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U.S. TAX BILL TO BOOST CONFIDENCE & CAPEX EMU & JAPAN TO LEAD MEDIUM-TERM

THE BULL ON STEROIDS, FEELING SHORT OF BREATH?

L/S EQUITY U.S. UPGRADED U/W NEUTRAL BIAS

HIGHER YIELDS AHEAD DIFFERENTIATING EMS COMDTY: LESS $ FUEL

O/W EVENT-DRIVEN NEUTRAL CTAS & MACRO STRATEGIES

LYXOR CROSS ASSET RESEARCH

I N V E S T M E N T S T R AT E G Y

EXTRA TIME FIRST QUARTER 2018

GUILLAUME LASSERRE

JEAN-MARC STENGER

JEANNE ASSERAF-BITTON

CIO for Active Investment Strategies

CIO for Alternative Investments

Head of Cross Asset Research

JEAN-BAPTISTE BERTHON

PHILIPPE FERREIRA

LIONEL MELIN

ANNE MAUNY

Senior Strategist

Senior Strategist

Senior Strategist

Research Analyst

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

FIRST QUARTER 2018

TABLE OF CONTENTS EXECUTIVE SUMMARY ......................................................................................... 3 MACRO & MARKET VIEWS................................................................................... 4 EXTRA TIME ........................................................................................................................................... 4  Is the bull feeling short of breath? ................................................................................................. 4  Eurozone & Japan to outperform the U.S. in the medium-term ...................................................... 5  Yield spreads and policy risks to dominate USD, JPY and EUR pairs ........................................... 6  Long U.S. Growth vs. Value as a hedge against activity and USD risk .......................................... 7  Extending our positive view on Eurozone Defense sector to the U.S. ............................................ 7  Volatility strategies to hedge geo-political tail risks ........................................................................ 8  The U.S. tax reform to boost business confidence and capex ....................................................... 8  The everlasting U.S. expansion … ............................................................................................... 9  Firmer Wage, Core & Headline inflations ...................................................................................... 9  Fed’s double normalization to compress the yield curve but … ................................................... 10  … Treasury yields to firm up alongside term premiums ............................................................... 11  U.S. Equity between Trends, Valuations, and Technicals........................................................ 11  U.S. High Yield unattractive risk-return profile ......................................................................... 12  Japan’s tentative exit from deflation ......................................................................................... 13  Positive on Japanese equities amid continued reflation and fair valuation .............................. 13  Emboldened EMU recovery… .................................................................................................. 14  ... facing frontloaded political risks ........................................................................................... 14  EMU inflation looking for 2018 trough ...................................................................................... 15  ECB purchases to cap the increase in yields ........................................................................... 15  Overweight EMU equity maintained ......................................................................................... 16  EMU recovery not priced-in sectors ......................................................................................... 16  CoCos look worth it within EU credit ........................................................................................ 17  Brexit sole driver of UK markets: one step forward… two steps back? ................................... 17  Two headwinds for EM assets: cyclical slowdown in China and monetary tightening ............. 18  EM credit downgraded to Neutral; spreads to widen as liquidity conditions tighten .................... 19  DM FX: A tilt does not make a call for G3 ................................................................................ 20  GBP focus: ST respite, MT headwinds .................................................................................... 20  EM FX – Neutral on the JPM EMCI Index ................................................................................ 21  Long PLN: Alternative play on the European pulse.................................................................. 21  Brent: On the sidelines at around $60/b ................................................................................... 22  Copper: sO/W until nearing $7000/mt ...................................................................................... 23  Gold: Balanced up/downside risks ........................................................................................... 24

ALTERNATIVE STRATEGIES.............................................................................. 25 STILL FAVORING BOTTOM-UP STRATEGIES .................................................................................. 25  A polarized Q4 for Hedge Funds .............................................................................................. 25  L/S Equity – The comeback of U.S. stock pickers?.................................................................. 25  Merger Arbitrage – Remain O/W, more juice, more risks......................................................... 28  Special Situations – Keep O/W, expect more volatility............................................................. 28  CTAs: Maintained at Neutral .................................................................................................... 29  Global Macro: Downgraded to Neutral as stance on EM Macro funds turns defensive ........... 29  Fixed Income Arbitrage (O/W): a protection against higher bond yields .................................. 30  L/S Credit (Neutral): Prefer market neutral to directional managers ........................................ 30

DISCLAIMER ........................................................................................................ 31 Contact: [email protected] - +33 (0) 1 42 13 31 31 Report drafted on December 15, 2017 Important Notice: For investors in the European Economic Area, this material is intended for clients (current or potential) who meet the definition of “Professional Counterparty” or “Eligible Counterparty” under the Markets in Financial Instruments Directive (“MiFiD”), and any products or services described falling within the scope of the MiFiD are only available to such clients. This document is considered marketing communication within the meaning of the MiFiD.

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

MARKET VIEWS

3M UW N

12M OW

United States

=

Growth vs. Value Domestic vs. Global Small vs. Large Healthcare P&S Banks Defense Discretionary vs. Staples

EQUITIES

FIRST QUARTER 2018

Europe

= = + + + = +

United Kingdom

+ + + + + + + -

Japan

+

France Construction Discretionary vs. Staples Banks Defense Greece Small caps

Emerging

= Korea Brazil Russia Turkey China India

= = = = = =

SOVEREIGN & INFLATION-LINKED U.S. Treasuries U.S. Breakeven

FIXED INCOME

Euro Govies

+ -

Gilts

= = -

JGBs

=

EM Govies ($)

=

EMU Breakeven OAT vs. Bund

CORPORATE & COCO U.S. IG

-

U.S. HY

-

EU IG

=

EU HY

=

CURRENCIES

=

EURUSD

COMDTY

EU CoCo

Brent

=

Copper

=

Gold

=

+

USDJPY

+

GBPUSD

-

EM FX (EMCI)

