keep the faith - citibank indonesia...keep the faith. demand becomes an engine of growth when...

Keep the Faith

2012 Mid-Year Outlook

CONTENTS

EQUITIESPage 1

FIXED INCOME Page 4

COMMODITIESPage 5

FOREIGN EXCHANGEPage 6

LIVING ON THE EDGE – THE US FISCAL CLIFFPage 7

It is mid-year again and just like last year, we are at a crossroad of directional uncertainty. Fear of more upheavals in Europe where there is a lack of clarity and resolve to solve the fiscal problems, is again highlighting the gravity of issues at hand.

The first half of 2012 was a tale of two quarters. Markets staged a powerful recovery in the first quarter after the sell-off in the latter part of 2011. This was however followed by a pullback in the second quarter as worries about the global economy resurfaced. Sounds familiar? This seems to bear some resemblance to the first half of 2011. So, does this mean that the second half of this year could pan out the same way as the last? Based on the current state of affairs, the picture looks eerily similar…

Thematically, most of our calls performed relatively in line with our expectations. Our overweight stance on fixed income was rewarded and most of the sub-classes posted positive returns. We had opted to focus on selective value plays within the equities space. In developed markets, our call on Germany was positive though we recently removed it as one of our themes given renewed worries about Europe’s ability to contain its fiscal problems. In emerging markets, Hong Kong was one of the better performers while Brazil was held back by an uncertain China outlook. Japan remains attractive on valuations but has failed to break out of its trading range. Our call on Gold was disappointing as the metal did not make much headway.

There seems to be very little optimism out there as we enter the second half of 2012. Recent political events in Europe, along with slowing growth in China appear to have prompted many investors to move to the sidelines. Europe is the predominant concern, especially now that political pressure is growing within to slow the pace of austerity. The current impasse in Greece to form a workable government to implement agreements with foreign creditors, plus evidence that austerity does seem to be solving the fiscal problems, has member states at odds to the German plan towards a fiscal compact. This on the heels of more evidence that the Chinese economy is cooling, has many worried that the global economy could be headed towards a period of lacklustre growth.

What should we do in such an environment? We continue to feel that the overall strategy that we talked about at the beginning of this year remains valid – stay defensive yet look for yield and value. As such, we remain overweight on fixed income with emphasis on Investment Grade, Emerging Market and High-Yield bonds. Within equities, focus should be on value and high dividend plays. We still feel that among the developed markets, Japan remains the cheapest and represents value. Among the emerging markets, Hong Kong is a good play on China reflating its economy in the second half of this year and Brazil on the commodity angle. Overall, commodities have had a difficult year but we remain constructive on Gold which now presents better opportunities after its recent correction. Finally, Hedge Funds should be part of one’s portfolio in these volatile times, and here we again believe Long/Short and Macro strategies should do well.

With the road ahead fraught with uncertainty, we believe it could pay to remain defensive and cautious as we manoeuvre through the rest of 2012. The risk/reward currently remains even and markets are likely to remain range bound but volatile, punctuated by periods of fear and optimism. In such a challenging environment, investors need to maintain a balance approach to their asset allocation and keep the faith in the long term returns.

Haren ShahSenior Investment StrategistInvestment Strategy GroupWealth Management, Asia PacificCiti

Figure 1. MSCI AC World Index – Price vs. Earnings-Per-Share (9 Month Lagged)

80

100

120

140

160

180

200

220

240

260

Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13

MSCI AC World

MSCI AC World Trailing EPS

Bottom up EPS Forecast

Top Down EPS

Forecast

CitiMkt Target

Global equities now suggesting

15% drop in EPS in 2012

Source: MSCI, Citi Investment Research and Analysis. As of May 23, 2012.

Figure 2. Top-down Global Earnings-Per-Share Growth Forecasts

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

2010A 2011E 2012E 2013E 2014E

Non-Financial Revenue Growth

Non-Financial Margin Expansion

Financials EPS Contribution

41.6%

7.1%4.0%

7.8% 9.8%

Source: Citi Investment Research and Analysis, Factset. As of May 23, 2012.

01

EQUITIES

After a strong start to the year, there is an increasing sense of déjà-vu as the rally we experienced in the first quarter looks to have run out of steam. Is this 2011 all over again? One thing is for sure though, the triple threat that equity markets faced last year remain in play. Global equity markets are once again being held hostage by concerns on the sustainability of the US economic recovery, slowing Chinese growth and most importantly, escalating Eurozone strains.

Indeed, the most pressing issue that investors have to deal with is the worsening debt crisis among members of the single currency. After the first inconclusive Greek election, Citi raised the probability of Greece exiting the Eurozone (Grexit) over the next year or two to 50-75% (from “close to 50%” previously). At the time of writing, it is not certain whether Greece will leave the Eurozone or, if it does, when. Moreover, there is huge uncertainty about the extent of post-Grexit contagion and policy responses.

While all eyes are on the Eurozone, let us not forget the other key concerns. China’s growth slowed markedly in 1Q12 and appears to be deteriorating further, to about 7.5% YoY in 2Q12. Citi analysts expect further easing of monetary and credit policies, as well as support from fiscal policy, to produce a rebound later this year. But, the necessary stimulus is not yet in place and so far the policy response has been quite slow. If further easing continues to be delayed, then the slowdown may prove more protracted, and risk spilling over into other economies with high export dependence on China’s economy. Furthermore, uncertainties remain high over the US fiscal outlook for 2013 and beyond. Citi’s base case assumes the US will avoid a fiscal calamity in 2013, but meaningful drag from the public sector (of about 1% of GDP for 2013) is still likely and risks around that are sizeable.

Against this backdrop, we continue to expect major central banks to keep monetary policy loose for an extended period and, in some cases, loosen further. The European Central Bank (ECB) is likely to cut policy rates to 0.5% and resume its multi-year long-term refinancing operations (LTRO) programme. The Bank of England (BoE) is expected to expand its quantitative easing (QE) programme, while further accommodation by the Federal Reserve (Fed) may be forthcoming if serious risks to growth arise and inflation runs well within desired ranges. Rate hikes are only anticipated further down the road – Fed in 2014, BoE in 2015 and ECB in 2016.

