Cross Asset Invt Strategy Monthly - December 2013 - VA

Cross asset
Research, Strategy and Analysis

December 2013 #
investment strategy
MONTHLY
12
Asset allocation: Amundi investment strategies
ECB sending ever clearer messages
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Insights
Risk factors Macroeconomic outlook Macroeconomic and financial forecasts
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Analysis
Does the eurozone still hold some appeal? A few genuine strengths and some well-identified risk factors Equity markets: a snapshot of long-term prospects Germany, source of deflation? What determines the euro-dollar? Essentially the ECBs (deflationary) stance US and European credit cycles are diverging Refunding risk of US and European High Yield companies in next two years Refinancing mortgage loans in Denmark: an envied but somewhat ambiguous model The reinvention of electronic components
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Document finalised at December 9, 2013. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry
December 2013 # 12
Asset allocation: Amundi investment strategies ECB sending ever clearer messages
PHILIPPE 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 excess liquidity (risking the creation of bubbles). But the risks associated with a scaling back of QE are back. The recent drop in ECBs interest rates in reaction to a further decline in inflation may not be an effective response to the eurozones current dilemmas (a weak credit market, the inability of banks in some peripheral countries to transfer low interest rates to the economy, the rising rate of unsuccessful credit applications by SMEs, weak investment...), but it is very indicative of the ECBs fears of deflationary risks. Long gone are the days when European central bankers viewed lowering inflation (or competitive disinflation) as the main objective of their monetary policy. The deflation-fearing camp is now the dominant voice within the ECB. The ECB is increasingly likely to take further measures to boost confidence in banks and revive the credit market. So while we speculate on when the US Fed may start scaling back QE, the question on the other side of the Atlantic concerns the type of measures the ECB may pursue in the future. So what can we expect? First and foremost, the supply of liquidity to banks in certain peripheral countries must be ensured. This is why there is so much discussion about the long-term course of LTROs. This liquidity must not be exclusively supplied via governmental bond purchases: it strengthens the link between banks and governments (a relationship frowned upon by the ECB and financial markets alike), 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 liquidity to banks that are eagerly buying up governments bonds does not solve the credit problem. A solution may be to offer liquidity to banks that have a good LCR, a measure of their lending capacity. 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 shift in asset allocation, in which corporate bonds and eurozone equities feature prominently. The choice is fitting, given that over the past three months, eurozone equities significantly outperformed their US counterparts. While the catch-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 debt ceiling (February7), the closer we are to an environment of increased volatility and risks associated with 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) downturn are 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, which translates into some profit taking on overweighted equities, particularly on outperforming European equities.
ASSET ALLOCATION 3 TO 6 MONTHS OUTLOOK

-- + ++
CASH
USD EUR
SOVEREIGN BOND
United States Eurozone (core countries) Eurozone (periph. countries) United kingdom Japan Emerging 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
PORTFOLIO TYPE
Equity portfolios
Short term risk increases due to US QE
Bond portfolios
Short term risk increases due to US QE
Diversified portfolios
Short term risk due to US QE perspectives Stay neutral to overweight US and Japan Profit taking on Euro equities; keep OW though Sectors (advanced countries): prefer cyclical
perspectives Stay neutral to overweight US and Japan Keep FX hedging on Japanese equities Prefer Euro zone equities EMG equitiesstay selective: UW Turkey, India, South Africa, neutral on China, OW Brazil, Russia, Peru, Thailand Sectors (advanced countries): prefer cyclical and industrial sectors Stay selective on financial securities with a more positive bias (in the awaiting of ECB actions) Maintain long USD, short JPY and EUR
perspectives Maintain overweight position on credit vs. sovereign bonds Maintain underweight/absent from peripheral countries having liquidity solvency issues Reduce exposure on EMG debt (both local and hard currencies debt) Stay selective on financial securities with a more positive bias (in the awaiting of ECB actions) Maintain Long USD, NOK, GBP, short JPY, AUD, NZD and EUR EMG currencies: stay highly selective (US QE perspectives a handicap)
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
Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry
December 2013 # 12
Risk Factors
DECEMBER
ONGOING RISK OF US TECHNICAL DEFAULT?
RISK LEVEL
US governance brought the country to the edge of default. Admittedly, it would only have been a technical default, and the debt ceiling was raised in the nick of time, but the political obstacles demonstrated the limits of US democracy and its problems. According to Bernanke, a default would cause a financial crisis and real chaos, and would deal a fatal blow to the economic recovery. We cannot continue to ignore such a risk given the implications and the fact that the problem will arise once again in January (for a potential shutdown) and February (in terms of another increase in the debt ceiling). The United States will not default, but the risk remains.
TOWARD A MORE PRONOUNCED SLOWDOWN IN EMERGING MARKET ECONOMIES?
LOW RISK
At first glance, the resumption of economic growth in developed countries is a good thing for emerging market economies and their exports, including commodities. But things are not as clear-cut as in the past. The fundamentals of several emerging countries have deteriorated and growth models are in flux. Now more than ever, the emerging bloc is not a bloc.
MODERATE RISK
MODERATE RISK
FRANCE, TOO WEAK GROWTH AND INSUFFICIENT CAPACITY TO CARRY OUT THE APPROPRIATE STRUCTURAL REFORMS
The eurozone is improving, thats a fact. However, economic growth is stronger in many peripheral countries and in Germany than in France. The improvement in competitiveness indicators (therefore in trade balances and current account balances) is also much more significant in peripheral countries. Will France be able to generate sufficient growth in order to forget the level of its public deficit and public debt? Will it be able to get the measure of its weaknesses (poor competitiveness, too heavy taxation, particularly in respect of labour, and size of public spending)? Currently in the soft underbelly of the eurozone and no longer really among the core countries, the challenge for France is not to find itself perceived as a country having the characteristics of peripheral countries but without having their growth..
SPAIN: THE RETURN OF THE DEBATE ON SOLVENCY, LIQUIDITY AND DEBT RESTRUCTURING?
Spanish recession is officially over, but the economic situation continues to provide cause for concern. The ability to ensure its growth potential will determine the countrys creditworthiness. The marked improvement in its current account balance and in government finance may not be enough to offer complete reassurance even if the current trend is positive. The economic adjustment is spectacular, but the country remains weakened by its low growth potential. Private sector deleveraging is far from over..
ITALY: FEARS SURROUNDING ITS ABILITY TO STABILISE ITS LEVEL OF DEBT?
MODERATE RISK
MODERATE RISK
So far, Italy has recovered from the crisis fairly well and, in particular, now maintains a high primary surplus while its political situation can be regarded as reassuring. Economic growth now looks more negative and doubts about public finances have resurfaced (will the primary surplus be enough to stabilise debt, which is already quite high?), to the point that Italys 10-year rates are now identical to Spains.
PHASE-OUT OF MONETARY POLICIES: ILL-PERCEIVED BY MARKETS?
MODERATE RISK
The Fed has postponed the reduction of its $85 billion in monthly asset purchases. This provided a boost to the markets and helped ease risk in the short term, however, it wont be long before it returns to centre-stage. Janet Yellen will replace Ben Bernanke in January and maintain the current policy, a factor that will reassure financial markets and economies. However, that will only last a little while. The market consensus is for a tapering of asset purchases in Q1 or Q2. The ECB is continuing on its path of easing monetary conditions. The sharp drop in inflation rates and sluggish activity are generating concerns that deflationary pressure may increase. The ECB reduced its key rate and is undoubtedly going to continue its unconventional policy. The challenge will be to find the best way of containing the decline in bank lending and ensuring that it resumes, especially in the peripheral countries.
EMERGING MARKETS: TOWARD A FULL-BLOWN CRISIS?
External systemic factors (the expected end of QE, the rebound of long rates and geopolitical tensions) are combining with specific endogenous factors (deteriorating current accounts, increase in private debt, poor currency management, the credit boom, a slight increase in risk aversion, the suspicion that bubbles are forming, etc.). The risk of an emerging market crisis is looming again. The Feds status quo is succeeding in curbing this risk, however, it is clear that the strength of emerging currencies is inextricably linked to the surplus liquidity pumped in by QE.
TOWARD A REBOUND OF VOLATILITY AND FINANCIAL MARKET STRESS IN EUROPE?
MODERATE RISK
MODERATE RISK
Volatility has returned to risky assets. The movement has been keenly felt, but it is not overpowering. Financial market stress is contained for now on both sides of the Atlantic. Fears of a sharp surge in sovereign bond rates, the scant protection offered by current spreads and the debt metrics of some countries remain danger factors. Risk is asymmetrical on sovereign spreads...theres more to be lost than to be gained.
EUROZONE GROWTH: TOWARDS A TRIPLE DIP?
MODERATE RISK
After the post-financial crisis recession and the post-debt crisis recession, economic indicators seem to indicate that the worst is behind us. At least thats the opinion of the international institutions that are counting on positive growth in all eurozone countries for 2014. However, the situation remains fragile and domestic (investment and consumption) as well as external (exports) growth drivers should be carefully monitored. At this stage, there is nothing that indicates a real pick-up in growth.
December 2013 # 12
Macroeconomic outlook
DECEMBER
AMERICAS UNITED STATES RISK FACTORS
> A cyclical recovery is underway. Consumption will accelerate moderately in 2014, helped by the continuing increase of real wages (benefiting from low inflation and from the gradual strengthening of 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 profits remain on a strong trend, they have room to improve and contribute positively to growth, even more so if the uncertainty linked to budget/debt ceiling weighs less 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 risen the 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 fragile to support a rapid rise in long-term rates. > 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 substantial 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 unanimously decided to raise its Selic rate by 50 bp to 10% on 27 Nov. (+275 bp in all), with the aim of reducing inflation to 4.5% (midpoint of its inflation target). Inflation stabilised at 5.8% yoy in October. The tightening cycle is probably nearing its end. > Brazil faces supply problems (insufficient infrastructure, tight labour market) but should continue to attract FDI flows. FX reserves are elevated and external vulnerability is thus limited. > Sluggish recovery. Across the Eurozone, exports and the loosening of austerity will help, although quite differently 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 in both 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. > Deflationary pressure may intensify further in peripherals, while disinflation is on the menu in core economies. Financial fragmentation will continue to hamper credit in Southern Europe, especially to SMEs. Progress toward the Banking Union may help, but will probably yield substantial results only late in 2014. > The ECB will maintain a very accommodative bias. Should deflationary pressure intensify and/or monetary conditions tighten, all options would be on the table. > The growth momentum is quite strong. After a 2013 recovery led essentially by consumption and residential investment, exports and business investment should help it continue in 2014. While an upturn in real wages will take some time, it should be helped by a gradual decline in inflation. > The Treasury and BoE programmes (Funding for Lending, Help to buy) are bearing fruit. Credit is up (despite still-low demand from SMEs), and real estate is rebounding. > The BoE has still time before raising its key rates. Inflation has definitely decelerated and we do not expect the unemployment rate to fall below the 7% threshold before mid-2015.
> Renewed tensions on interest rates with tapering > New clash between Republicans and Democrats in January/February 2014
BRAZIL
> BCB: decided to promote combating inflation at the risk of weighing on activity > Possible decline in the real with Fed tapering
EUROPE EUROZONE
> Deflationary pressures intensifying (Spain, Portugal) > Rising money rates and bond yields on the back of Feds tapering (contagion) > Social and political risks with the rise of mass unemployment
UNITED KINGDOM
> New real estate bubble created > Excessive increase in long-term rates under the influence 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 to > Sporadic interbank strong growth in Q4. However, the November PMIs point to a slight weakening in domestic demand. tensions > 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, it reflects the strength of global demand. > Tighter credit conditions > The authorities want to slow liquidity growth to a more sustainable level. Looking ahead, firms and households will thus probably face rising borrowing costs which could weigh on internal demand. > GDP slightly accelerated to 4.8% yoy in Q3 (from 4.4% in Q2 a four-year low): private consumption accelerated to 2.2% (from 1.6%), government spending contracted 1.1% while investment jumped 2.6%. > Inflations accelerated in October (+10% yoy), due to the rupees depreciation. It should recede somewhat in 2014 (monetary tightening, rupee stabilisation). The RBI will continue to tighten its policy to contain inflationary pressure. > India suffers from twin deficits that will persist in the coming years. Reviving growth is key, unless the credit rating may be cut to junk in 2014. All eyes are focused on the general elections (which should be held by May 2014). > Abenomics: a recovery driven by public spending and consumption, not by business investment. The trade deficit continues to worsen, despite the yens decline. > Inflation returned in positive territory 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 deflation. > The VAT hike (from 5 to 8% on 1 April) is putting activity at risk in Q2 14, but should boost consumption by this date. A 5 trln stimulus plan will counter the effects. The BoJ may take additional measures to secure an exit from deflation. > Persistence of high current deficit. > The Feds tapering put at risk the currency
INDIA
JAPAN
> VAT hike vs. stimulus plan: Great uncertainty on impact > Business investment and real wages not picking up
December 2013 # 12
Macroeconomic and financial forecasts