= EURPLN

-

L/S Equity Diversified

ALTERNATIVE

U.S. EU JP EM

L/S Equity Neutral Merger Arbitrage Special Situations FI Arbitrage L/S Credit Multi-strategy

Global Macro Diversified Sov FI / FX Bias EM focus

CTAs

3

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

MACRO & MARKET VIEWS

FIRST QUARTER 2018

Asset class performances* in local currency

EXTRA TIME U.S. sustained expansion and the recovery gaining strength in the Eurozone and Japan should preserve global growth while the drag from China’s controlled slowdown could be modest. We anticipate milder returns in cyclical commodities. Wage pressures will likely start to increase in the U.S. due to labor shortages, prompting us to consider U.S. breakevens. However, we expect the overall inflation picture to remain contained, allowing major central banks to proceed with their soft normalization. We believe that the supportive backdrop for risk assets will extend into 2018 and continue preferring Equity to Bonds (rated slightly underweight). Eurozone and Japanese assets, benefitting from ongoing reflation, should outperform their U.S. counterparts which are slowly exiting a goldilocks environment. We hold the view that the greenback will firm up in H1, while EMU political hazards are frontloaded, easing the catch-up process. However, the risk that a weaker USD will favor U.S. assets as in 2017 cannot be ruled out. Therefore, we maintain an overweight stance on Eurozone and Japanese equities and we complement our neutral position on U.S. equities by resuming our Long U.S. Growth vs. Value. The upcoming U.S. tax reform and the positive cyclical momentum in Eurozone and Japan should support capex and Tech stocks. We stay slight overweight on banks and defense stocks.



Eurozone and Japan outperformed … in USD terms

Is the bull feeling short of breath?

As 2017 draws to an end, it appears that financial markets performed well and volatility, as measured by the VIX index and sometimes referred to as the “fear factor”, failed to be revived. Despite the prevailing riskon mood, safe-havens, such as high-quality sovereign 10-year bonds, yielded roughly 2% to 3% year-to-date (YTD) in local currency terms on both sides of the Atlantic. Similarly, Europe and U.S. high-yield issues returned above 6%. Commodities (S&P GSCI Index) showed little progress (+0.3% YTD in USD), concealing mixed results and uneven profiles. Gold recently eased towards $1,250 per ounce while oil prices gained close to 50% over the second semester. Equity space offered shareholders material and, in some instances, impressive total returns (in local currency terms). Emerging Markets (EM) led the way, gaining +27%, followed by U.S. equities (S&P 500) and Japanese equities (Nikkei 1000) respectively up +22% and +20%. Eurozone equities (Euro Stoxx) lagged with a +13% return, hindered by the Euro (effective exchange rate) 7% appreciation. Economic reflation made progress. Growth picked up and (Bloomberg consensus) estimates for 2017 have been revised up to 2.3% in the U.S. and the Eurozone (EMU) and 1.6% in Japan. 5

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

On the equity side, Japanese equities performed so far this year neck and neck with U.S. stocks as JPY firmedup against USD. By contrast, Eurozone equities lagged, hindered by the 13% rise in EURUSD.

FIRST QUARTER 2018

A compelling valuation gap …

Looking forward, we believe conditions are ripe for an outperformance of EMU and Japanese stocks over U.S. stocks. Let us examine the various drivers: 1) The recovery in the EMU and Japan is likely to gain further strength while U.S. growth should, at best, firm up in this late phase of expansion. 2) We expect inflation to creep higher in the U.S. whereas pricing pressures should remain subdued in the EMU and Japan. 3) Monetary normalization will probably continue to reflect the disparity in the fundamental backdrop with the Fed ahead, followed by the ECB and the BoJ.

Source: Bloomberg, Macrobond, Lyxor AM

USDJPY tracking the 10-year yield spread

In summary, we anticipate that U.S. markets will slowly exit their goldilocks environment while the reflation process will still benefit EMU and Japan equities. Trends in currencies should prove pivotal in that regard.

 Yield spreads and policy dominate USD, JPY and EUR pairs

risks

to

Examining different potential factors affecting the USDJPY pair, we find that the 10-year yield spread between U.S. Treasuries and JGBs has been the more relevant driver for almost two years.

Source: Macrobond, Lyxor AM

Futures already positioned for a JPY depreciation

As detailed in later sections, we expect U.S. 10-year yields to creep higher while 10-year JGB yields should hardly move unless the BOJ decides to alter its policy of anchoring the 10-year yield at 0%. The upside on the yield spread signals a probable depreciation of the JPY. However, the theme has already attracted investors and futures positions have turned massively short. All in all, we believe the USDJPY could trade sideways. EURUSD has proven more complex and the dominant factor has shifted, over time, between several drivers including macro momentum gap, differential in monetary policy and rate expectations, 2-year and 10year yield spreads and political issues.

Source: Macrobond, Lyxor AM

Monetary policy not fully priced-in EURUSD

Our fitted model, designed to capture monetary and yield gap influences, showed a growing disconnect over 2017 suggesting a material 5% to 10% downside towards 1.1 over the coming months. The geopolitical and policy risks on both sides of the Atlantic add to the case for a firmer USD. In particular, Catalonian elections, Italian elections and Brexit negotiations could weigh on EUR in H1. In contrast, U.S. mid-term elections (due next November) could weaken the USD in H2. The potential gain and associated risks keep us from exiting our strategic Neutral recommendation. Source: Macrobond, Lyxor AM

7

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

 Volatility strategies to hedge geo-political tail risks

FIRST QUARTER 2018

Volatility regimes may well linger

Last quarter, we examined equity volatility over the last 50 years and concluded that a low volatility regime is not as rare as one might think. Periods of low volatility were often associated with a late cycle, goldilocks macro-backdrop (such as in the 60’s), and sometimes excessive risk-taking (such as in 2007). In our view, the current regime is supported by low economic volatility, which is unlikely to revive in the near future. In our base case, we do not anticipate a premature monetary withdrawal or the return of macro cyclicality. Financial markets appear frothy but risktaking and herding behavior do not seem excessive, as evidenced by the modest cross-asset correlation.

