UniCredit-Euro Compass Quarterly 3Q2010

8/9/2019 UniCredit-Euro Compass Quarterly 3Q2010

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3Q2010

EuroCompass

Economics & FI/FX Research

Credit Research

Equity Research

Cross Asset Research

Still on track


2/49

3Q 2010 Economics & FI/FX Research

Euro Compass

Still on track

Six months after the publication of our 2010 Outlook, we provide anassessment of the track record of our main macro calls. We did a goodjob on GDP and CPI, where our current projections are very similar to theones outlined at end-2009. Sovereign debt woes and fiscal tightening didnot materially change the picture for growth and inflation, mostly becausethe euro worked as an automatic stabilizer and depreciated sharply sincethe beginning of the year. The impact on monetary policy, however, wasmaterial, with the ECB forced to delay its exit strategy and the refi ratelikely to remain on hold until 4Q 2011.

Signs of peaking in world growth are starting to emerge, and this willprobably translate into a softer export dynamic in the next few quarters.

Using a simple VAR (Vector Autoregression) framework, we show how aslower pace of export growth can dent the improving trend in both capexand the labor market.

With data for full-2009 now available, we provide an updated assessmentof the financial position of the eurozone corporate and household sector.We show that the financing gap of non-financial corporations hasnarrowed significantly, but we highlight that a return to positive self-financing requires a sustainable return to profitability, as most of thebenefits from the cost side have been exploited. For what concernshouseholds, the savings rate has probably peaked and consumption hasembarked into a slow recovery, but weak income dynamics and renewed

uncertainty on financial wealth remain an important source of concern.

We stress the consistency of our baseline scenario envisaging anotheryear of easing in core inflation. Looking at a broad set of indicators thatprovide useful information on the turning points in core CPI cycles andaveraging their messages, we find that our central scenario remainswell on track. If anything, several indicators suggest that the trough incore inflation could occur later than we currently expect. At the time ofwriting, selling price expectations are the only variable that hints at someupside risks to our view.

FI: The recent increase in demand at ECB refinancing operations signals

renewed tensions in the eurozone money market. The amount of liquiditybid at the 3M and 1W auctions following the expiry of the 12M LTRO inJune will signal how many troubled banks are still present in the EMU.We expect the amount that will be rolled-over to be lower than theexpiring EUR 442bn. We expect little impact on money market rates afterthe June expiry as banks will continue to bid all the liquidity they need.

FX: Despite its recent recovery attempts, there is no indication of a trendreversal and EUR-USD should weaken to at least 1.18.

Chief Economist - UniCredit GroupGlobal Head of Economics & FI/FX ResearchMarco Annunziata+44 20 [email protected]

EditorMarco Valli+39 02 [email protected]

Editorial deadlineTuesday 15 June 2010, 13:00Prices at: Tuesday 15 June 2010, 8:00

BloombergUCGR, UCFR

Internetwww.research.unicreditgroup.eu

UniCredit Research page 1 See last pages for disclaimer.


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Euro Compass

Contents

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7

15

19

20

26

29

31

33

37

38

39

44

Key Eurozone ForecastsEurope in a nutshell

Executive Summary

5 Still on track

The European Economist

7 A mid-year assessment of our key macro calls

9 What to expect when exports start slowing

11 Private sector: deleveraging and re-leveraging

Inflation Watch

15 Core disinflation: where is the end?

18 UniCredit Inflation Forecasts

ECB Most Watched

The Eurozone Economists Toolbox

European Central Banks Watch

26 BoE Sticky inflation complicates central banks job

27 SNB Swiss franc strength directs monetary policy

28 Nordics increasing chances of a Riksbank hike in July

FI Strategizer

29 The expiry of the first 12M LTRO is approaching

Eurozone Debt Structure

32 Eurozone Scorecard

FX Strategizer

33 EUR: It cant rain forever, but no rainbow is in sight yet!

FX Monitor: G-10 Monthly Change

FX Monitor: G-10 Implied Volatility Curves

Country Outlook

39 Germany Industry remains on course

40 France GDP rebound is in store for 2Q

41 Italy A solid 1Q, moderation ahead

42 Spain Strong headwinds on the recovery

43 Austria Signs of stronger GDP growth in 2Q

UniCredit Forecasts



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Euro Compass


Key Eurozone Forecasts

2009 2010 2011 Annual average1Q-09 2Q-09 3Q-09 4Q-09 1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 2009 2010 2011

GDP -2.5 -0.1 0.4 0.1 0.2 0.5 0.3 0.2 0.3 0.3 0.4 0.4 - - -

GDP (% yoy) -5.2 -4.9 -4.1 -2.1 0.6 1.2 1.1 1.2 1.3 1.1 1.2 1.5 -4.1 1.0 1.3

Private Consumption -0.6 0.1 -0.2 0.2 -0.1 -0.1 0.0 0.1 0.1 0.2 0.2 0.2 -1.2 -0.1 0.4

Government Consumption 0.7 0.7 0.7 0.0 0.6 0.2 0.1 0.1 0.1 0.1 0.1 0.1 2.7 1.3 0.3

Gross Fixed Capital Formation -5.1 -1.7 -1.0 -1.3 -1.1 1.0 0.0 0.1 0.3 0.5 0.6 0.8 -10.9 -2.3 1.5

Change in Inventories* -1.1 -0.5 0.5 0.1 0.8 0.1 0.0 0.0 0.0 0.0 0.1 0.1 -0.9 1.1 0.1

Domestic Total Expenditure -1.3 -0.2 -0.2 -0.2 -0.1 0.2 0.0 0.1 0.1 0.2 0.2 0.3 -3.5 0.9 0.6

Exports -8.4 -1.1 2.8 1.7 2.5 1.9 1.2 0.9 1.1 1.3 1.4 1.5 -13.2 7.3 4.9

Imports -8.1 -2.7 2.8 1.2 4.0 1.2 0.6 0.5 0.7 1.1 1.3 1.4 -11.9 7.1 3.5

Net Exports* -0.1 0.6 0.0 0.2 -0.6 0.3 0.3 0.2 0.2 0.1 0.1 0.1 -0.8 0.1 0.6

HICP Inflation (% yoy) 1.0 0.2 -0.4 0.4 1.1 1.5 1.6 1.8 1.7 1.6 1.8 1.9 0.3 1.5 1.8

Core HICP Inf lat ion (% yoy) 1.6 1.6 1.3 1.1 0.9 0.8 0.7 0.5 0.4 0.3 0.4 0.5 1.4 0.7 0.4

Unit Labour Costs (% yoy) 5.7 4.6 3.4 1.3 -0.4 -0.9 -0.4 -0.3 -0.2 0.3 0.2 0.2 3.8 -0.5 0.1Employment growth -0.8 -0.5 -0.5 -0.2 0.0 0.0 0.0 0.1 0.1 0.2 0.2 0.3 -1.9 -0.5 0.5

Unemployment rate (%) 8.8 9.3 9.7 9.8 10.0 10.2 10.4 10.5 10.6 10.6 10.5 10.4 9.4 10.3 10.5

Current Account (% GDP) - - - - - - - - - - - - -0.6 -0.2 0.1

Budget Balance (% GDP) - - - - - - - - - - - - -6.3 -6.5 -5.9

ECB Ref i rate 1.50 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.25 - - -

3M Euribor rate 1.51 1.10 0.75 0.70 0.66 0.72 0.85 0.85 0.90 1.05 1.20 1.60 - - -

2yr 1.24 1.37 1.27 1.30 1.04 0.50 0.85 1.05 1.15 1.30 1.60 1.95 - - -

5yr 2.23 2.49 2.40 2.45 2.20 1.50 1.83 2.10 2.25 2.35 2.60 2.85 - - -

10yr 2.99 3.39 3.22 3.40 3.15 2.64 3.00 3.25 3.35 3.40 3.50 3.65 - - -

30yr 3.86 4.20 3.95 4.15 3.89 3.36 3.60 3.80 3.85 3.90 3.95 4.10 - - -

EUR/USD 1.33 1.40 1.46 1.43 1.35 1.23 1.24 1.22 1.20 1.18 1.20 1.24 - - -

EUR effective exchange rate (EER-21) 112.4 112.0 113.2 111.9 106.8 105.0 102.0 100.0 98.00 97.00 98.00 102.0 - - -

All data are % qoq unless otherwise specified; GDP data are working-day adjusted; interest and exchange rates are end of period

*Contribution to growth Source: UniCredit Research


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Euro Compass

Executive Summary

Still on trackMarco Annunziata+44 20 [email protected]

In the first main section of this Compass we take stock of our main macroeconomic forecastsfor the year. The first observation is that, as we approach the end of the first semester, ourGDP growth forecast for the eurozone as a whole is very much on track. This is remarkable,given the turmoil that has engulfed the continent over the last three months, with fears of asystemic sovereign debt crisis leading to the shock and awe support package, ECBpurchases of government debt, and a drastic depreciation in the value of the euro.

The depreciation of the euro, together with a stronger than expected rebound in global trade, isof course helping, with an extra boost to exports that compensated a somewhat softer domesticdemand. But an important message that emerges from our forecasts is that we do not sharethe widespread concern that the eurozone might be condemning itself to a new recession via areckless rush to austerity. Over the past months, many eurozone countries have announcednew fiscal consolidation measures: Greeces IMF program has been followed byannouncements by Portugal, Spain, Italy, Germany and most recently France. This hastriggered criticisms and fears that this tightening might be premature and excessive,forced by the pressure of the markets and not consistent with the still tentative nature of theeurozones economic recovery. This fear have also affected trans-Atlantic relations, stoking USconcerns that the eurozones embrace of fiscal austerity will make the continent even moredependent on exports, shifting again the burden onto the US consumer and heightening therisk that global imbalances will soon represent themselves in a serious way.