MACROECONOMIC OUTLOOK
United States: cyclical recovery underway. Sharp slowdown expected in Q4 in light of the substantial contribution from inventories to growth in Q3. However, growth will pick up 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 stable growth, however, the trend will be somewhat turbulent (Q1/Q2 2014). Eurozone: weak growth and disinfl ation on the horizon - All - or almost all - countries will post positive growth in 2014, however, unemployment will 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 the recovery. 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: inflation remains a major concern for the central bank. Growth is expected to stabilise. China: a slowdown in domestic demand is likely, however, external demand remains strong. Growth is expected to stabilise at around 7%-7.5% in 2014. annual averages (%) US Japan Eurozone Germany France Italy Spain Netherlands Greece Portugal Ireland UK Russia Turkey China India Indonesia Brazil Real GDP growth, % 2012 2.8 2.0 -0.5 0.9 0.0 -2.6 -1.6 -1.3 -6.4 -3.2 0.2 0.1 3.4 2.6 7.8 5.0 6.2 0.9 2013 1.6 1.8 -0.4 0.6 0.1 -1.7 -1.4 -1.1 -4.5 -2.0 0.8 1.3 2.0 3.5 7.6 5.5 5.5 2.3 2014 2.3 1.9 0.9 1.8 0.6 0.2 0.2 0.4 -0.4 0.0 2.0 2.2 2.5 3.8 7.3 5.5 5.0 2.8 Inflation (CPI, yoy, %) 2012 2.1 0.0 2.5 2.1 2.2 3.3 2.4 2.8 1.5 2.8 1.9 2.8 5.1 8.9 2.7 9.3 4.3 5.4 2013 1.6 0.1 1.4 1.7 1.2 1.6 1.2 1.8 0.0 0.4 1.0 2.8 5.5 6.1 2.6 8.5 6.0 6.0 2014 1.7 1.9 1.1 1.6 1.0 0.9 0.7 1.2 -0.4 0.8 1.2 2.3 4.8 6.0 3.4 8.0 5.5 5.5
KEY INTEREST RATE OUTLOOK

FED: the start of tapering should occur in Q1. However, there is no predefi ned rate for reeling 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 reduced its inflation forecast to below that of the consensus (1.1% vs. 1.3%). It will not hesitate to act in the 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 US Eurozone Japan UK 0.25 0.25 0.10 0.50 Amundi Consensus Amundi Consensus + 6m. Q1 2014 + 12m. Q3 2014 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.10 0.10 0.10 0.10 0.50 0.50 0.50 0.50
LONG RATE OUTLOOK

United States: in the short term, tapering may lead to further steepening of the yield curve. That said, the rise in long yields will be contained. The traditional bear fl attening, associated with a rise in key rates, will not occur before mid-2014 at the earliest, thanks to 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 and banks would not be able to use the liquidity 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 labour market mean that we are pricing in a rise in yields in line with the United States. Japan: Japanese government bond rates are entirely under the BoJs control. As long as QE continues, there is no reason for rates to move signifi cantly.
2 Y. Bond yield forecasts Amundi Consensus Amundi Consensus 09/12/13 + 6m. Q2 2014 + 12m. Q4 2014 US 0.29 0.40/0.60 0.60 0.60/0.80 0.93 Germany 0.22 0.20/0.40 0.28 0.40/0.60 0.46 Japan 0.09 0.10/0.20 0.14 0.10/0.20 0,16 UK 0.50 0.40/0.60 0.75 0.60/0.80 1.07 10Y. Bond yield forecasts Amundi Consensus Amundi Consensus 9/12/2013 + 6m. Q2 2014 + 12m. Q4 2014 US 2.84 3.20/3.40 3.08 3.40/3.60 3.41 Germany 1.84 2.00/2.20 2.09 2.20/2.40 2.36 Japan 0.66 0.80/1.00 0.87 0.80/1.00 0.95 UK 2.91 3.00/3.20 3.11 3.20/3.40 3.37
CURRENCY OUTLOOK
EUR: slightly to the downside due to weak growth. The euro is strong for several reasons (historical current account balance, contraction of the ECBs balance sheet, capital infl ows), some of which are expected to reverse in 2014. USD: the gradual reduction in securities purchases by the Fed is expected to underpin the dollar 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 for additional action by the BoJ in the spring. GBP: moderately to the downside. Fundamentals are improving more sharply in the United Kingdom. The rate spread is expected to underpin sterling. AUD: expect a drop in the AUD/USD exchange rate. 05/12/2013 EUR/USD USD/JPY GBP/USD USD/CHF USD/NOK USD/SEK USD/CAD AUD/USD NZD/USD 1.37 102.1 1.63 0.90 6.16 6.50 1.06 0.90 0.82 Amundi Consensus Amundi Consensus + 6m. Q2 2014 + 12m. Q4 2014 1.30 1.30 1.30 1.28 105 104 110 108 1.63 1.58 1.56 1.58 0.96 0.96 0.96 0.99 6.08 6.07 6.24 6.18 6.62 6.67 6.80 6.8 1.10 1.07 1.10 1.07 0.90 0.89 0.85 0.89 0.80 0.80 0.80 0.80 5
December 2013 # 12
1 Does the eurozone still hold some appeal?
A few genuine strengths and some well-identified risk factors

