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Volume 8, Issue 5

Allianz Global Investors Insights May 2016

Global View

More Volatility Hits Markets as Growth Remains Dull Asset markets endured a great deal of sound and fury during the first quarter, as fears surrounding China, oil, negative interest-rate policies (NIRP) and politics all served to undermine investor confidence. That, in turn, led to a severe rout in the first half of the first quarter, which was followed by a strong rally that nearly moved markets back to starting levels. So where are we now and how might the second quarter play out? Amusingly, despite all this market volatility, global economic growth has remained as dull as we expected it to be, with our financial repression thesis in full effect.

pace, which has allowed the US Federal Reserve to sound more dovish once again. In turn, the dollar has weakened somewhat, which boosts the prospects for US earnings and emerging economies. We expect more of the same in the second quarter, although it seems prudent to expect one hike in interest rates before the summer: The Fed does not want to implement a policy change during the serious election campaigning later this year.

China

As a result, growth expectations have progressively fallen toward a sub-2-per-cent

Fears of a massive renminbi (RMB) devaluation, a recessionary economy and a credit bubble have ameliorated somewhat as China’s government has agreed on – and started to execute – its next Five-Year Plan. Beijing knows it needs economic growth while it transforms from exports and manufacturing toward consumption and services, and we expect China’s economy to become more stable this year. This transformation will take time and will structurally alter the level of demand for many commodities where

2 Perspective on Europe

4 Soundbites from Research

3 Viewpoint

4 GrassrootsSM Research

The United States

Notably, US economic data remain lacklustre and unconvincing, despite the fact that during the same time last year, economic performance was weak due to a polar vortex. Industrial production has stalled, employment is stable and wage data are flat, so there are few real drivers for the US economy.

Euro-Zone Periphery Must Use Low Yields to Boost Growth

Keys to the New ‘Mega Plan’ Guiding China to 2020

Online Clothing Specialists Have a Winning Formula

China Seeking Foreign-Exchange Stability

Neil Dwane Global Strategist

excess supply capacity has been created; as a result, we would still avoid many commodities-driven emerging-market economies.

Europe The European Union (EU) has quietly had yet another good quarter – possibly outgrowing the US – as austerity benefits continue to pay off and as the European Central Bank (ECB) finds increasingly innovative initiatives to support and invigorate both the weak EU banking system and the underlying demand for credit in the real economy.

(Continued on page 5)

Allianz Global Investors Insights

Perspective on Europe

Euro-Zone Periphery Must Use Low Yields to Boost Growth Financial repression continues to take a growing toll on the euro zone, driving yields further into negative territory. The ECB’s main refinancing rate is at 0 per cent, while its deposit rate runs at -0.4 per cent. Moreover, policymakers went even further at the ECB’s March 10 meeting, announcing several new initiatives: ◾◾ Starting this June, the ECB will provide liquidity to banks through a new longterm refinancing operation. ◾◾ Toward the end of the first half of 2016, the range of assets the ECB will directly purchase through its quantitative-easing program will be expanded to include high-quality corporate bonds. We believe these measures have the potential to lead to further spread compression between euro-zone peripheral countries’ debt and German bunds. Euro-zone spreads have continued to tighten in recent years, and are now not too far from the levels last seen in November 2011 – before the euro-zone crisis erupted. This result is clearly a success for the ECB, but the time is coming when ECB support alone will no longer be sufficient. As a result, market participants – including Allianz Global Investors – will become

increasingly concerned with whether or not member countries on the periphery have the capacity to use the current ultra-lowyield environment to boost growth and reduce debt. Ireland and Portugal provide two good examples. Both countries were in trouble during the 2011 euro-zone crisis and both eventually fell to below-investment-grade levels, which resulted in an increase in the cost of their debt compared to German bunds. While both have benefited from spread compression – driven by the ECB’s bold actions – their economic paths clearly diverged after 2013. In fact, Ireland’s real gross domestic product (GDP) grew 5.2 per cent in 2014 and 7.8 per cent in 2015, while Portugal’s grew a meager 0.9 per cent and 1.5 per cent, respectively. The accompanying chart clearly shows how different growth paths have substantially impacted gross debt-to-GDP ratios for the two countries.

Mauro Vittorangeli CIO Conviction Fixed Income

Portugal’s debt is at further risk; while Ireland’s debt has returned to the stable investment-grade camp, Portugal’s debt is still stuck at sub-investment grade, and its 10-year bond yields are close to 3.5 per cent. Clearly, those investing in the debt of eurozone peripheral countries will start becoming more selective as time goes by, and they will begin to reward countries that have done a better job with public finances – particularly given that the ongoing environment of financial repression shows no sign of waning anytime soon.