Undoubtedly, investors are worried about the European crisis and equity markets have moved to price in a global recession (global earnings-per-share (EPS) contracting by 15% in 2012 as seen in Figure 1). However, Citi analysts believe this is unlikely to happen and instead expect 4.0% EPS growth this year and 7.8% in 2013 (Figure 2).

Having said that, while Citi analysts see potential for more upside from here until year-end, investors should not be anticipating the gains we had during the 2009 rally. Back then, there was both a rerating of stock markets and a recovery in global EPS, both from depressed levels. Currently, valuations are low, but global corporate earnings are not depressed like they were in 2009. Citi analysts as such believe that the trajectory of the stock market is more likely to be similar to the one we had in 2010-11, and are sticking with their end-2012 target of 360 for the MSCI AC World index.

All in, although the prospect of more Eurozone-induced volatility represents a significant challenge in the months ahead, Citi analysts highlight that valuations are already pricing in a lot of bad news. Indeed, global equities were trading on a price-to-book value (PBV) of 1.5x as of 23 May 2012, already at last year’s trough and 30% below the 40-year average of 2.1x. In their view, cheap valuations should help limit the downside. This coupled with the belief that the global economy is not heading into a double-dip recession and expectations for corporate earnings to stay healthy makes us cautious buyers into weakness in the coming months.

2012 Mid-Year Outlook:Keep the Faith

demand becomes an engine of growth when support from rebuilding efforts start to disappear. Against this backdrop, the Bank of Japan may opt to take on additional easing measures, particularly if upward pressures on the yen intensify amid global risk aversion.

Citi’s end-2012 targets of 960 for TOPIX and 11,200 for Nikkei 225 are based on the assumption that a financial crisis is avoided in Europe. With valuations having declined below the November 2011 low, Citi analysts believe Japanese equities could potentially snap back to reflect their fundamentals if proper policy action is taken in Europe. They prefer the high-beta Financial and Consumer Discretionary sectors.

Asia-Pacific ex-JapanCiti analysts think that, with the exception of China, Indonesia, Malaysia and the Philippines, most Asian economies’ growth rates (particularly Korea, Taiwan, India and Singapore) look relatively vulnerable to external growth slowdown risks. GDP growth in the region is thus expected to slow to 6.8% in 2012. But while growth risks are rising, hurdles to monetary easing are high for many countries in Asia as most of them are still showing sequential export expansion, while domestic demand indicators such as labour markets and retail sales remain very resilient, helping explain why core inflation and inflation expectations have been stickier than headline. As such, with the exception of Vietnam, China and India, Citi economists’ base case almost everywhere else is an extended pause in monetary policy.

Citi believes this region may be fundamentally more immune to the euro crisis compared to other emerging markets. However, they think it is vulnerable to any further Eurozone disruptions in some indirect ways. First, withdrawal of liquidity from Asia as a result of a stronger US dollar could have a negative impact on equity markets. Second, any potential reduction in global growth forecasts may cause downward earnings revisions which tend to lead weaker share prices. Nevertheless, it is important to highlight that the region is now trading at 1.5x price-to-book, similar to October 2011 levels. The MSCI Asia ex Japan index has traded higher than 1.5x for 69% of the last 37 years. In other words, it appears a lot of the bad news is already being priced in. Furthermore, from an earnings perspective, the implied earnings growth rate at 0.6% to perpetuity is close to the lows seen in 2003 and 2008. As such, Citi analysts are maintaining their end-2012 forecast of 585 for the MSCI Asia ex Japan index and their preference for the North Asian markets of Hong Kong, Korea and Taiwan.

ChinaThe political economics in a year of leadership transition suggest that the authorities may not like to see a continued economic slowdown into 3Q12, right before the National Party Congress. Indeed, the government’s surprise move to cut interest rates shows its determination to contain downside risk in the economy. Further policy easing may include: (i) two more interest rate cuts this year; (ii) two additional reserve requirement ratio (RRR) cuts this year to bring M2 growth to 14%; (iii) fiscal deficit close to the budgeted level (effectively 2.4% of GDP); (iv) extension of property policy easing from first home purchase to second home purchase, accompanied by adequate funding of social housing programs; and (v) launch of new infrastructure projects under the 12th Five-Year Plan. Against this backdrop, Citi analysts believe above 8% growth is still achievable (though they have lowered their 2012 GDP growth forecast from 8.4% to 8.1%).

USEconomic recovery remains on a modest track and Citi anticipates 2012 GDP growth of 2.1%. Earlier concerns about rising gasoline prices and consumer spending have eased on recent price falls. Housing indicators also continue to transition from deeply depressed levels toward moderate growth. Still, the upside to growth remains checked by financial headwinds and ongoing fiscal drag. Citi continues to expect further Fed accommodation in the outlook but the timing may depend on how the economy reacts to the global vulnerability after the completion of Operation Twist in June. The readiness to act is contingent still on signs of serious risks to growth and, with inflation remaining well within desired ranges, the hurdles for additional QE measures are higher. With growth expected to remain below Fed projections and the threat of major fiscal tightening for 2013, this debate is likely to linger and the Fed is expected to anchor low interest rates for the foreseeable future.

Citi analysts believe that a repeat of 2011’s near-bear market correction is unlikely and stick to their end-2012 targets of 1,425 and 13,550 for the S&P 500 and Dow Jones Industrial Average respectively. Indeed, leading indicators such as supportive credit conditions do not back that view although external global risks could make the ride a volatile one. Moreover, implied earnings growth and relative valuation appear to protect the S&P 500's downside. In terms of sectors, they favour Food & Staples Retailing, Food Beverage & Tobacco, Household & Personal Products, Insurance, Semiconductors & Semi Equipment, Technology Hardware & Equipment, Telecom Services and Utilities.

EuropeWith the probability of Grexit seen at between 50% to 75%, Citi’s base scenario is now that Greece will leave the Euro Area. In order to contain the contagion, the ECB is likely to take further action by providing additional multi-year LTROs and expanding the eligible collateral pool substantially (probably on a country-by-country basis). Citi also expects the ECB to cut rates by 50 bps to 0.5% in 3Q12. With increasing pressure, there is likely to be more integration in the financial sector including a Euro Area wide solution for banks and a resolution fund to back large cross-border financial institutions. However, Grexit will have negative repercussions in the Euro Area, which is likely to move back into recession in 2H12 (2012 GDP growth forecast: -0.6%).