PHILIPPE ITHURBIDE, Global Head of Research, Strategy and Analysis Paris
The essential
Is the recent impressive performance from European risky assets likely run up against fresh fears of deflation, sluggish economic activity and bank lending fragility? Do current market valuations (equities and credit spreads, risk premia, etc.) adequately reward risk? These are the fundamental concerns that investors have 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 for the foreseeable future, new unconventional measures are a possibility, financial market stress is low, investment opportunities abound in some countries and sectors, a lag relative to US markets in terms of valuation and leveraging, etc. As to risk, it is nearly unchanged but it exists all the same.
A few months ago, we held the view that Europe, and more specifically the eurozone, had entered a particularly dynamic growth phase, especially as far as the equity markets were concerned (see some of our recent issues: European equity markets a sleeping ready to awaken, Special Focus September 2013). Outperformance was (+19% for Eurozone equities, between June 30th and December 2nd, compared to 12% for US equities, for instance), but the actual situation is still not optimistic. To virtually everyones surprise, the sharp drop in inflation rates forced the ECB to ease its monetary policy stance, providing insight into the deflationary fears perceived by this European monetary institution. Admittedly, eurozone countries are emerging one after another from recession but 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 stable from negative but we know perfectly well that the solvency issues bedevilling some 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 view lower inflation, the burden of public expenditure and the labour market in this policy mix as significant 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, financial market stress is very low Perhaps the decline in financial market stress can be attributed to central bankers, who, through their statements and actions (maintaining low short-term interest rates and unconventional, expansionary policies), have managed to provide some assurance in the area of systemic risks. The over-abundance of liquidity is a fact and it is projected to persist in Japan and in the eurozone; meanwhile the United States seems 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 outlook forecasting positive GDP growth in 2014 for that country. The fact that all the countries in the eurozone have returned to a growth track is without doubt good news amidst fears 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 purchase programme sometime in mid-2014. Furthermore, we know that the Bank of England has expressed scepticism as to the effectiveness of quantitative easing measures. As to the ECB, reviving of bank lending and supporting Europes economy (the peripheral countries as well as France, which is showing signs of entering a downturn) will involve new measures. What we are talking about now are purchases of long-term government securities (a long-term LTRO) combined with purchases of corporate securities from banks. However, such programmes can only be implemented for short periods of time.
Positive growth in all eurozone countries in 2014? Thats what the IMF projects
December 2013 # 12
4. Conventional monetary policy will remain accommodative in the eurozone far longer than in the United States or the United Kingdom. Although an initial 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 deflation 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 the foreseeable future. 5. Less pressure on long rates Growth is projected to remain weaker in the eurozone than in the United States or the United Kingdom and long rates will remain low as there is absolutely no internal justification for an increase. There is no pressure to the upside on long euro rates that could come from monetary policy, inflation or growth. US rates will remain the most important factor influencing European rates. The ECBs unconventional programme will contain long rates (for that matter, its one of its objectives). American financial governance removes a trump card from US bonds. Pursuit of greater diversification following the extreme risk posed by a technical default by the United States on Federal debt is becoming indispensable (see our November article, Debt, deficits 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 significant strengths: Firstly, the market is transitioning. Without adequate bank lending, the HY credit market has welcomed more than 50 new issuers since the beginning of the year and 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 few more opportunities. The gradual emergence from recession offers country-by-country, sector-bysector and region-by-region opportunities, which is a significant advantage for alpha strategies. European corporations are more investor-friendly because of their position in the credit cycle. Overall, although US growth is doing a good job of protecting the US corporate bond market (however, this should be put in perspective in light of the debate on the debt and the deficit, the risk of a shutdown and technical default), the strengths of the eurozone are easily identifiable. 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 European economy? But first, let us recall that large European sovereigns (with France and Germany at the 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 at risk (Spain, Italy and Ireland).
7
Moving toward new unconventional measures in the eurozone
A number of opportunities on the European corporate bond market
Higher long rates hold more than drawbacks for the eurozone
December 2013 # 12
Banks normally stress their loan portfolios as interest rates move -a legitimate practice. But it is hard to argue that the total cost of risk increases when interest rates are climbing. Higher rates do not necessarily entail harmful effects only. On the other hand, when higher rates are unjustified 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 a rise in short-term interest rates, which is a favourable scenario for banks as they pursue 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 months Europe has switched from repair mode to challenger, ultimately achieving a star ranking in the (good) company of the United States and Japan. We are aware that the United States are ahead of the cycle, which has barely begun in Europe. This explains why portfolios have been overweight for quite some time. European equity markets have priced in an improvement in profits. The PER calculated on profits over the last 12 months has returned to its 2007 level. Now, earnings have to actually follow suit. Of course, a pause is possible, but normalisation will continue. Profits are still 30% lower than in 2007, whereas they are already 30% higher in the United 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 rapid growth of new investment vehicles, such as bank lending portfolios. 10. The US fiscal 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 financial and economic crisis has become a necessity. The risk of default, even if technical and only temporary, is no longer merely an exercise in style it is a low-probability extreme risk whose terrifying implications are hard to measure. Any default would trigger a haircut, margin calls and sales of US bonds. Whether this transpires or not, diversifying your portfolio and collateralisation assets simply makes sense its indisputable that there is always a role for Europe to play.
The European market is lagging behind the cycle and in international portfolios
1
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Germany
Mortgage Markets split by type of interest rates
Netherlands
Denmark
Source: ECB, Amundi Research
Fixed Rate Variable Rate
A climate that bodes well for diversification... notably in Europes favour
Portugal
Ireland
UK
Norway
Italy
Sweden
Belgium
Finland
France
Spain
December 2013 # 12
2 Equity markets: a snapshot of long-term
prospects
ERIC MIJOT, Co-Head of Strategy and Economic Research Paris DELPHINE GEORGES, Strategy and Economic Research Paris
The essential
We have used a two-dimensional approach (valuation and momentum) to represent the long-term prospects of equity markets.
Valuation (corresponding to the x-axis) offers a reading at least 10 years into the future. By factoring in momentum (y-axis), we can analyse the data more comprehensively and look at a shorter timeframe (3-5 years). What emerges is that equities hold more potential than government bonds, but that the established order within equity markets may be revised. In the developed countries, it would seem appropriate to diversify assets outside the United States, both in the long and medium term, in particular by turning to the eurozone and Japan. In the emerging camp, the challenge for the star performers of recent years will be to steer clear of the Falling Angels quadrant.
2013 is not over yet, but it will go down in history as a good year for equity markets. Next month will be the opportunity to take stock and make projections for 2014. In the meantime, this article gives an overview of long-term prospects for 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. These four criteria are equally weighted and graded on a scale of 0 to 100 shown on the x-axis (see second and third graphs). The further to the right the market is positioned on the graph, the more expensive it is. The CVI is a measure that simply allows the classic valuation ratios to be compared over a long-term period, as a means of counteracting cyclicality. The risk premium compares the earnings yield (the inverse of the P/E ratio) with real long-term bond yields (for these purposes, we use long-term rates less the fi ve year average inflation). The lower real yields are, the higher the equilibrium risk premium will be, we therefore also include the real yield level as a separate criterion. The cyclically-adjusted P/E ratios are calculated on the basis of data supplied by MSCI. For the momentum, we take into account trends in equity prices against their 1-year, 4-year and 10-year averages. We also include the market ownership level, looking at accumulated flows over a three-year period. These criteria are weighted 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 longterm momentum is. The markets positioned between 50 and 75 on the y-axis are either neutral trendwise, with a reasonable level of ownership, or positive in terms of price trend and under-owned. Above 75, the markets have both a strong price momentum and a high level of ownership by investors. This combination is the sign of an excessive momentum.
Prefer equities to governement bonds
The valuation figure (x-axis) gives us a reading approximately 10 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 the P/E ratio corresponds to the long-term performance we can expect from the market at least 10 years into the future. A cyclically-adjusted P/E ratio of 15x would make the real average profi tability of the US market 6.7%; at 20x it would be 5%, while at 10x it would be 10%. Calculated in this way, the US markets projected real long-term annualized total return (+4.7%) at a cyclicallyadjusted P/E ratio of 21 would be lower than its historical average. If we consider reported profits (as Robert Shiller), the CAPE is 25x and long term expected return falls to 4%. It is also possible to use a regression of annualized returns on CAPE to be more precise. In this case long term returns would be even 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 risk premium is not very attractive either. If we assumed a normalisation of US 10-year rates towards approximately 4% in fi ve years time, the real annualised performance of US government bonds would be only +0.5%a differential of 2.5% to 4.2% in favour of equity depending on the method.
1
100
US market and cyclically adjusted PE

10000
90
80 70 60
CAPE* 15 +/- 5 Trend
15 S&P 500
1000
50
40 30 20
100
10
10
0 1
* Cyclically Adjusted PE
Source: Shiller data, Amundi Research
1881 1889 1897 1905 1913 1921 1929 1937 1945 1953 1961 1969 1977 1985 1993 2001 2009
December 2013 # 12
Long term momentum
In the long run, this plays for a diversification out of the US; in the longterm, the US equity market looks less attractive than other markets. The relationship between cyclically-adjusted P/E ratios and projected long-term returns is historically easier to demonstrate in the United States than elsewhere thanks to the quality and depth of US statistics. Nonetheless, the relationship can be calculated for the other markets as well. Based on anticipated US market expected returns, we can use the distance from this measure on the x-axis in our 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 is more expensive than the average. The US is not aloneDenmark, Switzerland, the Netherlands, Belgium and Australia (the countries furthest to the right on the graph) are also above the average. On the cheaper end are Austria, Greece, Italy, Norway and Japan.
2
Strong
Mapping: developped countries

100
90 80 70 60 50 40 30 20 10 0
Value traps?
Opportunities?
US NO
GB IE
excessive optimism?
DK NL SE CH JP CA IT HK SG ES BE FI FR AU AT GR DE PT
60
70
10
20
30
40
50
80
90 90
Several observations can be made: 1) Most of the markets are situated in the top two quadrants. Contrary to what is commonly believed, equity markets are definitively on a long-term positive trend. One cannot exclude the possibility that this trend will continue. The equity markets have erased the 2007 crisis in the United States and the 2010 crisis 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 this market is expensive (as demonstrated earlier), it is also overbought (situated higher than 75 on the y-axis). Thus it may be prudent to diversify outside the United States, not only on a long-term basis but also for the medium term. This issue was addressed from a different angle by Philippe Ithurbide in last months Cross Asset publication (see Article 1 from November 2013: Debt, deficits and governance. Diversifying outside of the United States: simple common sense). 3) Japan offers an interesting alternative. The Japanese market has come out of the lower left-hand quadrant (Potential value traps), where it was situated for a long period of time, occupying a more neutral position since March, a sign of positive momentum. It is no longer on a negative trend, and flows are returning, albeit partly due to the purchases by the BoJ. Despite the weak yen (a short-term boon), Abenomics still has to deliver convincing structural reforms to secure the medium-term performance of the Japanese market. 4) The markets of Southern Europe left the lower left-hand quadrant even more recently, this August. They are now also in more neutral territory. Spain is slightly more expensive than Italy. Only Portugal lags behind. Investors appear to be convinced 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, and this is not only the case for the Southern European countries. Germany, for one, comes out very favourably on both axes in our graph. 5) On the emerging markets front (see the third graph), the BRIC nations and several European markets are situated in the Opportunities quadrant (upper left-hand side). However, their path has been the reverse of Japan and Southern Europe, which slightly mitigates the positive side of their positioning. In some instances they even come close to the Potential value traps quadrant (e.g. Brazil). Meanwhile, some other emerging markets are more expensive and sometimes overbought (the Philippines, South Africa, Colombia and Turkey). Their ability to attract higher flows can now be questioned, at least for the most fragile of them in terms of fundamentals (current account balance, basic balance, etc.). The exceptional period they went through from the 1997 Asian financial crisis to the Arab Spring in 2011 may be nearing its end. In 2013, the discussion on Fed tapering served as a reminder of these countries dependence on US monetary policy. Among the five countries reputed to be the most fragile, those that pose the biggest risk according to this approach are
10
Cheap
Source: Amundi Research
Valuation
Expensive
In the long-term, Europe and Japan are more attractive than the United States
3
Strong
Mapping: emerging countries

100
90
Opportunities?
PH KR TR
80
Long term momentum 70
CN
IN HU RU CZ TW BR
AR PL
CO
ZA optimism? ID MX MY
excessive
60
50
TH
40
30 20 10 0
Value traps?
PE
CL
Falling angels?
Weak
60
70
10
20
30
40
50
80
Cheap
Source: Amundi Research
Valuation
Expensive
100
100
Lets now add momentum to the picture. The input from this second variable (y-axis) allows for a more thorough analysis and a shorter predictive timeframe (three to five years)
Weak
Falling angels?
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 certain advantage, but it seems the market has taken notice of this fact, which harms its long-term prospects. Finally, Peru and Chile are less convincing in terms of momentum, although their valuation is quite average compared to the other markets.
Conclusion
This approach offers a snapshot of the equity markets. It appears that in the long term, equities hold potential, but that the established order may be revised. In the developed countries, it seems opportune to diversify assets outside the United States, particularly into the eurozone markets and Japan. In the emerging markets, there is no guarantee that the star performers of recent years will retain this status forever. For the most fragile among these, the challenge is to steer clear of the Falling Angels camp.
South Africa, Turkey and Indonesia: Future Falling Angels?
11
December 2013 # 12
3 Germany, source of deflation?