Higher growth has allowed Ireland to reverse the trend of its gross debt-to-GDP ratio, which returned to below 100 per cent at the end of 2015, while Portugal’s gross debt-toGDP ratio was stuck at 130.5 per cent. If for any reason interest rates start to increase,

Gross Debt-to-GDP Ratios Show Stark Contrast Between Ireland and Portugal Thanks to Ireland’s higher growth, it has reversed the trend of its gross debt-to-GDP ratio, while Portugal’s ratio has remained stuck in a rut. 140

Portugal

Ireland

Gross Debt-to-GDP Ratio

120 100 80 60 40 20 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 Q3 2011 Q1 2012 Q3 2012 Q1 2013 Q3 2013 Q1 2014 Q3 2014 Q1 2015 Q3 2015 Source: Eurostat as at April 2016. 2

Allianz Global Investors Insights

Viewpoint

Keys to the New ‘Mega Plan’ Guiding China to 2020 The 13th Five-Year Plan In a few years, 2016 could be viewed as an important milestone in China’s economic development. It marks the start of the 13th Five-Year Plan (FYP), which will guide China’s direction until 2020. Approved in March by the State Council, the 13th FYP comes squarely on the heels of the post-globalfinancial-crisis drop in export demand, and in context of the recent fallout from China’s RMB 4 trillion fiscal investment package.

The new Five-Year Plan is characterized by its emphasis on the quality of growth and on central governmentdirected planning. Notably, the objective of this new FYP is to establish a more stable, balanced and sustainable society. In contrast to China’s previous provincial economic race, which mostly focused on the pace of growth, the new FYP is characterized by its emphasis on the quality of growth and on central government-directed planning. Among the long list of policy targets under this FYP, five key areas may become major themes in China’s market and are therefore worth investors’ attention: ◾◾ Maintaining the target of doubling 2010 GDP by 2020, which requires an annual GDP growth rate of about 6.5 per cent for the next five years. ◾◾ Making China’s institutional, technological and cultural initiatives more innovative. ◾◾ Seeking balanced development through industrial upgrades, modernization of agriculture, urbanization and regional coordination. ◾◾ Making ecological improvements, including improving energy conservation and environmental protections. ◾◾ Strengthening social welfare initiatives, including education, vocational training, social security and insurance protection.

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T his mega plan addresses many structural problems, such as over-reliance on capital investment, overcapacity in the industrial sector, environmental pollution and wealth inequality. If implemented successfully, this FYP would bring China to a new level compared with other developed countries. Nonetheless, reform is never easy, and many of these new initiatives involve changing the existing rules of the game. For these changes to be implemented successfully, it is essential that Chinese President Xi Jinping and other leaders demonstrate determination and execution power. Investors should closely monitor relevant policy details and keep track of the reform measures’ progress.

Economic outlook for 2016 There has been a subtle shift of policy priority in China since the fourth quarter of last year, as government leaders seem to be increasingly concerned about the stability of both the banking system and society overall. While making a successful economic transition toward a consumptionbased economy remains an important medium-term target, China’s near-term priority has shifted; policymakers are now focused on containing economic downside risk. Selective expansionary measures – including offering tax cuts for car purchases, relaxing mortgage-loan restrictions and setting up specialized construction funds for infrastructure projects – were introduced to counter the pressure of economic deceleration. Clearly, China’s policy stance has turned more accommodative. As reflected in recently announced macroeconomic data, the policy stimulus measures that China has launched in the past six months are starting to take effect. In March, China’s official manufacturing Purchasing Managers’ Index (PMI) and services PMI – which reached 50.2 and 53.8, respectively – beat market expectations and moved into the expansionary zone. In addition, China’s Producer Price Index had its first month-over-month increase since August 2013. With China’s housing market

Raymond Chan CIO Equity Asia Pacific

and infrastructure investment regaining momentum, there are also signs that demand for construction machinery and building materials is gradually picking up. Barring any external shock, China should see sequential improvements in the second half of 2016, and it should be on track to achieve its 6.5 per cent growth target.

The real challenge for China’s government now seems to be whether it can balance the near-term target of supporting growth and the longer-term objective of transforming the economy. On the flip side, containing near-term economic downside risk would come at the expense of the country’s progress in economic transformation and deleveraging. In fact, we may continue to see the public sector incur higher leverage – at least in 2016 – to fund infrastructure investment and public-service expenditures. Therefore, the real challenge for China’s government now seems to be whether it can balance the near-term target of supporting growth and the longer-term objective of transforming the economy. Meanwhile, the volatility of the RMB exchange rate, capital outflows and accelerating inflation are the biggest risk factors with the potential to derail China’s game plan.

