IIF Weekly Insight

SUNNY MARKETS, DESPITE GEOPOLITICS

iif.com Copyright 2014. The Institute of International Finance, Inc. All rights reserved.
JULY 24, 2014
1.1
1. Global equities supported by strong U.S. earnings re-
ports: This has been another week in which markets
shrugged off bad news on the geopolitical front. U.S. equi-
ties in particular have been buoyed by a strong start to the
Q2 earnings season, unfazed at present by geopolitical ten-
sions or concern about valuations. Indeed, U.S. earnings
have been solid, with some 70% of companies reporting to
date surprising on the positive side. Better-than-expected
earnings from tech giant Apple and enthusiasm about Face-
books mobile ad initiative have helped propel key equity
benchmarks to new highs, with the S&P 500 up over 7.5%
year-to-date. A reality check against 2000-2014 average
forward price-to-earnings ratios (Chart 1.1) suggests that
neither large-caps (S&P 500) nor the even better-performing
small-caps (Russell 2000) are overvalued by this metric: both
indices are hovering around average forward P/E levels.
Good news from the U.S. has contributed to positive senti-
ment more broadly across global equities, with even Japan
and Chinawhich have lagged other major markets this
yearseeing solid gains in recent weeks. Economic data
this week have provided a further boost, with the Chinese
PMI touching an 18-month high in July, while Euro Area
composite PMIs also moved up this month (see below).
The risk-on/risk-off pattern of the past fve years appears to
be shifting, with asset classes that have moved together
now seemingly breaking with trend. In recent weeks, the
U.S. dollar index has moved highertogether with U.S. eq-
uitieshelping push the euro to an 8-month low. In the high
yield space, the HYG ETF has decoupled recently from the
S&P 500 (Chart 1.2). This move lower in high-yield bond
prices is also refected in weaker fows to high-yield mutual
bond funds (a total of $6 billion in Q2, down from $14 bil-
lion in Q1) and a decline in issuance. While this may appear
surprising given the ongoing hunt for yield, infows have
compressed yields to a point where these no longer com-
pensate investors for default risk, triggering asset rotation.
Case in pointChart 1.3 depicts the cumulative perfor-
mance of the JP Morgan emerging markets bond ETF
against an equal-weighted portfolio of the three most popu-
lar high-yield ETFs: since the taper tantrum cooled off late
Global equities supported by strong U.S. earnings reports
Divergence in risk-on assets: high-yield sector falters
Flash PMIs--overall, a positive glimpse into Q3
Increased activity in the auto loan ABS market
Markets remain short euro; many EM currencies rally

1.2
1.3
Source: Bloomberg, IIF
Source: Bloomberg, IIF
Source: Bloomberg, IIF. High Yield Portfolio = equal weighted HYG, JNK, HIS.
6
8
10
12
14
16
18
20
22
24
2009 2010 2011 2012 2013 2014
S&P 500 S&P 500 Avg
Russell 2000 Russell 2000 Avg
S&P 500 and Russell 2000 Valuations
forward price earnings ratio
89
90
91
92
93
94
95
96
160
165
170
175
180
185
190
195
200
205
Jul 13 Oct 13 Jan 14 Apr 14 Jul 14
S&P 500 ETF
High Yield ETF (rhs)
S&P 500 Spider ETF versus High Yield ETF
ETF, price index, HYG
-18
-16
-14
-12
-10
-8
-6
-4
-2
0
2
4
Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14
High-yield portfolio
JPM EM bonds ETF
Portfolio of High Yield ETFs vs Emerging Markets Bond ETF
bps
IIF WEEKLY INSIGHT | July 24, 2014 page 2
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summer last year, the EM ETF has outperformed the high-
yield ETF basket.
2. Flash PMIsoverall, a positive glimpse into Q3: The
Markit flash manufacturing PMIs for July give support to the
view that the second half of the year should see global
growth accelerating, albeit with some nuances across re-
gions (For our current views see the July Global Economic
Monitor and our latest Chartbook). The increase in Chinas
PMI (HSBC measure) to 52 in July, a strong rebound from
Junes level of 50.8, is noteworthy (Chart 2.1). The PMI now
stands at its highest level since January 2013 and above the
official NBS PMI (which stood at 51 in June). The strength of
the PMI is in line with our projection of stronger growth in
the Chinese economy in Q3 (we forecast 9.1% q/q, saar af-
ter 8.2% in Q2), in response to policy stimulus.
While the U.S. Markit PMI fell 1 point to 56.3, it has re-
mained at elevated levels since the spring. Taken together
with the other data we track, we are optimistic that next
weeks Q2 GDP release (Thursday) will show a solid rebound
from the exceptionally weak first quarter (we project quar-
terly growth of 2.8%, saar, after 2.9% in Q1).
The latest PMI numbers for Japan suggest that a second
half rebound in activity after the VAT hike in April still re-
mains an uncertain prospect. In July, the manufacturing PMI
printed 50.8, a slight fall from June (Chart 2.2). Over the
past few months, the indicator showed some rebound from
its April trough, but the July PMI level is still somewhat be-
low the 2013 average of 51.8. Viewed optimistically, the
economy has recovered to close to its underlying growth
trend pre-VAT hike, but it seems too soon to suggest that
Japan is yet out of the post-VAT hike woods.
Finally, the manufacturing PMI in the Euro Area remained
broadly stable at 51.9, but the split between Germany (up
0.9 to 52.9) and France (down 0.6 to 47.6) has widened fur-
ther. The main positive news in July was a strong rise in the
Euro Area services PMI to its highest level in 3 years. While
we tend to focus more on the manufacturing measure,
which has proven to be more strongly correlated with GDP
over the more recent past (see Euro Area: Tracking Growth
with PMIs, June 2013), the rise in the composite PMI is at
least supportive of our general view that growth in the Euro
Area will pick up to around 1.5% q/q, saar in H2 (Chart 2.3).