While equity markets appear to be supported by a combination of the liquidity left over from previous LTROs and the hope of further intervention to minimize the contagion of Grexit, Citi analysts believe markets are likely to stay volatile and look for protection of income and capital through dividends that grow. As well as yield and growth, they also look for companies with balance sheet strength. In particular, companies with emerging market exposure are favoured. Sector overweights include Autos, Basic Resources, Chemicals, Food & Beverage, Healthcare, Insurance, Personal & Health Care. Citi’s end-2012 target for the Stoxx Europe 600 index stands at 285.

JapanDespite expectations for a Euro Area recession and global economic slowdown in 2012, Citi now forecast Japanese GDP growth of 2.6% in 2012 (up from 2.0% previously), given that public investment amid rebuilding demand is likely to ensure growth at an above-trend pace of 2% in 2Q12. Thereafter, the focal point of the economy is likely to be on whether external

02 2012 Mid-Year Outlook:Keep the Faith

Equities

Equities


The recent sell-off, triggered by external uncertainties and domestic policy delay, has erased most of gains in the Hang Seng China Enterprises index (HSCEI) while the Shanghai A-share market outperformed in the first half of 2012. But market opportunity lies in the fact that the Chinese authorities have the firepower to stabilize growth, although there are risks on how soon the policy action would turn into growth recovery and the quality of growth. Nevertheless, the H-share market could outperform if the oversold rebound materializes in the near term. Citi analysts thus favour those sectors that were sold-off but with solid valuation and earnings support. In particular, they are overweight Transportation, Insurance, Consumer Discretionary, Capital Goods, Banks, Materials, Health Care and Property. Citi analysts continue to believe the Hang Seng China Enterprises index (HSCEI) could trade within a range of 10,700-12,000, with upside potential to 14,000, while the Shanghai A-share index may range-trade between 2,400 and 2,800, with an upside bias to 3,200.

IndiaThere is now near-consensus that the India story has de-rated, with growth at best likely in the 6% to 7% range during FY13. The unfortunate part is that the problems appear self-inflicted, in Citi’s view, e.g. (1) in-ordinate delays in project approvals and fuel supply issues; and (2) controversies surrounding foreign investment – General Anti-Avoidance Rules (GAAR), Telecom, Gas pricing. The macro focus has also centred on quadruplet deficits (current account, fiscal, governance and liquidity). Although India’s lingering inflation continues to pose a constraint to monetary policy, the odds are in line with Citi’s and consensus expectations of one more rate cut of 25 bps this year on the back of the sharp deceleration in growth.

Citi analysts continue to see moderate upside to the Indian equity market and are maintaining their end-2012 Sensex target of 18,400 and their overweight on the Banks, Autos and Capital Goods sectors. They do however temper their overweight stance a bit on these rate cyclicals given strong year-to-date performance and a more modest interest rate decline outlook.

Central & Eastern Europe, the Middle East and Africa (CEEMEA) Citi analysts have reduced their 2012 GDP growth forecasts for Central & Eastern Europe (CEE) and Middle East and Africa (MEA) to 2.8% and 4.3% respectively, but the big question now is how these countries respond to a deeper sense of crisis in the Eurozone. Since CEEMEA contains the countries which have the emerging market’s largest external financing requirements – Ukraine, Turkey, Poland, Romania, South Africa, for example – sustained risk aversion could leave these countries with more downside risks to growth and more asset price volatility.

Looking forward, there is reason to be cautious on the equity market outlook across CEEMEA. Weaker GDP growth prospects compared with their emerging market peers, higher exposure to the Eurozone, and weaker corporate earnings growth could all weigh on the outlook. Balancing this is valuation: the region remains attractively valued relative to other emerging market regions as well as to its own history, with the dividend yield looking particularly appealing. Key will be commodity price trends and risk appetite towards peripheral European markets. Citi’s preferred market is South Africa thanks largely to its strong and resilient earnings growth outlook. Their end-2012 target for the MSCI EM EMEA index stands at 350.

RussiaThe Russian economy expanded 4.9% YoY in 1Q12, on the back of aggressive pre-election spending which supported strong retail sales through wages. However, strong public spending is unlikely to continue at the pre-election pace of 4Q11 and 1Q12. In Citi’s baseline scenario, consumption growth is likely to moderate to 5-6%, and along with it, GDP could slow down by the year-end and grow by 3.5% in 2012 as a whole.

Citi analysts believe direct exposure of Russia to Europe is limited. If the problems of Europe deteriorate to the extent that they drag down oil prices, then Russia is of course vulnerable as index profits are very closely linked to oil prices. On the contrary, Oil and Gas sectors in Russia tend to be relatively defensive in the event of external shocks as they are cheaper, underowned and beneficiaries of a weaker currency. Having said that, Russian valuations are relatively attractive with the price-to-book value of the MSCI Russia index roughly at 0.7x, just 16% above the trough of March 2009, and the price-to-earnings of the market at approximately 4.3x, just 8% above the trough. Citi analysts have set an end-2012 Russian RTS index target of 1,600.

Latin AmericaThe region is unlikely to be dragged into a recession unless the outlook deteriorates markedly in China. GDP growth is expected to hold up at 3.6% in 2012 and 4.1% in 2013. The mechanism by which Latin America could be hit would be through the sensitivity of commodity prices. The two economies with the most direct exposure to Europe are Brazil and Peru, but even here they send just 18.2% and 17.1% of total exports to the Eurozone respectively. This is equivalent to 1.8% and 3.4% of GDP. Mexico and Colombia are least exposed.

Citi analysts continue to hold a constructive outlook for Latam equities and are sticking to their end-2012 target of 4,900 on the MSCI Latam index. Within the sectors, Mining, Pulp and Paper, Food, and Airlines have some degree of direct European exposure. Financials do not have direct exposure but risks come from select European banks with subsidiaries in Latin America. Within the region, Brazil and Chile appear to be the most attractively valued markets, while Mexico appears the most expensive.