DIDIER BOROWSKI, Co-Head of Strategy and Economic Research Paris
The essential
Is Germanys current account surplus excessive? And, if so, is it a source of deflation? These questions may seem surprising. When it comes to the balance of trade, the tendency is to point the finger at the countries with excessive deficits, not those with excessive surpluses. But to do this is to forget that, on a global scale, the deficit of one country is the surplus of another. And when imbalances become excessive, the burden to correct the imbalance cannot be borne solely by the deficit-producing countries For Germany, the recent rise of its current account surplus (to 7% of GDP) was the spark that triggered a warning by the European Commission.
The debate that pits the German government against the European Commission, the IMF and even the US Treasury should (1) revive the debate on which macroeconomic adjustments are required in order to absorb excessive imbalances in current account transactions; and (2) serve as a reminder that the origins of deflation are not only to be found in (peripheral) countries that are deleveraging, but also in those with excess savings (i.e. Germany). As disinflationary pressures mount across the monetary union, the challenge is not only for the German government, but also for the ECB. And is the end to the crisis to be achieved through a mix of structural reforms (peripheral countries and France), fiscal stimulus measures (Germany) and renewed monetary accommodation measures (liquidity or securities purchases)?
Is Germanys current account surplus excessive? At first, this question may seem surprising. When it comes to the balance of trade, the tendency is to point the finger at the countries with excessive deficits, not those with excessive surpluses. The former are seen as wasteful spenders while the latter are lauded for their productivity, cost control and effective specialisation, among other things. Seen from this angle, the countries with excessive deficits appear to be the appropriate candidates for adjustment reforms (lowering costs, structural reforms, productivity gains). But to do this is to forget that the deficit of one country is the surplus of another. And when imbalances become excessive, the burden to correct the imbalance cannot be borne solely by the deficit-producing countriesespecially within a monetary union where, in the absence of nominal exchange rate adjustments, price changes and relative costs are the only means by which a country can improve its foreign competitiveness. For Germany, the recent rise of its current account surplus (to 7% of GDP) was the spark that triggered a warning by the European Commission. In this article, we will revisit a debate that has the German government squared off against the combined force of the European Commission, the IMF and even the US Treasury. We will also explore what may happen if the adjustment in the eurozone also occurred through a rebalancing of relative demand.
Current account deficits and surpluses: two sides of the same coin
Viewed globally, trade surpluses are, by definition, offset by trade deficits across different countries. When the imbalances become excessivesay, above 5% or 6% of GDPthey reflect an undesirable macroeconomic trend that is often paralleled in a clearly defined region. Just as there are good and bad deficits, there are also good and bad surpluses. The situation of a country whose current account deficit is the result of a private investment boom fi nanced by inflows of foreign direct investment and purchases of domestic equities by non-residents (like the United States in the second half of the 1990s) is quite different from that of a country experiencing a boom in consumption from a soaring property market largely financed by debt (like Spain in the 2000s). In the former example, the investment is to some extent a driver of future growth; in the latter, the excess debt is bound to stifle growth. In the eurozones peripheral countries, the explosion of current account deficits in the 2000s was a refl ection of soaring private sector debt (households and non-financial enterprises), leading to a sharp worsening of these countries net external liability positions. With the single currency, governments wrongly assumed they were finally unbound by external constraints. What they forgot was that the accumulation of deficits translates into an increase in liabilities vis-vis the rest of the world. And accumulating debt for consumption needs is not quite the same as financing productive investments via FDIs.
So far, the correction in imbalances has been uneven

Although trade imbalances have largely narrowed in the eurozone (with France a notable exception), this has had more to do with a decline in domestic demand and gains in price-competitiveness in the deficit countries than with a strengthening of domestic demand in the surplus countries. The eurozones current account balance, which was near equilibrium in 2009-2011, rose to above 2% of GDP in 2013, while Germanys current account surplus rose to nearly 7% of GDP. Between 2010 and 2012 in Germany, net exports contributed one percentage point to growth. Were it not for the positive contribution of
With euro, governments wrongly assumed they were finally unbound by external constraints
12
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 grow much less rapidly than exports outside the eurozone. This clearly shows that Europe is relying too much on foreign demand for its recovery and not enough on domestic demand, which is too weak in the surplus countries. Excessive current account deficits are no longer part of the landscape of Europes trade 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 by Keynes after World war II, the international monetary system would be more balanced if surplus-producing countries were treated the same as countries with deficits. And what is true for the international monetary system is also true in the context of a monetary union.
1
46% 45% 44% 43% 42% 41%
Germany: Exports (to) and imports (from) the eurozone (% of total)

15%
14%
13% Exports Imports (Rhs)
40% 39% 38% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source Datastream, Amundi Research
Is Germany the new China?

Until recently, the US Treasurys semi-annual reports on exchange rate policy trends have pointed the finger at China. Lacking or insufficient flexibility in its exchange rate regime resulted in a rapid accumulation of foreign exchange reserves. But things have changed. Chinas currency has appreciated while its current account surplus has fallen significantly (from 10% of GDP in 2007 to 2.3% of GDP in 2013), to the extent that its contribution to domestic growth is now close to nil. German and Chinese current account surpluses are now very close (in US dollar terms). In late October, the US Treasury took the Europeans by surprise by turning its attention away from China and towards Germany. The message was that countries with excessive current account surpluses had to undergo an adjustment. Under a flexible exchange rate system, their exchange rates would automatically appreciate, helping to rebalance their accounts. Countries using fi xed (or centrally-managed) exchange rates, like China, would see their foreign exchange reserves grow continuouslyan unacceptable outcome. But what happens in a monetary union such as the eurozone? There is no mechanism in place to guarantee that the surplus countries will recycle their surpluses towards eurozone countries that need it most. A single currency does not guarantee an optimal allocation of savings within the monetary union. This is ultimately one of the reasons why the European Commission established a multilateral surveillance procedure to monitor current account imbalances. As in the case of China, the needed correction cannot be achieved through foreign exchange policy alonedemand also has to play a part. An increase in domestic demand in Germany (both investment and consumption) could play the same role as the rebalancing of Chinas growth model in favour of domestic consumption.
12%
The international monetary system would be more balanced if surplus-producing countries were treated the same as countries with deficits
Germanys surplus exerts a deflationary bias

Defl ationary pressure in the eurozone is often portrayed as the result of internal devaluation policies undertaken by Southern European countries. These policies are viewed as necessary for offsetting previous excesses (excess debt but also infl ation). After all, when prices decline more sharply than wages in Southern Europe, this results in a distribution of gains in purchasing power to households. But how do we account for the weak inflation of the core countries? In Germany, falling unemployment and rising real wages should have generated upward pressure on prices. But in spite of the high degree of fragmentation in the eurozones economic cycle, inflation is slowing simultaneously in most countries. Ultimately, this is because deleveraging in the peripheral countries has been accompanied by Germanys current account surplus as a source of deflation. The European Commission says as much when it singles out Germany to take responsibility. Germanys excess savings are now seen as being as reprehensible as the excess debt accumulated by the peripheral countries before. The latter were guilty of doping growth and creating infl ation; the former of curbing growth and exerting defl ationary pressure at the worst possible time, which complicates the task of the ECB.
2
350
300 250 200 150 100
Trade balance: Germany vs. China (USD bn)
Germany 50 China
0
Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2009 Q1 2010 Q1 2012 Q1 2013
Q1 2003
Q1 2008
Source: Datastream, Amundi Research
Q1 2011
13
December 2013 # 12
It is striking to see the European Commission and US Treasury on the same side of the issue. But since the Great Recession, the global economy has been in search 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. Chinas economy, meanwhile, is struggling to rebalance its growth model in favour of domestic consumption. What the global economy is ultimately waiting for is the German consumer. The eurozones trade balance is exerting upward pressure on the currency, which is having counterproductive impacts for countries undertaking internal devaluation.
3
55 50
Germany: Foreign trade (% of GDP)
45
40
Its time for Germany to act

Between reunification and 2007, Germanys trend growth (five-year moving average) was below that of France, Italy and even Spain. And while Germany was successful in implementing its structural reforms (particularly on the labour market), this was largely thanks to the fact that it could count on strong demand from its main trading partners. The large share of exports in its GDP (over 50%), meanwhile, allowed it to reap some benefit from its trading partners growing debt. Today, the situation is the reverse: Germany is where the most solid growth is occurring. In the same way that the European authorities urged Spain to undergo an internal devaluation (among other things) to absorb its current account deficit, it is legitimate to ask Germany to absorb part of its excessive surplus (i.e. to reduce its savings surplus). Naturally, Germany refuses to undergo an internal revaluation (i.e. allow wages to rise), as this would harm a competitive advantage earned through sustained effort over decades (investment in R&D, specialisation in high value-added goods, productivity efforts, wage moderation, etc.). But it has no obligation to do so. The required correction canand shouldtake the form of an adjustment to demand, and not to prices.
35
Exports 30 Imports 25 Q1 1999 Q1 2000 Q1 2001 Q1 2003 Q1 2004 Q1 2005 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012
Q1 2002
Q1 2006
Is Germany headed for a change of course?

