Cross Asset Invt Strategy Monthly_December 2013_VA

8/13/2019 Cross Asset Invt Strategy Monthly_December 2013_VA

1/28Document for the exclusive attention of professional clients, investment services providers and any other professional of the nancial industry

Cross asset

strategyinvestment

MONTHLYResearch, Strategy and Analysis

Document nalised at December 9, 2013.

December 2013 #12

Insights

Analysis

Asset allocation:

Amundi investment strategies Page 2ECB sending ever clearer messages

Risk factors Page 3

Macroeconomic outlook Page 4

Macroeconomic and nancial forecasts Page 5

1 Does the eurozone still hold some appeal? Page 6A few genuine strengths and some well-identied

risk factors

2 Equity markets: a snapshot of long-term prospects Page 9

3 Germany, source of deation ? Page 12

4 What determines the euro-dollar? Page 15Essentially the ECBs (deationary) stance

5 US and European credit cycles are diverging Page 18

6 Refunding risk of US and European High Yield Page 20companies in next two years

7 Renancing mortgage loans in Denmark: Page 22an envied but somewhat ambiguous model

8 The reinvention of electronic components Page 25



2

December 2013 #12

Asset allocation: Amundi investment strategies

PORTFOLIO TYPE

Equity portfolios Bond portfolios Diversi ed portfolios

hort term risk increases due to U Eperspectives

Stay neutral to overweight US and JapanKeep FX hedging on Japanese equitiesPrefer Euro zone equitiesEMG equitiesstay selective: UW Turkey, India,

South Africa, neutral on China, OW Brazil,Russia, Peru, Thailand

Sectors (advanced countries): prefer cyclicaland industrial sectors

Stay selective on nancial securi ties with amore positive bias (in the awaiting of ECBactions)

Maintain long USD, short JPY and EUR

hort term risk increases due to U Eperspectives

Maintain overweight position on credit vs.sovereign bonds

Maintain underweight/absent from peripheralcountries having liquidity solvency issues

Reduce exposure on EMG debt (both localand hard currencies debt)

Stay selective on nancial securities witha more positive bias (in the awaiting of ECBactions)

Maintain Long USD, NOK, GBP, short JPY,AUD, NZD and EUR

EMG currencies: stay highly selective(US QE perspectives a handicap)

hort term risk due to U E perspectives Stay neutral to overweight US and Japan Prot taking on Euro equities ; keep OW though Sectors (advanced countries): prefer cyclical

and industrial sectors Keep FX hedging on Japanese equities Stay UW on EMG equities towards a

selective comeback later Maintain long position on corporate bonds

(IG and HY) and convertibles Stay UW on core Euro sovereign bonds Stay UW on EMG debt: tactical positions only Maintain Long USD, short EUR (a mid-term

position) and JPY Maintain low cash exposure

ECB sending ever clearer messagesPHILIPPE ITHURBIDE,Global Head of Research, Strategy and Analysis Paris

It made sense for the Fed to take the risk of maintaining unconventional policies for too long(to consolidate growth), rather than abruptly ending the policies to avert the dangers of excessliquidity (risking the creation of bubbles). But the risks associated with a scaling back of QE areback.

The recent drop in ECBs interest rates in reaction to a further decline in ination may not bean effective response to the eurozones current dilemmas (a weak credit market, the inability ofbanks in some peripheral countries to transfer low interest rates to the economy, the rising rateof unsuccessful credit applications by SMEs, weak investment...), but it is very indicative of theECBs fears of deationary risks. Long gone are the days when European central bankers viewedlowering ination (or competitive disination) as the main objective of their monetary policy. Thedeation-fearing camp is now the dominant voice within the ECB. The ECB is increasingly likely

to take further measures to boost condence in banks and revive the credit market. So whilewe speculate on when the US Fed may start scaling back QE, the question on the other side ofthe Atlantic concerns the type of measures the ECB may pursue in the future. So what can weexpect?

First and foremost, the supply of liquidity to banks in certain peripheral countries must beensured. This is why there is so much discussion about the long-term course of LTROs. Thisliquidity must not be exclusively supplied via governmental bond purchases: it strengthens the linkbetween banks and governments (a relationship frowned upon by the ECB and nancial marketsalike), and it is also detrimental to the supply of credit to the real economy.

The task, then, is to revitalise the credit market while remaining selective. Offering cheap liquidityto banks that are eagerly buying up governments bonds does not solve the credit problem. Asolution may be to offer liquidity to banks that have a good LCR, a measure of their lendingcapacity.

If the ECB does proceed with such measuresand we believe it willwe can count on a bit more

optimism on growth and employment.Overall, the events of November do not call for a radical shif t in asset allocation, in which corporatebonds and eurozone equities feature prominently. The choice is tting, given that over the pastthree months, eurozone equities signicantly outperformed their US counterparts. While thecatch-up across the Atlantic is still underway, three important details call out for our attention:

The closer we get to the debateand the riskssurrounding the US budget (January) and debtceiling (February 7), the closer we are to an environment of increased volatility and risks associatedwith the scaling back of unconventional policy, and thus a rise in long-term interest rates.

We are not in a period of accelerating economic growth. The signs of a (non-severe) downturnare visible, which cautions against increasing equity positions.

In terms of valuation, what was very appealing four to six months ago is much less so today.

Therefore, we are maintaining our overall asset position but adding a dash of prudence, whichtranslates into some prot taking on overweighted equities, particularly on outperforming

European equities.

ASSET ALLOCATION3 TO 6 MONTHS OUTLOOK

- - - + ++

CASH

USD

EUR

SOVEREIGN BOND

United States

Eurozone (core countries)

Eurozone (periph. countries)

United kingdom

JapanEmerging market debt (local)

CORPORATE BONDS

Investment Grade Europe

Investment Grade US

High Yield Europe

High Yield US

EQUITIES

United States

Eurozone

Europe excl. eurozone

Japan

Emerging markets

CURRENCIES

US dollar

Euro

Yen

Emerging market currencies

(--) Significantly underweighted (UW )

(-) Underweighted

( ) Neutral

(+) Overweighted (OW)

(++) Significantly overweighted


3/28



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December 2013 #12

Macroeconomic outlook

DECEMBERAMERICAS RISK FACTORS

UNITED STATES >A cyc lical recovery is underway. Consumpt ion will accelerate moderately in 2014, he lped by thecontinuing increase of real wages (beneting from low ination and from the gradual strengtheningof the job market) and positive wealth effects due to the good performance of the equity market

and recovering house prices.

>Corporate investment is still below historical average. As prots remain on a strong trend, theyhave room to improve and contribute positively to growth, even more so if the uncertainty linked

to budget/debt ceiling weighs l ess heavily than in 2013. Residential investment will continue to

increase at a steady pace.

>The Fed is about to start tapering its asset purchases. The November employment report has risenthe odds that it will start on 18 December. But the Fed will probably wait more. No preset course :

the tapering will be data dependent. If Treasury yields overreact, the Fed would immediately stop.

The economy is indeed too fragi le to support a rapid rise in long-term rates.

> Renewed tensions on

interest rates with tapering

> New clash between

Republicans and Demo-

crats in January/February

2014

BRAZIL >GDP fell 0.5% in Q3 (qoq) after very strong growth in Q2 (1.8%). While business investment fell back

sharply in Q3 (-2.2%), public spending posted substantia l growth (1.2%), like consumer spending(1.0%). GDP growth stands at 2.2% yoy. Recent data (Octobers industrial output, still high capacity

utilisation rates) are encouraging and suggest activity will stabilise or even re-accelerate at years end.

>Once again, the BCB unan imously decided to raise i ts Selic rate by 50 bp to 10% on 27 Nov. (+275bp in all), with the aim of reducing ination to 4.5% (midpoint of its ination target). Ination stabili sed

at 5.8% yoy in October. The tightening cycle is probably nearing its end.

>Brazil faces supply problems (insufcient inf rastructure, tight labour market) but should continue toattract FDI ows. FX reserves are elevated and external vulnerability is thus limited.

> BCB: decided to pro-

mote combating inationat the risk of weighing on

activity

> Possible decline in the

real with Fed tapering

EUROPE

EUROZONE >Sluggish recovery. Across the Eurozone, exports and the loosening of austerity will help, although quitedifferently from one member state to the other. Divergences among countries will remain substantial.

>Germany is the sole engine of growth: cyclical recovery underway, with substantial improvement inboth consumption and investment. Rebalancing of the economy towards internal demand will continue.

>In France, Italy and Spain, internal demand will remain subdued, and GDP growth stay negative(watch France). Nowhere outside Germany, the recovery will be strong enough to allow for a

marked improvement in the job market.>Deationary pressure may intensify further in peripherals, while disination is on the menu in coreeconomies. Financial fragmentation will continue to hamper credit in Southern Europe, especiallyto SMEs. Progress toward the Banking Union may help, but will probably yield substantial resultsonly late in 2014.

