms of innovation and technology on the other.

By analogy, future economic growth must be based on the busi- ness sector and its productivity, the end-product of its innova- tion, its technological investment, its staff training, its opera- tional efficiency, its integration within a globalised market, and lastly, its visibility on the profitability of its activity. Of course, the authorities can intervene to prepare the landing strip, by guaranteeing infrastructures, attractive framework conditions (fiscal and social), and that clearly appears to be the intention of Donald Trump in particular. Nevertheless, the acceleration of growth depends essentially on businesses and their capacity to generate profits.

Some regions clearly offer greater potential than others, es- pecially through the drive of businesses wishing to remain in the quest for productivity. This is the case for Switzerland, the United States and also for Germany, markets we are continuing to give preference to in our allocations.

The business world did not change the day after the Ameri- can elections, it is simply that the perception of financial and economic investors was awakened, a bit "unbeknown to them- selves". So, we continue to focus our preference on the shares of businesses investing in the future. We are remaining cautious on the bond asset class normalisation phase of rising rates.

Our vision of the real economy, as you will note, has not been modified by the unexpected events of 2016. The first few months of this new year could confirm or refute SerendipiTrump!

Wishing you an excellent and productive 2017.

EDITORIAL 2

SerendipiTrump?

FOCUS 4

Bond markets in the face of anticipation or science fiction?

MACRO SUMMARY 6

MARKET SUMMARY 7

& STRATEGIC DECISIONS

ECONOMIC & FINANCIAL OUTLOOK 8

SWITZERLAND Macro 9

Interest rates & currency 10

Stock markets 11

EUROZONE Macro 12

Interest rates & currency 13

Stock markets 14

UNITED STATES Macro 15

Interest rates & currency 16

Stock markets 17

EMERGING REGION Macro 18

Emerging Debt 19

Stock markets 20

COMMODITIES 21

BCGE Group Investment Strategy 1st quarter 2017

FOCUS

4

Valérie Lemaigre Chief Economist

Bond markets in the face of anticipation or science fiction?

"Difficult to see. Always in motion is the future." Yoda

How is it that the suffix "flation" can be associated so rapidly with all scenarios? Over recent years, DEflation has largely dom- inated minds, giving way now and again to STAGflation and more recently, with the advent of the new US president, people dare speak of REflation. This volatility in neologisms between inflation and growth reflects the instability of bond investors' sentiment in the face of fundamentals that have been weakly anchored for several years now. And, political movements of a similar nature, advocating something of a return to protection- ism, have, in the course of 2016, set in motion very differing market reactions; drop in interest rates and in sterling as regards Brexit, interest rate and dollar hikes as far as the American elec- tions were concerned.

Finally, passing over these movements, the rise of more than 80 basis points in interest rates since last summer's lowest point on some American maturities, has dragged along in its wake the slightly more moderate increase in European rates (60 basis points). This increase is nothing more and nothing less than in- vestors adjusting their perception of inflation which, since last summer, has already picked up; the opportunity to understand the importance of inflation anticipations, both for financial play- ers, economic players and monetary policies.

Inflation is commonly understood and measured as the weight- ed increase in the prices of goods which make up the average household shopping basket in each region. It adds imported goods and services (~30% in the developed regions) to those that are sourced domestically. The main determining factors for imported prices are energy costs and currency variations, whereas domestic prices are affected above all by the wage dis- tributions granted within the economy.

From these current and realistic scenes measured monthly are born the inflation anticipations so often referred to by economic players and financial investors alike. And, monetary policies and bond markets are very dependent on this concept which has nothing to do with science fiction because it's happening right now and it conditions economic behaviours and adjustments. There are numerous examples of individual economic and finan- cial reactions being triggered by anticipations; the business owner invests in projects for the future on the basis of demand and pro- ject profitability anticipations; collective and individual wage ne- gotiations depend a lot on price anticipations over the period of employment contracts. Lastly, the interest rates set on the bond markets incorporate this psychological dimension of inflation an- ticipations. This concept, defined by Irving Fisher in 1930, starts from the premise that a bond must protect the capital over the whole holding period. The interest rate must therefore provide coverage against the inflation expected over the life of the bond.

Consequently, monetary policies and bond markets operate in concert with these expectations. For central bankers, anchoring these anticipations is critical in fixing commercial banks' short- term lending rates as well as having a handle on the evolution of bond yields. The key is then understanding how these inflation expectations are defined, in full knowledge that they do not fall within the realm of science fiction but entail a clever mix of perception of the past, the present and the future. This is how inflation over the last 5 to 10 years defines the fairly stable trend of anticipations expressed through the opinion surveys of eco- nomic players. As regards financial investors, whose expecta- tions are picked up through bond sector financial products tied to inflation, their sensitivity is more short-termist and depends on factors such as oil prices and business leader opinion surveys.

BCGE Group Investment Strategy 1st quarter 2017