A world of higher yields Prepare for take off

Please refer to important information at the end of the reportGLOBAL MARKETS - CORPORATE & INSTITUTIONAL BANKINGROBERT MCADIE - GLOBAL MARKETS HEAD OF RESEARCH AND STRATEGYDECEMBER 2016 - BNP PARIBAS LONDON BRANCHGLOBAL MARKETS STRATEGY OUTLOOKA world of higher yieldsPrepare for take off CONTENTS78123456GLOBAL MARKET OVERVIEW 3TRADE RECOMMENDATIONS7G10 RATES11G10 FX20EMERGING MARKETS28EQUITIES35CREDIT41COMMODITIES452 GLOBAL MARKET OVERVIEW1Robert McAdieGlobal Markets Head of Research and Strategy3 Global market themes for 2017Global markets head into 2017 with an elevated level of uncertainty,whichwe see as having been created by:1.Shifting global political agendas, with a new policy direction in the US, achange of leadership in China, the start of the UK’s negotiations to leave theEU and elections in the major eurozone economies.2.Changes in major central bank policy: The Fed raising rates and the ECBtapering its quantitative easing programme. China’s foreign currency reservesto decline.3.Macroeconomic uncertainty, as Trump’s policies impact on trade, and USfiscal stimulus boosts GDP at a time when the labour market appears to be atfull capacity. Furthermore, 2017 could be the year for fiscal stimulus with thepotential for expansionary fiscal programmes in Japan, UK and Europe.Volatility is on the rise, but in our view this means opportunities for the diligent,disciplined and prepared investor.As such our key themes for the start of 2017are:Theme 1: Global yields to rise along with uncertainty, causing the unwind of the global carry tradeThe search for yield environment, fuelled by global central bank liquidity, thatdominated markets for most of 2016 is coming to an end. We expect global yieldsto continue to rise (both nominal and real), driven by the US. With higher rates inthe major bond markets, the relative attractiveness of equities and credit willcontinue to fade, especially with equity valuations appearing stretched and creditspreads so narrow.In our view the improvement from strong US growth will not be enough to offsetthe impact of higher yields, especially in European and EM assets. So far, therisky correction has been relatively muted (Table 1), but as real yields rise andpolitical risk increases, we expect a more marked correction in risky asset classesoverall. A move in USD real yields up to and beyond 50bp will consolidate abroader risk-off shift.4Table 1: Risky assets have further to fall in 2017Source: BNP ParibasChart 1: Rising real yields mark the end of ‘hunt for yield’ Source: BNP Paribas Global market themes for 2017Theme 2: Dispersion to rise across sectors and marketsAcross and within asset classes we expect dispersion to rise as thedependency on central bank liquidity weakens, political risk factors rise,rates rise and the macroeconomic outlook adjusts to a world of higherinflation. Dispersion will rise and correlation will fall as the focus oncarry shifts to fundamentals. For example, Chart 2 shows the recentsharp decline in the correlation across the S&P sectors.Even commodity prices, which in the past have been very highlycorrelated, have dispersed in recent months, driven by the expectedinfrastructure spending programmes of the US and China. As a result,investors will have to conduct deeper analysis in 2017 when makinginvestment decisions especially in equities, commodities and credit.Name, asset and sector selection will be key.Theme 3: Higher rates to impact US and eurozone assets differently: eurozone risk premium is risingRates are rising in the US because of higher growth and inflation, but inEurope rates are rising because of higher yields elsewhere and risingsovereign credit risk.The divergence of fundamentals is likely be seen most in creditmarkets, where US companies will be able to withstand higher yieldswithout a marked impact on credit metrics. In Europe, earnings growthwill be softer and corporates more sensitive to rising yields. Moreover,heightened political risk in Europe, coupled with potential tapering ofasset purchases by the ECB will push up peripheral and semi-core riskpremia. This in turn will put further pressure on European banks andpressure on peripheral stocks and credits.5Chart 2: Correlation between equity sectors is decliningSource: BNP ParibasChart 3: Rising eurozone risk premia to weigh on financialsSource: BNP Paribas6080100120140Nov-15Feb-16May-16Aug-16Fin CDSFR, IT and Sp 10y spread vs Germany Global market themes for 2017Theme 4: US headwinds for emerging markets - tight USD liquidityHigher US real rates and a stronger broad trade weighted USD will lower USDliquidity globally, which in turn will tighten EM financial conditions. As such EMwill struggle in 2017. The low yielding Asian currencies (SGD, TWD and KRW)appear particularly at risk in response to