>The ECB will maintain a very accommodative bias. Should deationary pressure intensify and/ormonetary conditions tighten, all options would be on the table.

> Deationary pressures

intensifying (Spain,

Portugal)

> Rising money rates

and bond yields on the

back of Feds tapering

(contagion)

> Social and political riskswith the rise of mass

unemployment

UNITED KINGDOM >The growth momentum is quite strong. After a 2013 recovery led essentially by consumption andresidential investment, exports and business investment should help it continue in 2014. Whilean upturn in real wages will take some time, it should be helped by a gradual decline in ination.

>The Treasury and BoE programmes (Funding for Lending, Help to buy) are bearing fruit. Credit isup (despite still-low demand from SMEs), and real estate is rebounding.

>The BoE has still time before raising its key rates. Ination has denitely decelerated and we donot expect the unemployment rate to fall below the 7% threshold before mid-2015.

> New real estate bubble

created

> Excessive increase in

long-term rates under the

inuence of US rates

ASIA

CHINA>GDP growth was better than expected in Q3 (7.8% yoy vs. 7.5% in Q2) and PMIs continue to point tostrong growth in Q4. However, the November PMIs point to a slight weakening in domestic demand.>Export growth rebounded in November (+12.7% yoy) and the trade surplus reached its highest level

since Jan. 2009. Even if it was partly driven by a basis effect, i t reects the strength of global demand.>The authorities want to slow liquidity growth to a more sustainable level. Looking ahead, rms and

households will thus probably face rising borrowing costs which could weigh on internal demand.

> Sporadic interbanktensions

> Tighter credit conditions

INDIA >GDP slightly accelerated to 4.8% yoy in Q3 (from 4.4% in Q2 a four-year low): private consumptionaccelerated to 2.2% (from 1.6%), government spending contracted 1.1% while investment jumped 2.6%.

>Inations accelerated in October (+10% yoy), due to the rupees depreciation. It should recedesomewhat in 2014 (monetary tightening, rupee stabilisation). The RBI will continue to tighten itspolicy to contain inationary pressure.

>India suf fers from twin decits that will persist in the coming years. Reviving growth is key, unlessthe credit rating may be cut to junk in 2014. All eyes are focused on the general elections (whichshould be held by May 2014).

> Persistence of highcurrent decit.

> The Feds tapering put at

risk the currency

JAPAN >Abenomics: a recovery driven by public spending and consumption, not by business investment.The trade decit continues to worsen, despite the yens decline.

>Ination returned in positive terri tory with the increase in import prices tied to devaluation, but wages(excl. bonuses) have stagnated so far. This is the key variable for gauging an exit from deation.

>The VAT hike (from 5 to 8% on 1 April) is putting activity at risk in Q2 14, but should boostconsumption by this date. A 5 trln stimulus plan will counter the effects. The BoJ may takeadditional measures to secure an exit from deation.

> VAT hike vs. stimulus

plan: Great uncertainty on

impact

> Business investment and

real wages not picking up



5

December 2013 #12

annualaverages (%)

Real GDP growth, % Ination (CPI, yoy, %)

2012 2013 2014 2012 2013 2014

US 2.8 1.6 2.3 2.1 1.6 1.7

Japan 2.0 1.8 1.9 0.0 0.1 1.9

Eurozone -0.5 -0.4 0.9 2.5 1.4 1.1

Germany 0.9 0.6 1.8 2.1 1.7 1.6

France 0.0 0.1 0.6 2.2 1.2 1.0

Italy -2.6 -1.7 0.2 3.3 1.6 0.9

Spain -1.6 -1.4 0.2 2.4 1.2 0.7

Netherlands -1.3 -1.1 0.4 2.8 1.8 1.2

Greece -6.4 -4.5 -0.4 1.5 0.0 -0.4

Portugal -3.2 -2.0 0.0 2.8 0.4 0.8

Ireland 0.2 0.8 2.0 1.9 1.0 1.2

UK 0.1 1.3 2.2 2.8 2.8 2.3

Russia 3.4 2.0 2.5 5.1 5.5 4.8

Turkey 2.6 3.5 3.8 8.9 6.1 6.0

China 7.8 7.6 7.3 2.7 2.6 3.4

India 5.0 5.5 5.5 9.3 8.5 8.0

Indonesia 6.2 5.5 5.0 4.3 6.0 5.5

Brazil 0.9 2.3 2.8 5.4 6.0 5.5

Macroeconomic and nancial forecasts

EUR: slightly to the downside due to weak growth. The euro is strong for severalreasons (historical current account balance, contraction of the ECBs balance sheet,capital inows), some of which are expected to reverse in 2014.

USD:the gradual reduction in securities purchases by the Fed is expected to underpin thedollar as US rates are likely to rise further than other advanced countries.

JPY:the yen is expected to continue to weaken, especially if the anticipations strengthen foradditional action by the BoJ in the spring.

GBP:moderately to the downside. Fundamentals are improving more sharply in the UnitedKingdom. The rate spread is expected to underpin sterling.

AUD:expect a drop in the AUD/USD exchange rate.

CURRENCY OUTLOOK

05/12/2013 Amundi

+ 6m.Consensus

Q2 2014Amundi+ 12m.

ConsensusQ4 2014

EUR/USD 1.37 1.30 1.30 1.30 1.28

USD/JPY 102.1 105 104 110 108

GBP/USD 1.63 1.63 1.58 1.56 1.58

USD/CHF 0.90 0.96 0.96 0.96 0.99

USD/NOK 6.16 6.08 6.07 6.24 6.18

USD/SEK 6.50 6.62 6.67 6.80 6.8

USD/CAD 1.06 1.10 1.07 1.10 1.07

AUD/USD 0.90 0.90 0.89 0.85 0.89

NZD/USD 0.82 0.80 0.80 0.80 0.80

United States:in the short term, tapering may lead to further steepening of the yieldcurve. That said, the rise in long yields wil l be contained. The traditional bear attening,associated with a rise in key rates, will not occur before mid-2014 at the earliest, thanksto improved forward guidance.

Eurozone:the expected rise in long yields will come from an improving growth trend,but above all from the rise in yields in the United States. Noteworthy developments: (1)surplus global liquidity should ensure continued low spreads, both on sovereign debt

and corporate bonds; (2) a new VLTRO from the ECB would come with conditions andbanks would not be able to use the liquidit y to increase their sovereign debt exposure.Peripheral spreads are therefore expected to stabilise.

United Kingdom:the solid growth trend and the gradual recovery of the l abour marketmean that we are pricing in a rise in yi elds in line with the United States.

Japan:Japanese government bond rates are entirely under the BoJs control. As longas QE continues, there is no reason for rates to move signicantly.

LONG RATE OUTLOOK 2 Y. Bond yield forecasts

09/12/13 Amundi

+ 6m.Consensus

Q2 2014Amundi+ 12m.

ConsensusQ4 2014

US 0.29 0.4 0/0.6 0 0.6 0 0.60 /0.80 0.9 3

Germany 0.22 0.20 /0.4 0 0.28 0.4 0/ 0.6 0 0.4 6

Japan 0.0 9 0.10/ 0.2 0 0.14 0.10/ 0.20 0,16

UK 0.50 0.40 /0.6 0 0.75 0.6 0/ 0.80 1.07

10Y. Bond yield forecasts

9/12/2013 Amundi+ 6m.

ConsensusQ2 2014

Amundi+ 12m.

ConsensusQ4 2014

US 2.8 4 3.20 /3.40 3.0 8 3.4 0/ 3.6 0 3.41

Germany 1 .84 2.0 0/ 2.20 2.0 9 2.20/ 2.4 0 2.36

Japan 0.66 0.8 0/ 1.0 0 0.87 0.8 0/ 1.0 0 0.95

UK 2.91 3.0 0/ 3.2 0 3.11 3.20/ 3.4 0 3.37

KEY INTEREST RATE OUTLOOK

FED: the start of tapering should occur in Q1. However, there is no predened rate forreeling in securities purchases and no intention to hike key rates before H2 2015.

ECB: no hike in key rates until at least 2016. All options are on the table. The ECB reducedits ination forecast to below that of the consensus (1.1% vs. 1.3%). It will not hesitate to act inthe event of increases in money-market or bond rates associated with upward US rate trends.

BoJ: further quantitative easing measures likely in spring or summer 2014.

BoE:no additional QE. But no hike in key rates before 2015.

10/12/2013 Amundi

+ 6m.Consensus

Q1 2014Amundi+ 12m.