Source: Macrobond, Lyxor AM

Business confidence & Capex plans

However, markets often display vulnerability to rising geo-political risks, especially in a multi-polar world with several regional conflicts or tensions. The volatility asymmetric risk-reward profile prompts us to prefer volatility strategies to hedge geo-political tail events.

 The U.S. tax reform to boost business confidence and capex Congress Republicans have just reached an agreement in principle on the tax reform that should allow them to pass a bill through the House and the Senate before year-end.

Source: Macrobond, Lyxor AM

Orders signal strong Capex trends …

The main provisions suggest decisive tax relief for businesses. In particular, a corporate tax rate of 21% effective in 2018, the repeal of the corporate alternative minimum tax (AMT) and full expensing of equipment for the next five years are beneficial to businesses. Base erosion measures, deemed repatriation and capping interest deduction should constitute only partial offsets. The provisions for individuals seem less favorable. True, the top income tax rate would fall to 37% but this is to prevent a large tax increase on wealthy households that could no longer deduct more than ten thousand dollars of state & local property taxes. Since Trump’s election and, more so recently, amid rising odds of a tax bill being passed, most surveys have been painting a buoyant picture of business confidence, which is a key ingredient to capex and employment growth. Strong profitability and cashflow generation will probably remain supportive of capex trends that have already turned up as evidenced by the latest readings on non-defense capital goods orders excluding aircraft (a good proxy for U.S. nonresidential investment).

Source: Macrobond, Lyxor AM

… that need to be sustained!

Moreover, aging U.S. assets (over 16 years on average for the private sector) call for added investment efforts. Overall, we believe that prospects for capex in 2018 will surprise to the upside. Source: Macrobond, Lyxor AM

9

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

We do not expect that firmer wage growth will swiftly translate into higher core inflation. Over the coming quarter and probably semester, the main drivers will probably be related to the specific factors that precipitated the fall of core inflation from 2.2% last January to 1.7% in July. First, the drop in telephone services prices (up to 9% yearover-year) should slow, thereby lessening its negative contribution to core inflation. Second, medical service prices could rebound with the looming repeal of the individual mandate. Last, rent moderation (that tends to reflect house price trends with a one-year delay) should last, in our view. All in all, we estimate that core inflation will strengthen back to 2% in H1 2018. Assuming core CPI inflation evolves close to trend (at 2%), our analysis suggests that headline CPI inflation prints would be largely dictated by past and future oil prices. Base effects should pressure headline inflation down before triggering a marked acceleration until summer 2018. Successive moves do seem to have been priced-in yet in inflation breakevens. The potential inflation downside may not be worth chasing. Rather, we believe that investors should search for an entry point in inflation breakevens probably in Q1 2018 if and when inflation prints weaken. So far, the diffusion index (that we calculate over about 60 components) appears very weak, a sign that current readings reflect a narrow inflation. Headline inflation will probably broaden before accelerating …

 Fed’s double normalization to compress the yield curve but …

FIRST QUARTER 2018

U.S. CPI inflation to firm up in 2018

Source: Bloomberg, Macrobond, Lyxor AM

Searching for an entry point in U.S. Breakevens

Source: Macrobond, Lyxor AM

U.S. low inflation to cap the interest rate cycle

As expected, the Fed announced its balance sheet reduction last September for an actual kick-off in October and raised funding rates again in December. We continue to hold the view that the central bank will pursue its normalization. We anticipate three rate hikes: in March, in June and in December 2018. We believe that monetary authorities, keen to not interfere with political deadlines, will avoid the September option that would be too close to the midterms. Futures imply two to three rate hikes in 2018, slightly below Fed guidance. However, when adjusted for the current negative term premium, Fed fund futures fit well with the latest DOTS path published by the Fed, which would mean funding rates at 2.125% a year from now. Will this be the end of the tightening cycle? Probably, unless the Fed faces higher inflation that would warrant funding rates above the natural interest rate.

Source: Macrobond, Lyxor AM

U.S. Yield curve and Fed normalization

Given the Fed’s maturing bond holdings, we estimate that the Fed will reduce its balance sheet by roughly $250bn in 2018 while reinvesting about $200bn in Treasury markets. Noteworthy, the later does not differ much from Fed’s 2017 bond purchases. How will the Fed’s dual normalization affect the yield curve? Our fitted model suggests a further compression to 50 bps in December 2018. 11

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

Valuations look expensive.

FIRST QUARTER 2018

U.S. Equities look expensive

With the S&P 500 climbing from record to record, valuations continued to deteriorate. Whatever metrics we consider, U.S. equities look overstretched. Structural measures, such as the cyclically adjusted Shiller PE ratio (above 31x) or the Tobin’s Q (at 1.1x), have reached levels not seen in the past three decades, excluding the Tech bubble period. The same is true for the widely used 12-month forward PE ratio (at 18.5x) and the Price to Book ratio (at 3.3x) while the Price to Sales ratio has exceeded 2x, a high which was last seen in 2000 during the Tech bubble. Source: Bloomberg, Macrobond, Lyxor AM

Frothy markets are typically most vulnerable in periods of decreasing liquidity. The Fed’s looming withdrawal of monetary support could trigger a correction of U.S. equities. The solid fundamentals keep us invested but watchful of deteriorating Technicals.

The eye-catching S&P 500 uptrend

So far, Technicals appear mixed. The post-crisis equity uptrend looks well entrenched. Long Futures positions of institutional asset managers have receded to below average levels. Market breadth, illustrated by the relative performance of equal-weighted indices, has fallen but seems to be stabilizing now. 