All eyes are now on Germanys new government. The country is posting twin surpluses and its debt-to-GDP ratio began to decline in 2013. The need for infrastructure investment has been clearly identifi ed. Germany could easily borrow to finance its investment plansGermanys total funding requirement (maturing debt) stands at only 8% of GDP, compared to 22% on average in the advanced economies. In addition, it could lighten the tax burden (which has a punishing effect on consumption) and raise the minimum wage to give households a boost. The German government could confidently finance such measures without putting its public fi nances in danger or causing a long-term interest rate spike. The supportive effect for its trading partners would be significant.
Deleveraging in the peripheral countries has been accompanied by Germanys current account surplus as a source of deflation
Conclusion: wait and see

Germanys current account surplus and its causes will remain hot topics for some time. This has some positive consequences; firstly, it will help revive an old debate on which macroeconomic adjustments are required in order to absorb excessive imbalances in current account transactions. Secondly, it will serve as a reminder that the origins of deflation are not only to be found in countries with spiralling debt, but also in those with excess savings (i.e. Germany). As disinfl ationary pressures mount across the eurozone, the challenge is not only for the German government, but also for the ECB. And if the end to the crisis were to be achieved through a mix of structural reforms (peripheral countries and France), fiscal stimulus measures (Germany) and renewed monetary accommodation measures (liquidity or securities purchases), this would spell good news for the eurozone on all frontsit would (1) stimulate domestic demand; (2) provide support to the banking sector to finance the economy; and (3) diminish the eurozones current account surplus and cause the euro to depreciate. On this last point, the increase in the ECBs balance sheet would strengthen trading channels to help push down the euro (see Article 4), which would boost the foreign competitiveness of the most fragile countries. If deflationary pressure intensifies in the months to come, this will be the only way out.
14
4
4,5 4
3,5 3 2,5
Eurozone: Current account vs inflation

-2 -1,5
-1 -0,5 0
2
1,5 1 0,5
0
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)

Q1 2013
0,5
1 1,5 2
2,5
December 2013 # 12
4 What determines the euro-dollar?
Essentially the ECBs (deflationary) stance

NICOLAS DOISY, Strategy and Economic Research Paris BASTIEN DRUT, Strategy and Economic Research Paris
The essential
Based on traditional PPP models, deflation in the Eurozone (while the Fed is reflating the US economy) would raise the euro-dollar fair value to 1.32 in 2015 (from 1.25 currently), thus appreciating the euro and further pushing the Eurozone into a Japan-style lost decade Beyond giving a similar fair value (1.32), a simple monetary model of the euro-dollar shows that it is the ECBs lack of large liquidity injections that is pushing the eurodollar up and not so much the Feds current QE-3, thus calling for an expansion of the ECBs balance sheet Using this last model, simulations of alternative scenarios of Fed tapering and/or ECB LTRO strategy (no or limited balancesheet expansion) show that an end to the Feds asset purchases would have a much smaller impact on the euro-dollar than larger ECB liquidity supply.
Towards a stronger euro in case of deflation

The very weak Eurozone inflation figure released in October (+0.7% y-o-y) and Spains negative performance (-0.1% y-o-y) have revived fears of deflation. At the November monetary policy committee, Mario Draghi, the ECB President, has himself mentioned for the first time an prolonged period of low inflation. Meanwhile, the euro has been under an appreciating pressure ever since mid-2012, despite the Eurozones poor economic performance. One can only draw a parallel with the yen, as Japans economic history over the past 25 years provides a unique benchmark deflation-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 deflation was to set in durably in the Eurozone? The purchasing power parity (PPP), one of the most used theoretical relationships in financial markets, has been spectacularly and powerfully illustrated by the yen history, ever since Japan entered deflation in the early 1990s. With the quasistagnation of prices in Japan over this period of time, the nominal fair value of the yen to the dollar has risen significantly. If deflation was to set in durably in the Eurozone and not in the United States, one should expect a substantial nominal appreciation of the euro versus the dollar. Ever since the early 1990s, the inflation differential between the United States and Japan has been 2.3% on average (and only 0.4% between the United States and the Eurozone). Taking as an assumption a similar inflation differential over the years to come between the United States and the Eurozone (a deflation scenario in the Eurozone and not in the United States), the PPP would indicate a fair value of 1.32 by end 2015 versus roughly 1.25 today (based on an estimation period running from 1990 to date). However, one should not overly trust the fair values given by the PPP, as this method is extremely sensitive to the estimation period under consideration. Above all, one should note that the EUR/USD fair value indicated by the PPP would rise substantially. Beyond, an inflation close to zero in the Eurozone would entail that the appreciation/depreciation of the real exchange rate would take place exclusively via the nominal exchange rate.
A currency war between the Fed and the ECB? Rather an ECB bias towards a strong euro
Actually, ever since the announcement of QE-2, a regime change has occurred in the determination of the euro-dollar parity: ever since June 2010, the eurodollar exchange rate has been and remains driven essentially by the excess liquidity extended by the ECB (and more marginally the Fed). Indeed, a simple monetarist pocket model of exchange rates explains between 50% and 75% of the changes in the euro-dollar parity. Thus, against conventional wisdom, the euros appreciating trend has, so far, had more to do with the deflationary stance of the ECB than the reflationary stance of the Fed.
What can be expected of the euro if deflation sets in durably in the Eurozone?
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-dollar parity 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.
15
December 2013 # 12
This pocket model is clearly nested in a general monetarist model of foreignexchange that reads(2) : FX=[M M*][Y* Y][i i*]a with: where: M and M*: home and foreign nominal stock of money; Y and Y*: home and foreign real national income; i, i* and a: home and foreign nominal interest rate, interest elasticity of money demand; r and r*: home and foreign real interest rate; E(m,I) and E*(m*,I*): home and foreign inflation expectations as a function of the stock of base money (m and m*)(3) and all other relevant information (I and I*). It is important to note that in the empirical reduced form presented above, FED stands for m and ECB stands for m*: this means that the Fed and ECB liquidity are (theoretically considered to be and empirically validated as) the sole drivers of the movements in the euro-dollar parity. Accordingly, the impact of all the other determinants included in the theoretical general monetarist model of foreignexchange is much smaller than that of the Fed and ECB liquidity: to this extent, they are considered to be summarized in the equations intercept, i.e. to influence only the (medium- and long-term) fair values of the currency pair, which is an acceptable empirical simplification of the theoretical model. i i * = [r+E(m,I)] [r*+E* (m*,I*)]
1
200 180 160 140 120 100 80 60 40 20 1970 0
Consumer prices index (100 in Jan. 1990)
Eurozone US Japan
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
The models insights: scarce ECB liquidity is the main driver of 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 shown above: The amount of ECB excess liquidity is the main driver of the euro-dollar parity around 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 specification finally retained; The fair value of the parity is given by the empirical models intercept in the long term, i.e. when excess liquidity extended by the Fed and the ECB cancel out (which means that both central banks have a similar inflationary stance); The fair value of the parity equals the euro-dollar average value in the medium term (i.e. 1.32 since the announcement of QE-2) in a context where the ECB liquidity is kept bounded (due to the Bundesbanks anti-inflation bias) and the FED liquidity is free to keep expanding; The current fair value equals the medium-term fair value + central bank relative liquidity: in simpler terms, the euro-dollar current fair value is determined
(1) This version is presented here as an example more than as a defi nitive one. Various other versions were tested, which differ from each other by either the data used to proxy the ECB and/or Fed liquidity or the econometric specifi cations used to estimate it (simple OLS, VECM, SURE systems,). These will be further investigated in future work with a view to selecting the specifi cation most appropriate to determine the euro-dollar fair value, which is given by the empirical models intercept. (2) This general specifi cation is taken from A monetarist model of exchange rate determination by Thomas M. Humphrey (Federal Reserve Bank of Richmond) published in 1977. (3) The empirical defi nition of m and m* is the one innovation introduced in the above monetarist model, as it takes the form of central bank liquidity (base money) rather than the growth of monetary aggregates. (4) A Wald test confi rms that both coeffi cients are weights to the extent that they sum to 1, remembering that the negative sign before the ECB coeffi cient has to be dropped to perform the test since the latter reduces/increases the number of euro per dollar when ECB liquidity increases/decreases. 16
The amount of ECB excess liquidity is the main driver of the euro-dollar parity
2
1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80
EUR/USD: PPP (estimation from 1990 to today) and simulation in case of deflation
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
EUR/USD PPP PPP deflation scenario