BrazilCiti analysts have maintained their 2012 GDP growth forecast of 3.3%, given signs of domestic demand growth acceleration on the back of fiscal and monetary stimuli. However, the intensification of global turmoil and its consequent impact through trade, credit and confidence, among others, suggests setting downward biases in those estimates. Regarding monetary policy, the dovish message in the last central bank minutes as well as developments related to the savings accounts scheme leads Citi to expect the Selic rate to fall further, potentially reaching 7.75% in August. Currency depreciation is likely to have a limited impact on inflation, given the simultaneous drop in commodity prices. Citi analysts are as such sticking to their 2012 CPI inflation forecast of 5.3%.

Citi analysts are maintaining their contrarian overweight on Brazilian equities, in large part due to compelling valuations and in the face of outright negative investor sentiment towards the market. In terms of sectors, they prefer Financials and Telecoms. Their end-2012 target for the Brazilian Ibovespa index currently stands at 68,000.

04

FIXED INCOME

Central Bank Rates & Domestic Currency Sovereign Bonds

Investment Grade and High-Yield USD Denominated Bonds

With Europe’s continuing sovereign debt concerns and the uncertain path of policy response, the market has been reluctant to take directional bets in the sovereign bond space.

We remain favourably disposed towards better-quality and high value names, on the basis that market weaknesses may provide opportunities to accumulate names that exhibit relatively low refinancing risk and low default probability. Nevertheless, macro concerns and liquidity strains due to funding blockages in the Euro Area financial system are a key concern and could put near-term refinancing dependent bonds under the gun. Such concerns should not be underestimated, particularly when it comes to playing the high-beta sector. Nonetheless, there may still be some advantage in getting into certain good quality oversold names given the high carry available at the risk of some (limited) downside.

Within G10 – Federal Reserve (Fed) officials have focused accommodation efforts on rate guidance but additional asset purchases could be forthcoming if financial conditions deteriorate sharply or improvement in the job market stalls. With economic growth expected to remain below Fed projections and the threat of major fiscal tightening for 2013, the Fed is expected to anchor super-low rates until 2014. In order to contain the contagion from Greece to the rest of the Euro Area, the European Central Bank (ECB) is likely to provide additional multi-year long-term refinancing operations (LTRO) and expand the eligible collateral pool substantially (probably on a country-by-country basis). The ECB may also cut interest rates to 0.50% in 3Q12. With the UK economy back in recession and inflation slowing, the Monetary Policy Committee is likely to expand its quantitative

European and US bond outlook – Pressure from sovereigns and regulatory reform headlines in Europe may weigh on spreads in the near term, but we remain constructive on quality names

Given the situation in Europe, bonds in general have been more resilient than other asset classes in the first half of 2012. Returns were positive in every category except European High-Yield.

With ongoing negative headlines in Europe, especially from Greece, and now Spain, and potentially spreading to Italy, and impacting France and Germany to a smaller extent, we are standing at a crossroads to either a viable and comprehensive solution to this crisis, or lingering uncertainty.

Key headline risks in the near term include uncertainty in the European peripheries with concerns arising from Greece’s potential exit from the Eurozone, likelihood that Spain’s bailout may not just be limited to its banks, high Italian debt levels, France’s ability to reign in its deficits, the need to recapitalize the large European banks in a effective and timely manner and concerns of a sustainable US economic recovery which has recently demonstrated mixed economic data. To a lesser extent, a material slowdown in China could add to global concerns, although we expect the slowdown to be more moderate than material.

We believe the widening in Eurozone periphery spreads can drive volatility in the near term, as has been the case. By the same token, sentiment can change just as rapidly if the ECB and its partners like the International Monetary Fund (IMF) intervene on a massive scale to stem the contagion arising from the likelihood of Greece restructuring/defaulting further, or even exiting the Eurozone. Keeping this in mind, we suggest gradually getting exposure to quality credits in the US and EU corporate space, with selective exposure to the top banks in the senior debt space.


easing programme further. Interest rates are expected to stay at 0.50% until 2015. The Bank of Japan is also expected to retain interest rates at 0.10% until 2015, though it may ease monetary policy further given that inflation is likely to undershoot official forecasts.

Monetary policy is also expected to retain an accommodative stance in the commodity-linked economies of Australia, New Zealand and Canada. Given the ongoing uncertainty about how events will unfold in the Euro Area, Citi analysts now expect one further rate cut by the Reserve Bank of Australia (probably in August at the earliest). The Reserve Bank of New Zealand is likely to maintain rates at current levels given that the economy remains fragile at a time when global developments threaten to slow it further. The Bank of Canada has adopted a hawkish tone, stating that some modest withdrawal of the present considerable degree of monetary policy stimulus may become appropriate. Nonetheless, Citi analysts remain cautious about the outlook as key uncertainties are yet unresolved and maintain their call for current rates to be maintained through year-end.

Within Asian Emerging Market Sovereigns – Given that worries about China growth and Eurozone financial strains have escalated significantly, central banks in Asia are likely to sound more dovish than before, though they are likely to stop short of pre-emptive easing. While growth risks are rising, hurdles to monetary easing remain high for many in Asia. With the exception of Vietnam, China and India, Citi’s base case almost everywhere else is an extended pause in monetary policy.

Asian markets bond outlook – Contagion from European sovereigns could impact spreads near-term but fundamentals stay strong

Asian credit spreads have widened as Europe’s sovereign debt crisis has deteriorated, with growing uncertainty about how EU policymakers will respond. But good quality oversold names may be worth taking a look at, given the high carry on some of these credits, based on their fundamental outlook.

Investment grade bond issuance in Asia picked up in the first quarter of this year primarily with the North Asian names. While they priced at the tight end of the range when issued, we expect some spread widening in the near term based on market weakness.

From an industry perspective, policy is expected to remain a near-term overhang for China’s property sector. We are starting to see the weaker names experience business and liquidity pressure, followed by negative ratings impact. This may deter real money from buying aggressively, though we remain selectively positive on the sector as the financial profiles of the top tier property developers remain relatively healthy.

Away from the Chinese property names, there have been a slew of Chinese industrial sector names, including some State-Owned Enterprises (SOEs) that have issued USD bonds in Asia, both in terms of dated bonds as well as corporate perpetuals, offering an opportunity to diversify out of the property sector in China. However, corporate governance issues in this space with respect to certain names has caused the entire sector’s spread to widen, giving opportunity to look at the better quality credits.