U.S. High Yield unattractive risk-return

profile The stronger macro backdrop that we detailed in previous sections should warrant strong cash-flow generation, supporting the asset class.

Source: Macrobond, Lyxor AM

U.S. High-yield pricing-in, a stronger macro momentum

Financial health may appear weak when considering the elevated indebtedness of U.S. corporations but debt service should be kept low alongside the level of interest rates. Certainly, the upcoming tax reform that will probably limit interest deductibility (to 30% of EBITDA until 2021 and 30% of EBIT thereafter) should affect lower quality high-yield issues. Overall, default rates are expected to fall from roughly 4.5% on average in 2017 to 2.5% next year. Current expensive valuations largely reflect these supportive fundamentals, in our opinion. Spreads have already compressed to levels coherent with U.S. growth accelerating above 3% in the near future. Our fitted model on yield to worst suggests that high-yield valuations are in line with most other U.S. assets. Factoring-in our expectations on U.S. Treasuries yields, we estimate that high-yield total return will barely reach 2.5% in 2018.

Source: Bloomberg, Macrobond, Lyxor AM

High-yield is no exception, U.S. assets are expensive

Will that be enough to attract the demand needed to absorb issuance? We believe that high-yield supply should be manageable at roughly the same amount (~$270bn) as in 2017. However, headwinds and liquidity risks are growing. We rank the asset class at slight U/W as a hedge on U.S. risk assets. Source: Bloomberg, Macrobond, Lyxor AM

13

INVESTMENT STRATEGY



By LYXOR CROSS ASSET RESEARCH

FIRST QUARTER 2018

EMU activity on strong uptrend…

Emboldened EMU recovery…

Long awaited, Eurozone’s activity has exited its doubledip torpor. Can the momentum extend into next year? We believe it can and will. Consumption growth looks healthy but already at full cyclical speed. The dynamics should be sustained thanks to the reducing slack in labor markets. Government expenditure should reach a trough now that the EU Commission recommends profligate –structural– expenses. France and Spain have understood the message. All GDP segments have upward potential and capex should be the leading contributor. We see capital expenditure acceleration in the making: capacity utilization levels are stretched, demand is improving across sectors, the political risk premium has receded, and financing is plentiful.

Source: Macrobond, Lyxor AM

… already fueling tightness in capex and labor

The export balance could be in a tougher spot due to stronger import demand and Euro. However, an improved global growth picture and peaking currency could actually keep the net export contribution positive. The conjunction of tailwinds has the potential to lift EMU growth to the upper end of analyst forecasts: we see 2018 GDP able to grow 2.5% year-over-year (YOY).



... facing frontloaded political risks Source: Macrobond, Lyxor AM

Time and again, the cohesion of the Euro block was jeopardized over the past decade. After a couple more tests in early 2018, the horizon could be clear.

Italian Rosatellum attenuates M5S disruption risk

st

On December 21 , Catalonia’s Parliamentary election will determine whether the secessionist push of last October is put behind in favor of increased autonomy discussions or not. It is the key wildcard this quarter as polls are evenly split, while a win for the secessionist would put the minority government in Madrid at risk. th

Second, the Italian elections are due before May 20 . Disruption risks have receded noticeably thanks to the new Rosatellum electoral rule. The law favors coalitions, and consequently limits the future influence of the far-left anti-European M5S party, which however continues to lead the polls. The majority of political analysts expect another centrist coalition that should neither reform nor jeopardize Italy’s place in Europe. In Germany, after failing to agree with the FDP, Ms. Merkel seems en-route to another Grand coalition with the center-left SPD and the Greens. The resulting proEU integration should coordinate well with that of France, which should continue its structural reforms. Joint defense programs should be pushed forward. Greece could eventually be under optimistic spotlights through H1. The country is working on regaining access rd to market financing ahead of the end of its 3 bailout program in August. Debt forgiveness / restructuring should be on the table at the June 29 Euro-meeting.

Source: Macrobond, Lyxor AM

Grand coalition to support Franco-German couple

CDU/CSU 35%

Grüne 9%

SPD 22%

FDP 11% AfD 13%

Linke 10%

Bundestag (% share of seats) Source: Lyxor AM

15

INVESTMENT STRATEGY



By LYXOR CROSS ASSET RESEARCH

Overweight EMU equity maintained

FIRST QUARTER 2018

Valuation and dividends favor EMU to U.S. stocks

Despite a few disappointing quarters, we continue to believe that Eurozone reflation justifies an overweight equity stance. EMU stocks are expensive but relatively less than elsewhere. Our EMU vs. U.S. risk premium measure (combined dividend and earnings yields adjusted for sector composition) shows that so far investors are ready to give up yearly 1% returns (compared to pre-GFC) to hold U.S. names. In terms of fundamentals, the 9% IBES consensus EPS growth forecast for 2018 looks likely to be revised upward. Our macro scenario validates a nominal growth at 3.5% which should support similar top-line dynamics. Then, recovering margins alone (fueled by operating leverage) should infuse a +10% impact on EPS. Last, the x14.5 12-month forward PE valuation looks cheap compared to the x18.5 U.S. PE.

Source: Bloomberg, IBES, Macrobond, Lyxor AM

Foreign demand, the missing piece of the EMU puzzle

We think that the recent below-expectation stock price dynamic was mostly due to foreign investors who have stayed on the sidelines since mid-2017 (as clearly visible in U.S. investors’ ETFs), while political concerns reignited (e.g. Catalonia). Political risks & U.S. investors may hold the key to EMU equity performance in 2018.