ConsensusQ3 2014

US 0.25 0.25 0.25 0.25 0.25

Eurozone 0.25 0.25 0.25 0.25 0.25Japan 0.10 0.10 0.10 0.10 0.10

UK 0.50 0.50 0.50 0.50 0.50

United States: cyclical recovery underway. Sharp slowdown expected in Q4 i n light ofthe substantial contribution from inventories to growth in Q3. However, growth will pickup again in 2014; risks are to the upside, particularly in terms of investment.

Japan: major uncertainty in light of the VAT increase next April. We are expecting stablegrowth, however, the trend will be somewhat turbulent (Q1/Q2 2014).

Eurozone: weak growth and disination on the horizon

-All - o r almost al l - countries wi ll post posit ive growth in 2014, however, unemploymentwill continue to rise everywhere (Germany is an exception).

- Exports will barely offset the weakness of domestic demand in Spain and Italy.

- Bank lending to SMEs remains frozen in peripheral countries, which is hampering therecovery.

Emerging vs. developed countries: the emerging bloc is particularly fragmented. In

2014, the growth rate in advanced countries will almost double, while in emerging countries,it will remain stable.

Asia will remain the most buoyant region in the emerging markets.

Brazil: ination remains a major concern for the central bank. Growth is expected tostabilise.

China: a slowdown in domestic demand is likely, however, external demand remains strong.Growth is expected to stabil ise at around 7%-7.5% in 2014.

MACROECONOMIC OUTLOOK



6

December 2013 #12

A few months ago, we held the view that Europe, and more specically theeurozone, had entered a particularly dynamic growth phase, especially as far asthe equity markets were concerned (see some of our recent issues: Europeanequity markets a sleeping ready to awaken, Special Focus September 2013).Outperformance was (+19% for Eurozone equities, between June 30th andDecember 2nd, compared to 12% for US equities, for instance), but the actualsituation is still not optimistic.

To virtually everyones surprise, the sharp drop in ination rates forced the ECB

to ease its monetary policy stance, providing insight into the deationary fearsperceived by this European monetary institution.

Admittedly, eurozone countries are emerging one after another from recessionbut the rebound is very subdued (+0.1% for Spain, for instance) and shaky.

The credit rating agencies have upgraded the outlook on Portugals debt to stablefrom negative but we know perfectly well that the solvency issues bedevillingsome countries on the EU periphery have not been solved: the lower the growth,the greater the risk to solvency.

The labour market remains very depressed.

France is beginning to cause alarm, including our German partners, who viewlower ination, the burden of public expenditure and the labour market in thispolicy mix as signicant signs of weakness.

Government debt is not yet under control in a number of countries.

What are the strengths of the eurozone?

1. Just as in the United States, nancial market stress is very low

Perhaps the decline in nancial market stress can be attributed to central bankers,who, through their statements and actions (maintaining low short-term interestrates and unconventional, expansionary policies), have managed to provide someassurance in the area of systemic risks. The over-abundance of liquidity is a fact andit is projected to persist in Japan and in the eurozone; meanwhile the United Statesseems reluctant to rush the tapering of government asset purchasing programmes.

2. Europe is gradually pulling out of recession

Ireland in Q2, Spain in Q3 and Greece any time now, if you trust the IMFs outlookforecasting positive GDP growth in 2014 for that country. The fact that all the countriesin the eurozone have returned to a growth track is without doubt good news amidstfears that the entire region may be plunged into a new recession (a triple dip).

3. Unconventional monetary policy will remain accommodative

in the eurozone far longer than in the United States or the United Kingdom

Under the best-case scenario, the Fed will taper its Treasury securities purchaseprogramme sometime in mid-2014. Furthermore, we know that the Bank ofEngland has expressed scepticism as to the effectiveness of quantitative easingmeasures. As to the ECB, reviving of bank lending and supporting Europeseconomy (the peripheral countries as well as France, which is showing signs ofentering a downturn) will involve new measures. What we are talking about now are

purchases of long-term government securities (a long-term LTRO) combined withpurchases of corporate securities from banks. However, such programmes canonly be implemented for short periods of time.

Does the eurozone still hold some appeal?A few genuine strengths and some

well-identi ed risk factorsPHILIPPE ITHURBIDE, Global Head of Research, Strategy and Analysis Paris

1

Positive growth in all eurozonecountries in 2014? Thats

what the IMF projects

The essential

Is the recent impressive performancefrom European risky assets likely runup against fresh fears of deation,sluggish economic activity andbank lending fragility? Do currentmarket valuations (equities andcredit spreads, risk premia, etc.)adequately reward risk? These are thefundamental concerns that investorshave raised yet again.

The eurozone still has a number of key

strengths: it has pulled out of recession,interest rates are projected to remain low forthe foreseeable future, new unconventionalmeasures are a possibility, nancial marketstress is low, investment opportunitiesabound in some countries and sectors, a lagrelative to US markets in terms of valuationand leveraging, etc. As to risk, it is nearlyunchanged but it exists all the same.



7

December 2013 #12

4. Conventional monetary policy will remain accommodative in the eurozonefar longer than in the United States or the United Kingdom.

Although an init ial hike in US interest rates is expected sometime in 2015, it is very

hard to imagine that the ECB will reverse its interest policy any time before 2016.The ECBs stated objective is fourfold:

Curb deation risks

Consolidate growth

Revitalise the bank lending market

Prevent a sharp appreciation in the euro

These four objectives suggest that short-term interest rate will be kept low for theforeseeable future.

5. Less pressure on long rates

Growth is projected to remain weaker in the eurozone than in the United States orthe United Kingdom and long rates will remain low as there is absolutely no internaljustication for an increase. There is no pressure to the upside on long euro ratesthat could come from monetary policy, ination or growth. US rates will remainthe most important factor inuencing European rates. The ECBs unconventionalprogramme will contain long rates (for that matter, its one of its objectives).American nancial governance removes a trump card from US bonds. Pursuit ofgreater diversication following the extreme risk posed by a technical default bythe United States on Federal debt is becoming indispensable (see our Novemberarticle, Debt, decits and governance.Diversifying outside of the United States:simple common sense .

6. The European corporate bond market is still more attractive.

Credit spreads are tight and default rates are low in both the United States and

the eurozone. However, in our view, the eurozone has a number of signicantstrengths:

Firstly, the market is transitioning. Without adequate bank lending, the HY creditmarket has welcomed more than 50 new issuers since the beginning of the yearand is very dynamic (more than 40 issues last month alone) ensuring liquidity,diversity and opportunities.

The eurozone remains fragmented, which offers investors more opportunities.

Country after country is emerging from recession. Unlike the United States,growth is currently uneven among the European states but this also offers a fewmore opportunities.

The gradual emergence from recession offers country-by-country, sector-by-sector and region-by-region opportunities, which is a signicant advantage foralpha strategies.

European corporations are more investor-friendly because of their position in thecredit cycle.

Overall, although US growth is doing a good job of protecting the US corporatebond market (however, this should be put in perspective in light of the debate onthe debt and the decit, the risk of a shutdown and technical default), the strengthsof the eurozone are easily identiable.

7. Higher long rates are not jeopardising banks or the economy

We stated earlier that one of the main risks to European long rates is US rates.If these begin to rise again, what will be the consequences for the Europeaneconomy?

But rst, let us recall that large European sovereigns (with France and Germany atthe top of the list) are far more sensitive to long rates than to short rates.

Furthermore, countries with a higher proportion of variable-rate loans are more atrisk (Spain, Italy and Ireland).

Moving toward newunconventional measures inthe eurozone

A number of opportunities onthe European corporate bondmarket

Higher long rates hold morethan drawbacks for the

eurozone



8

December 2013 #12

Banks normally stress their loan portfolios as interest rates move -a legitimatepractice. But it is hard to argue that the total cost of risk increases when interestrates are climbing. Higher rates do not necessarily entail harmful effects only. On

the other hand, when higher rates are unjustied given the health of the economy,the effects on loans are negative.

Any pickup in long rates is expected to be limited and is likely to occur without arise in short-term interest rates, which is a favourable scenario for banks as theypursue their transition efforts.

8. Flows to European equity markets are expected to last

Using our method for country selection (see our Special Focus January 2013:Country equity allocation: methodology note), in the space of a few monthsEurope has switched from repair mode to challenger, ultimately achieving a starranking in the (good) company of the United States and Japan. We are aware thatthe United States are ahead of the cycle, which has barely begun in Europe. Thisexplains why portfolios have been overweight for quite some time. European equity

markets have priced in an improvement in prots. The PER calculated on protsover the last 12 months has returned to its 2007 level. Now, earnings have toactually follow suit. Of course, a pause is possible, but normalisation will continue.Prots are still 30% lower than in 2007, whereas they are already 30% higher in theUnited States. This trend is likely to continue to attract investors.