We feel that these concerns are disproportionate to the actual eurozone-wide fiscal

adjustment which is currently envisioned. While some of the smaller countries need and areplanning a serious fiscal consolidation, Germany and Italy start from a much stronger deficitposition and are targeting only a moderate adjustment; and Frances targets do not appearoverly ambitious. In other words, the eurozone as a whole is very different from Greece.Moreover, a well designed fiscal consolidation can actually boost GDP, as demonstratedby a solid 20-year old strand of academic literature. What is crucial is the quality of the fiscaladjustment: as we have noted already in discussing the Italian plans, a fiscal consolidationwhich relies largely on durable cuts in public expenditures can easily have an expansionaryeffect on growthall the more so in countries which start with very high levels of publicspending and taxation, and where there are huge efficiency gains to be reaped by freeing upmore resources for private investment. There are indeed some encouraging signs in the fiscaladjustment plans tabled by Spain, Italy and France. While the eurozones track record does notbode well, there is some room to hope that governments might turn necessity into virtue.

The governments job will be made easier by the fact that the ECB will almost certainly

maintain a very supportive stance throughout the next 6-12 months at least. Our inflationforecasts are also on track, and confirm that the disinflation trend in core prices is wellentrenched. As a consequence, we do not see any significant inflation risks at the horizonand neither does the ECB, which is therefore able to focus fully on preserving stability in thefinancial system. Last weeks monthly press conference confirmed that the ECB will continue toprovide unlimited liquidity to the banking system for as long as necessarya crucial supportmeasure now that the tensions in the eurozone banking sector have re-emerged, withperceived counterparty risk coming back onto the stage, and banks again parking significantamounts of liquidity with the ECB itself. More transparency is needed to bolster confidence inthe European financial system, and a new round of more detailed stress tests, with resultstransparently disclosed on an institution by institution basis, would probably be the best way togothis of course would require being prepared to quickly deal with any institutions that mightbe revealed to be excessively weak. This is a job for national regulators and governments. For

its part, the ECB should bring more transparency to its government bonds purchaseprogram if it really wants to bring back more liquidity into the market.



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Euro Compass

Be it as it may, there is little doubt in our minds that the ECB will maintain very supportivemonetary conditions for some time, and the euro is unlikely to recover soon, which means thatoverall financial conditions should remain reasonably supportive, provided we do not get a

further increase in financial markets tensions. Overall, this sets a fairly supportive backgroundfor eurozone governments to bite the bullet and provide us with a fresh batch of textbookexamples of expansionary fiscal contractions.



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Euro Compass

The European Economist

A mid-year assessment of our key macro callsMarco Valli(UniCredit Bank Milan)+39 02 [email protected]

Main growth trends: exports andinventories drive the recovery,domestic demand lags behind

Six months after the publication of our 2010 Outlook, we provide a brief assessment of thetrack record of our main macroeconomic forecasts.

Growth. For the time being, it looks like we did a good job on economic growth. The GDPprojections contained in our 2010 Outlook (0.9% in 2010 and 1.3% in 2011) are still verymuch on track, as our forecast is 1.0% for this year and remains at 1.3% for next year. Risksto these projections are balanced in 2010, to the downside in 2011. The newly-updated ECBforecasts envisage a very similar growth picture: 1.0% in 2010 (revised up by 0.2pp fromMarch) and 1.2% in 2011 (adjusted downwards by 0.3pp). On balance, we were right on themain growth trends for 2010, with exports and inventories leading the way up and

offsetting weakness in final domestic demand. This doesnt mean, however, that

everything unfolded exactly as we had anticipated six months ago. In particular, the exportrecovery was more buoyant than originally thought, and this was largely due to a stronger-than-expected rebound in world trade in contrast, the beneficial effect of euro depreciationsince the beginning of the year will be felt mostly in 2H 2010 and 1H 2011. As we explain inthe next note, the strong export performance of the last few quarters helped put a floor undercapex, which stabilized somewhat sooner than we had originally expected. In turn, thisprevented a dramatic deterioration in the labor market. Also the inventory contribution aroundthe turn of the year was significantly stronger than previously thought. These positivesurprises were offset in large part by stronger-than-envisaged import growth and, to a lesserextent, by a weaker profile for construction investment and government consumption. Notethat strong import growth did not mirror so much a positive surprise in final domestic demand,because household consumption marginally disappointed relative to our original projections.Rather, it mostly reflects the leg up of the inventory cycle and the corresponding strong

increase in imports of intermediate goods, which are now feeding through the productionprocess. As the boost of the inventory cycle fades, however, import growth will fall back tolevels that are more in line with still anemic final domestic demand. Together with aweaker currency, this (often neglected) factor should help eurozone GDP avoid a massiveslowdown in response to financial market turmoil, slowing world growth, and domestic fiscaltightening.

Inflation. Also our CPI call was fairly accurate. At the time of writing, our official projectionsenvisage 1.5% inflation this year and 1.8% in 2011, vs. 1.3% and 1.8% published six monthsago. A somewhat stronger near-term profile for euro-denominated oil prices explains virtuallythe whole revision.

OUR GDP PROJECTIONS: CHANGES IN THE LAST SIX MONTHS INVENTORY CYCLE BOOSTS IMPORTS

2010 2011 2010 2011 2010 2011

GDP 1.0 1.3 0.9 1.3 0.1 0.0

Private Consumption -0.1 0.4 0.0 0.7 -0.1 -0.3

Government Consumption 1.3 0.3 1.4 1.0 -0.1 -0.7

Investment -2.3 1.5 -1.5 1.6 -0.8 -0.1

Change in Inventories* 1.1 0.1 0.4 0.1 0.7 0.0

Exports 7.3 4.9 3.5 3.5 3.8 1.4

Imports 7.1 3.5 1.8 2.8 5.3 0.7

Net Exports* 0.1 0.6 0.7 0.3 -0.6 0.3

* Contribution to growth

Dec 09Current Delta (Current-Dec 09)

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

Q1 2002 Q1 2004 Q1 2006 Q1 2008 Q1 2010

-1.1

-0.8

-0.5

-0.2

0.1

0.4

0.7

1.0

Import (in %, qoq) - LS

Inventories (contr. to qoq GDP growth) - RS

Source: Eurostat, UniCredit Research



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Euro Compass

Core disinflation proceeds,more to come

Most important of all, the key forecast of further core disinflation has proved correct, withcore CPI ex food, energy, alcohol and tobacco continuing its downward trend and easingfrom 1.1% yoy in December 2009 to 0.8% in April 2010. This should not be the end of the

story, and we expect core inflation to slow well into 2011 and trough close to zero inresponse to an unprecedented degree of economic slack. The Inflation Watch sectiondeals with risks to our forecast of another year of core disinflation. We take a look at severalindicators that display leading properties for core CPI, and show that, on balance, risks aretilted towards a delayed trough in core prices with respect to our current projections. Wecontinue to remain absolutely relaxed on the inflation risks stemming from excess

liquidity: as long as banks remain risk averse and the money multiplier does not resumenormal functioning, broad money growth is bound to stay weak, and so will upside risks toprice stability. Coming to the ECB bond-buying program, for the foreseeable future the mainrisk will remain political rather than inflationary, and will come in the form of a growing dividebetween the position of core vs. peripheral countries, and hawks vs. doves within the centralbank.

Sovereign rating woes delaythe beginning of the tighteningcycle

ECB. Consistent with our story of only moderate recovery and core disinflation, we started theyear sticking to our long-held view that the tightening cycle would begin only in March 2011, amore cautious stance than the one implied by Euribor futures at that time. As the recoveryproved tamer than many (but not the ECB) had expected, the call paid off and remained wellon track until the escalation of the sovereign debt crisis at the beginning of May, whichprompted the ECB to buy government bonds outright, reverse course on liquidity policy andadopt a more cautious stance on GDP prospects for 2011. Our new refi rate forecastoutlined last month projects the first hike in 4Q 2011, with risks tilted towards a further

delay of the tightening. This lower trajectory for the policy rate doesnt reflect a more dovishset of GDP/CPI projections, mostly because the euro worked as an automatic stabilizer anddepreciated sharply in response to the shock. Rather, our rate call reflects the view thatsovereign rating woes will not recede shortly, keeping the banking sector under pressure and

prompting the ECB to accept a more protracted period of low rates in exchange for tougherfiscal consolidation.

CORE DISINFLATION HAS FURTHER TO GO THE MONEY MULTIPLIER IS NOT FUNCTIONING

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11

Headline (in %, yoy)

Core (in %, yoy)

Our Forecast

(In %, yoy)

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

Jan-99 Nov-00 Sep-02 Jul-04 May-06 Mar-08 Jan-10

M3

loans to private sector

Source: Eurostat, ECB, UniCredit Research



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Euro Compass

What to expect when exports start slowingChiara Corsa(UniCredit Bank Milan)+39 02 [email protected]

Marco Valli(UniCredit Bank Milan)+39 02 [email protected]

What happens to domesticdemand when exports slow

Strong and quick impact of anexport shock on capex....

and employment follows suit

Since the last issue of our Euro Compass, signs of peaking in world growth have become

more convincing. This underpins our view that the strong performance of eurozoneexports seen in the last year is bound to moderate in the coming quarters. Evidence of aslowdown in the global cycle are clear if we look at the OECD leading indicators, whichidentify signs of a downturn in China, France and Italy, together withmoderation in the paceof expansion in all the main industrialized economies. In the manufacturing sector, onereliable indicator of cyclical turning points is the new orders-stock ratio of the PMI survey. Inthe eurozone, US and China, this ratio seems to have already peaked, suggesting that firmsacross the globe have already carried out most of the inventory adjustment needed to meetcurrent demand conditions. This hints at a significant moderation in the pace of stock buildingdown the road which, in turn, should translate into an easing in the pace of global industrialactivity. In the eurozone, the weaker currency will probably offset only in part the slowdown offoreign demand.