In general, we continue to favour good quality bonds in the region in order to posture ourselves in a defensive manner, and especially those that offer good carry. We prefer scaling in on market weakness.

Three major tail risks remain in play as we head into the second half of the year – 1) a potential meltdown in the Eurozone; 2) risk of a double-dip in the US economy; and 3) a hard landing in China. Fundamentally, commodities appear to be in an either/or market whereby policy responses – or lack there of – could drive the market higher or lower, in conjunction with any meaningful shift in the macro environment. Developments in Europe lack a blueprint and the potential knock-on impact on global growth calls for commodity markets to stay volatile. Yet the potential for further stimulus in the US and China to support growth could potentially stabilize and spur commodity markets higher in 2H12. On balance, Citi analysts hold a more constructive outlook for commodities, especially energy and precious metals, in 2H12.

ENERGY: A weak macro backdrop and the potential for a further increase in Saudi production add a bearish tinge to the outlook for crude oil prices. Citi analysts however believe crude oil prices may be due for a bounce as demand typically rises in the summer months and as the EU embargo on Iran (effective July 1) lend some support. Moreover, a myriad of supply tail risks are still prevalent across the Organization of the Petroleum Exporting Countries (OPEC) – Iran, Iraq, Venezuela and Libya in particular. Citi analysts forecast WTI prices to average US$95/bbl in 2012 and Brent prices to average US$115/bbl in 2012.

Citi analysts see potential for US natural gas prices to average US$2.4/MMBtu in 2012 though they acknowledge downside risks posed by the combination of high gas and coal inventories. Three factors may however support prices around mid-US$2/MMBtu: (1) the continued decline of the inventory surplus versus last year creates the perception that current prices could work off the excess gas necessary to avoid storage congestion; (2) a hot summer could still make a difference in boosting demand, where a repeat of the 2010 or 2011 summer could reduce inventory by around 150-Bcf versus the 10-year average; and (3) spark spreads (profit margins of gas-fired power plants) typically attain their highest point during the summer, and strong profit margins provide attractive incentives for gas units to buy gas and generate.

BASE METALS: Base metals remain challenged given the current macroeconomic climate. Accounting for close to 40% of total base metals consumption, Chinese demand is expected to be the key price catalyst with local stimulus policies potentially providing for positive price momentum in 2H12. An improvement in the global macro environment may lend further support.

Copper – Prices may average US$8,491/t in 2012. Demand has been sluggish in 1Q12, largely due to slower Chinese demand, but this situation is likely to improve in 2H12, with an expectation of a modest relaxation of controls impacting property markets, while new auto markets stimulus could help improve domestic production rates after a sluggish 1H12.

Aluminium – Whilst China is likely to remain balanced in terms of supply/demand, the continued tightness in metal availability in the West is expected to support prices. Prices could average US$2,279/t in 2012.

Nickel – The market is expected to move from a small annual deficit in 2011 to a modest surplus in 2012. Nickel prices are expected to average US$19,430/t for 2012.

Zinc – Citi analysts see potential for prices to pick-up through 2H12 in line with the expectation of recovering Chinese construction activity as the government releases the sector from its 2011 imposed clampdown. Prices could average US$2,121/t in 2012.

PRECIOUS METALS: Gold prices could remain supported given low real interest rates and continued financial interest from central banks and private investors. However, price action may be volatile as markets are caught between changing inflation and monetary policy expectations, political turnover and sudden demand for liquidity. Mine supply is expected to grow from 2,811 mt in 2011 to 2,902 mt in 2012 as new mines and expansions are largely offset by the closure of ageing mines. Scrap supply is also expected to pick up on rising gold prices into 2013 and therefore total gold supply (mines + scrap) may rise substantially year-on-year from 2011 to 2012. Citi analysts forecast gold prices to average US$1,720/oz in 2012.

The silver market is expected to remain well supplied, with production likely to be boosted by several key projects such as Pascua-Lama, Concheno and Pueblo Viejo. Industrial demand is likely to grow at a subdued pace of 1.9% in 2012, a far cry from the growth rates in excess of 10%, seen during the pre-crisis boom years. Photographic demand is expected to stay tepid as it maintains a decline, while momentum in the middle income luxury-goods cycle may result in jewellery demand growth of 2.4% in 2012. After 156.8m oz of investment demand in 2011, it is estimated that 187.1m oz of demand may be needed in 2012 to balance the market, a level that may be difficult to attain. Citi analysts forecast silver prices to average US$30.60/oz in 2012.

BULK COMMODITIES: The thermal coal market remains pressured on all sides, with Indonesian production and exports running high, inventories bulging and Chinese buyers more price sensitive than they were in the past. Power demand in Europe is weakened by ongoing Eurozone woes, mild weather and competition from renewables. In the US, a collapse in US natural gas prices has resulted in about 6 Bcf/d of coal-to-gas switching which has swelled both inventories and exports of thermal coal. Demand appears marginally better in the Pacific Basin. Japan is nuclear-free as of early May, and some damaged coal-fired generating capacity is due back online in 2H12. China is also in the process of restocking for the summer, and in South Korea, a power failure at the country’s oldest power plant is fuelling anti-nuclear sentiment which could potentially boost demand for thermal coal. Citi analysts forecast thermal coal prices to average US$119/MT in 2012.

AGRICULTURE: The United States Department of Agriculture (USDA) forecast that US feed grain supplies for 2012/13 may rise 16% year-on-year to a record 416.3-m tons. Corn production in the US is expected to rise to 375.7-m tons, an almost 17% year-on-year rise. Both record planted acres and ‘return-to-trend’ yields of 166-bu/acre contribute to the USDA’s bearish assessment. Citi forecast corn prices to average US$6.28/bu in 2012.

The 2012/13 outlook for wheat is mixed and Citi analysts continue to expect prices to average US$6.38/bu even though the USDA expects lower prices ahead with both supplies and use in the US expected to make gains. Old and new crop ending stocks were lower than market expectations in May and wheat use for 2012/13 is projected to rise nearly 10% year-on-year driven by higher food and exports. Global wheat supplies for 2012/13 are projected to be 2% lower on the year by the USDA, as a 23.8-mt reduction in foreign production offsets the increase in US output.