9. New sources of return

The decline in bank lending and continued bank deleveraging have led to the rapidgrowth of new investment vehicles, such as bank lending portfolios.

10. The US scal position: a challenge for governance and extreme risks

Since the month of January for the budget and since February for the debt ceiling,forestalling political gridlock, a shutdown or even a technical default with the

risk of an easily imaginable exploding global nancial and economic crisis hasbecome a necessity. The risk of default, even if technical and only temporary, isno longer merely an exercise in style it is a low-probability extreme risk whoseterrifying implications are hard to measure. Any default would trigger a haircut,margin calls and sales of US bonds. Whether this transpires or not, diversifyingyour portfolio and collateralisation assets simply makes sense its indisputablethat there is always a role for Europe to play.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Germany

France

Belgium

Netherlands

Denmark

Sweden

UK

Italy

Spain

Ireland

Norway

Finland

Portugal

Source: ECB, Amundi Research

Fixed Rate

Variable Rate

1 Mortgage Markets splitby type of interest rates

The European market islagging behind the cycle andin international portfolios

A climate that bodes well fordiversi cation... notably inEuropes favour



9

December 2013 #12

2013 is not over yet, but it will go down in history as a good year for equitymarkets. Next month will be the opportunity to take stock and make projectionsfor 2014. In the meantime, this article gives an overview of long-term prospectsfor equities by explaining one of our models.

Our approach combines two aspects: valuation and momentum

For valuation, we use four criteria: 1) cyclically-adjusted price-earnings ratios(CAPE), 2) a composite valuation index (CVI) combining price-earnings ratio,price to book ratio and dividend yield, 3) risk premia ; and 4) real yields. Thesefour criteria are equally weighted and graded on a scale of 0 to 100 shown onthe x-axis (see second and third graphs). The further to the r ight the market ispositioned on the graph, the more expensive it is.

The CVI is a measure that simply allows the classic valuation ratios to becompared over a long-term period, as a means of counteracting cyclicality. Therisk premium compares the earnings yield (the inverse of the P/E ratio) withreal long-term bond yields (for these purposes, we use long-term rates less theve year average ination). The lower real yields are, the higher the equilibriumrisk premium will be, we therefore also include the real yield level as a separatecriterion. The cyclically-adjusted P/E ratios are calculated on the basis of datasupplied by MSCI.

For the momentum, we take into account trends in equity prices against their1-year, 4-year and 10-year averages. We also include the market ownership

level, looking at accumulated ows over a three-year period. These criteria areweighted equally and graded on a scale of 0 to 100 corresponding to the y-axis.The higher up the axis the market is situated, the more positive its long-term momentum is.

The markets positioned between 50 and 75 on the y-axis are either neutral trend-wise, with a reasonable level of ownership, or positive in terms of price trend andunder-owned. Above 75, the markets have both a strong pr ice momentum and ahigh level of ownership by investors. This combination is the sign of an excessivemomentum.

The valuation gure (x-axis) gives us a reading approximately10 years into the future

Cyclically-adjusted P/E ratios are particularly useful (see graph 1). There is a

golden rule that applies to the US market which states that the opposite of theP/E ratio corresponds to the long-term performance we can expect from themarket at least 10 years into the future. A cyclically-adjusted P/E ratio of 15xwould make the real average protability of the US market 6.7%; at 20x it wouldbe 5%, while at 10x it would be 10%. Calculated in this way, the US marketsprojected real long-term annualized total return (+4.7%) at a cyclically-adjusted P/E ratio of 21would be lower than its historical average.

If we consider reported prots (as Robert Shiller), the CAPE is 25x and long termexpected return falls to 4%. It is also possible to use a regression of annualizedreturns on CAPE to be more precise. In this case long term returns would beeven lower, in the region of 3%.

Given the rates on government bonds (2.8% for 10-year debt and 3.8% for

30-year debt), the comparison comes out in favour of equities but the riskpremium is not very attractive either. If we assumed a normalisation of US10-year rates towards approximately 4% in ve years time, the real annualisedperformance of US government bonds would be only +0.5%a differential of2.5% to 4.2% in favour of equity depending on the method.

The essential

We have used a two-dimensionalapproach (valuation and momentum)to represent the long-term prospectsof equity markets.

Valuation (corresponding to the x-axis) offersa reading at least 10 years into the future.By factoring in momentum (y-axis), we cananalyse the data more comprehensivelyand look at a shorter timeframe (3-5 years).What emerges is that equities hold morepotential than government bonds, but thatthe established order within equity marketsmay be revised. In the developed countries,it would seem appropriate to diversifyassets outside the United States, both inthe long and medium term, in particular byturning to the eurozone and Japan. In theemerging camp, the challenge for the starperformers of recent years will be to steerclear of the Falling Angels quadrant.

Equity markets: a snapshot of long-termprospects

ERIC MIJOT, Co-Head of Strategy and Economic Research Par is

DELPHINE GEORGES,Strategy and Economic Research Paris

2

1

10

100

1000

10000

0

10

20

30

40

50

60

70

80

90

100

1881

1889

1897

1905

1913

1921

1929

1937

1945

1953

1961

1969

1977

1985

1993

2001

2009

Source: Shiller data, Amundi Research

CAPE* 15

15 +/- 5 S&P 500

Trend

* Cyclically Adjusted PE

1 US market and cyclically adjusted PE

Prefer equitiesto governement bonds



10

December 2013 #12

In the long run, this plays for a diversification out of the US; in the long-term, the US equity market looks less attractive than other markets.The re lationship between cyclical ly-adjusted P/E ratios and projected long-term

returns is historically easier to demonstrate in the United States than elsewherethanks to the quality and depth of US statistics. Nonetheless, the relationshipcan be calculated for the other markets as well. Based on anticipated US marketexpected returns, we can use the distance from this measure on the x-axis inour graph to estimate the long-term expected return of every other market.Without going into specific numbers, it can be said that the United States ismore expensive than the average. The US is not aloneDenmark, Switzerland,the Netherlands, Belgium and Australia (the countries furthest to the right onthe graph) are also above the average. On the cheaper end are Austria, Greece,Italy, Norway and Japan.

Lets now add momentum to the picture. The input fromthis second variable (y-axis) allows for a more thoroughanalysis and a shorter predictive timeframe (three to ve years)

Several observations can be made:

1) Most of the markets are situated in the top two quadrants. Contrary to what iscommonly believed, equity markets are definitively on a long-term positivetrend. One cannot exclude the possibility that this trend will continue. Theequity markets have erased the 2007 crisis in the United States and the 2010crisis in Europe, which is a sign of confidence in the future.

2) It is clear that the US market is on a bullish trend (see graph 2). But while thismarket is expensive (as demonstrated earlier), it is also overbought (situatedhigher than 75 on the y-axis). Thus it may be prudent to diversify outsidethe United States, not only on a long-term basis but also for the mediumterm.This issue was addressed from a different angle by Philippe Ithurbide inlast months Cross Asset publication (see Article 1 from November 2013: Debt,

deficits and governance. Diversifying outside of the United States: simplecommon sense).

3)Japan offers an interesting alternative.The Japanese market has comeout of the lower left-hand quadrant (Potential value traps), where it wassituated for a long period of time, occupying a more neutral position sinceMarch, a sign of positive momentum. It is no longer on a negative trend, andflows are returning, albeit partly due to the purchases by the BoJ. Despitethe weak yen (a short-term boon), Abenomics still has to deliver convincingstructural reforms to secure the medium-term performance of the Japanesemarket.

4) The markets of Southern Europe left the lower left-hand quadrant even morerecently, this August. They are now also in more neutral territory. Spain is slightlymore expensive than Italy. Only Portugal lags behind. Investors appear to beconvinced that the eurozone crisis is over for good. If this is indeed the case,then the eurozone markets could be among the long-term winners, andthis is not only the case for the Southern European countries.Germany, forone, comes out very favourably on both axes in our graph.

5) On the emerging markets front (see the third graph), the BRIC nationsand several European markets are situated in the Opportunities quadrant(upper left-hand side). However, their path has been the reverse of Japanand Southern Europe, which slightly mitigates the positive side of theirpositioning.In some instances they even come close to the Potential valuetraps quadrant (e.g. Brazil). Meanwhile, some other emerging markets are moreexpensive and sometimes overbought (the Philippines, South Africa, Colombiaand Turkey). Their ability to attract higher flows can now be questioned, at leastfor the most fragile of them in terms of fundamentals (current account balance,basic balance, etc.). The exceptional period they went through from the 1997Asian financial cris is to the Arab Spring in 2011 may be nearing its end. In2013, the discussion on Fed tapering served as a reminder of these countriesdependence on US monetary policy. Among the five countries reputed to bethe most fragile, those that pose the biggest risk according to this approach are

In the long-term, Europe andJapan are more attractive thanthe United States

AT

DE

SG

NO

JP

FR

GB

FI

CH

IT

GR

AU

NLSE

HK

CA

ES

US

DK

BE

PT

IE

0

10

20

30

40

50

60

70

80

90

100

010

20

30

40

50

60

70

80

90

100

Longtermm

omentum

Valuation

Source: Amundi Research

Cheap Expensive

Weak

Strong

Value traps?