The next step is to understand the implications for domestic demand of an environmentof slower export growth. To better investigate the link between exports and domesticdemand, we estimate a VAR model where the endogenous variables are the quarterly growthrate of eurozone exports, machinery/equipment investment (from now on capex) andemployment, together with the first difference in the 3M Euribor that represents a proxy fordomestic monetary conditions. The best model specification is one with two lags. Note thattotal exports can be safely treated as an endogenous variable because they include alsointra-area trade which, for example, is a function of domestic capex growth. A standardexogeneity test confirms this intuition. After estimating the model, impulse response functionshave been generated to feature the response of capex, employment and interest rates to ashock to export growth. For our purpose, we focus in particular on the response function ofcapex and employment growth.

The right chart below shows a strong and statistically significant capex response to anexport shock. The maximum impact is felt quickly (i.e. one quarter after the shock), but theresponse weakens substantially thereafter and fades completely after about one year.Unsurprisingly, the employment response displays somewhat different features (see leftchart on the next page). While the timing of the peak resembles the one of capex, the overallresponse is more contained and more persistent than capexs (though the statisticalsignificance of the response weakens visibly after a few quarters). The response function ofthe interest rate (not shown in the charts) closely resembles the one of machinery/equipmentinvestment.

How do we put this evidence into context?

EMU: BEST PART OF THE INVENTORY CYCLE IS BEHIND US STRONG CAPEX RESPONSE TO AN EXPORT SHOCK

33

36

39

42

45

48

51

54

57

60

63

Jun-97 Sep-01 Dec-05 Mar-10

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

Mfg PMI - LS

New Orders-to-Stock Ratio - RS

-1.0

-0.5

0. 0

0. 5

1. 0

1. 5

2. 0

1 2 3 4 5 6 7 8 9 10

R e s p o ns e o f D 1 C A P E X to D 1 E X P O R T

Response to Nonfactor i zed On e S.D. Innovat ions 2 S.E.

Source: Eurostat, EC, UniCredit Research



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Euro Compass

Strong exports helped stabilizecapex..

and softened the pace of jobshedding

1) In a backward-looking perspective, we strongly believe that the export rebound thatstarted in 3Q 2009 has played a crucial role in stabilizing capex and, in turn, preventing adramatic deterioration in the labor market. In fact, in the last few quarters, exports surprised to

the upside relative to our forecasts rising more than 7% between 3Q 2009 and 1Q 2010 and concurrently the pace of contraction of investments in machinery and equipment slowedat a faster pace than we had originally projected. Capex moved from the -11.3% qoq troughhit in 1Q 2009 to stabilization at the turn of the year, while we previously had thought that thedecline would have stopped only around mid-2010. Similarly, the improvement in the labormarket from the trough of spring 2009has been significant and, overall, the pace of jobshedding was less severe than one would have expected given the depth of the economicdownturn. In about one-year's time, our survey-based employment indicator rose from 2.7 st.dev. below the mean to only -0.6 st. dev., marking a pace of improvement that isunprecedented in the history of this gauge. Translated into hard data, this means that theemployment decline eased from a 3% annualized pace in 1Q 2009 to 1% in 4Q 2009, withstabilization achieved in 1Q 2010. At the current level (as of May), our employment indicator

confirms that job shedding has come to a halt.

Slower exports ahead to dentcapex and labor market recovery

2) Going forward, the most straightforward implication is that a slower pace of exportgrowth will dent the improving trend in both capex and labor market. In other words,while at this stage a double dip recession seems unlikely, we are probably in for a fewquarters of only modest capex expansion and little, if any, improvement in terms of jobcreation. When we look at capex fundamentals, there are indeed some encouraging signals:as Loredana Federico and Davide Stroppa highlight in the next note, the financing gap ofnon-financial corporations has narrowed significantly in the last year and has nowvirtually closed. As a matter of fact, this gauge is back to the level which, in mid-2005,coincided with a decisive acceleration of capex growth. However, differently from that capexcycle, this time corporate sector debt (as a share of GDP) is significantly higher: 102% vs.83.5%. This makes it is more likely that firms will remain in a deleveraging mode for the next

few quarters, rather than take on additional debt. Consistent with this picture, the BLS (BankLending Survey) keeps showing a large contraction in loan demand for fixed investments,while monthly ECB data show still negative flows of lending to NFC. Therefore, improvingbut still shaky fundamentals including the still low level of capacity utilization and tightcredit conditions will add to a slowing exportdynamic and keep capex on a subduedgrowth path throughout this year and probably part of the next. Accordingly, we expect firmsto remain very cautious in their hiring plans. This should lead to employment growth movingsideways in the near term, and post an only modest recovery in 2011. The unemploymentrate should peak at around 10.5-10.6% between the end of 2010 and the beginning of 2011.

EMPLOYMENT RESPONSE: SOFTER, BUT MORE PERSISTENT LOAN DEMAND FOR FIXED INVESTMENT KEEPS FALLING

-.04

.0 0

.0 4

.0 8

.1 2

1 2 3 4 5 6 7 8 9 10

Response of D1EMP to D1EXP ORT

Response to N onfactorized One S .D. Innovat ions 2 S .E.

-70

-60

-50

-40

-30

-20

-10

0

10

20

30

Q4 2002 Q3 2004 Q2 2006 Q1 2008 Q4 2009

-15

-10

-5

0

5

Loan demand for fixed investment (Balance) - LS

GFCF (in % yoy, 2Q-ma) - RS

Source: ECB, Eurostat, UniCredit Research



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Euro Compass

Private sector: deleveraging and re-leveragingLoredana Federico(UniCredit Bank Milan)+39 02 8862 [email protected]

Davide Stroppa(UniCredit Bank Milan)+39 02 8862 [email protected]

During the last year, we have devoted much effort to developing a very comprehensive

framework to analyze income and financial conditions of Non-Financial Corporations(NFCs) and Households (HHs) in the eurozone. So far, the main message of our analysishas been that during the years preceding the crisis both sectors experienced a substantialincrease in the degree of their financial leverage. While the degree of leveraging of thehousehold sector did not reach alarming proportions, the financial situation of NFCs left themin a rather uncomfortably precarious situation as a period of substantial leveraging has beenfollowed by a collapse in profitability. This fundamental-based analysis laid the groundwork forour cautious stance on both consumption and investment prospects in 2010.

An assessment after 4Q 2009data releases

With data for full-2009 now available, we are now in a better position to assesshow therecession actually impacted the private sectors balance sheets. For NFCs, the cost sideallowed a significant improvement, but a return to positive self-financing can be provided onlyby a sustainable return to profitability. For HHs, while the savings rate should have peaked,

thus supporting a consumption recovery, weak income dynamics and renewed uncertainty onfinancial wealth represent the main concerns.

NFCs: Profitability is expectedto be restored

Non-Financial Corporations: Our analysis starts from the inspection of profit dynamics,through developments in the Gross Operating Surplus (GOS), to show how much profits canbe derived from the operating activity, thus abstracting from the financial side. The fact thatprofits play a key role in shaping investment decisions is confirmed by the strong co-movement of investment and operating profits (see chart on the left). Unsurprisingly, therecession took a heavy toll on profitability: yearly growth of the GOS peaked at 7.1% in3Q 2007 and plunged notably afterwards, bottoming out at -9.2% in 3Q 2009. The last quarterof 2009 saw only a mild improvement to -8.7%, but anecdotal evidence is already sendingsome encouraging signals. In fact, while euro area sector account data for 1Q and 2Q 2010are not yet available, companies reports already hint that a solid return to profitability

actually occurred in the first part of the year, thus implying further improvement down theroad. This is also confirmed by the dynamics of the New Orders index of the ManufacturingPMI, which leads profit growth by three/four quarters and which troughed between end-2009/early-2010, rebounding steeply thereafter (see chart below on the left).

but caution is still warranted While the recovery of profitability is a welcome sign, as it is the basis for a genuine

investment recovery, two caveats are in order. First, during this cycle, profit growthbecame negative for the first time ever, and even the size of the plunge was unprecedented;these two factors clearly make it difficult to apply precisely past relationships to recentdevelopments. Second, the global cycle is already showing signs of peaking, and this mightimply that the rebound in profit dynamics might lose some steam in the second half of 2010.