Despite higher soybean production in the US and 2012/13 global oilseed production projected at a record 471.5-mt, Citi analysts believe summer prices for soybean could potentially spike above US$15/bu as inventories remain tight and the production outlook could still falter. Chinese buying also continue to be supportive of US export markets on the back of dismal South American output. Stockpiling is expected to continue into this summer with the USDA increasing its China import number more in line with Citi’s view from 55-mt to 56-mt. Citi analysts forecast soybean prices to average US$1.369/bu in 2012.

05

COMMODITIES


06

FOREIGN EXCHANGE


The rising prospects for a Greek exit from the Eurozone (Citi’s base case with a 50-75% probability) and concerns about the policy gridlock surrounding bank recapitalization in the Eurozone is likely to continue to weigh on EUR and the risk currencies (AUD and NZD) over the rest of this year.

And while it is entirely possible that a potential Greek exit may ultimately be containable in the sense that no other countries are forced to exit the European Monetary Union (EMU) and the European banking system continues to function albeit under much greater stress, the unavoidable strains on EMU sovereigns in the form of poor credit availability and the resultant economic weakness potentially leading to a prolonged recession in the Eurozone, are likely to see markets biased towards selling EUR on any short covering rallies.

Under such a scenario, demand for USD is likely to remain high across the board with EUR/USD likely falling towards 1.20 and AUD/USD below 0.95. We are likely to see a similar move against GBP and CHF (currencies closely correlated with EUR).

Within the commodity bloc (AUD, NZD and CAD), CAD is likely to be more resilient to further gains in USD, protected by a relatively strong banking system, healthy external surpluses and a modestly hawkish Bank of Canada (BoC). Indeed, many analysts (including Citi) see the BoC as one of the first within the G10 to raise interest rates when markets stabilize.

Within the euro bloc, it is GBP that is likely to outperform both EUR and (the pegged) CHF even if the Bank of England decides to deliver more quantitative easing. GBP’s outperformance is linked to the sheer magnitude of the flows out of EUR, the magnitude of which will likely only increase should the euro crisis deepen further.

For the commodity linked (AUD and NZD) and Asian emerging market (EM) currencies, China’s economic growth slowdown and what this means for USD/CNY is an added factor that is likely to weigh on sentiment. China’s economic growth slowed markedly in 1Q12 and appears to be slowing further – to about 7.5% YoY in 2Q12. The slowdown so far has been well flagged but more recent data has added downside risks to the outlook.

The China slowdown will directly feed into the outlook for USD/CNY. Citi’s forecasts have USD/CNY flat lining around current spot at 6.33 in the next three months and 6.21 over the next 6-12 months. Risks though are titled towards a weaker and more volatile CNY in the very near term in a risk off, strong USD setting.

With CNY likely to be under pressure, most Asia EM and commodity linked currencies (AUD and NZD) are also likely to remain under pressure. IDR and INR in particular may be most vulnerable within the Asia EM sphere due to their widening current account deficits and monetary policy constraints, while SGD could comparatively be the most resilient given the Monetary Authority of Singapore’s (MAS’s) focus on inflation risks and tightening bias.

The outlook for the US economy and prospects for further quantitative easing by the Federal Reserve (Fed) is the third factor that is likely to influence FX sentiment. Currently, the US recovery is on a modest expansion track and that has made Fed officials reluctant to extend further monetary stimulus beyond Operations Twist that ends in June.

Their position may well change if financial conditions deteriorate sharply in the US or improvement in the job market stalls. This though seems unlikely in the near term and the end of Operation Twist (with no replacement) is likely to provide further support to USD across the board including against JPY where the Bank of Japan remains under greater political pressure to add further stimulus/intervention (as it did earlier in the year). As a result, the 78 level on USD/JPY represents what is likely to be a very difficult level to breach.

0

200

400

600

800

1000

1200

1400

1600B

09 11 13 15 17 19 21

0

2

4

6

8

10

12

Billions (Left) Percent of GDP (Right)

Fiscal deficit projected to fall by US$607 Billion (4% of GDP)

Source: Congressional Budget Office. As of May 25, 2012.

LIVING ON THE EDGE – THE US FISCAL CLIFF

Attention has been squarely focused on the state of Europe’s fiscal affairs, but the US’ own fiscal situation is likely to come back in the spotlight in the lead up to the Presidential elections in November. Economic recovery in the US has continued to advance at a modest 2% pace despite headwinds emanating from Europe, with resilience seen in consumer spending and improvements in the housing sector and labour market. But with large government spending cuts due to take effect in 2013, risks run high that the US could slip back into recession.

As most would recall, the US government breached its borrowing limit in August last year and after much political wrangling, the Democrats and Republicans reached a deal to raise the debt ceiling and averted a default. The Budget Control Act of 2011 (BCA) which became law on August 2 2011, allowed the debt ceiling to be increased by up to US$2.8 trillion and also included provisions to reduce the fiscal deficit by US$2.3 trillion over 10 years through caps on discretionary spending and recommendations of the Super Committee. The Super Committee however failed to submit a proposal to reduce the deficit by the required US$1.2 trillion in November, and as a result, automatic across-the-board spending cuts of US$1.2 trillion which are to be implemented from 2013-2021 were triggered.

The question now is whether the still fragile US economic recovery will come to a grinding stop, especially considering that in addition to the scheduled cuts in spending imposed by the Budget Control Act, previously extended Bush era tax cuts and unemployment benefits are also due to expire in 2013.

According to the Congressional Budget Office (CBO), the US government faces a fiscal cliff where the budget deficit is due to fall by US$607 billion between fiscal year 2012 and 2013, or roughly 4% of GDP, if all the scheduled tax increases and spending cuts are implemented.

The Fiscal Cliff: Congressional Budget Office Deficit Projections Based on Current Law, Fiscal Year 2009-2022

Estimated economic impact and policy options

Citi analysts estimate that the impact of these changes could reduce US GDP growth over the course of 2013 by about four percentage points relative to the underlying path. Although economic expansion is expected to pick up steam in 2013 as earlier drags fade, this kind of shock is likely to bring the recovery process to a halt. The effect on activity may be especially severe in the first half of the year, with declines in GDP estimated at annual rates of -2% to -3%, followed by a gradual pickup in the second half. Congressional Budget Office economists tell a broadly similar story but from a much stronger baseline view of recovery with a first half decline of -1.3% in GDP, followed by a +2.3% advance, netting to 4Q/4Q growth of +0.5% versus Citi’s estimates of a small decline.