2014
2014
December 2013 # 12
by the ECB/Fed relative inflationary stances over the medium-term, as proxied by their (relative) excess liquidity.
3
1.50 1.45 1.40 1.35 1.30 1.25
Evolution of the EUR/USD parity according to the scenarios
The simulations show that the ECB has the euros future in its hands
Based on these insights, this simple model can be used to simulate the impact of changes in both central banks infl ationary stances on the euro-dollar parity by tweaking the ECB and FED variables in the future, according to various scenarios of: the Fed tapering, depending on the timing, size and pace of the announced reduction in the asset purchases conducted within the framework of QE-2 and QE-3; and/or ECB inflexion towards a more refl ationary stance coming in the form of a balance-sheet expansion (either an expansion of the LTRO or e.g. outright asset purchases). This model shows clearly one thing: while the Fed is about to slow down the pace of its asset purchases, the future of the euro rests in the hands of the ECB. If the ECB was to leave deflationary pressures to materialize without reacting, the euro would continue appreciating towards dangerous levels (that would accelerate the fall into deflation). Conversely, the euro would depreciate if the ECB was to start expanding the size of its balance sheet. In order to clarify further this issue, we have run scenarios based on this model according 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 in March 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 continues QE-3 Scenario 5: the ECB announces a new LTRO in early 2014 the Fed reduces QE-3 gradually starting in March Scenario 6: the ECB announces a new LTRO in early 2014 the Fed reduces QE-3 abruptly in March The simulations of our pocket model show that the evolution of the EUR/USD parity should be driven by the policy chosen by the ECB to fight deflationary pressures. If it were to decide an expansion of its balance sheet, it could drive the equilibrium value of the parity below 1.35. However, if the ECB were not to adopt this policy, the EUR/USD parity could drift above 1.45 according to the model and exacerbate the deflation threat
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The simulations of our pocket model show that the evolution of the EUR/USD parity should be driven by the policy chosen by the ECB to fight deflationary pressures
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December 2013 # 12
5 US and European credit cycles
are diverging
VALENTINE AINOUZ, Strategy and Economic Research Paris
The essential
The credit cycle is closely correlated to the macroeconomic cycle. US and European companies are located at different points on the credit cycle. US companies are once again leveraging up, in contrast to European companies, who remain cautious in their investments.
The combined growth in corporate debt and earnings during the cycle generally makes it possible to anticipate bond and equity performance. But we have not been in this configuration since the Lehman crisis. Asset performances are heavily influenced by monetary policy. Central banks are promoting an environment of low rates and abundant liquidity. The quest for yield is making valuations irrational. In both the United States and Europe, fixed-income valuations no longer precisely reflect a macro and micro reality, and this situation could last further, especially in Europe. Our baseline scenario assumes new nonconventional measures from the ECB, while we expect the Fed to begin tapering off its asset purchases in 2014.
The credit cycle is closely linked to the macroeconomic cycle. Investment spending and, hence, corporate debt is closely linked to lending conditions and the economic outlook. The positioning in the cycle generally makes it possible to anticipate bond and equity performance. Below, we review the positions of US and 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 default risk increases and as the value of mortgage collateral that they can be put up declines. A classic credit cycle has four phases: Phase 1: the economic outlook stabilises. Companies try to deleverage. They generate productivity gains and preserve their cash-flow to pay down their debt. All these measures are favourable to bondholders. At the start of this reestablishment 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 rise faster 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. Debt expands faster than profi ts. During this phase equities continue to do well, while bonds begin to perform poorly. Phase 4: the credit bubble bursts. Credit conditions worsen fast. Corporate fi nancing becomes more expensive and more difficult. Profits get hammered. In this phase, equities and bonds are both hit hard. From 1999 until the Lehmann crisis, credit spreads tracked the combined growth of earnings and debt throughout the macroeconomic cycle. Moreover, bond performance preceded equity performance (see chart).
What point are we at in the cycle?

With the bursting of the Lehmann bubble, credit conditions have worsened considerably. Companies have drastically reduced their investments. The fundamentals 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 investment spending. Debt ratios are worsening, as spending rises faster than earnings. In Europe, companies are preserving their cash flow, as they feel that the economic environment is too uncertain. However, the situation varies from company to company. On the periphery, access to credit is harder and more expensive. Moreover, peripheral bond issuers close dependence on their domestic market limits earnings growth and deleveraging. The utilities and telecoms sectors account for 68% of outstanding debt of peripheral nonfinancial companies. These companies are having difficulties in deleveraging and remain cautious in their spending. In contrast, companies with the strongest cash flow (mainly in core countries) have managed to deleverage and 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 euro zone countries. Many companies have been hit hard by the lack of growth and are not generating enough cash flow to deleverage.
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Heavy, across-the-board debt levels in Europe are slowing earnings growth and the upturn in investment
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Banks themselves are generating defl ationary pressures. Restructuring of the fi nancial system will continue to weigh on lending volumes and conditions. Banks restrictive attitude is being aggravated by: - 1) Their volume of non-performing loans, which reflects the slowing in economic activity. - 2) Their sovereign debt holdings. In Spain, domestic banks hold 42% of Spanish bonds vs. 25% in early 2008. - 3) Their obligation to comply with new prudential rules. Ongoing deleveraging by various economic actors is weighing on earnings growth and an upturn in investment.
Asset performances are being dictated by monetary policy
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Why are performances decorrelated from the cycle?

Expansion in both corporate debt and earnings during the cycle used to generally provide some insight into future bond and equity performance, but that has not been the case since the Lehmann crisis. Asset performances are being dictated by monetary policy. Central banks are promoting an environment of low rates and abundant liquidity. Against this backdrop, investors are going all out in their quest for yield, which is generating irrational valuations. The bond market environment is very different between the US and Europe: In Europe, the outlook for growth is still weak (Amundi forecast: +0.9% in 2014). Our baseline scenario assumes new non-conventional measures from the ECB. As a result, the credit market is likely to continue to benefit from abundant liquidity. The supply of paper has been restrained by issuers need to deleverage. The situation on the US market is different and offers better prospects for growth (Amundi forecast: +2.3% in 2014). We also expect non-conventional monetary policies to begin to be phased out beginning in the first quarter of next year. Moreover, the supply of new paper is likely to remain solid, given companies financing needs. We therefore remain bullish on the euro zone corporate bond market, which is likely to continue to be driven by ECB-supplied liquidity. Moreover, we do not expect an upturn in investment in the euro zone (except in Germany), as companies will remain cautious in their investments.
Non-Performing Loans as a proportion of total lending
Our scenario assumes new non-conventional measures from the ECB
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December 2013 # 12
6 Refunding risk of US and European High Yield
companies in next two years

SERGIO BERTONCINI, Strategy and Economic Research Milan
The essential
Corporate default rate cycle has mainly to do with macro and micro business cycles, but at the same time, short-term refunding needs as other bottom-up factors may have a role in its turning points.
A unique feature of this cycle has to do with the record volumes of new bonds supplied by speculative grade companies: this is mainly true for the US speculative grade market, but it has been increasingly the case also for Euro High Yield bonds. As around half of this record issuance was for refinancing purposes, evidence shows that speculative grade companies significantly reduced their refunding risks looming in 2014 and 2015. The very last data published by Moodys on European LBOs confirmed an improved picture also in Europe, sustaining the rationale for a stable default rate at low levels over the next year.
Corporate default rate cycle has mainly to do with macro and micro business cycles, 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 cycle is in very different stages on both sides of the Atlantic and even among major Eurozone countries. Among other drivers of the default cycles we consider the so called bottom up factors, like the average credit quality and the purpose of new issuance as well as the debt maturity schedule. Looking at past cycles, evidence shows that in phases of mature or late real growth, companies tend to embark in aggressive spending and re-leveraging strategies, while investors tend to accept lower quality debt as risk appetite reaches new peaks. Typically, when the percentage of low rated debt issued for aggressive purposes (like LBOs or PIKs) rises to high proportion of overall primary market activity, then a hike in default rates tends to follow when the economic cycle falls into recession. At the same time, high short-term refunding needs measured by volumes of maturing bonds and leveraged loans may represent another 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 bonds and leveraged loans issued by speculative grade companies: this record issuance, furthermore has proved to be quite strong in size in each of the last four years, though 2013 has already exceeded previous three years in terms of 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 therefore take a look at a few numbers, starting with US companies. So far, 2013 already saw USD 660 bn overall new issuance of HY bonds and leveraged loans, the highest ever in history: in the last four years, the yearly average issuance runs at USD 235 bn and USD 275 bn respectively for bonds and leveraged loans. If we consider speculative grade bonds only, this year is likely to be just a bit less active than 2012, as year to date supply runs at USD 246 bn vs last year USD 280 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 for refi nancing and mainly for loans refinancing: in the last three years around USD 250 bn of new bonds went to refi nance bonds and 275 bn went to refinance loans. At the same time, 440 bn of new leveraged loans were for loans refi nancing. The following two graphs shows to what extent this activity led to a massive fl attening of 2014/2015 maturity wall US companies were facing just a few years ago. As of end 2010, 2014 and 2015 maturity schedules for combined bonds and loans respectively were at USD 250 bn and USD 180 bn. Both figures, and in particular 2014 one was then hugely compressed in following years. At the time of writing, speculative grade companies will face just marginal redemptions next year, namely 19 bn of bonds and 10 bn of loans, while they will face respectively 36 bn and 8 bn in 2015. Overall, a very manageable schedule even combining next two years overall volumes: USD 75 bn of combined bonds and loans. Furthermore, this dramatic fall in short-term redemption looks even more impressive if considered on a relative basis vs the jump in overall outstanding debt. The last graph shows that at the end of 2010 companies were facing a 7% of their overall maturing in the following two years, 3% due in 2011 and the remaining 4% in 2012. Then, thanks to huge supply volumes, short-term refi nancing 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 of issuance US speculative grade companies may theoretically refinance all 2014 and 2015 redemptions in just a couple of quarters and precisely within H1- 2014.
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At current pace of issuance, US speculative grade companies may theoretically refinance all 2014 and 2015 redemptions within H1- 2014
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Lets move now to European HY companies: according to data recently released by Moodys (European HY newsletter, published on 12 November), thanks to the very active issuance of HY bonds of the last two years, LBOs cumulative maturities have been strongly pre-financed and previously much worrying maturity wall of 2014 pushed and flattened. European unrated LBOs had an overall volume of debt maturing in 2014 above Eur 80 bn as of December 2010: this figure was reduced by just a limited Eur 10 bn in 2011, but then it fell to Eur 40 bn last year and to slightly above than Eur 20 bn by August this year. At the same time also cumulative maturities on unrated LBOs fell from a peak of around Eur 230 bn less than three years ago to Eur 100 bn by last August. A large part of HY bonds issued over the last years went to refinance loans, therefore reducing a previous major concern on next year redemptions at a time when bank credit trends still look weak. At the same time, tempering a bit the optimism arising from this analysis, Moodys notes that what is left to be refinanced is debt issued by relatively weak companies which are among lowest rated companies, typically B-rated or CCCrated, mainly belonging to UK and core countries. 2013 supply by European HY companies was the highest on record, as it is heading to almost US$ equivalent 84 bn vs last year overall 65 bn and previous two years figures respectively at 57 bn and 59 bn. In conclusion, short-term refunding risk for HY companies look quite manageable in the US and recently eased also in Europe, though to a lower extent. US companies profited from a stronger primary market activity and for longer than European companies: furthermore they could count also on a very supportive leverage loan markets over the last two years. Credit conditions and bank lending standards are still much easier in the US than in Europe. At the same time, this gap favours an early re-leverage from US companies which ultimately partly balance better macro and financing conditions.
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December 2013 # 12
7 Refinancing mortgage loans in Denmark:
an envied but somewhat ambiguous model