FROM A REBOUND IN PROFITS TO CAPEX RECOVERY THE FINANCING GAP HAS (ALMOST) CLOSED

% yoy change of 4-quarter cumulated transactions % of Gross Value Added

-16

-12

-8

-4

0

4

8

12

Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08 Dec-09

15

20

25

30

35

40

45

50

55

60

65

Gross Operating Surplus (% yoy) - LS

Gross fixed capital formation (% yoy) - LS

Manufacturing PMI - New Orders - RS

-10

-8

-6

-4

-2

0

2

4

6

8

10


-2

2

6

10

14

18

22

26

30Financing Gap - LS

Gross Fixed Capital Formation - RS

Gross Savings - RS

Source: Eurostat, Markit, UniCredit Research



13/49


Euro Compass

While the financing gap hasnarrowed sizably,

We consider then a crucial variable of our framework, namely the financing gap, which is thedifference between internally-generated funds1 and capital spending. The financing gap givesus an idea of the amount of funds that needs to be raised externally (see right chart on the

previous page). After having hovered around -6% of Gross Value Added between 2Q 2008and 1Q 2009, the financing gap narrowed sizably over the last three quarters, reaching-0.5% in 4Q 2009, a value even smaller than at end-2004, when the investment recovery wasready to take off. However, the positive message stemming from a narrower financinggap should not be overstated. While less need for external finance removes one importantobstacle to the incentive to invest, a closer look at its drivers still calls for some caution.

the recovery in Gross Savingsis still partial

waiting for a sustainedprofitability rebound

First, it is not surprising that the improvement of the financing gap occurred on the back of arapid decline in investment (from 23.4% of GVA in 3Q 2008 to 20.8% in 4Q 2009) and anincrease in Gross Savings (up from 15.3% in 1Q 2009 to 17.2% in 4Q 2009). However, evenafter a significant rebound over the last three quarters, savings are still well below the peakreached at end-2004 (19.2% of GVA),hinting that some fragility in firms balance sheets stillpersists. Second, further caution comes from the breakdown of annual changes in

Gross Saving among operating profits (i.e. GOS), net other income and net interest (seechart on the left). Historically, the evolution of Gross Savings has been driven mainly bydevelopments in profitability, with financial expenses dragging them down in periods of strongleveraging and generous dividend policies (which usually characterize expansion phases). Incontrast, the financial side provides some relief only during periods of deleveraging and of amore cautious dividend policy. The last year was no exception, as the plunge ininternally-generated funds during 2009 (-7.4% yoy) was due largely to a plunge in

profits, while net interest payments and other income provided a positive contribution (mainlysince 2Q).Thus, the room for further improvement on the cost side seems very limited, sothat only a return to profitability could lead to a sustainable pick-up in self-financing.

The cost side has given animportant help to firms

but high debt and uncertaintyin financial markets remain themain obstacles

To be sure, the unprecedented fall in interest rates is bringing some relief: our indicator ofdebt service capacity, i.e. the ratio of EBIT to interest expenses, has been increasing over the

past year from 2.7 to 3.9. However, while the price of debt has declined steeply, itsquantity remains elevated: the debt-to-GDP ratio has risen steeply over the last years,breaching the 100% threshold. While there is still room for the ratio to improve further (in 1Q2010 loans to NFCs kept contracting at around a 2.5% yoy pace), the fact that the debt ratio isstill around 20pp higher than in 2005 makes itmore difficult to generate an investmentrecovery as sustained as the last one. Moreover, while monetary conditions will remainaccommodative for a longer period than previously envisaged, recent tensions in thesovereign debt market have renewed pressure on firms financing costs.

PROFITABILITY HOLDS THE KEY TO RESTORE SAVINGS LOWER INTEREST PAYMENTS BRING IMPORTANT RELIEF

% yoy change of Gross Saving, and pp contributions

6.0 5.53.3

-7.4

-20

-15

-10

-5

0

5

10

15

20

Dec '00 - Dec '01 Mar '02 - Sept '05 Dec '05 - Sep '08 Dec '08 - Dec '09

Gross operating surplus Net other income

Net interest Gross Saving

60

65

70

75

80

85

90

95

100

105


2.0

2.5

3.0

3.5

4.0

4.5

5.0

Total Debt of NFCs/GDP - LS

Earnings/Interest ratio - RS, (inverse scale)


1We derive this measure simply as the difference between retained internally-generated funds (i.e. the Gross Operating Surplus plus net other income and net

interest payments, minus taxes - which we label as Gross Savings) and gross business capital spending, inclusive of inventories.



14/49


Euro Compass

Household debt: a new start?

Financial conditions remainsupportive

Households: According to euro area sector accounts, in 4Q 2009 household debt (basicallyloans) recorded a further increase: the ratio of total debt to disposable income reached94.4% in 4Q 2009, increasing 1.5pp from 1Q 2009; in fact, household debt kept increasing at

a still modest pace, but nonetheless higher than that of disposable income. Obviously, thisdynamics is much more emphasized when nominal GDP is taken as a reference, as the latterkept contracting (in annual terms) during last year. Thus, in terms of debt-to-GDP, theincrease in household indebtedness has been steeper, reaching around 65% in 4Q 2009,from 62% in 1Q 2009. Going ahead, although the dynamics of total households debt do notmatch perfectly that of bank loans to households (which bottomed out in 3Q 2009, recoveringsteadily since then), we can expect households debt to keep augmenting in 2010. Such apick-up was undoubtedly underpinned by the decisive ECB monetary easing that hasalleviated significantly the financial burden of households: our composite financing interestrate for households declined to 4.78% in December 2009 and then was down to 4.69% inMarch 2010, the lowest level since March 2006, and it is likely to remain around these levelsfor some time to come. The important support provided to households finances is already

visible: the debt service as a percentage of disposable income, an important measure ofhouseholds ability to face repayment commitments, kept declining, falling to 2.3% in 4Q2009. The household interest cover has now reached the lowest level recorded over the

last decade (see chart below on the left), although in the current juncture households aremore indebted than in the past.

4Q 2009: no positive news (yet)from the income side

Turning to household income, the last part of 2009 was still characterized by a very

subdued dynamics, which still did not provide any indications of a recovery in the

pipeline. In fact, disposable income increased 0.6% yoy in real terms in 4Q 2009 and, given aslight reduction in the consumption deflator, was matched by a rather modest dynamics ofnominal disposable income (+0.5% yoy). Looking at the contributions of different componentsto the growth of nominal disposable income, worsening labor income dynamics have not

brought any meaningful relief yet. In fact, compensation of employees and self-employmentincome provided a negative contribution of 0.2pp and of 0.6pp, respectively, that came on topof reduced support from other income earned (-0.9pp). Thus, even considering that most ofthe relief kept deriving from net social benefits received (1.7pp) and reduced taxes paid (0.5pp), the overall picture on the income side remains weak. Therefore, we stress that the costside will need to play a prominent role in preventing a new leverage cycle to become

overly onerous, given that the income side has not yet given signs of a convincing

pick-up.

LOW COST OF DEBT SUPPORTS THE RE-LEVERAGING SUBDUED INCOME, SPIKING SAVINGS RATE

Cumulated 4-quarter transactions

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09

55

60

65

70

75

80

85

90

95

100

Interest payments / disposable income (in %) - LS

Household debt / disposable income (in %) - RS

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

13.0

13.5

14.0

14.5

15.0

15.5

16.0

Real gross disposable income (in %, yoy) - LS

Real consumption expenditure (in % yoy) - LS

Saving rate - RS




15/49


Euro Compass

A slight improvement in the labormarket will move the savings rateaway from the peak

In addition, the subdued dynamics of household income and in particular the still dismalperformance of the labor market kept holding the household savings rate at high levels: incumulated terms, in 4Q 2009 it stood at 15.4%, the highest level over the last ten years.

Looking ahead, employment growth should have troughed at around -2.0% yoy in the last twoquarters of 2009 and the pace of contraction will progressively decline, flattening out in 4Q2010. As we already detected the existence of a very strong negative correlation betweenemployment and savings, we believe that the peak of the savings rate is clearly behindus. However, a sustainable downward trend of the savings rate will necessarily comevia a more genuine recovery in household consumption, which currently is not ourbaseline scenario. In fact, while private consumption is off the lows hit at the end of last year,the rising trajectory from here will remain very subdued.

as confirmed by financialwealth transactions

Financial wealth transactions move hand in hand with the savings rate and provide afurther confirmation that the peak should have been reached at the end of 2009 (see leftchart). In fact, the increase in financial wealth transactions has remained substantially stableat 3.6% yoy in 3Q-4Q 2009, as the slight increase in financial liabilities was offset by a very

small decline in the acquisition of financial assets (see right chart). For the current year, we donot expect a further reduction of financial investments, as this did not materialize in 2009,when households were more financially constrained and a more severe deceleration inincome was in the pipeline. Thus, (as said above) given that financial liabilities are expectedto increase during this year, transactions in financial wealth should decline slightly, inducingthe household savings rate to stabilize (and eventually decline).

The sovereign debt crisis mighthamper financial wealth

Notwithstanding the stabilization of transactions, in 4Q 2009 households recorded a strongimprovement in net financial wealth, which increased 8.5% yoy (after having troughed at-11.6% in 4Q 2008), well above the 8.0% yoy marked in 2Q 2007, just before the eruption ofthe financial crisis. This was completely due to the recovery of the market value of financialassets, which provided again a positive contribution by around 5pp to the annual growth offinancial wealth in 4Q 2009. To be sure, this provided some relief to households balance

sheets. However, although the market losses are still not comparable with what we saw afterthe Lehman collapse, the sovereign debt crisis introduces new uncertainty in ourbaseline scenario of a steady recovery of households financial wealth. This, jointly withthe small support expected from housing wealth for all 2010, should leave households netwealth stretched, and introduce a further downside risk to the consumption recovery.

Thus, while the outlook for the household sector could be characterized by a very

prudent optimism, end-2009 figures confirm that the situation is still fragile. On the onehand, monetary policy will remain accommodative, leaving interest payments at extremely lowlevels and warranting the continuation of the re-leveraging process. On the other hand, laborand housing markets remain weak, undermining prospects for a sound recovery inconsumption. Further strains might come from the sovereign debt crisis, as losses in financialmarkets should eliminate the expected aid coming from financial wealth.

SAVINGS RATE SHOULD REVERSE ITS TREND IS THE RECOVERY IN FINANCIAL WEALTH UNDER THREAT?