Policymakers do however have the option to implement all or none of the scheduled changes, or choose to head off parts of the scheduled spending cuts or extend certain policies for a limited period. Of the two extreme policy options, Citi analysts are more concerned about allowing the full brunt of spending cuts that could unleash severe second round effects that are difficult to anticipate. They caution that monetary policy may not be able to effectively buffer a large-scale fiscal shock, and an already serious long-term unemployment problem could morph into a more significant structural challenge, while a very tentative housing recovery may be set back by significant negative feedback effects on credit quality and financial stress. Additionally, policymakers need to weigh the uncertain feedback effects of another US recession on an already vulnerable global financial system.


LIVING ON THE EDGE – THE US FISCAL CLIFF

08 2012 Mid-Year Outlook:Keep the Faith

Moreover, with a package composed almost entirely of tax increases and discretionary spending cuts, the long-term challenge of reforming middle class entitlements (retirement and health care programs) which are at the core of rising debt projections would be left untouched. That leaves some important questions about the net benefits of taking the economy down in the short run.

Citi analysts currently forecast US GDP growth of 2.1% in both 2012 and 2013. Their base case assumes that most of the major tax changes would be deferred, while the scheduled end to payroll tax relief, extended unemployment benefits and new health care taxes would go through. The scheduled cuts in spending imposed by the Budget Control Act are expected to be partially supplanted by alternative cuts which are stretched out.

Impact on growth may be seen as early as 2H12

In late February 2012, Congress passed a law authorizing that the Extended Unemployment Benefits and Emergency Unemployment Compensation programs be funded through the end of 2012. However, the recent decline in the unemployment rate, along with changing criteria for benefits, is triggering a much earlier effective end to parts of these programs in most states. Citi analysts believe we are likely to see the direct effects of these programs phasing out this year in two places: a drop-off in unemployment beneficiaries in the weekly initial claims report, and a decline in transfer income growth.

While the unemployment benefit programs represent only a small component of the prospective fiscal shock, Citi analysts deem them to be important to the outlook for the following reasons. First, unlike most other provisions of the fiscal cliff, the ending of these programs will not be averted or delayed. Second, the impact on growth may become evident this year rather than at the beginning of next year. Currently, these two extended unemployment benefits programs cost about US$50 billion annually. Citi analysts estimate that the end of these programs could subtract about one-quarter percentage point from GDP growth over the next year, with about half of this drag likely occurring this year and the rest hitting at the start of 2013.

Policy uncertainty to hang over the outlook

The threat of policy missteps continues to cloud the outlook. Risks remain that the tax and spending changes will be adjusted only after a confidence sapping showdown, perhaps akin to the 2011 debt ceiling debate, though repeat exposure could limit shock value. Citi analysts see a high chance for anxiety about US policy to build late in 2012, but not likely in the period well ahead of the US election given that concerns about policy mistakes have historically shown through sharply in confidence and spending data only very close to the actual or potential events.

Moreover, since Citi analysts first ran estimates of the impact of the scheduled restraint, one significant change has been the expected timing of the breach of the public debt limit. The Administration’s own financing projections had anticipated borrowing needs of US$1.45 trillion for fiscal year 2012, which would be consistent with hitting the limit by the Presidential election. But with market borrowing needs for the year now estimated around US$1.16 trillion courtesy of continued modest declines in the deficit, the limit is unlikely to be reached until a few months into 2013. As a result, it is unlikely to be a lever for addressing the threatened cliff effect.

It is however important to keep in mind that the US faces the risk of a further credit ratings downgrade if they fail to act adequately to address their escalating fiscal liabilities. With policymakers at odds over the tax component of the deficit reduction plan, common ground still needs to be found. Admittedly, the US is in better shape than the more constrained European countries that cannot print their own money. But there is general consensus that America needs to address its long-term liabilities and this could go a long way in making investors feel more comfortable about the country’s long-term economic and earnings prospects.

2011

Current 3Q12 4Q12 1Q13 2Q13

Exchange Rate Forecasts (vs. USD)

Source: Forecasts from Citi Investment Research and Analysis, as of May 23, 2012.

Source: Forecasts from Citi Investment Research and Analysis, as of May 23, 2012.

Source: Forecasts from Citi Investment Research and Analysis, as of May 23, 2012. Current rates as of June 11, 2012.