Opportunities? excessiveoptimism?

Fallingangels?

2 Mapping: developped countries

RUHUTW

CZ

AR

PLCN

KR

TH

IN MY

BR

PH

ID

PE

MX

CL

COTR

ZA

0

10

20

30

40

50

60

70

80

90

100

010

20

30

40

50

60

70

80

90

100

Longtermm

omentum

Valuation

Source: Amundi Research

Cheap Expensive

Weak

Strong

Value traps?

Opportunities? excessiveoptimism?

Fallingangels?

3 Mapping: emerging countries



11

December 2013 #12

South Africa, Indonesia and Turkey. India would be in an intermediary position,and Brazil would be slightly more solid. An interesting case is that of Mexico,with a lower ownership level but very expensive. Its proximity to the United

States gives it a cer tain advantage, but it seems the market has taken notice ofthis fact, which harms its long-term prospects. Finally, Peru and Chile are lessconvincing in terms of momentum, although their valuation is quite averagecompared to the other markets.

Conclusion

This approach offers a snapshot of the equity markets. It appears that inthe long term, equities hold potential, but that the established order may berevised. In the developed countries, it seems opportune to diversify assetsoutside the United States, particularly into the eurozone markets and Japan.In the emerging markets, there is no guarantee that the star performers ofrecent years will retain this status forever. For the most fragile among these, thechallenge is to steer clear of the Falling Angels camp.

South Africa, Turkey andIndonesia: Future FallingAngels?



12

December 2013 #12

The essential

Is Germanys current account surplusexcessive? And, if so, is it a sourceof deation? These questions mayseem surprising. When it comes tothe balance of trade, the tendencyis to point the nger at the countrieswith excessive decits, not those withexcessive surpluses. But to do this isto forget that, on a global scale, thedecit of one country is the surplusof another. And when imbalancesbecome excessive, the burden tocorrect the imbalance cannot beborne solely by the decit-producingcountries For Germany, the recentrise of its current account surplus(to 7% of GDP) was the spark thattriggered a warning by the EuropeanCommission.

The debate that pits the German governmentagainst the European Commission, theIMF and even the US Treasury should (1)revive the debate on which macroeconomicadjustments are required in order to absorb

excessive imbalances in current accounttransactions; and (2) serve as a reminderthat the origins of deation are not only tobe found in (peripheral) countries that aredeleveraging, but also in those with excesssavings (i.e. Germany).

As disinationary pressures mount acrossthe monetary union, the challenge is notonly for the German government, but alsofor the ECB. And is the end to the crisisto be achieved through a mix of structuralreforms (peripheral countries and France),scal stimulus measures (Germany) and

renewed monetary accommodation measures(liquidity or securities purchases)?

Is Germanys current account surplus excessive? At rst, this question mayseem surprising. When it comes to the balance of trade, the tendency is topoint the nger at the countries with excessive decits, not those with excessivesurpluses. The former are seen as wasteful spenders while the latter are laudedfor their productivity, cost control and effective specialisation, among otherthings. Seen from this angle, the countries with excessive decits appear to bethe appropriate candidates for adjustment reforms (lowering costs, structuralreforms, productivity gains). But to do this is to forget that the decit of onecountry is the surplus of another. And when imbalances become excessive, theburden to correct the imbalance cannot be borne solely by the decit-producingcountriesespecially within a monetary union where, in the absence of nominalexchange rate adjustments, price changes and relative costs are the only means

by which a country can improve its foreign competitiveness. For Germany, therecent rise of its current account surplus (to 7% of GDP) was the spark thattriggered a warning by the European Commission. In this article, we will revisita debate that has the German government squared off against the combinedforce of the European Commission, the IMF and even the US Treasury. We willalso explore what may happen if the adjustment in the eurozone also occurredthrough a rebalancing of relative demand.

Current account decits and surpluses: two sides of the samecoin

Viewed globally, trade surpluses are, by denit ion, of fset by trade decits acrossdifferent countries. When the imbalances become excessivesay, above 5%or 6% of GDPthey reect an undesirable macroeconomic trend that is often

paralleled in a clearly dened region.Just as there are good and bad decits, there are also good and badsurpluses. The situation of a country whose current account decit is the resultof a private investment boom nanced by inows of foreign direct investment andpurchases of domestic equities by non-residents (like the United States in thesecond half of the 1990s) is quite different from that of a country experiencinga boom in consumption from a soaring property market largely nanced bydebt (like Spain in the 2000s). In the former example, the investment is to someextent a driver of future growth; in the latter, the excess debt is bound to stiegrowth. In the eurozones peripheral countries, the explosion of current accountdecits in the 2000s was a reection of soaring private sector debt (householdsand non-nancial enterprises), leading to a sharp worsening of these countriesnet external liability positions. With the single currency, governments wronglyassumed they were nally unbound by external constraints. What they forgotwas that the accumulation of decits translates into an increase in liabilities vis--vis the rest of the world. And accumulating debt for consumption needs is notquite the same as nancing productive investments via FDIs.

So far, the correction in imbalances has been uneven

Although trade imbalances have largely narrowed in the eurozone (with Francea notable exception), this has had more to do with a decline in domesticdemand and gains in price-competitiveness in the decit countries than witha strengthening of domestic demand in the surplus countries. The eurozonescurrent account balance, which was near equilibrium in 2009-2011, rose toabove 2% of GDP in 2013, while Germanys current account surplus rose tonearly 7% of GDP. Between 2010 and 2012 in Germany, net expor ts contributedone percentage point to growth. Were it not for the positive contribution of

Germany, source of de ation ?

DIDIER BOROWSKI,Co-Head of Strategy and Economic Research Paris

3

With euro, governmentswrongly assumed they were nally unbound by externalconstraints



13

December 2013 #12

foreign trade, Germany would have been in recession in 2012. Meanwhile,exports from the eurozones peripheral countries have tended to decline or growmuch less rapidly than exports outside the eurozone. This clearly shows that

Europe is relying too much on foreign demand for its recovery and not enoughon domestic demand, which is too weak in the surplus countries.

Excessive current account decits are no longer part of the landscape of Europestrade imbalances, but the same cannot be said of excessive surplusesthese,by contrast, have been growing. There is something wrong with this picture.Surpluses result in excess savings, a less-than-optimal situation. As taught byKeynes after World war II, the international monetary system would be morebalanced if surplus-producing countries were treated the same as countrieswith decits. And what is true for the international monetary system is also truein the context of a monetary union.

Is Germany the new China?

Until recently, the US Treasurys semi-annual reports on exchange rate policy

trends have pointed the nger at China. Lacking or insufcient exibility in itsexchange rate regime resulted in a rapid accumulation of foreign exchangereserves. But things have changed. Chinas currency has appreciated while itscurrent account surplus has fallen signicantly (from 10% of GDP in 2007 to2.3% of GDP in 2013), to the extent that its contribution to domestic growth isnow close to nil. German and Chinese current account surpluses are now veryclose (in US dollar terms).

In late October, the US Treasury took the Europeans by surprise by turningits attention away from China and towards Germany. The message wasthat countries with excessive current account surpluses had to undergo anadjustment. Under a exible exchange rate system, their exchange rates wouldautomatically appreciate, helping to rebalance their accounts. Countries usingxed (or centrally-managed) exchange rates, like China, would see their foreign

exchange reserves grow continuouslyan unacceptable outcome. But whathappens in a monetary union such as the eurozone? There is no mechanismin place to guarantee that the surplus countries will recycle their surplusestowards eurozone countries that need it most. A single currency does notguarantee an optimal allocation of savings within the monetary union. Thisis ultimately one of the reasons why the European Commission established amultilateral surveillance procedure to monitor current account imbalances.

As in the case of China, the needed correction cannot be achieved through foreignexchange policy alonedemand also has to play a par t. An increase in domesticdemand in Germany (both investment and consumption) could play the same roleas the rebalancing of Chinas growth model in favour of domestic consumption.