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-0912.0

12.5

13.0

13.5

14.0

14.5

15.0

15.5

16.0

Employment (in %, yoy) - LS

Net financial wealth (transactions, in % yoy) - LS

Household savings rate (in %) - RS

-20

-15

-10

-5

0

5

10

15

20

25

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09

Net financial wealth (transactions, in % yoy)

Net changes in value of financial wealth (in %)

Net financial wealth (in %, yoy)




16/49


Euro Compass

Inflation Watch

Core disinflation: where is the end?Marco Valli (UniCredit Bank Milan)+39 02 [email protected]

Core CPI: focus on the turningpoint

In the eurozone, we started seeing tentative signs of rising pipeline price pressure. Thisoccurs from extremely depressed levels and BEs remain very well behaved, but the recentsignificant weakening of the euro, both in trade-weighted terms and vis--vis the USD,suggests that upside CPI risk should not be completely dismissed. In the following, we stressthe consistency of our baseline scenario i.e. inflation set to remain extremely well

behaved throughout 2011 (and likely beyond) against the most recent data/survey

evidence. In doing so, we prefer focusing on core inflation, particularly on its turning point,because our benign CPI assessment strongly relies on the view that core pressures will keepslowing for another year or so in response to a large output gap. The obvious limit of thisapproach is that core and headline CPI trends can diverge significantly at times of risingcommodity prices, and it is well known that the ECB is particularly sensitive to headline CPI.

However, we are confident that our simplification should not cause any major loss o finformation going forward: given the extremely uncertain growth outlook and lingeringfinancial market tensions, we think that the ECB will avoid touching the policy rate at least foras long as core inflation keeps easing. Looking at a broad set of indicators that provide usefulinformation on turning points in core inflation and averaging their messages, we find that ourbaseline CPI scenario remains well on track. If anything, several indicators suggest thatthe trough in core inflation could occur later than we currently expect. At the time ofwriting, selling price expectations are the only variable that hints at some upside risks to ourbaseline scenario. These expectations need to be closely monitored going forward, but for thetime being they have shown up in hard data only in the form of increased pressure inintermediate goods PPI. We remain deeply skeptical of a full pass-through to core goods CPI.

Output gap: core CPI to slow for(at least) another year

Output gap. As our readers know, we forecast eurozone core CPI cycles relying mostly on a

PMI-based measure of output gap built with an a priori assumption on the potential growthrate of the economy. In the past, this gauge led core inflation by at least one year, and ifwe assume a similar pattern also this time (and given that the output gap bottomed out inearly 2010), we end up having core CPI slowing into 2011. In particular, our baselinescenario sees core CPI bottoming out sometime in 1H 2011 close to zero. However, boththe timing of the trough and the size of the deceleration to get there are subject to a numberof risks, because its difficult to find a model specification in which the output gap (which perse is uncertain) is linked to core prices in a satisfactory way. This is due both to the varyinglength of the lag with which slack affects core prices, and the varying intensity of this effect.Hence, there is a need to cross-check our baseline scenario using alternative indicators. Asalready mentioned, the focus is on the timing of the next turning point of core CPI.

OUTPUT GAP LEADS CORE CPI AND SO DOES THE UNEMPLOYMENT RATE

3M Moving Average

-100

-80

-60

-40

-20

0

20

40

60

80

100

Mar-98 Mar-02 Mar-06 Mar-10

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Output Gap - LS

Core CPI (in %, yoy) - RS

(2)(2)

(1)

(1)

(3)

(3)

(4)

(4)

(5)

3M Moving Average

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

Mar-96 Sep-99 Mar-03 Sep-06 Mar-10

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Unemployment rate - LS

Core CPI (in %, yoy) - RS (inv)

(1)(1)

(2)

(2)

(3)

(3)

(4)

(4)

Source: Eurostat, Markit, UniCredit Research



17/49


Euro Compass

Unemployment rate: core CPI toresume rising in 2H 2011

Unemployment rate. Labor market slack displays clear leading properties for core inflationand in the past the unemployment rate has always turned before core CPI (see rightchart on the previous page). The lead tends to vary over time, but apart from the very long

one recorded in the first years since the euro inception (the unemployment rate peaked inearly 1997, core CPI troughed three years later), the average seems to be less than oneyear. In the last few months, the upward trend of the unemployment rate has slowedsignificantly, in large part due to a trend reversal in Germany, but a turning point at the area-wide level doesnt seem imminent yet. In our projections, eurozone unemployment drifts to10.5-10.6% of the labor force by end-2010/early 2011, and starts falling moderately thereafter.If our forecast proves correct, we should expect core inflation to fall further from here andbegin rising moderately no earlier than 2H 2011. Even if we are too pessimistic and theunemployment rate is already at a peak, core inflation is unlikely to turn before early 2011.

Lending vs. core CPI: highlyuncertain lag length

Lending. Credit is not among the most commonly cited drivers of core inflation, but a visualinspection shows a fairly strong degree of co-movement between core CPI and lendingto the private sector. Note that the seemingly negative correlation that appears from the leftchart is due to the long lag existing between credit and core CPI cycles: obviously, theunderlying correlation is positive, with the former leading the latter. In some cases, the lagwas so long that core CPI even bottomed out when credit was heading for a new peak, andvice versa. This was the case in the three episodes of turning point in core inflation thatoccurred in Jul 2000 (trough), May 2002 (peak), and Mar 2006 (trough). In 2008-2009, the lagwas clearly shorter, but still of one year. Even if we assume that a similar short lag will bevisible also in the next leg up, and considering that lending to the private sector bottomed out(in negative territory) at end-2009, core inflation would resume a rising trend no earlier thanearly 2011. However, if the response of core CPI to credit developments were to resemblepre-crisis trends, we should expect core prices to trough in 2H 2011 at the earliest.

Hawkish sign, but to be put intocontext

Manufacturers selling price expectations. The index of manufacturing selling price

expectations of the EC survey is the indicator that shows the most hawkish signal, havingaccelerated sharply from the all-time low of March 2009 (2.4 st. dev. below the mean) to hit itslong-term average in May 2010. The upward trend of this indicator has been quite steep in thelast few months, signaling an improvement of the pricing power that has allowedmanufacturers to pass onto their customers higher (euro-denominated) commodity prices. Inother words, as also shown by the good leading properties of selling price expectations vs.core (ex-energy) PPI see right chart higher import prices have begun to feed throughthe price chain. Based on past cycles, we could even be approaching the point in whichhigher selling price expectations start impacting core CPI. We take stock of this indication andrank selling price expectations as the main variable to monitor in the coming months toassess upside risks to our projected turning point in core CPI.

LENDING VS. CORE CPI SELLING PRICE EXPECTATIONS VS. CORE PPI

3M Moving Average (in %, yoy)

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan-94 Jan-98 Jan-02 Jan-06 Jan-10

0.8

1.2

1.6

2.0

2.4

Lending - LS

Core CPI - RS

(4)

(4)

(3)

(3)

(2)

(2)

(1)

(1)(5)


-15

-10

-5

0

5

10

15

20

25

Mar-94 Mar-98 Mar-02 Mar-06 Mar-10

-4.5

-2.5

-0.5

1.5

3.5

5.5

7.5

Selling price expectations - LS

Core PPI - RS

Source: Eurostat, ECB, EC, UniCredit Research



18/49


Euro Compass

We expect no significant spill-over onto core CPI

However, one should put all this into context, because higher pipeline pressures do nottranslate mechanically into an acceleration of core CPI. At this particular juncture, the steeprise in manufacturers selling price expectations is driven almost entirely by the intermediate

goods sector, which is highly commodity-intensive. In April (the last available data because inMay the breakdown by sector was not released due to a methodological change in thesurvey), the intermediate goods sub-index climbed to 0.6 st. dev. above the mean, while boththe consumer and investment goods sectors recorded quite weak readings (-1.0 and -1.2,respectively). In both cases, the gap vs. intermediate goods is close to a record high. Thesedevelopments are well reflected into the breakdown of core PPI, which shows a pick-up inintermediate goods, while the trend for consumer and investment goods remains subdued,though clearly off the lows. The left chart shows that yoy consumer goods PPI has turned, butremains at a level that is below past cyclical lows. Admittedly, selling price expectations inintermediate goods lead (by about three months) selling price expectations both in consumerand investment goods, which makes it likely that in the near future we will see a firming of PPIpressures also for consumer and investment goods. But we expect this increase to remain

overall moderate and, importantly, higher consumer goods PPI should not be able to spillover to retail consumer prices in any meaningful way, given the projected sluggishness inconsumer spending throughout the forecast horizon. Moreover, it can be easily seen that thesensitivity of core CPI to consumer goods PPI has weakened substantially in the last cyclicalupswing, and other survey price gauges, for example the PMIs, depict a similar picture.Accordingly, the hawkish signal that emerges here becomes somewhat blurred.

Bottom line: risks skewedtowards a delayed trough

The table below summarizes the main findings of our analysis. Among the possibledeterminates of core CPI, we include also capacity utilization (available at a quarterlyfrequency) to take into account one indicator whose message is not affected by a drop in thepotential growth rate of the economy. Its easy to see that the lag pattern varies very muchacross cycles, but in general the credit crisis and the bursting of the commodity bubble led toa decline in the average lag between the turning point in core CPI and its determinants, which

however should not be considered surprising given the magnitude of the shock. Obviously, wedo not pretend that the current core cycle will be similar to others seen in the past. But if wecompute a simple (i.e. un-weighted) average of the information coming from the differentleading indicators across cycles, it emerges that risks are skewed towards a delay of thetiming of the trough in core CPI, currently seen in about one-years time. This is truealso when capacity utilization is taken into account. If history is of any guide, the capacityutilization rate (which bottomed out below 70% in mid-2009) suggests that the next low pointin core inflation could occur somewhere between end-2010 and mid-2012. All in all, we arequite comfortable with the balance of risks that stems from this analysis. In our view, anunprecedented output gap, persistently high (and still rising) unemployment, low credit growthand fiscal austerity argue for the risk of a delayed trough of core CPI.