RMI JEANNIARD, Credit Analysis Paris
The essential
Denmark has a long tradition of financing mortgage loans directly on the market.
The system has weathered all of the crises over more than two centuries and affords the Danes some of the lowest borrowing costs in the world. Today, the Danish model is struggling to reinvent itself, threatened by a deflating real estate bubble and extremely high leverage rates.
Danish debt issues are a safe haven for investors eager for AAA-rated bonds, a commodity that has grown dramatically scarce with the sovereign debt crisis. The 340 billion in Danish covered bonds are deemed to be an excellent offshoot of the very rare government bond issues of this country with little debt. This is all the more true since the CRD IV Directive suggest to assign these instruments to the most favourable category of government bonds and the equivalent, which are the most liquid of assets. It is this investor hunger that allows the Danes to issue debt under such favourable conditions. Mortgage bonds are the only way to refi nance mortgage loans. They are traded on a dedicated market, which ensures them liquidity that is unique for this kind of debt instrument. These features, combined with the sharp increase in prices over the last few decades, have made Denmark, with its population of 5.5 million, the number two market in Europe for covered bonds behind Spain and far ahead of Germany and France. If this bond inventory were compared as a percent of GDP, then Denmark would be number one globally. The Danes have the highest rate of private debt in the world: in fact, according to Eurostat, their debt represents 267.3% of their average income. In neighbouring Sweden this rate is 149% while in the United States it is 93.9%. However, Denmark is at the bottom end of the EU ranking of home ownership: 21st out of 27 (source: Eurostat 2011), with only 58%, ahead of France and the Netherlands. How did we get here? The origins of the mortgage bond market date back to 1795, when a group of wealthy individuals decided to rebuild Copenhagen, which had been nearly entirely destroyed by fire. They founded an association that organised an exchange for borrowers and lenders based on the following principle: the borrower contracts a loan from the association, which is then immediately refinanced by the issue of a covered bond with the same term, amortisation and interest rate and underwritten by one or more lenders. For more than 200 years, the Danish system of home loans has been operating based on this principle. The associations have been replaced by mortgage banks and contacts are now established in a full-blown market, where securities are issued and quoted daily. But the general principle remains the same: each home loan taken out by an individual is directly refinanced by the mortgage bank via the issue of a corresponding security on the mortgage bond market. The systems stability over the long term combined with zero mortgage bond losses and Denmarks AAA rating has helped Danish households secure borrowing rates that are among the most competitive in the world. The Danish system seems to have squared the circle that every nation dreams about to ensure the refinancing of its mortgage system: transparency, convenience, little to no dependence on the banking system and international markets, and low financing costs. To the point that both public and private initiatives have sought to replicate the Danish model in several other countries (Mexico and Norway) or to draw on it (United States for the reform of Freddie and Fannie, South Africa, the Netherlands, etc.). Nevertheless, a number of signs would seem to indicate that the situation in Denmark is far from ideal.
The Danish model has long been considered as an unbreachable paradigm,its replication was attempted many times in other countries
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Is something rotten in the state of Denmark?

The number of banks and savings institutions fell from 147 in 2008 to 78 in 2013. Most of these changes stem from combinations and mergers, some of which were imposed by the regulator. In a dozen other cases, the banks were liquidated. So far, Denmark is the European country that has seen, relatively speaking, the highest number of banks (local or regional) to have suffered this fate. The Danish government was also the first in Europe to implement resolution plans entailing losses for senior creditors. Falling property prices and the crisis in the agricultural sector were involved each time. By the same token, it is worth noting that Denmark experienced the strongest growth in home prices in Europe
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in the mid-2000s: 50% in three years, followed by a continuous decline of 26%. These swings are unique in Europe. Because of the financialisation of the housing market and in the light of the degree of leverage attained and housing price trends, it is tempting to search outside of Europe, in particular in the United States, for elements that could be compared to the Danish situation. When talk turns to excessive mortgage debt in the United States, subprime loans, responsible for the liquidation of several hundred local US banks and the freeze-up of the global interbank system for several years, immediately come to mind.
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Is comparison with subprime loans legitimate?

The two systems have a number of similarities. Intermediation: in Denmark, the institutions issuing mortgage bonds are frequently not the ones originating the loans. In fact, debt is issued by institutions strongly resembling conduits and, strictly speaking, has no connection to the initial loan. It may be very tempting for an originating bank to transfer poor quality assets to the mortgage bond issuer. In the United States as well, home loans were written by independent brokers, forwarded to the banks with little or no verification and then bundled into special purpose vehicles ending up as debt instruments traded on the capital markets. No link in this chain had the slightest concern about future default on the loan. The temptation to originate more and more loans without regard for quality proved to outweigh notions of fairness and common sense. Borrower discrimination: in Denmark, borrowers with poor credit history or selfverified sources of income are not denied access to loans. Since the rate at which Danes can borrow is precisely (give or take) the going rate on the market, this means that all borrowers receive the same rate. In the United States too, the system for granting loans was not focused on the creditworthiness of the borrower but on the value of the asset since it was generally assumed that this value would only increase over time. At one time, the initial appraisal of the property had to be certified by an expert but the widespread practice of taking guidance from non-independent experts or using computerised valuation models made this practice obsolete. Financial innovation: a trend toward increasingly sophisticated home loans very soon arose in both countries, with changes in the amortisation profile or the type of interest rate coupled with prepayment options, capped rates, etc. but at the price of increasing complexity. The Danes are taking full advantage of the great freedom they are granted to pay back their loans early whenever market conditions are favourable. The high prepayment rates not long after the grant of the loan are also an integral part of the Danish model. Americans also have a very high propensity to repay their loans early due to the most widespread loan format, the 2/28 Adjustable-Rate Mortgage, which, after twenty-four months, causes monthly payments to go up 32% on average (and much higher than that if market rates are rising).
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However, there are some very pronounced differences between the two systems, which suggests that a subprime-type scenario is not inevitable in Denmark. The borrowers creditworthiness: this is central to the loan granting process in Denmark, unlike the practices long observed in the United States. The determining factor is the borrowers ability to guarantee the future service of his or her debt and to make an initial down payment (usually 20%, but sometimes up to 25%, based on the loan type). It is also important to note that a good number of practices, common in the United States, are so far unknown in Denmark. To our knowledge, there is no predatory lending or doctored documentation on a large scale. Personal bankruptcy: the Danish legal framework does not recognise this concept. In the United States, this practice allowed many borrowers with negative equity in their homes to erase their debt in exchange for relinquishing ownership. Remortgage: prepayments in Denmark are usually motivated by desire to lower costs or the amount of the mortgage. In the United States, refinancing was frequently used to increase leverage thanks to the portion of equity released.
Is it really a unique model?
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Involvement and compensation of intermediaries: the originating Danish bank is personally and directly involved in appraising the property and assessing the borrowers creditworthiness, underwriting the loan and refinancing it via the issue of mortgage bonds. Compensation occurs over time and only if the loan proves to be performing throughout its lifetime. With the issue of mortgage bonds, there is just the act of refinancing and no transfer of all the credit risk to the market. On the other hand, the US system had a structure that was fundamentally biased as the compensation of agents across the loan production chain was not linked to (or even inversely proportional to) the quality or the honesty of their work. Each link in the chain received a commission and none of them harboured the slightest concern regarding potential future default on the loan. Ultimately, the US bank transferred all its risk to the market. Pressure from the public authorities: the practice of granting mortgage loans based on lax standards in terms of the loan-to-value ratio or the debt-to-income ratio was subject to constant pressure on Freddie Mac and Fannie Mae from the government and the Department of Housing and Urban Development (HUD) since the late 1990s. Nothing of the sort has been seen in Denmark. Matching assets with liabilities: a striking characteristic of the Danish model resides in its asset and liability matching approach (the balance principle). In fact, financing must accurately reflect lending activities in terms of maturity, interest rate and, most importantly, the rate of amortisation. Danish mortgage bonds have this feature, at one time unique, allowing them to be amortised based on the prepayment speed on the underlying loans. Several categories of mortgage bonds exist side by side based on the structure of the collateralised loans. Within a same mortgage bond, all loans must be uniform as regards interest rate and repayment structure. The ALM risk is therefore totally eliminated. This principle, strictly applied in the past, was considerably relaxed in 2007 as a pragmatic step. Now asset and liability matching can be provided by options, overcollateralisation and statutory reserves.
Absence of moral hazard in the loan origination chain
Conclusion
The points of divergence between the two systems are significant. The spiral that transformed subprime loans into time bombs for US banks is unlikely to occur in this Nordic kingdom. However, factors contributing to instability remain and are far from reassuring. In fact, the asset-liability matching that underpins the Danish system has been considerably tempered as regards duration since 2007. The bonds enabling the home mortgages that have enjoyed the most success since 1996 (30 years of annually reset interest rates at the expense of the traditional 30-year fixed mortgage) to be refinanced are securities maturing in one year. This maturity mismatch is not anecdotal, since 50% of Danish borrowers refinance their loans each year, which translates into an average of 169 billion in short-term bonds issued each year, i.e. 66% of GDP. It is true that these debt issues have always found takers, possibly under slightly deteriorated volume and rate conditions, and even in the throes of the recent financial crises. This argument does not appear to have completely reassured the credit rating agencies, which are showing increasing signs of concern over this dependence on the market. In an effort to address those concerns, the two main mortgage bond issuers have begun to test the waters of the market with three-year bonds. A decision was also taken to increase the margin applied to annually resettable 30year loans to make them less attractive to borrowers. Curiously, the proposal by the Ministry for the Economy to include an option for extension to 30 years (in just one go) in all bonds with a maturity of one year does not seem to have won the favour of investors or issuers. Other proposals will undoubtedly be pulled out of the toolbox in an attempt to reduce this liquidity gap. The most recent proposal includes options for automatic 12-month to 12-month extensions of mortgage bonds with a maturity of one year should the auction fail or rates rise too high. Any miracle solution will not be easy to come by. As long as short-term mortgage bonds continue to be massively purchased by domestic investors, this non-dependence on the international markets will continue to sustain the Danish model. This one tiny aspect remains the key element in the models stability. But for how much longer?
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December 2013 # 12
8 The reinvention of electronic components