Flash PMIsoverall, a positive glimpse into Q3
Source: Markit Economics, National Sources, IIF.
Source: Markit Economics, Haver Analytics.
Source: Markit Economics.
2.1
2.2
2.3
46
48
50
52
54
56
58
60
Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14
US Markit US ISM
China HSBC China NBS
Manufacturing PMI in G2
index, breakeven=50, dots represent July flash estimates
46
48
50
52
54
56
58
Oct 13 Jan 14 Apr 14 Jul 14
2013 Average
Japan Manufacturing PMI
index, 50=breakeven; July data is flash estimate
VAT Hike
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
42
44
46
48
50
52
54
56
58
60
2010 2011 2012 2013 2014
Manufacturing PMI
Real GDP (rhs)
Euro Area: Manufacturing PMIs and Real GDP
index, 50=breakeven; %q/q, saar
IIF Forecast
July Flash
Estimate
IIF WEEKLY INSIGHT | July 24, 2014 page 3
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Increased activity in the auto loan ABS market; Markets remain short euro; many EM currencies rally
3. Increased activity in the auto loan ABS market: While
activity in the high-yield sector has slowed somewhat in
recent weeks, issuance of some types of high-risk debt
has been particularly robust this yearincluding covenant-
lite loans, payment-in-kind (PIK) bonds and, of note, U.S.
subprime auto loans, where issuance is almost back to pre-
crisis levels. Lower-credit borrowers, who were virtually
locked out of the auto loan market in 2008-2011, have had
increasing access to fnancing at much more favorable
terms since 2012. For new car loans, the share of subprime
loans has risen above pre-crisis levels, while for used cars
this share is very close to pre-crisis levels. With almost 17
million cars expected to be sold this yeara 7% increase
from 2013subprime auto loan originations are expected
to continue to rise.
This increase has given rise to increased activity in auto loan
asset-backed securities (ABS) market, as lenders turn to se-
curitization markets for funding. Indeed, auto loan ABS issu-
ance amounted to $56 billion in the frst half of 2014an
all-time record on an annualized basis, surpassing 2005s
$106 billion. In the rated auto ABS space, almost 30% of
these securities were subprime in H1 2014. Given these
high levels of issuance in recent years, there is now $30
billion of subprime auto loan ABS outstanding, comprising
18% of all outstanding U.S. auto loan ABSanother all time
record (Chart 3.1).
4. Markets remain short euro; many EM currencies rally:
Although the U.S. dollar has reached its highest level in a
month, and the euro has weakened accordingly, euro short
positioning remains substantial (Chart 4.1). Other major
mature market currencies have also softened: despite to-
days policy rate hike, the New Zealand dollarhas lost
ground against the U.S. dollar, with the central bank de-
scribing the strength of the NZD as unsustainable. By con-
trast many EM currencies have done well over the past
week: some appear to have benefted from weakness in the
Russian ruble, with little evidence of contagion since the
U.S. expanded sanctions against Russia on July 16 (Chart
4.2). Gains in South African rand (in part supported by the
recent rate increase), Turkish lira, Colombian peso, and the
Indonesian rupiah (enjoying a election-related boost) have
been robust, suggesting that turmoil in Russia/Ukraine may
be diverting portfolio fows to other emerging markets (for
example, the Turkish lira and Hungarian forint have appreci-
ated despite recent policy rate cuts in those countries).

Source: Bloomberg
Source: SIFMA, IIF.
Source: Bloomberg
3.1
4.1
4.2
0
2
4
6
8
10
12
14
16
18
20
0
5
10
15
20
25
30
35
40
'96 '99 '02 '05 '08 '11 14Q1
Subprime ABS outstanding
Share of subprime ABS (rhs)
U.S. Sub-prime Auto ABS Outstanding
USD billion percent
1.20
1.25
1.30
1.35
1.40
1.45
1.50
-80
-60
-40
-20
0
20
40
60
80
2010 2011 2012 2013 2014
Net positions
One stdev. interval
EURUSD (rhs)
Large Speculators Net Positions in EUR Futures
percent of total open interest
-2 -1 0 1 2
RUB
CZK
PLN
MXN
UAH
HUF
BRL
MYR
PHP
THO
IDR
COP
TRY
ZAR
Emerging Market Currencies vs. U.S. Dollar
percent change since July 16
page 4 IIF WEEKLY INSIGHT | July 24, 2014
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What to Watch For Next Week:
Monday: Japan Retail Sales (June)
Tuesday: U.S. House Prices (May) and Consumer Confdence (July), Japan IP (June)
Wednesday: U.S. GDP (Q2) and FOMC Meeting Announcement, ECB Lending Survey (Q2)
Thursday: Euro Area HICP (July), Philippines and Czech Republic Monetary Policy Meeting
Friday: Final July Manufacturing PMIs across countries, U.S. Non-farm payrolls (July)
page 5 IIF WEEKLY INSIGHT | July 24, 2014
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CAPITAL MARKETS

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+1-202-682-7449

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GLOBAL MACROECONOMIC ANALYSIS

Charles Collyns, Managing Director & Chief Economist
ccollyns@iif.com
+1-202-682-3609

Felix Hfner, Deputy Director, GMA
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+1-202-857-3651

Robin Koepke, Economist
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+1-202-857-3313

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Saacha Mohammed, Research Assistant
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Litia Shaw, Senior Program Assistant
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