Germanys surplus exerts a deationary bias

Deationary pressure in the eurozone is often portrayed as the result of internaldevaluation policies undertaken by Southern European countries. These policiesare viewed as necessary for offsetting previous excesses (excess debt but alsoination). After all, when prices decline more sharply than wages in SouthernEurope, this results in a distribution of gains in purchasing power to households.But how do we account for the weak ination of the core countries? In Germany,falling unemployment and rising real wages should have generated upwardpressure on prices.

But in spite of the high degree of fragmentation in the eurozones economiccycle, ination is slowing simultaneously in most countries. Ultimately, this isbecause deleveraging in the peripheral countries has been accompanied byGermanys current account surplus as a source of deation. The EuropeanCommission says as much when it singles out Germany to take responsibility.

Germanys excess savings are now seen as being as reprehensible as theexcess debt accumulated by the peripheral countries before. The latter wereguilty of doping growth and creating ination; the former of curbing growthand exerting deationary pressure at the worst possible time, which complicatesthe task of the ECB.

0

50

100

150

200

250

300

350

Q11999

Q12000

Q12001

Q12002

Q12003

Q12004

Q12005

Q12006

Q12007

Q12008

Q12009

Q12010

Q12011

Q12012

Q12013

Source: Datastream, Amundi Research

Germany

China

2 Trade balance: Germany vs. China (USD bn)

12%

13%

14%

15%

38%

39%

40%

41%

42%

43%

44%

45%

46%

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Source Datastream, Amundi Research

Exports

Imports (Rhs)

1 Germany: Exports (to) and imports (from)the eurozone (% of total)

The international monetarysystem would be more

balanced if surplus-producingcountries were treated thesame as countries with de cits



14

December 2013 #12

It is striking to see the European Commission and US Treasury on the same sideof the issue. But since the Great Recession, the global economy has been insearch of a consumer of last resort. Before 2007, the US consumer played

this role. But US consumption is no longer as robust as it used to be. Chinaseconomy, meanwhile, is struggling to rebalance its growth model in favour ofdomestic consumption. What the global economy is ultimately waiting for is theGerman consumer. The eurozones trade balance is exerting upward pressureon the currency, which is having counterproductive impacts for countriesundertaking internal devaluation.

Its time for Germany to act

Between reunication and 2007, Germanys trend growth (ve-year moving average)was below that of France, Italy and even Spain. And while Germany was successfulin implementing its structural reforms (particularly on the labour market), this waslargely thanks to the fact that it could count on strong demand from its maintrading partners. The large share of exports in its GDP (over 50%), meanwhile,allowed it to reap some benet from its trading partners growing debt.

Today, the situation is the reverse: Germany is where the most sol id growth isoccurring. In the same way that the European authorit ies urged Spain to undergoan internal devaluation (among other things) to absorb its current account deci t,it is legitimate to ask Germany to absorb part of its excessive surplus (i.e. toreduce its savings surplus). Naturally, Germany refuses to undergo an internalrevaluation (i.e. allow wages to rise), as this would harm a competitive advantageearned through sustained effort over decades (investment in R&D, specialisationin high value-added goods, productivity efforts, wage moderation, etc.). But ithas no obligation to do so. The required correction canand shouldtake theform of an adjustment to demand, and not to prices.

Is Germany headed for a change of course?

All eyes are now on Germanys new government. The country is posting twinsurpluses and its debt-to-GDP ratio began to decline in 2013. The need forinfrastructure investment has been clearly identied. Germany could easilyborrow to nance its investment plansGermanys total funding requirement(maturing debt) stands at only 8% of GDP, compared to 22% on average inthe advanced economies. In addition, it could lighten the tax burden (whichhas a punishing effect on consumption) and raise the minimum wage to givehouseholds a boost. The German government could condently nance suchmeasures without putting its public nances in danger or causing a long-terminterest rate spike. The supportive effect for its trading partners would besignicant.

Conclusion: wait and see

Germanys current account surplus and its causes will remain hot topics for

some time. This has some posit ive consequences; rstly, it will help revive an olddebate on which macroeconomic adjustments are required in order to absorbexcessive imbalances in current account transactions. Secondly, it will serveas a reminder that the origins of deation are not only to be found in countrieswith spiralling debt, but also in those with excess savings (i.e. Germany). Asdisinationary pressures mount across the eurozone, the challenge is not onlyfor the German government, but also for the ECB.

And if the end to the cris is were to be achieved through a mix of structuralreforms (peripheral countries and France), scal stimulus measures (Germany)and renewed monetary accommodation measures (liquidity or securitiespurchases), this would spell good news for the eurozone on all frontsit would(1) stimulate domestic demand; (2) provide support to the banking sector tonance the economy; and (3) diminish the eurozones current account surplus

and cause the euro to depreciate. On this last point, the increase in the ECBsbalance sheet would strengthen trading channels to help push down the euro(see Article 4), which would boost the foreign competitiveness of the most fragilecountries. If deationary pressure intensies in the months to come, this will bethe only way out.

-2

-1,5

-1

-0,5

0

0,5

1

1,5

2

2,50

0,5

1

1,5

2

2,5

3

3,5

4

4,5

97 98 99 00 01 02 04 05 06 07 08 09 11 12 13


Inflation (% yoy, 3m MA)Current account (% of GDP, Rhs. inverted)

4 Eurozone: Current account vs ination

25

30

35

40

45

50

55

Q1

1999

Q1

2000

Q1

2001

Q1

2002

Q1

2003

Q1

2004

Q1

2005

Q1

2006

Q1

2007

Q1

2008

Q1

2009

Q1

2010

Q1

2011

Q1

2012

Q1

2013


Exports

Imports

3 Germany: Foreign trade (% of GDP)

Deleveraging in the

peripheral countries has beenaccompanied by Germanyscurrent account surplus as asource of de ation



15

December 2013 #12

Towards a stronger euro in case of deation

The very weak Eurozone ination gure released in October (+0.7% y-o-y) andSpains negative performance (-0.1% y-o-y) have revived fears of deation. At theNovember monetary policy committee, Mario Draghi, the ECB President, has himselfmentioned for the rst time an prolonged period of low ination. Meanwhile, theeuro has been under an appreciating pressure ever since mid-2012, despite theEurozones poor economic performance. One can only draw a parallel with the yen,as Japans economic history over the past 25 years provides a unique benchmarkdeation-of and the yen has been under appreciating pressures during that period

of time. In this context, what is to be expected for the euro if deation was to setin durably in the Eurozone?

The purchasing power parity (PPP), one of the most used theoretical relationshipsin nancial markets, has been spectacularly and powerfully illustrated by the yenhistory, ever since Japan entered deation in the early 1990s. With the quasi-stagnation of prices in Japan over this period of time, the nominal fair value of theyen to the dollar has risen signicantly.

If deation was to set in durably in the Eurozone and not in the United States, oneshould expect a substantial nominal appreciation of the euro versus the dollar.Ever since the early 1990s, the ination differential between the United States andJapan has been 2.3% on average (and only 0.4% between the United States andthe Eurozone). Taking as an assumption a similar ination differential over the yearsto come between the United States and the Eurozone (a deation scenario in the

Eurozone and not in the United States), the PPP would indicate a fair value of 1.32by end 2015 versus roughly 1.25 today (based on an estimation period runningfrom 1990 to date). However, one should not overly trust the fair values givenby the PPP, as this method is extremely sensitive to the estimation period underconsideration. Above all, one should note that the EUR/USD fair value indicated bythe PPP would rise substantially. Beyond, an ination close to zero in the Eurozonewould entail that the appreciation/depreciation of the real exchange rate wouldtake place exclusively via the nominal exchange rate.

A currency war between the Fed and the ECB? Rather an ECBbias towards a strong euro

Actually, ever since the announcement of QE-2, a regime change has occurredin the determination of the euro-dollar parity: ever since June 2010, the euro-

dollar exchange rate has been and remains driven essentially by the excessliquidity extended by the ECB (and more marginally the Fed). Indeed, a simplemonetarist pocket model of exchange rates explains between 50% and 75% of thechanges in the euro-dollar parity. Thus, against conventional wisdom, the eurosappreciating trend has, so far, had more to do with the deationary stance ofthe ECB than the reationary stance of the Fed.

The models structure: monetary drivers trump all other real/nominal determinants

In one of its simplest empirical versions(1), this pocket model of the euro-dollarparity reads:

$/ = + *FED *ECB +

where :

$/: the euro-dollar parity (measured as the number of dollars per euro),

FED: excess liquidity extended to the banking sector by the Fed,

ECB: excess liquidity extended to the banking sector by the ECB.