CONSUMER GOODS PPI VS. CORE CPI RESULTS AT A GLANCE


0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

Mar-97 May-99 Jul-01 Sep-03 Nov-05 Jan-08 Mar-10

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Core CPI - LS

Consumer Goods PPI - RS(1)

(1)

(2)

(2)

(3)

(3)

(4)

(4)

(5)

(1) (2) (3) (4)

LOW - Jul 00 HIGH - May 02 LOW - Mar 06 HIGH - Dec 08

Output Gap (PMI-based) -15m -14m -29m -12m

Unemployment Rate -36m -7m -10m -7m

Lending -70m -19m -33m -12m

PPI - core (ex-energy) -14m -17m -25m -3m

PPI - consumer goods -13m -10m -6m -7m

EC Selling Price Expectations -18m -18m -8m -4m

Output prices (PMI composite) -- -- -32m -4m

Capacity utilisation -6q -7q -12q -7q

Average -26m -15m -22m -9m

Core CPI cycles

Source: Eurostat, ECB, EC, UniCredit Research



19/49


Euro Compass

UniCredit Inflation Forecasts

EMU HICP HICP ex tobacco (unrevised) Core(Eurostat) France CPI ex tobacco Italy FOI ex tobacco

Index mom Yoy Index mom yoy yoy Index mom yoy Index mom yoy

Jan-09 106.98 -0.8 1.1 106.82 -0.9 1.1 1.6 117.13 -0.4 0.7 134.2 -0.2 1.5

Feb-09 107.42 0.4 1.2 107.26 0.4 1.2 1.7 117.59 0.4 0.9 134.5 0.2 1.5

Mar-09 107.82 0.4 0.6 107.66 0.4 0.5 1.4 117.81 0.2 0.3 134.5 0.0 1.0

Apr-09 108.21 0.4 0.6 108.04 0.4 0.5 1.8 118.00 0.2 0.1 134.8 0.2 1.0

May-09 108.27 0.1 0.0 108.10 0.1 0.0 1.5 118.18 0.2 -0.3 135.1 0.2 0.7

Jun-09 108.48 0.2 -0.1 108.27 0.2 -0.2 1.4 118.33 0.1 -0.5 135.3 0.1 0.4

Jul-09 107.77 -0.7 -0.6 107.51 -0.7 -0.8 1.3 117.80 -0.4 -0.7 135.3 0.0 -0.1

Aug-09 108.14 0.3 -0.2 107.89 0.4 -0.3 1.3 118.41 0.5 -0.2 135.8 0.4 0.2

Sep-09 108.16 0.0 -0.3 107.91 0.0 -0.5 1.2 118.12 -0.2 -0.4 135.4 -0.3 0.1

Oct-09 108.41 0.2 -0.1 108.17 0.2 -0.3 1.2 118.23 0.1 -0.2 135.5 0.1 0.2

Nov-09 108.54 0.1 0.5 108.28 0.1 0.4 1.0 118.31 0.1 0.3 135.6 0.1 0.7

Dec-09 108.88 0.3 0.9 108.61 0.3 0.8 1.1 118.60 0.2 0.8 135.8 0.1 1.0

Jan-10 108.05 -0.8 1.0 107.75 -0.8 0.9 0.9 118.32 -0.2 1.0 136.0 0.1 1.3

Feb-10 108.39 0.3 0.9 108.02 0.3 0.7 0.9 118.99 0.6 1.2 136.2 0.1 1.3

Mar-10 109.37 0.9 1.4 109.09 1.0 1.3 1.0 119.58 0.5 1.5 136.5 0.2 1.5

Apr-10 109.87 0.5 1.5 109.58 0.4 1.4 0.8 119.90 0.3 1.6 137.0 0.4 1.6

May-10 110.03 0.1 1.6 109.73 0.1 1.5 0.8 120.04 0.1 1.6 137.1 0.1 1.5

Jun-10 109.92 -0.1 1.3 109.60 -0.1 1.2 0.8 120.01 0.0 1.4 137.1 0.0 1.3

Jul-10 109.53 -0.4 1.6 109.14 -0.4 1.5 0.7 119.56 -0.4 1.5 137.4 0.2 1.6

Aug-10 109.77 0.2 1.5 109.38 0.2 1.4 0.6 120.02 0.4 1.4 137.7 0.2 1.4

Sep-10 110.04 0.2 1.7 109.65 0.2 1.6 0.7 119.95 -0.1 1.5 137.5 -0.1 1.6

Oct-10 110.37 0.3 1.8 109.98 0.3 1.7 0.6 120.04 0.1 1.5 137.8 0.2 1.7

Nov-10 110.40 0.0 1.7 110.00 0.0 1.6 0.5 120.09 0.0 1.5 137.8 0.0 1.6

Dec-10 110.86 0.4 1.8 110.46 0.4 1.7 0.4 120.41 0.3 1.5 138.1 0.2 1.7

Jan-11 109.99 -0.8 1.8 109.52 -0.9 1.6 0.4 120.00 -0.3 1.4 138.3 0.1 1.7

Feb-11 110.38 0.4 1.8 109.91 0.4 1.7 0.4 120.63 0.5 1.4 138.4 0.1 1.6

Mar-11 111.14 0.7 1.6 110.67 0.7 1.4 0.4 121.14 0.4 1.3 138.6 0.2 1.5

Apr-11 111.53 0.4 1.5 111.06 0.4 1.4 0.4 121.38 0.2 1.2 139.0 0.3 1.5

May-11 111.70 0.2 1.5 111.23 0.2 1.4 0.3 121.61 0.2 1.3 139.2 0.1 1.5

Jun-11 111.75 0.0 1.7 111.27 0.0 1.5 0.3 121.70 0.1 1.4 139.4 0.1 1.7

Jul-11 111.43 -0.3 1.7 110.88 -0.4 1.6 0.4 121.34 -0.3 1.5 139.8 0.3 1.7

Aug-11 111.74 0.3 1.8 111.18 0.3 1.6 0.4 121.88 0.4 1.5 140.1 0.2 1.7

Sep-11 112.07 0.3 1.8 111.51 0.3 1.7 0.4 121.83 0.0 1.6 140.0 -0.1 1.8

Oct-11 112.44 0.3 1.9 111.88 0.3 1.7 0.5 122.08 0.2 1.7 140.4 0.3 1.9

Nov-11 112.50 0.1 1.9 111.93 0.0 1.8 0.5 122.12 0.0 1.7 140.5 0.0 2.0Dec-11 113.00 0.4 1.9 112.43 0.4 1.8 0.6 122.47 0.3 1.7 140.8 0.2 2.0

2009 0.3 0.2 1.4 0.1 0.7

2010 1.5 1.4 0.7 1.4 1.5

2011 1.8 1.6 0.4 1.5 1.7

Source: Eurostat, INSEE, ISTAT, UniCredit Research

Marco Valli (UniCredit Bank Milan) Tullia Bucco (UniCredit Bank Milan)+39 02 8862.8688 +39 02 [email protected] [email protected]



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Euro Compass

ECB Most Watched

Chiara Silvestre(UniCredit Bank Milan)[email protected]

We expect GDP to rebound 0.5% qoq in 2Q, with the risk of an even stronger reading. Asmost growth indicators are showing signs of peaking, it seems quite likely that growthmomentum will weaken anew starting in 3Q.

The trade-weighted euro lost 1.1% since mid-May, while euro-denominated Brent rose by0.3%.

The May flash estimate shows that the inflation rate inched up by 0.1pp to 1.6% yoy. InJune, inflation will probably slow significantly on the back of falling energy prices.

In April, M3 growth remained stable at -0.1% yoy. After seven months of negative readings,loans to the private sector returned in positive territory (to +0.1% yoy from -0.2%) whilecorporate loans resumed weakening (-2.6% yoy vs. -2.4%).

ECB Forecasts ECB Key exogenous variables

June ECB Projections

Growth Inflation

2010 2011 2010 2011

1.0 1.2 1.5 1.6

UniCredit Forecasts

Growth Inflation

2010 2011 2010 2011

1.0 1.3 1.5 1.898

100

102

104

106

108

110

112

114

116

118

22-Jan-08 27-Aug-08 2-Apr-09 6-Nov-09 14-Jun-10

20

30

40

50

60

70

80

90

100EUR TW - LSBrent - RS

UniCredit Composite PMI & GDP Growth Inflation

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

Sep-98 Dec-00 Mar-03 Jun-05 Sep-07 Dec-09

38

43

48

53

58

63

GDP qoq (in %) - LS

UniCredit Composite PMI (qtr avg) - RS

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Sep-99 May-02 Jan-05 Sep-07 May-10

HICP (in %, yoy)

Core (in %, yoy)

M3 Dynamics Credit Dynamics

M3 (in %, yoy)

-2

0

2

4

6

8

10

12

14

Jan-99 Oct-02 Jul-06 Apr-10

-4

-2

0

2

4

6

8

10

12

14

16

18

Jan-00 Jun-03 Nov-06 Apr-10

Loans to households: total (in %, yoy)

Loans to households: mortgage (in %, yoy)

Loans to non-fin. corp. (in %, yoy)

Source: Datastream, ECB, Eurostat, Markit, UniCredit Research



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Euro Compass

The Eurozone Economists Toolbox

Chiara Corsa(UniCredit Bank Milan)+39 02 [email protected]

Loredana Federico(UniCredit Bank Milan)+39 02 8862 [email protected]

1. GDPUniCredit Composite PMI

Our Composite PMI in May rose to 56.1 from 56.0. Services activity improved further, butthe manufacturing PMI fell for the first time since February 2009, suggesting that the peakof the factory cycle is behind us. Still, our Composite PMI points to 0.7% qoq GDP in 2Q.