Economic Growth & Inflation Forecasts

GDP Inflation

Interest Rate Forecasts

2012F

3Q12 4Q12 1Q13 2Q13

2013F 2011 2012F 2013F

Global 3.0% 2.7% 2.9% 3.7% 3.0% 2.9%

US 1.7% 2.1% 2.1% 2.5% 1.9% 1.7%

Europe 1.5% -0.6% -0.7% 2.7% 2.5% 1.8%

Japan -0.7% 2.6% 1.5% -0.3% 0.4% 0.0%

Latin America 3.9% 3.6% 4.1% 6.8% 6.0% 6.3%

Emerging Europe 5.0% 2.8% 3.7% 6.7% 5.5% 5.8%

Middle East & North Africa 6.0% 4.3% 5.2% 5.6% 6.0% 6.0%

Asia 7.2% 6.8% 7.3% 5.7% 4.1% 4.0%

China 9.2% 8.1% 8.5% 5.4% 3.5% 3.5%

Hong Kong 5.0% 2.6% 4.2% 5.3% 4.0% 3.0%

India 6.9% 7.0% 7.5% 9.0% 7.0% 6.5%

Indonesia 6.5% 6.2% 6.5% 5.4% 4.4% 4.7%

Malaysia 5.1% 5.0% 5.3% 3.2% 2.3% 3.1%

Philippines 3.7% 4.6% 5.0% 4.8% 3.5% 4.0%

Singapore 4.9% 3.6% 5.0% 5.2% 4.4% 3.3%

South Korea 3.6% 3.4% 4.2% 4.0% 3.0% 3.2%

Taiwan 4.0% 3.3% 4.2% 1.4% 1.9% 2.1%

Thailand 0.1% 4.7% 5.0% 3.8% 2.9% 3.3%

Europe 1.23 1.24 1.25 1.26

Japan 80 80 80 81

UK 1.58 1.58 1.58 1.59

Australia 0.93 0.94 0.95 0.94

China 6.31 6.27 6.23 6.20

Hong Kong 7.75 7.75 7.76 7.76

India 54.2 54.5 54.8 54.5

Indonesia 9316 9349 9382 9394

Malaysia 3.12 3.08 3.03 3.00

Philippines 42.8 42.5 42.2 41.9

Singapore 1.26 1.25 1.24 1.23

South Korea 1170 1156 1142 1117

Taiwan 30.1 29.6 29.1 28.7

Thailand 31.7 31.1 30.5 30.2

US 0.25% 0.25% 0.25% 0.25% 0.25%

Europe 1.00% 0.50% 0.50% 0.50% 0.50%

Japan 0.10% 0.10% 0.10% 0.10% 0.10%

Australia 3.50% 3.25% 3.25% 3.25% 3.25%

UK 0.50% 0.50% 0.50% 0.50% 0.50%

Country Specific Disclosures:Australia: This document is distributed in Australia by Citigroup Pty Limited ABN 88 004 325 080, AFSL 238098.

For a full explanation of the risks of investing in any investment, please ensure that you fully read and understand the relevant Product Disclosure Statement prior to investing.

Hong Kong: This document is distributed in Hong Kong by Citibank (Hong Kong) Limited ("CHKL"). Prices and availability of financial instruments can be subject to change without notice. Certain high-volatility investments can be subject to sudden and large falls in value that could equal the amount invested.

India: This document is distributed in India by Citibank N.A. Investment are subject to market risk including that of loss of principal amounts invested. Products so distributed are not obligations of, or guaranteed by, Citibank and are not bank deposits. Past performance does not guarantee future performance. Investment products cannot be offered to US and Canada Persons. Investors are advised to read and understand the Offer Documents carefully before investing.

Indonesia: This report is made available in Indonesia through Citibank, N.A. Indonesia Branch, Citibank Tower Lt 7, Jend. Sudirman Kav 54-55, Jakarta. Citibank, N.A. Indonesia Branch is regulated by the Bank of Indonesia.

Korea: This document is distributed in South Korea by Citibank Korea Inc. Investors should be aware that investment products are not guaranteed by the Korea Deposit Insurance Corporation and are subject to investment risk including the possible loss of the principal amount invested. Investment products are not available to US persons.

Malaysia: This document is distributed in Malaysia by Citibank Berhad.

People's Republic This document is distributed by Citibank (China) Co., Ltd in the People's Republic of China (excluding theof China: Special Administrative Regions of Hong Kong and Macau, and Taiwan).

Philippines: This document is made available in Philippines by Citicorp Financial Services and Insurance Brokerage Phils. Inc, Citibank N.A. Philippines, and/or Citibank Savings Inc. Investors should be aware that Investment products are not insured by the Philippine Deposit Insurance Corporation or Federal Deposit Insurance Corporation or any other government entity.

Singapore: The information in this report has been sourced from Citigroup Global Markets Inc. ("CGMI") which is a member of FINRA and registered with the US Securities and Exchange Commission. This report is distributed in Singapore by Citibank Singapore Ltd ("CSL"). CSL provides no independent research or analysis of the substance or in preparation of this report. Investment products are not insured under the provisions of the Deposit Insurance and Policy Owners’ Protection Schemes Act 2011 of Singapore and are not eligible for deposit insurance coverage under the Deposit Insurance Scheme. CSL accepts legal responsibility for the content of this report. Please contact your CSL Relationship Manager if you have any queries on or any matters arising from or in connection with this report.

Thailand: This document is distributed in Thailand by Citibank N.A. and made available in English language only. Investment contains certain risk, please study prospectus before investing. Not an obligation of, or guaranteed by, Citibank. Not bank deposits. Subject to investment risks, including possible loss of the principal amount invested. Subject to price fluctuation. Past performance does not guarantee future performance. Not offered to US persons.

United Kingdom: This document is distributed in U.K. by Citibank International plc., it is registered in England with number 1088249. Registered office: Citigroup Centre, Canada Square, London E14 5LB. Authorised and regulated by the Financial Services Authority.

Disclaimer “Citi analysts” refers to investment professionals within Citi Investment Research and Analysis (“CIRA”), Citi Global Markets Inc. (“CGMI”) and voting members of the Citi Global Investment Committee.

Citibank N.A. and its affiliates / subsidiaries provide no independent research or analysis in the substance or preparation of this document. The information in this document has been obtained from reports issued by CGMI. Such information is based on sources CGMI believes to be reliable. CGMI, however, does not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute CGMI's judgment as of the date of the report and are subject to change without notice. This document is for general information purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or currency. No part of this document may be reproduced in any manner without the written consent of Citibank N.A. Information in this document has been prepared without taking account of the objectives, financial situation, or needs of any particular investor. Any person considering an investment should consider the appropriateness of the investment having regard to their objectives, financial situation, or needs, and should seek independent advice on the suitability or otherwise of a particular investment. Investments are not deposits, are not obligations of, or guaranteed or insured by Citibank N.A., Citigroup Inc., or any of their affiliates or subsidiaries, or by any local government or insurance agency, and are subject to investment risk, including the possible loss of the principal amount invested. Investors investing in funds denominated in non-local currency should be aware of the risk of exchange rate fluctuations that may cause a loss of principal. Past performance is not indicative of future performance, prices can go up or down. Some investment products (including mutual funds) are not available to US persons and may not be available in all jurisdictions. Investors should be aware that it is his/her responsibility to seek legal and/or tax advice regarding the legal and tax consequences of his/her investment transactions. If an investor changes residence, citizenship, nationality, or place of work, it is his/her responsibility to understand how his/her investment transactions are affected by such change and comply with all applicable laws and regulations as and when such becomes applicable. Citibank does not provide legal and/or tax advice and is not responsible for advising an investor on the laws pertaining to his/her transaction.