EMU recovery not priced-in sectors

EMU banks, which are reflation transmission tools, are healing and we believe that they deserve a slight equity overweight (sO/W). The regulatory burden is stabilizing, recapitalizations are under way, the ECB deposit rate is floored, and demand for loans is slowly on the mend. Low rates likely to move higher should prove motivating to borrowers and support banks’ profitability from lending thanks to a steeper yield curve. In sync with the banks’ call, we hold a structurally positive view on the construction sector that benefits from a pace-up of real estate prices. The relative cheapness of construction & materials stocks is a further support to this call. We extend our long call on Consumer Discretionary vs. Staples on valuation and earnings’ growth grounds. Conditions are aligned for Eurozone households to keep increasing their spending beyond basic needs. We are also positive on French reforms which should enhance long-term productivity. We keep a slight overweight on French stocks. The Telecom sector did outperform Health Care as expected this past quarter. Valuations and EPS growth should justify an extension of this call for Q1. However, we believe that bottom-up granularity on these sectors is required since both have only a couple of key players.

Source: Bloomberg, Macrobond, Lyxor AM

EMU sectors not yet pricing-in the recovery

Source: IBES, Macrobond, Lyxor AM

Curve steepening to benefit healthier EMU banks

Eventually, given our central scenario that sees Euro appreciation only in H2, we hold a short term neutral stance on Small Capitalization, while are sO/W for the longer term. 17

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

 Two headwinds for EM assets: cyclical slowdown in China and monetary tightening

FIRST QUARTER 2018

China decelerates as financial stability takes center stage

EM assets took a pause in Q4 and this may continue in Q1-18. EM equities underperformed DM and EM sovereign credit was flat, just in line with the U.S. dollar. Mexico, Brazil and Turkey dragged down EM equity performance in Q4 while China, India, Russia, South Korea and South Africa outperformed. In the near-term, we believe that growth deceleration in China and the removal of monetary accommodation globally may cause headwinds for EM assets. China’s growth is slowing down as authorities focus on financial stability. Fixed asset investment was growing at 5% YOY in November from 8.5% back in May. Credit growth and broad money (M2) are also decelerating. The PBOC is moderately tightening liquidity conditions in a context where core inflation is creeping higher (2.3% as of November). More broadly, the monetary cycle in EM is less supportive. Several EM central banks are following in the footsteps of the Fed, which has hiked rates three times in 2017 and is likely to continue to tighten at this pace in 2018. Over recent weeks, China, Mexico, Turkey and South Korea hiked interest rates. In parallel, inflation is accelerating in India though the RBI remains in neutral mode for the time being. A few exceptions: Russia and Brazil continued to cut rates in Q4. On balance, the overall conditions for EM equities will be slightly less supportive in the near-term. From a country picking perspective, we find value in Brazil, South Korea and Russia. Economic momentum has been supportive in those countries and equity valuations are attractive in Korea and Russia. Looming presidential elections in Russia (March) and Brazil (October) may also boost public spending and support economic activity. On a negative note we are uncomfortable with Turkey: economic momentum is adverse, the central bank is concerned with inflation and the current account deficit is widening. Longer term, we find that policy developments in China are positive. The focus on financial stability should contain credit risks, though at the cost of slower growth in the short-term. The leverage of SOEs peaked at high levels in mid-2017 and the authorities are addressing the issue with debt for equity swaps and capacity reductions in industry (steel, coal, aluminum).

Source: NBS, Macrobond, Lyxor AM

Credit growth is decelerating as the PBOC turns the screw

Source: MSCI, Bloomberg, Lyxor AM

EM equities: prefer Brazil, Korea and Russia. U/W Turkey Economic Monetary policy External Market momentum and inflation vulnerability momentum Valuation Total Last PMI vs CPI & mon pol 3m avg stance CA/ GDP (6m) 12MF PE China

=

-

=

+

=

=

Korea

+

=

+

=

+

+

Taiw an

+

=

+

-

+

+

India

+

=

=

=

-

=

Brazil

+

+

+

+

-

+

South Africa

-

=

+

+

-

=

Russia

=

+

=

+

+

+

Mexico

+

=

+

-

=

=

Indonesia

=

+

+

-

-

=

Malaysia

+

=

+

-

+

+

Thailand

=

=

+

+

-

=

Poland

+

=

=

=

+

=

Turkey

-

-

-

-

+

-

MSCI EM

+

=

+

=

=

=

Total return, local currency indices. Source: MSCI, Macrobond, Lyxor AM

The MSCI EM is highly Tech-oriented and should benefit the ongoing disruption in consumer patterns Sector composition (%) MSCI EM

On top of reassuring mid-term macro developments in China, the fact that Korean, Taiwanese and Chinese (offshore) equity benchmarks are heavily weighted by the Technology sector are supportive. Innovation is globally reshaping consumer patterns and sectors, such as retail, healthcare, communications and transportation, are experiencing structural changes. EM Asian companies in the technology sector appear to be well positioned to take advantage of the ongoing technology super cycle.

2.8

2.5 2.4

4.8

Information Technology

3.1

5.2

28.5

17.0

11.8

Financials Consumer Discretionary

3.1 2.8

6.6

Materials

MSCI World

11.5

Energy 18.1

6.8

Consumer Staples Industrials Telecommunication Services

9.0 7.2

6.2

12.2

Real Estate

5.1 23.2

10.1

Health Care Utilities

Source: MSCI, Lyxor AM

19

INVESTMENT STRATEGY



By LYXOR CROSS ASSET RESEARCH

DM FX: A tilt does not make a call for G3

Reduced G10 FX volatility 0

We anticipate G10 currencies will offer few compelling trends. Regional dynamics might be better played through other asset classes.

In that context, central banks moves would take center stage in FX. We expect them to overshadow country fundamentals. FX correlations to monetary trends would remain elevated while the changes in country equilibrium will be less regarded. When years of monetary reflation seem to be producing results, central banks will most likely remain cautious not to jeopardize the benefits. As a result, moderate normalization could constrain FX opportunities.