STILL SOLID, BUT SIGNS OF WEAKENING AHEADDavide Stroppa(UniCredit Bank Milan)+39 02 8862 [email protected]

Marco Valli(UniCredit Bank Milan)+39 02 8862 [email protected]

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

Sep-98 Dec-00 Mar-03 Jun-05 Sep-07 Dec-09

38

43

48

53

58

63

GDP qoq (in %) - LS

UniCredit Composite PMI (qtr avg) - RS

Source: Markit, Eurostat, UniCredit Research

UniCredit GDP Tracker

At the beginning of 2Q, our GDP Tracker signals 0.7% quarterly growth, despite persistentweakness in car registrations. Our official GDP forecast for 2Q is 0.5% qoq, but risks areskewed to the upside.

2Q STARTS ON A STRONG FOOTING

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

Q2 1995 Q1 2000 Q4 2004 Q3 2009

Actual GDP

GDP Tracker

Source: European Commission, Eurostat, ECB, National Sources, UniCredit Research

The UniCredit Composite PMI is a weighted average of manufacturing and services PMI (headline), with weights based of the sectors share of total GVA.Weights are updated quarterly. The composite PMI is available starting from 3Q-98 and explains about 70% of the volatility in qoq GDP.

The UniCredit GDP Tracker estimates qoq GDP growth using IP, construction, retail sales and car registrations, plus one index of services confidence toovercome the lack of hard data in the tertiary sector (ex retail).

mailto:[email protected]:[email protected]


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Euro Compass

2. Employment

UniCredit Employment Indicator

In May, our employment indicator was unchanged at -0.6, a level which is consistent withjob shedding coming to a halt.

EARLY SIGNS OF STABILIZATION

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Mar-97 May-99 Jul-01 Sep-03 Nov-05 Jan-08 Mar-10

UniCredit Employment Indicator

3M-ma

Source: European Commission, Eurostat, UniCredit Research

3. Money

In April, M3 held in negative territory, at -0.1% yoy. Loans to the private sector recorded afurther marginal improvement (+0.1% yoy vs. -0.2%). Lending to NFCs slipped to -2.6%yoy vs. -2.4%, while loans to households kept accelerating (2.5% yoy vs. 2.1%).

MONEY SUPPLY REMAINS WEAK

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

Jan-99 Nov-00 Sep-02 Jul-04 May-06 Mar-08 Jan-10

official M3

M3 corrected for portfolio shifts

loans to private sector

Source: ECB, UniCredit Research

The UniCredit Employment Indicator is a weighted average of standardized 12-month-ahead employment expectations in the industrial, construction, andservices sectors, as computed by the European Commission for its monthly survey. Weights are based on the share of total GVA of the three sectors, andare updated quarterly. The Indicator tracks both qoq and yoy employment growth (national accounts definition), but the latter fit is better.

The ECB estimates the size of portfolio shifts through a univariate time-series model of M3 that includes also a number of dummies and trends (see ECBMonthly Bulletin, October 2004). The estimate is carried out quarterly. However, given that this adjustment was particular to the nature of the portfolioshifts that occurred during 2001-2003, the growth rate of M3 corrected has coincided with that of official M3 for some time now, and continues to do so.



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Euro Compass

4. Inflation

UniCredit Underlying Inflation Index

Our underlying inflation gauge in April eased to 0.44% yoy vs. 0.58%. This is a new record-low level.

A NEW RECORD LOW

-1.0

0.0

1.0

2.0

3.0

4.0

Jan-02 Aug-03 Mar-05 Oct-06 May-08 Dec-09

Headline

Core

UniCredit Underlying


UniCredit Persistence-Weighted (PW) Inflation Index

In April, our PW Inflation measure stabilized at 1.3% yoy. This compares to 1.5% onheadline inflation, while core inflation (ex food, energy, alcohol and tobacco) eased to only0.8%.

NEGATIVE GAP WIDENS

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Jan-99 Apr-00 Jul-01 Oct-02 Jan-04 Apr-05 Jul-06 Oct-07 Jan-09 Apr-10

PW Index

HICP


Our UniCredit Underlying Inflation Index strips out erratic components (food, energy, alcohol) and administrative prices (among the most important:tobacco, social protection, education, medical, dental and hospital services). It covers 68% of the total HICP basket.

Our UniCredit Persistence-Weighted (PW) Inflation Index is an alternative measure of core inflation that gives more weight to the items of the HICPbasket displaying a higher degree of persistence. At any given point in time, the degree of persistence of each of the twelve HICP sub-components issimply given by the sum of its autoregressive coefficients, a proxy for the speed with which prices converge toward the mean after a shock. The sum ofautoregressive coefficients (if negative, it is put equal to zero) is then re-scaled to deliver the new, persistence-based and time-varying weight of the item.



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Euro Compass

5. Monetary Policy

UniCredit Coincident Taylor Rule

The PMI-based output gap narrowed further, while loans to the private sector resumedmarginally positive growth. Our coincident Taylor rule in June signals a further modestincrease of the fair refi rate, which now stands at 0.7%.

FAIR REFI RATE STILL BELOW 1%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jan-99 Oct-01 Jul-04 Apr-07 Jan-10

Actual

Fitted

Source: ECB, Markit, UniCredit Research

UniCredit Forward-looking Taylor Rule

The forward-looking Taylor Rule based on inflation expectations and output gap keepsignaling a fair value of the refi rate around 0.70% in June. Penciling in our inflationforecasts for this year and the next, the refi rate should climb towards 0.80% by year-end

MOVING UP SLOWLY

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Dec-99 Oct-01 Aug-03 Jun-05 Apr-07 Feb-09 Dec-10

Refi rate Fitted Forward looking TR

Source: ECB, Markit, The Economist, UniCredit Research

The UniCredit Coincident Taylor Rule is a monthly specification of the ECBs reaction function. It explains the level of the refi rate as a function of: 1) aPMI-based measure of output gap; 2) the yearly growth rate of lending to the private sector.The UniCredit Forward-Looking Taylor Rule explains the level of the refi rate as a function of: 1) a PMI-based measure of output gap; 2) a weightedaverage of the inflation expectations as published by The Economist magazine.



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Euro Compass

6. Monetary and Financial Conditions

UniCredit MCI/FCI

Over the last month, the disconnection between monetary and financial conditionscontinued, as our MCI eased some 50bp, on the back of a weaker currency. In contrast,our FCI eased only eased only slightly (6bp), following the weakness in equity market.

THE DISCONNECTION CONTINUES

96.0

96.5

97.0

97.5

98.0

98.5

99.0

99.5

100.0

1-Jan 3-Feb 8-Mar 8-Apr 11-May 11-Jun

UniCredit MCI

UniCredit FCI

1/1/2007=100

Source: Bloomberg, UniCredit Research

UniCredit Financing Costs Indices

In April, the Financing Costs Indices for Households and for Non-Financial Corporationskept stabilizing at around 4.7% and 5.6% respectively. The latter augmented slightly withrespect to March, as the cost of equity increased again in this month.

FINANCING COSTS KEPT STABILIZING

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10

Households

Non-Financial Corporations

Source: ECB, UniCredit Research

Our indicators are weighted sums of deviations of current asset prices from their long-term trend. The weights where obtained estimating an IS curve

relating changes in GDP growth with changes in real asset prices. The MCI includes short-term rates and the exchange rate, adding corporate yields andstock market prices for the FCI.Financing Costs Indices are computed weighting the cost of different sources of financing with the share of these sources in firms and householdsliabilities.



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Euro Compass

7. Financial Markets

UniCredit FMI

Our FMI shows that tensions are easing somewhat. In June, the peak was hit on the 8th at1.04, while on the 14th the indicator marked the fourth consecutive daily decline and settledat 0.43.

TENSIONS HAVE MODERATED

FMI

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1-Jan-99 1-Apr-01 1-Jul-03 1-Oct-05 1-Jan-08 1-Apr-10


UniCredit Barometer

The Barometer shows that on June 14 tension persists in bond markets, although fallingfrom 62 of last week to 54. The contagion to foreign exchange and equity markets eased,while money market conditions kept worsening (although the index remains at a low 20).

BOND MARKETS REMAIN CENTRE STAGE

0

10

20

30

40

50

60

70

80

90

100

1-Jan-07 1-Sep-07 1-May-08 1-Jan-09 1-Sep-09 1-May-10

Money markets Equity markets

Bond/Credit derivatives FX markets


The FMI aggregates in one single indicator the signal coming from the VDAX, DJ Euro Stoxx 50 and corporate spread (BBB, 5-7y). Volatility and spreadenter the algorithm with a positive sign, equity with a negative sign. The FMI is negatively correlated with economic growth and leads eurozone GDP by

one quarter and the Ifo expectations index by one month.The Barometer summarizes relevant US and EU financial market indicators in four market segments. For each market indicator, we compare the currentvalue with the value prevailing in the pre-(financial)crisis period in January-July 2007 (calibrated as zero) and with its crisis peak (calibrated as 100). Theaggregate signal for each segment market is obtained by calculating simple averages of these sub-sets of market indicators.