The essential

Based on traditional PPP models, deationin the Eurozone (while the Fed is reating theUS economy) would raise the euro-dollar fairvalue to 1.32 in 2015 (from 1.25 currently),thus appreciating the euro and furtherpushing the Eurozone into a Japan-style lostdecade

Beyond giving a similar fair value (1.32), asimple monetary model of the euro-dollarshows that it is the ECBs lack of largeliquidity injections that is pushing the euro-dollar up and not so much the Feds currentQE-3, thus calling for an expansion of theECBs balance sheet

Using this last model, simulations ofalternative scenarios of Fed tapering and/orECB LTRO strategy (no or limited balance-sheet expansion) show that an end to theFeds asset purchases would have a muchsmaller impact on the euro-dollar than largerECB liquidity supply.

What determines the euro-dollar?Essentially the ECBs (de ationary) stance

NICOLAS DOISY, Strategy and Economic Research Paris

BASTIEN DRUT,Strategy and Economic Research Paris

4

What can be expected of theeuro if de ation sets in durablyin the Eurozone?



16

December 2013 #12

This pocket model is clearly nested in a general monetarist model of foreign-exchangethat reads(2):

FX=[M M*][Y* Y][i i*]a

with: i i * = [r+E(m,I)] [r*+E* (m*,I*)]

where:

Mand M*: home and foreign nominal stock of money;

Yand Y*: home and foreign real national income;

i, i* and a: home and foreign nominal interest rate, interest elasticity of moneydemand;

randr*: home and foreign real interest rate;

E(m,I)and E*(m*,I*): home and foreign ination expectations as a function of thestock of base money (mandm*)(3)and all other relevant information ( Iand I*).

It is important to note that in the empirical reduced form presented above, FEDstands for m and ECB stands for m*: this means that the Fed and ECB liquidityare (theoretically considered to be and empirically validated as) the sole drivers ofthe movements in the euro-dollar parity. Accordingly, the impact of all the otherdeterminants included in the theoretical general monetarist model of foreign-exchange is much smaller than that of the Fed and ECB liquidity: to this extent, theyare considered to be summarized in the equations intercept, i.e. to inuence onlythe (medium- and long-term) fair values of the currency pair, which is an acceptableempirical simplication of the theoretical model.

The models insights: scarce ECB liquidity is the main driverof an under-valued dollar to the euro

A few key practical insights from these models are worth highlighting and illustrated

(for expositional purposes only: see footnote 1) with the empirical estimates shownabove:

The amount of ECB excess liquidity is the main driver of the euro-dollarparityaround its medium-term fair value, with a weight ranging from 60% to 80%versus 20% to 40% for the Fed liquidity (4)depending on the specication nallyretained;

The fair value of the parity is given by the empirical models intercept in thelong term, i.e. when excess liquidity extended by the Fed and the ECB cancel out(which means that both central banks have a similar inationary stance);

The fair value of the parity equals the euro-dollar average value in themedium term(i.e. 1.32 since the announcement of QE-2) in a context where theECB liquidity is kept bounded (due to the Bundesbanks anti-ination bias) and

the FED liquidity is free to keep expanding; The current fair value equals the medium-term fair value + central bankrelative liquidity:in simpler terms, the euro-dollar current fair value is determined

0

20

40

60

80

100

120

140

160

180

200

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014


Eurozone

US

Japan

1 Consumer prices index (100 in Jan. 1990)

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

199

0

199

2

199

4

199

6

199

8

200

0

200

2

200

4

200

6

200

8

201

0

201

2

201

4


EUR/USD

PPP

PPP deflation scenario

2 EUR/USD: PPP (estimation from 1990 to today)and simulation in case of deation

(1) This version is presented here as an example more than as a denitive one. Various

other versions were tested, which differ from each other by either the data used to proxythe ECB and/or Fed liquidity or the econometric specications used to estimate it (simple

OLS, VECM, SURE systems,). These will be further investigated in future work with

a view to selecting the specication most appropr iate to determine the euro-do llar fai r

value, which is given by the empirical models intercept.

(2) This general specication is taken from A monetarist model of exchange rate

determination by Thomas M. Humphrey (Federal Reserve Bank of R ichmond) published

in 1977.

(3) The empirical denition of m and m* is the one innovation introduced in the above

monetar ist mode l, as i t takes the form of cent ral bank l iquidity (base money) r ather thanthe growth of monetary aggregates.

(4) A Wald test conrms that both coefcients are weights to the extent that they sum to

1, remembering that the negative sign before the ECB coefcient has to be dropped to

perform the test since the latter reduces/increases the number of euro per dollar when

ECB liquidity increases/decreases.

The amount of ECB excessliquidity is the main driverof the euro-dollar parity



17

December 2013 #12

by the ECB/Fed relative inationary stances over the medium-term, as proxied bytheir (relative) excess liquidity.

The simulations show that the ECB has the euros futurein its hands

Based on these insights, this simple model can be used to simulate the impactof changes in both central banks inationary stances on the euro-dollar parityby tweaking the ECB and FED variables in the future, according to variousscenarios of:

the Fed tapering, depending on the timing, size and pace of the announcedreduction in the asset purchases conducted within the framework of QE-2 andQE-3;

and/or ECB inexion towards a more reationary stance coming in the form ofa balance-sheet expansion (either an expansion of the LTRO or e.g. outrightasset purchases).

This model shows clearly one thing: while the Fed is about to slow down thepace of its asset purchases, the future of the euro rests in the hands of the ECB.If the ECB was to leave deationary pressures to materialize without reacting,the euro would continue appreciating towards dangerous levels (that wouldaccelerate the fall into deation). Conversely, the euro would depreciate if theECB was to start expanding the size of its balance sheet.

In order to clarify further this issue, we have run scenarios based on this modelaccording to the respective options available to the ECB and the Fed.

Scenario 1: the ECB stays put the Fed continues QE-3

Scenario 2: the ECB stays put the Fed reduces QE-3 gradually starting inMarch

Scenario 3: the ECB stays put the Fed reduces QE-3 abruptly in March

Scenario 4: the ECB announces a new LTRO in early 2014 the Fed continuesQE-3

Scenario 5: the ECB announces a new LTRO in early 2014 the Fed reducesQE-3 gradually starting in March

Scenario 6: the ECB announces a new LTRO in early 2014 the Fed reducesQE-3 abruptly in March

The simulations of our pocket model show that the evolution of the EUR/USDparity should be driven by the policy chosen by the ECB to ght deationarypressures. If it were to decide an expansion of its balance sheet, it could drivethe equilibrium value of the parity below 1.35. However, if the ECB were not toadopt this policy, the EUR/USD parity could drift above 1.45 according to the

model and exacerbate the deation threat

1.20

1.25

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EUR/USD Model

Scenario 1 Scenario 2

Scenario 3 Scenario 4Scenario 5 Scenario 6

3 Evolution of the EUR/USD parity accordingto the scenarios

The simulations of our pocketmodel show that the evolutionof the EUR/USD parity should

be driven by the policychosen by the ECB to ghtde ationary pressures



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December 2013 #12

The credit cycle is closely linked to the macroeconomic cycle. Investmentspending and, hence, corporate debt is closely linked to lending conditions andthe economic outlook. The positioning in the cycle generally makes it possible toanticipate bond and equity performance. Below, we review the positions of USand European companies in the credit cycle.

What is a credit cycle?

Lending conditions and the cost of capital are at the heart of the credit cycle.When economic activity slows, lending conditions tighten, as borrower defaultrisk increases and as the value of mortgage collateral that they can be put updeclines. A classic credit cycle has four phases:

Phase 1: the economic outlook stabilises. Companies try to deleverage. Theygenerate productivity gains and preserve their cash-ow to pay down theirdebt. All these measures are favourable to bondholders. At the start of thisreestablishment phase, bonds generally outperform stocks.

Phase 2: the economic recovery gathers strength, and credit conditions ease.Corporate balance sheets strengthen. Earnings are solid and continue to risefaster than debt. Both asset classes perform well.

Phase 3: Growth stays on track and access to credit becomes easier.Companies undertake more and more investments and acquisitions. Debtexpands faster than prots. During this phase equities continue to do well,while bonds begin to perform poorly.

Phase 4: the credit bubble bursts. Credit conditions worsen fast. Corporatenancing becomes more expensive and more difcult. Prots get hammered.In this phase, equities and bonds are both hit hard.

From 1999 until the Lehmann crisis, credit spreads tracked the combinedgrowth of earnings and debt throughout the macroeconomic cycle. Moreover,bond performance preceded equity performance (see char t).

What point are we at in the cycle?

With the bursting of the Lehmann bubble, credit conditions have worsenedconsiderably. Companies have drastically reduced their investments. Thefundamentals of US and European companies are currently on different trends:

In the United States, companies are already in the midst of a releveraging cycle.Earnings are on a positive trend. Companies are expanding their investmentspending. Debt ratios are worsening, as spending rises faster than earnings.