Allianz Global Investors Insights

Soundbites from Research

Online Clothing Specialists Have a Winning Formula The winter of 2015-2016 was one of discontent for clothing retailers across the globe. Record high temperatures and increased discounts reduced profits in most cases. However, amongst all the carnage, one group of retailers stood out as more successful than the rest: the online specialists. The online clothing business seems to be reaching a tipping point, particularly in Europe, where barriers to shopping online are falling and consumer attitudes are shifting. Yet our research shows that attaining success in this area is certainly not as simple as launching a website and waiting for the cash to roll in. There are some key drivers that retailers need to get right if they want customers to shop in their virtual stores. ◾◾ It’s important to have a local-language website that loads quickly and is easy to

use, with minimal clicks required to complete a purchase. ◾◾ Retailers should have a reliable mobile app for each market, preferably with editorial content. ◾◾ Other helpful website features include multiple local-currency payment options, a free-delivery offer and a range of delivery methods to suit the consumers’ needs. ◾◾ Above all, retailers need to make it as easy as possible for consumers to return unwanted items, preferably at zero cost to them. Overcoming these hurdles requires retailers to have a wealth of expertise – not to mention make significant investments. As a result, many store-based retailers have been slow to develop their online capabilities. In particular, companies with extensive store estates and high market share that try a shift

Elizabeth Houston European Consumer Analyst

to online sales can see a painful effect on their profit margins. Customers abandon physical stores, where the cost base is largely fixed, in favour of shopping online, where costs are variable. And that’s on top of everything the company had to invest in its shiny new online distribution facilities. Some store-based retailers are getting it right, but they are few and far between. As a result, the outperformance of online specialists looks set to continue.

GrassrootsSM Research

China Seeking Foreign-Exchange Stability In February 2016, GrassrootsSM Research conducted two studies, speaking with a total of 40 branch managers at major banks in China, to gauge China’s banking business in terms of loan default risk, the appetite for loan business, the outlook for deposit growth and capital-outflow controls. In the first study, three-fourths of our sources noted a trend of increasing loan defaults in recent months, mainly in the heavy and lowend manufacturing industries, and an overall expectation for higher defaults in the first half of 2016. Banks are shifting loan exposure to sectors related to high-end manufacturing, health care, the Internet and environmental protection, which sources believe will be bright spots for fast growth in the coming years. In the second study, our sources expected muted overall deposit growth of 5 per cent

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due to an economic slowdown, lower consumer income for savings, RMB depreciation, low interest rates and inflation concerns. In addition, limits imposed on foreign-exchange activities have already caused a sense of worry and unhappiness among bank customers. That said, sources expect further capital-control measures to be implemented, including delaying or restricting foreign-exchange wire transfers and cracking down on grey-market currency exchanges. “Our internal GrassrootsSM Research confirms that China is implementing numerous administrative measures to stabilize its level of foreign-exchange reserves,” said Terence Law, Head of Research, Asia Pacific, at Allianz Global Investors. “This should lend support to the RMB and to market sentiment in general.”

Joey Wong GrassrootsSM Research Analyst

Allianz Global Investors Insights

(Continued from page 1)

Global View While the migration crisis still festers – including painful outbursts of anti-immigration sentiment in Brussels, home of the EU’s headquarters – another significant political threat will emerge in the second quarter: the Brexit referendum in late June. This vote will have important consequences for Europe if the UK votes to leave the EU, which we believe is unlikely; Brexit would add volatility to pound sterling and euro assets, and challenge politicians across the continent. Interestingly, the European identity crisis is still having effects on national politics around the region; with Ireland and Spain having

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Equities have tended to be volatile, and unlike bonds do not offer a fixed rate of return. Emerging markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates. Bond prices will normally decline as interest rates rise. Below investment grade convertible and fixed-income securities involve a greater risk to principal than investment grade securities. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice. References to specific securities are not intended to be, and should not be interpreted as an offer, solicitation or recommendation to purchase or sell any financial instrument, an indication that the purchase of such securities was or will be profitable, or representative of the composition or performance of any AllianzGI product. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or

both experienced incomplete election results recently, we expect European politics to remain a headline-grabber for the rest of the year.

Emerging markets

Other economies have continued the trends they followed in 2015. Brazil remains in a recession, and it faces a serious political crisis with the impending impeachment of its current president. South Africa, too, is facing its own recession and another African National Congress leadership crisis. On a positive note, Indonesia is seeing some improving investment under the leadership of Joko “Jokowi” Widodo. In India, Prime Minister Narendra Modi is getting inflation under control and starting to implement reforms; so far, he has been hampered only by abnormal monsoon

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seasons, caused by El Niño. Japan, on the other hand, has reacted badly to the implementation of NIRP, with an ageing population that currently fears inflation more than getting a return on its investments.

Investment implications

We continue to expect growth globally to remain slow, low and fragile, and we expect many asset markets will be buffeted by volatility – both from within, in terms of the economic and corporate sectors, and from without, especially from the political sphere. On a global scale, investors still have opportunities to find attractive income and capital appreciation potential, but they must be prepared to be active in their stock selection and asset allocation.

GrassrootsSM Research is a division of AllianzGI Research. Data used to generate GrassrootsSM Research recommendations is received from reporters and field force investigators who work as independent contractors for broker-dealers. Those broker dealers supply research to AllianzGI and certain of its affiliates that is paid for by commissions generated by orders executed on behalf of AllianzGI’s clients. Source of all data (unless otherwise stated): Allianz Global Investors as at March 2016. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Allianz Global Investors is a trademark, registered in various countries throughout the world, including the United States. © 2016 Allianz Global Investors. All rights reserved. www.allianzgi.com | AGI-2016-04-27-15205 | 01637