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Euro Compass

European Central Banks Watch

BoE Sticky inflation complicates central banks jobChiara Corsa(UniCredit Bank Milan)+39 02 8862 [email protected]

While evidence on the growth side continued to emerge that the recovery, albeit moderate, isstill underway, on the inflation side, things are getting thorny for the BoE. At the time ofwriting, CPI inflation decelerated to 3.4% in May, while core inflation declined to 2.9%, but itstill remains uncomfortably high. In the MPC assessment, there are some temporary factors(higher oil prices, the restoration of the standard rate of VAT in January and the sterlingdepreciation) that are masking the downward pressure on prices coming from the substantialmargin of spare capacity in the economy. Therefore, the BoEs central scenario remains oneof falling inflation throughout the forecast horizon. However, the MPC has repeatedlyhighlighted risks on this central scenario in both directions, on the downside, if the margin ofspare capacity proves to be more significant than assumed and, on the upside, if commodityprices continue to rise and inflation expectations increase, leading to some persistence in the

current high level of inflation. Some of these upside risks have indeed started to materialize,as different measures of short-term inflation expectations have shown a significantincrease of late: in particular, the Citigroup/YouGov measures of inflation expectations one-year ahead showed that in May inflation expectations rose to 2.8% from the previous 2.2%,while the BoE/NOP survey jumped to 3.3% in 2Q from the previous 2.5%. Anothercontentious point remains the impact of the margin of spare capacity on inflation: the latestQuarterly Bulletin pointed out that it is still unclearwhether and by how much the supplypotential of the economy has fallen as a consequence of the financial crisis. Moreover, thefact that Sentance called (for the first time since the eruption of the crisis) for a rate hikebefore the end of the year, saying that the margin of spare capacity in the economy might befar lower than the majority of the MPC thinks, suggests that the debate on this topic mightheat up in coming months. Clearly, an offsetting factor to the unfavorable dynamics on the

inflation side should come from developments on the fiscal front. The emergency budgetis due on June 22, after which we will have a more precise assessment of the impact ongrowth of the fiscal consolidation effort. Meanwhile, the updated projections issued on June14 by the Office for Budget Responsibility showed, compared to the March Budget: 1)significantly lower (and more credible) growth forecasts, 2) lower net borrowing through 2014-2015, but 3) higher cyclically-adjusted net borrowing. Against this newly-updated macro andfiscal picture, we expect that the government will adopt a strong fiscal consolidation plan inorder to reduce the cyclically-adjusted net borrowing.

UK FORECASTS

2009 2010 2011 Annual average

1Q-09 2Q-09 3Q-09 4Q-09 1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 2009 2010 2011

GDP -2.6 -0.7 -0.3 0.4 0.3 0.5 0.4 0.4 0.5 0.6 0.7 0.7 -- -- --

GDP (% yoy) -5.3 -5.9 -5.3 -3.1 -0.2 1.0 1.7 1.6 1.8 1.8 2.1 2.4 -4.9 1.0 2.0

Private Consumption -1.6 -0.9 0.0 0.4 0.0 0.2 0.2 0.2 0.3 0.3 0.4 0.4 -3.2 0.4 1.1

Government Consumption -0.4 0.9 0.6 1.0 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2.2 1.8 0.0

Gross Fixed Capital Formation -7.3 -7.2 2.8 -2.7 1.5 -0.2 -0.2 0.2 0.3 0.5 0.7 1.0 -14.9 -1.2 1.3

Exports -7.2 -1.8 0.6 3.8 0.0 0.8 1.2 1.2 1.5 1.6 1.7 2.0 -10.6 4.3 5.9

Imports -6.5 -2.9 1.2 4.7 1.4 0.4 0.6 0.7 0.5 0.4 0.4 0.7 -11.9 5.6 2.1

Net export* 0.0 0.4 -0.2 -0.3 -0.4 0.1 0.1 0.1 0.3 0.3 0.3 0.3 0.7 -0.5 0.9

CPI Inflation (% yoy) 3.0 2.1 1.5 2.1 3.3 3.5 3.1 2.9 2.3 2.0 2.4 2.4 2.2 3.2 2.3

Core CPI Inflation (% yoy) 1.5 1.6 1.7 2.2 3.0 3.0 2.6 2.1 1.7 1.4 1.4 1.4 1.8 2.7 1.5

Current Account (% GDP) -- -- -- -- -- -- -- -- -- -- -- -- -1.5 -1.4 -1.0

Pub. Sect. Net Borrowing (% GDP) -- -- -- -- -- -- -- -- -- -- -- -- -11.5 -9.0 -7.5

Repo rate 0.5 0.5 0.5 0.5 0.50 0.50 0.50 1.00 1.50 2.00 2.50 2.75 - - -3M GBP Libor (end quarter) 1.65 1.19 0.54 0.60 0.65 0.73 0.80 1.30 1.80 2.30 2.80 3.00 - - -

10 yr (end quarter) 3.17 3.69 3.59 3.95 4.15 3.55 4.40 4.70 4.90 5.00 5.10 5.15 - - -

EUR-GBP 0.93 0.85 0.92 0.89 0.89 0.83 0.82 0.78 0.75 0.72 - - - - -GBP-USD 1.43 1.65 1.60 1.67 1.51 1.47 1.52 1.57 1.60 1.63 - - - - -

All data are % qoq unless otherwise specified; GDP data are wda. *Contribution to growth; Source: ONS, UniCredit Research



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Euro Compass

SNB Swiss franc strength directs monetary policyAlexander Koch (UniCredit Bank)+49 89 [email protected]

The Swiss economy continued its broad-based recovery at the beginning of the year.

Moreover business sentiment maintained its upward trend recently. The PurchasingManagers Index even climbed to a new record-high in May. Moreover, the heavy rise insupplier delivery times suggests that capacity utilization has improved more strongly thaninitially expected. And the high level of backlog orders clearly argues for an ongoing solidindustrial performance in the coming months. Swiss GDP can be expected to reach its pre-crisis level again already by mid-year 2010.

In addition to the export-driven rebound in industry, also the fundamentals for the domesticeconomy remain favorable. Household spending continued to expand at a decent rate at thebeginning of spring, underscored by a further improvement in business expectations ofretailers. Consumer climate is supported by increasing signs of a stabilization in the labormarket. Adjusted unemployment has steadily declined since the beginning of the yearand working hours are pointing north again. And as employment plans have clearly risen

above the expansion threshold, private consumption should remain a reliable growth pillaralso this year.

In addition to the sound situation in the private sector, public finances remain in good shape.The Swiss general government budget balance can be expected to be broadly balanced eventhis year and the debt-to-GDP ratio remains at just above 40%.

As the Swiss economy is experiencing a V-shaped recovery, supported by a stable financialsector and solid government finances, according to the classical Taylor Rule, interest ratenormalization would, therefore, already be indicated. However, the continuing strength ofthe CHF, despite massive currency interventions, is preventing an early rate move . FXreserves have jumped by a stunning 400% since the start of the interventions in March lastyear until May 2010. The appreciation of the CHF is having an effect comparable to that of

conventional monetary policy tightening. According to our estimates, the appropriate level ofthe target rate based on the assumption of a sustained recovery and a EUR-CHF rate of 1.40 atthe end of this year is 0.5%; at a EUR-CHF rate of 1.30, the SNB should even refrain fromraising rates altogether.

Consequently, the chances for the start of a smooth interest rate normalization processalready in September have declined substantially. The latest CHF strength and the risks ofa further marked appreciation could let the SNB postpone a first target rate hike until

next year. The statement at the June quarterly meeting will provide more insight on thestance of SNB officials.

SWITZERLAND FORECASTS

2009 2010 2011 Annual average1Q- 2Q-09 3Q-09 4Q-09 1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 2009 2010 2011

GDP (% qoq) -1.1 -0.1 0.5 0.9 0.4 0.6 0.4 0.3 0.3 0.4 0.4 0.4 -1.5 2.0 1.5

GDP (% yoy) -2.1 -2.5 -1.4 0.2 1.7 2.4 2.3 1.7 1.6 1.4 1.4 1.5 - - -

Private Consumption (% qoq) 0.2 0.5 0.8 0.4 0.5 0.3 0.3 0.3 0.4 0.4 0.4 0.4 1.2 1.8 1.5

CPI Inflation (% yoy) 0.0 -0.7 -1.0 -0.2 1.1 1.1 1.0 1.0 1.0 1.1 1.1 1.1 -0.5 1.1 1.1

Unemployment rate (%) 3.1 3.6 4.0 4.1 4.1 4.0 3.8 3.7 3.7 3.6 3.4 3.3 3.7 3.9 3.5

Budget Balance (% GDP) - - - - - - - - - - - - 0.5 -0.3 -0.2

Public Debt (% GDP) - - - - - - - - - - - - 41 42 42

3M CHF Libor mid target rate 0.25 0.25 0.25 0.25 0.25 0.25 0.50 0.75 1.00 1.25 1.50 1.75 - - -

3 Months (end quarter) 0.40 0.40 0.29 0.35 0.20 0.03 0.60 0.85 1.25 1.50 - - - - -

10 yr (end quarter) 2.10 2.32 1.99 2.15 2.05 1.55 2.05 2.20 2.30 2.35 - - - - -

EUR-CHF 1.51 1.52 1.52 1.49 1.42 1.40 1.40 1.39 1.38 1.42 - - - - -

USD-CHF 1.14 1.09 1.04 1.01 1.05 1.15 1.13 1.14 1.15 1.20 - - - - -

GDP data are wda Source: National sources, UniCredit Research



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Euro Compass

Nordics increasing chances of a Riksbank hike in JulyStephan Maier(UniCredit Bank Milan)+39 02 8862 [email protected]

In Sweden, the growth momentum is much better than expected and there are

increasing chances that the Riksbank brings forward its first key rate hike fromSeptember to the July meeting. In Norway, the Norges Bank might prefer to remain on

hold at the next meeting as inflation is expected to continue to ease.

Riksbank: Following a strongfirst quarter and strong upwardrevisions to last years growthfigures, we see increasingchances for a rate hike alread

yin July

At the end of May, Swedish GDP was strongly revised upwards for the quarters from 2Q0

UniCredit-Euro Compass Quarterly 3Q2010

Documents

Transcript of UniCredit-Euro Compass Quarterly 3Q2010