VAN VU NGOC, Equity Analysis Paris
The essential
Since 2000, the gradual de-rating of the semiconductor sector has revealed its purely cyclical, deflationary and capital-intensive nature, in spite of its growth in volume.
However, a stronger case for the sector is growing within the current context characterised by the strength of technological innovation. For a start, the sector is in a phase of consolidation, allowing the best players to become very profitable. Furthermore, the industrys new growth opportunities can be found in efforts to improve the user interface in order to make communication with everyday objects even more intuitive. This raises the value of specialised expertise in analogue components, a field that is less capital-intensive and where Europe has historically been overrepresented.
Gordon Moore, co-founder of Intel, predicted in 1965 that transistors would undergo miniaturisation and the number of transistors on microchips would double every two years. He has been mostly right so far. Between 1970 and today, computational power has increased by a factor of approximately one million. To use an oft-quoted and amusing analogy, if cars miniaturised at the same rate, we would now be driving at the speed of sound in an automobile costing 15 pence (thankfully, we are not electrons). For investors, this rapid obsolescence has significant implications; miniaturisation lowers prices, thus generating volume growth, but it also demands a high degree of capital intensity. For example, Taiwan Semiconductor Manufacturing Company (TSMC) invests half of its revenue in equipment every year; Intel invests 20%. In comparison, the figure is much lower for car manufacturer BMW (6-10%) and steel and chemical companies (approximately 6-8%). Investors have taken stock of this dilemma between volume growth, deflation and capital intensity, paying an average enterprise-value-to-sales ratio of 5 in 2002, 3 in 2003-2004 and 2 since 2010. This gradual de-rating reveals the cyclical stance adopted by investors towards the semiconductors industry, condemned to sheepish investment behaviour and relentless miniaturisation, creating lower prices but also a narrow window of opportunity for margin generation. Adding to the industrys woes, the sector faces the prospect of reaching a limit to its exponential miniaturisation for purely physical reasons in the 2020-2030 decade, while the price of a single latest-generation photolithography(*) machine will probably reach the cost of an aeroplane in 2017 (100 million). Although not necessarily leading to a massive structural increase in capital intensity on an aggregated basis, there is no question that designing new microchips is increasingly difficult and poor choices in process technologies could result in two lost years. Despite the natural cynicism towards this purely cyclical sector, there are reasons to be more optimistic. We examine these below.
Diversification of opportunities
Counter-intuitively, the price of dynamic random-access memory (DRAM) in PCs increased by 20% from January to September 2013, against a backdrop of a 10% volume decline in the PC market. This suggests capex discipline on the part of manufacturers, or perhaps simply greater pragmatism. It should be mentioned that the number of manufacturers has shrunk from 20 in 1995 to just three today: Samsung and Hynix in South Korea and US firm Micron, which has just acquired Japans Elpida. DRAM is emblematic of Moores law, in its brute force aspect. But things are changing. DRAM opportunities are diversifying. PCs and servers accounted for 100% of the DRAM market until 2006; by 2015, this will shrink to 40%. As smartphones consume more and more DRAM, they will represent 40% of the market in 2015. The story of PCs and smartphones 30 years apart is a telling comparison. 300 million PCs are sold every year, compared to one billion smartphones and 230 million tablets. Mobility offers a market that is larger and less monolithic. The past duopoly of Intel and Microsoft is replaced by a more open (but highly competitive) environment for the development of new connectivity functions for smartphones.
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A significant impact of the boom in mobility has been an evolution of the user interface. Keyboards have been replaced with touchscreens and ever more intuitive ways of communicating with machines. A 2013 Samsung Galaxy S4 has no less
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(*) There is a billion transistors on a 100mm2 chip like the A7 inside the iPhone5 for instance. These transistors are engraved on the silicon through a photographic process whereby a mask bearing the transistor pattern is projected onto a small spot of silicon, then developed. Photolithography refers to this exposure and development process.
Source: Microsoft, Amundi Research
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Windows 1.0
December 2013 # 12
than 10 sensors: a microphone (for voice command), touch sensor, accelerometer to measure orientation and motion, proximity sensor, compass, gyroscope, barometer, thermometer, hygrometer and infrared sensor (remote control and user gestures). The key point is that these new ways of using the human-machine interface involve sensors, controllers and radio transmitters, all analogue components that are less susceptible to Moores law than a PC processor or memory chip, which are purely digital. In other words, todays growth prospects are less capital-intensive than in the past. More generally, the spread of human-machine interfaces will culminate in the Internet of Things, a marketing term denoting a range of interactions and new applications in everyday life, from Google Glass to microchips in clothing and watches, remote smart metering, domestic robots and home automation. These opportunities are difficult to quantify, but we estimate they will represent 10% of semiconductor volumes initially. This should generate an enormous volume of data that will need to be processed, creating a virtuous circle of growth potential.
The Internet of Things could initially represent 10% of the existing volume of semiconductor components, by 2016-2017
The evolution of cars

Cars, which account for 10% of the semiconductor market, are also an excellent example of technological evolution. The need to reduce fuel consumption was the inspiration behind tyre pressure sensors, start-stop systems at red lights, electric pumps and motors and, of course, hybrid vehicles, albeit at a low volume. The desire to make the automobile a connected object will mean more electronic systems on the dashboard, such as entertainment, telematics with Internet capacity, realtime geolocalised advertising, maintenance visit reminders, traffic alerts and toll payment. Safety applications, which face stringent requirements, already include parking assistance tools and computer-assisted steering. One key focus is that these applications should migrate from premium cars to the mass market. This is especially true for China, which leads demand in terms of volume and where the average semiconductor content in cars should see the fastest growth, at over 5% per year by 2016 according to Infineon Technologies (a car contains from $200 worth of electronics in Brazil to approximately $450 in Japan).
2
Sensors
Microphone Touch Accelerometer Proximity Compas Gyroscope Barometer Temperature Hygrometer Infrared
The new World

Galaxy S Galaxy S2 Galaxy S3 Galaxy S4 Functions 2010 2011 2012 2013
Sound Touch Speed Proximity Direction Rotation Pressure Heat Humidity Gesture
Conclusion: M&A opportunities

To conclude, lets consider matters closer to our own time. Moores law poses real economic challenges. The industrial development of laser sources to make microchips by 2017 is two years behind schedule. In the meantime, the industry underwent consolidation to deal with rising development costs; the equipment manufacturer Applied Materials (USA) is in the process of acquiring Tokyo Electron (Japan). We believe that the new applications of the Internet of Things will lead to a more diverse supply of components and will create demand for niche expertise: sensors, connectivity, OLED display, flexible display, deposition processes. Examples can be seen in ams (Austria), Melexis (Belgium) and STMicro (France/ Italy) in sensors; Dialog Semiconductor (Germany) and Infineon (Germany) in power components; CSR (UK) in connectivity; and ASM International (Netherlands) and Aixtron (Germany) in semiconductor deposition. We gave the example of DRAM, which now has a fully consolidated market structure. More generally, semiconductors remain a highly profitable industry for the big players, with operating margins of 20-30% at Intel, 20% at Samsung Semis, 35% at TSMC, 20-25% at ASML and 15-20% at Applied Materials. Current fears over market maturity for smartphones, coupled with the growing challenge of producing microchips as of 2017, may push the semiconductors further into the M&A trend.
Source : Samsung, Amundi Research
26
December 2013 # 12
NOTES
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December 2013 #
12
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Cross asset

Research, Strategy and Analysis

Risk factors Macroeconomic outlook Macroeconomic and financial forecasts

ASSET ALLOCATION 3 TO 6 MONTHS OUTLOOK

and industrial sectors

selective comeback later

(IG and HY) and convertibles

position) and JPY

Macroeconomic and financial forecasts

KEY INTEREST RATE OUTLOOK

LONG RATE OUTLOOK

1 Does the eurozone still hold some appeal?

A few genuine strengths and some well-identified risk factors

What are the strengths of the eurozone?

Moving toward new unconventional measures in the eurozone

A number of opportunities on the European corporate bond market

Mortgage Markets split by type of interest rates

Source: ECB, Amundi Research

Fixed Rate Variable Rate

A climate that bodes well for diversification... notably in Europes favour

2 Equity markets: a snapshot of long-term

Our approach combines two aspects: valuation and momentum

Prefer equities to governement bonds

US market and cyclically adjusted PE

CAPE* 15 +/- 5 Trend

Long term momentum

Mapping: developped countries

Mapping: emerging countries

South Africa, Turkey and Indonesia: Future Falling Angels?

3 Germany, source of deflation?

So far, the correction in imbalances has been uneven

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

13% Exports Imports (Rhs)

Is Germany the new China?

Germanys surplus exerts a deflationary bias

Trade balance: Germany vs. China (USD bn)

Source: Datastream, Amundi Research

Germany: Foreign trade (% of GDP)

Its time for Germany to act

Source: Datastream, Amundi Research

Is Germany headed for a change of course?

Conclusion: wait and see

Eurozone: Current account vs inflation

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

4 What determines the euro-dollar?

Essentially the ECBs (deflationary) stance

Towards a stronger euro in case of deflation

Consumer prices index (100 in Jan. 1990)

Source: Datastream, Amundi Research

EUR/USD PPP PPP deflation scenario

Evolution of the EUR/USD parity according to the scenarios

Scenario 1 Scenario 3 Scenario 5

Scenario 2 Scenario 4 Scenario 6

5 US and European credit cycles

What is a credit cycle?

What point are we at in the cycle?

Credit cycle: Euro IG Non-Fin

400 350 300 250 200 150 100 50

Asset performances are being dictated by monetary policy

Why are performances decorrelated from the cycle?

Non-Performing Loans as a proportion of total lending

Source: Bloomberg, Amundi Research