6

8

10 12

Source: Macrobond, Lyxor AM

Dispersion in DM curve and FX has peaked 1.3

Dispersion DM FX (TWI, 10d trail.), rhs 0.8

1.1

0.6 0.9

0.4

0.7 Dispersion DM Govies 10-2Y Curve (15 countries, 10d trail.), lhs

0.2

0.5 10

Finally some crosses will be unsettled by political developments. NZD, GBP and, to some extent, USD and EUR might be affected by these speculative factors. These are challenging to trade. The lack of fundamental pricing, limited monetary pulse, reduced differentiation, and the influence of politics, could constrain FX opportunities. We expect different paths for G3 currencies in Q1 but none of them are convincing enough to take an outright stance.

11

12

13

14

15

16

17

18

Taking liberty regarding the Taylor rule Taylor Rule estimate minus 10Y gvt yield -4 -2 0 2 4 6 8 Italy Spain France Norway Australia Netherlands New Zealand US Canada Japan Switzerland Ireland Sweden UK Germany

In summary, we expect USD to be marginally up in dispersed order. The positive impact from the continuing Fed normalization will be moderated by the flattening of the yield curve. We expect a better USD trend vs. JPY or CAD which could display greater monetary differential. We expect a weaker pulse vs. EUR or NZD given the smaller growth and valuation gaps.

21

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

Poland. Although it has yet to decide how far it is willing to go, its geopolitics, as well as its history, suggest it will seek multilateral links with the whole of Europe.

FIRST QUARTER 2018

Bright Polish economic pulse

Mr. Morawiecki replaced Ms. Szydlo who resigned. More moderate, he could contribute to improving Poland’s international relationships. In the short-term a controversial justice reform could push the EC to seek to impose sanctions, for which unanimity is required. With the support of Hungary, we doubt the EC will be able to implement its threats, all the more so it might not want to open a significant EU-integration front. Finally, PLN’s valuation remains attractive, its technicals do not show signs of overheat and carry remains positive. In our view, the main risk lies with NBP’s inflation tolerance.

Source: Macrobond, Lyxor AM

Demand / Supply sensitivity to oil changes

In 2017, PLN was of the very few positive currencies vs. EUR and ranked as one of the top performers vs. USD. We maintain our tactical call on EURPLN with a target at 4 and a stop loss at 4.4.



Brent: On the sidelines at around $60/b

Oil prices have enjoyed a remarkable rally since the summer. Several factors contributed to the rise. First, OPEC and non-OPEC members, which agreed to cut their production in 2016, displayed an elevated rate of compliance (about 90% in aggregate, with uneven efforts though). Second, talks to prolong the agreement intensified in recent weeks. Due to expire in March 2018, the agreement was extended by 9 months until the end of next year and included Nigeria. Meanwhile, global demand remained strong, inventories continued to moderate. Finally, geopolitics provided tailwinds, with the rhetorical heating up over North Korea, the start of an anti-corruption purge in Saudi Arabia, the economic collapse of Venezuela, and, to some extent, the stress regarding the Iranian nuclear deal. With these factors being priced in, risks seem balanced. All else being equal, we do not expect any of these factors to durably pull Brent prices out of their range. Demand would adjust if prices soared as well as OPEC’s compliance to its output agreement. In contrast, OPEC would probably step up if prices plunged. Members would not let oil prices slump way below their fiscal and external balance breakeven oil prices. The instability in key producing regions rose, justifying a premium for oil prices. However, we look for regular shifts in the perception of risk. We expect North Korean and Iranian nuclear deal issues to remain rhetorical as none of the parties involved would cross the red line. The financial and social collapse of Venezuela, and the struggle for power after the fall of Daesh in Kurdish regions are more credible threats in our view. Saudi Arabia’s accelerated political shift could add tail risk if the princes were to coalesce.

Source: Macrobond, Lyxor AM

Erratic path towards balance 2.5

Tight Supply

140

World Crude Demand vs. Supply (mb/d, 3M trail., Sce IEA), lhs

130 Forecast

1.5

120 110 100

0.5

90 80 -0.5

70 60

-1.5

50 40

WTI Crude, rhs -2.5

30

Ample Supply

06 07 08 09 10 11 12 13 14 15 16 17 18 19

Source: Macrobond, Lyxor AM

Lagging U.S. E&P equity reflect their lack of profitability 170

Brent WTI Crude

100 as of Jan16

171

160 155

150 140 130 120 113

110 100 90 SP1500 E&P Oil

80 70 Jan

Jul 16

Jan

Jul 17

Jan 18

Source: Macrobond, Lyxor AM

23

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

sufficient global liquidity. Meanwhile, the selective tightening effort in various segments of the Chinese economy could be reversed if need be. Focusing on copper, we maintain our constructive outlook for three reasons.

FIRST QUARTER 2018

Healthy Chinese demand in infrastructure and electronics 40 10000

30

20 8000

First, copper is facing an unusual risk of production disruptions in its two top producers, Chile and Peru. Multiple collective labor agreements will be renegotiated next year, likely to trigger strikes. Second, China is slowing, it is not collapsing. Moreover, the shift toward domestic consumption and toward a rise in the supply chain will support some copper intensive segments, including electric vehicles in the medium-term. Chinese copper demand is mainly driven by grid (~1/3), construction (~1/4), and electronic and electrical (~1/5) demand. Each of these segments actually peaked but remains positive. The grid capex and construction boost both seem over but infrastructure spending remains buoyant. Other electronic and electrical demand is off its peak but still grows about 10% a year.