In Europe, companies are preserving their cash ow, as they feel that theeconomic environment is too uncertain. However, the situation varies fromcompany to company. On the periphery, access to credit is harder and moreexpensive. Moreover, peripheral bond issuers close dependence on theirdomestic market limits earnings growth and deleveraging. The utilities andtelecoms sectors account for 68% of outstanding debt of peripheral non-nancial companies. These companies are having difculties in deleveragingand remain cautious in their spending. In contrast, companies with thestrongest cash ow (mainly in core countries) have managed to deleverageand are now beginning to invest.

In Europe, the cycle has been stretched out by heavy, across-the-board debt

levels.

Governments and households have remained heavily leveraged in most eurozone countries.

Many companies have been hit hard by the lack of growth and are notgenerating enough cash ow to deleverage.

The essential

The credit cycle is closely correlatedto the macroeconomic cycle. US andEuropean companies are locatedat different points on the creditcycle. US companies are once againleveraging up, in contrast to Europeancompanies, who remain cautious intheir investments.

The combined growth in corporate debt andearnings during the cycle generally makesit possible to anticipate bond and equity

performance. But we have not been inthis conguration since the Lehman crisis.Asset performances are heavily inuencedby monetary policy. Central banks arepromoting an environment of low ratesand abundant liquidity. The quest for yieldis making valuations irrational. In both theUnited States and Europe, xed-incomevaluations no longer precisely reect amacro and micro reality, and this situationcould last further, especially in Europe.Our baseline scenario assumes new non-conventional measures from the ECB, whilewe expect the Fed to begin tapering off its

asset purchases in 2014.

Heavy, across-the-boarddebt levels in Europe areslowing earnings growthand the upturn in investment

US and European credit cyclesare diverging

VALENTINE AINOUZ,Strategy and Economic Research Paris

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Source: Bloomberg, Amundi Research

Debt growth - LHS

EBITDA growth - LHS

Spread (year end value)

IV I&II III IV

1 Credit cycle: Euro IG Non-Fin



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December 2013 #12

Banks themselves are generating deationary pressures. Restructuring of thenancial system will continue to weigh on lending volumes and conditions.Banks restrictive attitude is being aggravated by:

- 1) Their volume of non-per forming loans, which reects the s lowing ineconomic activity.

- 2) Their sovereign debt holdings. In Spain, domestic banks hold 42% ofSpanish bonds vs. 25% in early 2008.

- 3) Their obligation to comply with new prudential rules.

Ongoing deleveraging by various economic actors is weighing on earningsgrowth and an upturn in investment.

Why are performances decorrelated from the cycle?

Expansion in both corporate debt and earnings during the cycle used to generallyprovide some insight into future bond and equity performance, but that has notbeen the case since the Lehmann crisis. Asset performances are being dictatedby monetary policy. Central banks are promoting an environment of low ratesand abundant liquidity. Against this backdrop, investors are going all out in theirquest for yield, which is generating irrational valuations.

The bond market environment is very di fferent between the US and Europe:

In Europe, the outlook for growth is still weak (Amundi forecast: +0.9% in2014). Our baseline scenario assumes new non-conventional measures fromthe ECB. As a result, the credit market is likely to continue to benet fromabundant liquidity. The supply of paper has been restrained by issuers needto deleverage.

The situation on the US market is dif ferent and offers better prospects forgrowth (Amundi forecast: +2.3% in 2014). We also expect non-conventionalmonetary policies to begin to be phased out beginning in the rst quarter ofnext year. Moreover, the supply of new paper is likely to remain solid, givencompanies nancing needs.

We therefore remain bullish on the euro zone corporate bond market, whichis likely to continue to be driven by ECB-supplied liquidity. Moreover, we donot expect an upturn in investment in the euro zone (except in Germany), ascompanies will remain cautious in their investments.

Asset performancesare being dictatedby monetary policy

Our scenario assumesnew non-conventionalmeasures from the ECB

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2Non-Performing Loans as a proportion

of total lending

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Eurozone Germany France

Spain Italy

3 MFI balance sheets size 2003as the base 100



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December 2013 #12

Corporate default rate cycle has mainly to do with macro and micro businesscycles, namely cyclical growth and corporate leverage trends: in this respect,macro prospects should improve next year for both US and Eurozone,contributing to keeping default rates low. On the other hand, the leverage cycleis in very different stages on both sides of the Atlantic and even among majorEurozone countries.

Among other drivers of the default cycles we consider the so called bottom upfactors, like the average credit quality and the purpose of new issuance as well asthe debt maturity schedule. Looking at past cycles, evidence shows that in phases

of mature or late real growth, companies tend to embark in aggressive spendingand re-leveraging strategies, while investors tend to accept lower quality debtas risk appetite reaches new peaks. Typically, when the percentage of low rateddebt issued for aggressive purposes (like LBOs or PIKs) rises to high proportion ofoverall primary market activity, then a hike in default rates tends to follow when theeconomic cycle falls into recession. At the same time, high short-term refundingneeds measured by volumes of maturing bonds and leveraged loans may representanother important catalyst of a turning point in default rates cycle.

A unique feature of this cycle has to do with the record volumes of new bondsand leveraged loans issued by speculative grade companies: this recordissuance, furthermore has proved to be quite strong in size in each of the lastfour years, though 2013 has already exceeded previous three years in termsof overall numbers. This is mainly true for the US speculative grade market,

but it has been increasingly the case also for Euro HY bonds. Lets thereforetake a look at a few numbers, starting with US companies. So far, 2013 alreadysaw USD 660 bn overall new issuance of HY bonds and leveraged loans, thehighest ever in history: in the last four years, the yearly average issuance runsat USD 235 bn and USD 275 bn respectively for bonds and leveraged loans. Ifwe consider speculative grade bonds only, this year is likely to be just a bit lessactive than 2012, as year to date supply runs at USD 246 bn vs last year USD280 bn, but still the second highest yearly volume in history.

Out of this huge wave of new debt, around half of the volumes were issued forrenancing and mainly for loans renancing: in the last three years around USD250 bn of new bonds went to renance bonds and 275 bn went to renance loans.At the same time, 440 bn of new leveraged loans were for loans renancing.

The following two graphs shows to what extent this activity led to a massiveattening of 2014/2015 maturity wall US companies were facing just a few yearsago. As of end 2010, 2014 and 2015 maturity schedules for combined bondsand loans respectively were at USD 250 bn and USD 180 bn. Both gures, andin particular 2014 one was then hugely compressed in following years. At thetime of writing, speculative grade companies will face just marginal redemptionsnext year, namely 19 bn of bonds and 10 bn of loans, while they will facerespectively 36 bn and 8 bn in 2015. Overall, a very manageable schedule evencombining next two years overall volumes: USD 75 bn of combined bonds andloans. Furthermore, this dramatic fall in short-term redemption looks even moreimpressive if considered on a relative basis vs the jump in overall outstandingdebt. The last graph shows that at the end of 2010 companies were facing a7% of their overall maturing in the following two years, 3% due in 2011 andthe remaining 4% in 2012. Then, thanks to huge supply volumes, short-term

renancing needs fell and are now just around 4% of overall outstanding debt,despite an increase of the latter by 27% over the same period.

What wed like to underline most with all these numbers is that at current pace ofissuance US speculative grade companies may theoretically renance all 2014and 2015 redemptions in just a couple of quarters and precisely with in H1- 2014.

The essential

Corporate default rate cycle hasmainly to do with macro and microbusiness cycles, but at the same time,short-term refunding needs as otherbottom-up factors may have a role inits turning points.

A unique feature of this cycle has to do withthe record volumes of new bonds suppliedby speculative grade companies: this ismainly true for the US speculative grademarket, but it has been increasingly the

case also for Euro High Yield bonds. Asaround half of this record issuance was forrenancing purposes, evidence shows thatspeculative grade companies signicantlyreduced their refunding risks looming in2014 and 2015. The very last data publishedby Moodys on European LBOs conrmed animproved picture also in Europe, sustainingthe rationale for a stable default rate at lowlevels over the next year.

Refunding risk of US and European High Yieldcompanies in next two years

SERGIO BERTONCINI,Strategy and Economic Research Milan

6

At current pace of issuance,US speculative gradecompanies may theoreticallyre nance all 2014 and 2015redemptions withinH1- 2014

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Lev Loans HY Bonds

1 US HY bonds and loans:new issuance volumes (in USD bn)



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December 2013 #12

Lets move now to European HY companies: according to data recently releasedby Moodys (European HY newsletter, published on 12 November), thanks tothe very active issuance of HY bonds of the last two years, LBOs cumulative

maturities have been strongly pre-nanced and previously much worrying maturitywall of 2014 pushe

Cross Asset Invt Strategy Monthly_December 2013_VA

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