10 6000

0 -10

China Copper Demand in Electrical & Electronics y/y China Infrastructure Capex (YTD, y/y) LME Copper 3M (rhs)

-20

4000

-30

2000 11

12

13

14

15

16

17

18

Source: Bloomberg, Lyxor AM

Support from hedging and Chinese new-year demand

Third, after weakening in sympathy with several underwhelming Chinese economic prints, copper valuation and Technicals are much healthier. Performance in 2018 should be more modest and we expect to turn increasingly tactical. We are sO/W until prices near $7000/mt. Source: Macrobond, Lyxor AM



Gold: Balanced up/downside risks

We have not altered our view on gold. We continue to see a balance of upside and downside risks, keeping us neutral. Gold slightly weakened over Q4 but proved resilient against weaker USD, low real yields, a tiring momentum in risky assets, and U.S. reflation uncertainties.

Steady Gold correlation with the U.S. monetary policy

We expect prices will be capped by the current macro environment, characterized by robust growth, the start of monetary normalization, and modest inflationary pressures. Additionally, given the heavy hedging positions, we struggle to see relays for flows. However, we also expect that gold prices will be floored. Notwithstanding a conducive environment, a number of uncertainties hover. If, as we expect, we see early signs of a peak in economic prints, gold will remain favored to protect against asset rotations. Geopolitics will also keep short positions hesitant.

Source: Macrobond, Lyxor AM

Giving up on gold hedges?

The physical market might not be the key gold driver, however, we acknowledge that fundamentals have marginally improved. Jewelry demand ahead of the Chinese New Year is recovering. Demand from hedging activity also remains supportive. We also note a recent de-hedging in futures markets, which improves technical conditions. We remain neutral. Source: Macrobond, Lyxor AM

25

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

We do not expect a repeat of the stellar equity performance recorded in 2017. Returns should be positive but more moderate. We also anticipate there will be more frequent stops and starts.

FIRST QUARTER 2018

Rebound in alpha generation in November

If, as we expect, a tax reform bill passes in the U.S., a rotation would quickly unfold favoring the stocks most exposed to the fiscal change. After this knee-jerk bottom-up rotation, we expect that the top-down implications of a meaningful tax reform will favor the hard-catalyst stocks. Instead, softer-catalyst stocks (without a convincing business or capital change story) will be dominated by monetary tectonic and global growth perceived pace. Not attractive for fundamental stock pickers. We expect some volatility as the concentration of L/S Equity funds on tech and crowded stocks increases.

Source: Bloomberg, Lyxor AM

Higher stock dispersion and low correlation

As a result, we expect a positive contribution from beta, but more moderate and bumpier than in 2017. This would open opportunities for the most tactical styles. Improving but regionally differentiated Alpha A worldwide rise in equity dispersion unfolded in recent months with falling correlations. This theoretically bodes well for alpha generation. Given the specific regional constraints, we would remain selective in our positioning. We would remain overall at benchmark on the L/S Equity strategy, with selective over/under weights. In short, we favor the U.S. deep value funds, diversified European funds, and the longest biased Japanese funds.

Source: Macrobond, Lyxor AM

U.S. funds to stage a come-back?

By contrast, we underweight the Neutral Quant funds, as well as the UK focused funds, where trading would remain messy and paced by Brexit developments. L/S Equity US: Time to reweight Rich stock valuations, a tiring momentum, and policy uncertainties kept U.S. investors highly demanding regarding the quality of earnings growth and the magnitude of surprises. As a result, many stocks with positive fundamentals were not rewarded in markets. This is a typically challenging environment for mainstream fundamental stock pickers. The valuation issue remains intact: we expect persisting investors’ requirements. However, assuming a meaningful tax reform, multiple catalysts will emerge for U.S. stocks. The chart to the right focuses on the S&P 500 tech stocks, plotting their correlation to a tax-reform basket and their efficient tax rate. We find that tax situations diverge widely and that stocks that are most sensitive to the Trump reform are also displaying the highest tax rates. Following the short-term rotation towards the prime beneficiaries of lower taxes, in the medium-term, the implications on capex, wages, and corporate activity will spur multiple themes and more sustainable stock discrimination. 27

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

Amid elevated leverage and the prospect of further rotation, challenging arbitrage for quants, the risk/reward is unappealing to us.

FIRST QUARTER 2018

Regulatory risk back in the Mergers picture 2,000 M&A Regulation risk - BBG Story Count 400

 Merger Arbitrage – Remain O/W, more juice, more risks

Antitrust Tax Inv ersion (rhs)

1,600

300 1,200

M&A operations are no longer “done deals”. The attractive merger carry and a low perception of risk had lured a number of non-merger specialists in the space. As a result, a growing number of operations became priced for perfection.

0

Moreover, prospects of a meaningful tax reform bode well for the activity. It should contribute to enhancing corporate profitability, giving greater incentive for investments. Besides, part of the foreign cash repatriation would be put to work through acquisitions. Back at around 4 to 6%, merger spreads provide better relative carry than dividend and credit. We remain overweight.

 Special Situations – Keep O/W, expect more volatility

0

09

10

11

12

13

14

15

16

17

18

Source: Bloomberg, Lyxor AM

Moderate acquirer equity underperformance Stock Return post-Announcement (50 US deals >1bn$)

Target Return Ann. date +2

40% 30% 20% 10%

0% -10% -20% -10%

0%

10%

20%

Buyer Return (Pre deal until Ann. date +5d)

Source: Bloomberg, Lyxor AM

Balanced allocation across companies’ cycle stages 60

TOP-LINE TURNING

FIRMING

Top activists' new campaigns since 2016 Ebitda vs. Revenue growth

Revenue Growth y/y

The backdrop is more supportive going forward. Conditions for decent M&A activity are still in place. Funding costs are moderate, acquirers can still count on banks’ support. The stock underperformance of acquirers following an M&A announcement remains moderate (which suggests investors are confident that the operations will be profitable).

100

400

The unexpected antitrust requirements for the Time Warner vs. AT&T deal put regulation risks back on the menu. Spreads widened meaningfully. While the Time Warner deal was a hit for a number of Merger specialists, they reasonably navigated a tougher environment. They were marginally positive over the last quarter. They focused on complex deals and became tactical on mainstream operations.

200

800

40

20

0

-20

We maintain our overweight on Special Situations funds, which remain the top 2017 performing strategy. The last quarter was more challenging as doubts about tax reform intensified, weighting on a number of positions sensitive to this theme.

WEAKENING -40

-20

COST RESTRUCTURING 0 20 Ebida Growth y/y

-40

40

Source: Bloomberg, Lyxor AM

Better reflation prospects could provide tailwind. However rich equity valuations could keep investors cautious and looking for hard-catalysts stocks. Special Situations funds fit well in this environment.

A detailed analysis of these stocks emphasizes a nice balance between riskier companies at an early stage of the business cycle, and more mature companies (which are rather driven by corporate activity).

Better economic growth and continued EPS recovery would particularly support turnaround positions.

We expect more volatility for the strategy in the coming quarter, as the equity momentum tires and as doubts about the sustainibility of global growth revive. We would manage portfolio beta through a smaller overall allocation to L/S Equity funds.

Again, we take note of the vibrant idea generation from hedge fund managers’. More than 30 campaigns have begun since the summer. The bulk of these additions were in tech and healthcare. The interest for energy assets is also increasing, which we find consistent with the ongoing restructuring of the sector. 29

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

 Fixed Income Arbitrage (O/W): a protection against higher bond yields

FIRST QUARTER 2018

FI Arbitrage offers protection against rising bond yields

We reiterate an overweight stance on Fixed Income Arbitrage, a strategy on which we have been positive over recent quarters. Most individual managers in this space are relative value investors which tend to perform well when bond yields rise. Such managers have also demonstrated their ability to generate steady returns with limited volatility over time. The albeit modest rise in sovereign bond yields across developed markets in 2017 has translated into a solid outperformance of relative value arbitrage strategies versus a long only fixed income benchmark. The HFRX relative value arbitrage has outperformed the Barclay’s Global Aggregate Bond index year-to-date. We believe the strategy is highly attractive for diversification purposes for long only fixed income investors.

Source: HFR, Lyxor AM

Attractive risk-adjusted FI Arb. funds performance

According to HFR indices, relative value funds represent more than 25% of global hedge fund’s assets under management. Within relative value strategies, Multi Strategy funds represent more than 60% of the assets under management. Meanwhile, corporate and asset backed relative value funds represent respectively over 15% and 10% of the assets under management of the strategy. Source: Credit Suisse, Lyxor AM

 L/S Credit (Neutral): Prefer market neutral to directional managers We maintain a cautious stance on directional L/S Credit funds and prefer neutral strategies. We believe that stronger economic fundamentals will lead to higher bond yields over the coming quarters. This should reduce the appeal of riskier credit segments in relative terms. There is a broad consensus on the fact that HY credit spreads do not currently adequately remunerate risks. European HY spreads started to edge higher in Q4-17. Consequently, we remain defensive on directional credit strategies and prefer market neutral L/S Credit funds. In the current market environment where risks on credit spreads are tilted to the upside, the latter appears to be in a better position to deliver higher risk adjusted returns with lower correlation to market movements.

31

INVESTMENT STRATEGY

By LYXOR CROSS ASSET RESEARCH

FIRST QUARTER 2018

This presentation contains the views of Lyxor AM analysts and/or strategies. The views espoused in this presentation may differ from opinions and recommendations produced by other departments of SG. Note about Indices: Indices are not available for direct investment. A comparison to an index is not meant to imply that an investment in a fund is comparable to an investment in the funds or securities represented by such index. A fund is actively managed while an index is a passive index of securities. Indices are not investable themselves, and thus do not include the deduction of fees and other expenses associated with an investment in a fund. Not all the funds that comprise indices cited herein are suitable for U.S. Investors as a result of, among other things, the implementation of the Volcker Rule. Please see the offering documentation for these funds for more details. Notice to U.S. Investors: Any potential investment in any securities or financial instruments, the categories of which are described herein, may not be suitable for all investors. Any prospective investment will require you to represent that you are an “accredited investor,” as defined in Regulation D under the Securities Act of 1933, as amended, and a “qualified purchaser,” as defined in Section 2(a)(51) of the Investment Company Act of 1940, as amended (the “40 Act”). The securities and financial instruments described herein may not be available in all jurisdictions. Investments in or linked to hedge funds are highly speculative and may be adversely affected by the unregulated nature of hedge funds and the use of trading strategies and techniques that are typically prohibited for funds registered under the ’40 Act. Also, hedge funds are typically less transparent in terms of information and pricing and have much higher fees than registered funds. Investors in hedge funds may not be afforded the same protections as investors in funds registered under the ’40 Act including limitations on fees, controls over investment policies and reporting requirements. Notice to Canadian Investors: Any potential investment in any securities or financial instruments, the categories of which are described herein, may not be suitable for all investors. Any prospective investment will require you to represent that you are a “permitted client,” as defined in Canadian Regulation National Instrument 31-103, and an “accredited investor,” as defined in National Instrument 45-106. The securities and financial instruments described herein may not be available in all jurisdictions of Canada. For more information, U.S. and Canadian investors and recipients should contact Lyxor Asset Management Inc., 1251 Avenue of the Americas, New York, NY 10020 or [email protected]. Notice to U.K. Investors: This communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorised and regulated by the Financial Conduct Authority in the UK under Registration Number 435658. Source: This document has been prepared by Lyxor Asset Management S.A.S., 17 cours Valmy, 92800 Puteaux. Lyxor AM is a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/UE) and AIFM (2011/61/EU) Directives. Lyxor AM is also registered with the U.S. Commodity Futures Trading Commission as a registered commodity pool operator and a commodity trading advisor.